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GLOBAL BUSINESS TODAY
Charles W. L. Hill
University of Washington
G. Tomas M. Hult
Michigan State University
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GLOBAL BUSINESS TODAY, ELEVENTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2020 by
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Library of Congress Cataloging-in-Publication Data
Names: Hill, Charles W. L., author. | Hult, G. Tomas M., author.
Title: Global business today / Charles W.L. Hill, University of Washington,
G. Tomas M. Hult, Michigan State University.
Description: 11e [edition]. | New York, NY : McGraw-Hill Education, [2020]
Identifiers: LCCN 2018050510| ISBN 9781260088373 (alk. paper) | ISBN
1260088375 (alk. paper)
Subjects: LCSH: International business enterprises—Management. |
International trade. | Investments, Foreign. | Capital market.
Classification: LCC HD62.4 .H548 2020 | DDC 658/.049—dc23 LC record available
at https://lccn.loc.gov/2018050510
e Internet addresses listed in the text were accurate at the time of publication. e inclusion of a
website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-
Hill Education does not guarantee the accuracy of the information presented at these sites.
mheducation.com/highered
Page iiiFor my mother June Hill, and the memory of my father, Mike Hill
—Charles W. L. Hill
For Gert & Margareta Hult, my parents
—G. Tomas M. Hult
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about the authors CHARLES W. L. HILL
University of Washington
Charles W. L. Hill is the Hughes M. and Katherine Blake Professor of Strategy and International
Business at the Foster School of Business, University of Washington. Professor Hill has taught in the
MBA, Executive MBA, Technology Management MBA, Management, and PhD programs at the
University of Washington. During his time at the University of Washington, he has received over 25
awards for teaching excellence, including the Charles E. Summer Outstanding Teaching Award. e
Foster School is consistently ranked as a Top-25 business school. Learn more about Professor Hill at
http://foster.uw.edu/faculty-research/directory/charles-hill.
A native of the United Kingdom, Professor Hill received his PhD from the University of
Manchester, UK. In addition to the University of Washington, he has served on the faculties of the
University of Manchester, Texas A&M University, and Michigan State University.
Professor Hill has published over 50 articles in top academic journals, including the Academy of
Management Journal, Academy of Management Review, Strategic Management Journal, and Organization
Science. Professor Hill has also published several textbooks, including International Business (McGraw-
Hill) and Global Business Today (McGraw-Hill). His work is among the most widely cited in
international business and strategic management.
Beginning in 2014, Dr. Hill partnered with Dr. Tomas Hult in a formidable co-authorship of the
International Business franchise of textbooks (International Business and Global Business Today).is
brought together two of the most cited international business scholars in history.
Professor Hill works on a private basis with a number of organizations. His clients have included
Microsoft, where he has been teaching in-house executive education courses for two decades. He has
also consulted for a variety of other large companies (e.g., AT&T Wireless, Boeing, BF Goodrich,
Group Health, Hexcel, Microsoft, Philips Healthcare, Philips Medical Systems, Seattle City Light,
Swedish Health Services, Tacoma City Light, ompson Financial Services, WRQ, and Wizards of the
Coast). Professor Hill has also served on the advisory board of several start-up companies.
For recreation, Professor Hill enjoys skiing and competitive sailing!
G. TOMAS M. HULT
Michigan State University
Dr. Tomas Hult is Professor of Marketing, Byington Endowed Chair, and Director of the
International Business Center in the Department of Marketing in the Eli Broad College of Business at
Michigan State University. He also teaches for the Broad College’s Department of Supply Chain
Management and Department of Management. Learn more about Professor Hult at
http://broad.msu.edu/facultystaff/hult.
A native of Sweden, Dr. Hult received a mechanical engineer degree in Sweden before obtaining
Bachelor and MBA degrees in the United States, followed by a PhD at e University of Memphis. In
addition to Michigan State University, he has served on the faculties of Florida State University and
the University of Arkansas at Little Rock. Dr. Hult holds visiting professorships in the International
Business Group of his native Uppsala University, Sweden, and the International Business Division of
Leeds University, United Kingdom. Michigan State, Uppsala, and Leeds are all ranked in the top 10 in
the world in international business research.
Dr. Hult serves as Executive Director and Board Member of the Academy of International Business
(AIB), President and Board Member of the Sheth Foundation, and serves on the U.S. District Export
Council. Tomas Hult hosts the radio show globalEDGE Business Beat on the Michigan Business
Network.
Hult is one of the world’s leading academic authorities (citations, publications) in marketing
strategy, international business, international marketing, strategic management, global supply chains,
and complex multinational corporations. He is one of only about 100 Elected Fellows of the Academy
of International Business, an accolade achieved by only the elite international business scholars. Dr.
Hult was also selected in 2016 as the Academy of Marketing Science/CUTCO-Vector Distinguished
Marketing Educator.
He regularly speaks at high profile events (e.g., European Commission, Swedish Entrepreneurship
Forum, United Nation's Conference on Trade and Development, U.S. Department of Education,
World Investment Forum) and publishes influential op-ed articles (e.g., Time, Fortune, Fortune, World
Economic Forum, e Conversation). Tomas has developed a large clientele of the world’s top
corporations (e.g., ABB, Albertsons, Avon, BG, Bechtel, Bosch, BP, Defense Logistics Agency,
Domino’s, FedEx, Ford, FreshDirect, General Motors, GroceryGateway, HSBC, IBM, Michigan
Economic Development Corporation, Masco, NASA, Raytheon, Shell, Siemens, State Farm, Steelcase,
Tech Data, and Xerox).
In addition to co-authoring with Charles W. L. Hill the market-share leading textbooks in
international business (Global Business Today, now in its 11th edition, and International Business, now
in its 12th edition), Dr. Hult has written several popular business trade books (e.g., Second Shift;
Global Supply Chain Management; Extending the Supply Chain; and Total Global Strategy).
Tennis, golf, and traveling are his favorite recreational activities.
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brief contents
PART ONE Introduction and Overview
Chapter One Globalization 2
PART TWO National Differences
Chapter Two National Differences in Political, Economic, and Legal Systems 36
Chapter ree National Differences in Economic Development 58
Chapter Four Differences in Culture 86
Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 122
PART THREE e Global Trade and Investment Environment
Chapter Six International Trade eory 150
Chapter Seven Government Policy and International Trade 184
Chapter Eight Foreign Direct Investment 212
Chapter Nine Regional Economic Integration 240
PART FOUR e Global Monetary System
Chapter Ten e Foreign Exchange Market 270
Chapter Eleven e International Monetary System 294
PART FIVE e Strategy of International Business
Chapter Twelve e Strategy of International Business 320
Chapter irteen Entering Developed and Emerging Markets 356
PART SIX International Business Functions
Chapter Fourteen Exporting, Importing, and Countertrade 382
Chapter Fifteen Global Production and Supply Chain Management 408
Chapter Sixteen Global Marketing and Business Analytics 438
Chapter Seventeen Global Human Resource Management 474
GLOSSARY 503
NAME INDEX 511
SUBJECT INDEX 513
ACRONYMS 531
COUNTRIES AND THEIR CAPITALS 532
Page vii
the proven choice for international business
Current. Application Rich, Relevant. Accessible and Student Focused. Global Business Today (GBT), the worldwide market leader among international business products, has
set a new standard for international business teaching. We have focused on creating resources that
Are comprehensive, state of the art, and timely.
Are theoretically sound and practically relevant.
Focus on applications of international business concepts.
Tightly integrate the chapter topics throughout.
Are fully integrated with results-driven technology.
Take full and integrative advantage of globalEDGE.msu.edu—the Google-ranked #1 web
resource for “international business resources.”
International Business (now in its 12th edition, 2019), also co-authored by Charles W. L. Hill and
G. Tomas M. Hult, is a more comprehensive and case-oriented version that lends itself to the core
course in international business for those that want a deeper focus on the global monetary system,
structure of international business, international accounting, and international finance.
GBT has always endeavored to be current, relevant, application rich, accessible, and student-
focused. Our goal has always been to cover macro and micro issues equally and in a relevant, practical,
accessible, and student-focused approach. We believe that anything short of such a breadth and depth
of coverage is a serious deficiency. Many of the students in these international business courses will
soon be working in global businesses, and they will be expected to understand the implications of
international business for their organization’s strategy, structure, and functions in the context of the
global marketplace. We are proud and delighted to have put together this international business
learning experience for the leaders of tomorrow.
Over the years, and now through 11 editions, Dr. Charles Hill has worked hard to adhere to these
goals. Since the ninth edition, Charles’ co-author, Dr. Tomas Hult, has followed the same approach.
In deciding what changes to make, we have been guided not only by our own reading, teaching, and
research but also by the invaluable feedback we received from professors and students around the
world, from reviewers, and from the editorial staff at McGraw-Hill Education. Our thanks go out to
all of them.
Comprehensive and Up-to-Date To be relevant and comprehensive, an international business package must
Page viii
Explain how and why the world’s cultures, countries, and regions differ.
Cover economics and politics of international trade and investment.
Tackle international issues related to ethics, corporate social responsibility, and sustainability.
Explain the functions and form of the global monetary system.
Examine the strategies and structures of international businesses.
Assess the special roles of the various functions of an international business.
Relevance and comprehensiveness also require coverage of the major theories. It has always been a goal
to incorporate the insights gleaned from recent academic scholarship into the book.
Consistent with this goal, insights from the following research, as a sample of theoretical
streams used in the book, have been incorporated:
New trade theory and strategic trade policy.
e work of Nobel Prize–winning economist Amartya Sen on economic development.
Samuel Huntington’s influential thesis on the “clash of civilizations.”
Growth theory of economic development championed by Paul Romer and Gene Grossman.
Empirical work by Jeffrey Sachs and others on the relationship between international trade and
economic growth.
Michael Porter’s theory of the competitive advantage of nations.
Robert Reich’s work on national competitive advantage.
e work of Nobel Prize–winner Douglass North and others on national institutional structures
and the protection of property rights.
e market imperfections approach to foreign direct investment that has grown out of Ronald
Coase and Oliver Williamson’s work on transaction cost economics.
Bartlett and Ghoshal’s research on the transnational corporation.
e writings of C. K. Prahalad and Gary Hamel on core competencies, global competition, and
global strategic alliances.
Insights for international business strategy that can be derived from the resource-based view of
the firm and complementary theories.
Paul Samuelson’s critique of free trade theory.
Conceptual and empirical work on global supply chain management—logistics, purchasing
(sourcing), operations, and marketing channels.
In addition to including leading-edge theory, in light of the fast-changing nature of the international
business environment, we have made every effort to ensure that this product is as up-to-date as
possible. A significant amount has happened in the world since we began revisions of this book. By
2016, almost $4 trillion per day were flowing across national borders. e size of such flows fueled
concern about the ability of short-term speculative shifts in global capital markets to destabilize the
world economy.
e world continued to become more global. As you can see in Chapter 1 on Globalization, trade
across country borders has almost exponentially escalated in the last few years. Several Asian
economies, most notably China and India, continued to grow their economies at a rapid rate. New
multinationals continued to emerge from developing nations in addition to the world’s established
industrial powers.
Increasingly, the globalization of the world economy affected a wide range of firms of all sizes, from
the very large to the very small. We take great pride in covering international business for small- and
medium-sized enterprises (SMEs), as well as larger multinational corporations. We also take great
Page ix
pride in covering firms from all around the world. Some sixty SMEs and multinational corporations
from all six core continents are covered in the chapters’ opening cases, closing cases, and/or
Management Focus boxes.
And unfortunately, global terrorism and the attendant geopolitical risks keep emerging in various
places globally, many new and inconceivable just a decade ago. ese represent a threat to global
economic integration and activity. Plus, with the United Kingdom opting to leave the European
Union (Brexit), which has implications past 2019, the election of President Donald Trump in the
United States (who espouses views on international trade that break with the long established
consensus), and several elections around the world, the globe—in many ways—has paid more
attention to nationalistic issues over trade. ese topics and many more are integrated into this text for
maximum learning opportunities.
WHAT’S NEW IN THE 11TH EDITION
e success of the first ten editions of Global Business Today (and its longer, more in-depth textbook
option and companion, International Business, now in the 12th edition) was based in part on the
incorporation of leading-edge research into the text, the use of the up-to-date examples and statistics
to illustrate global trends and enterprise strategy, and the discussion of current events within the
context of the appropriate theory. Building on these strengths, our goals for the 11th edition have
focused on the following:
1. Incorporate new insights from scholarly research.
2. Make sure the content covers all appropriate issues.
3. Make sure the text is up-to-date with current events, statistics, and examples.
4. Add new and insightful opening and closing cases in most chapters.
5. Incorporate value-added globalEDGETM features in every chapter.
6. Connect every chapter to a focus on managerial implications.
As part of the overall revision process, changes have been made to every chapter in the book. All
statistics have been updated to incorporate the most recently available data. As before, we provide the
only textbook in International Business that ensures that all material is up-to-date on virtually a daily
basis. e copyright for the book is 2020, but you are likely using the text somewhere between the
years 2019 to 2022. We keep the textbook updated to each semester you use the text in your course!
We do this by integrating Connect and globalEDGETM features in every chapter.
Specifically, combining McGraw Hill’s Connect platform with the Google number-one-ranked
globaledge.msu.edu site (for “international business resources”), we can add up-to-date materials and
exercises to each chapter to add value to the material and provide relevant data and information. is
keeps chapter material constantly and dynamically updated for teachers who want to infuse Connect
and globalEDGETM material into the chapter topics, and it keeps students abreast of current
developments in international business.
In addition to updating all statistics, figures, and maps to incorporate most recently published data,
a chapter-by-chapter selection of changes for the 10th edition include the following:
CHAPTER 1: GLOBALIZATION
New opening case: GM and Its Chevrolet Supercar, e Corvette ZR1
New materials on international trade, trade agreements, world production, and world
population
Explanations of differences in cross-border trade and in-country production; the value of trade
agreements; and population implications related to resource constraints
Revised Management Focus: Boeing’s Global Production System
Revised Management Focus: Wanda Group
New closing case: Globalization of BMW, Rolls-Royce, and the MINI
CHAPTER 2: NATIONAL DIFFERENCES IN POLITICAL, ECONOMIC, AND LEGAL SYSTEMS
New opening case: Transformation in Saudi Arabia
New Country Focus: Putin’s Russia
Updated data on corruption
Updated Country Focus: Corruption in Brazil
New closing case: e Decline of Zimbabwe
CHAPTER 3: NATIONAL DIFFERENCES IN ECONOMIC DEVELOPMENT
New opening case: Brazil’s Struggling Economy
Updated statistics and discussion in section Differences in Economic Development
Updated Country Focus: Property Rights in China
Updated statistics and discussion in section States in Transition
New closing case: Economic Development in Bangladesh
Page x
CHAPTER 4: DIFFERENCES IN CULTURE
New opening case: China, Hong Kong, Macau, and Taiwan
Deeper treatment of culture, values, and norms
Revised the foundation that most religions are now pro-business
Updated the Hofstede culture framework with new research
New Country Focus: Determining Your Social Class by Birth
New Country Focus: Turkey, Its Religion, and Politics
New Management Focus: China and Its Guanxi
New closing case: e Swatch Group and Cultural Uniqueness
CHAPTER 5: ETHICS, CORPORATE SOCIAL RESPONSIBILITY, AND SUSTAINABILITY
New opening case: Sustainability Initiatives at Natura, the Bodyshop, and Aesop
Deeper focus on corporate social responsibility and sustainability at the country, company, and
customer levels
New Management Focus: “Emissionsgate” at Volkswagen
New closing case: Woolworths’s Corporate Responsibility Strategy
CHAPTER 6: INTERNATIONAL TRADE THEORY
New opening case: “Trade Wars Are Good and Easy to Win”
Discussion of President Donald Trump’s approach to international trade
Updated Country Focus: Is China Manipulating Its Currency in Pursuit of a Neo-Mercantilist
Policy?
New closing case: e Trans Pacific Partnership (TPP) Is Dead; Long Live the CPTPP!
Updated Appendix: International Trade and the Balance of Payments with new data and revised
discussion
CHAPTER 7: GOVERNMENT POLICY AND INTERNATIONAL TRADE
New opening case: U.S. and South Korea Strike a Revised Trade Deal
New section: e World Trading System Under reat, which discusses the potential
ramifications of Brexit and the trade policies of the Trump administration
New Closing Case: Boeing and Airbus Are in a Dogfight over Illegal Subsidies
CHAPTER 8: FOREIGN DIRECT INVESTMENT
New opening case: Geely Goes Global
Updated statistics and discussion in the section Foreign Direct Investment in the World
Economy
New Management Focus: Burberry Shifts Its Entry Strategy in Japan
New closing case: FDI in the Indian Retail Sector
CHAPTER 9: REGIONAL ECONOMIC INTEGRATIONS
New opening case: NAFTA 2.0?
Extended discussion of Brexit and its ramifications
New section e Future of NAFTA, which discusses the renegotiation of NAFTA by the Trump
administration
New closing case: Free Trade in Africa: TFTA and CFTA
CHAPTER 10: THE FOREIGN EXCHANGE MARKET
New opening case: e Fluctuating Value of the Yuan Gives Chinese Business a Lesson in
Foreign Exchange Risk
New closing case: e Mexican Peso, the Japanese Yen, and Pokemon Go
CHAPTER 11: THE INTERNATIONAL MONETARY SYSTEM
New opening case: Can Dollarization Save Venezuela?
Updated statistics discussion of floating exchange rates through to early 2018
New Country Focus: China’s Exchange Rate Regime
New Closing Case: Egypt and the IMF
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CHAPTER 12: THE STRATEGY OF INTERNATIONAL BUSINESS
New opening case: Red Bull, a Leader in International Strategy
Deeper discussion of the rise of regionalism
Integration of global strategy thoughts
New Management Focus: IKEA’s Global Strategy
New Management Focus: Unilever’s Global Organization
New closing case: Sony Corporation: An International Innovator?
CHAPTER 13: ENTERING DEVELOPED AND EMERGING MARKETS
New opening case: IKEA Entering India, Finally!
New scope of the chapter to include entering developed and emerging markets, as well as aspects
of less developed markets
New closing case: Cutco Corporation—Sharpening Your Market Entry
CHAPTER 14: EXPORTING, IMPORTING, AND COUNTERTRADE
New opening case: Spotify and SoundCloud
New material on company readiness to export and import material
New and revised material on globalEDGETM Diagnostic Tools, with a focus on Company
Readiness to Export (CORE)
New Management Focus: Embraer and Brazilian Importing
New Management Focus: Exporting Desserts by a Hispanic Entrepreneur
New Management Focus: Two Men and a Truck
New closing case: Tata Motors and Exporting
CHAPTER 15: GLOBAL PRODUCTION AND SUPPLY CHAIN MANAGEMENT
New opening case: Procter & Gamble Remakes Its Global Supply Chains
Revised and new material on global logistics, global purchasing, and global operations
Revised sections Strategic Roles for Production Facilities, Make-or-Buy Decisions, and Global
Supply Chain Functions
New material in the sections Role of Information Technology, Coordination in Global Supply
Chains, and Interorganizational Relationships
New Management Focus: IKEA Production in China
New Management Focus: Amazon’s Global Supply Chains
New closing case: Alibaba and Global Supply Chains
CHAPTER 16: GLOBAL MARKETING AND BUSINESS ANALYTICS
New opening case: Fake News and Alternative Facts
Revised section Globalization of Markets and Brands
New section on Business Analytics; reordered with International Marketing Research to provide
a better flow of the chapter material
Revised section International Marketing Research
Inclusion of more social media topics throughout
Revised positioning of the Product Development and R&D section
New Management Focus: Global Branding, Marvel Studios, and Walt Disney Company
New Management Focus: Burberry’s Social Media Marketing
New closing case: ACSI and Satisfying Global Customers
Page xii
CHAPTER 17: GLOBAL HUMAN RESOURCE MANAGEMENT
New opening case: Global Mobility at Shell
New section: Building a Diverse Global Workforce, which looks at the benefits, challenges, and
policies for building a diverse global workforce in a multinational enterprise
New Closing Case: Sodexo: Building a Diverse Global Workforce
Beyond Uncritical Presentation and Shallow Explanation Many issues in international business are complex and thus necessitate considerations of pros and
cons. To demonstrate this to students, we have adopted a critical approach that presents the arguments
for and against economic theories, government policies, business strategies, organizational structures,
and so on.
Related to this, we have attempted to explain the complexities of the many theories and
phenomena unique to international business so the student might fully comprehend the statements of
a theory or the reasons a phenomenon is the way it is. We believe that these theories and
phenomena are explained in more depth in this work than they are in the competition,
which seem to use the rationale that a shallow explanation is little better than no explanation. In
international business, a little knowledge is indeed a dangerous thing.
Practical and Rich Applications We have always believed that it is important to show students how the material covered in the text is
relevant to the actual practice of international business. is is explicit in the later chapters of the
book, which focus on the practice of international business, but it is not always obvious in the first
half of the book, which considers macro topics. Accordingly, at the end of each chapter in Parts Two,
ree, and Four—where the focus is on the environment of international business, as opposed to
particular firms—there is a section titled Focus on Managerial Implications. In this section, the
managerial implications of the material discussed in the chapter are clearly explained. Additionally,
most chapters have at least one Management Focus box. e purpose of these boxes is to illustrate the
relevance of chapter material for the practice of international business.
A Did You Know? feature in each chapter challenges students to view the world around them
through the lens of international business (e.g., Did you know that sugar prices in the United States
are much higher than sugar prices in the rest of the world?). e authors recorded short videos
explaining the phenomenon.
In addition, each chapter begins with an opening case that sets the stage for the chapter and ends
with a closing case that illustrates the relevance of chapter material for the practice of international
business.
To help students go a step further in expanding their application-level understanding of
international business, each chapter incorporates two globalEDGETM research tasks designed and
written by Tomas Hult. e exercises dovetail with the content just covered.
Integrated Progression of Topics A weakness of many texts is that they lack a tight, integrated flow of topics from chapter to chapter.
is book explains to students in Chapter 1 how the book’s topics are related to each other.
Integration has been achieved by organizing the material so that each chapter builds on the material of
the previous ones in a logical fashion.
PART ONE
Chapter 1 provides an overview of the key issues to be addressed and explains the plan of the book.
Globalization of markets and globalization of production is the core focus.
PART TWO
Chapters 2 through 4 focus on country differences in political economy and culture, and Chapter 5
on ethics, corporate social responsibility, and sustainability issues in international business. Most
international business textbooks place this material at a later point, but we believe it is vital to discuss
national differences first. After all, many of the central issues in international trade and investment, the
global monetary system, international business strategy and structure, and international business
functions arise out of national differences in political economy and culture.
PART THREE
Chapters 6 through 9 investigate the political economy of global trade and investment. e purpose of
this part is to describe and explain the trade and investment environment in which international
business occurs.
PART FOUR
Chapters 10 and 11 describe and explain the global monetary system, laying out in detail the
monetary framework in which international business transactions are conducted.
PART FIVE
In Chapters 12 and 13, attention shifts from the environment to the firm. In other words, we move
from a macro focus to a micro focus at this stage of the book. We examine strategies that firms adopt
to compete effectively in the international business environment.
PART SIX
In Chapters 14 through 17, the focus narrows further to investigate business functions and related
operations. ese chapters explain how firms can perform their key functions—exporting, importing,
and countertrade; global production; global supply chain management; global marketing; global
research and development (R&D); human resource management—to compete and succeed in the
international business environment.
roughout the book, the relationship of new material to topics discussed in earlier chapters is
pointed out to the students to reinforce their understanding of how the material comprises an
integrated whole. We deliberately bring a management focus to the macro chapters (Chapters 1
through 11). We also integrate macro themes in covering the micro chapters (Chapters 12 through
17).
Page xiiiAcknowledgments Numerous people deserve to be thanked for their assistance in preparing this book. First, thank you to
all the people at McGraw-Hill Education who have worked with us on this project:
Anke Braun Weekes, Executive Brand Manager
Gabriela G. Velasco, Product Developer
Michael Gedatus, Senior Marketing Manager
Brittany Bernholdt, Marketing Coordinator
Mary Powers, Content Project Manager (Core)
Evan Roberts, Content Project Manager (Assessment)
Jennifer Pickel, Senior Buyer
Srdjan Savanovic, Designer
Lori Hancock, Content Licensing Specialist (Image)
DeAnna Dausener, Content Licensing Specialist (Text)
Second, our thanks go to the reviewers who provided good feedback that helped shape this book:
Ratee Apana, University of Cincinnati
Michael Ba Banutu-Gomez, Rowan University – Glassboro New Jersey
Constant Cheng, George Mason University
Jeongho Choi, St. John Fisher College, Rochester, NY
Susan Dragotta, Waukesha County Technical College
Wade Hampton Britt, IV, Drake University
Ralph Haug, Roosevelt University, Schaumburg, IL
Reinhard Janson, University of Texas Arlington
C. Jayachandran, Montclair State University
David Kelson, Ferris State University
Stephanie E. Kontrim-Baumann, Missouri Baptrist University, Saint Louis
Kim LaFevor, Athens State University-Athens, Alabama
Yunshan Lian, University of Wisconsin-Platteville
Manveer K. Mann, Montclair State University
John P. Marr, Boise State University
Lilac Nachum, Baruch College
J. Timothy Nolan, SUNY Buffalo State
Louis I. Nzegwu, University of Wisconsin-Platteville
Kathy Pennington, San Diego State University
Jim Ryan, Bradley University
Wayne H. Stewart Jr., Clemson University
Vas Taras, University of North Carolina at Greensboro
Siri Terjesen, American U & NHH
William H. Toel, Bradley University – Peoria, Illinois
A special thanks to David Closs and David Frayer for allowing us to borrow elements of the sections
on Strategic Roles for Production Facilities; Make-or-Buy Decisions; Global Supply Chain Functions;
Coordination in Global Supply Chains; and Interorganizational Relationships for Chapter 15 of this
text from Tomas Hult, David Closs, and David Frayer (2014), Global Supply Chain Management,
New York: McGraw-Hill.
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contents
PART ONE Introduction and Overview
Chapter one Globalization 2
Opening Case: GM and Its Chevrolet Supercar, the Corvette ZR1 3
Introduction 4
What Is Globalization? 6
e Globalization of Markets 6
e Globalization of Production 8
Management Focus: Boeing’s Global Production System 9
e Emergence of Global Institutions 9
Drivers of Globalization 11
Declining Trade and Investment Barriers 11
Role of Technological Change 15
e Changing Demographics of the Global Economy 16
e Changing World Output and World Trade Picture 17
Country Focus: India’s Software Sector 18
e Changing Foreign Direct Investment Picture 18
e Changing Nature of the Multinational Enterprise 20
Management Focus: Wanda Group 21
e Changing World Order 21
Global Economy of the Twenty-First Century 22
e Globalization Debate 23
Antiglobalization Protests 23
Country Focus: Protesting Globalization in France 24
Globalization, Jobs, and Income 24
Globalization, Labor Policies, and the Environment 26
Globalization and National Sovereignty 28
Globalization and the World’s Poor 28
Managing in the Global Marketplace 30
Summary 31
Critical inking and Discussion Questions 32
Research Task 33
Closing Case: Globalization of BMW, Rolls-Royce, and the MINI 33
Endnotes 34
PART TWO National Differences
Chapter Two National Differences in Political, Economic, and Legal Systems 36
Opening Case: Transformation in Saudi Arabia 37
Introduction 38
Political Systems 39
Collectivism and Individualism 39
Democracy and Totalitarianism 41
Country Focus: Putin’s Russia 42
Economic Systems 44
Market Economy 44
Command Economy 45
Mixed Economy 45
Legal Systems 46
Different Legal Systems 46
Differences in Contract Law 47
Property Rights and Corruption 48
Country Focus: Corruption in Brazil 50
Management Focus: Did Walmart Violate the Foreign Corrupt Practices Act? 51
e Protection of Intellectual Property 51
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Management Focus: Starbucks Wins Key Trademark Case in China 53
Product Safety and Product Liability 53
Focus on Managerial Implications:e Macro Environment Influences Market Attractiveness 54
Summary 55
Critical inking and Discussion Questions 55
Research Task 55
Closing Case: e Decline of Zimbabwe 56
Endnotes 57
Chapter ree National Differences in Economic Development 58
Opening Case: Brazil’s Struggling Economy 59
Introduction 60
Differences in Economic Development 60
Broader Conceptions of Development: Amartya Sen 64
Political Economy and Economic Progress 65
Innovation and Entrepreneurship are the Engines of Growth 65
Innovation and Entrepreneurship Require a Market Economy 66
Innovation and Entrepreneurship Require Strong Property Rights 66
Country Focus: Property Rights in China 67
e Required Political System 68
Economic Progress Begets Democracy 68
Geography, Education, and Economic Development 68
States in Transition 69
e Spread of Democracy 69
e New World Order and Global Terrorism 72
e Spread of Market-Based Systems 73
e Nature of Economic Transformation 74
Deregulation 74
Country Focus: India’s Economic Transformation 75
Privatization 76
Legal Systems 76
Implications of Changing Political Economy 77
Focus on Managerial Implications: Benefits, Costs, Risks, and Overall Attractiveness of Doing Business Internationally 78
Summary 82
Critical inking and Discussion Questions 82
Research Task 82
Closing Case: Economic Development in Bangladesh 83
Endnotes 84
Chapter Four Differences in Culture 86
Opening Case: China, Hong Kong, Macau, and Taiwan 87
Introduction 88
What Is Culture? 90
Values and Norms 91
Culture, Society, and the Nation-State 92
Determinants of Culture 93
Social Structure 93
Individuals and Groups 94
Social Stratification 96
Country Focus: Determining Your Social Class by Birth 97
Religious and Ethical Systems 98
Christianity 100
Islam 101
Country Focus: Turkey, Its Religion, and Politics 103
Hinduism 104
Buddhism 105
Confucianism 105
Management Focus: China and Its Guanxi 107
Language 107
Spoken Language 107
Unspoken Language 108
Education 109
Culture and Business 109
Cultural Change 113
Focus on Managerial Implications:Cultural Literacy and Competitive Advantage 114
Summary 116
Critical inking and Discussion Questions 117
Research Task 117
Closing Case: e Swatch Group and Cultural Uniqueness 118
Endnotes 119
Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 122
Opening Case: Sustainability Initiatives at Natura, the Bodyshop, and Aesop 123
Introduction 124
Ethics and International Business 126
Employment Practices 126
Management Focus: “Emissionsgate” at Volkswagen 127
Human Rights 127
Environmental Pollution 129
Corruption 130
Ethical Dilemmas 131
Roots of Unethical Behavior 132
Personal Ethics 133
Decision-Making Processes 133
Organizational Culture 133
Unrealistic Performance Goals 134
Leadership 134
Page xviii Societal Culture 134
Philosophical Approaches to Ethics 134
Straw Men 135
Utilitarian and Kantian Ethics 137
Rights eories 138
Justice eories 139
Focus on Managerial Implications: Making Ethical Decisions Internationally 140
Management Focus: Corporate Social Responsibility at Stora Enso 144
Summary 146
Critical inking and Discussion Questions 146
Research Task 147
Closing Case: Woolworths’ Corporate Responsibility Strategy 147
Endnotes 148
PART THREE e Global Trade and Investment Environment
Chapter Six International Trade eory 150
Opening Case: “Trade Wars are Good and Easy to Win” 151
Introduction 152
An Overview of Trade eory 153
e Benefits of Trade 153
e Pattern of International Trade 154
Trade eory and Government Policy 155
Mercantilism 155
Country Focus: Is China Manipulating Its Currency in Pursuit of a Neo-Mercantilist Policy? 156
Absolute Advantage 157
Comparative Advantage 159
e Gains from Trade 159
Qualifications and Assumptions 160
Extensions of the Ricardian Model 161
Country Focus: Moving U.S. White-Collar Jobs Offshore 164
Heckscher–Ohlin eory 165
e Leontief Paradox 166
e Product Life-Cycle eory 167
Product Life-Cycle eory in the Twenty-First Century 168
New Trade eory 168
Increasing Product Variety and Reducing Costs 169
Economies of Scale, First-Mover Advantages, and the Pattern of Trade 169
Implications of New Trade eory 170
National Competitive Advantage: Porter’s Diamond 171
Factor Endowments 172
Demand Conditions 172
Related and Supporting Industries 173
Firm Strategy, Structure, and Rivalry 173
Evaluating Porter’s eory 174
Focus on Managerial Implications: Location, First-Mover Advantages, and Government Policy 174
Summary 176
Critical inking and Discussion Questions 177
Research Task 177
Closing Case: e Trans Pacific Partnership (TPP) Is Dead; Long Live the CPTPP! 177
Appendix: International Trade and the Balance of Payments 179
Endnotes 182
Chapter Seven Government Policy and International Trade 184
Opening Case: U.S. and South Korea Strike a Revised Trade Deal 185
Introduction 186
Instruments of Trade Policy 187
Tariffs 187
Subsidies 188
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Country Focus: Are the Chinese Illegally Subsidizing Auto Exports? 188
Import Quotas and Voluntary Export Restraints 189
Export Tariffs and Bans 190
Local Content Requirements 190
Administrative Policies 191
Antidumping Policies 191
Management Focus: Protecting U.S. Magnesium 192
e Case for Government Intervention 192
Political Arguments for Intervention 192
Economic Arguments for Intervention 195
e Revised Case for Free Trade 197
Retaliation and Trade War 197
Domestic Policies 197
Development of the World Trading System 198
From Smith to the Great Depression 198
1947–1979: GATT, Trade Liberalization, and Economic Growth 199
1980–1993: Protectionist Trends 199
e Uruguay Round and the World Trade Organization 199
WTO: Experience to Date 200
e Future of the WTO: Unresolved Issues and the Doha Round 201
Country Focus: Estimating the Gains from Trade for America 204
Multilateral and Bilateral Trade Agreements 205
e World Trading System under reat 205
Focus on Managerial Implications: Trade Barriers, Firm Strategy, and Policy implications 206
Summary 208
Critical inking and Discussion Questions 209
Research Task 209
Closing Case: Boeing and Airbus are in a Dogfight over Illegal Subsidies 209
Endnotes 210
Chapter Eight Foreign Direct Investment 212
Opening Case: Geely Goes Global 213
Introduction 214
Foreign Direct Investment in the World Economy 214
Trends in FDI 214
e Direction of FDI 215
e Source of FDI 216
Country Focus: Foreign Direct Investment in China 216
e Form of FDI: Acquisitions versus Greenfield Investments 217
eories of Foreign Direct Investment 218
Why Foreign Direct Investment? 218
Management Focus: Burberry Shifts Its Entry Strategy in Japan 219
e Pattern of Foreign Direct Investment 221
e Eclectic Paradigm 222
Political Ideology and Foreign Direct Investment 223
e Radical View 223
e Free Market View 224
Pragmatic Nationalism 224
Shifting Ideology 225
Benefits and Costs of FDI 225
Host-Country Benefits 225
Host-Country Costs 228
Home-Country Benefits 229
Home-Country Costs 229
International Trade eory and FDI 230
Government Policy Instruments and FDI 230
Home-Country Policies 230
Host-Country Policies 231
International Institutions and the Liberalization of FDI 232
Focus on Managerial Implications: FDI and Government Policy 232
Summary 235
Critical inking and Discussion Questions 235
Research Task 236
Closing Case: FDI in the Indian Retail Sector 236
Endnotes 237
Chapter Nine Regional Economic Integration 240
Opening Case: NAFTA 2.0: e USMCA 241
Introduction 242
Levels of Economic Integration 243
e Case for Regional Integration 245
e Economic Case for Integration 245
e Political Case for Integration 245
Impediments to Integration 246
e Case against Regional Integration 246
Regional Economic Integration in Europe 247
Evolution of the European Union 247
Political Structure of the European Union 248
Management Focus: e European Commission and Intel 249
e Single European Act 250
e Establishment of the Euro 251
Enlargement of the European Union 254
Country Focus: e Greek Sovereign Debt Crisis 255
British Exit from the European Union (Brexit) 256
Regional Economic Integration in the Americas 257
e North American Free Trade Agreement 257
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e Andean Community 260
Mercosur 260
Central American Common Market, CAFTA, and CARICOM 261
Regional Economic Integration Elsewhere 262
Association of Southeast Asian Nations 262
Regional Trade Blocs in Africa 262
Other Trade Agreements 264
Focus on Managerial Implications: Regional Economic Integration reats 264
Summary 266
Critical inking and Discussion Questions 267
Research Task 267
Closing Case: Free Trade in Africa: TFTA and CFTA 267
Endnotes 268
PART FOUR e Global Monetary System
Chapter Ten e Foreign Exchange Market 270
Opening Case: e Fluctuating Value of the Yuan gives Chinese Business a Lesson in Foreign Exchange Risk 271
Introduction 272
e Functions of the Foreign Exchange Market 273
Currency Conversion 273
Insuring against Foreign Exchange Risk 275
Management Focus: Embraer and the Gyrations of the Brazilian Real 276
e Nature of the Foreign Exchange Market 277
Economic eories of Exchange Rate Determination 278
Prices and Exchange Rates 278
Country Focus: Quantitative Easing, Inflation, and the Value of the U.S. Dollar 282
Interest Rates and Exchange Rates 283
Investor Psychology and Bandwagon Effects 284
Summary of Exchange Rate eories 284
Exchange Rate Forecasting 285
e Efficient Market School 285
e Inefficient Market School 285
Approaches to Forecasting 285
Currency Convertibility 286
Focus on Managerial Implications: Foreign Exchange Rate Risk 287
Reducing Translation and Transaction Exposure 288
Reducing Economic Exposure 289
Other Steps for Managing Foreign Exchange Risk 289
Summary 290
Critical inking and Discussion Questions 291
Research Task 291
Closing Case: e Mexican Peso, the Japanese Yen, and Pokemon Go 292
Endnotes 292
Chapter Eleven e International Monetary System 294
Opening Case: Can Dollarization Save Venezuela? 295
Introduction 296
e Gold Standard 297
Mechanics of the Gold Standard 298
Strength of the Gold Standard 298
e Period between the Wars: 1918–1939 298
e Bretton Woods System 299
e Role of the IMF 299
e Role of the World Bank 300
e Collapse of the Fixed Exchange Rate System 301
e Floating Exchange Rate Regime 302
e Jamaica Agreement 302
Exchange Rates Since 1973 302
Fixed versus Floating Exchange Rates 305
e Case for Floating Exchange Rates 305
e Case for Fixed Exchange Rates 306
Who Is Right? 307
Exchange Rate Regimes in Practice 307
Pegged Exchange Rates 307
Country Focus: China’s Exchange Rate Regime 308
Currency Boards 309
Crisis Management by the IMF 309
Financial Crises in the Post–Bretton Woods Era 310
Country Focus: e IMF and Iceland’s Economic Recovery 310
Evaluating the IMF’s Policy Prescriptions 312
Focus on Managerial Implications: Currency Management, Business Strategy, and Government Relations 314
Management Focus: Airbus and the Euro 315
Summary 316
Critical inking and Discussion Questions 317
Research Task 318
Closing Case: Egypt and the IMF 318
Endnotes 319
PART FIVE e Strategy of International Business
Chapter Twelve e Strategy of International Business 320
Opening Case: Red Bull, A Leader in International Strategy 321
Introduction 322
Strategy and the Firm 323
Value Creation 324
Strategic Positioning 325
Page xxi
Management Focus: AB InBev, Beer Globally, and Creating Value 326
Operations: e Firm as a Value Chain 327
Global Expansion, Profitability, and Profit Growth 331
Expanding the Market: Leveraging Products and Competencies 331
Location Economies 332
Experience Effects 334
Leveraging Subsidiary Skills 336
Profitability and Profit Growth Summary 336
Cost Pressures and Pressures for Local Responsiveness 337
Pressures for Cost Reductions 337
Pressures for Local Responsiveness 338
Management Focus: IKEA’s Global Strategy 339
Choosing a Strategy 341
Global Standardization Strategy 342
Management Focus: Unilever’s Global Organization 343
Localization Strategy 343
Transnational Strategy 344
International Strategy 345
e Evolution of Strategy 345
Management Focus: Evolution of Strategy at Procter & Gamble 346
Strategic Alliances 347
e Advantages of Strategic Alliances 347
e Disadvantages of Strategic Alliances 348
Making Alliances Work 348
Summary 351
Critical inking and Discussion Questions 352
Research Task 352
Closing Case: Sony Corporation: An International Innovator? 352
Endnotes 353
Chapter irteen Entering Developed and Emerging Markets 356
Opening Case: IKEA Entering India, Finally! 357
Introduction 358
Basic Entry Decisions 359
Which Foreign Markets? 359
Timing of Entry 360
Management Focus: Tesco’s International Growth Strategy 361
Scale of Entry and Strategic Commitments 362
Market Entry Summary 363
Management Focus: e Jollibee Phenomenon 364
Entry Modes 364
Exporting 364
Turnkey Projects 365
Licensing 366
Franchising 367
Joint Ventures 368
Wholly Owned Subsidiaries 369
Selecting an Entry Mode 370
Core Competencies and Entry Mode 370
Pressures for Cost Reductions and Entry Mode 372
Management Focus: General Motors on the Upswing 372
Greenfield Venture or Acquisition? 373
Pros and Cons of Acquisitions 373
Pros and Cons of Greenfield Ventures 375
Which Choice? 375
Summary 376
Critical inking and Discussion Questions 377
Research Task 377
Closing Case: Cutco Corporation—Sharpening Your Market Entry 378
Endnotes 379
PART SIX International Business Functions
Chapter Fourteen Exporting, Importing, and Countertrade 382
Opening Case: Spotify and SoundCloud 383
Introduction 384
e Promise and Pitfalls of Exporting 386
Management Focus: Embraer and Brazilian Importing 388
Improving Export Performance 388
International Comparisons 388
Information Sources 389
Management Focus: Exporting Desserts by a Hispanic Entrepreneur 390
Service Providers 391
Export Strategy 391
Management Focus: Two Men and a Truck 392
e globalEDGE™ Exporting Tool 393
Export and Import Financing 394
Lack of Trust 394
Letter of Credit 396
Draft 396
Bill of Lading 397
A Typical International Trade Transaction 397
Export Assistance 398
Export-Import Bank 398
Export Credit Insurance 399
Countertrade 400
e Popularity of Countertrade 400
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Types of Countertrade 401
Pros and Cons of Countertrade 402
Summary 403
Critical inking and Discussion Questions 403
Research Task 404
Closing Case: Tata Motors and Exporting 404
Endnotes 405
Chapter Fifteen Global Production and Supply Chain Management 408
Opening Case: Procter & Gamble Remakes Its Global Supply Chains 409
Introduction 410
Strategy, Production, and Supply Chain Management 411
Where to Produce 414
Country Factors 414
Management Focus: IKEA Production in China 414
Technological Factors 415
Production Factors 418
e Hidden Costs of Foreign Locations 420
Management Focus: Amazon’s Global Supply Chains 421
Make-or-Buy Decisions 422
Global Supply Chain Functions 425
Global Logistics 425
Global Purchasing 427
Managing a Global Supply Chain 427
Role of Just-in-Time Inventory 428
Role of Information Technology 429
Coordination in Global Supply Chains 429
Interorganizational Relationships 430
Summary 432
Critical inking and Discussion Questions 433
Research Task 433
Closing Case: Alibaba and Global Supply Chains 434
Endnotes 435
Chapter Sixteen Global Marketing and Business Analytics 438
Opening Case: Fake News and Alternative Facts 439
Introduction 440
Globalization of Markets and Brands 442
Market Segmentation 443
Management Focus: Global Branding, Marvel Studios, and Walt Disney Company 444
Business Analytics 445
International Marketing Research 446
Product Attributes 449
Cultural Differences 449
Economic Development 450
Product and Technical Standards 450
Distribution Strategy 450
Differences Between Countries 451
Choosing a Distribution Strategy 453
Communication Strategy 453
Management Focus: Burberry’s Social Media Marketing 454
Barriers to International Communication 455
Push versus Pull Strategies 456
Global Advertising 457
Pricing Strategy 458
Price Discrimination 458
Strategic Pricing 459
Regulatory Influences on Prices 460
Configuring the Marketing Mix 461
Product Development and R&D 463
e Location of R&D 463
Integrating R&D, Marketing, and Production 464
Cross-Functional Teams 465
Building Global R&D Capabilities 466
Summary 467
Critical inking and Discussion Questions 468
Research Task 469
Closing Case: ACSI and Satisfying Global Customers 469
Endnotes 470
Chapter Seventeen Global Human Resource Management 474
Opening Case: Global Mobility at Shell 475
Introduction 476
Strategic Role of Global HRM: Managing a Global Workforce 477
Staffing Policy 478
Types of Staffing Policies 479
Expatriate Managers 482
Global Mindset 485
Training and Management Development 486
Training for Expatriate Managers 486
Repatriation of Expatriates 487
Management Focus: Monsanto’s Repatriation Program 488
Management Development and Strategy 488
Performance Appraisal 489
Performance Appraisal Problems 489
Guidelines for Performance Appraisal 489
Compensation 490
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National Differences in Compensation 490
Expatriate Pay 490
Management Focus: McDonald’s Global Compensation Practices 491
Building a Diverse Global Workforce 493
International Labor Relations 494
e Concerns of Organized Labor 494
e Strategy of Organized Labor 495
Approaches to Labor Relations 495
Summary 496
Critical inking and Discussion Questions 497
Research Task 497
Closing Case: Sodexo: Building a Diverse Global Workforce 498
Endnotes 499
GLOSSARY 503
NAME INDEX 511
SUBJECT INDEX 513
ACRONYMS 531
COUNTRIES AND THEIR CAPITALS 532
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1
Page 3
Part 1 Introduction and Overview
Globalization
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO1-1 Understand what is meant by the term globalization.
LO1-2 Recognize the main drivers of globalization.
LO1-3 Describe the changing nature of the global economy.
LO1-4 Explain the main arguments in the debate over the impact of globalization.
LO1-5 Understand how the process of globalization is creating opportunities and challenges for management practice.
GM and Its Chevrolet Supercar, the Corvette ZR1
opening case
e General Motors Company (gm.com), commonly abbreviated as GM (which is also the company’s symbol on the
New York Stock Exchange), is an American multinational corporation headquartered in Detroit, Michigan, that designs,
manufactures, markets, and distributes vehicles and vehicle parts. GM was founded in Flint, Michigan, on September
16, 1908. In addition, to support its auto operations, GM Financial is a wholly owned captive finance subsidiary of
General Motors, albeit headquartered in Fort Worth, Texas (and not at the main headquarters location in Detroit).
Page 4
Interestingly, GM is a large conglomerate with a one-industry focus on automobiles that operates as a holding
company for various vehicle brands. Consequently, there are no General Motors, or GM, branded cars. But the
company has been around for more than 100 years making vehicles. Today, there are eight distinctive automotive brands
under the General Motors umbrella: Chevrolet, Buick, GMC, Cadillac, Holden, Baojun, Wuling, and Jiefang. At one
point the company owned more than 20 automobile brands (e.g., Hummer, McLaughlin, Oakland, Oldsmobile, Opel,
Pontiac, Saab, Saturn, and Vauxhall).
Within its current brand umbrella, GM is served by about 180,000 employees who speak some 70 different
languages, and operate on five continents across 23 time zones. GM delivers about 9 million vehicles via 12,450 dealers
in 125 countries annually. China has become critical to GM’s operations as one of the company’s top markets in recent
years, now accounting for about 5 million of the 9 million vehicles sold globally on an annual basis. To support this
heavy Chinese focus, GM is building an additional five new manufacturing plants in the country (adding to its already
strong Chinese presence of 10 joint ventures and two wholly owned enterprises and more than 58,000 employees).
Within GM, the Chevrolet brand, or vehicle line, occupies a distinctive position for its range of car makes.
Amazingly, a Chevrolet is sold somewhere in the world every 8.33 seconds! Louis Chevrolet and then ousted GM
founder William C. Durant started Chevrolet in 1911 as the Chevrolet Motor Car Company, and it became part of the
General Motors Company in 1918. As of today, Chevrolet-branded vehicles are sold in all markets worldwide. Until
2017, Oceania had been an exception since GM had been represented in that part of the world since the 1980s by its
Australian subsidiary, Holden. However, GM has also decided to focus its India manufacturing on producing vehicles
for export only and will transition its South Africa manufacturing to Isuzu Motors. Consequently, GM’s Chevrolet
brand was phased out of both country markets by the end of 2017.
What is not phased out is the Corvette! Chevrolet’s sports car, Corvette, has been around since it was introduced at
the GM Motorama at the New York Auto Show in 1953. Myron Scott is credited for naming the sports car after a
relatively small, maneuverable warship called a corvette. As any automobile brand, the “Vette” or “Chevy
Corvette,” has several different brand designations, and the car models are priced from a low of about $60,000
to a high of $160,000. Uniquely, the Corvette ZR1 was again introduced in 2019 (produced from mid-year 2018). is
particular Corvette designation, ZR1, had been in production from 1969–1971, 1990–1995, and 2009–2013 before it
again made a comeback in 2019.
“ZR1 has returned to the throne to push the Corvette legacy to its highest point ever. It’s a supercar that’s at once
luxurious and overwhelmingly capable, delivering the icon’s fastest, most powerful, most advanced performance in a
production Corvette to date. Drivers, hail the new King.” In much of the world, the Chevrolet Corvette is an instantly
recognizable sports car. e pinnacle of its lineup is the ZR1, an extraordinary engine and performance pack that dates
back to the 1969 model. But for the 2019 model and on, only 2,000 to 3,000 ZR1s are expected to be produced each
year. e car has 755 horsepower, does zero to 60 miles per hour (about 97 kmh) in under 2.85 seconds, and has a top
speed of 212 mph (about 341 kmh).
e 2019 ZR1’s aerodynamics benefited in design from Corvette’s racing teams that compete in races around the
world (e.g., the annual 24 Hours of Le Mans endurance race in France). e new version has more carbon fiber parts
than any Corvette before it. is includes an optional high wing rising from the rear deck that generates such a powerful
downforce that it had to be mounted on the Vette’s frame since the trunk would buckle under the pressure. e wing is
needed to help keep the car planted solidly on the road at speeds where it might otherwise leave the ground.
Given its periodic dormant production within the Chevrolet Corvette product family, the Corvette ZR1 is a global
phenomenon. It is the top of the line Corvette, produced in small numbers, and produced only periodically (and not
every year as most other cars). e Corvette is a globally recognizable brand that inspires true passion, engagement, and
commitment from its owners.
e global branding and a testament to its staying power are nicely exemplified by the first 2019 Corvette ZR1
having been sold for $925,000 at a Barrett-Jackson auction in Scottsdale, Arizona. It was sold to Rick Hendrick,
Chairman of Hendrick Automotive Group and owner of the Hendrick Motorsports NASCAR team. e price was a
hefty markup paid to be first to get the new 2019 version of ZR1, since the Corvette ZR1 starts at about $120,000.
However, the full sales price benefited the Stephen Siller Tunnel to Towers Foundation—a charitable foundation—and
so the high sticker price went to a good cause. •
Sources: “Corvette ZR-1: Consider the Pace Set,” Chevrolet, www.chevrolet.com/performance/corvette-zr1-supercar (accessed April 16, 2018);
Hannah Elliott, “GM Takes On Ferrari and Lamborghini with the 2019 Corvette ZR1,” Bloomberg BusinessWeek, November 29, 2017; Bradley
Brownell, “e First Corvette ZR1 Just Sold For $925,000,” Jalopnik, January 21, 2018; Mark Phelan, “First Look: 2019 Chevy Corvette ZR1
Convertible Is Faster and More Powerful than Ever,” Detroit Free Press, November 29, 2017; David Hollister, Ray Tadgerson, David Closs, and
Tomas Hult, “Second Shift: e Inside Story of the Keep GM Movement,” McGraw-Hill Professional, 2016; and Chris Davies, “2019 Corvette
ZR1: 5 Fast Facts About Chevy’s New Supercar,” Slash Gear, November 13, 2017.
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Introduction
Over the past five decades, a fundamental shift has been occurring in the world economy. We have been
moving away from a world in which national economies were relatively self-contained entities, isolated from
each other by barriers to cross-border trade and investment; by distance, time zones, and language; and by
national differences in government regulation, culture, and business systems. As we will see later on in this
chapter and throughout the text, international trade across country borders has become the norm, with an
almost exponential increase in trade during the last decade.
We are moving toward a world in which barriers to cross-border trade and investment are declining;
perceived distance is shrinking due to advances in transportation and telecommunications technology; material
culture is starting to look similar the world over; and national economies are merging into an interdependent,
integrated global economic system. e process by which this transformation is occurring is commonly referred
to as globalization. At the same time, recent political world events (e.g., increase of terrorism in many
parts of the world, the United Kingdom leaving the European Union, and elections globally of
nationalistic politicians) create tension and uncertainty regarding the future of global trade activities. ese
political swings usually temper, or even out, over time in democratic societies, and long-term indications
generally are for stability in the marketplace. We are unlikely to backtrack on globalization and global
companies’ willingness to satisfy the needs and wants of global customers.
For example, as described in the opening case, General Motors and its Chevrolet brand are an illustration of
the trend toward the unique opportunities that globalization can present to a company. It is pretty amazing to
think that a Chevrolet is sold somewhere in the world every 8.33 seconds! However, it is clear that within GM’s
global product portfolio (Chevrolet, Buick, GMC, Cadillac, Holden, Baojun, Wuling, and Jiefang), the
Chevrolet brand occupies a distinctive position. People in the U.S. know Chevrolet along with GM’s other core
brands (Buick, GMC, and Cadillac) well but have not been exposed so much to Holden, Baojun, Wuling, and
Jiefang. GM uses Holden to focus on Oceania and also manufactures and sells numerous Baojun, Wuling, and
Jiefang vehicles in the important Chinese market. As we’ve mentioned, five million of GM’s nine million
annual vehicle sales are in the Chinese market.
Proponents of increased global trade argue that cross-cultural engagement and trade across country borders
is the future and that returning back to a nationalistic perspective is the past. On the other hand, the
nationalistic argument rests in citizens wanting their country to be sovereign, self-sufficient as much as possible,
and basically in charge of their own economy and country environment. As with any debate, both sides of the
argument have merit. We will explore many aspects of today’s global marketplace in this text’s 17 integrated and
topical chapters.
Globalization now has an impact on almost everything we do. For example, an American medical doctor—
let’s call her Laurie—might drive to work at her pediatric office in a sports utility vehicle (SUV) that was
designed in Stuttgart, Germany, and assembled in Leipzig, Germany, and Bratislava, Slovakia, by Porsche from
components from parts suppliers worldwide, which in turn were fabricated from Korean steel and Malaysian
rubber. Laurie may have filled her car with gasoline at a Shell service station owned by a British-Dutch
multinational company. e gasoline could have been made from oil pumped out of a well off the coast of
Africa by a French oil company that transported it to the United States in a ship owned by a Greek shipping
line. While driving to work, Laurie might talk to her stockbroker (using a hands-free, in-car speaker) on an
Apple iPhone that was designed in California and assembled in China using chip sets produced in Japan and
Europe, glass made by Corning in Kentucky, and memory chips from South Korea. Perhaps on her way Laurie
might tell the stockbroker to purchase shares in Lenovo, a multinational Chinese PC manufacturer whose
operational headquarters is in North Carolina and whose shares are listed on the New York Stock Exchange.
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is is the world in which we live. In many cases we simply do not know or perhaps even care where a
product was designed and where it was made. Just a couple of decades ago, “Made in the USA” or “Made in
Germany” (or “Made in the United Kingdom” for Charles W. L. Hill, the first author of this textbook, or
“Made in Sweden” for G. Tomas M. Hult, the second author of this textbook) had strong meaning and referred
to something. e U.S. often stood for quality and Germany often stood for sophisticated engineering. Now
the country of origin for a product has given way to, for example, “Made by BMW,” and the company is the
quality assurance platform, not the country. In many cases, it goes even beyond the company to the personal
relationship a customer has developed with a representative of the company, and so we focus on what has
become known as CRM (Customer Relationship Management).
Whether it is still the quality associated with the country of origin of a product, or the assurance given by a
specific company regardless of where they manufacture their product, we live in a world where the volume of
goods, services, and investments crossing national borders has expanded faster than world output for more than
half a century. It is a world in which international institutions such as the World Trade Organization and
gatherings of leaders from the world’s most powerful economies continue to work for even lower barriers to
cross-border trade and investment. e symbols of material culture and popular culture are increasingly global,
from Coca-Cola and Starbucks, to Sony PlayStation, Facebook, Netflix video streaming service, IKEA stores,
and Apple iPads and iPhones. Vigorous and vocal groups protest against globalization, which they blame for a
list of ills from unemployment in developed nations to environmental degradation and the
Westernization or Americanization of local cultures. ese protesters come from environmental groups,
which have been around for some time, but more recently also from nationalistic groups focused on their
countries being more sovereign.
Will the United States Produce Just Services?
e United States has the largest and most technologically powerful economy in the world, with a per capita GDP
(gross domestic product) of $57,466. e country’s overall GDP is valued at $18.57 trillion. Most of the labor force (80
percent) is employed in the services sector, with 19 percent employed in manufacturing industries, and only 1 percent in
the agricultural area. China, India, and the European Union have labor forces larger than that of the United States. Data
show that the United States has become much more of a service economy over the years. Will the United States
continue to increase its service sector at the cost of manufacturing and agriculture?
Source: U.S. Central Intelligence Agency, World Factbook, 2019. www.cia.gov.
For businesses, the globalization process has many opportunities. Firms can expand their revenues by selling
around the world and/or reduce their costs by producing in nations where key inputs, including labor, are
cheap. e global expansion of enterprises has been facilitated by generally favorable political and economic
trends. is has allowed businesses both large and small, from both advanced nations and developing nations,
to expand internationally. As globalization unfolds, it is transforming industries and creating anxiety among
those who believed their jobs were protected from foreign competition. Advances in technology, lower
transportation costs, and the rise of skilled workers in developing countries imply that many services no longer
need to be performed where they are delivered. As best-selling author omas Friedman has argued, the world
is becoming “flat.”1 People living in developed nations no longer have the playing field tilted in their favor.
Increasingly, enterprising individuals based in India, China, or Brazil have the same opportunities to better
themselves as those living in Western Europe, the United States, or Canada.
In this text, we will take a close look at these issues and many more. We will explore how changes in
regulations governing international trade and investment, when coupled with changes in political systems and
technology, have dramatically altered the competitive playing field confronting many businesses. We will
discuss the resulting opportunities and threats and review the strategies that managers can pursue to exploit the
Page 7
International Business Resources
opportunities and counter the threats. We will consider whether globalization benefits or harms national
economies. We will look at what economic theory has to say about the outsourcing of manufacturing and
service jobs to places such as India and China and look at the benefits and costs of outsourcing, not just to
business firms and their employees but to entire economies. First, though, we need to get a better overview of
the nature and process of globalization, and that is the function of this first chapter.
What Is Globalization?
LO 1-1 Understand what is meant by the term globalization.
As used in this text, globalization refers to the shift toward a more integrated and interdependent world
economy. Globalization has several facets, including the globalization of markets and the globalization of
production.
THE GLOBALIZATION OF MARKETS
e globalization of markets refers to the merging of historically distinct and separate national markets into
one huge global marketplace. Falling barriers to cross-border trade and investment have made it easier to sell
internationally. It has been argued for some time that the tastes and preferences of consumers in different
nations are beginning to converge on some global norm, thereby helping create a global market.2 Consumer
products such as Citigroup credit cards, Coca-Cola soft drinks, Sony video games, McDonald’s hamburgers,
Starbucks coffee, IKEA furniture, and Apple iPhones are frequently held up as prototypical examples of this
trend. e firms that produce these products are more than just benefactors of this trend; they are also
facilitators of it. By offering the same basic product worldwide, they help create a global market.
A company does not have to be the size of these multinational giants to facilitate, and benefit from, the
globalization of markets. In the United States, for example, according to the International Trade
Administration, more than 300,000 small- and medium-size firms with fewer than 500 employees export,
accounting for 98 percent of the companies that export. More generally, exports from small- and
medium-size companies account for 33 percent of the value of U.S. exports of manufactured goods.3
Typical of these is B&S Aircraft Alloys, a New York company whose exports account for 40 percent of its $8
million annual revenues.4 e situation is similar in several other nations. For example, in Germany, a
staggering 98 percent of small and midsize companies have exposure to international markets, via either exports
or international production. Since 2009, China has been the world’s largest exporter, sending more than $2
trillion worth of products and services last year to the rest of the world.
globalEDGE™ has been the
world’s go-to site online for
global business knowledge since 2001. Google ranks the site number 1 in the world for “international business
resources.” Created by a 30-member team in the International Business Center in the Eli Broad College of Business at
Michigan State University under the supervision of Dr. Tomas Hult, Dr. Tunga Kiyak, and Dr. Sarah Singer,
globalEDGE™ is a knowledge resource that connects international business professionals worldwide to a wealth of
information, insights, and learning resources on global business activities.
e site offers the latest and most comprehensive international business and trade content for a wide range of topics.
Whether conducting extensive market research, looking to improve your international knowledge, or simply browsing,
you’re sure to find what you need to sharpen your competitive edge in today’s rapidly changing global marketplace. e
easy, convenient, and free globalEDGE™ website’s tagline is “Your Source for Global Business Knowledge.” Take a look
Page 8
at the site at globaledge.msu.edu. We will use globalEDGE throughout this text for exercises, information, data, and to
keep every facet of the text up-to-date on a daily basis!
Despite the global prevalence of Citigroup credit cards, McDonald’s hamburgers, Starbucks coffee, and
IKEA stores, for example, it is important not to push too far the view that national markets are giving way to
the global market. As we shall see in later chapters, significant differences still exist among national markets
along many relevant dimensions, including consumer tastes and preferences, distribution channels, culturally
embedded value systems, business systems, and legal regulations. Uber, for example, the fast-growing ride-for-
hire service, is finding that it needs to refine its entry strategy in many foreign cities in order to take differences
in the regulatory regime into account. Such differences frequently require companies to customize marketing
strategies, product features, and operating practices to best match conditions in a particular country.
e most global of markets are not typically markets for consumer products—where national differences in
tastes and preferences can still be important enough to act as a brake on globalization—but markets for
industrial goods and materials that serve universal needs the world over. ese include the markets for
commodities such as aluminum, oil, and wheat; for industrial products such as microprocessors, DRAMs
(computer memory chips), and commercial jet aircraft; for computer software; and for financial assets from
U.S. Treasury bills to Eurobonds and futures on the Nikkei index or the euro. at being said, it is increasingly
evident that many newer high-technology consumer products, such as Apple’s iPhone, are being successfully
sold the same way the world over.
In many global markets, the same firms frequently confront each other as competitors in nation after nation.
Coca-Cola’s rivalry with PepsiCo is a global one, as are the rivalries between Ford and Toyota; Boeing and
Airbus; Caterpillar and Komatsu in earthmoving equipment; General Electric and Rolls-Royce in aero engines;
Sony, Nintendo, and Microsoft in video-game consoles; and Samsung and Apple in smartphones. If a firm
moves into a nation not currently served by its rivals, many of those rivals are sure to follow to prevent their
competitor from gaining an advantage.5 As firms follow each other around the world, they bring with them
many of the assets that served them well in other national markets—their products, operating strategies,
marketing strategies, and brand names—creating some homogeneity across markets. us, greater uniformity
replaces diversity. In an increasing number of industries, it is no longer meaningful to talk about “the German
market,” “the American market,” “the Brazilian market,” or “the Japanese market”; for many firms, there is only
the global market.
THE GLOBALIZATION OF PRODUCTION
e globalization of production refers to the sourcing of goods and services from locations around the globe
to take advantage of national differences in the cost and quality of factors of production (such as labor, energy,
land, and capital). By doing this, companies hope to lower their overall cost structure or improve the quality or
functionality of their product offering, thereby allowing them to compete more effectively. For example, Boeing
has made extensive use of outsourcing to foreign suppliers. Consider Boeing’s 777: eight Japanese suppliers
make parts for the fuselage, doors, and wings; a supplier in Singapore makes the doors for the nose landing
gear; three suppliers in Italy manufacture wing flaps; and so on.6 In total, some 30 percent of the 777, by value,
is built by foreign companies. And for its most recent jet airliner, the 787, Boeing has pushed this trend even
further; some 65 percent of the total value of the aircraft is outsourced to foreign companies, 35 percent of
which goes to three major Japanese companies.
Part of Boeing’s rationale for outsourcing so much production to foreign suppliers is that these suppliers are
the best in the world at their particular activity. A global web of suppliers yields a better final product, which
enhances the chances of Boeing winning a greater share of total orders for aircraft than its global rival, Airbus.
Boeing also outsources some production to foreign countries to increase the chance that it will win significant
Page 9
orders from airlines based in that country. For a more detailed look at the globalization of production at
Boeing, see the accompanying Management Focus.
Did You Know?
Did you know why your iPhone was assembled in China? It’s not what you might think.
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
Early outsourcing efforts were primarily confined to manufacturing activities, such as those undertaken by
Boeing and Apple. Increasingly, however, companies are taking advantage of modern communications
technology, particularly the Internet, to outsource service activities to low-cost producers in other nations. e
Internet has allowed hospitals to outsource some radiology work to India, where images from MRI scans and
the like are read at night while U.S. physicians sleep; the results are ready for them in the morning. Many
software companies, including Microsoft, now use Indian engineers to perform test functions on software
designed in the United States. e time difference allows Indian engineers to run debugging tests on software
written in the United States when U.S. engineers sleep, transmitting the corrected code back to the United
States over secure Internet connections so it is ready for U.S. engineers to work on the following day.
Dispersing value-creation activities in this way can compress the time and lower the costs required to develop
new software programs. Other companies, from computer makers to banks, are outsourcing customer service
functions, such as customer call centers, to developing nations where labor is cheaper. In another example from
health care, workers in the Philippines transcribe American medical files (such as audio files from doctors
seeking approval from insurance companies for performing a procedure). Some estimates suggest the
outsourcing of many administrative procedures in health care, such as customer service and claims processing,
could reduce health care costs in America by more than $100 billion.
e economist Robert Reich has argued that as a consequence of the trend exemplified by companies such as
Boeing, Apple, and Microsoft, in many cases it is becoming irrelevant to talk about American products,
Japanese products, German products, or Korean products. Increasingly, according to Reich, the outsourcing of
productive activities to different suppliers results in the creation of products that are global in nature, that is,
“global products.”7 But as with the globalization of markets, companies must be careful not to push the
globalization of production too far. As we will see in later chapters, substantial impediments still make it
difficult for firms to achieve the optimal dispersion of their productive activities to locations around the globe.
ese impediments include formal and informal barriers to trade between countries, barriers to foreign direct
investment, transportation costs, issues associated with economic and political risk, and the sheer managerial
challenge of coordinating a globally dispersed supply chain (an issue for Boeing with the 787 Dreamliner, as
discussed in the Management Focus). For example, government regulations ultimately limit the ability of
hospitals to outsource the process of interpreting MRI scans to developing nations where radiologists are
cheaper.
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to
learnsmartadvantage.com for help.
Nevertheless, the globalization of markets and production will probably continue. Modern firms are
important actors in this trend, their very actions fostering increased globalization. ese firms, however, are
merely responding in an efficient manner to changing conditions in their operating environment—as well they
should.
m a n a g e m e n t F O C U S
Boeing’s Global Production System
Executives at the Boeing Corporation, America’s largest exporter, say that building a large commercial jet aircraft like the
787 Dreamliner involves bringing together more than a million parts in flying formation. Half a century ago, when the
early models of Boeing’s venerable 737 and 747 jets were rolling off the company’s Seattle-area production lines, foreign
suppliers accounted for only 5 percent of those parts on average. Boeing was vertically integrated and manufactured
many of the major components that went into the planes. e largest parts produced by outside suppliers were the jet
engines, where two of the three suppliers were American companies. e lone foreign engine manufacturer was the
British company Rolls-Royce.
Fast-forward to the modern era, and things look very different. In the case of Boeing’s super-efficient 787
Dreamliner, 50 outside suppliers spread around the world account for 65 percent of the value of the aircraft. Italian firm
Alenia Aeronautica makes the center fuselage and horizontal stabilizer. Kawasaki of Japan makes part of the forward
fuselage and the fixed trailing edge of the wing. French firm Messier-Dowty makes the aircraft’s landing gear. German
firm Diehl Luftahrt Elektronik supplies the main cabin lighting. Sweden’s Saab Aerostructures makes the access doors.
Japanese company Jamco makes parts for the lavatories, flight deck interiors, and galleys. Mitsubishi Heavy Industries of
Japan makes the wings. KAA of Korea makes the wing tips. And so on.
Why the change? One reason is that 80 percent of Boeing’s customers are foreign airlines, and to sell into those
nations, it often helps to be giving business to those nations. e trend started in 1974 when Mitsubishi of Japan was
given contracts to produce inboard wing flaps for the 747. e Japanese reciprocated by placing big orders for Boeing
jets. A second rationale was to disperse component part production to those suppliers who are the best in the world at
their particular activity. Over the years, for example, Mitsubishi has acquired considerable expertise in the manufacture
of wings, so it was logical for Boeing to use Mitsubishi to make the wings for the 787. Similarly, the 787 is the first
commercial jet aircraft to be made almost entirely out of carbon fiber, so Boeing tapped Japan’s Toray Industries, a
world-class expert in sturdy but light carbon-fiber composites, to supply materials for the fuselage. A third reason for the
extensive outsourcing on the 787 was that Boeing wanted to unburden itself of some of the risks and costs associated
with developing production facilities for the 787. By outsourcing, it pushed some of those risks and costs onto suppliers,
who had to undertake major investments in capacity to ramp up to produce for the 787.
So what did Boeing retain for itself? Engineering design, marketing and sales, and final assembly are done at its
Everett plant north of Seattle, all activities where Boeing maintains it is the best in the world. Of major component
parts, Boeing made only the tail fin and wing to body fairing (which attaches the wings to the fuselage of the plane).
Everything else was outsourced.
As the 787 moved through development, it became clear that Boeing had pushed the outsourcing paradigm too far.
Coordinating a globally dispersed production system this extensive turned out to be very challenging. Parts turned up
late, some parts didn’t “snap together” the way Boeing had envisioned, and several suppliers ran into engineering
problems that slowed down the entire production process. As a consequence, the date for delivery of the first jet was
pushed back more than four years, and Boeing had to take millions of dollars in penalties for late deliveries. e
problems at one supplier, Vought Aircraft in North Carolina, were so severe that Boeing ultimately agreed to acquire the
company and bring its production in-house. Vought was co-owned by Alenia of Italy and made parts of the main
fuselage.
ere are now signs that Boeing is rethinking some of its global outsourcing policy. For its next jet, a new version of
its popular wide-bodied 777 jet, the 777X, which will use the same carbon-fiber technology as the 787, Boeing will
bring wing production back in-house. Mitsubishi and Kawasaki of Japan produce much of the wing structure for the
787 and for the original version of the 777. However, recently Japan’s airlines have been placing large orders with
Airbus, breaking with their traditional allegiance to Boeing. is seems to have given Boeing an opening to bring wing
production back in-house. Boeing executives also note that Boeing has lost much of its expertise in wing production
over the last 20 years due to outsourcing, and bringing it back in-house for new carbon-fiber wings might enable Boeing
to regain these important core skills and strengthen the company’s competitive position.
Sources: M. Ehrenfreund, “e Economic Reality Behind the Boeing Plane Trump Showed Off,” e Washington Post, February 17, 2017; K. Epstein and J. Crown, “Globalization Bites Boeing,” Bloomberg Businessweek, March 12, 2008; H. Mallick, “Out of Control Outsourcing Ruined Boeing’s Beautiful Dreamliner,” e Star, February 25, 2013; P. Kavilanz, “Dreamliner: Where in the World Its Parts Come From,” CNN Money, January 18, 2013; S. Dubois, “Boeing’s Dreamliner Mess: Simply Inevitable?” CNN Money, January 22, 2013; and A. Scott and T. Kelly, “Boeing’s Loss of a $9.5 Billion Deal Could Bring Jobs Back to the U.S.,” Business Insider, October 14, 2013.
Page 10
e Emergence of Global Institutions
As markets globalize and an increasing proportion of business activity transcends national borders, institutions
are needed to help manage, regulate, and police the global marketplace and to promote the establishment of
multinational treaties to govern the global business system. Over the past half-century, a number of important
global institutions have been created to help perform these functions, including the General Agreement on
Tariffs and Trade (GATT) and its successor, the World Trade Organization; the International Monetary Fund
and its sister institution, the World Bank; and the United Nations. All these institutions were created by
voluntary agreement between individual nation-states, and their functions are enshrined in international
treaties.
e World Trade Organization (WTO) (like the GATT before it) is primarily responsible for policing the
world trading system and making sure nation-states adhere to the rules laid down in trade treaties
signed by WTO member states. As of 2017, 164 nations that collectively accounted for 98 percent of
world trade were WTO members, thereby giving the organization enormous scope and influence. e WTO is
also responsible for facilitating the establishment of additional multinational agreements among WTO member
states. Over its entire history, and that of the GATT before it, the WTO has promoted the lowering of barriers
to cross-border trade and investment. In doing so, the WTO has been the instrument of its member states,
which have sought to create a more open global business system unencumbered by barriers to trade and
investment between countries. Without an institution such as the WTO, the globalization of markets and
production is unlikely to have proceeded as far as it has. However, as we shall see in this chapter and in Chapter
7 when we look closely at the WTO, critics charge that the organization is usurping the national sovereignty of
individual nation-states.
Can the International Court of Justice Be Effective?
e International Court of Justice (www.icj-cij.org) is the principal judicial organ of the United Nations (UN). Of the
six principal organs of the UN, it is the only one not located in New York (United States); instead, the seat of the Court
is at the Peace Palace in e Hague (Netherlands). e court’s role is to settle, in accordance with international law, legal
disputes submitted to it by countries and to give advisory opinions on legal questions referred to it by authorized United
Nations organs and specialized agencies. But how effective can the UN International Court of Justice really be in the
global marketplace with its many legal systems?
Source: www.icj-cij.org/en/court.
e International Monetary Fund (IMF) and the World Bank were both created in 1944 by 44 nations
that met at Bretton Woods, New Hampshire. e IMF was established to maintain order in the international
monetary system; the World Bank was set up to promote economic development. In the more than seven
decades since their creation, both institutions have emerged as significant players in the global economy. e
World Bank is the less controversial of the two sister institutions. It has focused on making low-interest loans to
cash-strapped governments in poor nations that wish to undertake significant infrastructure investments (such
as building dams or roads).
e IMF is often seen as the lender of last resort to nation-states whose economies are in turmoil and whose
currencies are losing value against those of other nations. During the past two decades, for example, the IMF
has lent money to the governments of troubled states including Argentina, Indonesia, Mexico, Russia, South
Korea, ailand, and Turkey. More recently, the IMF took a proactive role in helping countries cope with some
Page 11
of the effects of the 2008–2009 global financial crisis. IMF loans come with strings attached, however; in return
for loans, the IMF requires nation-states to adopt specific economic policies aimed at returning their troubled
economies to stability and growth. ese requirements have sparked controversy. Some critics charge that the
IMF’s policy recommendations are often inappropriate; others maintain that by telling national governments
what economic policies they must adopt, the IMF, like the WTO, is usurping the sovereignty of nation-states.
We will look at the debate over the role of the IMF in Chapter 11.
e United Nations (UN) was established October 24, 1945, by 51 countries committed to preserving
peace through international cooperation and collective security. Today, nearly every nation in the world belongs
to the United Nations; membership now totals 193 countries. When states become members of the United
Nations, they agree to accept the obligations of the UN Charter, an international treaty that establishes basic
principles of international relations. According to the charter, the UN has four purposes: to maintain
international peace and security, to develop friendly relations among nations, to cooperate in solving
international problems and in promoting respect for human rights, and to be a center for harmonizing the
actions of nations. Although the UN is perhaps best known for its peacekeeping role, one of the organization’s
central mandates is the promotion of higher standards of living, full employment, and conditions of economic
and social progress and development—all issues that are central to the creation of a vibrant global economy. As
much as 70 percent of the work of the UN system is devoted to accomplishing this mandate. To do so, the UN
works closely with other international institutions such as the World Bank. Guiding the work is the belief that
eradicating poverty and improving the well-being of people everywhere are necessary steps in creating
conditions for lasting world peace.8
Another institution in the news is the Group of Twenty (G20). Established in 1999, the G20 comprises the
finance ministers and central bank governors of the 19 largest economies in the world, plus
representatives from the European Union and the European Central Bank. Collectively, the G20
represents 90 percent of global GDP and 80 percent of international global trade. Originally established to
formulate a coordinated policy response to financial crises in developing nations, in 2008 and 2009 it became
the forum through which major nations attempted to launch a coordinated policy response to the global
financial crisis that started in America and then rapidly spread around the world, ushering in the first serious
global economic recession since 1981.
How Important is the European Union Among the Group of Twenty (G20)?
ere have been twelve G20 Leaders’ Summits since they started in 2008. e Group of Twenty includes 19 prominent
countries and the European Union (Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia,
Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, United States, and the
European Union). G20 members represent about 85 percent of global GDP, 80 percent of global trade, and about two-
thirds of the world’s population. Now, is it really right for the G20 to include 19 countries and one union entity (the
European Union), or should the European Union countries be selected individually (as some already are)?
Source: www.g20.org/en.
Drivers of Globalization
LO 1-2 Recognize the main drivers of globalization.
Two macro factors underlie the trend toward greater globalization.9 e first is the decline in barriers to the free
flow of goods, services, and capital that has occurred in recent decades. e second factor is technological
Page 12
change, particularly the dramatic developments in communication, information processing, and transportation
technologies.
DECLINING TRADE AND INVESTMENT BARRIERS
During the 1920s and 1930s, many of the world’s nation-states erected formidable barriers to international
trade and foreign direct investment. International trade occurs when a firm exports goods or services to
consumers in another country. Foreign direct investment (FDI) occurs when a firm invests resources in
business activities outside its home country. Many of the barriers to international trade took the form of high
tariffs on imports of manufactured goods. e typical aim of such tariffs was to protect domestic industries
from foreign competition. One consequence, however, was “beggar thy neighbor” retaliatory trade policies,
with countries progressively raising trade barriers against each other. Ultimately, this depressed world demand
and contributed to the Great Depression of the 1930s.
Having learned from this experience, the advanced industrial nations of the West committed themselves
after World War II to progressively reducing barriers to the free flow of goods, services, and capital among
nations.10 is goal was enshrined in the General Agreement on Tariffs and Trade. Under the umbrella of
GATT, eight rounds of negotiations among member states worked to lower barriers to the free flow of goods
and services. e first round of negotiations went into effect in 1948. e most recent negotiations to be
completed, known as the Uruguay Round, were finalized in December 1993. e Uruguay Round further
reduced trade barriers; extended GATT to cover services as well as manufactured goods; provided enhanced
protection for patents, trademarks, and copyrights; and established the World Trade Organization to police the
international trading system.11 Table 1.1 summarizes the impact of GATT agreements on average tariff rates
for manufactured goods among several developed nations. As can be seen, average tariff rates have
fallen significantly since 1950 and now stand at about 2.0–3.0 percent. Comparable tariff rates in
2017 for China and India were about 8 percent. However, it should be noted that while the long term trend
has been towards lower tariff rates, it is possible that recent increases in tariff rates imposed by the Trump
Administration in the U.S. could signify a reversal of this trend.
1.1 TABLE
Average Tariff Rates on Manufactured Products as Percentage of Value
Sources: e 1913–1990 data are from “Who Wants to Be a Giant?” e Economist: A Survey of the Multinationals, June 24, 1995, pp.
3–4. e 2017 data are from the World Development Indicators, World Bank.
Knowledge Society and Trade Agreements Figure 1.1 reports on the value of world trade, world production, and active regional trade agreements in the world along with the world population from 1960 to
2020 (the last three years being forecast data). Trade and production are indexed to 100 in 1960 (the index
calculation is based on current prices and not adjusted for inflation). e figure illustrates some interesting
changing globalization trends. For example, according to the World Trade Organization, the value of world
Page 13
trade in merchandised goods has grown consistently faster than the world economy since 1960, and the chart
shows that this growth has been markedly higher since the turn of the century (note that the index values in the
chart are based on current prices, and are not adjusted for inflation).
1.1 FIGURE
Index value of world trade and world production (1960=100), world population (billions), and number of regional trade agreements.
Sources: World Bank, 2018; World Trade Organization, 2018; United Nations, 2018.
As a consequence, when adjusted for inflation, by 2020 the value of world trade is expected to be around 21
times larger than it was in 1960, whereas the world economy will be around 9.3 times larger. is trend has
continued into the modern era. Between 2000 and 2017, the value of world trade increased 98 percent whereas
the world economy has increased by 74 percent in real terms (adjusted for inflation). e forecast is that world
trade will continue to increase more rapidly than world production for the foreseeable future.
e difference in the growth rates of world production and world trade is why studying international
business is so important. While we produce more goods and services today compared with before, a far greater
proportion of that production is being traded across national borders than at any time in modern history.
Moreover, the knowledge society that we live in has resulted in consumers knowing more than ever about goods
and services being produced worldwide. From a customer perspective, this is driving demand for internationally
traded goods. us, the larger the difference between the growth rates of world trade and world production, the
greater the extent of globalization and the more important it becomes to understand international business.
Additionally, despite the recent wave of nationalism around the world (e.g., Brexit, the 2016 U.S.
presidential election), many countries have been progressively removing restrictions to foreign direct investment
over the past 20 years. According to the United Nations, some 80 percent of the 1,440 changes made
worldwide since 2000 in the laws governing foreign direct investment created a more favorable environment for
FDI. Basically, the pressure from customers to make available any goods and services anywhere for their needs
and wants has been facilitated by country governments removing restrictions on imports to their countries.
Such customer pressures and restrictions removal by countries have been driving both the globalization of
markets and the globalization of production. e lowering of barriers to international trade enables firms to
view the world, rather than a single country, as their market. e lowering of trade and investment barriers also
Page 14
allows firms to base production at the optimal location for that activity. us, a firm might design a product
in one country, produce component parts in two other countries, assemble the product in yet another country,
and then export the finished product around the world.
Another important facilitator of trade across country borders is the increased number of trade agreements
that have been implemented in the world. Figure 1.1 reports on regional trade agreements in force today (more
than two countries involved), with another roughly 300 bilateral trade agreements between two countries also
active worldwide. ere is no doubt that trade at least between the countries in a trade agreement has been a
strong reason for the increase overall in world trade. Figure 1.1 illustrates the almost 1:1 match of the trade
agreement and world trade curves on the chart. at is, as regional trade agreements in force increase year-by-
year, so does world trade across country borders at the same pace.
Two additional implications can be gleaned from the data in Figure 1.1 that could become important for the
global marketplace. ese are illustrated in separate charts in Figure 1.2. e first implication relates to
sustainability—a topic we will cover much more in Chapter 5. In 2000, the United Nations
established the Millennium Development Goals to reduce the number of people who live in extreme
poverty by 2015. Subsequently, in September 2015, the United Nations and its 193 member countries ratified
the Sustainable Development Goals that set targets to end poverty, protect the planet, and ensure prosperity for
all countries by 2030 as part of a new sustainability agenda.12 e urgency of delivering on the UN’s
Sustainable Development Goals can be traced to the difference between the world production and population
data. As world production approaches the total population curve, we can infer that resource availability for all
of our needs and wants in the world’s 260 countries and territories will potentially be drastically constrained.
1.2 FIGURE
Comparisons of index of world trade and world population; index of world trade and number of regional trade agreements; world population and index of world production; and world population and index of world trade (index 1960 = 100).
Sources: World Bank, 2019; World Trade Organization, 2018; United Nations, 2018.
©Ariel Skelley/Blend Images LLC
e chart in Figure 1.1 also indicates that our needs worldwide are still rather “spiky” and not as flat as Tom
Friedman projected in 2004. Trading across country borders is significantly more pronounced today than ever
before, growing at a rate above the population growth of the world. ese two curves are likely to not intersect
any time soon, and coupled with the large difference between world trade and world production, especially in
the last 20 years, we will see a world consumer market where localized needs and wants are still very much
unique in a large set of industries and product categories. Overall, though, the fact that the volume of world
trade has been growing faster than world GDP implies several things.
e fact that the volume of world trade has been growing faster than world GDP implies several things.
First, more firms are doing what Boeing does with the 777 and 787: dispersing parts of their production
process to different locations around the globe to drive down production costs and increase product quality.
Second, the economies of the world’s nation-states are becoming ever more intertwined. As trade expands,
nations are becoming increasingly dependent on each other for important goods and services. ird, the world
has become significantly wealthier in the last two decades. e implication is that rising trade is the engine that
has helped pull the global economy along.
Evidence also suggests that foreign direct investment is playing an increasing role in the global economy as
firms increase their cross-border investments. e average yearly outflow of FDI increased from $14 billion in
1970 to about $1.5 trillion today, audited by the United Nations Conference on Trade and Development
(UNCTAD).13 As a result of the strong FDI flow, the global stock of FDI is about $28 trillion. More than
80,000 parent companies had more than 800,000 affiliates in foreign markets that collectively employed more
than 75 million people abroad and generated value accounting for about 11 percent of global GDP. e foreign
affiliates of multinationals had $36 trillion in global sales, higher than the value of global exports of goods and
services, which stood at close to $23.4 trillion.14
e globalization of markets and production and the resulting growth of world trade, foreign direct
investment, and imports all imply that firms are finding their home markets under attack from foreign
competitors. is is true in China, where U.S. companies such as Apple, General Motors, and Starbucks are
expanding their presence. It is true in the United States, where Japanese automobile firms have taken market
share away from General Motors and Ford over the past three decades, and it is true in Europe, where the once-
dominant Dutch company Philips has seen its market share in the consumer electronics industry taken by
Japan’s Panasonic and Sony and Korea’s Samsung and LG. e growing integration of the world economy into
a single, huge marketplace is increasing the intensity of competition in a range of manufacturing and service
industries.
Page 15
However, declining barriers to cross-border trade and investment cannot be taken for granted. As we shall
see in subsequent chapters, demands for “protection” from foreign competitors are still often heard in countries
around the world, including the United States. Although a return to the restrictive trade policies of the 1920s
and 1930s is unlikely, it is not clear whether the political majority in the industrialized world favors further
reductions in trade barriers. Indeed, the global financial crisis of 2008–2009 and the associated drop
in global output that occurred led to more calls for trade barriers to protect jobs at home. If trade
barriers decline no further, this may slow the rate of globalization of both markets and production.
ROLE OF TECHNOLOGICAL CHANGE
e lowering of trade barriers made globalization of markets and production a theoretical possibility.
Technological change has made it a tangible reality. Every year that goes by comes with unique and oftentimes
major advances in communication, information processing, and transportation technology, including the
explosive emergence of the “Internet of ings.”
Communications Perhaps the single most important innovation since World War II has been the development of the microprocessor, which enabled the explosive growth of high-power, low-cost computing,
vastly increasing the amount of information that can be processed by individuals and firms. e microprocessor
also underlies many recent advances in telecommunications technology. Over the past 30 years, global
communications have been revolutionized by developments in satellite, optical fiber, wireless technologies, and
of course the Internet. ese technologies rely on the microprocessor to encode, transmit, and decode the vast
amount of information that flows along these electronic highways. e cost of microprocessors continues to
fall, while their power increases (a phenomenon known as Moore’s law, which predicts that the power of
microprocessor technology doubles and its cost of production falls in half every 18 months).15
e Internet e explosive growth of the Internet since 1994, when the first web browser was introduced, has revolutionized communications and commerce. In 1990, fewer than 1 million users were connected to the
Internet. By 1995, the figure had risen to 50 million. By 2017, the Internet had 3.8 billion users, or 51 percent
of the global population.16 us, 2017 marked the first year that more than half of the world’s population were
Internet users. It is no surprise that the Internet has developed into the information backbone of the global
economy.
In North America alone, e-commerce retail sales will surpass $520 billion in 2020 (up from almost nothing
in 1998), while global e-commerce sales surpassed $2 trillion for the first time in 2017.17 Viewed globally, the
Internet has emerged as an equalizer. It rolls back some of the constraints of location, scale, and time zones.18
e Internet makes it much easier for buyers and sellers to find each other, wherever they may be located and
whatever their size. It allows businesses, both small and large, to expand their global presence at a lower cost
than ever before. Just as important, it enables enterprises to coordinate and control a globally dispersed
production system in a way that was not possible 25 years ago.
Transportation Technology In addition to developments in communications technology, several major innovations in transportation technology have occurred since the 1950s. In economic terms, the most
important are probably the development of commercial jet aircraft and superfreighters and the introduction of
containerization, which simplifies transshipment from one mode of transport to another. e advent of
commercial jet travel, by reducing the time needed to get from one location to another, has effectively shrunk
the globe. In terms of travel time, New York is now “closer” to Tokyo than it was to Philadelphia in the colonial
days.
Containerization has revolutionized the transportation business, significantly lowering the costs of shipping
goods over long distances. Because the international shipping industry is responsible for carrying about 90
percent of the volume of world trade in goods, this has been an extremely important development.19 Before the
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advent of containerization, moving goods from one mode of transport to another was very labor intensive,
lengthy, and costly. It could take days and several hundred longshore workers to unload a ship and reload goods
onto trucks and trains. With the advent of widespread containerization in the 1970s and 1980s, the whole
process can now be executed by a handful of longshore workers in a couple of days. As a result of the efficiency
gains associated with containerization, transportation costs have plummeted, making it much more economical
to ship goods around the globe, thereby helping drive the globalization of markets and production. Between
1920 and 1990, the average ocean freight and port charges per ton of U.S. export and import cargo
fell from $95 to $29 (in 1990 dollars).20 Today, the typical cost of transporting a 20-foot container
from Asia to Europe carrying more than 20 tons of cargo is about the same as the economy airfare for a single
passenger on the same journey.
Implications for the Globalization of Production As transportation costs associated with the globalization of production have declined, dispersal of production to geographically separate locations has
become more economical. As a result of the technological innovations discussed earlier, the real costs of
information processing and communication have fallen dramatically in the past two decades. ese
developments make it possible for a firm to create and then manage a globally dispersed production system,
further facilitating the globalization of production. A worldwide communications network has become essential
for many international businesses. For example, Dell uses the Internet to coordinate and control a globally
dispersed production system to such an extent that it holds only three days’ worth of inventory at its assembly
locations. Dell’s Internet-based system records orders for computer equipment as they are submitted by
customers via the company’s website and then immediately transmits the resulting orders for components to
various suppliers around the world, which have a real-time look at Dell’s order flow and can adjust their
production schedules accordingly. Given the low cost of airfreight, Dell can use air transportation to speed up
the delivery of critical components to meet unanticipated demand shifts without delaying the shipment of final
product to consumers. Dell has also used modern communications technology to outsource its customer service
operations to India. When U.S. customers call Dell with a service inquiry, they are routed to Bangalore in
India, where English-speaking service personnel handle the call.
Implications for the Globalization of Markets In addition to the globalization of production, technological innovations have facilitated the globalization of markets. Low-cost global communications
networks, including those built on top of the Internet, are helping create electronic global marketplaces. As
noted earlier, low-cost transportation has made it more economical to ship products around the world, thereby
helping create global markets. In addition, low-cost jet travel has resulted in the mass movement of people
between countries. is has reduced the cultural distance between countries and is bringing about some
convergence of consumer tastes and preferences. At the same time, global communications networks and global
media are creating a worldwide culture. U.S. television networks such as CNN and HBO are now received in
many countries, Hollywood films are shown the world over, while non-U.S. news networks such as the BBC
and Al Jazeera also have a global footprint. In any society, the media are primary conveyors of culture; as global
media develop, we must expect the evolution of something akin to a global culture. A logical result of this
evolution is the emergence of global markets for consumer products. Clear signs of this are apparent. It is now
as easy to find a McDonald’s restaurant in Tokyo as it is in New York, to buy an iPad in Rio as it is in Berlin,
and to buy Gap jeans in Paris as it is in San Francisco.
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to
learnsmartadvantage.com for help.
Despite these trends, we must be careful not to overemphasize their importance. While modern
communications and transportation technologies are ushering in the “global village,” significant national
differences remain in culture, consumer preferences, and business practices. A firm that ignores differences
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among countries does so at its peril. We shall stress this point repeatedly throughout this text and elaborate on
it in later chapters.
e Changing Demographics of the Global Economy
LO 1-3 Describe the changing nature of the global economy.
Hand in hand with the trend toward globalization has been a fairly dramatic change in the demographics of the
global economy over the past decades. Half a century ago, four facts described the demographics of the global
economy. e first was U.S. dominance in the world economy and world trade picture. e second was U.S.
dominance in world foreign direct investment. Related to this, the third fact was the dominance of large,
multinational U.S. firms on the international business scene. e fourth was that roughly half the globe—the
centrally planned economies of the communist world—was off-limits to Western international businesses. All
four of these facts have changed rapidly.
THE CHANGING WORLD OUTPUT AND WORLD TRADE PICTURE
In the early 1960s, the United States was still by far the world’s dominant industrial power. In 1960, the United
States accounted for 38.3 percent of world output, measured by gross domestic product (GDP). By 2018, the
United States accounted for 24 percent of world output, with China now at 15.2 percent of world output and
the global leader in this category (see Table 1.2). e United States was not the only developed nation to see its
relative standing slip. e same occurred to Germany, France, Italy, the United Kingdom, and Canada—as just
a few examples. ese were all nations that were among the first to industrialize globally.
1.2 TABLE
Changing Demographics of World Output and World Exports
Sources: Output data from World Bank database, 2019. Trade data from WTO Statistical Database, 2019.
Of course, the change in the U.S. position was not an absolute decline because the U.S. economy grew
significantly between 1960 and 2018 (the economies of Germany, France, Italy, the United Kingdom, and
Canada also grew during this time). Rather, it was a relative decline, reflecting the faster economic growth of
several other economies, particularly China as well as several other nations in Asia. For example, as can be seen
from Table 1.2, from 1960 to today, China’s share of world output increased from a trivial amount to 15.2
percent, making it the world’s second largest economy in terms of its share in world output (the U.S. is still the
Page 18
largest economy overall). Other countries that markedly increased their share of world output included Japan,
ailand, Malaysia, Taiwan, Brazil, and South Korea.
By the end of the 1980s, the U.S. position as the world’s leading trading nation was being challenged. Over
the past 30 years, U.S. dominance in export markets has waned as Japan, Germany, and a number of newly
industrialized countries such as South Korea and China have taken a larger share of world exports. During the
1960s, the United States routinely accounted for 20 percent of world exports of manufactured goods. But as
Table 1.2 shows, the U.S. share of world exports of goods and services has slipped to 8.2 percent, significantly
behind that of China.
As emerging economies such as Brazil, Russia, India, and China—coined the BRIC countries—continue to
grow, a further relative decline in the share of world output and world exports accounted for by the United
States and other long-established developed nations seems likely. By itself, this is not bad. e relative decline of
the United States reflects the growing economic development and industrialization of the world economy, as
opposed to any absolute decline in the health of the U.S. economy.
Most forecasts now predict a continued rise in the share of world output accounted for by developing
nations such as China, India, Russia, Indonesia, ailand, South Korea, Mexico, and Brazil and a
commensurate decline in the share enjoyed by rich industrialized countries such as the United Kingdom,
Germany, Japan, and the United States. e United Kingdom, in particular, presents an interesting case study
with Britain’s exit from the European Union (Brexit) looming. Perhaps more important, if current trends
continue, the Chinese economy could ultimately be larger than that of the United States on a purchasing power
parity basis as well, while the economy of India will become the third largest by 2030.21
Overall, the World Bank has estimated that today’s developing nations may account for more than 60
percent of world economic activity by 2025, while today’s rich nations, which currently account for
more than 55 percent of world economic activity, may account for only about 38 percent. Forecasts
are not always correct, but these suggest that a shift in the economic geography of the world is now under way,
although the magnitude of that shift is not totally evident. For international businesses, the implications of this
changing economic geography are clear: Many of tomorrow’s economic opportunities may be found in the
developing nations of the world, and many of tomorrow’s most capable competitors will probably also emerge
from these regions. A case in point has been the dramatic expansion of India’s software sector, which is profiled
in the accompanying Country Focus.
c o u n t r y F O C U S
India’s Software Sector
Some 30 years ago, a number of small software enterprises were established in Bangalore, India. Typical of these
enterprises was Infosys Technologies, which was started by seven Indian entrepreneurs with about $1,000 among them.
Infosys now has annual revenues of $10.2 billion and some 200,000 employees, but it is just one of more than 100
software companies clustered around Bangalore, which has become the epicenter of India’s fast-growing information
technology sector. From a standing start in the mid-1980s, this sector is now generating export sales of more than $100
billion.
e growth of the Indian software sector has been based on four factors. First, the country has an abundant supply of
engineering talent. Every year, Indian universities graduate some 400,000 engineers. Second, labor costs in the Indian
software sector have historically been low. As recently as 2008, the cost to hire an Indian graduate was roughly 12
percent of the cost of hiring an American graduate (however, this gap is narrowing fast with pay in the sector now only
30–40 percent less than in the United States). ird, many Indians are fluent in English, which makes coordination
between Western firms and India easier. Fourth, due to time differences, Indians can work while Americans sleep,
creating unique time efficiencies and an around-the-clock work environment.
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Initially, Indian software enterprises focused on the low end of the software industry, supplying basic software
development and testing services to Western firms. But as the industry has grown in size and sophistication, Indian firms
have moved up the market. Today, the leading Indian companies compete directly with the likes of IBM and EDS for
large software development projects, business process outsourcing contracts, and information technology consulting
services. Over the past 15 years, these markets have boomed, with Indian enterprises capturing a large slice of the pie.
One response of Western firms to this emerging competitive threat has been to invest in India to garner the same kind
of economic advantages that Indian firms enjoy. IBM, for example, has invested $2 billion in its Indian operations and
now has 150,000 employees located there, more than in any other country. Microsoft, too, has made major investments
in India, including a research and development (R&D) center in Hyderabad that employs 4,000 people and was located
there specifically to tap into talented Indian engineers who did not want to move to the United States.
Sources: “Ameerpet, India’s Unofficial IT Training Hub,” e Economist, March 30, 2017; “America’s Pain, India’s Gain: Outsourcing,” e Economist, January 11, 2003, p. 59; “e World Is Our Oyster,” e Economist, October 7, 2006, pp. 9–10; “IBM and Globalization: Hungry Tiger, Dancing Elephant,” e Economist, April 7, 2007, pp. 67–69; P. Mishra, “New Billing Model May Hit India’s Software Exports,” Live Mint, February 14, 2013; and “India’s Outsourcing Business: On the Turn,” e Economist, January 19, 2013.
THE CHANGING FOREIGN DIRECT INVESTMENT PICTURE
Reflecting the dominance of the United States in the global economy, U.S. firms accounted for 66.3 percent of
worldwide foreign direct investment flows in the 1960s. British firms were second, accounting for 10.5 percent,
while Japanese firms were a distant eighth, with only 2 percent. e dominance of U.S. firms was so great that
books were written about the economic threat posed to Europe by U.S. corporations.22 Several European
governments, most notably France, talked of limiting inward investment by U.S. firms.
However, as the barriers to the free flow of goods, services, and capital fell, and as other countries increased
their shares of world output, non-U.S. firms increasingly began to invest across national borders. e
motivation for much of this foreign direct investment by non-U.S. firms was the desire to disperse production
activities to optimal locations and to build a direct presence in major foreign markets. us, beginning in the
1970s, European and Japanese firms began to shift labor-intensive manufacturing operations from their home
markets to developing nations where labor costs were lower. In addition, many Japanese firms invested in North
America and Europe—often as a hedge against unfavorable currency movements and the possible imposition of
trade barriers. For example, Toyota, the Japanese automobile company, rapidly increased its investment in
automobile production facilities in the United States and Europe during the late 1980s and 1990s. Toyota
executives believed that an increasingly strong Japanese yen would price Japanese automobile exports
out of foreign markets; therefore, production in the most important foreign markets, as opposed to
exports from Japan, made sense. Toyota also undertook these investments to head off growing political
pressures in the United States and Europe to restrict Japanese automobile exports into those markets.
One consequence of these developments is illustrated in Figure 1.3, which shows how the stock of foreign
direct investment by the United States, China, Japan, United Kingdom, European Union countries, Developed
Economies, and the World changed between 1995 and today. (e stock of foreign direct investment (FDI)
refers to the total cumulative value of foreign investments as a percentage of the country’s GDP.) As expected, in
all cases in Figure 1.3, we invest more today outside of our own country than we did in 1995. For example, in
1995 the stock of FDI held by U.S. firms was equivalent to 17.8 percent of U.S. GDP; today the figure is 34.4
percent. Collectively, the global stock of FDI is now equal to 34.6% of global GDP, an increase from 12.8% in
1995. Bottom line, the world is becoming more globalized in investment mentality and opportunities are no
longer as restricted to the home country of a firm as they used to be even as recently as 1995.
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1.3 FIGURE
Share of FDI outward stock as a percentage of GDP.
Sources: OECD data 2017, FDI stocks.
Figure 1.4 illustrates two other important trends—the sustained growth in cross-border flows of foreign
direct investment that has occurred since 1990 and the increasing importance of developing nations as the
destination of foreign direct investment. roughout the 1990s, the amount of investment directed at both
developed and developing nations increased dramatically, a trend that reflects the increasing internationalization
of business corporations. A surge in foreign direct investment from 1998 to 2000 was followed by a slump from
2001 to 2004, associated with a slowdown in global economic activity after the collapse of the financial bubble
of the late 1990s and 2000. e growth of foreign direct investment resumed at “normal” levels for that time in
2005 and continued upwards through 2007, when it hit record levels, only to slow again in 2008 and 2009 as
the global financial crisis took hold. However, throughout this period, the growth of foreign direct investment
into developing nations remained robust. Among developing nations, the largest recipient has been
China, which received about $250 billion in inflows last year. As we shall see later in this text, the
sustained flow of foreign investment into developing nations is an important stimulus for economic growth in
those countries, which bodes well for the future of countries such as China, Mexico, and Brazil—all leading
beneficiaries of this trend.
1.4 FIGURE
FDI inflows (in millions of dollars).
Source: United Nations Conference on Trade and Development, World Investment Report 2018. (Data for 2019–2020 are forecast.)
THE CHANGING NATURE OF THE MULTINATIONAL ENTERPRISE
A multinational enterprise (MNE) is any business that has productive activities in two or more countries. In
the last half a century, two notable trends in the demographics of the multinational enterprise have been (1) the
rise of non-U.S. multinationals and (2) the growth of mini-multinationals.
Non-U.S. Multinationals In the 1960s, global business activity was dominated by large U.S. multinational corporations. With U.S. firms accounting for about two-thirds of foreign direct investment
during the 1960s, one would expect most multinationals to be U.S. enterprises. According to the data
summarized in Figure 1.5, in 2003 when Forbes started compiling its ranking of the top 2000 multinational
corporations, 38.8 percent of the world’s 2000 largest multinationals were U.S. firms (776 of the 2000 on the
list). e second-largest source country was Japan with 16.6 percent of the largest multinationals. e United
Kingdom accounted for 6.6 percent of the world’s largest multinationals at the time. e large number of U.S.
multinationals has long reflected U.S. economic dominance in the half a century after World War II, while the
large number of British multinationals reflected that country’s industrial dominance in the early decades of the
twentieth century, which has carried on to some degree until today.
1.5 FIGURE
National share of largest multinational corporations.
Source: Forbes Global 2000 in 2003 and 2017.
By now, things have shifted. Some 27 percent, or 540 firms, of the top 2000 global firms are now U.S.
multinationals, a drop of 236 firms among the top 2000 global firms in only about a decade and a half. Japan
and the United Kingdom also saw drops in their firms’ inclusion among the top 2000 firms in the world.
ese shifts in powerful multinational corporations and their home bases can be expected to continue.
Specifically, we expect that even firms from developing nations will emerge as important competitors in global
markets, further shifting the axis of the world economy away from North America and Western Europe and
challenging the long dominance of companies from the so-called developed world. One such rising competitor,
the Dalian Wanda Group, is profiled in the accompanying Management Focus.
e Rise of Mini-Multinationals Another trend in international business has been the growth of small- and medium-size multinationals (mini-multinationals).23 When people think of international businesses, they
tend to think of firms such as ExxonMobil, General Motors, Ford, Panasonic, Procter & Gamble, Sony, and
Unilever—large, complex multinational corporations with operations that span the globe. Although most
international trade and investment is still conducted by large firms, many medium-size and small businesses are
becoming increasingly involved in international trade and investment. e rise of the Internet is lowering the
barriers that small firms face in building international sales.
Consider Lubricating Systems Inc. of Kent, Washington. Lubricating Systems, which manufactures
lubricating fluids for machine tools, employs 25 people, and generates sales of $6.5 million. It’s hardly a large,
complex multinational, yet more than $2 million of the company’s sales are generated by exports to a score of
Page 21
countries, including Japan, Israel, and the United Arab Emirates. Lubricating Systems has also set up a joint
venture with a German company to serve the European market.24
Consider also Lixi Inc., a small U.S. manufacturer of industrial X-ray equipment; more than half of Lixi’s
$24.4 million in revenues comes from exports to Japan.25 Or take G. W. Barth, a manufacturer of cocoa-bean
roasting machinery based in Ludwigsburg, Germany. Employing just 65 people, this small company
has captured 70 percent of the global market for cocoa-bean roasting machines.26 International
business is conducted not just by large firms but also by medium-size and small enterprises.
m a n a g e m e n t F O C U S
Wanda Group
e Dalian Wanda Group is perhaps the world’s largest real estate company, although as yet it is little known outside of
China. Established in 1988, Dalian Wanda Group is the largest owner of five-star hotels in the world. e company’s
real estate portfolio includes 133 Wanda shopping malls and 84 hotels. It also has extensive activities in the film
business, sports holdings, tourism, and children’s entertainment. e stated ambition of Dalian Wanda is to become a
world-class multinational by 2020 with assets of $200 billion, revenue of $100 billion, and net profits of $10 billion.
In 2012, Dalian Wanda made a significant step in this direction when it acquired the U.S. cinema chain AMC
Entertainment Holdings for $2.6 billion. At the time, the acquisition was the largest ever of a U.S. company by a
Chinese enterprise, surpassing the $1.8 billion takeover of IBM’s PC business by Lenovo in 2005. AMC is the second-
largest cinema operator in North America, where moviegoers spend more than $10 billion a year on tickets. After the
acquisition was completed, the headquarters of AMC remained in Kansas City. Dalian, however, indicated that it would
inject capital into AMC to upgrade its theaters to show more IMAX and 3D movies.
In 2015, Wanda followed its AMC acquisition with the purchase of Hoyts Group, an Australian cinema operator
with more than 150 cinemas. By combining AMC movie theaters with Hoyts and its already extensive movie properties
in China, Dalian Wanda has become the largest cinema operator in the world with more than 500 cinemas. is puts
Wanda in a strong position when negotiating distribution terms with movie studios.
Wanda is also expanding its international real estate operations. In 2014, it announced that it won a bid for a prime
plot of land in Beverly Hills, Los Angeles. Wanda plans to invest $1.2 billion to construct a mixed-use development.
e company also has a sizable project in Chicago, where it is investing $900 million to build the third-tallest building
in the city. In addition, Wanda has real estate projects in Spain, Australia, and London.
Today, the Wanda Group is already among the top 400 companies in the world with some 130,000 employees, $90
billion in assets, and about $45 billion in revenue.
Sources: Keith Weir, “China’s Dalian Wanda to Acquire Australia’s Hoyts for $365.7 Million,” Reuters, June 24, 2015; Zachary Mider, “China’s Wanda to Buy AMC Cinema Chain for $2.6 Billion,” Bloomberg Businessweek, May 21, 2012; and Wanda Group Corporate, www.wanda-group.com.
THE CHANGING WORLD ORDER
Historically, between 1989 and 1991, a series of democratic revolutions swept the communist world. For
reasons that are explored in more detail in Chapter 3, in country after country throughout eastern Europe and
eventually in the Soviet Union itself, Communist Party governments collapsed. e Soviet Union receded into
history, replaced by 15 independent republics. Czechoslovakia divided itself into two states, while Yugoslavia
dissolved into a bloody civil war among its five successor states.
Page 22
Which Is More Important—Similarities or Differences?
International strategy has seen significant changes in recent years. Multinational enterprises now have to evaluate their
core uniqueness and how they can drive their uniqueness to be leveraged in the global marketplace better. For some,
such thinking may represent a major shift—to focus on similarities across nations and customers instead of differences.
is could be an important shift because companies and their people are trained to look for differences and form
strategies based on satisfying the needs of customers with slight or significant differences across the globe. In the future,
we may be looking for similarities first and then focusing on the similarities that outweigh the differences in tastes,
wants, and needs. Do you agree that focusing on similarities across countries is a better way to developing strategy than
focusing on differences?
Source: globalEDGE.msu.edu/content/gbr/gbr7-2.pdf.
Since then, many of the former communist nations of Europe and Asia have seemed to share a commitment
to democratic politics and free market economics. For half a century, these countries were essentially closed to
Western international businesses. Now, they present a host of export and investment opportunities. ree
decades later, the economies of many of the former communist states are still relatively undeveloped, however,
and their continued commitment to democracy and market-based economic systems cannot be taken for
granted. Disturbing signs of growing unrest and totalitarian tendencies are seen in several eastern European and
central Asian states, including Russia, which has shown signs of shifting back toward greater state involvement
in economic activity and authoritarian government.27 us, the risks involved in doing business in such
countries are high, but so may be the returns.
In addition to these changes, quieter revolutions have been occurring in China, other states in Southeast
Asia, and Latin America. eir implications for international businesses may be just as profound as the collapse
of communism in eastern Europe and Russia some time ago. China suppressed its pro-democracy
movement in the bloody Tiananmen Square massacre of 1989. On the other hand, China continues
to move progressively toward greater free market reforms. If what is occurring in China continues for two more
decades, China may move from third-world to industrial superpower status even more rapidly than Japan did.
If China’s GDP per capita grows by an average of 6 to 7 percent, which is slower than the 8 to 10 percent
growth rate achieved during the past decade, then by 2030 this nation of 1.4 billion people could boast an
average GDP per capita of about $23,000, roughly the same as that of Chile or Poland today.
e potential consequences for international business are enormous. On the one hand, China represents a
huge and largely untapped market. Reflecting this, between 1983 and today, annual foreign direct investment
in China increased from less than $2 billion to $250 billion annually. On the other hand, China’s new firms are
proving to be very capable competitors, and they could take global market share away from Western and
Japanese enterprises (see the Management Focus on the Wanda Group). us, the changes in China are
creating both opportunities and threats for established international businesses.
As for Latin America, both democracy and free market reforms have been evident there too. For decades,
most Latin American countries were ruled by dictators, many of whom seemed to view Western international
businesses as instruments of imperialist domination. Accordingly, they restricted direct investment by foreign
firms. In addition, the poorly managed economies of Latin America were characterized by low growth, high
debt, and hyperinflation—all of which discouraged investment by international businesses. In the past two
decades, much of this has changed. roughout most of Latin America, debt and inflation are down,
governments have sold state-owned enterprises to private investors, foreign investment is welcomed, and the
region’s economies have expanded. Brazil, Mexico, and Chile have led the way. ese changes have increased
the attractiveness of Latin America, both as a market for exports and as a site for foreign direct investment. At
the same time, given the long history of economic mismanagement in Latin America, there is no guarantee that
Page 23
these favorable trends will continue. Indeed, Bolivia, Ecuador, and most notably Venezuela have seen shifts
back toward greater state involvement in industry in the past few years, and foreign investment is now less
welcome than it was during the 1990s. In these nations, the government has seized control of oil and gas fields
from foreign investors and has limited the rights of foreign energy companies to extract oil and gas from their
nations. us, as in the case of eastern Europe, substantial opportunities are accompanied by substantial risks.
GLOBAL ECONOMY OF THE TWENTY-FIRST CENTURY
e past quarter century has seen rapid changes in the global economy. Barriers to the free flow of goods,
services, and capital have been coming down. As their economies advance, more nations are joining the ranks of
the developed world. A generation ago, South Korea and Taiwan were viewed as second-tier developing nations.
Now they boast large economies, and firms based there are major players in many global industries, from
shipbuilding and steel to electronics and chemicals. e move toward a global economy has been further
strengthened by the widespread adoption of liberal economic policies by countries that had firmly opposed
them for two generations or more. In short, current trends indicate the world is moving toward an economic
system that is more favorable for international business.
But it is always hazardous to use established trends to predict the future. e world may be moving toward a
more global economic system, but globalization is not inevitable. Countries may pull back from the recent
commitment to liberal economic ideology if their experiences do not match their expectations. ere are clear
signs, for example, of a retreat from liberal economic ideology in Russia. If Russia’s hesitation were to become
more permanent and widespread, the liberal vision of a more prosperous global economy based on free market
principles might not occur as quickly as many hope. Clearly, this would be a tougher world for international
businesses.
Also, greater globalization brings with it risks of its own. is was starkly demonstrated in 1997 and 1998,
when a financial crisis in ailand spread first to other East Asian nations and then to Russia and Brazil.
Ultimately, the crisis threatened to plunge the economies of the developed world, including the United States,
into a recession. We explore the causes and consequences of this and other similar global financial crises in
Chapter 11. Even from a purely economic perspective, globalization is not all good. e opportunities for
doing business in a global economy may be significantly enhanced, but as we saw in 1997–1998, the risks
associated with global financial contagion are also greater. Indeed, during 2008–2009, a crisis that
started in the financial sector of America, where banks had been too liberal in their lending policies to
homeowners, swept around the world and plunged the global economy into its deepest recession since the early
1980s, illustrating once more that in an interconnected world a severe crisis in one region can affect the entire
globe. Still, as explained later in this text, firms can exploit the opportunities associated with globalization while
reducing the risks through appropriate hedging strategies. ese hedging strategies may also become more and
more important as the world balances globalization efforts with a potential increase in nationalistic tendencies
by some countries (e.g., recently in the United States and United Kingdom).
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e Globalization Debate
LO 1-4 Explain the main arguments in the debate over the impact of globalization.
Page 24
Is the shift toward a more integrated and interdependent global economy a good thing? Many influential
economists, politicians, and business leaders seem to think so.28 ey argue that falling barriers to international
trade and investment are the twin engines driving the global economy toward greater prosperity. ey say
increased international trade and cross-border investment will result in lower prices for goods and services. ey
believe that globalization stimulates economic growth, raises the incomes of consumers, and helps create jobs in
all countries that participate in the global trading system. e arguments of those who support globalization are
covered in detail in Chapters 6, 7, and 8. As we shall see, there are good theoretical reasons for believing that
declining barriers to international trade and investment do stimulate economic growth, create jobs, and raise
income levels. Moreover, as described in Chapters 6, 7, and 8, empirical evidence lends support to the
predictions of this theory. However, despite the existence of a compelling body of theory and evidence,
globalization has its critics.29 Some of these critics are vocal and active, taking to the streets to demonstrate
their opposition to globalization. Here, we look at the nature of protests against globalization and briefly review
the main themes of the debate concerning the merits of globalization. In later chapters, we elaborate on many
of these points.
ANTIGLOBALIZATION PROTESTS
Popular demonstrations against globalization date back to December 1999, when more than 40,000 protesters
blocked the streets of Seattle in an attempt to shut down a World Trade Organization meeting being held in the
city. e demonstrators were protesting against a wide range of issues, including job losses in industries under
attack from foreign competitors, downward pressure on the wage rates of unskilled workers, environmental
degradation, and the cultural imperialism of global media and multinational enterprises, which was seen as
being dominated by what some protesters called the “culturally impoverished” interests and values of the
United States. All of these ills, the demonstrators claimed, could be laid at the feet of globalization. e World
Trade Organization was meeting to try to launch a new round of talks to cut barriers to cross-border trade and
investment. As such, it was seen as a promoter of globalization and a target for the protesters. e protests
turned violent, transforming the normally placid streets of Seattle into a running battle between “anarchists”
and Seattle’s bemused and poorly prepared police department. Pictures of brick-throwing protesters and
armored police wielding their batons were duly recorded by the global media, which then circulated the images
around the world. Meanwhile, the WTO meeting failed to reach an agreement, and although the protests
outside the meeting halls had little to do with that failure, the impression took hold that the demonstrators had
succeeded in derailing the meetings.
Emboldened by the experience in Seattle, antiglobalization protesters have made a habit of turning up at
major meetings of global institutions. Smaller-scale protests have periodically occurred in several countries, such
as France, where antiglobalization activists destroyed a McDonald’s restaurant in 1999 to protest the
impoverishment of French culture by American imperialism (see the accompanying Country Focus for details).
While violent protests may give the antiglobalization effort a bad name, it is clear from the scale of the
demonstrations that support for the cause goes beyond a core of anarchists. Large segments of the population in
many countries believe that globalization has detrimental effects on living standards, wage rates, and the
environment. Indeed, the strong support for President Donald Trump in the 2016 U.S. election was primarily
based on his repeated assertions that trade deals had exported U.S. jobs overseas and created unemployment
and low wages in America.
c o u n t r y F O C U S
Protesting Globalization in France
It all started one night in August 1999, but it might as well have been today. Back in 1999, 10 men under the leadership
of local sheep farmer and rural activist José Bové crept into the town of Millau in central France and vandalized a
McDonald’s restaurant under construction, causing an estimated $150,000 in damage. ese were no ordinary vandals,
however, at least according to their supporters, for the “symbolic dismantling” of the McDonald’s outlet had noble aims,
or so it was claimed. e attack was initially presented as a protest against unfair American trade policies. e European
Union (EU) had banned imports of hormone-treated beef from the United States, primarily because of fears that it
might lead to health problems (although EU scientists had concluded there was no evidence of this). After a careful
review, the World Trade Organization stated the EU ban was not allowed under trading rules that the EU and United
States were party to and that the EU would have to lift it or face retaliation. e EU refused to comply, so the U.S.
government imposed a 100 percent tariff on imports of certain EU products, including French staples such as foie gras,
mustard, and Roquefort cheese. On farms near Millau, Bové and others raised sheep whose milk was used to make
Roquefort. ey felt incensed by the American tariff and decided to vent their frustrations on McDonald’s.
Bové and his compatriots were arrested and charged. About the same time in the Languedoc region of France,
California winemaker Robert Mondavi had reached agreement with the mayor and council of the village of Aniane and
regional authorities to turn 125 acres of wooded hillside belonging to the village into a vineyard. Mondavi planned to
invest $7 million in the project and hoped to produce top-quality wine that would sell in Europe and the United States
for $60 a bottle. However, local environmentalists objected to the plan, which they claimed would destroy the area’s
unique ecological heritage. José Bové, basking in sudden fame, offered his support to the opponents, and the protests
started. In May 2001, the socialist mayor who had approved the project was defeated in local elections in which the
Mondavi project had become the major issue. He was replaced by a communist, Manuel Diaz, who denounced the
project as a capitalist plot designed to enrich wealthy U.S. shareholders at the cost of his villagers and the environment.
Following Diaz’s victory, Mondavi announced he would pull out of the project. A spokesperson noted, “It’s a huge
waste, but there are clearly personal and political interests at play here that go way beyond us.”
So, are the French opposed to foreign investment? e experience of McDonald’s and Mondavi seems to suggest so,
as does the associated news coverage, but look closer and a different reality seems to emerge. Today, McDonald’s has
more than 1,200 restaurants in France. McDonald’s employs 69,000 workers in the country. France is the most
profitable market for McDonald’s after the United States. In short, 20 years after the protests, France is a major success
story for McDonald’s. Moreover, France has long been one of the most favored locations for inward foreign direct
investment, receiving more than $700 billion of foreign investment between 2000 and 2017, which makes it one of the
top destinations for foreign investment in Europe. American companies have always accounted for a significant
percentage of this investment. French enterprises have also been significant foreign investors; some 1,100 French
multinationals have about $1.1 trillion of assets in other nations. For all of the populist opposition to globalization,
French corporations and consumers appear to be embracing it.
Sources: “Behind the Bluster,” e Economist, May 26, 2001; “e French Farmers’ Anti-Global Hero,” e Economist, July 8, 2000; C. Trueheart, “France’s Golden Arch Enemy?” Toronto Star, July 1, 2000; J. Henley, “Grapes of Wrath Scare Off U.S. Firm,” e Economist, May 18, 2001, p. 11; United Nations, World Investment Report, 2014 (New York & Geneva: United Nations, 2011); and Rob Wile, “e True Story of How McDonald’s Conquered France,” Business Insider, August 22, 2014.
Both theory and evidence suggest that many of these fears are exaggerated; both politicians and
businesspeople need to do more to counter these fears. Many protests against globalization are tapping into a
general sense of loss at the passing of a world in which barriers of time and distance, and significant differences
in economic institutions, political institutions, and the level of development of different nations produced a
world rich in the diversity of human cultures. However, while the rich citizens of the developed world may have
the luxury of mourning the fact that they can now see McDonald’s restaurants and Starbucks coffeehouses on
their vacations to exotic locations such as ailand, fewer complaints are heard from the citizens of those
countries, who welcome the higher living standards that progress brings.
GLOBALIZATION, JOBS, AND INCOME
One concern frequently voiced by globalization opponents is that falling barriers to international trade destroy
manufacturing jobs in wealthy advanced economies such as the United States and Western Europe. Critics
argue that falling trade barriers allow firms to move manufacturing activities to countries where wage rates are
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much lower.30 Indeed, due to the entry of China, India, and states from eastern Europe into the global trading
system, along with global population growth, the pool of global labor has increased more than fivefold between
1990 and today. Other things being equal, we might conclude that this enormous expansion in the global labor
force, when coupled with expanding international trade, would have depressed wages in developed nations.
is fear is often supported by anecdotes. For example, D. L. Bartlett and J. B. Steele, two
journalists for the Philadelphia Inquirer who gained notoriety for their attacks on free trade, cite the case of
Harwood Industries, a U.S. clothing manufacturer that closed its U.S. operations, where it paid workers $9 per
hour, and shifted manufacturing to Honduras, where textile workers received 48 cents per hour.31 Because of
moves such as this, argue Bartlett and Steele, the wage rates of poorer Americans have fallen significantly over
the past quarter of a century.
In the past few years, the same fears have been applied to services, which have increasingly been outsourced
to nations with lower labor costs. e popular feeling is that when corporations such as Dell, IBM, or
Citigroup outsource service activities to lower-cost foreign suppliers—as all three have done—they are
“exporting jobs” to low-wage nations and contributing to higher unemployment and lower living standards in
their home nations (in this case, the United States). Some U.S. lawmakers have responded by calling for legal
barriers to job outsourcing.
Supporters of globalization reply that critics of these trends miss the essential point about free trade
agreements—the benefits outweigh the costs.32 ey argue that free trade will result in countries specializing in
the production of those goods and services that they can produce most efficiently, while importing goods and
services that they cannot produce as efficiently. When a country embraces free trade, there is always some
dislocation—lost textile jobs at Harwood Industries or lost call-center jobs at Dell—but the whole economy is
better off as a result. According to this view, it makes little sense for the United States to produce textiles at
home when they can be produced at a lower cost in Honduras or China. Importing textiles from China leads to
lower prices for clothes in the United States, which enables consumers to spend more of their money on other
items. At the same time, the increased income generated in China from textile exports increases income levels
in that country, which helps the Chinese purchase more products produced in the United States, such as
pharmaceuticals from Amgen, Boeing jets, microprocessors made by Intel, Microsoft software, and Cisco
routers.
e same argument can be made to support the outsourcing of services to low-wage countries. By
outsourcing its customer service call centers to India, Dell can reduce its cost structure and thereby its prices for
computers. U.S. consumers benefit from this development. As prices for computers fall, Americans can spend
more of their money on other goods and services. Moreover, the increase in income levels in India allows
Indians to purchase more U.S. goods and services, which helps create jobs in the United States. In this manner,
supporters of globalization argue that free trade benefits all countries that adhere to a free trade regime.
If the critics of globalization are correct, three things must be shown. First, the share of national income
received by labor, as opposed to the share received by the owners of capital (e.g., stockholders and
bondholders), should have declined in advanced nations as a result of downward pressure on wage rates.
Second, even though labor’s share of the economic pie may have declined, this does not mean lower living
standards if the size of the total pie has increased sufficiently to offset the decline in labor’s share—in other
words, if economic growth and rising living standards in advanced economies have offset declines in labor’s
share (this is the position argued by supporters of globalization). ird, the decline in labor’s share of national
income must be due to moving production to low-wage countries, as opposed to improvement in production
technology and productivity.
Several studies shed light on these issues.33 First, the data suggest that over the past two decades, the share of
labor in national income has declined. However, detailed analysis suggests the share of national income enjoyed
by skilled labor has actually increased, suggesting that the fall in labor’s share has been due to a fall in the share
taken by unskilled labor. A study by the IMF suggested the earnings gap between workers in skilled and
Page 26
unskilled sectors has widened by 25 percent over the past two decades.34 Another study that focused on U.S.
data found that exposure to competition from imports led to a decline in real wages for workers who performed
unskilled tasks, while having no discernible impact on wages in skilled occupations. e same study found that
skilled and unskilled workers in sectors where exports grew saw an increase in their real wages.35 ese figures
suggest that unskilled labor in sectors that have been exposed to more efficient foreign competition probably has
seen its share of national income decline over the past three decades.
However, this does not mean that the living standards of unskilled workers in developed nations have
declined. It is possible that economic growth in developed nations has offset the fall in the share of national
income enjoyed by unskilled workers, raising their living standards. Evidence suggests that real labor
compensation has expanded in most developed nations since the 1980s, including the United States.
Several studies by the Organisation for Economic Co-operation and Development (OECD), whose members
include the 34 richest economies in the world, conclude that while the gap between the poorest and richest
segments of society in OECD countries has widened, in most countries real income levels have increased for all,
including the poorest segment. In one study, the OECD found that real household income (adjusted for
inflation) increased by 1.7 percent annually among its member states. e real income level of the poorest 10
percent of the population increased at 1.4 percent on average, while that of the richest 10 percent increased by
2 percent annually (i.e., while everyone got richer, the gap between the most affluent and the poorest sectors of
society widened). e differential in growth rates was more extreme in the United States than most other
countries. e study found that the real income of the poorest 10 percent of the population grew by just 0.5
percent a year in the United States, while that of the richest 10 percent grew by 1.9 percent annually.36
As noted earlier, globalization critics argue that the decline in unskilled wage rates is due to the migration of
low-wage manufacturing jobs offshore and a corresponding reduction in demand for unskilled workers.
However, supporters of globalization see a more complex picture. ey maintain that the weak growth rate in
real wage rates for unskilled workers owes far more to a technology-induced shift within advanced economies
away from jobs where the only qualification was a willingness to turn up for work every day and toward jobs
that require significant education and skills. ey point out that many advanced economies report a shortage of
highly skilled workers and an excess supply of unskilled workers. us, growing income inequality is a result of
the wages for skilled workers being bid up by the labor market and the wages for unskilled workers being
discounted. In fact, evidence suggests that technological change has had a bigger impact than globalization on
the declining share of national income enjoyed by labor.37 is suggests that a solution to the problem of slow
real income growth among the unskilled is to be found not in limiting free trade and globalization but in
increasing society’s investment in education to reduce the supply of unskilled workers.38
Finally, it is worth noting that the wage gap between developing and developed nations is closing as
developing nations experience rapid economic growth. For example, one estimate suggests that wages in China
will approach Western levels in two decades.39 To the extent that this is the case, any migration of unskilled
jobs to low-wage countries is a temporary phenomenon representing a structural adjustment on the way to a
more tightly integrated global economy.
GLOBALIZATION, LABOR POLICIES, AND THE ENVIRONMENT
A second source of concern is that free trade encourages firms from advanced nations to move manufacturing
facilities to less developed countries that lack adequate regulations to protect labor and the environment from
abuse by the unscrupulous.40 Globalization critics often argue that adhering to labor and environmental
regulations significantly increases the costs of manufacturing enterprises and puts them at a competitive
disadvantage in the global marketplace vis-à-vis firms based in developing nations that do not have to comply
with such regulations. Firms deal with this cost disadvantage, the theory goes, by moving their production
Page 27
facilities to nations that do not have such burdensome regulations or that fail to enforce the regulations they
have.
If this were the case, we might expect free trade to lead to an increase in pollution and result in firms from
advanced nations exploiting the labor of less developed nations.41 is argument was used repeatedly by those
who opposed the 1994 formation of the North American Free Trade Agreement (NAFTA) among Canada,
Mexico, and the United States. ey painted a picture of U.S. manufacturing firms moving to Mexico in droves
so that they would be free to pollute the environment, employ child labor, and ignore workplace safety and
health issues, all in the name of higher profits.42 Interestingly, some of the same arguments are now
materializing again with the Donald Trump presidency in the United States. Many of his followers and
supporters have been presenting similar arguments against NAFTA. Consequently, the United States, Canada,
and Mexico appear set to renegotiate a number of the agreements included in the overall NAFTA agreement.
Supporters of free trade and greater globalization express doubts about this scenario. ey argue that tougher
environmental regulations and stricter labor standards go hand in hand with economic progress.43 In general,
as countries get richer, they enact tougher environmental and labor regulations.44 Because free trade
enables developing countries to increase their economic growth rates and become richer, this should
lead to tougher environmental and labor laws. In this view, the critics of free trade have got it backward: Free
trade does not lead to more pollution and labor exploitation; it leads to less. By creating wealth and incentives
for enterprises to produce technological innovations, the free market system and free trade could make it easier
for the world to cope with pollution and population growth. Indeed, while pollution levels are rising in the
world’s poorer countries, they have been falling in developed nations. In the United States, for example, the
concentration of carbon monoxide and sulfur dioxide pollutants in the atmosphere has decreased by 60 percent
since 1978, while lead concentrations have decreased by 98 percent—and these reductions have occurred
against a background of sustained economic expansion.45
A number of econometric studies have found consistent evidence of a hump-shaped relationship between
income levels and pollution levels (see Figure 1.6.).46 As an economy grows and income levels rise, initially
pollution levels also rise. However, past some point, rising income levels lead to demands for greater
environmental protection, and pollution levels then fall. A seminal study by Grossman and Krueger found that
the turning point generally occurred before per capita income levels reached $8,000.47
1.6 FIGURE
Income levels and environmental pollution.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
While the hump-shaped relationship depicted in Figure 1.6 seems to hold across a wide range of pollutants
—from sulfur dioxide to lead concentrations and water quality—carbon dioxide emissions are an important
Page 28
exception, rising steadily with higher-income levels. Given that carbon dioxide is a heat-trapping gas and given
that there is good evidence that increased atmospheric carbon dioxide concentrations are a cause of global
warming, this should be of serious concern. e solution to the problem, however, is probably not to roll back
the trade liberalization efforts that have fostered economic growth and globalization but to get the nations of
the world to agree to policies designed to limit carbon emissions. In the view of most economists, the most
effective way to do this would be to put a price on carbon-intensive energy generation through a carbon tax. To
ensure that this tax does not harm economic growth, economists argue that it should be revenue neutral, with
increases in carbon taxes offset by reductions in income or consumption taxes.48
Although UN-sponsored talks have had reduction in carbon dioxide emissions as a central aim since the
1992 Earth Summit in Rio de Janeiro, until recently there has been little success in moving toward the
ambitious goals for reducing carbon emissions laid down in the Earth Summit and subsequent talks in Kyoto,
Japan, in 1997, Copenhagen in 2009, and Paris in 2015, for example. In part, this is because the largest
emitters of carbon dioxide, the United States and China, failed to reach agreements about how to proceed.
China, a country whose carbon emissions are increasing at a rapid rate, has until recently shown little appetite
for tighter pollution controls. As for the United States, political divisions in Congress and a culture of denial
have made it difficult for the country to even acknowledge, never mind move forward with, legislation designed
to tackle climate change. However, in late 2014, the United States and China struck a historic deal under which
both countries agreed to potentially significant reductions in carbon emissions. is was followed by a broadly
based multilateral agreement reached in Paris in 2015 that has committed the nations of the world to
carbon reduction targets. If these agreements hold, progress may be made on this important issue.
Notwithstanding this, supporters of free trade point out that it is possible to tie free trade agreements to the
implementation of tougher environmental and labor laws in less developed countries. NAFTA, for example,
was passed only after side agreements had been negotiated that committed Mexico to tougher enforcement of
environmental protection regulations. us, supporters of free trade argue that factories based in Mexico are
now cleaner than they would have been without the passage of NAFTA.49
ey also argue that business firms are not the amoral organizations that critics suggest. While there may be
some rotten apples, most business enterprises are staffed by managers who are committed to behaving in an
ethical manner and would be unlikely to move production offshore just so they could pump more pollution
into the atmosphere or exploit labor. Furthermore, the relationship between pollution, labor exploitation and
production costs may not be that suggested by critics. In general, a well-treated labor force is productive, and it
is productivity rather than base wage rates that often has the greatest influence on costs. e vision of greedy
managers who shift production to low-wage countries to exploit their labor force may be misplaced.
GLOBALIZATION AND NATIONAL SOVEREIGNTY
Another concern voiced by critics of globalization is that today’s increasingly interdependent global economy
shifts economic power away from national governments and toward supranational organizations such as the
World Trade Organization, the European Union, and the United Nations. As perceived by critics, unelected
bureaucrats now impose policies on the democratically elected governments of nation-states, thereby
undermining the sovereignty of those states and limiting the nation’s ability to control its own destiny.50
e World Trade Organization is a favorite target of those who attack the headlong rush toward a global
economy. As noted earlier, the WTO was founded in 1995 to police the world trading system established by
the General Agreement on Tariffs and Trade. e WTO arbitrates trade disputes among its 162 member states.
e arbitration panel can issue a ruling instructing a member state to change trade policies that violate GATT
regulations. If the violator refuses to comply with the ruling, the WTO allows other states to impose
appropriate trade sanctions on the transgressor. As a result, according to one prominent critic, U.S.
environmentalist, consumer rights advocate, and sometime presidential candidate Ralph Nader:
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Under the new system, many decisions that affect billions of people are no longer made by local or national
governments but instead, if challenged by any WTO member nation, would be deferred to a group of
unelected bureaucrats sitting behind closed doors in Geneva (which is where the headquarters of the WTO
are located). e bureaucrats can decide whether or not people in California can prevent the destruction of
the last virgin forests or determine if carcinogenic pesticides can be banned from their foods; or whether
European countries have the right to ban dangerous biotech hormones in meat . . . . At risk is the very basis
of democracy and accountable decision making.51
In contrast to Nader, many economists and politicians maintain that the power of supranational
organizations such as the WTO is limited to what nation-states collectively agree to grant. ey argue that
bodies such as the United Nations and the WTO exist to serve the collective interests of member states, not to
subvert those interests. Supporters of supranational organizations point out that the power of these bodies rests
largely on their ability to persuade member states to follow a certain action. If these bodies fail to serve the
collective interests of member states, those states will withdraw their support and the supranational
organization will quickly collapse. In this view, real power still resides with individual nation-states, not
supranational organizations.
GLOBALIZATION AND THE WORLD’S POOR
Critics of globalization argue that despite the supposed benefits associated with free trade and investment, over
the past 100 years or so the gap between the rich and poor nations of the world has gotten wider. In 1870, the
average income per capita in the world’s 17 richest nations was 2.4 times that of all other countries. In 1990,
the same group was 4.5 times as rich as the rest. In 2019, the 34 member states of the Organisation
for Economic Co-operation and Development (OECD), which includes most of the world’s rich
economies, had an average gross national income (GNI) per person of more than $40,000, whereas the world’s
40 least developed countries had a GNI of under $1,000 per capita—implying that income per capita in the
world’s 34 richest nations was 40 times that in the world’s 40 poorest.52
While recent history has shown that some of the world’s poorer nations are capable of rapid periods of
economic growth—witness the transformation that has occurred in some Southeast Asian nations such as South
Korea, ailand, and Malaysia—there appear to be strong forces for stagnation among the world’s poorest
nations. A quarter of the countries with a GDP per capita of less than $1,000 in 1960 had growth rates of less
than zero, and a third had growth rates of less than 0.05 percent.53 Critics argue that if globalization is such a
positive development, this divergence between the rich and poor should not have occurred.
Although the reasons for economic stagnation vary, several factors stand out, none of which has anything to
do with free trade or globalization.54 Many of the world’s poorest countries have suffered from totalitarian
governments, economic policies that destroyed wealth rather than facilitated its creation, endemic corruption,
scant protection for property rights, and prolonged civil war. A combination of such factors helps explain why
countries such as Afghanistan, Cuba, Haiti, Iraq, Libya, Nigeria, Sudan, Syria, North Korea, and Zimbabwe
have failed to improve the economic lot of their citizens during recent decades. A complicating factor is the
rapidly expanding populations in many of these countries. Without a major change in government, population
growth may exacerbate their problems. Promoters of free trade argue that the best way for these countries to
improve their lot is to lower their barriers to free trade and investment and to implement economic policies
based on free market economics.55
Many of the world’s poorer nations are being held back by large debt burdens. Of particular concern are the
40 or so “highly indebted poorer countries” (HIPCs), which are home to some 700 million people. Among
these countries, the average government debt burden has been as high as 85 percent of the value of the
economy, as measured by gross domestic product, and the annual costs of serving government debt have
consumed 15 percent of the country’s export earnings.56 Servicing such a heavy debt load leaves the
governments of these countries with little left to invest in important public infrastructure projects, such as
Page 30
education, health care, roads, and power. e result is the HIPCs are trapped in a cycle of poverty and debt that
inhibits economic development. Free trade alone, some argue, is a necessary but not sufficient prerequisite to
help these countries bootstrap themselves out of poverty. Instead, large-scale debt relief is needed for the world’s
poorest nations to give them the opportunity to restructure their economies and start the long climb toward
prosperity. Supporters of debt relief also argue that new democratic governments in poor nations should not be
forced to honor debts that were incurred and mismanaged long ago by their corrupt and dictatorial
predecessors.
In the late 1990s, a debt relief movement began to gain ground among the political establishment in the
world’s richer nations.57 Fueled by high-profile endorsements from Irish rock star Bono (who has been a tireless
and increasingly effective advocate for debt relief ), the Dalai Lama, and influential Harvard economist Jeffrey
Sachs, the debt relief movement was instrumental in persuading the United States to enact legislation in 2000
that provided $435 million in debt relief for HIPCs. More important perhaps, the United States also backed an
IMF plan to sell some of its gold reserves and use the proceeds to help with debt relief. e IMF and World
Bank have now picked up the banner and have embarked on a systematic debt relief program.
For such a program to have a lasting effect, however, debt relief must be matched by wise investment in
public projects that boost economic growth (such as education) and by the adoption of economic policies that
facilitate investment and trade. Consistent with this, in June 2005, the finance ministers from several of the
world’s richest economies (including the United States) agreed to provide enough funds to the World Bank and
IMF to allow them to cancel a further $55 billion in debt owed by the HIPCs. e goal was to enable the
HIPCs to redirect resources from debt payments to health and education programs, and for alleviating poverty.
e richest nations of the world also can help by reducing barriers to the importation of products from the
world’s poorest nations, particularly tariffs on imports of agricultural products and textiles. High-tariff barriers
and other impediments to trade make it difficult for poor countries to export more of their agricultural
production. e World Trade Organization has estimated that if the developed nations of the world
eradicated subsidies to their agricultural producers and removed tariff barriers to trade in agriculture,
this would raise global economic welfare by $128 billion, with $30 billion of that going to poor nations, many
of which are highly indebted. e faster growth associated with expanded trade in agriculture could
significantly reduce the number of people living in poverty according to the WTO.58
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Despite the large gap between the rich and poor nations, there is some evidence that progress is being made.
In 2015, the United Nations adopted what were known as the Sustainable Development Goals. ese were 17
economic and human development goals for the world. We address these goals in Chapter 5. Overall, it is hard
to escape the conclusion that globalization and lower barriers to cross-border trade and investment are major
factors in this remarkable prospect.
Managing in the Global Marketplace
LO 1-5 Understand how the process of globalization is creating opportunities and challenges
for management practice.
Much of this text is concerned with the challenges of managing in an international business. An international
business is any firm that engages in international trade or investment. A firm does not have to become a
multinational enterprise, investing directly in operations in other countries, to engage in international business,
although multinational enterprises are international businesses. All a firm has to do is export or import
Page 31
products from other countries. As the world shifts toward a truly integrated global economy, more firms—both
large and small—are becoming international businesses. What does this shift toward a global economy mean
for managers within an international business?
As their organizations increasingly engage in cross-border trade and investment, managers need to recognize
that the task of managing an international business differs from that of managing a purely domestic business in
many ways. At the most fundamental level, the differences arise from the simple fact that countries are
different. Countries differ in their cultures, political systems, economic systems, legal systems, and levels of
economic development. Despite all the talk about the emerging global village and despite the trend toward
globalization of markets and production, as we shall see in this text, many of these differences are very profound
and enduring.
Differences among countries require that an international business vary its practices country by country.
Marketing a product in Brazil may require a different approach from marketing the product in Germany;
managing U.S. workers might require different skills from managing Japanese workers; maintaining close
relations with a particular level of government may be very important in Mexico and irrelevant in Great Britain;
the business strategy pursued in Canada might not work in South Korea; and so on. Managers in an
international business must not only be sensitive to these differences but also adopt the appropriate policies and
strategies for coping with them. Much of this text is devoted to explaining the sources of these differences and
the methods for successfully coping with them.
A further way in which international business differs from domestic business is the greater complexity of
managing an international business. In addition to the problems that arise from the differences between
countries, a manager in an international business is confronted with a range of other issues that the manager in
a domestic business never confronts. e managers of an international business must decide where in the world
to site production activities to minimize costs and maximize value added. ey must decide whether it is ethical
to adhere to the lower labor and environmental standards found in many less developed nations. en they
must decide how best to coordinate and control globally dispersed production activities (which, as we shall see
later in the text, is not a trivial problem). e managers in an international business also must decide which
foreign markets to enter and which to avoid. ey must choose the appropriate mode for entering a particular
foreign country. Is it best to export its product to the foreign country? Should the firm allow a local company to
produce its product under license in that country? Should the firm enter into a joint venture with a local firm
to produce its product in that country? Or should the firm set up a wholly owned subsidiary to serve the
market in that country? As we shall see, the choice of entry mode is critical because it has major implications
for the long-term health of the firm.
Conducting business transactions across national borders requires understanding the rules governing the
international trading and investment system. Managers in an international business must also deal with
government restrictions on international trade and investment. ey must find ways to work within the limits
imposed by specific governmental interventions. As this text explains, even though many governments
are nominally committed to free trade, they often intervene to regulate cross-border trade and
investment. Managers within international businesses must develop strategies and policies for dealing with such
interventions.
Cross-border transactions also require that money be converted from the firm’s home currency into a foreign
currency and vice versa. Because currency exchange rates vary in response to changing economic conditions,
managers in an international business must develop policies for dealing with exchange rate movements. A firm
that adopts the wrong policy can lose large amounts of money, whereas one that adopts the right policy can
increase the profitability of its international transactions.
In sum, managing an international business is different from managing a purely domestic business for at
least four reasons: (1) countries are different, (2) the range of problems confronted by a manager in an
international business is wider and the problems themselves more complex than those confronted by a manager
in a domestic business, (3) an international business must find ways to work within the limits imposed by
government intervention in the international trade and investment system, and (4) international transactions
involve converting money into different currencies.
In this text, we examine all these issues in depth, paying close attention to the different strategies and
policies that managers pursue to deal with the various challenges created when a firm becomes an international
business. Chapters 2, 3, and 4 explore how countries differ from each other with regard to their political,
economic, legal, and cultural institutions. Chapter 5 takes a detailed look at the ethical issues, corporate social
responsibility, and sustainability issues that arise in international business. Chapters 6, 7, 8, and 9 look at the
global trade and investment environment within which international businesses must operate. Chapters 10 and
11 review the global monetary system. ese chapters focus on the nature of the foreign exchange market and
the emerging global monetary system. Chapters 12 and 13 explore the strategy, organization, and market entry
choices of an international business. Chapters 14, 15, 16, and 17 look at the management of various functional
operations within an international business, including exporting, importing, countertrade, production, supply
chain management, marketing, R&D, and human resources. By the time you complete this text, you should
have a good grasp of the issues that managers working in international business have to grapple with on a daily
basis, and you should be familiar with the range of strategies and operating policies available to compete more
effectively in today’s rapidly emerging global economy.
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to
learnsmartadvantage.com for help.
Key Terms
globalization, p. 6
globalization of markets, p. 6
globalization of production, p. 8
factors of production, p. 8
General Agreement on Tariffs and Trade (GATT), p. 9
World Trade Organization (WTO), p. 9
International Monetary Fund (IMF), p. 10
World Bank, p. 10
United Nations (UN), p. 10
Group of Twenty (G20), p. 10
international trade, p. 11
foreign direct investment (FDI), p. 11
Moore’s law, p. 15
stock of foreign direct investment (FDI), p. 19
multinational enterprise (MNE), p. 20
international business, p. 30
Summary
is chapter has shown how the world economy is becoming more global and reviewed the main drivers of
globalization, arguing that they seem to be thrusting nation-states toward a more tightly integrated global
economy. It looked at how the nature of international business is changing in response to the changing global
economy, discussed concerns raised by rapid globalization, and reviewed implications of rapid globalization for
individual managers. e chapter made the following points:
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1. Over the past three decades, we have witnessed the globalization of markets and production.
2. e globalization of markets implies that national markets are merging into one huge marketplace.
However, it is important not to push this view too far.
3. e globalization of production implies that firms are basing individual productive activities at the
optimal world locations for the particular activities. As a consequence, it is increasingly
irrelevant to talk about American products, Japanese products, or German products because
these are being replaced by “global” products. Or, in some cases, they are simply replaced by products
made by specific companies, such as Apple, Sony, or Microsoft products.
4. Two factors seem to underlie the trend toward globalization: declining trade barriers and changes in
communication, information, and transportation technologies.
5. Since the end of World War II, barriers to the free flow of goods, services, and capital have been lowered
significantly. More than anything else, this has facilitated the trend toward the globalization of
production and has enabled firms to view the world as a single market.
6. As a consequence of the globalization of production and markets, in the last decade, world trade has
grown faster than world output, foreign direct investment has surged, imports have penetrated more
deeply into the world’s industrial nations, and competitive pressures have increased in industry after
industry.
7. e development of the microprocessor and related developments in communication and information
processing technology have helped firms link their worldwide operations into sophisticated information
networks. Jet air travel, by shrinking travel time, has also helped link the worldwide operations of
international businesses. ese changes have enabled firms to achieve tight coordination of their
worldwide operations and to view the world as a single market.
8. In the 1960s, the U.S. economy was dominant in the world, U.S. firms accounted for most of the foreign
direct investment in the world economy, U.S. firms dominated the list of large multinationals, and
roughly half the world—the centrally planned economies of the communist world—was closed to
Western businesses.
9. By the 2020s, the U.S. share of world output will have been cut in half, with major shares now being
accounted for by European and Southeast Asian economies. e U.S. share of worldwide foreign direct
investment will have fallen by about two-thirds. U.S. multinationals will be facing competition from a
large number of multinationals. In addition, the emergence of mini-multinationals was noted.
10. One of the most dramatic developments of the past 30 years has been the collapse of communism in
eastern Europe, which has created enormous opportunities for international businesses. In addition, the
move toward free market economies in China and Latin America is creating opportunities (and threats)
for Western international businesses.
11. e benefits and costs of the emerging global economy are being hotly debated among businesspeople,
economists, and politicians. e debate focuses on the impact of globalization on jobs, wages, the
environment, working conditions, national sovereignty, and extreme poverty in the world’s poorest
nations.
12. Managing an international business is different from managing a domestic business for at least four
reasons: (a) countries are different, (b) the range of problems confronted by a manager in an international
business is wider and the problems themselves more complex than those confronted by a manager in a
domestic business, (c) managers in an international business must find ways to work within the limits
imposed by governments’ intervention in the international trade and investment system, and (d)
international transactions involve converting money into different currencies.
Critical inking and Discussion Questions
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1. Describe the shifts in the world economy over the past 30 years. What are the implications of these shifts
for international businesses based in the United Kingdom? North America? Hong Kong?
2. “e study of international business is fine if you are going to work in a large multinational enterprise,
but it has no relevance for individuals who are going to work in small firms.” Evaluate this statement.
3. How have changes in technology contributed to the globalization of markets and production? Would the
globalization of production and markets have been possible without these technological changes?
4. “Ultimately, the study of international business is no different from the study of domestic business. us,
there is no point in having a separate course on international business.” Evaluate this statement.
5. How does the Internet affect international business activity and the globalization of the world economy?
6. If current trends continue, China may be the world’s largest economy by 2035. Discuss the possible
implications of such a development for
a. the world trading system
b. the world monetary system
c. the business strategy of today’s European and U.S.-based global corporations
d. global commodity prices
7. Reread the Management Focus “Boeing’s Global Production System” and answer the following
questions:
a. What are the benefits to Boeing of outsourcing manufacturing of components of the Boeing 787 to
firms based in other countries?
b. What are the potential costs and risks to Boeing of outsourcing?
c. In addition to foreign subcontractors and Boeing, who else benefits from Boeing’s decision
to outsource component part manufacturing assembly to other nations? Who are the potential losers?
d. If Boeing’s management decided to keep all production in America, what do you think the effect
would be on the company, its employees, and the communities that depend on it?
e. On balance, do you think that the kind of outsourcing undertaken by Boeing is a good thing or a bad
thing for the American economy? Explain your reasoning.
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. As the drivers of globalization continue to pressure both the globalization of markets and the
globalization of production, we continue to see the impact of greater globalization on worldwide trade
patterns. HSBC, a large global bank, analyzes these pressures and trends to identify opportunities across
markets and sectors through its trade forecasts. Visit the HSBC Global Connections site and use the trade
forecast tool to identify which export routes are forecast to see the greatest growth over the next 15 to 20
years. What patterns do you see? What types of countries dominate these routes?
2. You are working for a company that is considering investing in a foreign country. Investing in countries
with different traditions is an important element of your company’s long-term strategic goals.
Management has requested a report regarding the attractiveness of alternative countries based on the
potential return of FDI. Accordingly, the ranking of the top 25 countries in terms of FDI attractiveness is
a crucial ingredient for your report. A colleague mentioned a potentially useful tool called the Foreign
Direct Investment (FDI) Confidence Index. e FDI Confidence Index is a regular survey of global
executives conducted by A.T. Kearney. Find this index and provide additional information regarding how
the index is constructed.
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G l o b a l i z a t i o n o f B M W, R o l l s - R o y c e , a n d t h e M I N I
c l o s i n g c a s e
Bayerische Motoren Werke, which is German for Bavarian Motor Works, is better known globally for its acronym
BMW (bmwgroup.com). BMW was created as a combination of three German manufacturing companies: Rapp
Motorenwerke and Bayerische Flugzeugwerke in Bavaria and Fahrzeugfabrik Eisenach in uringia. Aircraft engine
manufacturer Rapp Motorenwerke became Bayerische Motorenwerke in 1916, and the company added motorcycles to
its product repertoire in 1923. BMW expanded to automobiles in 1929 when it purchased Fahrzeugfabrik Eisenach,
which built Austin 7 cars under a license from Dixi. Fittingly, the first BMW car was called the BMW Dixi.
Globally, BMW is known for streamlined design, incredible luxury, and top-notch performance. e company has
more than 125,000 employees, delivers about 2.4 million vehicles annually, and has a revenue of €95 billion (about
$103 billion in U.S. dollars). Its leadership spans products in automobiles, motorcycles, and aircraft engines. Innovation
is one of the main success factors for the BMW Group, and innovation is infused into all of BMW’s product lines. e
company claims that focusing on the future is an important part of BMW’s identity and day-to-day work, and the
reason for its global success. In addition to the well-known BMW brand, BMW also owns the iconic Rolls-Royce brand
and the distinctive MINI automobiles.
BMW and “driving pleasure” are synonymous, even by people not owning a BMW! BMW creates driving pleasure
from the perfect combination of dynamic, sporty performance; ground-breaking innovations; and breath-taking design.
With a range of car models, a unique feature of BMW is its “M” designation models that takes the “driving pleasure” to
another level. BMW “M” (for Motorsport) was initially created to facilitate BMW’s racing program but has since
become a supplement to BMW’s vehicles portfolio with specially modified higher trim features. BMW M is part of an
outstanding motorsports heritage and stands for high performance out of passion, with the latest addition to the line
being the BMW M760. It’s the evolutionary link that connects BMW and Rolls-Royce, bridging the gap between the 7
Series and the entry-level Rolls-Royce Ghost.
Rolls-Royce is considered the most exclusive luxury automobile brand in the world. is reputation is rooted in the
brand’s long history and rich tradition. Rolls-Royce delivers the promise of effortless power, luxury, quality, and perfect
sanctuary. e entry-level Rolls-Royce Ghost carries a price tag around $250,000, and the models escalate from that
price point. Rolls-Royce has, from its early days of daring experimentation, created a vision for luxury that is rooted in
constantly chasing perfection. is perfection drives the supreme quality, exquisite hand craftsmanship, and attention to
the finest detail to maintain its global position as the pinnacle luxury automobile manufacturer in the world. Like Rolls-
Royce, the MINI also traces its roots to the United Kingdom.
MINI is a car brand owned by BMW that specializes in small cars. e full platform of MINI cars is small, with the
idea of maximizing the experience and concentrating on the essential. A long-standing attention to clever
solutions with distinctive designs unlocks urban driving and caters to customers’ individual needs. e most
iconic is the MINI Cooper, named after British racing legend John Cooper. e MINI Cooper product line has a
uniquely sporting blend of classic British mini-car heritage and appeal with precise German engineering and
construction. According to the MINI team, they are targeting affluent urban dwellers in their 20s and 30s who enjoy
the fun, freedom, and individuality that the MINI cars offer—or perhaps we should just say they target newly graduated
college students living in cities!
©jvdwolf/123RF
To help with its targeting of affluent urban dwellers for the MINI or the even more affluent clientele for the BMW or
Rolls-Royce, the BMW Group’s leaders have studied brands outside of the automobile industry to create the company’s
future retail strategy. Enter the “product genius.” BMW’s product genius is a noncommissioned car expert who will
spend whatever time it takes or is needed to educate customers about their car choices, options, and any issue that the
customer wants to get more information on. is shifts the “performance” from closing the sale of a car to making the
customer satisfied, which lessens the typical pressure most customers feel when walking in to a car dealership (and
likewise lessens the pressure of the salesperson to sell a car to get commission).
Sources: Jonathan M. Gitlin, “e 2017 BMW M760i Is a Hell of a Car, but Is It an M?” ARS Technica, February 8, 2017; “BMW at 100:
Bavarian Rhapsody,” e Economist, March 12, 2016; Carmine Gallo, “BMW Radically Rethinks the Car Buying Experience,” Forbes, April 18,
2014; “How German Cars Beat British Motors—and Kept Going,” BBC News, August 2, 2013; and Hannah Elliott, “e Best Luxury Sedan Is
Still a BMW,” Bloomberg BusinessWeek, June 6, 2016.
CASE DISCUSSION QUESTIONS
1. How do you think BMW integrates its various unique brands into a global effort that works for them
(BMW, Rolls-Royce, and the MINI) across the world’s many global markets?
2. What is your reaction to the global brand of BMW when you hear the name, think of the brand, and
see the BMW vehicles on the road?
3. e Rolls-Royce chase of perfection drives the supreme quality, exquisite hand craftsmanship, and
attention to the finest detail to maintain its global position as the pinnacle luxury automobile
manufacturer in the world. How do you think the Rolls-Royce brand helps, or hurts, the other BMW
brands globally (BMW, the MINI)?
4. e MINI is a unique car offering in the BMW portfolio. It has long-standing attention to clever
solutions with distinctive designs that unlock urban driving and cater to customers’ individual needs
—at least that is what the target focus is for the MINI. Do you agree that this is the focus, and do you
think it is working as advertised globally?
Endnotes
1. omas L. Friedman, e World Is Flat (New York: Farrar, Straus and Giroux, 2005).
2. T. Levitt, “e Globalization of Markets,” Harvard Business Review, May–June 1983, pp. 92–102.
3. U.S. Department of Commerce, Internal Trade Administration, “Profile of U.S. Exporting and
Importing Companies, 2012–2013,” April 2015.
4. C. M. Draffen, “Going Global: Export Market Proves Profitable for Region’s Small Businesses,” Newsday,
March 19, 2001, p. C18.
5. See F. T. Knickerbocker, Oligopolistic Reaction and Multinational Enterprise (Boston: Harvard Business
School Press, 1973); R. E. Caves, “Japanese Investment in the U.S.: Lessons for the Economic Analysis of
Foreign Investment,” e World Economy 16 (1993), pp. 279–300.
6. I. Metthee, “Playing a Large Part,” Seattle Post-Intelligencer, April 9, 1994, p. 13.
7. R. B. Reich, e Work of Nations (New York: Knopf, 1991).
8. United Nations, “About the United Nations,” www.un.org/en/about-un.
9. J. A. Frankel, “Globalization of the Economy,” National Bureau of Economic Research, working paper
no. 7858, 2000.
10. J. Bhagwati, Protectionism (Cambridge, MA: MIT Press, 1989).
11. F. Williams, “Trade Round Like is May Never Be Seen Again,” Financial Times, April 15, 1994, p. 8.
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12. United Nations Sustainable Development Goals, 2015, www.un.org/sustainabledevelopment/sustainable-
development-goals.
13. United Nations Conference on Trade and Development (UNCTAD), June 22, 2017.
14. United Nations, World Investment Report, 2015.
15. Moore’s law is named after Intel founder Gordon Moore.
16. Data compiled from various sources and listed at www.internetworldstats.com/stats.htm.
17. From www.census.gov/mrts/www/ecomm.html. See also S. Fiegerman, “Ecommerce Is Now a Trillion
Dollar Industry,” Mashable Business, February 5, 2013.
18. For a counterpoint, see “Geography and the Net: Putting It in Its Place,” e Economist, August 11,
2001, pp. 18–20.
19. International Chamber of Shipping, Key Facts, www.ics-shipping.org/shipping-facts/key-facts.
20. Frankel, “Globalization of the Economy.”
21. Raj Kumar Ray, “India’s Economy to Become 3rd Largest, Surpass Japan, Germany by 2030,” Hindustan
Times, April 28, 2017.
22. N. Hood and J. Young, e Economics of the Multinational Enterprise (New York: Longman,
1973).
23. S. Chetty, “Explosive International Growth and Problems of Success Among Small and Medium Sized
Firms,” International Small Business Journal, February 2003, pp. 5–28.
24. R. A. Mosbacher, “Opening Up Export Doors for Smaller Firms,” Seattle Times, July 24, 1991, p. A7.
25. “Small Companies Learn How to Sell to the Japanese,” Seattle Times, March 19, 1992.
26. W. J. Holstein, “Why Johann Can Export, but Johnny Can’t,” BusinessWeek, November 3, 1991.
Archived at www.businessweek.com/stories/1991-11-03/why-johann-can-export-but-johnny-cant.
27. N. Buckley and A. Ostrovsky, “Back to Business—How Putin’s Allies Are Turning Russia into a
Corporate State,” Financial Times, June 19, 2006, p. 11.
28. J. E. Stiglitz, Globalization and Its Discontents (New York: W. W. Norton, 2003); J. Bhagwati, In Defense
of Globalization (New York: Oxford University Press, 2004); Friedman, e World Is Flat.
29. See, for example, Ravi Batra, e Myth of Free Trade (New York: Touchstone Books, 1993); William
Greider, One World, Ready or Not: e Manic Logic of Global Capitalism (New York: Simon & Schuster,
1997); D. Radrik, Has Globalization Gone Too Far? (Washington, DC: Institution for International
Economics, 1997).
30. E. Goldsmith, “e Winners and the Losers,” in e Case Against the Global Economy, ed. J. Mander and
E. Goldsmith (San Francisco: Sierra Club, 1996); Lou Dobbs, Exporting America (New York: Time
Warner Books, 2004).
31. D. L. Bartlett and J. B. Steele, “America: Who Stole the Dream,” Philadelphia Inquirer, September 9,
1996.
32. For example, see Paul Krugman, Pop Internationalism (Cambridge, MA: MIT Press, 1996).
33. For example, see B. Milanovic and L. Squire, “Does Tariff Liberalization Increase Wage Inequality?”
National Bureau of Economic Research, working paper no. 11046, January 2005; B. Milanovic, “Can
We Discern the Effect of Globalization on Income Distribution?” World Bank Economic Review 19
(2005), pp. 21–44. Also see the summary in omas Piketty, “e Globalization of Labor,” in Capital in
the Twenty First Century (Cambridge, MA: Harvard University Press, 2014).
34. See Piketty, “e Globalization of Labor.”
35. A. Ebenstein, A. Harrison, M. McMillam, and S. Phillips, “Estimating the Impact of Trade and
Offshoring on American Workers Using the Current Population Survey,” Review of Economics and
Statistics 67 (October 2014), pp. 581–95.
36. M. Forster and M. Pearson, “Income Distribution and Poverty in the OECD Area,” OECD Economic
Studies 34 (2002); OECD, “Growing Income Inequality in OECD Countries,” OECD Forum, May 2,
2011.
37. See Piketty, “e Globalization of Labor.”
38. See Krugman, Pop Internationalism; D. Belman and T. M. Lee, “International Trade and the Performance
of U.S. Labor Markets,” in U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic
Policy Institute, 1996).
39. R. B. Freeman, “Labor Market Imbalances: Shortages, Surpluses, or What?” Volume 51, Conference
Series, Federal Reserve Bank of Boston, 2006.
40. E. Goldsmith, “Global Trade and the Environment,” in e Case Against the Global Economy, eds. J.
Mander and E. Goldsmith (San Francisco: Sierra Club, 1996).
41. P. Choate, Jobs at Risk: Vulnerable U.S. Industries and Jobs Under NAFTA (Washington, DC:
Manufacturing Policy Project, 1993).
42. P. Choate, Jobs at Risk: Vulnerable U.S. Industries and Jobs Under NAFTA (Washington, DC:
Manufacturing Policy Project, 1993).
43. B. Lomborg, e Skeptical Environmentalist (Cambridge, UK: Cambridge University Press, 2001).
44. H. Nordstrom and S. Vaughan, Trade and the Environment, World Trade Organization Special Studies No.
4 (Geneva: WTO, 1999).
45. Figures are from “Freedom’s Journey: A Survey of the 20th Century. Our Durable Planet,” e Economist,
September 11, 1999, p. 30.
46. For an exhaustive review of the empirical literature, see B. R. Copeland and M. Scott Taylor, “Trade,
Growth and the Environment,” Journal of Economic Literature, March 2004, pp. 7–77.
47. G. M. Grossman and A. B. Krueger, “Economic Growth and the Environment,” Quarterly Journal of
Economics 110 (1995), pp. 353–78.
48. For an economic perspective on climate change, see William Nordhouse, e Climate Casino (Princeton,
NJ: Yale University Press, 2013).
49. Krugman, Pop Internationalism.
50. R. Kuttner, “Managed Trade and Economic Sovereignty,” in U.S. Trade Policy and Global Growth, ed. R.
A. Blecker (New York: Economic Policy Institute, 1996).
51. Ralph Nader and Lori Wallach, “GATT, NAFTA, and the Subversion of the Democratic Process,” U.S.
Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996), pp. 93–
94.
52. Lant Pritchett, “Divergence, Big Time,” Journal of Economic Perspectives 11, no. 3 (Summer 1997), pp. 3–
18. e data are from the World Bank’s World Development Indicators, 2015.
53. Lant Pritchett, “Divergence, Big Time,” Journal of Economic Perspectives 11, no. 3 (Summer 1997), pp. 3–
18. e data are from the World Bank’s World Development Indicators, 2015.
54. W. Easterly, “How Did Heavily Indebted Poor Countries Become Heavily Indebted?” World Development,
October 2002, pp. 1677–96; J. Sachs, e End of Poverty (New York: Penguin Books, 2006).
55. See D. Ben-David, H. Nordstrom, and L. A. Winters, Trade, Income Disparity and Poverty. World Trade
Organization Special Studies No. 5 (Geneva: WTO, 1999).
56. William Easterly, “Debt Relief,” Foreign Policy, November–December 2001, pp. 20–26.
57. Jeffrey Sachs, “Sachs on Development: Helping the World’s Poorest,” e Economist, August 14, 1999,
pp. 17–20.
58. World Trade Organization, Annual Report 2003 (Geneva: WTO, 2004).
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill
Education
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2
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Part 2 National Differences
National Differences in Political, Economic, and Legal Systems
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO2-1 Understand how the political systems of countries differ.
LO2-2 Understand how the economic systems of countries differ.
LO2-3 Understand how the legal systems of countries differ.
LO2-4 Explain the implications for management practice of national differences in political economy.
Transformation in Saudi Arabia
opening case
e desert kingdom of Saudi Arabia is a rarity in the modern world, an absolute monarchy whose laws are
based upon interpretations of a religious text, the Qur’an, the holy book of Islam. Despite its adherence to an
archaic form of government, the Saudi economy has historically performed well, primarily due to the
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country’s position as the world’s largest oil exporter. In 2017, the country’s GDP per capita on a purchasing
power parity basis was $55,300, not far behind the $59,500 GDP per capita of the United States.
e oil sector accounts for around 87 percent of government revenues, 42 percent of GDP, and 90 percent
of export earnings. In times of high oil prices, the Saudi government has used oil revenues to finance a
sprawling government apparatus and to subsidize energy prices, which are among the lowest in the world. In
2014, however, oil prices collapsed, wiping out an annual government surplus. In 2015, the government
deficit ballooned to 15 percent of GDP, and it hit 20 percent of GDP in 2016, forcing the country to issue
more debt and draw down its foreign exchange reserves.
To compound matters, Saudi Arabia has a young population—some 70 percent of the population is under
the age of 30—and unemployment is high at 12 percent, a combination of factors that many see as a recipe
for social unrest. e high unemployment reflects the fact that while there are jobs available outside of the
government sector, most of them are taken by low-paid foreign workers, who account for 80 percent of the
labor force.
Following the death of his brother, in January 2015 Salman bin Abd al-Aziz Al Saud became King.
Breaking with tradition, the aging King quickly devolved substantial power to his son, crown prince
Muhammad bin Salman (commonly known as “MBS”). e young crown prince articulated a different vision
for Saudi Arabia. Known as Vision 2030, this calls for reducing the kingdom’s dependence on oil revenues,
privatizing the state-owned oil company Saudi Aramco, cutting energy and water subsidies, growing the
private sector, investing $500 billion in a new city called NEOM that will serve as a hub for private and
foreign investment, and introducing a value-added tax in order to close the government deficit. At the same
time, the crown prince is seeking to loosen the stifling moral codes that have limited cultural life and to
promote a “moderate Islam open to the world and all religions.”
Not surprisingly, this vision has met with resistance, particularly from members of the sprawling royal
family and conservative clergy who have benefited from the status quo. To counter this, the crown prince
consolidated his power, removing members of the royal family that disagreed with him and putting his allies
in positions of power. is culminated in an unprecedented shake-up in November 2017 when scores of
people, including some of the most powerful princes in the kingdom, were arrested in a massive
anticorruption sweep and jailed in, of all places, Riyadh’s opulent Ritz Carlton.
Whether this power grab will help the crown prince achieve his goals for Saudi Arabia remains to be seen.
e government has had to backtrack on plans to reduce subsidies after strong resistance from the population,
but it did introduce a 5 percent value-added tax in January 2018. Plans for the privatization of Saudi Aramco
are under way, and the government budget deficit has been cut in half since 2015—although stronger oil
prices have had a lot to do with that. Some of the stricter laws have also been relaxed. Women are now
allowed to drive and some banned cultural entertainments once seen as decadent, including going to the
cinema, may soon be allowed. In the long run though, transforming the Saudi economy will require growth in
the non-oil private sector, and that is a challenging task. Moreover, the scandal surrounding the murder of
journalist Jamal Khoshoggi by Saudi operatives in Turkey in October 2018 has at the very least potentially
weakened the power of the crown prince and the resulting fallout may constitute a significant setback to his
reform efforts. •
Sources: Asa Fitch, “Saudi Arabia Plans Record Spending in New Budget,” e Wall Street Journal, December 19, 2017; Brittany De
Lea, “Saudi Citizens Plagued by New Taxes, High Unemployment after Oil Price Collapse,” Fox Business, October 26, 2017; and
“Saudi Arabia’s Unprecedented Shake-up,” e Economist, November 5, 2017.
Introduction
International business is much more complicated than domestic business because countries differ in
many ways. Countries have different political, economic, and legal systems. ey vary significantly in
their level of economic development and future economic growth trajectory. Cultural practices can
Get Insights by Country
Page 39
vary dramatically, as can the education and skill levels of the population. All these differences can and
do have major implications for the practice of international business. ey have a profound impact on
the benefits, costs, and risks associated with doing business in different countries; the way in which
operations in different countries should be managed; and the strategy international firms should
pursue in different countries. e main function of this chapter and the next two is to develop an
awareness of and appreciation for the significance of country differences in political systems, economic
systems, legal systems, economic development, and societal culture. Another function of the three
chapters is to describe how the political, economic, legal, and cultural systems of many of the world’s
nation-states are evolving and to draw out the implications of these changes for the practice of
international business.
is chapter focuses on how the political, economic, and legal systems of countries differ.
Collectively, we refer to these systems as constituting the political economy of a country. We use the
term political economy to stress that the political, economic, and legal systems of a country are
interdependent; they interact with and influence each other, and in doing so, they affect the level of
economic well-being. In Chapter 3, we build on the concepts discussed here to explore in detail how
differences in political, economic, and legal systems influence the economic development of a nation-
state and its likely future growth trajectory. In Chapter 4, we look at differences in societal culture and
at how these differences influence the practice of international business. Moreover, as we will see in
Chapter 4, societal culture has an influence on the political, economic, and legal systems in a nation
and thus its level of economic well-being. We also discuss how the converse may occur: how political,
economic, and legal systems may also shape societal culture.
e opening case illustrates some of the issues discussed in this chapter. Saudi Arabia is an absolute
monarchy where the state controls large portions of economic activity and where laws are directly
informed by religious teachings taken from the Qur’an. In this regard, the country could not be more
different than an advanced Western nation such as the United States. At the same time, Saudi Arabia
is now actively trying to change its economic system, diversifying activity away from oil, and in doing
so seeks to attract more foreign investment, creating an opportunity for international business. To be
successful in the country, however, international businesses need to understand the political economy
and the culture of the Saudi nation. Moreover, the kind of transformation in political economy and
culture that Saudi Arabia is embarking upon is risky, and failure is possible—a fact that anyone
seeking to invest in the Kingdom needs to take into account.
e “Get Insights by
Country” section of
globalEDGE™ (globaledge.msu.edu/global-insights/by/country) is your source for information and statistical
data for nearly every country around the world (more than 200 countries). As related to Chapter 2 of the text,
globalEDGE™ has a wealth of information and data on national differences in political economy. ese
differences are available across a dozen menu categories in the country sections (e.g., economy, history,
government, culture, risk). e “Executive Memos” on each country page are also great for abbreviated
fingertip access to current information. At a minimum, we suggest that you take a look at the country pages of
the United Kingdom and Sweden because the authors of this text are from those countries—have you figured
out who is from the UK and who is from Sweden yet?
Page 40
Political Systems
LO 2-1 Understand how the political systems of countries differ.
e political system of a country shapes its economic and legal systems.1 us, we need to understand
the nature of different political systems before discussing economic and legal systems. By political
system, we mean the system of government in a nation. Political systems can be assessed according to
two dimensions. e first is the degree to which they emphasize collectivism as opposed to
individualism. e second is the degree to which they are democratic or totalitarian. ese dimensions
are interrelated; systems that emphasize collectivism tend to lean toward totalitarianism, whereas those
that place a high value on individualism tend to be democratic. However, a large gray area exists in the
middle. It is possible to have democratic societies that emphasize a mix of collectivism and
individualism. Similarly, it is possible to have totalitarian societies that are not collectivist.
COLLECTIVISM AND INDIVIDUALISM
Collectivism refers to a political system that stresses the primacy of collective goals over individual
goals.2 When collectivism is emphasized, the needs of society as a whole are generally viewed as being
more important than individual freedoms. In such circumstances, an individual’s right to do
something may be restricted on the grounds that it runs counter to “the good of society” or to “the
common good.” Advocacy of collectivism can be traced to the ancient Greek philosopher Plato (427–
347 B.C.), who, in e Republic, argued that individual rights should be sacrificed for the good of the
majority and that property should be owned in common. Plato did not equate collectivism with
equality; he believed that society should be stratified into classes, with those best suited to rule (which
for Plato, naturally, were philosophers and soldiers) administering society for the benefit of all. In
modern times, the collectivist mantle has been picked up by socialists.
Socialism Modern socialists trace their intellectual roots to Karl Marx (1818–1883), although socialist thought clearly predates Marx (elements of it can be traced to Plato). Marx argued that the
few benefit at the expense of the many in a capitalist society where individual freedoms are not
restricted. While successful capitalists accumulate considerable wealth, Marx postulated that the wages
earned by the majority of workers in a capitalist society would be forced down to subsistence levels.
He argued that capitalists expropriate for their own use the value created by workers, while paying
workers only subsistence wages in return. According to Marx, the pay of workers does not reflect the
full value of their labor. To correct this perceived wrong, Marx advocated state ownership of the basic
means of production, distribution, and exchange (i.e., businesses). His logic was that if the state
owned the means of production, the state could ensure that workers were fully compensated for their
labor. us, the idea is to manage state-owned enterprise to benefit society as a whole, rather than
individual capitalists.3
In the early twentieth century, the socialist ideology split into two broad camps. e communists
believed that socialism could be achieved only through violent revolution and totalitarian dictatorship,
whereas the social democrats committed themselves to achieving socialism by democratic
means, turning their backs on violent revolution and dictatorship. Both versions of socialism
waxed and waned during the twentieth century.
e communist version of socialism reached its high point in the late 1970s, when the majority of
the world’s population lived in communist states. e countries under Communist Party rule at that
time included the former Soviet Union; its eastern European client nations (e.g., Poland,
Czechoslovakia, Hungary); China; the southeast Asian nations of Cambodia, Laos, and Vietnam;
various African nations (e.g., Angola and Mozambique); and the Latin American nations of Cuba and
Nicaragua. By the mid-1990s, however, communism was in retreat worldwide. e Soviet Union had
collapsed and had been replaced by a collection of 15 republics, many of which were at least nominally
structured as democracies. Communism was swept out of eastern Europe by the largely bloodless
revolutions of 1989. Although China is still nominally a communist state with substantial limits to
individual political freedom, in the economic sphere, the country has moved sharply away from strict
adherence to communist ideology. Old-style communism, with state control over all economic
activity, hangs on in only a handful of small fringe states, most notably North Korea.
Social democracy also seems to have passed a high-water mark, although the ideology may prove to
be more enduring than communism. Social democracy has had perhaps its greatest influence in a
number of democratic Western nations, including Australia, Denmark, Finland, France, Germany,
Great Britain, Norway, Spain, and Sweden, where social democratic parties have often held political
power. Other countries where social democracy has had an important influence include India and
Brazil. Consistent with their Marxist roots, after World War II social democratic government in some
nations nationalized some private companies, transforming them into state-owned enterprises to be
run for the “public good rather than private profit.” is trend was most marked in Great Britain
where by the end of the 1970s state-owned companies had a monopoly in the telecommunications,
electricity, gas, coal, railway, and shipbuilding industries, as well as substantial interests in the oil,
airline, auto, and steel industries.
However, experience demonstrated that state ownership of the means of production ran counter to
the public interest. In many countries, state-owned companies performed poorly. Protected from
competition by their monopoly position and guaranteed government financial support, many became
increasingly inefficient. Individuals paid for the luxury of state ownership through higher prices and
higher taxes. As a consequence, a number of Western democracies voted many social democratic
parties out of office in the late 1970s and early 1980s. ey were succeeded by political parties, such as
Britain’s Conservative Party and Germany’s Christian Democratic Party, that were more committed to
free market economics. ese parties sold state-owned enterprises to private investors (a process
referred to as privatization). Even where social democratic parties regained the levers of power, as in
Great Britain in 1997 when the left-leaning Labor Party won control of the government, they too were
now committed to continued private ownership.
Individualism e opposite of collectivism, individualism refers to a philosophy that an individual should have freedom in his or her economic and political pursuits. In contrast to
collectivism, individualism stresses that the interests of the individual should take precedence over the
interests of the state. Like collectivism, individualism can be traced to an ancient Greek philosopher,
in this case Plato’s disciple Aristotle (384–322 B.C.). In contrast to Plato, Aristotle argued that
individual diversity and private ownership are desirable. In a passage that might have been taken from
a speech by contemporary politicians who adhere to a free market ideology, he argued that private
property is more highly productive than communal property and will thus stimulate progress.
According to Aristotle, communal property receives little care, whereas property that is owned by an
individual will receive the greatest care and therefore be most productive.
Page 41
Individualism was reborn as an influential political philosophy in the Protestant trading nations of
England and the Netherlands during the sixteenth century. e philosophy was refined in the work of
a number of British philosophers, including David Hume (1711–1776), Adam Smith (1723–1790),
and John Stuart Mill (1806–1873). Individualism exercised a profound influence on those in the
American colonies that sought independence from Great Britain. Indeed, the concept underlies the
ideas expressed in the Declaration of Independence. In the twentieth century, several Nobel
Prize–winning economists—including Milton Friedman, Friedrich von Hayek, and James
Buchanan—championed the philosophy.
What About People’s Future Rights?
Individualism versus collectivism is a centuries-old debate topic and an inherently interesting issue. For
example, does an individual’s life belong to him or her or to the community, society, or country in which he
or she resides? Most people have a direct and immediate answer, but there is no consensus on which answer,
depending on which country you reside in or which personal “compass” you subscribe to. Everyone has
tendencies toward being both individualistic and collectivistic but prefers one way more than the other. So,
which of these ideas—individualism or collectivism—do you think is correct, and which cultural belief do
you prefer and why?
Source: Objective Standard, March 3, 2014. www.theobjectivestandard.com.
Individualism is built on two central tenets. e first is an emphasis on the importance of
guaranteeing individual freedom and self-expression. e second tenet of individualism is that the
welfare of society is best served by letting people pursue their own economic self-interest, as opposed
to some collective body (such as government) dictating what is in society’s best interest. Or, as Adam
Smith put it in a famous passage from e Wealth of Nations, “an individual who intends his own gain
is led by an invisible hand to promote an end that was no part of his intention. Nor is it always worse
for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of
the society more effectually than when he really intends to promote it. is author has never known
much good done by those who effect to trade for the public good.”4
e central message of individualism, therefore, is that individual economic and political freedoms
are the ground rules on which a society should be based. is puts individualism in conflict with
collectivism. Collectivism asserts the primacy of the collective over the individual; individualism
asserts the opposite. is underlying ideological conflict shaped much of the recent history of the
world. e Cold War, for example, was in many respects a war between collectivism, championed by
the former Soviet Union, and individualism, championed by the United States. From the late 1980s
until about 2005, the waning of collectivism was matched by the ascendancy of individualism.
Democratic ideals and market economics replaced socialism and communism in many states. Since
2005, there have been some signs of a small swing back toward left-leaning socialist ideas in several
countries, including several Latin America nations such as Venezuela, Bolivia, and Paraguay, along
with Russia (see the Country Focus for details). Also, the global financial crisis of 2008–2009 caused
some reevaluation of the trends toward individualism, and it remains possible that the pendulum
might tilt back the other way.
Page 42
DEMOCRACY AND TOTALITARIANISM
Democracy and totalitarianism are at different ends of a political dimension. Democracy refers to a
political system in which government is by the people, exercised either directly or through elected
representatives. Totalitarianism is a form of government in which one person or political party
exercises absolute control over all spheres of human life and prohibits opposing political parties. e
democratic–totalitarian dimension is not independent of the individualism–collectivism dimension.
Democracy and individualism go hand in hand, as do the communist version of collectivism and
totalitarianism. However, gray areas exist; it is possible to have a democratic state in which collective
values predominate, and it is possible to have a totalitarian state that is hostile to collectivism and in
which some degree of individualism—particularly in the economic sphere—is encouraged. For
example, China and Vietnam have seen a move toward greater individual freedom in the economic
sphere, but those countries are stilled ruled by parties that have a monopoly on political power and
constrain political freedom.
Democracy e pure form of democracy, as originally practiced by several city-states in ancient Greece, is based on a belief that citizens should be directly involved in decision making. In complex,
advanced societies with populations in the tens or hundreds of millions, this is impractical. Most
modern democratic states practice representative democracy. e United States, for example, is a
constitutional republic that operates as a representative democracy. In a representative democracy,
citizens periodically elect individuals to represent them. ese elected representatives then form a
government whose function is to make decisions on behalf of the electorate. In a representative
democracy, elected representatives who fail to perform this job adequately will be voted out of office at
the next election.
c o u n t r y F O C U S
Putin’s Russia
e modern Russian state was born in 1991 after the dramatic collapse of the Soviet Union. Early in the post-
Soviet era, Russia embraced ambitious policies designed to transform a communist dictatorship with a
centrally planned economy into a democratic state with a market-based economic system. e policies,
however, were imperfectly implemented. Political reform left Russia with a strong presidency that—in
hindsight—had the ability to subvert the democratic process. On the economic front, the privatization of
many state-owned enterprises was done in such a way as to leave large shareholdings in the hands of the
politically connected, many of whom were party officials and factory managers under the old Soviet system.
Corruption was also endemic, and organized crime was able to seize control of some newly privatized
enterprises. In 1998, the poorly managed Russian economy went through a financial crisis that nearly bought
the country to its knees.
Fast-forward to 2018, and Russia still is a long way from being a modern democracy with a functioning
free market–based economic system. On the positive side, the economy grew at a healthy clip during most of
the 2000s, helped in large part by high prices for oil and gas, Russia’s largest exports (in 2013 oil and gas
accounted for 75 percent of all Russian exports). Between 2000 and 2013, Russia’s gross domestic product
(GDP) per capita more than doubled when measured by purchasing power parity. e country now boasts the
world’s 12th-largest economy. anks to government oil revenues, public debt is also low by international
standards—at just 12 percent of GDP in 2017 (in the United States, by comparison, public debt amounts to
70 percent of GDP). Indeed, Russia has run a healthy trade surplus on the back of strong oil and gas exports
for the last decade.
On the other hand, the economy is overly dependent on commodities, particularly oil and gas. is was
exposed in mid-2014 when the price of oil started to tumble as a result of rapidly increasing supply from the
United States. Between mid-2014 and early 2016, the price of oil fell from $110 a barrel to a low of around
$27 before rebounding to $50. is drove a freight train through Russia’s public finances. Much of Russia’s oil
and gas production remains in the hands of enterprises in which the state still has a significant ownership
stake. e government has a controlling ownership position in Gazprom and Rosneft, two of the country’s
largest oil and gas companies. e government used the rise in oil and gas revenues between 2004 and 2014
to increase public spending through state-led investment projects and increases in wages and pensions for
government workers. While this boosted private consumption, there has been a dearth of private investment,
and productivity growth remains low. is is particularly true among many state-owned enterprises that
collectively still account for about half of the Russian economy. Now with lower oil prices, Russia is having to
issue more debt to finance public spending.
Russian private enterprises are also hamstrung by bureaucratic red tape and endemic corruption. e
World Bank ranks Russia 92nd in the world in terms of the ease of doing business and 88th when it comes to
starting a business (for comparison, the United States is ranked 4th and 20th, respectively). Transparency
International, which ranks countries by the extent of corruption, ranked Russia 135 out of 176 nations in
2017. e state and state-owned enterprises are famous for pushing work to private enterprises that are owned
by political allies, which further subverts market-based processes.
On the political front, Russia is becoming less democratic with every passing year. Since 1999, Vladimir
Putin has exerted increasingly tight control over Russian politics, either as president or as prime minister.
Under Putin, potential opponents have been sidelined, civil liberties have been progressively reduced, and the
freedom of the press has been diminished. For example, in response to opposition protests in 2011 and 2012,
the Russian government passed laws increasing its control over the Internet, dramatically raising fines for
participating in “unsanctioned” street protests, and expanded the definition of treason to further limit
opposition activities. Vocal opponents of the régime—from business executives who do not toe the state line
to protest groups such as the punk rock protest band Pussy Riot—have found themselves jailed on dubious
charges. To make matters worse, Putin has recently been tightening his grip on the legal system. In late 2013,
Russia’s parliament, which is dominated by Putin supporters, gave the president more power to appoint and
fire prosecutors, thereby diminishing the independence of the legal system.
Freedom House, which produces an annual ranking tracking freedom in the world, classifies Russia as “not
free” and gives it low scores for political and civil liberties. Freedom House notes that in the March 2012
presidential elections, Putin benefited from preferential treatment by state-owned media, numerous abuses of
incumbency, and procedural “irregularities” during the vote count. Putin won 63.6 percent of the vote against
a field of weak, hand-chosen opponents, led by Communist Party leader Gennadiy Zyuganove, with 17.2
percent of the vote. Under a Putin-inspired 2008 constitutional amendment, the term of the presidency was
expanded from four years to six. Putin was elected to another six-year term in 2018 in an election that many
observers thought was a sham.
In 2014, Putin burnished his growing reputation for authoritarianism when he took advantage of unrest in
the neighboring country of Ukraine to annex the Crimea region and to support armed revolt by Russian-
speaking separatists in eastern Ukraine. Western powers responded to this aggression by imposing economic
sanctions on Russia. Taken together with the rapid fall in oil prices, this pushed the once-booming Russian
economy into a recession. In 2014, the economy grew by just 0.6 percent, while the Russian ruble tumbled,
losing half of its value against other major currencies. e economy contracted by 2.8 percent in 2015 and
another 0.2 percent in 2016 before growing by 1.8 percent in 2017. Despite economic weaknesses, there is no
sign that Putin’s hold on power has been diminished; in fact, quite the opposite seems to have occurred.
Sources: “Putin’s Russia: Sochi or Bust,” e Economist, February 1, 2014; “Russia’s Economy: e S Word,”
e Economist, November 9, 2013; Freedom House, “Freedom in the World 2017:
Russia,” www.freedomhouse.org; and K. Hille, “Putin Tightens Grip on Legal System,” Financial Times,
November 27, 2013.
Page 43 To guarantee that elected representatives can be held accountable for their actions by the
electorate, an ideal representative democracy has a number of safeguards that are typically
enshrined in constitutional law. ese include (1) an individual’s right to freedom of expression,
opinion, and organization; (2) a free media; (3) regular elections in which all eligible citizens are
allowed to vote; (4) universal adult suffrage; (5) limited terms for elected representatives; (6) a fair
court system that is independent from the political system; (7) a nonpolitical state bureaucracy; (8) a
nonpolitical police force and armed service; and (9) relatively free access to state information.5
Totalitarianism In a totalitarian country, all the constitutional guarantees on which representative democracies are built—an individual’s right to freedom of expression and organization, a free media,
and regular elections—are denied to the citizens. In most totalitarian states, political repression is
widespread, free and fair elections are lacking, media are heavily censored, basic civil liberties are
denied, and those who question the right of the rulers to rule find themselves imprisoned or worse.
Four major forms of totalitarianism exist in the world today. Until recently, the most widespread
was communist totalitarianism. Communism, however, is in decline worldwide, and most of the
Communist Party dictatorships have collapsed since 1989. Exceptions to this trend (so far) are China,
Vietnam, Laos, North Korea, and Cuba, although most of these states exhibit clear signs that the
Communist Party’s monopoly on political power is eroding. In many respects, the governments of
China, Vietnam, and Laos are communist in name only because those nations have adopted wide-
ranging, market-based economic reforms. ey remain, however, totalitarian states that deny many
basic civil liberties to their populations. On the other hand, there are signs of a swing back toward
communist totalitarian ideas in some states, such as Venezuela, where the government of the late Hugo
Chávez displayed totalitarian tendencies. e same is true in Russia, where the government of
Vladimir Putin has become increasingly totalitarian over time (see the Country Focus).
A second form of totalitarianism might be labeled theocratic totalitarianism. eocratic
totalitarianism is found in states where political power is monopolized by a party, group, or individual
that governs according to religious principles. e most common form of theocratic totalitarianism is
based on Islam and is exemplified by states such as Iran and Saudi Arabia. ese states limit freedom
of political and religious expression with laws based on Islamic principles.
A third form of totalitarianism might be referred to as tribal totalitarianism. Tribal totalitarianism
has arisen from time to time in African countries such as Zimbabwe, Tanzania, Uganda, and Kenya.
e borders of most African states reflect the administrative boundaries drawn by the old European
colonial powers rather than tribal realities. Consequently, the typical African country contains a
number of tribes (e.g., in Kenya there are more than 40 tribes). Tribal totalitarianism occurs when a
political party that represents the interests of a particular tribe (and not always the majority tribe)
monopolizes power. In Kenya, for example, politicians from the Kikuyu tribe have long dominated the
political system.
A fourth major form of totalitarianism might be described as right-wing totalitarianism. Right-
wing totalitarianism generally permits some individual economic freedom but restricts individual
political freedom, frequently on the grounds that it would lead to the rise of communism. A common
feature of many right-wing dictatorships is an overt hostility to socialist or communist ideas. Many
right-wing totalitarian governments are backed by the military, and in some cases, the government
may be made up of military officers. e fascist regimes that ruled Germany and Italy in the 1930s
Page 44
and 1940s were right-wing totalitarian states. Until the early 1980s, right-wing dictatorships, many of
which were military dictatorships, were common throughout Latin America (e.g., Brazil was ruled by a
military dictatorship between 1964 and 1985). ey were also found in several Asian countries,
particularly South Korea, Taiwan, Singapore, Indonesia, and the Philippines. Since the early
1980s, however, this form of government has been in retreat. Most Latin American countries
are now genuine multiparty democracies. Similarly, South Korea, Taiwan, and the Philippines have all
become functioning democracies, as has Indonesia.
Is Representative Democracy the Best Way?
Chile is a country in South America that borders the South Pacific Sea. Neighboring countries include
Argentina, Bolivia, and Peru—also representative democracies. Chile has a strategic location relative to
sealanes between the Atlantic and Pacific Oceans, including the Strait of Magellan, the Beagle Channel, and
the Drake Passage. Chile has a market-oriented economy in which the prices of goods and services are
determined in a free price system. e government system is a republic (and it returned to a democracy in
1990). e chief of state and head of government is the president. Presidential and congressional elections are
held periodically, with each election since the post-Pinochet era (which ended in 1988) being viewed as free
and fair. How often do you believe elections should be held for the head of state?
Source: http://globalEDGE.msu.edu/countries/chile/government.
Pseudo-Democracies Many of the world’s nations are neither pure democracies nor iron-clad totalitarian states. Rather they lie between pure democracies and complete totalitarian systems of
government. ey might be described as imperfect or pseudo-democracies, where authoritarian
elements have captured some or much of the machinery of state and use this in an attempt to deny
basic political and civil liberties. In the Russia of Vladimir Putin, for example, elections are still held,
people compete through the ballot box for political office, and the independent press does not always
toe the official line. However, Putin has used his position to systematically limit the political and civil
liberties of opposition groups. His control is not yet perfect, though. Voices opposing Putin are still
heard in Russia, and in theory, elections are still contested. But in practice, it is becoming increasingly
difficult to challenge a man and régime that have systematically extended their political, legal, and
economic power over the past two decades (see the Country Focus).
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Economic Systems
LO 2-2 Understand how the economic systems of countries differ.
Page 45
It should be clear from the previous section that political ideology and economic systems are
connected. In countries where individual goals are given primacy over collective goals, we are more
likely to find market-based economic systems. In contrast, in countries where collective goals are given
preeminence, the state may have taken control over many enterprises; markets in such countries are
likely to be restricted rather than free. We can identify three broad types of economic systems: a
market economy, a command economy, and a mixed economy.
MARKET ECONOMY
In the archetypal pure market economy, all productive activities are privately owned, as opposed to
being owned by the state. e goods and services that a country produces are not planned by anyone.
Production is determined by the interaction of supply and demand and signaled to producers through
the price system. If demand for a product exceeds supply, prices will rise, signaling producers to
produce more. If supply exceeds demand, prices will fall, signaling producers to produce less. In this
system, consumers are sovereign. e purchasing patterns of consumers, as signaled to producers
through the mechanism of the price system, determine what is produced and in what quantity.
For a market to work in this manner, supply must not be restricted. A supply restriction occurs
when a single firm monopolizes a market. In such circumstances, rather than increase output in
response to increased demand, a monopolist might restrict output and let prices rise. is allows the
monopolist to take a greater profit margin on each unit it sells. Although this is good for the
monopolist, it is bad for the consumer, who has to pay higher prices. It also is probably bad for the
welfare of society. Because a monopolist has no competitors, it has no incentive to search for ways to
lower production costs. Rather, it can simply pass on cost increases to consumers in the form of higher
prices. e net result is that the monopolist is likely to become increasingly inefficient, producing
high-priced, low-quality goods, and society suffers as a consequence.
Given the dangers inherent in monopoly, one role of government in a market economy is to
encourage vigorous free and fair competition between private producers. Governments do this by
banning restrictive business practices designed to monopolize a market (antitrust laws serve this
function in the United States and European Union). Private ownership also encourages vigorous
competition and economic efficiency. Private ownership ensures that entrepreneurs have a right to the
profits generated by their own efforts. is gives entrepreneurs an incentive to search for better ways of
serving consumer needs. at may be through introducing new products, by developing more efficient
production processes, by pursuing better marketing and after-sale service, or simply through managing
their businesses more efficiently than their competitors. In turn, the constant improvement in product
and process that results from such an incentive has been argued to have a major positive impact on
economic growth and development.6
COMMAND ECONOMY
In a pure command economy, the government plans the goods and services that a country produces,
the quantity in which they are produced, and the prices at which they are sold. Consistent with the
collectivist ideology, the objective of a command economy is for government to allocate resources for
“the good of society.” In addition, in a pure command economy, all businesses are state owned, the
rationale being that the government can then direct them to make investments that are in the best
interests of the nation as a whole rather than in the interests of private individuals. Historically,
Page 46
command economies were found in communist countries where collectivist goals were given priority
over individual goals. Since the demise of communism in the late 1980s, the number of command
economies has fallen dramatically. Some elements of a command economy were also evident in a
number of democratic nations led by socialist-inclined governments. France and India both
experimented with extensive government planning and state ownership, although government
planning has fallen into disfavor in both countries.
While the objective of a command economy is to mobilize economic resources for the public good,
the opposite often seems to have occurred. In a command economy, state-owned enterprises have little
incentive to control costs and be efficient because they cannot go out of business. Also, the abolition
of private ownership means there is no incentive for individuals to look for better ways to serve
consumer needs; hence, dynamism and innovation are absent from command economies. Instead of
growing and becoming more prosperous, such economies tend to stagnate.
MIXED ECONOMY
Mixed economies can be found between market and command economies. In a mixed economy,
certain sectors of the economy are left to private ownership and free market mechanisms, while other
sectors have significant state ownership and government planning. Mixed economies were once
common throughout much of the developed world, although they are becoming less so. Until the
1980s, Great Britain, France, and Sweden were mixed economies, but extensive privatization has
reduced state ownership of businesses in all three nations. A similar trend occurred in many other
countries where there was once a large state-owned sector, such as Brazil, Italy, and India (although
there are still state-owned enterprises in all of these nations). As a counterpoint, the involvement of the
state in economic activity has been on the rise again in countries such as Russia and Venezuela, where
authoritarian regimes have seized control of the political structure, typically by first winning
power through democratic means and then subverting those same structures to maintain
their grip on power.
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go
to learnsmartadvantage.com for help.
North Korean leader Kim Jong-un visiting a factory.
©AFP/Getty Images
In mixed economies, governments also tend to take into state ownership troubled firms whose
continued operation is thought to be vital to national interests. For example, in 2008 the U.S.
government took an 80 percent stake in AIG to stop that financial institution from collapsing, the
theory being that if AIG did collapse, it would have very serious consequences for the entire financial
system. e U.S. government usually prefers market-oriented solutions to economic problems, and in
the AIG case, the intention was to sell the institution back to private investors as soon as possible. e
United States also took similar action with respect to a number of other troubled private enterprises,
including Citigroup and General Motors. In all these cases, the government stake was seen as nothing
more than a short-term action designed to stave off economic collapse by injecting capital into
troubled enterprises in highly unusually circumstances. As soon as it was able to, the government sold
these stakes. In early 2010, for example, the U.S. government sold its stake in Citigroup. e
government stake in AIG was sold off in 2012, and by 2014, it had also disposed of its stake in GM.
Legal Systems
LO 2-3 Understand how the legal systems of countries differ.
e legal system of a country refers to the rules, or laws, that regulate behavior along with the
processes by which the laws are enforced and through which redress for grievances is obtained. e
legal system of a country is of immense importance to international business. A country’s laws regulate
business practice, define the manner in which business transactions are to be executed, and set down
the rights and obligations of those involved in business transactions. e legal environments of
countries differ in significant ways. As we shall see, differences in legal systems can affect the
attractiveness of a country as an investment site or market.
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Like the economic system of a country, the legal system is influenced by the prevailing political
system (although it is also strongly influenced by historical tradition). e government of a country
defines the legal framework within which firms do business, and often the laws that regulate business
reflect the rulers’ dominant political ideology. For example, collectivist-inclined totalitarian states tend
to enact laws that severely restrict private enterprise, whereas the laws enacted by governments in
democratic states where individualism is the dominant political philosophy tend to be pro-private
enterprise and pro-consumer.
Here, we focus on several issues that illustrate how legal systems can vary—and how such variations
can affect international business. First, we look at some basic differences in legal systems. Next we look
at contract law. ird, we look at the laws governing property rights with particular reference to
patents, copyrights, and trademarks. en we discuss protection of intellectual property. Finally, we
look at laws covering product safety and product liability.
DIFFERENT LEGAL SYSTEMS
ere are three main types of legal systems—or legal traditions—in use around the world: common
law, civil law, and theocratic law.
Common Law e common law system evolved in England over hundreds of years. It is now found in most of Great Britain’s former colonies, including the United States. Common law is based
on tradition, precedent, and custom. Tradition refers to a country’s legal history, precedent to cases that
have come before the courts in the past, and custom to the ways in which laws are applied in specific
situations. When law courts interpret common law, they do so with regard to these characteristics.
is gives a common law system a degree of flexibility that other systems lack. Judges in a common
law system have the power to interpret the law so that it applies to the unique circumstances of an
individual case. In turn, each new interpretation sets a precedent that may be followed in future cases.
As new precedents arise, laws may be altered, clarified, or amended to deal with new situations.
Civil Law A civil law system is based on a detailed set of laws organized into codes. When law courts interpret civil law, they do so with regard to these codes. More than 80 countries—including
Germany, France, Japan, and Russia—operate with a civil law system. A civil law system
tends to be less adversarial than a common law system because the judges rely on detailed
legal codes rather than interpreting tradition, precedent, and custom. Judges under a civil law system
have less flexibility than those under a common law system. Judges in a common law system have the
power to interpret the law, whereas judges in a civil law system have the power only to apply the law.
eocratic Law A theocratic law system is one in which the law is based on religious teachings. Islamic law is the most widely practiced theocratic legal system in the modern world, although usage
of both Hindu and Jewish law persisted into the twentieth century. Islamic law is primarily a moral
rather than a commercial law and is intended to govern all aspects of life.7 e foundation for Islamic
law is the holy book of Islam, the Koran, along with the Sunnah, or decisions and sayings of the
Prophet Muhammad, and the writings of Islamic scholars who have derived rules by analogy from the
principles established in the Koran and the Sunnah. Because the Koran and Sunnah are holy
documents, the basic foundations of Islamic law cannot be changed. However, in practice, Islamic
jurists and scholars are constantly debating the application of Islamic law to the modern world. In
reality, many Muslim countries have legal systems that are a blend of Islamic law and a common or
civil law system.
Do You Agree with the Unique System of Islamic Banking?
How can a banking system operate without interest (riba in Arabic)? e basic economic idea is that
commercial risk should be shared. In the Western approach, interest guarantees the banker a return, so on a
collateralized loan, the banker avoids much of the commercial risk that’s inherent in business. No matter what
happens to the business, the banker gets a return. In contrast, Islam requires that the banker share this
commercial risk. If the business venture is successful, the banker shares the profit. If the venture doesn’t do
well, neither does the banker. e value of community in Islam is stronger than the value of individual profit.
As a result, Islamic Banking was born in the mid-1970s and has grown ever since, now to the point of having
millions of clients, a resilient code of ethics, and engagement from many conventional banks around the
world. What do you think? Should the banker be paid regardless of entrepreneurial success, or is the Islamic
Banking system a better way to share commercial risk?
Although Islamic law is primarily concerned with moral behavior, it has been extended to cover
certain commercial activities. An example is the payment or receipt of interest, which is considered
usury and outlawed by the Koran. To the devout Muslim, acceptance of interest payments is seen as a
grave sin; the giver and the taker are equally damned. is is not just a matter of theology; in several
Islamic states, it has also become a matter of law. In the 1990s, for example, Pakistan’s Federal Shariat
Court, the highest Islamic lawmaking body in the country, pronounced interest to be un-Islamic and
therefore illegal and demanded that the government amend all financial laws accordingly. In 1999,
Pakistan’s Supreme Court ruled that Islamic banking methods should be used in the country after July
1, 2001.8 By the late 2000s, there were some 500 Islamic financial institutions in the world, and as of
2014, they collectively managed more than $1 trillion in assets. In addition to Pakistan, Islamic
financial institutions are found in many of the Gulf states, Egypt, Malaysia, and Iran.9
DIFFERENCES IN CONTRACT LAW
e difference between common law and civil law systems can be illustrated by the approach of each
to contract law (remember, most theocratic legal systems also have elements of common or civil law).
A contract is a document that specifies the conditions under which an exchange is to occur and details
the rights and obligations of the parties involved. Some form of contract regulates many business
transactions. Contract law is the body of law that governs contract enforcement. e parties to an
agreement normally resort to contract law when one party feels the other has violated either the letter
or the spirit of an agreement.
Because common law tends to be relatively ill specified, contracts drafted under a common law
framework tend to be very detailed with all contingencies spelled out. In civil law systems, however,
contracts tend to be much shorter and less specific because many of the issues are already covered in a
civil code. us, it is more expensive to draw up contracts in a common law jurisdiction, and resolving
contract disputes can be very adversarial in common law systems. But common law systems have the
advantage of greater flexibility and allow judges to interpret a contract dispute in light of the prevailing
situation. International businesses need to be sensitive to these differences; approaching a contract
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dispute in a state with a civil law system as if it had a common law system may backfire, and vice
versa.
When contract disputes arise in international trade, there is always the question of which country’s
laws to apply. To resolve this issue, a number of countries, including the United States, have
ratified the United Nations Convention on Contracts for the International Sale of Goods
(CISG). e CISG establishes a uniform set of rules governing certain aspects of the making and
performance of everyday commercial contracts between sellers and buyers who have their places of
business in different nations. By adopting the CISG, a nation signals to other adopters that it will treat
the convention’s rules as part of its law. e CISG applies automatically to all contracts for the sale of
goods between different firms based in countries that have ratified the convention, unless the parties to
the contract explicitly opt out. One problem with the CISG, however, is that as of 2016, only 83
nations had ratified the convention (the CISG went into effect in 1988).10 Some of the world’s
important trading nations, including India and the United Kingdom, have not ratified the CISG.
When firms do not wish to accept the CISG, they often opt for arbitration by a recognized
arbitration court to settle contract disputes. e most well known of these courts is the International
Court of Arbitration of the International Chamber of Commerce in Paris, which handles more than
500 requests per year from more than 100 countries.11
PROPERTY RIGHTS AND CORRUPTION
In a legal sense, the term property refers to a resource over which an individual or business holds a legal
title, that is, a resource that it owns. Resources include land, buildings, equipment, capital, mineral
rights, businesses, and intellectual property (ideas, which are protected by patents, copyrights, and
trademarks). Property rights refer to the legal rights over the use to which a resource is put and over
the use made of any income that may be derived from that resource.12 Countries differ in the extent
to which their legal systems define and protect property rights. Almost all countries now have laws on
their books that protect property rights. Even China, still nominally a communist state despite its
booming market economy, finally enacted a law to protect the rights of private property holders in
2007 (the law gives individuals the same legal protection for their property as the state has).13
However, in many countries these laws are not enforced by the authorities, and property rights are
violated. Property rights can be violated in two ways: through private action and through public
action.
Private Action In terms of violating property rights, private action refers to theft, piracy, blackmail, and the like by private individuals or groups. Although theft occurs in all countries, a weak
legal system allows a much higher level of criminal action. For example, in the chaotic period
following the collapse of communism in Russia, an outdated legal system, coupled with a weak police
force and judicial system, offered both domestic and foreign businesses scant protection from
blackmail by the “Russian Mafia.” Successful business owners in Russia often had to pay “protection
money” to the Mafia or face violent retribution, including bombings and assassinations (about 500
contract killings of businessmen occurred per year in the 1990s).14
Russia is not alone in having organized crime problems (and the situation in Russia has improved
since the 1990s). e Mafia has a long history in the United States (Chicago in the 1930s was similar
to Moscow in the 1990s). In Japan, the local version of the Mafia, known as the yakuza, runs
Page 49
protection rackets, particularly in the food and entertainment industries.15 However, there was a big
difference between the magnitude of such activity in Russia in the 1990s and its limited impact in
Japan and the United States. e difference arose because the legal enforcement apparatus, such as the
police and court system, was weak in Russia following the collapse of communism. Many other
countries from time to time have had problems similar to or even greater than those experienced by
Russia.
Public Action and Corruption Public action to violate property rights occurs when public officials, such as politicians and government bureaucrats, extort income, resources, or the property
itself from property holders. is can be done through legal mechanisms such as levying excessive
taxation, requiring expensive licenses or permits from property holders, taking assets into state
ownership without compensating the owners, or redistributing assets without compensating the prior
owners. It can also be done through illegal means, or corruption, by demanding bribes from businesses
in return for the rights to operate in a country, industry, or location.16
Corruption has been well documented in every society, from the banks of the Congo River to the
palace of the Dutch royal family, from Japanese politicians to Brazilian bankers, and from government
officials in Zimbabwe to the New York City Police Department. e government of the late Ferdinand
Marcos in the Philippines was famous for demanding bribes from foreign businesses wishing to set up
operations in that country. e same was true of government officials in Indonesia under the rule of
former President Suharto. No society is immune to corruption. However, there are systematic
differences in the extent of corruption. In some countries, the rule of law minimizes corruption.
Corruption is seen and treated as illegal, and when discovered, violators are punished by the full force
of the law. In other countries, the rule of law is weak and corruption by bureaucrats and politicians is
rife. Corruption is so endemic in some countries that politicians and bureaucrats regard it as a perk of
office and openly flout laws against corruption. is seems to have been the case in Brazil until
recently; the situation there may be evolving in a more positive direction.
According to Transparency International, an independent nonprofit organization dedicated to
exposing and fighting corruption, businesses and individuals spend some $400 billion a year
worldwide on bribes related to government procurement contracts alone.17 Transparency
International has also measured the level of corruption among public officials in different countries.18
As can be seen in Figure 2.1, the organization rated countries such as New Zealand and Sweden as
clean; it rated others, such as Russia, India, Zimbabwe and Venezuela, as corrupt. Somalia ranked last
out of all 180 countries in the survey (the country is often described as a “failed state”).
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2.1 FIGURE
Rankings of corruption by country, 2017.
Source: Constructed by the author from raw data from Transparency International, Corruption Perceptions Index 2017.
Economic evidence suggests that high levels of corruption significantly reduce the foreign direct
investment, level of international trade, and economic growth rate in a country.19 By siphoning off
profits, corrupt politicians and bureaucrats reduce the returns to business investment and, hence,
reduce the incentive of both domestic and foreign businesses to invest in that country. e lower level
of investment that results hurts economic growth. us, we would expect countries with high levels of
corruption such as Indonesia, Nigeria, and Russia to have a lower rate of economic growth
than might otherwise have been the case. A detailed example of the negative effect that
corruption can have on economic development is given in the accompanying Country Focus, which
looks at the impact of corruption on economic growth in Brazil.
c o u n t r y F O C U S
Corruption in Brazil
Brazil is the seventh-largest economy in the world with a gross domestic product of $2 trillion. e country
has a democratic government and an economy characterized by moderately free markets, although the
country’s largest oil producer (Petrobras) and one of its top banks (Banco do Brazil) are both state owned.
Many economists, however, have long felt that the country has never quite lived up to its considerable
economic potential. A major reason for this has been an endemically high level of corruption that favors those
with political connections and discourages investment by more ethical businesses.
Transparency International, a nongovernmental organization that evaluates countries based on perceptions
of how corrupt they are, ranked Brazil 96th out of the 180 countries it looked at in its 2017 report. e
problems it identifies in Brazil include public officials who demand bribes in return for awarding government
contracts and “influence peddling,” in which elected officials use their position in government to obtain favors
or preferential treatment. Consistent with this, according to a study by the World Economic Forum, Brazil
ranks 135th out of 144 countries in the proper use of public funds.
Over the last decade, several corruption scandals have come to light that serve to emphasize Brazil’s
corruption problem. In 2005, a scandal known as the mensalao (the monthly payoff scandal) broke. e
scandal started when a midlevel postal official was caught on film pocketing a modest bribe in exchange for
promises to favor certain businesses in landing government contracts. Further investigation uncovered a web
of influence peddling in which fat monthly payments were given to lawmakers willing to back government
initiatives in National Congress. After a lengthy investigation, in late 2012 some 25 politicians and business
executives were found guilty of crimes that included bribery, money laundering, and corruption.
e public uproar surrounding the mensalao scandal was just starting to die down when in March 2014
another corruption scandal captured the attention of Brazilians. is time it involved the state-owned oil
company, Petrobras. Under a scheme that seems to have been operating since 1997, construction firms
wanting to do business with Petrobras agreed to pay bribes to the company’s executives. Many of these
executives were themselves political appointees. e executives would inflate the value of contracts they
awarded, adding a 3 percent “fee,” which was effectively a kickback. e 3 percent fee was shared among
Petrobras executives, construction industry executives, and politicians. e construction companies
established shell companies to make payments and launder the money. According to prosecutors investigating
the case, the total value of bribes may have exceeded $3.7 billion.
Four former Petrobras officials and at least 23 construction company executives have been charged with
crimes that include corruption and money laundering. In addition, Brazil’s Supreme Court has given
prosecutors the go-ahead to investigate 48 current or former members of Congress, including the former
Brazilian President Fernando Collor de Mello. e Brazilian president, Dilma Rousseff, was also tainted by
the scandal. In June 2016, she was suspended from the presidency pending an impeachment trial. She was
chair of Petrobras during the time this was occurring. She is also a member of the governing Workers’ Party,
several members of which seem to have been among the major beneficiaries of the kickback scandal. Although
there is no evidence that Rousseff knew of the bribes or profited from them, her ability to govern effectively
has been severely damaged by association. e scandal has so rocked Brazil that it has pushed the country
close to a recession. In August 2016, Rousseff was impeached and removed from the presidency.
If there is a bright spot in all of this, it is that the scandals are coming to light. Backed by Supreme Court
rulings and public outrage, corrupted politicians, government officials, and business executives are being
prosecuted. In the past, that was far less likely to occur.
Sources: Will Conners and Luciana Magalhaes, “Brazil Cracks Open Vast Bribery Scandal,” e Wall Street
Journal, April 7, 2015; Marc Margolis, “In Brazil’s Trial of the Century, Lula’s Reputation Is at Stake,”
Newsweek, July 27, 2012; “e Big Oily,” e Economist, January 3, 2015; Donna Bowater, “Brazil’s
Continuing Corruption Problem,” BBC News, September 18, 2015; Simon Romero, “Dilma Rousseff Is
Ousted as Brazil’s President in Impeachment Vote,” e New York Times, August 31, 2016.
Foreign Corrupt Practices Act In the 1970s, the United States passed the Foreign Corrupt Practices Act (FCPA) following revelations that U.S. companies had bribed government officials in
foreign countries in an attempt to win lucrative contracts. is law makes it illegal to bribe a foreign
Page 51
government official to obtain or maintain business over which that foreign official has authority, and it
requires all publicly traded companies (whether or not they are involved in international trade) to keep
detailed records that would reveal whether a violation of the act has occurred. In 2012, evidence
emerged that in its eagerness to expand in Mexico, Walmart may have run afoul of the FCPA (for
details, see the Management Focus feature).
In 1997, trade and finance ministers from the member states of the Organisation for Economic
Co-operation and Development (OECD), an association of 34 major economies including
most Western economies (but not Russia, India or China), adopted the Convention on
Combating Bribery of Foreign Public Officials in International Business Transactions.20 e
convention obliges member states to make the bribery of foreign public officials a criminal offense.
Did You Know?
Did you know that it’s illegal for Americans to bribe public officials to gain business in a foreign country, even if bribery
is commonplace in that nation?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from
the authors.
m a n a g e m e n t F O C U S
Did Walmart Violate the Foreign Corrupt Practices Act?
In the early 2000s, Walmart wanted to build a new store in San Juan Teotihuacan, Mexico, barely a mile from
ancient pyramids that drew tourists from around the world. e owner of the land was happy to sell to
Walmart, but one thing stood in the way of a deal: the city’s new zoning laws. ese prohibited commercial
development in the historic area. Not to be denied, executives at the headquarters of Walmart de Mexico
found a way around the problem: ey paid a $52,000 bribe to a local official to redraw the zoning area so
that the property Walmart wanted to purchase was placed outside the commercial-free zone. Walmart then
went ahead and built the store, despite vigorous local opposition, opening it in late 2004.
A former lawyer for Walmart de Mexico subsequently contacted Walmart executives at the company’s
corporate headquarters in Bentonville, Arkansas. He told them that Walmart de Mexico routinely resorted to
bribery, citing the altered zoning map as just one example. Alarmed, executives at Walmart started their own
investigation. Faced with growing evidence of corruption in Mexico, top Walmart executives decided to
engage in damage control, rather than coming clean. Walmart’s top lawyer shipped the case files back to
Mexico and handed over responsibility for the investigation to the general council of Walmart de Mexico. is
was an interesting choice as the very same general council was alleged to have authorized bribes. e general
council quickly exonerated fellow Mexican executives, and the internal investigation was closed in 2006.
For several years nothing more happened; then, in April 2012, e New York Times published an article
detailing bribery by Walmart. e Times cited the changed zoning map and several other examples of bribery
by Walmart: for example, eight bribes totaling $341,000 enabled Walmart to build a Sam’s Club in one of
Mexico City’s most densely populated neighborhoods without a construction license, an environmental
permit, an urban impact assessment, or even a traffic permit. Similarly, thanks to nine bribe payments totaling
$765,000, Walmart built a vast refrigerated distribution center in an environmentally fragile flood basin north
of Mexico City, in an area where electricity was so scarce that many smaller developers were turned away.
Walmart responded to e New York Times article by ramping up a second internal investigation into
bribery that it had initiated in 2011. By mid-2015, there were reportedly more than 300 outside lawyers
Page 52
working on the investigation, and it had cost more than $612 million in fees. In addition, the U.S.
Department of Justice and the Securities and Exchange Commission both announced that they had started
investigations into Walmart’s practices. In November 2012, Walmart reported that its own investigation into
violations had extended beyond Mexico to include China and India. Among other things, it was looking into
the allegations by the Times that top executives at Walmart, including former CEO Lee Scott Jr., had
deliberately squashed earlier investigations. In late 2016 people familiar with the matter stated that the federal
investigation had not uncovered evidence of widespread bribery. In November 2017 it was reported that
Walmart had settled with the Justice Department and paid a $283 million fine, significantly less than had
been expected.
Sources: David Barstow, “Vast Mexican Bribery Case Hushed Up by Wal-Mart after Top Level Struggle,” e
New York Times, April 21, 2012; Stephanie Clifford and David Barstow, “Wal-Mart Inquiry Reflects Alarm on
Corruption,” e New York Times, November 15, 2012; Nathan Vardi, “Why Justice Department Could Hit
Wal-Mart Hard over Mexican Bribery Allegations,” Forbes, April 22, 2012; Phil Wahba,“Walmart Bribery
Probe by Feds Finds No Major Misconduct in Mexico,” Fortune, October 18, 2015; T. Schoenberg and
M. Robinson, “Wal-Mart Balks at Paying $600 Million in Bribery Case,” Bloomberg, October 6, 2016; and
Sue Reisinger, “Wal-Mart Reserves $283 million to Settle Mexico FCPA Case,” Corporate Counsel, November
17, 2017.
Both the U.S. law and OECD convention include language that allows exceptions known as
facilitating or expediting payments (also called grease payments or speed money), the purpose of which is
to expedite or to secure the performance of a routine governmental action.21 For example, they allow
small payments made to speed up the issuance of permits or licenses, process paperwork, or just get
vegetables off the dock and on their way to market. e explanation for this exception to general
antibribery provisions is that while grease payments are, technically, bribes, they are distinguishable
from (and, apparently, less offensive than) bribes used to obtain or maintain business because they
merely facilitate performance of duties that the recipients are already obligated to perform.
THE PROTECTION OF INTELLECTUAL PROPERTY
Intellectual property refers to property that is the product of intellectual activity, such as computer
software, a screenplay, a music score, or the chemical formula for a new drug. Patents, copyrights, and
trademarks establish ownership rights over intellectual property. A patent grants the inventor of a new
product or process exclusive rights for a defined period to the manufacture, use, or sale of
that invention. Copyrights are the exclusive legal rights of authors, composers, playwrights,
artists, and publishers to publish and disperse their work as they see fit. Trademarks are designs and
names, officially registered, by which merchants or manufacturers designate and differentiate their
products (e.g., Christian Dior clothes). In the high-technology “knowledge” economy of the twenty-
first century, intellectual property has become an increasingly important source of economic value for
businesses. Protecting intellectual property has also become increasingly problematic, particularly if it
can be rendered in a digital form and then copied and distributed at very low cost via pirated DVDs
or over the Internet (e.g., computer software, music, and video recordings).22
e philosophy behind intellectual property laws is to reward the originator of a new invention,
book, musical record, clothes design, restaurant chain, and the like for his or her idea and effort. Such
laws stimulate innovation and creative work. ey provide an incentive for people to search for novel
ways of doing things, and they reward creativity. For example, consider innovation in the
pharmaceutical industry. A patent will grant the inventor of a new drug a 20-year monopoly in
production of that drug. is gives pharmaceutical firms an incentive to undertake the expensive,
difficult, and time-consuming basic research required to generate new drugs (it can cost $1 billion in
R&D and take 12 years to get a new drug on the market). Without the guarantees provided by
patents, companies would be unlikely to commit themselves to extensive basic research.23
e protection of intellectual property rights differs greatly from country to country. Although
many countries have stringent intellectual property regulations on their books, the enforcement of
these regulations has often been lax. is has been the case even among many of the 185 countries
that are now members of the World Intellectual Property Organization, all of which have signed
international treaties designed to protect intellectual property, including the oldest such treaty, the
Paris Convention for the Protection of Industrial Property, which dates to 1883 and has been
signed by more than 170 nations. Weak enforcement encourages the piracy (theft) of intellectual
property. China and ailand have often been among the worst offenders in Asia. Pirated computer
software is widely available in China. Similarly, the streets of Bangkok, ailand’s capital, are lined
with stands selling pirated copies of Rolex watches, Levi’s jeans, DVDs, and computer software.
e computer software industry is an example of an industry that suffers from lax enforcement of
intellectual property rights. A study published in 2012 suggested that violations of intellectual
property rights cost personal computer software firms revenues equal to $63 billion a year.24
According to the study’s sponsor, the Business Software Alliance, a software industry association, some
42 percent of all software applications used in the world were pirated. One of the worst large countries
was China, where the piracy rate ran at 77 percent and cost the industry more than $9.8 billion in lost
sales, up from $444 million in 1995. e piracy rate in the United States was much lower at 19
percent; however, the value of sales lost was significant because of the size of the U.S. market.25
How Important Are Intellectual Property Rights?
Burundi is a landlocked country in the Great Lake region of eastern Africa. Neighboring countries include
Rwanda, Tanzania, and the Democratic Republic of the Congo. Burundi is hilly and mountainous, with
access to Lake Tanganyika. e government system is a republic, with the chief of state and head of
government being the president. Burundi has a traditional economic system in which the allocation of
available resources is made on the basis of primitive methods, and many citizens engage in subsistence
agriculture. At the same time, Burundi was last of the 131 countries ranked in the 2013 International
Property Rights Index (IPRI). e IPRI is conducted by a partnership of 74 international organizations. e
IPRI takes into account legal and political environment, physical property rights, and intellectual property
rights. How much should companies focus on intellectual property rights in deciding where to (1) produce
their products and (2) sell their products? Does it differ if you produce or sell in the country?
Source: www.internationalpropertyrightsindex.org.
International businesses have a number of possible responses to violations of their intellectual
property. ey can lobby their respective governments to push for international agreements to ensure
that intellectual property rights are protected and that the law is enforced. Partly as a result of such
actions, international laws are being strengthened. As we shall see in Chapter 7, the most recent world
trade agreement, signed in 1994, for the first time extends the scope of the General Agreement on
Tariffs and Trade to cover intellectual property. Under the new agreement, known as the Trade-Related
Page 53
Aspects of Intellectual Property Rights (TRIPS), as of 1995 a council of the World Trade Organization
is overseeing enforcement of much stricter intellectual property regulations. ese regulations oblige
WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years
after the death of the author. Rich countries had to comply with the rules within a year. Poor
countries, in which such protection generally was much weaker, had five years of grace, and
the very poorest have 10 years.26 (For further details of the TRIPS agreement, see Chapter 7.)
m a n a g e m e n t F O C U S
Starbucks Wins Key Trademark Case in China
Starbucks has big plans for China. It believes the fast-growing nation will become the company’s second-
largest market after the United States. Starbucks entered the country in 1999, and by the end of 2016 it had
opened more than 1,300 stores. But in China, copycats of well-established Western brands are common.
Starbucks faced competition from a look-alike, Shanghai Xing Ba Ke Coffee Shop, whose stores closely
matched the Starbucks format, right down to a green-and-white Xing Ba Ke circular logo that mimics
Starbucks’ ubiquitous logo. e name also mimics the standard Chinese translation for Starbucks. Xing means
“star,” and Ba Ke sounds like “bucks.”
In 2003, Starbucks decided to sue Xing Ba Ke in Chinese court for trademark violations. Xing Ba Ke’s
general manager responded by claiming it was just an accident that the logo and name were so similar to that
of Starbucks. He claimed the right to use the logo and name because Xing Ba Ke had registered as a company
in Shanghai in 1999, before Starbucks entered the city. “I hadn’t heard of Starbucks at the time,” claimed the
manager, “so how could I imitate its brand and logo?”
However, in January 2006, a Shanghai court ruled that Starbucks had precedence, in part because it had
registered its Chinese name in 1998. e court stated that Xing Ba Ke’s use of the name and similar logo was
“clearly malicious” and constituted improper competition. e court ordered Xing Ba Ke to stop using the
name and to pay Starbucks $62,000 in compensation. While the money involved here may be small, the
precedent is not. In a country where violation of trademarks has been common, the courts seem to be
signaling a shift toward greater protection of intellectual property rights. is is perhaps not surprising
because foreign governments and the World Trade Organization have been pushing China hard recently to
start respecting intellectual property rights.
Sources: M. Dickie, “Starbucks Wins Case against Chinese Copycat,” Financial Times, January 3, 2006, p. 1;
“Starbucks: Chinese Court Backs Company over Trademark Infringement,” e Wall Street Journal, January 2,
2006, p. A11; and “Starbucks Calls China Its Top Growth Focus,” e Wall Street Journal, February 14, 2006,
p. 1.
In addition to lobbying governments, firms can file lawsuits on their own behalf. For example,
Starbucks won a landmark trademark copyright case in China against a copycat that signaled a change
in the approach in China (see the accompanying Management Focus for details). Firms may also
choose to stay out of countries where intellectual property laws are lax, rather than risk having their
ideas stolen by local entrepreneurs. Firms also need to be on the alert to ensure that pirated copies of
their products produced in countries with weak intellectual property laws don’t turn up in their home
market or in third countries. U.S. computer software giant Microsoft, for example, discovered that
pirated Microsoft software, produced illegally in ailand, was being sold worldwide as the real thing.
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PRODUCT SAFETY AND PRODUCT LIABILITY
Product safety laws set certain safety standards to which a product must adhere. Product liability
involves holding a firm and its officers responsible when a product causes injury, death, or damage.
Product liability can be much greater if a product does not conform to required safety standards. Both
civil and criminal product liability laws exist. Civil laws call for payment and monetary damages.
Criminal liability laws result in fines or imprisonment. Both civil and criminal liability laws are
probably more extensive in the United States than in any other country, although many other Western
nations also have comprehensive liability laws. Liability laws are typically the least extensive in less
developed nations. A boom in product liability suits and awards in the United States resulted in a
dramatic increase in the cost of liability insurance. Many business executives argue that the high costs
of liability insurance make American businesses less competitive in the global marketplace. Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go
to learnsmartadvantage.com for help.
In addition to the competitiveness issue, country differences in product safety and liability laws raise
an important ethical issue for firms doing business abroad. When product safety laws are tougher in a
firm’s home country than in a foreign country or when liability laws are more lax, should a firm doing
business in that foreign country follow the more relaxed local standards or should it adhere to the
standards of its home country? While the ethical thing to do is undoubtedly to adhere to home-
country standards, firms have been known to take advantage of lax safety and liability laws to do
business in a manner that would not be allowed at home.
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go
to learnsmartadvantage.com for help.
Focus on Managerial Implications
LO 2-4 Explain the implications for management practice of national differences in political
economy.
THE MACRO ENVIRONMENT INFLUENCES MARKET ATTRACTIVENESS
e material discussed in this chapter has two broad implications for international business. First, the
political, economic, and legal systems of a country raise important ethical issues that have implications
for the practice of international business. For example, what ethical implications are associated with
doing business in totalitarian countries where citizens are denied basic human rights, corruption is
rampant, and bribes are necessary to gain permission to do business? Is it right to operate in such a
setting? A full discussion of the ethical implications of country differences in political economy is
reserved for Chapter 5, where we explore ethics in international business in much greater depth.
Second, the political, economic, and legal environments of a country clearly influence the
attractiveness of that country as a market or investment site. e benefits, costs, and risks associated
with doing business in a country are a function of that country’s political, economic, and legal
systems. e overall attractiveness of a country as a market or investment site depends on balancing
the likely long-term benefits of doing business in that country against the likely costs and risks.
Because this chapter is the first of two dealing with issues of political economy, we will delay a detailed
discussion of how political economy impacts the benefits, costs, and risks of doing business in
different nation-states until the end of the next chapter, when we have a full grasp of all the relevant
variables that are important for assessing benefits, costs, and risks.
For now, other things being equal, a nation with democratic political institutions, a market-based
economic system, and strong legal system that protects property rights and limits corruption is clearly
more attractive as a place in which to do business than a nation that lacks democratic institutions,
where economic activity is heavily regulated by the state, and where corruption is rampant and the
rule of law is not respected. On this basis, for example, a country like Canada is a better place in
which to do business than the Russia of Vladimir Putin (see the Country Focus: Putin’s Russia). at
being said, the reality is often more nuanced and complex. For example, China lacks democratic
institutions; corruption is widespread; property rights are not always respected; and even though the
country has embraced many market-based economic reforms, there are still large numbers of state-
owned enterprises—yet many Western businesses feel that they must invest in China. ey do so
despite the risks because the market is large, the nation is moving toward a market-based system,
economic growth has been strong (although it faltered in 2015–2016), legal protection of property
rights has been improving, and China is already the second largest economy in the world and could
ultimately replace the United States as the world’s largest. us, China is becoming increasingly
attractive as a place in which to do business, and given the future growth trajectory, significant
opportunities may be lost by not investing in the country. We will explore how changes in political
economy affect the attractiveness of a nation as a place in which to do business in Chapter 3.
Key Terms
political economy, p. 39
political system, p. 39
collectivism, p. 39
socialists, p. 39
communists, p. 39
social democrats, p. 39
privatization, p. 40
individualism, p. 40
democracy, p. 41
totalitarianism, p. 41
representative democracy, p. 41
communist totalitarianism, p. 43
theocratic totalitarianism, p. 43
tribal totalitarianism, p. 43
right-wing totalitarianism, p. 43
market economy, p. 44
command economy, p. 45
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legal system, p. 46
common law, p. 46
civil law system, p. 46
theocratic law system, p. 47
contract, p. 47
contract law, p. 47
United Nations Convention on Contracts for the International Sale of Goods (CISG), p. 48
property rights, p. 48
private action, p. 48
public action, p. 48
Foreign Corrupt Practices Act (FCPA), p. 50
intellectual property, p. 51
patent, p. 51
copyrights, p. 52
trademarks, p. 52
World Intellectual Property Organization, p. 52
Paris Convention for the Protection of Industrial Property, p. 52
product safety laws, p. 53
product liability, p. 53
Summary
is chapter has reviewed how the political, economic, and legal systems of countries vary. e
potential benefits, costs, and risks of doing business in a country are a function of its political,
economic, and legal systems. e chapter made the following points:
1. Political systems can be assessed according to two dimensions: the degree to which they
emphasize collectivism as opposed to individualism and the degree to which they are democratic
or totalitarian.
2. Collectivism is an ideology that views the needs of society as being more important than the
needs of the individual. Collectivism translates into an advocacy for state intervention in
economic activity and, in the case of communism, a totalitarian dictatorship.
3. Individualism is an ideology that is built on an emphasis of the primacy of the individual’s
freedoms in the political, economic, and cultural realms. Individualism translates into an
advocacy for democratic ideals and free market economics.
4. Democracy and totalitarianism are at different ends of the political spectrum. In a representative
democracy, citizens periodically elect individuals to represent them, and political freedoms are
guaranteed by a constitution. In a totalitarian state, political power is monopolized by a party,
group, or individual, and basic political freedoms are denied to citizens of the state.
5. ere are three broad types of economic systems: a market economy, a command economy, and
a mixed economy. In a market economy, prices are free of controls, and private ownership is
predominant. In a command economy, prices are set by central planners, productive assets are
owned by the state, and private ownership is forbidden. A mixed economy has elements of both
a market economy and a command economy.
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6. Differences in the structure of law between countries can have important implications for the
practice of international business. e degree to which property rights are protected can vary
dramatically from country to country, as can product safety and product liability legislation and
the nature of contract law.
Critical inking and Discussion Questions
1. Free market economies stimulate greater economic growth, whereas state-directed economies
stifle growth. Discuss.
2. A democratic political system is an essential condition for sustained economic progress. Discuss.
3. What is the relationship between corruption in a country (i.e., government officials taking
bribes) and economic growth? Is corruption always bad?
4. You are the CEO of a company that has to choose between making a $100 million investment
in Russia or Poland. Both investments promise the same long-run return, so your choice is
driven by risk considerations. Assess the various risks of doing business in each of these nations.
Which investment would you favor and why?
5. Read the Management Focus “Did Walmart Violate the Foreign Corrupt Practices Act?” What
is your opinion? If you think it did, what do you think the consequences will be for Walmart?
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. e definition of words and political ideas can have different meanings in different contexts
worldwide. In fact, the Freedom in the World survey published by Freedom House evaluates the
state of political rights and civil liberties around the world. Provide a description of this survey
and a ranking (in terms of “freedom”) of the world’s country leaders and laggards. What factors
are taken into consideration in this survey?
2. As the chapter discusses, differences in political, economic, and legal systems have considerable
impact on the benefits, costs, and risks of doing business in various countries. e World Bank’s
“Doing Business Indicators” measure the extent of business regulations in countries around the
world. Compare Brazil, Ghana, India, New Zealand, the United States, Sweden, and Turkey in
terms of how easily contracts are enforced, how property can be registered, and how investors
can be protected. Identify in which area you see the greatest variation from one country to the
next.
T h e D e c l i n e o f Z i m b a b w e
c l o s i n g c a s e
In 1980, the southern African state of Zimbabwe gained independence from its colonial master, Great Britain.
Speaking at the time, the late Tanzanian President, Julius Nyerere, described Zimbabwe as “the jewel of
Africa.” It was a country that boasted a strong economy, abundant natural resources, and a vibrant agricultural
sector. As part of the independence process, the British bequeathed Zimbabwe with democratic political
institutions.
Zimbabwe’s birth as an independent nation was a difficult one. In 1965, the minority white rulers of what
was then known as Rhodesia unilaterally declared independence from Britain, setting up an apartheid state
where blacks were excluded from power. e British government wanted majority rule, stated that the
declaration of independence was an illegal rebellion, and imposed sanctions on Rhodesia. Other nations that
followed suit included the United States. An armed conflict ensued with two guerrilla movements waging war
against Rhodesia’s white government. One of those guerrilla movements, the Zimbabwe African National
Union (ZANU) was headed by Robert Mugabe, who aligned himself and his movement with the Maoist
version of communism. A combination of international sanctions and guerrilla activity eventually forced the
white minority rulers of Rhodesia to end their rebellion. In 1979, Rhodesia reverted to British colonial status.
e following year Zimbabwe gained legal independence. Robert Mugabe was elected as the country’s first
prime minister. irty-seven years later Mugabe was still in power, now as President. His ZANU-PF party had
won every election since independence. Once a largely ceremonial position, Mugabe had systematically
consolidated power in the Presidency and restricted his political opponents. He was re-elected as President in
2013 in a general election which like many in the Mugabe era was widely seen as rigged. e country has also
been beset by endemic corruption. Corruption watchdog Transparency International recently ranked
Zimbabwe as one of the most corrupt nations in the world.
Zimbabwe’s economic performance in recent years ranks among the worst in the world. Although the
economy maintained a positive economic growth rate through the 1980s and 1990s, it has deteriorated
rapidly since 2000. Between 1999 and 2009 Zimbabwe saw the lowest economic growth rate ever recorded,
with an annual decline of 6.1 percent in GDP.
©Philimon Bulawayo/Reuters
e decline occurred after Mugabe launched a “fast-track” land reform program that encouraged the
seizure by the state without compensation of land owned by white farmers. At the time, some 4,000 white
farmers were the backbone of the country’s strong agricultural sector. e land was given to members of the
ZANU-PF party and other supporters of Mugabe, who lacked experience with modern agricultural practices
and had never farmed at all. In the wake of the land reform program, agricultural productivity slumped and
the country is now a net importer of food.
Another drag on the country’s growth was the 2008 Indigenisation and Economic Empowerment Act,
which required that enterprises doing business in Zimbabwe have at least 51 percent local ownership. In
practice, this often meant high-ranking ZANU-PF party members. After the act was passed, a number of
foreign corporations doing business in the country pulled out.
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e country’s mining sector remains potentially lucrative, with large platinum and diamond deposits
mined by private enterprises, but almost all of the licensing revenues due to the state have reportedly
disappeared into the hands of army officers and ZANU-PF politicians. Taxes and tariffs are high for private
enterprises, which discourages private business formation, while state-owned enterprises are strongly
subsidized. Tourism, once a big revenue earner, has declined as Zimbabwe’s wildlife has been decimated by
poaching and deforestation. As economic activity slumped, the country’s formal unemployment rate reached a
staggering 80 percent.
To complicate matters, Zimbabwe was devastated by the AIDS epidemic, with HIV infection rates hitting
a high of 40 percent of the population in 1998. Due to AIDS and other public health problems, life
expectancy fell to just 43.1 years in 2003, down from 61.6 years in 1986. By 2014, with HIV prevalence
down to 15 percent, life expectancy had risen back to 54 years.
With tax revenues collapsing, Mugabe funded government programs by printing money. Inflation quickly
spiraled out of control, reaching 231,000,000 percent in 2008 and requiring the Central Bank to introduce a
100 trillion Zimbabwe dollar note! In April 2009, the Zimbabwe dollar was suspended (at the time the
trillion dollar note was worth around $0.40 USD). Zimbabwe allowed trade to be conducted using other
currencies, particularly the U.S. dollar, the South Africa Rand, the euro, and the British pound.
Despite the country’s economic implosion, the World Bank still believes that Zimbabwe has enormous
potential for sustained economic growth given its generous endowment of natural resources, its existing stock
of public infrastructure, and comparatively skilled human resources. Attaining that potential will require a
change in leadership and policies.
Mugabe showed no signs of giving up the reins of power. In February 2017, he held a lavish 93rd birthday
party for himself and stated that he wanted to stand for another five-year term as president in 2018. However,
much to the surprise of many observers, in November 2017, Mugabe was forced to resign from office after his
own party started impeachment proceedings against him. He was quickly replaced by his former vice
president, Emmerson Mnangagwa, whom Mugabe had fired on November 6th in an action that
precipitated the impeachment hearings. Mnangagwa has stated that he will get rid of Mugabe’s more
ruinous policies in an effort to improve Zimbabwe’s battered economy.
Sources: “Will Emmerson Mnangagwa Be Better than Robert Mugabe?” e Economist, November 30, 2017; “How Robert Mugabe
Ruined Zimbabwe,” e Economist, February 26, 2017; Irwin Chifera, “What Happened to Zimbabwe, Once Known as the Jewel
of Africa?” VoaZimbabwe, April 17, 2015; “e Real Balancing Rocks on Every Zimbabwe Dollar,” Slate, January 23, 2017;
“Diamonds in the Rough,” Human Rights Watch Report, June 26, 2009; “Zimbabwe,” e World Bank,
http://www.worldbank.org/en/country/zimbabwe/overview.
CASE DISCUSSION QUESTIONS
1. Why has Zimbabwe’s economic performance been so poor?
2. Do you think that Zimbabwe’s economic performance would have been better under a
different system of government? Which one? Explain your reasoning.
3. What steps need to be taken now to improve the economic outlook for Zimbabwe?
Endnotes
1. As we shall see, there is not a strict one-to-one correspondence between political systems and
economic systems. A. O. Hirschman, “e On-and-Off Again Connection between Political
and Economic Progress,” American Economic Review 84, no. 2 (1994), pp. 343–48.
2. For a discussion of the roots of collectivism and individualism, see H. W. Spiegel, e Growth of
Economic ought (Durham, NC: Duke University Press, 1991). A discussion of collectivism
and individualism can be found in M. Friedman and R. Friedman, Free to Choose (London:
Penguin Books, 1980).
3. For a classic summary of the tenets of Marxism, see A. Giddens, Capitalism and Modern Social
eory (Cambridge, UK: Cambridge University Press, 1971).
4. Adam Smith, e Wealth of Nations, 1776.
5. R. Wesson, Modern Government—Democracy and Authoritarianism, 2nd ed. (Englewood Cliffs,
NJ: Prentice Hall, 1990).
6. For a detailed but accessible elaboration of this argument, see Friedman and Friedman, Free to
Choose. Also see P. M. Romer, “e Origins of Endogenous Growth,” Journal of Economic
Perspectives 8, no. 1 (1994), pp. 2–32.
7. T. W. Lippman, Understanding Islam (New York: Meridian Books, 1995).
8. “Islam’s Interest,” e Economist, January 18, 1992, pp. 33–34.
9. M. El Qorchi, “Islamic Finance Gears Up,” Finance and Development, December 2005, pp. 46–
50; S. Timewell, “Islamic Finance—Virtual Concept to Critical Mass,” e Banker, March 1,
2008, pp. 10–16; Lydia Yueh, “Islamic Finance Growing Fast, But Can It Be More an a
Niche Market?” BBC News, April 14, 2014.
10. is information can be found on the UN’s treaty website at
www.uncitral.org/uncitral/en/uncitral_texts/sale_goods/1980CISG.html.
11. International Court of Arbitration, www.iccwbo.org/index_court.asp.
12. D. North, Institutions, Institutional Change, and Economic Performance (Cambridge, UK:
Cambridge University Press, 1991).
13. “China’s Next Revolution,” e Economist, March 10, 2007, p. 9.
14. P. Klebnikov, “Russia’s Robber Barons,” Forbes, November 21, 1994, pp. 74–84; C. Mellow,
“Russia: Making Cash from Chaos,” Fortune, April 17, 1995, pp. 145–51; “Mr. Tatum Checks
Out,” e Economist, November 9, 1996, p. 78.
15. K. van Wolferen, e Enigma of Japanese Power (New York: Vintage Books, 1990), pp. 100–105.
16. P. Bardhan, “Corruption and Development: A Review of the Issues,” Journal of Economic
Literature, September 1997, pp. 1320–46.
17. Transparency International, “Global Corruption Report, 2014,” www.transparency.org, 2014.
18. Transparency International, Corruption Perceptions Index 2016, www.transparency.org.
19. J. Coolidge and S. Rose Ackerman, “High Level Rent Seeking and Corruption in African
Regimes,” World Bank policy research working paper no. 1780, June 1997; K. Murphy, A.
Shleifer, and R. Vishny, “Why Is Rent-Seeking So Costly to Growth?” AEA Papers and
Proceedings, May 1993, pp. 409–14; M. Habib and L. Zurawicki, “Corruption and Foreign
Direct Investment,” Journal of International Business Studies 33 (2002), pp. 291–307; J. E.
Anderson and D. Marcouiller, “Insecurity and the Pattern of International Trade,” Review of
Economics and Statistics 84 (2002), pp. 342–52; T. S. Aidt, “Economic Analysis of Corruption:
A Survey,” e Economic Journal 113 (November 2003), pp. 632–53; D. A. Houston, “Can
Corruption Ever Improve an Economy?” Cato Institute 27 (2007), pp. 325–43; S. Rose
Ackerman and B.J. Palifka, Corruption and Government, 2nd ed. (Cambridge, UK: Cambridge
University Press, 2016).
20. Details can be found at www.oecd.org/corruption/oecdantibriberyconvention.htm.
21. D. Stackhouse and K. Ungar, “e Foreign Corrupt Practices Act: Bribery, Corruption, Record
Keeping and More,” Indiana Lawyer, April 21, 1993.
22. For an interesting discussion of strategies for dealing with the low cost of copying and
distributing digital information, see the chapter on rights management in C. Shapiro and H. R.
Varian, Information Rules (Boston: Harvard Business School Press, 1999). Also see C. W. L. Hill,
“Digital Piracy,” Asian Pacific Journal of Management, 2007, pp. 9–25.
23. Douglass North has argued that the correct specification of intellectual property rights is one
factor that lowers the cost of doing business and, thereby, stimulates economic growth and
development. See North, Institutions, Institutional Change, and Economic Performance.
24. Business Software Alliance, “Ninth Annual BSA Global Software Piracy Study,” May 2012,
www.bsa.org.
25. Business Software Alliance, “Ninth Annual BSA Global Software Piracy Study,” May 2012,
www.bsa.org.
26. “Trade Tripwires,” e Economist, August 27, 1994, p. 61.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-
Hill Education
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3
Part 2 National Differences
National Differences in Economic Development
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO3-1 Explain what determines the level of economic development of a nation.
LO3-2 Identify the macropolitical and macroeconomic changes occurring worldwide.
LO3-3 Describe how transition economies are moving toward market-based systems.
LO3-4 Explain the implications for management practice of national difference in political economy.
Brazil’s Struggling Economy
opening case
Between 2000 and 2012, Brazil had one of the fastest growing economies in the world, expanding by over 5 percent per
year. In 2012, the Brazilian economy temporarily surpassed that of the United Kingdom, making it the world’s sixth
largest economy. However, since then Brazil has been beset by a deep economic malaise. Economic growth decelerated
in 2013. e economy entered into a serious recession in 2014. Economic activity contracted by over 3.5 percent in
both 2015 and 2016 before growing by a sluggish 0.7 percent in 2017.
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Brazil’s economic problems were partly due to a fall in global commodity prices—Brazil is a major exporter of coffee,
soybeans, and iron ore—but the country has other deep structural problems. Under the leadership of President Dilma
Rousseff and her left of center Workers’ Party, between 2011 and 2014 the government spent extravagantly and
unwisely on higher pensions and unproductive tax breaks for favored industries. When the recession hit, unemployment
surged to over 12 percent and tax revenues slumped. As a result of higher outlays and lower tax revenues, the fiscal
deficit swelled from 2 percent of GDP in 2010 to 10 percent in 2015. is pushed up total government debt to
70 percent of GDP and required higher interest rates to sell government bonds, which were seen as increasingly risky.
e government also raised interest rates to keep inflation in check, which historically has been a problem in Brazil.
Because of high interest rates, the cost of servicing government debt expanded to 7 percent of GDP—and of course,
higher interest rates, by raising borrowing costs for consumers and businesses, further depressed economic activity.
Given high interest rates, the only way for the government to get the fiscal deficit under control is to cut spending
and raise taxes. is has not been easy to do. A central problem in Brazil is the country’s pension obligations. e
pension system entitles Brazilians to retire, on average, at just 54. Pension obligations already account for 13 percent of
GDP. Without reform, that figure could balloon to 25 percent by mid-century as the population ages.
In addition, tariff barriers protecting inefficient local enterprises from foreign competition, labor laws, and
burdensome tax laws have long been seen as a drag on the Brazilian economy. A typical manufacturing firm spends
2,600 hours a year complying with the country’s complex tax code; the Latin American average is 356 hours. Labor laws
make it expensive to fire even incompetent workers. And protection from international competition has resulted in
manufacturing productivity that is low by international standards. To compound matters, the country has been beset by
a massive corruption scandal that has reached into the highest levels of government. is resulted in the impeachment of
Rousseff in 2016 and further damaged confidence in the economy (see the Country Focus “Corruption in Brazil” in
Chapter 2).
In 2016, Michel Temer replaced Rousseff as President. He made a promising start to reforming the economy. Public
spending has been frozen in real terms for the next twenty years. He also overhauled the country’s labor laws,
making it much easier to fire unproductive workers. Inflation has moderated significantly and global economic
recovery, together with a rise in commodity prices, has helped increase exports. is has allowed the central bank to
reduce interest rates to 6.75 percent (they were as high as 12 percent), further boosting economic growth. ere has also
been a rash of privatizations—including that of the leading electric utility, Eletrobras—as the government seeks to raise
capital by selling state assets and tries to increase the efficiency of the economy. As a consequence of such actions, in
2018 the International Monetary Fund (IMF) forecasts that the Brazilian economy will grow by close to 2 percent.
What remains is to fix the country’s pension problems. At a minimum, this will require raising the retirement age
significantly. Temer is running up against strong resistance. His initial proposals failed to garner enough votes in the
Brazilian congress to change the law on pensions. Unless these can be changed, government debt will continue to grow
as the population ages, and Brazil could fall back into a crisis. •
Sources: Denise Chrispim Marin, “Brazil’s Half Glass Economy,” Global Finance, October 3, 2017; “Michel Temer Is Trying to Fix Brazil’s
Pension Systems,” e Economist, February 15, 2018; “Will Brazil’s Future Arrive?” e Economist, August 17, 2017; and “Brazil’s Fall,” e
Economist, January 2, 2016.
Introduction
In Chapter 2, we described how countries differ with regard to their political systems, economic systems, and
legal systems. In this chapter, we build on this material to explain how these differences influence the level of
economic development of a nation and, thus, how attractive it is as a place for doing business. We also look at
how economic, political, and legal systems are changing around the world and what the implications of this are
for the future rate of economic development of nations and regions. e past three decades have seen a general
move toward more democratic forms of government, market-based economic reforms, and adoption of legal
systems that better enforce property rights. Taken together, these trends have helped foster greater economic
development around the world and have created a more favorable environment for international business. In
the final section of this chapter, we pull all this material together to explore how differences in political,
economic, and legal institutions affect the benefits, costs, and risks of doing business in different nations.
e opening case, which looks at the state of the Brazilian economy, highlights some of the issues that we
will discuss in this chapter. Brazil is one of the world’s largest emerging economies (together with China and
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India). is nation of 210 million people enjoyed strong economic growth from 2000 to 2012 due to market-
based reforms and strong export growth, making it an attractive location for international business. Since then,
however, the economy has stalled. e reasons include poor economic management by the government
of Dilma Rousseff, corruption scandals that sapped confidence in the economy, trade barriers that protected
inefficient local enterprises from foreign competition, labor laws that made it difficult to remove unproductive
employees, and pension obligations that, if left unreformed, could result in higher tax rates and slower
economic growth down the road. Fixing the economy and unleashing Brazil’s considerable potential requires
economic reforms, and while progress has been made in key areas, significant structural problems still remain,
particularly with regard to pension obligations and trade barriers. Unless these structural problems are fixed by
the government, they will negatively impact economic growth in Brazil, and reduce the attractiveness of the
country going forward as a location for investment by international businesses.
Differences in Economic Development
LO 3-1 Explain what determines the level of economic development of a nation.
Different countries have dramatically different levels of economic development. One common measure of
economic development is a country’s gross national income (GNI) per head of population. GNI is regarded as
a yardstick for the economic activity of a country; it measures the total annual income received by residents of a
nation. Map 3.1 summarizes the GNI per capita of the world’s nations in 2017. As can be seen, countries such
as Japan, Sweden, Switzerland, the United States, and Australia are among the richest on this measure, whereas
the large developing countries of China and India are significantly poorer. Japan, for example, had a 2017 GNI
per capita of $38,550, but China achieved only $8,690 and India just $1,820.1
3.1 MAP
GNI per capita, 2017.
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GNI per person figures can be misleading because they don’t consider differences in the cost of living. For
example, although the 2017 GNI per capita of Switzerland at $80,560 exceeded that of the United States by a
wide margin, the higher cost of living in Switzerland meant that U.S. citizens could actually afford almost as
many goods and services as the average Swiss citizen. To account for differences in the cost of living, one can
adjust GNI per capita by purchasing power. Referred to as a purchasing power parity (PPP) adjustment, it
allows a more direct comparison of living standards in different countries. e base for the adjustment is the
cost of living in the United States. e PPP for different countries is then adjusted (up or down) depending on
whether the cost of living is lower or higher than in the United States. For example, in 2017 the GNI per capita
for China was $8,690, but the PPP per capita was $15,500, suggesting that the cost of living was lower in
China and that $8,260 in China would buy as much as $16,760 in the United States. Table 3.1 gives the GNI
per capita measured at PPP in 2017 for a selection of countries, along with their GNI per capita and their
growth rate in gross domestic product (GDP) from 2008 to 2017. Map 3.2 summarizes the GNI PPP per
capita in 2017 for the nations of the world.
3.1 TABLE
Economic Data for Select Countries
Source: World Development Indicators Online, 2018.
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3.2 MAP
GNI PPP per capita, 2017.
Did You Know?
Did you know that the United States has an economy that is 70 percent larger than that of China and has four times the standard of
living?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
As can be seen, there are striking differences in the standards of living among countries. Table 3.1 suggests
the average Indian citizen can afford to consume only about 12 percent of the goods and services consumed by
the average U.S. citizen on a PPP basis. Given this, we might conclude that despite having a population of 1.2
billion, India is unlikely to be a very lucrative market for the consumer products produced by many Western
international businesses. However, this would be incorrect because India has a fairly wealthy middle class of
close to 250 million people, despite its large number of poor citizens. In absolute terms, the Indian economy
now rivals that of Russia.
To complicate matters, in many countries the “official” figures do not tell the entire story. Large amounts of
economic activity may be in the form of unrecorded cash transactions or barter agreements. People engage in
such transactions to avoid paying taxes, and although the share of total economic activity accounted for by such
transactions may be small in developed economies such as the United States, in some countries (India being an
example), they are reportedly very significant. Known as the black economy or shadow economy, estimates suggest
that in India it may be around 50 percent of GDP, which implies that the Indian economy is half as big again
as the figures reported in Table 3.1. Estimates produced by the European Union suggest that the shadow
economy accounted for between 10 and 12 percent of GDP in the United Kingdom and France but 21 percent
in Italy and as much as 23 percent in Greece.2
Page 64
What If We Were a Community of 100 People?
e “Miniature Earth” project was developed by Allysson Luca in 2001 as a way to better illustrate and create
understanding of differences in the world. He thought that reducing the world’s population to a community of only 100
people would be a useful and easy-to-understand illustration of various dynamics in the global marketplace. And this
Miniature Earth captures a variety of issues related to the political economy and economic development that are
discussed in this chapter. At the basic level, if the earth were a community of 100 people, 61 people would be Asian, 13
African, 12 European, 8 North American, 5 South American, and 1 would be from Oceania. Twenty people would own
75 percent of the financial wealth. If you could decide, how would you redistribute wealth among the 100 people? Make
some richer, make the wealth among people more even, or let market forces distribute wealth as we have it now?
Source: www.miniature-earth.com.
e GNI and PPP data give a static picture of development. ey tell us, for example, that China is much
poorer than the United States, but they do not tell us if China is closing the gap. To assess this, we have to look
at the economic growth rates achieved by countries. Table 3.1 gives the rate of growth in gross domestic
product (GDP) per capita achieved by a number of countries between 2008 and 2017. Map 3.3 summarizes
the annual average percentage growth rate in GDP from 2008 to 2017. Although countries such as
China and India are currently relatively poor, their economies are already large in absolute terms and
growing far more rapidly than those of many advanced nations. ey are already huge markets for the products
of international businesses. In 2010, China overtook Japan to become the second-largest economy in the world
after the United States. Indeed, if both China and the United States maintain their current economic growth
rates, China will become the world’s largest economy sometime during the next decade. On current trends,
India too will be among the largest economies in the world. Given that potential, many international businesses
are trying to establish a strong presence in these markets.
Country Comparator
3.3 MAP
Average annual growth rate in GDP (%), 2008–2017.
e “Country Comparator” tool
on globalEDGE™
(globaledge.msu.edu/comparator) includes data from as early as 1960 to the most recent year. Using this tool, it is easy
to compare countries across a variety of macro variables to better understand the economic changes occurring in
countries. As related to Chapter 3, the globalEDGE™ Country Comparator tool is an effective way to statistically get an
overview of the political economy and economic development by country worldwide. Comparisons of up to 20
countries at a time can be made in table format. Sometimes we talk about the BRIC countries when referring to Brazil,
Russia, India, and China—in essence, we broadly classify them as “superstar” emerging markets, but are they really that
similar? Using the Country Comparator tool on globalEDGE, we find that the GDP adjusted for purchasing power
parity is by far the greatest in Russia. Where do you think Brazil, India, and China fall on the GDP PPP scale?
BROADER CONCEPTIONS OF DEVELOPMENT: AMARTYA SEN
e Nobel Prize–winning economist Amartya Sen has argued that development should be assessed less by
material output measures such as GNI per capita and more by the capabilities and opportunities that people
enjoy.3 According to Sen, development should be seen as a process of expanding the real freedoms that people
experience. Hence, development requires the removal of major impediments to freedom: poverty as well as
tyranny, poor economic opportunities as well as systematic social deprivation, and neglect of public facilities as
well as the intolerance of repressive states. In Sen’s view, development is not just an economic process but a
political one too, and to succeed requires the “democratization” of political communities to give citizens a voice
Page 65
in the important decisions made for the community. is perspective leads Sen to emphasize basic health care,
especially for children, and basic education, especially for women. Not only are these factors desirable for their
instrumental value in helping achieve higher income levels, but they are also beneficial in their own right.
People cannot develop their capabilities if they are chronically ill or woefully ignorant.
Sen’s influential thesis has been picked up by the United Nations, which has developed the Human
Development Index (HDI) to measure the quality of human life in different nations. e HDI is based on
three measures: life expectancy at birth (a function of health care); educational attainment (measured by a
combination of the adult literacy rate and enrollment in primary, secondary, and tertiary education); and
whether average incomes, based on PPP estimates, are sufficient to meet the basic needs of life in a country
(adequate food, shelter, and health care). As such, the HDI comes much closer to Sen’s conception of how
development should be measured than narrow economic measures such as GNI per capita—although Sen’s
thesis suggests that political freedoms should also be included in the index, and they are not. e HDI is scaled
from 0 to 1. Countries scoring less than 0.5 are classified as having low human development (the quality of life
is poor), those scoring from 0.5 to 0.8 are classified as having medium human development, and those that
score above 0.8 are classified as having high human development. Map 3.4 summarizes the HDI scores for
2015, the most recent year for which data is available.
3.4 MAP
Human Development Index, 2015.
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Page 66
Political Economy and Economic Progress
It is often argued that a country’s economic development is a function of its economic and political systems.
What then is the nature of the relationship between political economy and economic progress? Despite the long
debate over this question among academics and policymakers, it is not possible to give an unambiguous answer.
However, it is possible to untangle the main threads of the arguments and make a few generalizations as to the
nature of the relationship between political economy and economic progress.
INNOVATION AND ENTREPRENEURSHIP ARE THE ENGINES OF GROWTH
ere is substantial agreement among economists that innovation and entrepreneurial activity are the engines of
long-run economic growth.4 ose who make this argument define innovation broadly to include not just new
products, but also new processes, new organizations, new management practices, and new strategies. us,
Uber’s strategy of letting riders hail a cab using a smartphone application can be seen as an innovation because
it was the first company to pursue this strategy in its industry. Similarly, the development of mass-market online
retailing by Amazon.com can be seen as an innovation. Innovation and entrepreneurial activity help increase
economic activity by creating new products and markets that did not previously exist. Moreover, innovations in
production and business processes lead to an increase in the productivity of labor and capital, which
further boosts economic growth rates.5
Innovation is also seen as the product of entrepreneurial activity. Often, entrepreneurs first commercialize
innovative new products and processes, and entrepreneurial activity provides much of the dynamism in an
economy. For example, the U.S. economy has benefited greatly from a high level of entrepreneurial activity,
which has resulted in rapid innovation in products and process. Firms such as Apple, Google, Facebook,
Amazon, Dell, Microsoft, Oracle, and Uber were all founded by entrepreneurial individuals to exploit new
technology. All these firms created significant economic value and boosted productivity by helping
commercialize innovations in products and processes. us, we can conclude that if a country’s economy is to
sustain long-run economic growth, the business environment must be conducive to the consistent production
of product and process innovations and to entrepreneurial activity.
INNOVATION AND ENTREPRENEURSHIP REQUIRE A MARKET ECONOMY
is leads logically to a further question: What is required for the business environment of a country to be
conducive to innovation and entrepreneurial activity? ose who have considered this issue highlight the
advantages of a market economy.6 It has been argued that the economic freedom associated with a market
economy creates greater incentives for innovation and entrepreneurship than either a planned or a mixed
economy. In a market economy, any individual who has an innovative idea is free to try to make money out of
that idea by starting a business (by engaging in entrepreneurial activity). Similarly, existing businesses are free to
improve their operations through innovation. To the extent that they are successful, both individual
entrepreneurs and established businesses can reap rewards in the form of high profits. us, market economies
contain enormous incentives to develop innovations.
In a planned economy, the state owns all means of production. Consequently, entrepreneurial individuals
have few economic incentives to develop valuable new innovations because it is the state, rather than the
individual, that captures most of the gains. e lack of economic freedom and incentives for innovation was
probably a main factor in the economic stagnation of many former communist states and led ultimately to their
collapse at the end of the 1980s. Similar stagnation occurred in many mixed economies in those sectors where
Page 67
the state had a monopoly (such as coal mining and telecommunications in Great Britain). is stagnation
provided the impetus for the widespread privatization of state-owned enterprises that we witnessed in many
mixed economies during the mid-1980s and that is still going on today (privatization refers to the process of
selling state-owned enterprises to private investors; see Chapter 2 for details).
A study of 102 countries over a 20-year period provided evidence of a strong relationship between economic
freedom (as provided by a market economy) and economic growth.7 e study found that the more economic
freedom a country had between 1975 and 1995, the more economic growth it achieved and the richer its
citizens became. e six countries that had persistently high ratings of economic freedom from 1975 to 1995
(Hong Kong, Switzerland, Singapore, the United States, Canada, and Germany) were also all in the top 10 in
terms of economic growth rates. In contrast, no country with persistently low economic freedom achieved a
respectable growth rate. In the 16 countries for which the index of economic freedom declined the most during
1975 to 1995, gross domestic product fell at an annual rate of 0.6 percent. Other studies have reached broadly
similar conclusions.
INNOVATION AND ENTREPRENEURSHIP REQUIRE STRONG PROPERTY RIGHTS
Strong legal protection of property rights is another requirement for a business environment to be conducive to
innovation, entrepreneurial activity, and hence economic growth.8 Both individuals and businesses must be
given the opportunity to profit from innovative ideas. Without strong property rights protection, businesses
and individuals run the risk that the profits from their innovative efforts will be expropriated, either by criminal
elements or by the state. e state can expropriate the profits from innovation through legal means, such as
excessive taxation, or through illegal means, such as demands from state bureaucrats for kickbacks in
return for granting an individual or firm a license to do business in a certain area (i.e., corruption).
According to the Nobel Prize–winning economist Douglass North, throughout history many governments have
displayed a tendency to engage in such behavior.9 Inadequately enforced property rights reduce the incentives
for innovation and entrepreneurial activity—because the profits from such activity are “stolen”—and hence
reduce the rate of economic growth.
e influential Peruvian development economist Hernando de Soto has argued that much of the developing
world will fail to reap the benefits of capitalism until property rights are better defined and protected.10 De
Soto’s arguments are interesting because he says the key problem is not the risk of expropriation but the chronic
inability of property owners to establish legal title to the property they own. As an example of the scale of the
problem, he cites the situation in Haiti, where individuals must take 176 steps over 19 years to own land
legally. Because most property in poor countries is informally “owned,” the absence of legal proof of ownership
means that property holders cannot convert their assets into capital, which could then be used to finance
business ventures. Banks will not lend money to the poor to start businesses because the poor possess no proof
that they own property, such as farmland, that can be used as collateral for a loan. By de Soto’s calculations, the
total value of real estate held by the poor in third-world and former communist states amounted to more than
$9.3 trillion in 2000. If those assets could be converted into capital, the result could be an economic revolution
that would allow the poor to bootstrap their way out of poverty. Interestingly enough, the Chinese seem to have
taken de Soto’s arguments to heart. Despite still being nominally a communist country, in October 2007 the
government passed a law that gave private property owners the same rights as the state, which significantly
improved the rights of urban and rural landowners to the land that they use (see the accompanying Country
Focus).
c o u n t r y F O C U S
Page 68
Property Rights in China
On October 1, 2007, a new property law took effect in China, granting rural and urban landholders far more secure
property rights. e law was a much-needed response to how China’s economy has changed over the past 30 years as it
transitions from a centrally planned system to a more dynamic market-based economy where two-thirds of economic
activity is in the hands of private enterprises.
Although all land in China still technically belongs to the state—an ideological necessity in a country where the
government still claims to be guided by Marxism—urban landholders had been granted 40- to 70-year leases to use the
land, while rural farmers had 30-year leases. However, the lack of legal title meant that landholders were at the whim of
the state. Large-scale appropriation of rural land for housing and factory construction had rendered millions of farmers
landless. Many were given little or no compensation, and they drifted to the cities where they added to a growing
underclass. In both urban and rural areas, property and land disputes had become a leading cause of social unrest.
According to government sources, in 2006 there were about 23,000 “mass incidents” of social unrest in China, many
related to disputes over property rights.
e 2007 law, which was 14 years in gestation due to a rearguard action fought by left-wing Communist Party
activists who objected to it on ideological grounds, gives urban and rural land users the right to automatic renewal of
their leases after the expiration of the 30- to 70-year terms. In addition, the law requires that land users be fairly
compensated if the land is required for other purposes, and it gives individuals the same legal protection for their
property as the state. Taken together with a 2004 change in China’s constitution, which stated that private property “was
not to be encroached upon,” the new law significantly strengthens property rights in China.
Nevertheless, the law has its limitations; most notably, it still falls short of giving peasants marketable ownership
rights to the land they farm. If they could sell their land, tens of millions of underemployed farmers might find more
productive work elsewhere. ose who stayed could acquire bigger landholdings that could be used more efficiently.
Also, farmers might be able to use their landholdings as security against which they could borrow funds for investments
to boost productivity.
Recognizing such limitations, in 2016 the ruling Communist Party released a set of guidelines for further shoring up
property rights protection, including better legal enforcement of property rights. ere is no doubt that additional
protection is needed. Chinese firms and residents have continued to suffer under poor property protections, facing
eviction to make way for new developments and facing fierce competition as patents and copyrights are repeatedly
violated. Whether these new guidelines will improve matters, however, remains to be seen.
Sources: “China’s Next Revolution—Property Rights in China,” e Economist, March 10, 2007, p. 11; “Caught between the Right and Left,” e Economist, March 10, 2007, pp. 25–27; Z. Keliang and L. Ping, “Rural Land Rights under the PRC Property Law,” China Law and Practice, November 2007, pp. 10–15; and Sara Hsu, “China Is Finally Improving Property Rights Protection,” Forbes, November 30, 2016.
THE REQUIRED POLITICAL SYSTEM
Much debate surrounds which kind of political system best achieves a functioning market economy with strong
protection for property rights.11 People in the West tend to associate a representative democracy with a market
economic system, strong property rights protection, and economic progress. Building on this, we tend to argue
that democracy is good for growth. However, some totalitarian regimes have fostered a market economy and
strong property rights protection and have experienced rapid economic growth. Five of the fastest-growing
economies of the past 40 years—China, South Korea, Taiwan, Singapore, and Hong Kong—had one thing in
common at the start of their economic growth: undemocratic governments. At the same time, countries with
stable democratic governments, such as India, experienced sluggish economic growth for long periods. In 1992,
Lee Kuan Yew, Singapore’s leader for many years, told an audience, “I do not believe that democracy necessarily
leads to development. I believe that a country needs to develop discipline more than democracy. e
exuberance of democracy leads to undisciplined and disorderly conduct which is inimical to development.”12
However, those who argue for the value of a totalitarian regime miss an important point: If dictators made
countries rich, then much of Africa, Asia, and Latin America should have been growing rapidly during 1960 to
1990, and this was not the case. Only a totalitarian regime that is committed to a market system and strong
Page 69
protection of property rights is capable of promoting economic growth. Also, there is no guarantee that a
dictatorship will continue to pursue such progressive policies. Dictators are rarely benevolent. Many are
tempted to use the apparatus of the state to further their own private ends, violating property rights and stalling
economic growth. Given this, it seems likely that democratic regimes are far more conducive to long-term
economic growth than are dictatorships, even benevolent ones. Only in a well-functioning, mature democracy
are property rights truly secure.13 Nor should we forget Amartya Sen’s arguments reviewed earlier. Totalitarian
states, by limiting human freedom, also suppress human development and therefore are detrimental to progress.
ECONOMIC PROGRESS BEGETS DEMOCRACY
While it is possible to argue that democracy is not a necessary precondition for a market economy in which
property rights are protected, subsequent economic growth often leads to establishment of a democratic regime.
Several of the fastest-growing Asian economies adopted more democratic governments during the past three
decades, including South Korea and Taiwan. us, although democracy may not always be the cause of initial
economic progress, it seems to be one consequence of that progress.
Democracy in the Arab World: New Realities in an Ancient Land?
Democracy is finally making an appearance in the ancient lands of the Middle East, as witnessed by the recent uprisings
known as the “e Arab Spring.” Wissam Yafi, an expert in technology and international development, believes geo-
economic, geosocial, technological, and geo-political forces will lead to inevitable changes in the Arab world. Economic
forces will make these governments cut many of the social services offered, putting people out of work, which will lead
toward democratic alternatives. Technology is another major binding force connecting populations across the Middle
East, which will mean less censorship—something that has been widespread in many parts of the Arab world. People
will continue to challenge the status quo as rapid urbanization, population growth, and movements toward self-
determination grow. Wissam Yafi has a lot of guesses on what will happen. Do you agree with his forecasts?
Source: carnegieendowment.org.
A strong belief that economic progress leads to adoption of a democratic regime underlies the fairly
permissive attitude that many Western governments have adopted toward human rights violations in China.
Although China has a totalitarian government in which human rights are violated, many Western countries
have been hesitant to criticize the country too much for fear that this might hamper the country’s march toward
a free market system. e belief is that once China has a free market system, greater individual freedoms and
democracy will follow. Whether this optimistic vision comes to pass remains to be seen.
GEOGRAPHY, EDUCATION, AND ECONOMIC DEVELOPMENT
While a country’s political and economic systems are probably the big engine driving its rate of economic
development, other factors are also important. One that has received attention is geography.14 But the belief
that geography can influence economic policy, and hence economic growth rates, goes back to Adam Smith.
e influential economist Jeffrey Sachs argues that
throughout history, coastal states, with their long engagements in international trade, have been more
supportive of market institutions than landlocked states, which have tended to organize themselves as
hierarchical (and often militarised) societies. Mountainous states, as a result of physical isolation, have often
neglected market-based trade. Temperate climes have generally supported higher densities of population
and thus a more extensive division of labour than tropical regions.15
Sachs’s point is that by virtue of favorable geography, certain societies are more likely to engage in trade than
others and are thus more likely to be open to and develop market-based economic systems, which in turn
promotes faster economic growth. He also argues that, irrespective of the economic and political institutions a
country adopts, adverse geographic conditions—such as the high rate of disease, poor soils, and hostile climate
that afflict many tropical countries—can have a negative impact on development. Together with colleagues at
Harvard’s Institute for International Development, Sachs tested for the impact of geography on a country’s
economic growth rate between 1965 and 1990. He found that landlocked countries grew more slowly than
coastal economies and that being entirely landlocked reduced a country’s growth rate by roughly 0.7 percent
per year. He also found that tropical countries grew 1.3 percent more slowly each year than countries in the
temperate zone.
Education emerges as another important determinant of economic development (a point that Amartya Sen
emphasizes). e general assertion is that nations that invest more in education will have higher growth rates
because an educated population is a more productive population. Anecdotal comparisons suggest this is true. In
1960, Pakistanis and South Koreans were on equal footing economically. However, just 30 percent of Pakistani
children were enrolled in primary schools, while 94 percent of South Koreans were. By the mid-1980s, South
Korea’s GNP per person was three times that of Pakistan.16 A survey of 14 statistical studies that looked at the
relationship between a country’s investment in education and its subsequent growth rates concluded investment
in education did have a positive and statistically significant impact on a country’s rate of economic growth.17
Similarly, the work by Sachs discussed earlier suggests that investments in education help explain why some
countries in Southeast Asia, such as Indonesia, Malaysia, and Singapore, have been able to overcome the
disadvantages associated with their tropical geography and grow far more rapidly than tropical nations in Africa
and Latin America.
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States in Transition
LO 3-2 Identify the macropolitical and macroeconomic changes occurring worldwide.
e political economy of many of the world’s nation-states has changed radically since the late 1980s. ree
trends have been evident. First, during the late 1980s and early 1990s, a wave of democratic revolutions swept
the world. Totalitarian governments fell and were replaced by democratically elected governments that were
typically more committed to free market capitalism than their predecessors had been. Second, over the same
period, there has been a move away from centrally planned and mixed economies and toward a more free
market economic model. ird, and somewhat counter to the two prior trends, since 2012 there has been a
shift back toward greater authoritarianism in some nations, and there are some signs that certain nations may
be retreating from the free market model, particularly in the area of international trade where protectionism is
on the rise again.
THE SPREAD OF DEMOCRACY
One notable development of the last 30 years has been the spread of democracy (and, by extension, the decline
of totalitarianism). Map 3.5 reports on the extent of totalitarianism in the world as determined by Freedom
House.18 is map charts political freedom in 2018, grouping countries into three broad groupings: free, partly
free, and not free. In “free” countries, citizens enjoy a high degree of political and civil freedoms. “Partly free”
Page 70
countries are characterized by some restrictions on political rights and civil liberties, often in the context of
corruption, weak rule of law, ethnic strife, or civil war. In “not free” countries, the political process is tightly
controlled and basic freedoms are denied.
3.5 MAP
Freedom in the world, 2018.
Source: e Freedom House Survey Team, “Freedom in the World 2018,” www.freedomhouse.org.
Freedom House classified some 88 countries as free in 2018, accounting for about 45 percent of the world’s
nations. ese countries respect a broad range of political rights. Another 58 countries accounting for 30
percent of the world’s nations were classified as partly free, while 49 countries representing
approximately 25 percent of the world’s nations were classified as not free. e number of democracies
in the world has increased from 69 nations in 1987 to 125 in 2018. But not all democracies are free, according
to Freedom House, because some democracies still restrict certain political and civil liberties. For example,
although Russia is nominally a democracy, it has consistently been rated “not free” since the early 2000s.
According to Freedom House,
Russia’s step backwards into the Not Free category is the culmination of a growing trend . . . to concentrate
political authority, harass and intimidate the media, and politicize the country’s law-enforcement system.19
Similarly, Freedom House argues that democracy was restricted in Venezuela under the leadership of the late
Hugo Chávez, a trend that continued under his successor Nicolas Maduro.
Many of the newer democracies are to be found in eastern Europe and Latin America, although there also
have been notable gains in Africa during this time, including South Africa and Nigeria. Entrants into the ranks
of the world’s democracies during the last 25 years include Mexico, which held its first fully free and fair
presidential election in 2000 after free and fair parliamentary and state elections in 1997 and 1998; Senegal,
where free and fair presidential elections led to a peaceful transfer of power; Myanmar, where in 2015, after
Page 71decades of rule by a military dictatorship, the opposition party won a landslide victory in elections
that were mostly free and fair; and Nigeria, where in 2015 for the first time the opposition won an
election and there was a peaceful transfer of power.
ree main reasons account for the spread of democracy.20 First, many totalitarian regimes failed to deliver
economic progress to the vast bulk of their populations. e collapse of communism in eastern Europe, for
example, was precipitated by the growing gulf between the vibrant and wealthy economies of the West and the
stagnant economies of the communist East. In looking for alternatives to the socialist model, the populations of
these countries could not have failed to notice that most of the world’s strongest economies were governed by
representative democracies. Today, the economic success of many of the newer democracies—such as Poland
and the Czech Republic in the former communist bloc, the Philippines and Taiwan in Asia, and Chile in Latin
America—has strengthened the case for democracy as a key component of successful economic advancement.
Voters wait in a queue in front of the election center in the city of Lagos, Nigeria.
©Anadolu Agency/Getty Images
Second, new information and communication technologies—including satellite television, desktop
publishing, and, most important, the Internet and associated social media—have reduced a state’s ability to
control access to uncensored information. ese technologies have created new conduits for the spread of
democratic ideals and information from free societies. Today, the Internet is allowing democratic ideals to
penetrate closed societies as never before.21 Young people who utilized Facebook and Twitter to reach large
numbers of people very quickly and coordinate their actions organized the demonstrations in 2011 that led to
the overthrow of the Egyptian government.
ird, in many countries, economic advances have led to the emergence of increasingly prosperous middle
and working classes that have pushed for democratic reforms. is was certainly a factor in the democratic
transformation of South Korea. Entrepreneurs and other business leaders, eager to protect their property rights
and ensure the dispassionate enforcement of contracts, are another force pressing for more accountable and
open government.
Despite this, it would be naive to conclude that the global spread of democracy will continue unchallenged.
Democracy is still rare in large parts of the world. In sub-Saharan Africa in 2018, only 9 countries were
considered free, 21 were partly free, and 19 were not free. Among the post-communist countries in eastern and
central Europe and the former Soviet Union, only 13 are classified as free (primarily in eastern Europe). And
there are only 2 free states among the 18 nations of the Middle East and North Africa. Although the wave of
unrest that spread across the Middle East during 2011–2013 created hope for change, with the exception of
Tunisia, this as not been realized.
Moreover, authoritarianism has been gaining ground in several countries where political and civil liberties
have been progressively limited in recent years, including Russia, Ukraine, Indonesia, Ecuador, and Venezuela.
An increasingly autocratic Russia annexed the Crimea region from the Ukraine in 2014 and has actively
supported pro-Russian rebels in eastern Ukraine. Libya, where there was hope that a democracy might be
Page 72
established, appears to have slipped into anarchy. In Egypt, after a brief flirtation with democracy, the military
stepped in, removing the government of Mohamed Morsi, after Morsi and his political movement, the Muslim
Brotherhood, had exhibited its own authoritarian tendencies. e military-backed government, however, has
also acted in an authoritarian manner, effectively reversing much of the progress that had occurred after the
revolution of 2011. Indeed, Freedom House observes that since the mid-2000s, there has been a notable decline
in civil and political freedoms in many parts of the world, suggesting that the shift toward greater democracy
that occurred during the 1985–2005 period has peaked for the time being and that there have been some
notable reversals in states such as Russia and Venezuela. Freedom House also expressed concerns that
under the leadership of Donald Trump, America has withdrawn from its traditional role of promoting
democracy and human rights around the world, a development that it views with some alarm since pressure
from the United States has historically helped to spread democratic ideals.
Is World Peace rough Commerce Possible?
Interested in world peace? Business students worldwide can participate in Peace rough Commerce’s “Matrix of Peace,”
an integrated program that shows how business schools can promote peace. e program is sponsored by the
Association to Advance Collegiate Schools of Business (AACSB International), the global accrediting organization of
business schools. Peace rough Commerce is built on the premise that peace is achieved and maintained by an
interdependent system of commerce, consciousness, and laws and structure. As the AACSB puts it: “If we educate
students that it is their responsibility to advance society, over a generation we may be able to have more impact than
governments have had.” What do you think? Can business people advance global societies more than governments if
educated according to the framework of the “Matrix of Peace”?
Source: www.peacethroughcommerce.com.
THE NEW WORLD ORDER AND GLOBAL TERRORISM
e end of the Cold War and the “new world order” that followed the collapse of communism in eastern
Europe and the former Soviet Union, taken together with the demise of many authoritarian regimes in Latin
America, gave rise to intense speculation about the future shape of global geopolitics. In an influential book, 25
years ago author Francis Fukuyama argued, “We may be witnessing . . . the end of history as such: that is, the
end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final
form of human government.”22 Fukuyama went on to argue that the war of ideas may be at an end and that
liberal democracy has triumphed.
Many questioned Fukuyama’s vision of a more harmonious world dominated by a universal civilization
characterized by democratic regimes and free market capitalism. In a controversial book, the late influential
political scientist Samuel Huntington argued there is no “universal” civilization based on widespread acceptance
of Western liberal democratic ideals.23 Huntington maintained that while many societies may be modernizing
—they are adopting the material paraphernalia of the modern world, from automobiles and Facebook to Coca-
Cola and smartphones—they are not becoming more Western. On the contrary, Huntington theorized that
modernization in non-Western societies can result in a retreat toward the traditional, such as the resurgence of
Islam in many traditionally Muslim societies. He wrote,
e Islamic resurgence is both a product of and an effort to come to grips with modernization. Its
underlying causes are those generally responsible for indigenization trends in non-Western societies:
urbanization, social mobilization, higher levels of literacy and education, intensified communication and
media consumption, and expanded interaction with Western and other cultures. ese developments
undermine traditional village and clan ties and create alienation and an identity crisis. Islamist symbols,
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commitments, and beliefs meet these psychological needs, and Islamist welfare organizations, the social,
cultural, and economic needs of Muslims caught in the process of modernization. Muslims feel a need to
return to Islamic ideas, practices, and institutions to provide the compass and the motor of
modernization.24
us, the rise of Islamic fundamentalism is portrayed as a response to the alienation produced by
modernization.
In contrast to Fukuyama, Huntington envisioned a world split into different civilizations, each of which has
its own value systems and ideology. Huntington predicted conflict between the West and Islam and between the
West and China. While some commentators originally dismissed Huntington’s thesis, in the aftermath of the
terrorist attacks on the United States on September 11, 2001, Huntington’s views received new attention. e
dramatic rise of the Islamic State (ISIS) in war-torn Syria and neighboring Iraq during 2014–2015 drew further
attention to Huntington’s thesis, as has the growing penchant for ISIS to engage in terrorist acts outside the
Middle East, as in Paris in 2015.
If Huntington’s views are even partly correct, they have important implications for international business.
ey suggest many countries may be difficult places in which to do business, either because they are shot
through with violent conflicts or because they are part of a civilization that is in conflict with an enterprise’s
home country. Huntington’s views are speculative and controversial. More likely than his predictions coming to
pass is the evolution of a global political system that is positioned somewhere between Fukuyama’s universal
global civilization based on liberal democratic ideals and Huntington’s vision of a fractured world. at would
still be a world, however, in which geopolitical forces limit the ability of business enterprises to operate in
certain foreign countries.
As for terrorism, in Huntington’s thesis, global terrorism is a product of the tension between civilizations
and the clash of value systems and ideology. e terror attacks undertaken by al-Qaeda and ISIS are consistent
with this view. Others point to terrorism’s roots in long-standing conflicts that seem to defy political
resolution—the Palestinian, Kashmir, and Northern Ireland conflicts being obvious examples. It is also
true that much of the terrorism perpetrated by al-Qaeda affiliates in Iraq during the 2000s and more recently by
ISIS in Iraq and Syria can be understood in part as a struggle between radicalized Sunni and Shia factions
within Islam. Moreover, a substantial amount of terrorist activity in some parts of the world, such as Colombia,
has been interwoven with the illegal drug trade. As former U.S. Secretary of State Colin Powell has maintained,
terrorism represents one of the major threats to world peace and economic progress in the twenty-first
century.25
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Chinese construction workers build the new African Union Buildings in Addis Ababa, Ethiopia.
©Per-Anders Pettersson/Getty Images
THE SPREAD OF MARKET-BASED SYSTEMS
Paralleling the spread of democracy since the 1980s has been the transformation from centrally planned
command economies to market-based economies. More than 30 countries that were in the former Soviet Union
or the eastern European communist bloc have changed their economic systems. A complete list of countries
where change is now occurring also would include Asian states such as China and Vietnam, as well as African
countries such as Angola, Ethiopia, and Mozambique.26 ere has been a similar shift away from a mixed
economy. Many states in Asia, Latin America, and Western Europe have sold state-owned businesses to private
investors (privatization) and deregulated their economies to promote greater competition.
e rationale for economic transformation has been the same the world over. In general, command and
mixed economies failed to deliver the kind of sustained economic performance that was achieved by countries
adopting market-based systems, such as the United States, Switzerland, Hong Kong, and Taiwan. As a
consequence, even more states have gravitated toward the market-based model.
Map 3.6, based on data from the Heritage Foundation, a politically conservative U.S. research foundation,
gives some idea of the degree to which the world has shifted toward market-based economic systems. e
Heritage Foundation’s index of economic freedom is based on 10 indicators, including the extent to which the
government intervenes in the economy, trade policy, the degree to which property rights are protected, foreign
investment regulations, taxation rules, freedom from corruption, and labor freedom. A country can score
between 100 (freest) and 0 (least free) on each of these indicators. e higher a country’s average score across all
10 indicators, the more closely its economy represents the pure market model.
3.6 MAP
Index of economic freedom, 2018.
Source: e Heritage Foundation, "2018 Index of Economic Freedom," www.heritage.org/index/heatmap.
According to the 2018 index, which is summarized in Map 3.6, the world’s freest economies are (in rank
order) Hong Kong, Singapore, New Zealand, Switzerland, Australia, Ireland, Estonia, United Kingdom,
Canada, and the United Arab Emirates. e United States was ranked 17, Germany came in at 25, Japan at 30,
Mexico at 63, France at 71, Russia at 107, China at 110, India at 130, and Brazil at 153. e economies of
Zimbabwe, Venezuela, Cuba, and North Korea are to be found at the bottom of the rankings.27
Economic freedom does not necessarily equate with political freedom, as detailed in Map 3.6. For example,
the two top states in the Heritage Foundation index, Hong Kong and Singapore, cannot be classified as
politically free. Hong Kong was reabsorbed into communist China in 1997, and the first thing Beijing did was
shut down Hong Kong’s freely elected legislature. Singapore is ranked as only partly free on Freedom House’s
index of political freedom due to practices such as widespread press censorship.
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e Nature of Economic Transformation
LO 3-3 Describe how transition economies are moving toward market-based systems.
e shift toward a market-based economic system often entails a number of steps: deregulation, privatization,
and creation of a legal system to safeguard property rights.28
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DEREGULATION
Deregulation involves removing legal restrictions to the free play of markets, the establishment of private
enterprises, and the manner in which private enterprises operate. Before the collapse of communism, the
governments in most command economies exercised tight control over prices and output, setting both through
detailed state planning. ey also prohibited private enterprises from operating in most sectors of the economy,
severely restricted direct investment by foreign enterprises, and limited international trade.
Deregulation in these cases involved removing price controls, thereby allowing prices to be set by the
interplay between demand and supply; abolishing laws regulating the establishment and operation of private
enterprises; and relaxing or removing restrictions on direct investment by foreign enterprises and international
trade.
In mixed economies, the role of the state was more limited; but here, too, in certain sectors the state set
prices, owned businesses, limited private enterprise, restricted investment by foreigners, and restricted
international trade. For these countries, deregulation has involved the same kind of initiatives that we have seen
in former command economies, although the transformation has been easier because these countries often had
a vibrant private sector. India is an example of a country that has substantially deregulated its economy over the
past two decades (see the Country Focus on India).
c o u n t r y F O C U S
India’s Economic Transformation
After gaining independence from Britain in 1947, India adopted a democratic system of government. e economic
system that developed in India after 1947 was a mixed economy characterized by a large number of state-owned
enterprises, centralized planning, and subsidies. is system constrained the growth of the private sector. Private
companies could expand only with government permission. It could take years to get permission to diversify into a new
product. Much of heavy industry, such as auto, chemical, and steel production, was reserved for state-owned enterprises.
Production quotas and high tariffs on imports also stunted the development of a healthy private sector, as did labor laws
that made it difficult to fire employees.
By the early 1990s, it was clear this system was incapable of delivering the kind of economic progress that many
Southeast Asian nations had started to enjoy. In 1994, India’s economy was still smaller than Belgium’s, despite having a
population of 950 million. Its GDP per capita was a paltry $310, less than half the population could read, only
6 million had access to telephones, and only 14 percent had access to clean sanitation; the World Bank estimated that
some 40 percent of the world’s desperately poor lived in India, and only 2.3 percent of the population had an annual
household income in excess of $2,484.
e lack of progress led the government to embark on an ambitious economic reform program. Starting in 1991,
much of the industrial licensing system was dismantled. Several areas once closed to the private sector were opened,
including electricity generation, parts of the oil industry, steelmaking, air transport, and some areas of the
telecommunications industry. Investment by foreign enterprises, formerly allowed only grudgingly and subject to
arbitrary ceilings, was suddenly welcomed. Approval was made automatic for foreign equity stakes of up to 51 percent in
an Indian enterprise, and 100 percent foreign ownership was allowed under certain circumstances. Raw materials and
many industrial goods could be freely imported, and the maximum tariff that could be levied on imports was reduced
from 400 percent to 65 percent. e top income tax rate was also reduced, and corporate tax fell from 57.5 percent to
46 percent in 1994, and then to 35 percent in 1997. e government also announced plans to start privatizing India’s
state-owned businesses, some 40 percent of which were losing money in the early 1990s.
Judged by some measures, the response to these economic reforms has been impressive. e Indian economy
expanded at an annual rate of about 7 percent from 1997 to 2017. Foreign investment, a key indicator of how attractive
foreign companies thought the Indian economy was, jumped from $150 million in 1991 to over $40 billion in 2017. In
the information technology sector, India has emerged as a vibrant global center for software development with sales of
$150 billion and exports of $117 billion in 2017, up from sales of just $150 million in 1990. In pharmaceuticals, too,
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Indian companies are emerging as credible players in the global marketplace, primarily by selling low-cost, generic
versions of drugs that have come off patent in the developed world.
However, the country still has a long way to go. Attempts to further reduce import tariffs have been stalled by
political opposition from employers, employees, and politicians who fear that if barriers come down, a flood of
inexpensive Chinese products will enter India. e privatization program continues to hit speed bumps—the latest in
September 2003 when the Indian Supreme Court ruled that the government could not privatize two state-owned oil
companies without explicit approval from the parliament. State-owned firms still account for 38 percent of national
output in the nonfarm sector, yet India’s private firms are 30 to 40 percent more productive than state-owned
enterprises. ere has also been strong resistance to reforming many of India’s laws that make it difficult for private
business to operate efficiently. For example, labor laws make it almost impossible for firms with more than 100
employees to fire workers, creating a disincentive for entrepreneurs to increase their enterprises beyond 100 employees.
Other laws mandate that certain products can be manufactured only by small companies, effectively making it
impossible for companies in these industries to attain the scale required to compete internationally.
Sources: “India’s Breakthrough Budget?” e Economist, March 3, 2001; “America’s Pain, India’s Gain,” e Economist, January 11, 2003, p. 57; Joanna Slater, “In Once Socialist India, Privatizations Are Becoming More Like Routine
Matters,” e Wall Street Journal, July 5, 2002, p. A8; “India’s Economy: Ready to Roll Again?” e Economist, September 20, 2003, pp. 39–40; Joanna Slater, “Indian Pirates Turned Partners,” e Wall Street Journal, November 13, 2003, p. A14; “e Next Wave: India,” e Economist, December 17, 2005, p. 67; M. Dell, “e Digital Sector Can Make Poor Nations Prosper,” Financial Times, May 4, 2006, p. 17; “What’s Holding India Back,” e Economist, March 8, 2008, p. 11; “Battling the Babu Raj,” e Economist, March 8, 2008, pp. 29–31; Rishi Lyengar, “India Tops Foreign Investment Rankings Ahead of U.S. and China,” Time, October 11, 2015; and “FDI in India,” Indian Brand Equity Foundation, March 2018.
PRIVATIZATION
Hand in hand with deregulation has come a sharp increase in privatization. Privatization, as discussed in
Chapter 2, transfers the ownership of state property into the hands of private individuals, frequently by the sale
of state assets through an auction.29 Privatization is seen as a way to stimulate gains in economic efficiency by
giving new private owners a powerful incentive—the reward of greater profits—to search for increases in
productivity, to enter new markets, and to exit losing ones.30
e privatization movement started in Great Britain in the early 1980s when then–Prime Minister Margaret
atcher started to sell state-owned assets such as the British telephone company, British Telecom (BT). In a
pattern that has been repeated around the world, this sale was linked with the deregulation of the British
telecommunications industry. By allowing other firms to compete head to head with BT, deregulation ensured
that privatization did not simply replace a state-owned monopoly with a private monopoly. Since the 1980s,
privatization has become a worldwide phenomenon. More than 8,000 acts of privatization were completed
around the world between 1995 and 1999.31 Some of the most dramatic privatization programs occurred in
the economies of the former Soviet Union and its eastern European satellite states. In the Czech Republic, for
example, three-quarters of all state-owned enterprises were privatized between 1989 and 1996, helping push the
share of gross domestic product accounted for by the private sector up from 11 percent in 1989 to 60 percent
in 1995.32
Privatization is still ongoing today. For example, in 2017 the Brazilian government announced the
privatization of a state-owned electric company, airports, highways, ports, and the lottery (see the opening
case). In Saudi Arabia, the government has plans to privatize the state-owned oil company, Saudi Aramco.
Conversely, in China the privatization of inefficient state-owned enterprises has slowed down somewhat as the
state pursues a “mixed ownership” strategy.33
Despite this three-decade trend, large amounts of economic activity are still in the hands of state-owned
enterprises in many nations. In China, for example, state-owned companies still dominate the banking, energy,
telecommunications, health care, and technology sectors. Overall, they account for about 40 percent of the
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country’s GDP. e World Bank cautioned China that unless it reformed these sectors—liberalizing them and
privatizing many state-owned enterprises—the country runs the risk of experiencing a serious economic
crisis.34
As privatization has proceeded, it has become clear that simply selling state-owned assets to private investors
is not enough to guarantee economic growth. Studies of privatization have shown that the process often fails to
deliver predicted benefits if the newly privatized firms continue to receive subsidies from the state and if they
are protected from foreign competition by barriers to international trade and foreign direct investment.35 In
such cases, the newly privatized firms are sheltered from competition and continue acting like state monopolies.
When these circumstances prevail, the newly privatized entities often have little incentive to restructure their
operations to become more efficient. For privatization to work, it must also be accompanied by a more general
deregulation and opening of the economy. us, when Brazil decided to privatize the state-owned telephone
monopoly, Telebrás Brazil, the government also split the company into four independent units that were to
compete with each other and removed barriers to foreign direct investment in telecommunications services.
is action ensured that the newly privatized entities would face significant competition and thus would have
to improve their operating efficiency to survive.
Is Selling in China a Good Strategy?
If China and the United States continue to grow like they did in recent years, some estimates indicate that China will be
the world’s largest economy by 2030. Let’s assume this is true. en China is clearly a country to take a closer look at—
not just to outsource from (i.e., build factories in the country, produce products, and then sell those products to other
parts of the world), but also to sell into to target their increasing customer base with purchasing power. Between 2000
and 2011, for example, the U.S. increased exports to China by 542 percent, roughly three times that of the increase to
Brazil (which was ranked second in increase during the same period). Also, by 2020 China is expected to have some 190
million customers in the middle- and upper-income categories, making this the largest population segment of any
country’s middle-/upper-income citizens. If you were a global manager for a company, would you concentrate on selling
your products in China without having a production facility in the country?
Source: solutions.mckinsey.com/insightschina.
LEGAL SYSTEMS
As noted in Chapter 2, a well-functioning market economy requires laws protecting private property rights and
providing mechanisms for contract enforcement. Without a legal system that protects property rights and
without the machinery to enforce that system, the incentive to engage in economic activity can be reduced
substantially by private and public entities, including organized crime, that expropriate the profits generated by
the efforts of private-sector entrepreneurs. For example, when communism collapsed in eastern Europe, many
countries lacked the legal structure required to protect property rights, all property having been held by the
state. Although many nations have made big strides toward instituting the required system, it may be years
before the legal system is functioning as smoothly as it does in the West. For example, in most eastern European
nations, the title to urban and agricultural property is often uncertain because of incomplete and inaccurate
records, multiple pledges on the same property, and unsettled claims resulting from demands for restitution
from owners in the pre-communist era. Also, although most countries have improved their commercial codes,
institutional weaknesses still undermine contract enforcement. Court capacity is often inadequate, and
procedures for resolving contract disputes out of court are often lacking or poorly developed.36 Nevertheless,
progress is being made. In 2004, for example, China amended its constitution to state that “private property
was not to be encroached upon,” and in 2007 it enacted a new law on property rights that gave property
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holders many of the same protections as those enjoyed by the state (see the Country Focus “Property Rights in
China”).37
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Implications of Changing Political Economy
e global changes in political and economic systems discussed earlier have several implications for
international business. e long-standing ideological conflict between collectivism and individualism that
defined the twentieth century is less in evidence today. e West won the Cold War, and Western ideology is
more widespread. Although command economies remain and totalitarian dictatorships can still be found
around the world, the tide has been running in favor of free markets and greater democracy for 30 years. It
remains to be seen, however, whether the global financial crisis of 2008–2009 and the recession that followed
will lead to a retrenchment. Certainly many commentators have blamed the problems that led to this crisis on a
lack of regulation, and some reassessment of Western political ideology seems likely.
Notwithstanding the crisis of 2008–2009, the trends of the past 30 years have enormous implications for
business. For nearly 50 years, half of the world was off-limits to Western businesses. Now much of that has
changed. Many of the national markets of eastern Europe, Latin America, Africa, and Asia may still be
underdeveloped, but they are potentially enormous. With a population of more than 1.3 billion, the Chinese
market alone is potentially bigger than that of the United States, the European Union, and Japan combined.
Similarly, India, with about 1.2 billion people, is a potentially huge market. Latin America has another 600
million potential consumers. It is unlikely that China, Russia, Vietnam, or any of the other states now moving
toward a market system will attain the living standards of the West soon. Nevertheless, the upside potential is so
large that companies need to consider making inroads now. For example, if China and the United States
continue to grow at the rates they did during 1996–2017, China will surpass the United States to become the
world’s largest national economy within the next two decades.
Just as the potential gains are large, so are the risks. ere is no guarantee that democracy will thrive in many
of the world’s newer democratic states, particularly if these states have to grapple with severe economic setbacks.
Totalitarian dictatorships could return, although they are unlikely to be of the communist variety. Although the
bipolar world of the Cold War era has vanished, it may be replaced by a multipolar world dominated by a
number of civilizations. In such a world, much of the economic promise inherent in the global shift toward
market-based economic systems may stall in the face of conflicts between civilizations. While the long-term
potential for economic gain from investment in the world’s new market economies is large, the risks associated
with any such investment are also substantial. It would be foolish to ignore these. e financial system in
China, for example, is not transparent, and many suspect that Chinese banks hold a high proportion of
nonperforming loans on their books. If true, these bad debts could trigger a significant financial crisis during
the next decade in China, which would dramatically lower growth rates.
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Focus on Managerial Implications
Page 79
LO 3-4 Explain the implications for management practice of national difference in political economy.
BENEFITS, COSTS, RISKS, AND OVERALL ATTRACTIVENESS OF DOING BUSINESS INTERNATIONALLY
As noted in Chapter 2, the political, economic, and legal environments of a country clearly influence the
attractiveness of that country as a market or investment site. In this chapter, we argued that countries with
democratic regimes, market-based economic policies, and strong protection of property rights are more likely to
attain high and sustained economic growth rates and are thus a more attractive location for international
business. It follows that the benefits, costs, and risks associated with doing business in a country are a function
of that country’s political, economic, and legal systems. e overall attractiveness of a country as a market or
investment site depends on balancing the likely long-term benefits of doing business in that country against the
likely costs and risks. Here, we consider the determinants of benefits, costs, and risks.
Benefits In the most general sense, the long-run monetary benefits of doing business in a country are a function of the size of the market, the present wealth (purchasing power) of consumers in that market, and the
likely future wealth of consumers. While some markets are very large when measured by number of consumers
(e.g. India), relatively low living standards may imply limited purchasing power and, therefore, a relatively small
market when measured in economic terms. International businesses need to be aware of this distinction, but
they also need to keep in mind the likely future prospects of a country. In 1960, South Korea was viewed as just
another impoverished third-world nation. By 2017, it had the world’s 11th-largest economy. International firms
that recognized South Korea’s potential in 1960 and began to do business in that country may have reaped
greater benefits than those that wrote off South Korea.
By identifying and investing early in a potential future economic star, international firms may build brand
loyalty and gain experience in that country’s business practices. ese will pay back substantial dividends if that
country achieves sustained high economic growth rates. In contrast, late entrants may find that they
lack the brand loyalty and experience necessary to achieve a significant presence in the market. In the
language of business strategy, early entrants into potential future economic stars may be able to reap substantial
first-mover advantages, while late entrants may fall victim to late-mover disadvantages.38 (First-mover
advantages are the advantages that accrue to early entrants into a market. Late-mover disadvantages are the
handicaps that late entrants might suffer.) is kind of reasoning has been driving significant inward
investment into China, which may become the world’s largest economy by 2030 if it continues growing at
current rates (China is already the world’s second-largest national economy). For more than two decades, China
has been the largest recipient of foreign direct investment in the developing world as international businesses—
including General Motors, Volkswagen, Coca-Cola, and Unilever—try to establish a sustainable advantage in
this nation.
Coca-Cola has been in China for about 40 years, and about 140 million servings of the company’s
products are enjoyed daily in China.
©testing/Shutterstock
A country’s economic system and property rights regime are reasonably good predictors of economic
prospects. Countries with free market economies in which property rights are protected tend to achieve greater
economic growth rates than command economies or economies where property rights are poorly protected. It
follows that a country’s economic system, property rights regime, and market size (in terms of population)
probably constitute reasonably good indicators of the potential long-run benefits of doing business in a country.
In contrast, countries where property rights are not well respected and where corruption is rampant tend to
have lower levels of economic growth. We must be careful about generalizing too much from this, however,
because both China and India have achieved high growth rates despite relatively weak property rights regimes
and high levels of corruption. In both countries, the shift toward a market-based economic system has
produced large gains despite weak property rights and endemic corruption.
Costs A number of political, economic, and legal factors determine the costs of doing business in a country. With regard to political factors, a company may be pushed to pay off politically powerful entities in a country
before the government allows it to do business there. e need to pay what are essentially bribes is greater in
closed totalitarian states than in open democratic societies where politicians are held accountable by the
electorate (although this is not a hard-and-fast distinction). Whether a company should actually pay bribes in
return for market access should be determined on the basis of the legal and ethical implications of such action.
We discuss this consideration in Chapter 5, when we look closely at the issue of business ethics.
With regard to economic factors, one of the most important variables is the sophistication of a country’s
economy. It may be more costly to do business in relatively primitive or undeveloped economies because of the
lack of infrastructure and supporting businesses. At the extreme, an international firm may have to provide its
own infrastructure and supporting business, which obviously raises costs. When McDonald’s decided to open
its first restaurant in Moscow, it found that to serve food and drink indistinguishable from that served in
McDonald’s restaurants elsewhere, it had to vertically integrate backward to supply its own needs. e quality
of Russian-grown potatoes and meat was too poor. us, to protect the quality of its product, McDonald’s set
up its own dairy farms, cattle ranches, vegetable plots, and food-processing plants within Russia. is raised the
cost of doing business in Russia, relative to the cost in more sophisticated economies where high-quality inputs
could be purchased on the open market.
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As for legal factors, it can be more costly to do business in a country where local laws and regulations set
strict standards with regard to product safety, safety in the workplace, environmental pollution, and the like
(because adhering to such regulations is costly). It can also be more costly to do business in a country like the
United States, where the absence of a cap on damage awards has meant spiraling liability insurance rates. It can
be more costly to do business in a country that lacks well-established laws for regulating business practice (as is
the case in many of the former communist nations). In the absence of a well-developed body of business
contract law, international firms may find no satisfactory way to resolve contract disputes and, consequently,
routinely face large losses from contract violations. Similarly, local laws that fail to adequately protect
intellectual property can lead to the theft of an international business’s intellectual property and lost income.
Risks As with costs, the risks of doing business in a country are determined by a number of political, economic, and legal factors. Political risk has been defined as the likelihood that political forces will
cause drastic changes in a country’s business environment that adversely affect the profit and other goals of a
business enterprise.39 So defined, political risk tends to be greater in countries experiencing social unrest and
disorder or in countries where the underlying nature of a society increases the likelihood of social unrest. Social
unrest typically finds expression in strikes, demonstrations, terrorism, and violent conflict. Such unrest is more
likely to be found in countries that contain more than one ethnic nationality, in countries where competing
ideologies are battling for political control, in countries where economic mismanagement has created high
inflation and falling living standards, or in countries that straddle the “fault lines” between civilizations.
Social unrest can result in abrupt changes in government and government policy or, in some cases, in
protracted civil strife. Such strife tends to have negative economic implications for the profit goals of business
enterprises. For example, in the aftermath of the 1979 Islamic revolution in Iran, the Iranian assets of numerous
U.S. companies were seized by the new Iranian government without compensation. Similarly, the violent
disintegration of the Yugoslavian federation into warring states, including Bosnia, Croatia, and Serbia,
precipitated a collapse in the local economies and in the profitability of investments in those countries.
More generally, a change in political regime can result in the enactment of laws that are less favorable to
international business. In Venezuela, for example, the populist socialist politician Hugo Chávez held power
from 1998 until his death in 2013. Chávez declared himself to be a “Fidelista,” a follower of Cuba’s Fidel
Castro. He pledged to improve the lot of the poor in Venezuela through government intervention in private
business and frequently railed against American imperialism, all of which is of concern to Western enterprises
doing business in the country. Among other actions, he increased the royalties that foreign oil companies
operating in Venezuela had to pay the government from 1 to 30 percent of sales.
Other risks may arise from a country’s mismanagement of its economy. An economic risk can be defined as
the likelihood that economic mismanagement will cause drastic changes in a country’s business environment
that hurt the profit and other goals of a particular business enterprise. Economic risks are not independent of
political risk. Economic mismanagement may give rise to significant social unrest and, hence, political risk.
Nevertheless, economic risks are worth emphasizing as a separate category because there is not always a one-to-
one relationship between economic mismanagement and social unrest. One visible indicator of economic
mismanagement tends to be a country’s inflation rate. Another is the level of business and government debt in
the country.
e collapse in oil prices that occurred in 2014–2015 exposed economic mismanagement and increased
economic risk in a number countries that had been overly dependent upon oil revenues to finance profligate
government spending. In countries such as Russia, Saudi Arabia, and Venezuela, high oil prices had enabled
national governments to spend lavishly on social programs and public sector infrastructure. As oil prices
collapsed, these countries saw government revenues tumble. Budget deficits began to climb sharply, their
currencies fell on foreign exchange markets, price inflation began to accelerate as the price of imports rose, and
their economies started to contract, increasing unemployment and creating the potential for social disruption.
None of this was good for those countries, nor did it benefit foreign business that had invested in those
economies.
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On the legal front, risks arise when a country’s legal system fails to provide adequate safeguards in the case of
contract violations or to protect property rights. When legal safeguards are weak, firms are more likely to break
contracts or steal intellectual property if they perceive it as being in their interests to do so. us, a legal risk
can be defined as the likelihood that a trading partner will opportunistically break a contract or expropriate
property rights. When legal risks in a country are high, an international business might hesitate entering into a
long-term contract or joint-venture agreement with a firm in that country. For example, in the 1970s when the
Indian government passed a law requiring all foreign investors to enter into joint ventures with Indian
companies, U.S. companies such as IBM and Coca-Cola closed their investments in India. ey
believed that the Indian legal system did not provide adequate protection of intellectual property
rights, creating the very real danger that their Indian partners might expropriate the intellectual property of the
American companies—which for IBM and Coca-Cola amounted to the core of their competitive advantage.
Overall Attractiveness e overall attractiveness of a country as a potential market or investment site for an international business depends on balancing the benefits, costs, and risks associated with doing business in
that country (see Figure 3.1). Generally, the costs and risks associated with doing business in a foreign country
are typically lower in economically advanced and politically stable democratic nations and greater in less
developed and politically unstable nations. e calculus is complicated, however, because the potential long-run
benefits are dependent not only on a nation’s current stage of economic development or political stability but
also on likely future economic growth rates. Economic growth appears to be a function of a free market system
and a country’s capacity for growth (which may be greater in less developed nations). is leads us to conclude
that, other things being equal, the benefit–cost–risk trade-off is likely to be most favorable in politically stable
developed and developing nations that have free market systems and no dramatic upsurge in either inflation
rates or private-sector debt. It is likely to be least favorable in politically unstable developing nations that
operate with a mixed or command economy or in developing nations where speculative financial bubbles have
led to excess borrowing.
3.1 FIGURE
Country attractiveness.
Key Terms
gross national income (GNI), p. 60
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purchasing power parity (PPP), p. 61
Human Development Index (HDI), p. 64
innovation, p. 65
entrepreneurs, p. 66
deregulation, p. 74
first-mover advantages, p. 79
late-mover disadvantages, p. 79
political risk, p. 80
economic risk, p. 80
legal risk, p. 80
Summary
is chapter reviewed how the political, economic, and legal systems of countries vary. e potential benefits,
costs, and risks of doing business in a country are a function of its political, economic, and legal systems. e
chapter made the following points:
1. e rate of economic progress in a country seems to depend on the extent to which that country has a
well-functioning market economy in which property rights are protected.
2. Many countries are now in a state of transition. ere is a marked shift away from totalitarian
governments and command or mixed economic systems and toward democratic political institutions and
free market economic systems.
3. e attractiveness of a country as a market and/or investment site depends on balancing the likely long-
run benefits of doing business in that country against the likely costs and risks.
4. e benefits of doing business in a country are a function of the size of the market (population), its
present wealth (purchasing power), and its future growth prospects. By investing early in countries that
are currently poor but are nevertheless growing rapidly, firms can gain first-mover advantages that will pay
back substantial dividends in the future.
5. e costs of doing business in a country tend to be greater where political payoffs are required to gain
market access, where supporting infrastructure is lacking or underdeveloped, and where adhering to local
laws and regulations is costly.
6. e risks of doing business in a country tend to be greater in countries that are politically unstable,
subject to economic mismanagement, and lacking a legal system to provide adequate safeguards in the
case of contract or property rights violations.
Critical inking and Discussion Questions
1. What is the relationship among property rights, corruption, and economic progress? How important are
anticorruption efforts in the effort to improve a country’s level of economic development?
2. You are a senior manager in a U.S. automobile company considering investing in production facilities in
China, Russia, or Germany. ese facilities will serve local market demand. Evaluate the benefits, costs,
and risks associated with doing business in each nation. Which country seems the most attractive target
for foreign direct investment? Why?
3. Reread the Country Focus “India’s Economic Transformation,” and answer the following questions:
a. What kind of economic system did India operate under during 1947–1990? What kind of system is it
moving toward today? What are the impediments to completing this transformation?
b. How might widespread public ownership of businesses and extensive government regulations have
affected (i) the efficiency of state and private businesses and (ii) the rate of new business formation in
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India during the 1947–1990 time frame? How do you think these factors affected the rate of economic
growth in India during this time frame?
c. How would privatization, deregulation, and the removal of barriers to foreign direct investment affect
the efficiency of business, new business formation, and the rate of economic growth in India during
the post-1990 period?
d. India now has pockets of strengths in key high-technology industries such as software and
pharmaceuticals. Why do you think India is developing strength in these areas? How might success in
these industries help generate growth in the other sectors of the Indian economy?
e. Given what is now occurring in the Indian economy, do you think the country represents an attractive
target for inward investment by foreign multinationals selling consumer products? Why?
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. Increased instability in the global marketplace can introduce unanticipated risks in a company’s daily
transactions. Your company must evaluate these commercial transaction risks for its foreign operations in
Argentina, China, Egypt, Poland, and South Africa. A risk analyst at your firm said that you could
evaluate both the political and commercial risk of these countries simultaneously. Provide a commercial
transaction risk overview of all five countries for top management. In your evaluation, indicate
possible corrective measures in the countries with considerably high political and/or commercial
risk.
2. Managers at your firm are very concerned about the influence of terrorism on its long-term strategy. To
counter this issue, the CEO has indicated you must identify the countries where terrorism threat and
political risk are minimal. is will provide the basis for the development of future company facilities,
which need to be built in all major continents in the world. Include recommendations on which
countries in each continent would serve as a good candidate for your company to further analyze.
E c o n o m i c D e v e l o p m e n t i n B a n g l a d e s h
c l o s i n g c a s e
When Bangladesh gained independence from Pakistan in 1971 after a brutal civil war that may have left as many as 3
million dead, the U.S. National Security Adviser, Henry Kissinger, referred to the country as a “basket case.” Kissinger’s
assessment was accurate enough. At the time, Bangladesh was one of the world’s poorest nations. Although most of the
country is dominated by the fertile Ganges-Brahmaputra delta, a lack of other natural resources, coupled with poor
infrastructure, political instability, and high levels of corruption, long held the country back. To compound matters,
Bangladesh is prone to natural disasters. Most of Bangladesh is less than 12 meters above sea level. e extensive low-
lying areas are vulnerable to tropical cyclones, floods, and tidal bores.
Beginning in the mid-1990s, however, Bangladesh began to climb the ladder of economic progress. From the early
2000s onward, the country grew its economy at around 6 percent per annum compounded. Today, this Muslim
majority country of 160 million people has joined the ranks of lower-middle-income nations. Poverty reduction has
been dramatic, with the percentage of the population living in poverty falling from 44.2 percent in 1991 to 18.5 percent
in 2010, an achievement that raised 20.5 million people out of abject poverty. Today the country ranks 64th out of the
154 countries included in the World Bank’s global poverty database. It has a considerable way to go, but it is no longer
one of the world’s poorest countries.
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Garment workers working inside a factory in Gazipur in Bangladesh, on May 14, 2017. Bangladesh is the
second largest apparel exporter in the world after China.
©NurPhoto/Contributor/Getty Images
Several reasons underlie Bangladesh’s relative economic success. In its initial post-independence period, Bangladesh
adopted socialist policies, nationalizing many companies and subsidizing the costs of agricultural production and basic
food products. ese policies failed to deliver the anticipated gains. Policy reforms in the 1980s were directed toward the
withdrawal of food and agricultural subsidies, the privatization of state-owned companies, financial liberalization, and
the withdrawal of some import restrictions. Further reforms aimed at liberalizing the economy were launched in the
1990s. ese included making the currency convertible (which led to a floating exchange rate in 2003), reducing import
duties to much lower levels, and removing most of the controls on the movement of foreign private capital
(which allowed for more foreign direct investment). e reforms of the 1990s coincided with the transition to
a parliamentary democracy from semi-autocratic rule.
Bangladesh’s private sector has expanded rapidly since then. Leading the growth has been the country’s vibrant textile
sector, which is now the second-largest exporter of ready-made garments in the world after China. Textiles account for
80 percent of Bangladesh’s exports. e development of the textile industry has been helped by the availability of low-
cost labor, managerial skills, favorable trade agreements, and government policies that eliminated import duties on
inputs for the textile business, such as raw materials. e Bangladesh economy has also benefited from its productive
agricultural sector and remittances from more than 10 million Bangladesh citizens who work in other nations.
Bangladesh is also home of the microfinance movement, which has enabled entrepreneurs with no prior access to the
banking system to borrow small amounts of capital to start businesses.
is being said, the country still faces considerable impediments to sustaining its growth. Infrastructure remains
poor; corruption continues to be a major problem; and the political system is, at best, an imperfect democracy where
opposition is stifled. e country is too dependent upon its booming textile sector and needs to diversify its industrial
base. Bangladesh is also one of the countries most prone to the adverse affects of climate change. A one-meter rise in sea
level would leave an estimated 10 percent of the country under water and increase the potential for damaging floods in
much of the remainder. Nevertheless, according to the U.S. investment bank Goldman Sachs, Bangladesh is one of the
11 lower-middle-income nations poised for sustained growth.
Sources: W. Mahmud, S. Ahmed, and S. Mahajan, “Economic Reforms, Growth, and Governance: e Political Economy Aspects of
Bangladesh’s Development Surprise,” World Bank Commission on Development and Growth, 2008; “Freedom in the World 2016,” Freedom
House; “Tiger in the Night,” e Economist, October 15, 2016; Sanjay Kathuria, “How Will Bangladesh Reach High Levels of Prosperity?”
World Bank blog, January 5, 2017; and Qimiao Fan, “Bangladesh: Setting a Global Standard in Ending Poverty,” World Bank blog, October 5,
2016.
CASE DISCUSSION QUESTIONS
1. What were the principal reasons for the economic stagnation of Bangladesh after its war for
independence?
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2. Explain how the liberalization program in the 1990s enabled Bangladesh to start climbing the ladder
of economic progress.
3. Bangladesh is dependent for its prosperity upon agriculture and textile exports. What are the risks
here? How might Bangladesh diversify its industrial and commercial base?
Endnotes
1. World Bank, World Development Indicators Online, 2018.
2. Brindusa Mihaela Tudose and Raluca Irina Clipa, “An Analysis of the Shadow Economy in EU
Countries,” CES Working Papers,” Volume 111, Issue 2, pp. 303–312, 2018.
www.ceswp.uaic.ro/articles/CESWP2016_VIII2_TUD.pdf.
3. A. Sen, Development as Freedom (New York: Knopf, 1999).
4. G. M. Grossman and E. Helpman, “Endogenous Innovation in the eory of Growth,” Journal of
Economic Perspectives 8, no. 1 (1994), pp. 23–44; P. M. Romer, “e Origins of Endogenous Growth,”
Journal of Economic Perspectives 8, no. 1 (1994), pp. 2–22.
5. W. W. Lewis, e Power of Productivity (Chicago: University of Chicago Press, 2004).
6. F. A. Hayek, e Fatal Conceit: Errors of Socialism (Chicago: University of Chicago Press, 1989).
7. J. Gwartney, R. Lawson, and W. Block, Economic Freedom of the World: 1975–1995 (London: Institute of
Economic Affairs, 1996); C. Doucouliagos and M. Ali Ulubasoglu, “Economic Freedom and Economic
Growth: Does Specification Make a Difference?” European Journal of Political Economy 22 (March 2006),
pp. 60–81.
8. D. North, Institutions, Institutional Change, and Economic Performance (Cambridge, UK: Cambridge
University Press, 1991). See also K. M. Murphy, A. Shleifer, and R. Vishney, “Why Is Rent Seeking So
Costly to Growth?,” American Economic Review 83, no. 2 (1993), pp. 409–14; K. E. Maskus, “Intellectual
Property Rights in the Global Economy,” Institute for International Economics, 2000.
9. North, Institutions, Institutional Change and Economic Performance.
10. H. de Soto, e Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New
York: Basic Books, 2000).
11. A. O. Hirschman, “e On-and-Off Again Connection between Political and Economic Progress,”
American Economic Review 84, no. 2 (1994), pp. 343–48; A. Przeworski and F. Limongi, “Political
Regimes and Economic Growth,” Journal of Economic Perspectives 7, no. 3 (1993), pp. 51–59.
12. Hirschman, “e On-and-Off Again Connection between Political and Economic Progress.”
13. For details of this argument, see M. Olson, “Dictatorship, Democracy, and Development,” American
Political Science Review, September 1993.
14. For example, see Jared Diamond’s Pulitzer Prize–winning book Guns, Germs, and Steel (New York:
Norton, 1997). Also see J. Sachs, “Nature, Nurture and Growth,” e Economist, June 14, 1997, pp. 19–
22; J. Sachs, e End of Poverty (New York: Penguin Books, 2005).
15. Sachs, “Nature, Nurture and Growth.”
16. “What Can the Rest of the World Learn from the Classrooms of Asia?” e Economist, September 21,
1996, p. 24.
17. J. Fagerberg, “Technology and International Differences in Growth Rates,” Journal of Economic Literature
32 (September 1994), pp. 1147–75.
18. See e Freedom House Survey Team, “Freedom in the World 2018,” and associated materials,
www.freedomhouse.org.
19. “Russia Downgraded to Not Free,” Freedom House (Press Release), December 20, 2004,
www.freedomhouse.org.
20. Freedom House, “Democracies Century: A Survey of Political Change in the Twentieth Century, 1999,”
www.freedomhouse.org.
21. L. Conners, “Freedom to Connect,” Wired, August 1997, pp. 105–6.
22. F. Fukuyama, “e End of History,” e National Interest 16 (Summer 1989), p. 18.
23. S. P. Huntington, e Clash of Civilizations and the Remaking of World Order (New York: Simon &
Schuster, 1996).
24. Huntington, e Clash of Civilizations and the Remaking of World Order.
25. U.S. National Counterterrorism Center, Reports on Incidents of Terrorism, 2005, April 11, 2006.
26. S. Fischer, R. Sahay, and C. A. Vegh, “Stabilization and the Growth in Transition Economies: e Early
Experience,” Journal of Economic Perspectives 10 (Spring 1996), pp. 45–66.
27. M. Miles et al., 2018 Index of Economic Freedom (Washington, DC: Heritage Foundation, 2018).
28. International Monetary Fund, World Economic Outlook: Focus on Transition Economies (Geneva: IMF,
October 2000). “Transition Economies, an IMF Perspective on Progress and Prospects,” IMF, November
3, 2000.
29. J. C. Brada, “Privatization Is Transition—Is It?” Journal of Economic Perspectives, Spring 1996, pp. 67–86.
30. See S. Zahra et al., “Privatization and Entrepreneurial Transformation,” Academy of Management Review
3, no. 25 (2000), pp. 509–24.
31. N. Brune, G. Garrett, and B. Kogut, “e International Monetary Fund and the Global Spread of
Privatization,” IMF Staff Papers 51, no. 2 (2003), pp. 195–219.
32. Fischer et al., “Stabilization and Growth in Transition Economies.”
33. Shannon Sims, “Brazil’s Privatization Push,” US News and World Reports, October 11, 2017; Jane Cai,
“Forget Privatization, Xi Has Other Big Plans for Bloated State Firms,” South China Morning Post,
September 6, 2017.
34. “China 2030,” World Bank, 2012.
35. J. Sachs, C. Zinnes, and Y. Eilat, “e Gains from Privatization in Transition Economies: Is Change of
Ownership Enough?” CAER discussion paper no. 63 (Cambridge, MA: Harvard Institute for
International Development, 2000).
36. M. S. Borish and M. Noel, “Private Sector Development in the Visegrad Countries,” World Bank, March
1997.
37. “Caught between Right and Left,” e Economist, March 8, 2007.
38. For a discussion of first-mover advantages, see M. Liberman and D. Montgomery, “First-Mover
Advantages,” Strategic Management Journal 9 (Summer Special Issue, 1988), pp. 41–58.
39. S. H. Robock, “Political Risk: Identification and Assessment,” Columbia Journal of World Business, July–
August 1971, pp. 6–20.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill
Education
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4
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Part 2 National Differences
Differences in Culture
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO4-1 Explain what is meant by the culture of a society.
LO4-2 Identify the forces that lead to differences in social culture.
LO4-3 Identify the business and economic implications of differences in culture.
LO4-4 Recognize how differences in social culture influence values in business.
LO4-5 Demonstrate an appreciation for the economic and business implications of cultural change.
China, Hong Kong, Macau, and Taiwan
opening case
A lot of international business discussion today centers on how much economic power, political influence, and
international competitiveness the People’s Republic of China (PRC) has achieved and is forecast to gain in the next
decades. China along with India, Brazil, and Russia form the BRIC (an acronym formulated using their initial
letters) countries, which have been viewed as the business engines of tomorrow (especially China) based on their
immense economic potential. e BRICs, which cover a quarter of the world’s landmass and contain 40 percent of its
population, had a combined GDP of $20 trillion in 2001. Today, these increasingly market-oriented economies boast a
GDP of $37 trillion (or 22 percent of global GDP), a figure forecast to reach $120 trillion by 2050. Together, they
control more than 43 percent of the world’s currency reserves ($4 trillion) and 20 percent of its trade.
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Basically, size of the population and size of the market were the two overriding factors that led former Goldman
Sachs chief economist Jim O’Neill to first coin the acronym BRIC to highlight the immense collective economic
potential of these four emerging markets. However, despite many countries’ and companies’ enthusiasm for increased
global interaction and economic exchange with the BRIC economies, especially China and India, many have found that
cultural differences hinder their ability to conduct business in these countries. Not only is the culture different between
each BRIC country and most other of the globe’s remaining 192 countries, but the business and societal cultures within
the BRIC countries are also vastly different from each other.
e outlook for the BRICs may not be as positive as we have been led to believe anyway. For example, the structural
transformation of China, which has been the main driver of the BRICs, from an export-driven economy to one relying
more on domestic consumption, has added some woes. e likelihood is that the trend of annual increases of exports to
China from much of the developed world also will slow down (but that we will see trade increases nevertheless, just not
as significantly as in the past decade).
Importantly, China is still trying to implement the “one country, two systems” approach—a constitutional principle
formulated by Deng Xiaoping—which involves how to merge mainland China with Hong Kong and Macau. In
addition, Taiwan presents an even bigger ongoing structural, legal, and cultural challenge for China.
Hong Kong, a business port located off the southeast coast of China in eastern Asia, traces its history to the Old
Stone Age, and really became entrenched in today’s infrastructure with its inclusion into the Chinese empire during the
Qin dynasty (221–206 B.C.). However, Hong Kong was a self-governing British colony from 1841 to 1997, at which
time Hong Kong became a Special Administrative Region (SAR) of the People’s Republic of China (on July 1, 1997),
pursuant to the 1984 Sino-British Joint Declaration. e backdrop is that, throughout the colonial era, Hong
Kong’s citizens developed a distinctive “Hong Kong identity.” To this day, the cultural differences between
mainland China and Hong Kong are often pronounced, and they are potentially becoming more contentious with
mainland China asserting its influence. e sentiment in Hong Kong is that it needs to be recognized as having a
unique culture and “national identity.” Hong Kong is in many ways often at odds with mainland China, and periodic
clashes flare between Hong Kong and China, as happened in 2012.
Prior to 1999, Macau was a Portuguese colony, followed by being an overseas province under Portuguese
administration from 1887 to 1999. Macau was both the first and last European colony in China. Just before its return
to China in 1999, Macau had been experiencing a number of economic difficulties. Macau’s biggest revenue items—
gaming and tourism—decreased in 1993, followed by the collapse of the property market in 1994, and then the
economic crisis in 1997 that affected much of Asia. By the time 1999 came around for a handover from Portugal to
China, most locals welcomed the change because of deteriorating public order, rising crime rates, and widespread
corruption that had infiltrated the culture during the last years of the Portuguese-Macau government. Today, Macau is
being positioned as a key diplomatic player in China’s relations with Portuguese-speaking countries.
Taiwan, officially the Republic of China (ROC), is an island nation (Island of Taiwan, formerly Formosa). It is the
most populous country and the largest economy that is not a member of the United Nations. Taiwan was ceded by the
Qing dynasty to Japan in 1895 after the Sino-Japanese War. e Republic of China was established in 1912 after the fall
of the Qing dynasty while Taiwan was under Japanese rule. However, China has consistently claimed sovereignty over
Taiwan and asserted that the Republic of China is no longer in legitimate existence. Under its One-China Policy, China
even refuses to engage in diplomatic relations with any country that recognizes Taiwan. In this semi-independent state,
Taiwan has experienced solid economic growth and industrialization, creating a stable industrial economy. e culture
blends Confucianist Han Chinese and Taiwanese aboriginal influences.
When we combine mainland China, Hong Kong, Macau, and Taiwan, we often talk about the entity “Greater
China” or the “Greater China Region.” Obviously, there is no legal entity or sovereignty associated with this “greater
region,” except in business/economic development terms. Some argue that the “region” can be seen as being culturally
homogeneous but such arguments do not hold up well given the clashes between mainland China and Hong Kong and
Taiwan. Interestingly, Macau has been more positive about its relationship or partnership with China, perhaps due to
experiencing such serious financial difficulties immediately prior to the 1999 handover (that were essentially solved in
the China partnership). Given the strained relationships and the nuances of political issues between China and its close
cultural neighbors, the phrase “sinophone world” (“Chinese-speaking world”) is often used instead of Greater China to
incorporate mainland China, Hong Kong, Macau, and Taiwan. •
Sources: Tomas Hult, “e U.S. Shouldn’t Fret over Cheaper Yuan,” Time, August 14, 2015; Tomas Hult, “Why the Fed Is No Longer Center
of the Financial Universe,” Fortune, September 17, 2015; Tomas Hult, “Does the Global Stock Market Sell-Off Signal the BRIC Age Is Already
Over?” e Conversation, August 28, 2015; Tomas Hult, “U.S. Shouldn’t Fret over Cheaper Yuan: China’s Growing Middle Class Will Keep
Buying ‘Made In America,’” e Conversation, August 13, 2015; Tomas Hult, “e BRIC Countries,” globalEDGE Business Review, 3 (4), 2009;
Bruce Keillor, Tomas Hult, Robert Erffmeyer, and Emin Babakus, “NATID: e Development and Application of a National Identity Measure
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for Use in International Marketing,” Journal of International Marketing, 4 (2), 1996, pp. 57–73; Erkan Ozkaya, Cornelia Droge, Tomas Hult,
Roger Calantone, and Elif Ozkaya, “Market Orientation, Knowledge Competence, and Innovation,” International Journal of Research in
Marketing, 32 (3), 2015, pp. 309–18; and Mark Esposito, Amit Kapoor, and Deepti Mathur, “What Is the State of the BRICS Economies?”
World Economic Forum, April 19, 2016.
Introduction
In Chapters 2 and 3, we saw how national differences in political, economic, and legal systems influence the
benefits, costs, and risks associated with doing business in different countries. In this “cultural” chapter, we
explore how differences in culture across and within countries can have an effect on the development and
implementation of a company’s international business strategies. is includes a focus on the operations of all
types of multinational companies—from small to medium to large companies. Several themes run
through this chapter. e first is that business success in many, if not most, countries requires what we
call cross-cultural literacy. By cross-cultural literacy, we mean an understanding of how cultural differences
across and within nations can affect the way business is practiced. It is sometimes easy to forget how different
various cultures really are, even today.1 Underneath the veneer of modernism and globalization, deep cultural
differences often remain.2
e opening case on China, Hong Kong, Macau, and Taiwan highlights that deep cultural differences exist
in what many would consider to be a region with a very similar cultural background, i.e., Greater China.
Instead, what we find is that throughout the colonial era, Hong Kong’s citizens developed a distinct “Hong
Kong identity” that seeks to be recognized as a unique culturally based “national identity.” Meanwhile, the
Taiwanese culture, a blend of Confucian Han Chinese and Taiwanese aboriginal cultures, is often at odds with
mainland China. Interestingly, Macau has had a better experience with the Chinese takeover due to the
economic difficulties that preceded the handover from Portugal in 1999, resulting in a much better partnership
between China and Macau. Macau is being positioned as a key diplomatic player in China’s relations with
Portuguese-speaking countries. While some observers around the world may simply refer to the Greater China
Region as “Chinese,” the deeply ingrained cultural values and norms in the region are very different from each
other as a practical matter.
e chapter’s closing case on e Swatch Group illustrates the various cultural differences that exist in the
world and how these cultural differences can be used when developing watches that fit a large number of global
customer segments. While Swatch has become a very well-known company and most people would recognize a
Swatch watch from a distance, Swatch’s large-scale production of watches and jewelry is used to help create
individually and culturally based customer uniqueness. e company thrives on playing to country-specific
cultures that make people different from each other as well as personal characteristics people showcase in their
individualized Swatch use. e company encourages this individuality via the tags #MySwatch and #YourMove.
In this chapter, we make a case that it is important for foreign businesses to gain an understanding of the
culture that prevails in countries where they do business and indeed that success requires a foreign enterprise to
adapt, at least to some degree for most products and services, to the macro (overall) culture of its host country
as well as to dominant subcultures within the country.3
Another theme that we will develop in this chapter is that a relationship may exist between culture and the
cost of doing business in a country or region. Different countries will be either more or less supportive of the
market-based mode of production and sales to customers (i.e., where supply and demand set the prices for
products and services). For example, cultural factors may have lowered the costs of doing business in Japan and
may help explain Japan’s rapid economic ascent as an industrialized and competitive nation in the world about
half a century ago.4 Cultural factors can sometimes also raise the costs of doing business. Historically, class
divisions were an important aspect of British culture, and for a long time, firms operating in the United
Kingdom found it difficult to achieve cooperation between management and labor. Class divisions led to a high
level of industrial disputes in that country during the same period that Japan was developing into a global force.
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is raised the costs of doing business in Britain relative to the costs in countries such as Germany, Japan,
Norway, Sweden, and Switzerland, where class conflict was historically less prevalent.
e examples of Japan and the United Kingdom bring us to another theme that we explore in this chapter.
Culture is not static. Culture is rooted in the values and norms that we have as people, and those are generally
tied to doing something over a period of time. ink about it: If you do the same thing over and over, it
becomes a habit and then you almost take it for granted. But sometimes you break the habit and start
something new. Culture is very much the same. Culture can and does evolve, although the rate at which culture
can change is the subject of dispute (how easy or often do we change habits?). Generally, culture evolves as
behaviors of people become ingrained and coded in their values and norms. A cultural mindset develops
consistent with people’s behavior over time. But things happen sometimes to cause people’s behavior to change,
and so culture evolves.
Did You Know?
Did you know arriving late is expected in some cultures?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
You may recognize how your own personal cultural values and norms are hard to change. e same goes for
the culture of a society, which evolves when large population segments in a country or region adopt values
based on common ways of behaving, which change only slowly. Finally, multinational corporations operating
across national cultures can themselves have unique values and norms. Individuals may operate a certain way in
their personal lives, a different way at work, and yet a different way in society. is is not to say that there are
not overlaps—but many people also act differently in each context.
What Is Culture?
LO 4-1 Explain what is meant by the culture of a society.
People have a hard time agreeing on a simple definition of culture. is makes it difficult to build culture into
companies’ global operations across the world’s 196 countries. In the 1870s, anthropologist Edward Tylor
defined culture as “that complex whole which includes knowledge, belief, art, morals, law, custom, and other
capabilities acquired by man as a member of society.”5 Since then, thousands of definitions have been offered by
diverse experts from many cultures—in other words culture actually affects how different people define culture
itself!
Florence Kluckhohn and Fred Strodtbeck’s values orientation theory of culture states that all definitions of
culture must answer a limited number of universal problems, that the value-based solutions are limited in
number and universally known, and that different cultures have different preferences among them.6 Following
their work, other prominent specialists have supported the idea of a universal set of human values serving as the
basis for culture; see Milton Rokeach’s work on “the nature of human values” and Shalom Schwartz’s work on
the “theory of basic human values.”7
Also supportive of a finite set of human values, Geert Hofstede, a Dutch expert on cross-cultural differences
and international management, defined culture as “the collective programming of the mind which distinguishes
the members of one human group from another.”8 Hofstede’s work is by far the most used culture research in
both scholarship and business practice over the last half a century, and we have relied on his scientific approach
to understand how, when, and why culture has an impact on multinational corporations. Culture includes
systems of values, and values are among the building blocks of culture.9 Another complementary definition of
culture comes from sociologists Zvi Namenwirth and Robert Weber, who see culture as a system of ideas and
argue that these ideas constitute a design for living.10
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As authors of this textbook, we subscribe to the definitions of Hofstede and the team of Namenwirth and
Weber by viewing culture as a system of values and norms that are shared among a group of people and that
when taken together constitute a design for living. By values, we mean ideas about what a group believes to be
good, right, and desirable. Put differently, values are shared assumptions about how things ought to be.11 By
norms, we mean the social rules and guidelines that prescribe appropriate behavior in particular situations. We
use the term society to refer to a group of people sharing a common set of values and norms. While a society
may be equivalent to a country, some countries have several societies or subcultures, and some societies embrace
more than one country. For example, the Scandinavian countries of Denmark, Finland, Iceland, Norway, and
Sweden are often viewed as culturally being one society for the purpose of a multinational corporation engaging
in that marketplace. So, if one Scandinavian country’s people like a product from a company, there is
a very good chance customers from the other Scandinavian countries will as well.
Geert Hofstede, often viewed as the foremost expert on cross-cultural differences in international
business, presents his work in Istanbul, Turkey, at the Academy of International Business
conference.
©Academy of International Business (AIB)
VALUES AND NORMS
Values form the bedrock of a culture. Values provide the context within which a society’s norms are established
and justified. ey may include a society’s attitudes toward such concepts as individual freedom, democracy,
truth, justice, honesty, loyalty, social obligations, collective responsibility, women, love, sex, marriage, and so
on. Values are not just abstract concepts; they are invested with considerable emotional significance. People
argue, fight, and even die over values, such as freedom. Freedom and security are often the core reasons the U.S.
political leadership uses when justifying the country engaging in various parts of the world, in some way, as the
“global police” force. Values are also often reflected in the economic systems of a society. As we saw in Chapter
2, democratic free market capitalism is a reflection of a philosophical value system that emphasizes individual
freedom.12
Norms are the social rules that govern people’s actions toward one another. ese norms can be subdivided
into two major categories: folkways and mores. Both of these categories were coined a long time ago in 1906 by
William Graham Sumner, an American sociologist, and they are still applicable and embedded in our societies.
Folkways are the routine conventions of everyday life. Generally, folkways are actions of little moral
significance. Rather, they are social conventions that deal with things like appropriate dress code in a particular
situation, good social manners, eating with the correct utensils, neighborly behavior, and so on. Although
folkways define the way people are expected to behave, violation of them is not normally a serious matter.
People who violate folkways may be thought of as eccentric or ill-mannered, but they are not usually considered
to be evil or bad. In many countries, foreigners may initially be excused for violating folkways. However,
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traveling managers are increasingly expected to know about specific dress codes, social and professional
manners, eating with the correct utensils, and business etiquette. e evolution of norms now demands that
business partners at least try to behave according to the folkways in the country in which they are doing
business.
A good example of a folkway is people’s attitude toward time. People are very aware of what time it is, the
passage of time, and the importance of time in the United States and northern European cultures such as
Germany, Netherlands, and the Scandinavian countries (Denmark, Finland, Iceland, Norway, and Sweden). In
these cultures, businesspeople are very conscious about scheduling their time and are quickly irritated when
time is wasted because a business associate is late for a meeting or if they are kept waiting. Time is really money
in the minds of these businesspeople.
e opposite of the time-conscious Americans, Germans, Dutch, and Scandinavians, businesspeople in
many Arabic, Latin, and African cultures view time as more elastic. Keeping to a schedule is viewed as less
important than building a relationship or finishing an interaction with people. For example, an American
businessperson might feel slighted if he or she is kept waiting for 30 minutes outside the office of a Latin
American executive before a meeting. However, the Latin American person may simply be completing an
interaction with an associate and view the information gathered from this as more important than sticking to a
rigid schedule. e Latin American executive intends no disrespect, but due to a mutual misunderstanding
about the importance of time, the American may see things differently. Similarly, Saudi Arabian attitudes
toward time have been shaped by their nomadic Bedouin heritage, in which precise time played no
real role and arriving somewhere “tomorrow” might mean next week. Like Latin Americans, many
Saudis are unlikely to understand Westerners’ obsession with precise times and schedules.
Planning on Doing Business Internationally?
If a company is planning to export a product, two basic questions need to be asked. Is the product ready to be exported?
And, is the company ready to export the product (i.e., does the company have the infrastructure, knowledge, and skills
to export the product)? Culturally, the product is either ready for a global market or not (and, if not, the company can
modify it if the market is important enough). Company readiness is much more culturally sensitive. Having the
appropriate cultural knowledge and skills is important. If you have the basic information about a company, you can use
globalEDGE’s diagnostic tool called CORE (Company Readiness to Export) to assess both product and company
readiness to export. Which do you think is the most important: product readiness or company readiness?
Sources: globalEDGE’s CORE diagnostic tool, http://globalEDGE.msu.edu; Badenhausen, K., “America’s Best Small Companies,” Forbes,
October 9, 2013.
Folkways also include rituals and symbolic behavior. Rituals and symbols are the most visible manifestations
of a culture and constitute the outward expression of deeper values. For example, upon meeting a foreign
business executive, a Japanese executive will hold his business card in both hands and bow while presenting the
card to the foreigner.13 is ritual behavior is loaded with deep cultural symbolism. e card specifies the rank
of the Japanese executive, which is a very important piece of information in a hierarchical society such as Japan.
e bow is a sign of respect, and the deeper the angle of the bow, the greater the reverence one person shows for
the other. e person receiving the card is expected to examine it carefully (Japanese often have business cards
with Japanese printed on one side and English printed on the other), which is a way of returning respect and
acknowledging the card giver’s position in the hierarchy. e foreigner is also expected to bow when taking the
card and to return the greeting by presenting the Japanese executive with his or her own card, similarly bowing
in the process. To not do so and to fail to read the card that he or she has been given, instead casually placing it
in a jacket, pocket, or purse, violates this important folkway and is considered rude.
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Mores refer to norms that are more widely observed, have greater moral significance than folkways, and are
central to the functioning of a society and to its social life. Mores have a much greater significance than
folkways. Violating mores can bring serious retribution, ill will, and the collapse of any business deal. Mores are
often so important that they have been enacted into law. Mores, to use extreme examples, include laws against
theft, adultery, incest, and cannibalism. All advanced societies have laws against theft and cannibalism, among
other things, but in modern times not necessarily adultery. Many mores (and laws) differ across cultures. In the
United States, for example, drinking alcohol is widely accepted, whereas in Saudi Arabia the consumption of
alcohol is viewed as violating important social mores and is punishable by imprisonment (as some Western
citizens working in Saudi Arabia have discovered to their dismay). at said, countries like Saudi Arabia and
the United Arab Emirates are becoming more tolerant of Westerners behaving like Westerners in their countries
—such as drinking alcohol if they do not flaunt it. Over time, mores may be implemented differently
depending on where you are and who you are, and it pays to know the difference.
CULTURE, SOCIETY, AND THE NATION-STATE
We have defined a society as a group of people who share a common set of values and norms; that is, people
who are bound together by a common culture. ere is not a strict one-to-one correspondence between a
society and a nation-state. Nation-states are political creations. While nation-states are often studied for their
“national identity,” “national character,” and even “competitive advantage of nations,” in reality they may
contain a single culture or several subcultures.14 e French nation can be thought of as the political
embodiment of French culture. However, the nation of Canada has a French culture too, and at least three
cultures—an Anglo culture, a French-speaking “Quebecois” culture, and a Native American culture. Similarly,
many of the 55 African nations have important cultural differences among tribal groups, as horrifically
exhibited in the early 1990s when Rwanda dissolved into a bloody civil war between two tribes, the Tutsis and
Hutus. Africa is not alone in this regard. India, for example, is composed of many distinct cultural groups with
their own rich history and traditions (e.g., Andhras, Gonds, Gujaratis, Marathas, Oriya, Rajputs, Tamils).
Cultures can also embrace several nations, as the Scandinavian countries of Denmark, Finland, Iceland,
Norway, and Sweden. ere is a strong case that we can consider Islamic society as a culture that is shared by
the citizens of many different nations in the Middle East, Asia, and Africa. ere are nuances to the Islamic
world—those who adhere to various degrees, or to different elements, of Islam. As you will recall from Chapter
3, this view of expansive cultures that embrace several nations underpins Samuel Huntington’s view of a world
that is fragmented into different civilizations, including Western, Islamic, and Sinic (Chinese).15
To complicate things further, it is also possible to talk about culture at different levels. It is reasonable to talk
about “American society” and “American culture,” but there are several societies within America, each with its
own culture. For example, in the United States, one can talk about African American culture, Cajun culture,
Chinese American culture, Hispanic culture, Indian culture, Irish American culture, Southern culture, and
many more cultural groups. In some way, this means that the relationship between culture and country is often
ambiguous. Even if a country can be characterized as having a single homogeneous culture, often that national
culture is a mosaic of subcultures. To honor these cultural nuances, businesspeople need to be aware of the
delicate issues that pertain to folkways, and they also need to make sure not to violate mores in the country or
culture in which they intend to do business. Increased globalization has meant an increased number of business
relationships across countries and cultures, but not necessarily an increased cultural understanding to go with it.
Culture is a complex phenomenon with multiple dimensions and multiple levels always worthy of study.16
DETERMINANTS OF CULTURE
LO 4-2 Identify the forces that lead to differences in social culture.
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e values and norms of a culture do not emerge fully formed. ey evolve over time in response to a number
of factors, including prevailing political and economic philosophies, the social structure of a society, and the
dominant religion, language, and education (see Figure 4.1). We discussed political and economic philosophies
in Chapter 2. Such philosophies clearly influence the value systems of a society. For example, the values found
in communist North Korea toward freedom, justice, and individual achievement are clearly different from the
values found in Sweden, precisely because each society operates according to different political and economic
philosophies. In the next sections of this chapter, we discuss the influence of social structure, religion, language,
and education. e chain of causation runs both ways. While factors such as social structure and religion clearly
influence the values and norms of a society, the values and norms of a society can influence social structure and
religion.
4.1 FIGURE
Determinants of culture.
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Social Structure
A society’s social structure refers to its basic social organization. In essence, we are talking about how a society
is organized in terms of its values, norms, and the relationships that are part of the society’s fabric. How society
operates and how people, groups, and companies treat each other both emerge from and are determinants of
the behaviors of individuals in the specific society. Although the social structure consists of many different
aspects, two dimensions are particularly important when explaining differences. e first is the degree to which
the basic unit of a social organization is the individual, as opposed to the group, or even company for
which a person works. In general, western societies tend to emphasize the importance of the
individual, whereas groups tend to figure much larger in many other non-western societies. e second
dimension is the degree to which a society is stratified into classes or castes. Some societies are characterized by
a relatively high degree of social stratification and relatively low mobility between strata (India); other societies
are characterized by a low degree of social stratification and high mobility between strata (the United States).
INDIVIDUALS AND GROUPS
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A group is an association of two or more individuals who have a shared sense of identity and who interact with
each other in structured ways on the basis of a common set of expectations about each other’s behavior.17
Human social life is group life. Individuals are involved in families, work groups, social groups, recreational
groups, and potentially a myriad of other groups. Social media have expanded the boundaries of what is
included in group life and placed an added emphasis on what we can call extended social groups. Social media
clearly did not enter into the equation of what was possible in terms of group life. But, social media as a vehicle
to the creation of group life has unique possibilities that affect both individuals within a social group and the
group itself. For example, consumers are significantly more likely to buy from the brands they follow on
Instagram, Twitter, Facebook, or LinkedIn, or that they get exposed to via Snapchat, due to group influences.
However, while groups are found in all societies, some societies differ according to the degree to which the
group is viewed as the primary means of social organization.18 In some societies, individual attributes and
achievements are viewed as being more important than group membership; in others, the reverse is true.
LO 4-3 Identify the business and economic implications of differences in culture.
e Individual In Chapter 2, we discussed individualism as a political philosophy. However, individualism is more than just an abstract political philosophy. In many western societies, the individual is the basic building
block of social organization. is is reflected not just in the political and economic organization of society but
also in the way people perceive themselves and relate to each other in social and business settings. e value
systems of many western societies, for example, emphasize individual achievement. e social standing of
individuals is not so much a function of whom they work for as of their individual performance in whatever
work setting they choose. More and more, individuals are regarded as “independent contractors” even though
they belong to and work for a company. ese individuals, in essence, build their personal brands by the
knowledge, skills, and experience that they have, which often translates to increased salaries and promotions at
the current company or another company that believes that it can benefit from that person’s capabilities. In
science, the label “star scientist” has become synonymous with these individual high-producers of innovative
products based on their knowledge, skills, and experience.19
e emphasis on individual performance has both beneficial and harmful aspects. In the United States, the
emphasis on individual performance finds expression in an admiration of rugged individualism,
entrepreneurship, and innovation. One benefit of this is the high level of entrepreneurial activity in the United
States, in Europe, and throughout many of the so-called developed nations. Over time, entrepreneurial
individuals in the United States have created lots of new products and new ways of doing business (personal
computers, photocopiers, computer software, biotechnology, supermarkets, discount retail stores). One can
argue that the dynamism of the U.S. economy owes much to the philosophy of individualism. Highly
individualistic societies are often synonymous with those capable of constantly innovating by their creative ideas
for products and services.
Individualism also finds expression in a high degree of managerial mobility between companies, as our
“personal brand” example illustrated earlier, and this is not always a good thing. Although moving from
company to company may be good for individual managers who are trying to build impressive résumés and
increase their salaries, it is not necessarily a good thing for companies. e lack of loyalty and commitment to a
company and the tendency to move on for a better offer can result in managers who have good general skills
but lack the knowledge, experience, and network of contacts that come from years of working for the same
company. An effective manager draws on company-specific experience, knowledge, and a network of
contacts to find solutions to current problems, and companies may suffer if their managers lack these
attributes. One positive aspect of high managerial mobility, however, is that executives are exposed to different
ways of doing business. e ability to compare business practices helps executives identify how good practices
and techniques developed in one firm might be profitably applied to other firms.
Is Social Class Determined by Income?
In the text, we say that a class system is a less rigid form of social stratification than caste, in which social mobility is
possible. Class is a form of open stratification in which the position a person has by birth can be changed through his or
her own achievements or luck. Social class can broadly be divided into three levels, the upper (or rich), middle, and
lower (or poor). ese levels appear to be tied to income, but does a high income automatically bring power and
prestige? Is it the income that determines social class, or is it the social class that will determine the income? Or, is
income just a small portion of social class status?
Source: D. Francis, “Where Do You Fall in the American Economic Class System?” US News and World Report, September 13, 2012.
e Group In contrast to the Western emphasis on the individual, the group is the primary unit of social organization in many other societies. For example, in Japan, the social status of an individual has traditionally
been determined as much by the standing of the group to which he or she belongs as by his or her individual
performance.20 In traditional Japanese society, the group was the family or village to which an individual
belonged. Today, the group has frequently come to be associated with the work team or business organization.
In a now-classic study of Japanese society, Nakane noted how this expresses itself in everyday life:
When a Japanese faces the outside (confronts another person) and affixes some position to himself socially
he is inclined to give precedence to institution over kind of occupation. Rather than saying, “I am a
typesetter” or “I am a filing clerk,” he is likely to say, “I am from B Publishing Group” or “I belong to S
company.”21
Nakane goes on to observe that the primacy of the group often evolves into a deeply emotional attachment in
which identification with the group becomes very important in a person’s life. For example, as a student, you
will often identify yourself as going to XYZ University or, soon enough, as a graduate of XZY University—and
the latter identification as an alumnus of a university is something that you carry with you for life. In many
cases, we also extend that group thinking beyond a company, organization, or university. For example, we talk
about being a part of a university-related conference—for example, “I’m going to Michigan State University,
and we are part of the Big Ten Conference.”
At the country level, one central value of Japanese culture is the importance attached to group membership.
is may have beneficial implications for business firms. Strong identification with the group is argued to create
pressures for mutual self-help and collective action. If the worth of an individual is closely linked to the
achievements of the group, as Nakane maintains is the case in Japan, this creates a strong incentive for
individual members of the group to work together for the common good. Some argue that the success of some
Japanese companies in the global economy has been based partly on their ability to achieve close cooperation
between individuals within a company and between companies. is has found expression in the widespread
diffusion of self-managing work teams within Japanese organizations; the close cooperation among different
functions within Japanese companies (e.g., among manufacturing, marketing, and R&D); and the cooperation
between a company and its suppliers on issues such as design, quality control, and inventory reduction.22 In all
these cases, cooperation is driven by the need to improve the performance of the group.
e primacy of the value of group identification also discourages managers and other workers, in many
cases, moving from company to company. Lifetime employment in a particular company was long the norm in
certain sectors of the Japanese economy (estimates suggest that between 20 and 40 percent of all Japanese
employees have formal or informal lifetime employment guarantees), albeit those norms have changed
significantly in recent decades, with much more movement being seen between companies today. Over the
years, managers and workers build up knowledge, experience, and a network of interpersonal business contacts.
All these things can help managers perform their jobs more effectively and achieve cooperation with others.
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However, the primacy of the group is not always beneficial. Just as U.S. society is characterized by a great
deal of dynamism and entrepreneurship, reflecting the primacy of values associated with individualism, some
argue that Japanese society is characterized by a corresponding lack of dynamism and
entrepreneurship. Although the long-run consequences are unclear, one implication is that the United States
could continue to create more new industries than Japan and continue to be more successful at pioneering
radically new products and new ways of doing business. By most estimates, the United States has led the world
in innovation for some time, especially radically new products and services, and the country’s individualism is a
strong contributor to this innovative mindset. At the same time, some group-oriented countries such as Japan
do very well in innovation, especially non-radical “normal” innovations, according to the GE Global
Innovation Barometer.23 is is an indication that multiple paths to being innovative exist in both
individualistic and group-oriented cultures, drawing from the uniqueness of the particular culture and what
core competencies are reflected in the culture.24 Some argue that individualistic societies are great at creating
innovative ideas while collectivist, or group-oriented, societies are better at the implementation of those ideas
(taking the idea to the market).
SOCIAL STRATIFICATION
LO 4-2 Identify the forces that lead to differences in social culture.
All societies are stratified on a hierarchical basis into social categories—that is, into social strata. ese strata
are typically defined on the basis of socioeconomic characteristics such as family background, occupation, and
income. Individuals are born into a particular stratum. ey become a member of the social category to which
their parents belong. Individuals born into a stratum toward the top of the social hierarchy tend to have better
life chances than those born into a stratum toward the bottom of the hierarchy. ey are likely to have better
education, health, standard of living, and work opportunities. Although all societies are stratified to some
degree, they differ in two related ways. First, they differ from each other with regard to the degree of mobility
between social strata. Second, they differ with regard to the significance attached to social strata in business
contexts. Overall, social stratification is based on four basic principles:25
1. Social stratification is a trait of society, not a reflection of individual differences.
2. Social stratification carries over a generation to the next generation.
3. Social stratification is generally universal but variable.
4. Social stratification involves not just inequality but also beliefs.
Social Mobility e term social mobility refers to the extent to which individuals can move out of the strata into which they are born. Social mobility varies significantly from society to society. e most rigid
system of stratification is a caste system. A caste system is a closed system of stratification in which social
position is determined by the family into which a person is born, and change in that position is usually not
possible during an individual’s lifetime. Often, a caste position carries with it a specific occupation. Members of
one caste might be shoemakers, members of another might be butchers, and so on. ese occupations are
embedded in the caste and passed down through the family to succeeding generations. Although the number of
societies with caste systems diminished rapidly during the twentieth century, one partial example still remains.
India has four main castes and several thousand subcastes. Even though the caste system was officially abolished
in 1949, two years after India became independent, it is still a force in rural Indian society where occupation
and marital opportunities are still partly related to caste (for more details, see the accompanying Country Focus
on the caste system in India today).26
A class system is a less rigid form of social stratification in which social mobility is possible. It is a form of
open stratification in which the position a person has by birth can be changed through his or her own
achievements or luck. Individuals born into a class at the bottom of the hierarchy can work their way up;
conversely, individuals born into a class at the top of the hierarchy can slip down.
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While many societies have class systems, social mobility within a class system varies from society to society.
For example, some sociologists have argued that the United Kingdom has a more rigid class structure than
certain other western societies, such as the United States.27 Historically, British society was divided into three
main classes: the upper class, which was made up of individuals whose families for generations had wealth,
prestige, and occasionally power; the middle class, whose members were involved in professional, managerial,
and clerical occupations; and the working class, whose members earned their living from manual occupations.
e middle class was further subdivided into the upper-middle class, whose members were involved in
important managerial occupations and the prestigious professions (lawyers, accountants, doctors), and
the lower-middle class, whose members were involved in clerical work (bank tellers) and the less prestigious
professions (schoolteachers).
c o u n t r y F O C U S
Determining Your Social Class by Birth
Modern India is a country of dramatic contrasts. e country’s information technology (IT) sector is among the most
vibrant in the world, with companies such as Tata Consultancy Services, Cognizant Technology Solutions, Infosys, and
Wipro as powerful global players. Cognizant is an interesting company in that it was founded as a technology arm of
Dun & Bradstreet (USA), but it is typically considered an Indian IT company because a majority of its employees are
based in India. In fact, many IT companies locate or operate in India because of its strong IT knowledge, human
capital, and culture.
Traditionally, India has had one of the strongest caste systems in the world. Somewhat sadly, this caste system still
exists today even though it was officially abolished in 1949, and many Indians actually prefer it this way! At the core, the
caste system has no legality in India, and discrimination against lower castes is illegal. India has also enacted numerous
new laws and social initiatives to protect and improve living conditions of lower castes in the country.
Historically, India’s caste system was an impediment to social mobility. But the stranglehold on people’s
socioeconomic conditions is steadily becoming a fading memory among the educated, urban middle-class Indians who
make up the majority of employees in the high-tech economy. Unfortunately, the same is not true in rural India, where
some 70 percent of the nation’s population still resides. In the rural part of the country, the caste remains a pervasive
influence.
For example, a young female engineer at Infosys, who grew up in a small rural village and is a dalit (sometimes called a “scheduled caste”), recounts how she never entered the house of a Brahmin, India’s elite priestly caste, even though half of her village were Brahmins. And when a dalit was hired to cook at the school in her native village, Brahmins withdrew their children from the school. e engineer herself is the beneficiary of a charitable training scheme developed by
Infosys. Her caste, making up about 16 percent of the country (or around 165 million people), is among the poorest in
India, with some 91 percent making less than $100 a month, compared to 65 percent of Brahmins.
To try to correct this historical inequality, politicians have talked for years about extending the employment quota
system to private enterprises. e government has told private companies to hire more dalits and members of tribal communities and have been warned that “strong measures” will be taken if companies do not comply. Private employers
are resisting attempts to impose quotas, arguing with some justification that people who are guaranteed a job by a quota
system are unlikely to work very hard.
At the same time, progressive employers realize they need to do something to correct the inequalities, and unless
India taps into the lower castes, it may not be able to find the employees required to staff rapidly growing high-
technology enterprises. As a consequence, the Confederation of Indian Industry implemented a package of dalit-friendly measures, including scholarships for bright lower-caste children. Building on this, Infosys is leading the way among
high-tech enterprises. e company provides special training to low-caste engineering graduates who have failed to get a
job in industry after graduation. While the training does not promise employment, so far almost all graduates who
completed the seven-month training program have been hired by Infosys and other enterprises. Positively, Infosys
programs are a privatized version of the education offered in India to try to break down India’s caste system.
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Sources: Mari Marcel ekaekara, “India’s Caste System Is Alive and Kicking—and Maiming and Killing,” e Guardian, August 15, 2016; Noah Feldman, “India’s High Court Favors Nationalism over Democracy,” Bloomberg View, January 8, 2017; “Why Some of India’s Castes Demand to Be Reclassified,” e Economist, February 16, 2016.
e British class system exhibited significant divergence between the life chances of members of different
classes. e upper and upper-middle classes typically sent their children to a select group of private schools,
where they wouldn’t mix with lower-class children and where they picked up many of the speech accents and
social norms that marked them as being from the higher strata of society. ese same private schools also had
close ties with the most prestigious universities, such as Oxford and Cambridge. Until fairly recently, Oxford
and Cambridge guaranteed a certain number of places for the graduates of these private schools. Having been
to a prestigious university, the offspring of the upper and upper-middle classes then had an excellent chance of
being offered a prestigious job in companies, banks, brokerage firms, and law firms run by members of the
upper and upper-middle classes.
According to some commentators, modern British society is now rapidly leaving behind this class structure
and moving toward a classless society. However, sociologists continue to dispute this finding and present
evidence that this is not the case. For example, one study reported that state schools in the London Borough
(suburb) of Islington, which now has a population of 230,000, had only 79 candidates for university, while one
prestigious private school alone, Eton, sent more than that number to Oxford and Cambridge.28 is,
according to the study’s authors, implies that “money still begets money.” ey argue that a good
school means a good university, a good university means a good job, and merit has only a limited
chance of elbowing its way into this tight little circle. In another recent survey of the empirical literature, a
sociologist noted that class differentials in educational achievement have changed surprisingly little over the last
few decades in many societies, despite assumptions to the contrary.29
Another society for which class divisions have historically been of some importance has been China, where
there has been a long-standing difference between the life chances of the rural peasantry and urban dwellers.
Ironically, this historic division was strengthened during the high point of communist rule because of a rigid
system of household registration that restricted most Chinese to the place of their birth for their lifetime.
Bound to collective farming, peasants were cut off from many urban privileges—compulsory education, quality
schools, health care, public housing, varieties of foodstuffs, to name only a few—and they largely lived in
poverty. Social mobility was thus very limited. is system crumbled following the reforms of a few decades
ago, and as a consequence, migrant peasant laborers have flooded into China’s cities looking for work.
Sociologists now hypothesize that a new class system is emerging in China based less on the rural–urban divide
and more on urban occupation.30
e class system in the United States is less pronounced than in India, the United Kingdom, and China and
mobility is greater. Like the UK, the United States has its own upper, middle, and working classes. However,
class membership is determined to a much greater degree by individual economic achievements, as opposed to
background and schooling. us, an individual can, by his or her own economic achievement, move smoothly
from the working class to the upper class in a lifetime. Successful individuals from humble origins are highly
respected in American society.
LO 4-3 Identify the business and economic implications of differences in culture.
Significance From a business perspective, the stratification of a society is significant if it affects the operation of business organizations. In American society, the high degree of social mobility and the extreme emphasis on
individualism limit the impact of class background on business operations. e same is true in Japan, where
most of the population perceives itself to be middle class. In a country such as the United Kingdom or India,
however, the relative lack of class mobility and the differences between classes have resulted in the emergence of
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class consciousness. Class consciousness refers to a condition by which people tend to perceive themselves in
terms of their class background, and this shapes their relationships with members of other classes.
is has been played out in British society in the traditional hostility between upper-middle-class managers
and their working-class employees. Mutual antagonism and lack of respect historically made it difficult to
achieve cooperation between management and labor in many British companies and resulted in a relatively high
level of industrial disputes. However, the past two decades have seen a dramatic reduction in industrial disputes,
which bolsters the arguments of those who claim that the country is moving toward a classless society.
Alternatively, as noted earlier, class consciousness may be reemerging in urban China, and it may ultimately
prove to be significant in the country.
An antagonistic relationship between management and labor classes, and the resulting lack of cooperation
and high level of industrial disruption, tends to raise the costs of production in countries characterized by
significant class divisions. is can make it more difficult for companies based in such countries to establish a
competitive advantage in the global economy.
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to
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Religious and Ethical Systems
LO 4-2 Identify the forces that lead to differences in social culture.
Religion may be defined as a system of shared beliefs and rituals that are concerned with the realm of the
sacred.31 An ethical system refers to a set of moral principles, or values, that are used to guide and shape
behavior.32 Most of the world’s ethical systems are the product of religions. us, we can talk about Christian
ethics and Islamic ethics. However, there is a major exception to the principle that ethical systems are grounded
in religion. Confucianism and Confucian ethics influence behavior and shape culture in parts of Asia, yet it is
incorrect to characterize Confucianism as a religion.
e relationship among religion, ethics, and society is subtle and complex. Among the thousands of religions
in the world today, four dominate in terms of numbers of adherents: Christianity with roughly 2.20 billion
adherents, Islam with around 1.60 billion adherents, Hinduism with 1.10 billion adherents (primarily in
India), and Buddhism with about 535 million adherents (see Map 4.1). Although many other religions have an
important influence in certain parts of the modern world (e.g., Shintoism in Japan, with roughly 40 million
followers, and Judaism, which has 18 million adherents and accounts for 75 percent of the population of
Israel), their numbers pale in comparison with these dominant religions (although as the precursor of both
Christianity and Islam, Judaism has an indirect influence that goes beyond its numbers). We review these four
religions, along with Confucianism, focusing on their potential business implications.
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4.1 MAP
World religions.
Source: “Map 14,” in Allen, John L., and Sutton, Christopher J., Student Atlas of World Politics, 10th ed. New York, NY: McGraw-Hill
Companies, Inc., 2013.
Some scholars have theorized that the most important business implications of religion center on the extent
to which different religions shape attitudes toward work and entrepreneurship and the degree to which the
religious ethics affect the costs of doing business in a country. However, it is hazardous to make sweeping
generalizations about the nature of the relationship between religion and ethical systems and business practice.
While some professionals argue that there is a relationship between religious and ethical systems and business
practice in a society, in a world where nations with Catholic, Protestant, Muslim, Hindu, and Buddhist
majorities all show evidence of entrepreneurial activity and sustainable economic growth, it is important to view
such proposed relationships with a degree of skepticism. e proposed relationships may exist, but their impact
may be small compared with the impact of economic policy. On the other hand, research by
economists Robert Barro and Rachel McCleary does suggest that strong religious beliefs, particularly
beliefs in heaven, hell, and an afterlife, have a positive impact on economic growth rates, irrespective of the
particular religion in question.33 Barro and McCleary looked at religious beliefs and economic growth rates in
59 countries. eir conjecture was that higher religious beliefs stimulate economic growth because they help
sustain aspects of individual behavior that lead to higher productivity.
CHRISTIANITY
Christianity is the most widely practiced religion in the world with some 2.20 billion followers. e vast
majority of Christians live in Europe and the Americas, although their numbers are growing rapidly in Africa.
Christianity grew out of Judaism. Like Judaism, it is a monotheistic religion (monotheism is the belief in one
God). A religious division in the eleventh century led to the establishment of two major Christian organizations
Page 101
—the Roman Catholic Church and the Orthodox Church. Today, the Roman Catholic Church accounts for
more than half of all Christians, most of whom are found in southern Europe and Latin America. e
Orthodox Church, while less influential, is still of major importance in several countries (especially Greece and
Russia). In the sixteenth century, the Reformation led to a further split with Rome; the result was
Protestantism. e nonconformist nature of Protestantism has facilitated the emergence of numerous
denominations under the Protestant umbrella (Baptist, Methodist, Calvinist, and so on).
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Christianity Several sociologists have argued that of the main branches of Christianity—Catholic, Orthodox, and Protestant—the latter has the most important economic implications.
In 1904, prominent German sociologist Max Weber made a connection between Protestant ethics and “the
spirit of capitalism” that has since become famous.34 Weber noted that capitalism emerged in Western Europe,
where
business leaders and owners of capital, as well as the higher grades of skilled labor, and even more the higher
technically and commercially trained personnel of modern enterprises, are overwhelmingly Protestant.35
Weber theorized that there was a relationship between Protestantism and the emergence of modern capitalism.
He argued that Protestant ethics emphasizes the importance of hard work and wealth creation (for the glory of
God) and frugality (abstinence from worldly pleasures). According to Weber, this kind of value system was
needed to facilitate the development of capitalism. Protestants worked hard and systematically to accumulate
wealth. However, their ascetic beliefs suggested that rather than consuming this wealth by indulging in worldly
pleasures, they should invest it in the expansion of capitalist enterprises. us, the combination of hard work
and the accumulation of capital, which could be used to finance investment and expansion, paved the way for
the development of capitalism in Western Europe and subsequently in the United States. In contrast, Weber
argued that the Catholic promise of salvation in the next world, rather than this world, did not foster the same
kind of work ethic.
Protestantism also may have encouraged capitalism’s development in another way. By breaking away from
the hierarchical domination of religious and social life that characterized the Catholic Church for much of its
history, Protestantism gave individuals significantly more freedom to develop their own relationship with God.
e right to freedom of form of worship was central to the nonconformist nature of early Protestantism. is
emphasis on individual religious freedom may have paved the way for the subsequent emphasis on individual
economic and political freedoms and the development of individualism as an economic and political
philosophy. As we saw in Chapter 2, such a philosophy forms the bedrock on which entrepreneurial free market
capitalism is based. Building on this, some scholars claim there is a connection between individualism, as
inspired by Protestantism, and the extent of entrepreneurial activity in a nation.36 Again, we must be careful
not to generalize too much from this historical sociological view. While nations with a strong Protestant
tradition such as Britain, Germany, and the United States were early leaders in the Industrial Revolution,
nations with Catholic or Orthodox majorities show significant and sustained entrepreneurial activity and
economic growth in the modern world.
ISLAM
LO 4-2 Identify the forces that lead to differences in social culture.
With about 1.60 billion adherents, Islam is the second largest of the world’s major religions. Islam
dates to 610 A.D. when the Prophet Muhammad began spreading the word, although the Muslim calendar
begins in 622 A.D. when, to escape growing opposition, Muhammad left Mecca for the oasis settlement of
Yathrib, later known as Medina. Adherents of Islam are referred to as Muslims. Muslims constitute a majority
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in more than 40 countries and inhabit a nearly contiguous stretch of land from the northwest coast of Africa,
through the Middle East, to China and Malaysia in the Far East.
Islam has roots in both Judaism and Christianity (Islam views Jesus Christ as one of God’s prophets). Like
Christianity and Judaism, Islam is a monotheistic religion. e central principle of Islam is that there is but the
one true omnipotent God (Allah). Islam requires unconditional acceptance of the uniqueness, power, and
authority of God and the understanding that the objective of life is to fulfill the dictates of His will in the hope
of admission to paradise. According to Islam, worldly gain and temporal power are an illusion. ose who
pursue riches on earth may gain them, but those who forgo worldly ambitions to seek the favor of Allah may
gain the greater treasure: entry into paradise. Other major principles of Islam include (1) honoring and
respecting parents, (2) respecting the rights of others, (3) being generous but not a squanderer, (4) avoiding
killing except for justifiable causes, (5) not committing adultery, (6) dealing justly and equitably with others,
(7) being of pure heart and mind, (8) safeguarding the possessions of orphans, and (9) being humble and
unpretentious.37 Obvious parallels exist with many of the central principles of both Judaism and Christianity.
Islam is an all-embracing way of life governing the totality of a Muslim’s being.38 As God’s surrogate in this
world, a Muslim is not a totally free agent but is circumscribed by religious principles—by a code of conduct
for interpersonal relations—in social and economic activities. Religion is paramount in all areas of life. e
Muslim lives in a social structure that is shaped by Islamic values and norms of moral conduct. e ritual
nature of everyday life in a Muslim country is striking to a Western visitor. Among other things, orthodox
Muslim ritual requires prayer five times a day (business meetings may be put on hold while the Muslim
participants engage in their daily prayer ritual), demands that women should be dressed in a certain manner,
and forbids the consumption of pork and alcohol.
Islamic Fundamentalism e past three decades have witnessed the growth of a social movement often referred to as Islamic fundamentalism.39 In the West, Islamic fundamentalism is associated in the media with
militants, terrorists, and violent upheavals, such as the bloody conflict occurring in Algeria, the killing of
foreign tourists in Egypt, and the September 11, 2001, attacks on the World Trade Center and Pentagon in the
United States. For most, this characterization is misleading. Just as Christian fundamentalists are motivated by
deeply held religious values that are firmly rooted in their faith, so are Islamic fundamentalists.
A small minority of radical “fundamentalists” who have hijacked the religion to further their own political
and violent ends perpetrate the violence that the Western media associates with Islamic fundamentalism.
Radical Islamic fundamentalists exist in various forms today, but the most notorious is probably ISIS—an
acronym for Islamic State of Iraq and Syria. Now, the violence associated with radical Islamic fundamentalists
can be seen across other religions as well. Some Christian “fundamentalists” have incited their own political
engagement and violence. e vast majority of Muslims point out that Islam teaches peace, justice, and
tolerance, not violence and intolerance. In fact, the foundation is that Islam explicitly repudiates the violence
that a radical minority practices.
e rise of Islamic fundamentalism has no one cause. In part, it is a response to the social pressures created
in traditional Islamic societies by the move toward modernization and by the influence of Western ideas, such
as liberal democracy; materialism; equal rights for women; and attitudes toward sex, marriage, and alcohol. In
many Muslim countries, modernization has been accompanied by a growing gap between a rich urban minority
and an impoverished urban and rural majority. For the impoverished majority, modernization has offered little
in the way of tangible economic progress, while threatening the traditional value system. us, for a Muslim
who cherishes his or her traditions and feels that his or her identity is jeopardized by the
encroachment of alien Western values, Islamic fundamentalism has become a cultural anchor.
Fundamentalists demand a commitment to traditional religious beliefs and rituals. e result has been a
marked increase in the use of symbolic gestures that confirm Islamic values. In areas where fundamentalism is
strong, women have resumed wearing floor-length, long-sleeved dresses and covering their hair; religious studies
have increased in universities; the publication of religious tracts has increased; and public religious orations have
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risen.40 Also, the sentiments of some fundamentalist groups are often anti-Western. Rightly or wrongly,
Western influence is blamed for a range of social ills, and many fundamentalists’ actions are directed against
Western governments, cultural symbols, businesses, and even individuals.
In several Muslim countries, fundamentalists have gained political power and have used this to try to make
Islamic law (as set down in the Koran, the bible of Islam) the law of the land. ere are grounds for this in
Islamic doctrine. Islam makes no distinction between church and state. It is not just a religion; Islam is also the
source of law, a guide to statecraft, and an arbiter of social behavior. Muslims believe that every human
endeavor is within the purview of the faith—and this includes political activity—because the only purpose of
any activity is to do God’s will.41 (Some Christian fundamentalists also share this view.) Muslim
fundamentalists have been most successful in Iran, where a fundamentalist party has held power since 1979,
but they also have had an influence in many other countries, such as Afghanistan, Algeria, Egypt, Pakistan,
Saudi Arabia, and the Sudan.
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Islam e Koran establishes some explicit economic principles, many of which are pro-free enterprise.42 e Koran speaks approvingly of free enterprise and of earning legitimate profit
through trade and commerce (the Prophet Muhammad himself was once a trader). e protection of the right
to private property is also embedded within Islam, although Islam asserts that all property is a favor from Allah
(God), who created and so owns everything. ose who hold property are regarded as trustees rather than
owners in the Western sense of the word. As trustees, they are entitled to receive profits from the property but
are admonished to use it in a righteous, socially beneficial, and prudent manner. is reflects Islam’s concern
with social justice. Islam is critical of those who earn profit through the exploitation of others. In the Islamic
view of the world, humans are part of a collective in which the wealthy and successful have obligations to help
the disadvantaged. Put simply, in Muslim countries, it is fine to earn a profit, so long as that profit is justly
earned and not based on the exploitation of others for one’s own advantage. It also helps if those making profits
undertake charitable acts to help the poor. Furthermore, Islam stresses the importance of living up to
contractual obligations, keeping one’s word, and abstaining from deception. For a closer look at how Islam,
capitalism, and globalization can coexist, see the accompanying Country Focus on the region around Kayseri in
central Turkey.
Given the Islamic proclivity to favor market-based systems, Muslim countries are likely to be receptive to
international businesses as long as those businesses behave in a manner that is consistent with Islamic ethics,
customs, and business practices. Businesses that are perceived as making an unjust profit through the
exploitation of others, by deception, or by breaking contractual obligations are unlikely to be welcomed in an
Islamic country. In Islamic countries where fundamentalism is on the rise, general hostility toward Western-
owned businesses is likely to increase.
One economic principle of Islam prohibits the payment or receipt of interest, which is considered usury.
is is not just a matter of theology; in several Islamic states, it is also a matter of law. e Koran clearly
condemns interest, which is called riba in Arabic, as exploitative and unjust. For many years, banks operating in
Islamic countries conveniently ignored this condemnation, but starting in the 1970s with the establishment of
an Islamic bank in Egypt, Islamic banks opened in predominantly Muslim countries. Now there are hundreds
of Islamic banks in more than 50 countries with assets of around $1.6 trillion; plus more than $1 trillion is
managed by mutual funds that adhere to Islamic principles.43 Even conventional banks are entering
the market: both Citigroup and HSBC, two of the world’s largest financial institutions, now offer
Islamic financial services. While only Iran and Sudan enforce Islamic banking conventions, in an increasing
number of countries customers can choose between conventional banks and Islamic banks.
Page 104
c o u n t r y F O C U S
Turkey, Its Religion, and Politics
For years now, Turkey has been lobbying the European Union to allow it to join the free trade bloc as a member state. If
the EU says yes, it will be the first Muslim state in the union. But this is unlikely to happen any time soon; after all, it
has been half a century in the making!
Many critics in the EU worry that Islam and Western-style capitalism do not mix well and that, as a consequence,
allowing Turkey into the EU would be a mistake. However, a close look at what is going on in Turkey suggests this view
may be misplaced. Consider the area around the city of Kayseri in central Turkey. Many dismiss this poor, largely
agricultural region of Turkey as a non-European backwater, far removed from the secular bustle of Istanbul. It is a region
where traditional Islamic values hold sway. And yet it is a region that has produced so many thriving Muslim enterprises
that it is sometimes called the “Anatolian Tiger.” Businesses based here include large food manufacturers, textile
companies, furniture manufacturers, and engineering enterprises, many of which export a substantial percentage of their
production.
Local business leaders attribute the success of companies in the region to an entrepreneurial spirit that they say is part
of Islam. ey point out that the Prophet Muhammad, who was himself a trader, preached merchant honor and
commanded that 90 percent of a Muslim’s life be devoted to work in order to put food on the table. Outside observers
have gone further, arguing that what is occurring around Kayseri is an example of Islamic Calvinism, a fusion of
traditional Islamic values and the work ethic often associated with Protestantism in general and Calvinism in particular.
However, not everyone agrees that Islam is the driving force behind the region’s success. Saffet Arslan, the managing
director of Ipek, the largest furniture producer in the region (which exports to more than 30 countries), says another
force is at work: globalization! According to Arslan, over the past three decades, local Muslims who once eschewed
making money in favor of focusing on religion are now making business a priority. ey see the Western world, and
Western capitalism, as a model, not Islam, and because of globalization and the opportunities associated with it, they
want to become successful.
If there is a weakness in the Islamic model of business that is emerging in places such as Kayseri, some say it can be
found in traditional attitudes toward the role of women in the workplace and the low level of female employment in the
region. According to a report by the European Stability Initiative, the same group that holds up the Kayseri region as an
example of Islamic Calvinism, the low participation of women in the local workforce is the Achilles’ heel of the
economy and may stymie the attempts of the region to catch up with the countries of the European Union.
Sources: Marc Champion, “Turkey’s President Is Close to Getting What He’s Always Wanted,” Bloomberg BusinessWeek, February 8, 2017; “Dress in a Muslim Country: Turkey Covers Up,” e Economist, January 26, 2017; “Turkey’s Future Forward to the Past: Can Turkey’s Past Glories Be Revived by Its Grandiose Islamist President?” e Economist, January 3, 2015.
Conventional banks make a profit on the spread between the interest rate they have to pay to depositors and
the higher interest rate they charge borrowers. Because Islamic banks cannot pay or charge interest, they must
find a different way of making money. Islamic banks have experimented with two different banking methods—
the mudarabah and the murabaha.44
A mudarabah contract is similar to a profit-sharing scheme. Under mudarabah, when an Islamic bank lends
money to a business, rather than charging that business interest on the loan, it takes a share in the profits that
are derived from the investment. Similarly, when a business (or individual) deposits money at an Islamic bank
in a savings account, the deposit is treated as an equity investment in whatever activity the bank uses the capital
for. us, the depositor receives a share in the profit from the bank’s investment (as opposed to interest
payments) according to an agreed-upon ratio. Some Muslims claim this is a more efficient system
than the Western banking system because it encourages both long-term savings and long-term
Culture on globalEDGE
investment. However, there is no hard evidence of this, and many believe that a mudarabah system is less
efficient than a conventional Western banking system.
©Glow Images
e “Culture” section of
globalEDGE™
(globaledge.msu.edu/global-resources/culture) offers a variety of sources, information, and data on culture and
international business. In addition, the “Insights by Country” section (globaledge.msu.edu/global-insights/by/country),
with coverage of more than 200 countries and states, has culture coverage (e.g., what to do and not to do when visiting a
country). In Chapter 4, we cover a lot of material on culture, and Geert Hofstede’s research has been the most
influential on culture and business for about half a century. globalEDGE™ has “e Hofstede Centre” as one of its
cultural reference sources. is reference focuses on Hofstede’s research on cultural dimensions, including scores for
countries, regions, charts, and graphs. Are you interested in the scores for a country that we do not illustrate in Table
4.1? If so, check out “e Hofstede Centre” and its “Culture Compass,” and see what the scores are for your favored
country.
4.1 TABLE
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Work-Related Values for 15 Selected Countries
Source: Geert Hofstede, “e Cultural Relativity of Organizational Practices and eories,” Journal of International Business Studies 14
(Fall 1983), pp. 75–89.
e second Islamic banking method, the murabaha contract, is the most widely used among the world’s
Islamic banks, primarily because it is the easiest to implement. In a murabaha contract, when a firm wishes to
purchase something using a loan—let’s say a piece of equipment that costs $1,000—the firm tells the bank after
having negotiated the price with the equipment manufacturer. e bank then buys the equipment for $1,000,
and the borrower buys it back from the bank at some later date for, say, $1,100, a price that includes a $100
markup for the bank. A cynic might point out that such a markup is functionally equivalent to an interest
payment, and it is the similarity between this method and conventional banking that makes it so much easier to
adopt.
HINDUISM
LO 4-2 Identify the forces that lead to differences in social culture.
Hinduism has approximately 1.10 billion adherents, most of them on the Indian subcontinent. Hinduism
began in the Indus Valley in India more than 4,000 years ago, making it the world’s oldest major religion.
Unlike Christianity and Islam, its founding is not linked to a particular person. Nor does it have an officially
sanctioned sacred book such as the Bible or the Koran. Hindus believe that a moral force in society requires the
acceptance of certain responsibilities, called dharma. Hindus believe in reincarnation, or rebirth into a different
body, after death. Hindus also believe in karma, the spiritual progression of each person’s soul. A person’s karma
is affected by the way he or she lives. e moral state of an individual’s karma determines the challenges he or
she will face in the next life. By perfecting the soul in each new life, Hindus believe that an individual can
eventually achieve nirvana, a state of complete spiritual perfection that renders reincarnation no longer
necessary. Many Hindus believe that the way to achieve nirvana is to lead a severe ascetic lifestyle of material
and physical self-denial, devoting life to a spiritual rather than material quest.
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Hinduism Max Weber, famous for expounding on the Protestant work ethic, also argued that the ascetic principles embedded in Hinduism do not encourage the kind of
entrepreneurial activity in pursuit of wealth creation that we find in Protestantism.45 According to Weber,
traditional Hindu values emphasize that individuals should be judged not by their material achievements but by
their spiritual achievements. Hindus perceive the pursuit of material well-being as making the attainment of
nirvana more difficult. Given the emphasis on an ascetic lifestyle, Weber thought that devout Hindus would be
less likely to engage in entrepreneurial activity than devout Protestants.
Mahatma Gandhi, the famous Indian nationalist and spiritual leader, was certainly the embodiment of
Hindu asceticism. It has been argued that the values of Hindu asceticism and self-reliance that Gandhi
advocated had a negative impact on the economic development of postindependence India.46 But we must be
careful not to read too much into Weber’s rather old arguments. Modern India is a very dynamic
entrepreneurial society, and millions of hardworking entrepreneurs form the economic backbone of
the country’s rapidly growing economy, especially in the information technology sector.47
Historically, Hinduism also supported India’s caste system. e concept of mobility between castes within an
individual’s lifetime makes no sense to traditional Hindus. Hindus see mobility between castes as something
that is achieved through spiritual progression and reincarnation. An individual can be reborn into a higher caste
in his or her next life if he or she achieves spiritual development in this life. Although the caste system has been
abolished in India, as discussed earlier in the chapter, it still casts a long shadow over Indian life.
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BUDDHISM
LO 4-2 Identify the forces that lead to differences in social culture.
Buddhism, with some 535 million adherents, was founded in the sixth century B.C. by Siddhartha Gautama in
what is now Nepal. Siddhartha renounced his wealth to pursue an ascetic lifestyle and spiritual perfection. His
adherents claimed he achieved nirvana but decided to remain on earth to teach his followers how they, too,
could achieve this state of spiritual enlightenment. Siddhartha became known as the Buddha (which means “the
awakened one”). Today, most Buddhists are found in Central and Southeast Asia, China, Korea, and Japan.
According to Buddhism, suffering originates in people’s desires for pleasure. Cessation of suffering can be
achieved by following a path for transformation. Siddhartha offered the Noble Eightfold Path as a route for
transformation. is emphasizes right seeing, thinking, speech, action, living, effort, mindfulness, and
meditation. Unlike Hinduism, Buddhism does not support the caste system. Nor does Buddhism advocate the
kind of extreme ascetic behavior that is encouraged by Hinduism. Nevertheless, like Hindus, Buddhists stress
the afterlife and spiritual achievement rather than involvement in this world.
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Buddhism e emphasis on wealth creation that is embedded in Protestantism is historically not found in Buddhism. us, in Buddhist societies, we do not see the same kind
of cultural stress on entrepreneurial behavior that Weber claimed could be found in the Protestant West. But
unlike Hinduism, the lack of support for the caste system and extreme ascetic behavior suggests that a Buddhist
society may represent a more fertile ground for entrepreneurial activity than a Hindu culture. In effect,
innovative ideas and entrepreneurial activities may take hold throughout society independent of which caste a
person may belong to, but again, each culture is uniquely oriented toward its own types of entrepreneurial
behavior.
In Buddhism, societies were historically more deeply rooted to their local place in the natural world.48 is
means that economies were more localized, with relations between people and also between culture and nature
being relatively unmediated. In the modern economy, complex technologies and large-scale social institutions
have led to a separation between people and also between people and the natural world. Plus, as the economy
grows, it is difficult to understand and appreciate the potential effects people have on the natural world. Both of
these separations are antithetical to the Buddha’s teachings.
Interestingly, recent trends actually bring in the “Zen” orientation from Buddhism into business in the
Western world.49 Now there are some 700 trademarks containing the word Zen in the United States alone,
according to the U.S. Patent and Trademark Office. “In business, ‘Zen’ is often a synonym for ordinary
nothingness,” blogged Nancy Friedman, a corporate copywriter who consults with businesses on naming and
branding. She said that “Zen can be combined with mail to describe ‘an incoming e-mail message with no
message or attachments.’ Zen spin is a verb meaning ‘to tell a story without saying anything at all.’ And to zen a
computing problem means to figure it out in an intuitive flash—perhaps while you’re plugged into the
earphones of your ZEN MP3 player, available from Creative.”50
CONFUCIANISM
LO 4-2 Identify the forces that lead to differences in social culture.
Confucianism was founded in the fifth century B.C. by K’ung-Fu-tzu, more generally known as Confucius. For
more than 2,000 years until the 1949 communist revolution, Confucianism was the official ethical system of
China. While observance of Confucian ethics has been weakened in China since 1949, many people still follow
the teachings of Confucius, principally in China, Korea, and Japan. Confucianism teaches the importance of
attaining personal salvation through right action. Although not a religion, Confucian ideology has
become deeply embedded in the culture of these countries over the centuries and, through that, has
an impact on the lives of many millions more.51 Confucianism is built around a comprehensive ethical code
that sets down guidelines for relationships with others. High moral and ethical conduct and loyalty to others
are central to Confucianism. Unlike religions, Confucianism is not concerned with the supernatural and has
little to say about the concept of a supreme being or an afterlife.
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Confucianism Some scholars maintain that Confucianism may have economic implications as profound as those Weber argued were to be found in Protestantism, although they are
of a different nature.52 eir basic thesis is that the influence of Confucian ethics on the culture of China,
Japan, South Korea, and Taiwan, by lowering the costs of doing business in those countries, may help explain
their economic success. In this regard, three values central to the Confucian system of ethics are of particular
interest: loyalty, reciprocal obligations, and honesty in dealings with others.
In Confucian thought, loyalty to one’s superiors is regarded as a sacred duty—an absolute obligation. In
modern organizations based in Confucian cultures, the loyalty that binds employees to the heads of their
organization can reduce the conflict between management and labor that we find in more class-conscious
societies. Cooperation between management and labor can be achieved at a lower cost in a culture where the
virtue of loyalty is emphasized in the value systems.
However, in a Confucian culture, loyalty to one’s superiors, such as a worker’s loyalty to management, is not
blind loyalty. e concept of reciprocal obligations is important. Confucian ethics stresses that superiors are
obliged to reward the loyalty of their subordinates by bestowing blessings on them. If these “blessings” are not
forthcoming, then neither will be the loyalty. is Confucian ethic is central to the Chinese concept of guanxi,
which refers to relationship networks supported by reciprocal obligations.53 Guanxi means relationships,
although in business settings it can be better understood as connections. Today, Chinese will often cultivate a
guanxiwang, or “relationship network,” for help. Reciprocal obligations are the glue that holds such networks
together. If those obligations are not met—if favors done are not paid back or reciprocated—the reputation of
the transgressor is tarnished, and the person will be less able to draw on his or her guanxiwang for help in the
future. us, the implicit threat of social sanctions is often sufficient to ensure that favors are repaid, obligations
are met, and relationships are honored. In a society that lacks a rule-based legal tradition, and thus legal ways of
redressing wrongs such as violations of business agreements, guanxi is an important mechanism for building
long-term business relationships and getting business done in China. For an example of the importance of
guanxi, read the accompanying Management Focus on China.
A third concept found in Confucian ethics is the importance attached to honesty. Confucian thinkers
emphasize that although dishonest behavior may yield short-term benefits for the transgressor, dishonesty does
not pay in the long run. e importance attached to honesty has major economic implications. When
companies can trust each other not to break contractual obligations, the costs of doing business are lowered.
Expensive lawyers are not needed to resolve contract disputes. In a Confucian society, people may be less
hesitant to commit substantial resources to cooperative ventures than in a society where honesty is less
pervasive. When companies adhere to Confucian ethics, they can trust each other not to violate the terms of
cooperative agreements. us, the costs of achieving cooperation between companies may be lower in societies
such as Japan relative to societies where trust is less pervasive.
For example, it has been argued that the close ties between the automobile companies and their component
parts suppliers in Japan are facilitated by a combination of trust and reciprocal obligations. ese close ties
allow the auto companies and their suppliers to work together on a range of issues, including inventory
reduction, quality control, and design. e competitive advantage of Japanese auto companies such as Toyota
may in part be explained by such factors.54 Similarly, the combination of trust and reciprocal obligations is
central to the workings and persistence of guanxi networks in China.
Page 107
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m a n a g e m e n t F O C U S
China and Its Guanxi
A few years ago, DMG emerged as one of China’s fastest-growing advertising agencies with a client list that includes
Budweiser, Unilever, Sony, Nabisco, Audi, Volkswagen, China Mobile, and dozens of other Chinese brands. Dan Mintz,
the company’s founder, says that the success of DMG was connected strongly to what the Chinese call guanxi.
Guanxi literally means relationships, although in business settings it can be better understood as connections. Guanxi has its roots in the Confucian philosophy of valuing social hierarchy and reciprocal obligations. Confucian ideology has
a 2,000-year-old history in China. Confucianism stresses the importance of relationships, both within the family and
between master and servant. Confucian ideology teaches that people are not created equal. In Confucian thought,
loyalty and obligations to one’s superiors (or to family) are regarded as a sacred duty, but at the same time, this loyalty
has its price. Social superiors are obligated to reward the loyalty of their social inferiors by bestowing “blessings” upon
them; thus, the obligations are reciprocal. Chinese will often cultivate a guanxiwang, or “relationship network,” for help. ere is a tacit acknowledgment that if you have the right guanxi, legal rules can be broken, or at least bent.
Mintz, who is now fluent in Mandarin, cultivated his guanxiwang by going into business with two young Chinese who had connections, Bing Wu and Peter Xiao. Wu, who works on the production side of the business, was a former
national gymnastics champion, which translates into prestige and access to business and government officials. Xiao
comes from a military family with major political connections. Together, these three have been able to open doors that
long-established Western advertising agencies could not. ey have done it in large part by leveraging the contacts of
Wu and Xiao and by backing up their connections with what the Chinese call Shi li, the ability to do good work.
A case in point was DMG’s campaign for Volkswagen, which helped the German company become ubiquitous in
China. e ads used traditional Chinese characters, which had been banned by Chairman Mao during the cultural
revolution in favor of simplified versions. To get permission to use the characters in film and print ads—a first in
modern China—the trio had to draw on high-level government contacts in Beijing. ey won over officials by arguing
that the old characters should be thought of not as “characters” but as art. Later, they shot TV spots for the ad on
Shanghai’s famous Bund, a congested boulevard that runs along the waterfront of the old city. Drawing again on
government contacts, they were able to shut down the Bund to make the shoot. Steven Spielberg had been able to close
down only a portion of the street when he filmed Empire of the Sun. DMG has also filmed inside Beijing’s Forbidden City, even though it is against the law to do so. Using his contacts, Mintz persuaded the government to lift the law for
24 hours. As Mintz has noted, “We don’t stop when we come across regulations. ere are restrictions everywhere you
go. You have to know how get around them and get things done.”*
Today, DMG Entertainment has expanded into being a Chinese-based production and distribution company. While
it began as an advertising agency, the company started distributing non-Chinese movies in the Chinese market in the
late 2000s (e.g., Iron Man 3, the sixth-highest-grossing film of all time in China) as well as producing Chinese films, the first being Founding of a Republic, a movie that marked the 60th anniversary of the People’s Republic of China. In these activities, DMG is also enjoying guanxi in the country. Variety reported that DMG benefited from “strong connections” with Chinese government officials and the state-run China Film Group Corporation.
*Graser, M., “Featured Player,” Variety, October 18, 2004, p. 6.
Sources: Rob Cain, “Chinese Studio DMG Emerges as Bidder for Major Stake in Paramount Pictures,” Media and Entertainment, March 15, 2016; Ali Jaafar, “China’s DMG Inks Deal with Hasbro to Launch First ‘Transformers’ Live Action Attraction,” Deadline Hollywood, January 16, 2016; A. Busch, “China’s DMG and Valiant Entertainment Partner to Expand Superhero Universe,” Deadline Hollywood, March 12, 2015; C. Coonan, “DMG’s Dan Mintz: Hollywood’s Man in China,” Variety, June 5, 2013; and Simon Montlake, “Hollywood’s Mr China: Dan Mintz, DMG,” Forbes, August 29, 2012.
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Language
One obvious way in which many countries differ is language. By language, we mean both the spoken and the
unspoken means of communication. Language is also one of the defining characteristics of a culture.
Oftentimes, learning a language entails learning a culture and vice versa. Some would even argue that a person
cannot get entrenched in a culture without knowing its dominant language.
SPOKEN LANGUAGE
Language does far more than just enable people to communicate with each other. e nature of a language also
structures the way we perceive the world. e language of a society can direct the attention of its members to
certain features of the world rather than others. e classic illustration of this phenomenon is that whereas the
English language has but one word for snow, the language of the Inuit (Eskimos) lacks a general term for it.
Instead, distinguishing different forms of snow is so important in the lives of the Inuit that they have 24 words
that describe different types of snow (e.g., powder snow, falling snow, wet snow, drifting snow).55
Because language shapes the way people perceive the world, it also helps define culture. Countries with more
than one language often have more than one culture. Canada has an English-speaking culture and a French-
speaking culture. Tensions between the two can run quite high, with a substantial proportion of the French-
speaking minority demanding independence from a Canada “dominated by English speakers.” e same
phenomenon can be observed in many other countries. Belgium is divided into Flemish and French speakers,
and tensions between the two groups exist; in Spain, a Basque-speaking minority with its own distinctive
culture has been agitating for independence from the Spanish-speaking majority for decades; on the
Mediterranean island of Cyprus, the culturally diverse Greek- and Turkish-speaking populations of the island
continually engage in some level of conflict. e island is now partitioned into two parts as a consequence.
While it does not necessarily follow that language differences create differences in culture and, therefore,
separatist pressures (witness the harmony in Switzerland, where four languages are spoken), there certainly
seems to be a tendency in this direction.56
Can You Speak the Most Important Languages?
Mastering your own native language is important to doing business in your home country. Mastering the language of a
foreign country is also an added value in any cross-cultural relationship. English leads the way in terms of business
languages, but which languages are important after English? Spanish? No, not necessarily. e three languages that are
important for business after English are Mandarin Chinese, French, and Arabic. Spanish is fifth, so it is clearly
important, but not as useful as English, Mandarin, French, and Arabic because of the number of people who speak these
languages. Do you agree with the rank order of these languages? Why or why not? Did you know that you can now
learn a new language online? Check out the Language Resources on globalEDGETM (globalEDGE.msu.edu/global-
resources/language-resources), and learn a new language (including Mandarin, French, Arabic, and Spanish).
Source: S. Kim, “Top 3 Useful Foreign Languages for Business Excludes Spanish,” ABC News, September 1, 2011, http://abcnews.go.com/business/t/blogEntry?id=14427844.
Mandarin (Chinese) is the mother tongue of the largest number of people, followed by English and Hindi,
which is spoken in India. However, the most widely spoken language in the world is English, followed by
French, Spanish, and Mandarin (many people speak English as a second language). English is increasingly
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becoming the language of international business throughout the world, as it has been in much of the developed
world for years. When Japanese and German businesspeople get together to do business, it is almost certain that
they will communicate in English. However, although English is widely used, learning the local language yields
considerable advantages. Most people prefer to converse in their own language, and being able to speak the
local language can build rapport and goodwill, which may be very important for a business deal. International
businesses that do not understand the local language can make major blunders through improper translation.
For example, the Sunbeam Corporation used the English words for its “Mist-Stick” mist-producing hair-
curling iron when it entered the German market, only to discover after an expensive advertising campaign that
mist means excrement in German. General Motors was troubled by the lack of enthusiasm among Puerto Rican
dealers for its new Chevrolet Nova. When literally translated into Spanish, nova means star. However, when
spoken it sounds like “no va,” which in Spanish means “it doesn’t go.” General Motors changed the name of the
car to Caribe.57 Ford made a similar and somewhat embarrassing mistake in Brazil. e Ford Pinto may well
have been a good car, but the Brazilians wanted no part of a car called “pinto,” which is slang for tiny male
genitals in Brazil. Even the world’s largest furniture manufacturer, IKEA from Sweden, ran into branding issues
when it named a plant pot “Jättebra” (which means great or superbly good in Swedish). Unfortunately, Jättebra
resembles the ai slang word for sex. Pepsi’s slogan “come alive with the Pepsi Generation” did not quite work
in China. People in China took it literally to mean “bring your ancestors back from the grave.”
UNSPOKEN LANGUAGE
LO 4-2 Identify the forces that lead to differences in social culture.
Unspoken language refers to nonverbal communication. We all communicate with each other by a host of
nonverbal cues. e raising of eyebrows, for example, is a sign of recognition in most cultures, while a smile is a
sign of joy. Many nonverbal cues, however, are culturally bound. A failure to understand the nonverbal cues of
another culture can lead to a communication failure. For example, making a circle with the thumb and the
forefinger is a friendly gesture in the United States, but it is a vulgar sexual invitation in Greece and Turkey.
Similarly, while most Americans and Europeans use the thumbs-up gesture to indicate that “it’s all right,” in
Greece the gesture is obscene.
Another aspect of nonverbal communication is personal space, which is the comfortable amount of distance
between you and someone you are talking with. In the United States, the customary distance apart
adopted by parties in a business discussion is five to eight feet. In Latin America, it is three to five
feet. Consequently, many North Americans unconsciously feel that Latin Americans are invading their personal
space and can be seen backing away from them during a conversation. Indeed, the American may feel that the
Latin is being aggressive and pushy. In turn, the Latin American may interpret such backing away as aloofness.
e result can be a regrettable lack of rapport between two businesspeople from different cultures.
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Education
LO 4-2 Identify the forces that lead to differences in social culture.
Formal education plays a key role in a society, and it is usually the medium through which individuals learn
many of the languages and other skills that are indispensable in a modern society. Formal education also
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supplements the family’s role in socializing the young into the values and norms of a society. Values and norms
are taught both directly and indirectly. Schools generally teach basic facts about the social and political nature
of a society. ey also focus on the fundamental obligations of citizenship. Cultural norms are also taught
indirectly at school. Respect for others, obedience to authority, honesty, neatness, being on time, and so on are
all part of the “hidden curriculum” of schools. e use of a grading system also teaches children the value of
personal achievement and competition.58
From an international business perspective, one important aspect of education is its role as a determinant of
national competitive advantage.59 e availability of a pool of skilled and knowledgeable workers is a major
determinant of the likely economic success of a country. In analyzing the competitive success of Japan, for
example, Harvard Business School Professor Michael Porter notes that after the last World War, Japan had
almost nothing except for a pool of skilled and educated human resources:
With a long tradition of respect for education that borders on reverence, Japan possessed a large pool of
literate, educated, and increasingly skilled human resources. . . . Japan has benefited from a large pool of
trained engineers. Japanese universities graduate many more engineers per capita than in the United States. .
. . A first-rate primary and secondary education system in Japan operates based on high standards and
emphasizes math and science. Primary and secondary education is highly competitive. . . . Japanese
education provides most students all over Japan with a sound education for later education and training. A
Japanese high school graduate knows as much about math as most American college graduates.60
Porter’s point is that Japan’s excellent education system is an important factor explaining the country’s postwar
economic success. Not only is a good education system a determinant of national competitive advantage, but it
is also an important factor guiding the location choices of international businesses. e recent trend to
outsource information technology jobs to India, for example, is partly due to the presence of significant
numbers of trained engineers in India, which in turn is a result of the Indian education system. By the same
token, it would make little sense to base production facilities that require highly skilled labor in a country
where the education system was so poor that a skilled labor pool was not available, no matter how attractive the
country might seem on other dimensions. It might make sense to base production operations that require only
unskilled labor in such a country.
e general education level of a country is also a good index of the kind of products that might sell in a
country and of the type of promotional material that should be used. As a direct example, a country where
more than 50 percent of the population is illiterate is unlikely to be a good market for popular books. But
perhaps more importantly, promotional material containing written descriptions of mass-marketed products is
unlikely to have an effect in a country where a half of the population cannot read. It is far better to use pictorial
promotions in such circumstances.
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Culture and Business
LO 4-4 Recognize how differences in social culture influence values in business.
Of considerable importance for a multinational corporation, or any company—small, medium or large—with
operations in different countries is how a society’s culture affects the values found in the
workplace. Management processes and practices may need to vary according to culturally determined work-
related values. For example, if the cultures of Brazil and the United Kingdom or the United States
and Sweden result in different work-related values, a company with operations in the different
countries should vary its management processes and practices to account for these differences.
e most famous study of how culture relates to values in the workplace was undertaken by Geert
Hofstede.61 As part of his job as a psychologist working for IBM, Hofstede collected data on employee
attitudes and values for more than 116,000 individuals. Respondents were matched on occupation, age, and
gender. e data later on enabled him to compare dimensions of culture across 50 countries. Hofstede initially
isolated four dimensions that he claimed summarized the different cultures62—power distance, uncertainty
avoidance, individualism versus collectivism, and masculinity versus femininity—and then, later on, he added a
fifth dimension inspired by Confucianism that he called long-term versus short-term orientation.63
e fifth dimension was added as a function of the data obtained via the Chinese Value Survey (CVS), an
instrument developed by Michael Harris Bond based on discussions with Hofstede.64 Bond used input from
“Eastern minds,” as Hofstede called it, to develop the Chinese Value Survey. Bond also references Chinese
scholars as helping him create the values that exemplify this new long-term versus short-term orientation. In his
original research, Bond called the fifth dimension “Confucian work dynamism,” but Hofstede said that in
practical terms, the dimension refers to a long-term versus short-term orientation.
Hofstede’s power distance dimension focused on how a society deals with the fact that people are unequal
in physical and intellectual capabilities. According to Hofstede, high power distance cultures were found in
countries that let inequalities grow over time into inequalities of power and wealth. Low power distance
cultures were found in societies that tried to play down such inequalities as much as possible.
e individualism versus collectivism dimension focused on the relationship between the individual and
his or her fellows. In individualistic societies, the ties between individuals were loose, and individual
achievement and freedom were highly valued. In societies where collectivism was emphasized, the ties between
individuals were tight. In such societies, people were born into collectives, such as extended families, and
everyone was supposed to look after the interest of his or her collective.
Hofstede’s uncertainty avoidance dimension measured the extent to which different cultures socialized their
members into accepting ambiguous situations and tolerating uncertainty. Members of high uncertainty
avoidance cultures placed a premium on job security, career patterns, retirement benefits, and so on. ey also
had a strong need for rules and regulations; the manager was expected to issue clear instructions, and
subordinates’ initiatives were tightly controlled. Lower uncertainty avoidance cultures were characterized by a
greater readiness to take risks and less emotional resistance to change.
Hofstede’s masculinity versus femininity dimension looked at the relationship between gender and work
roles. In masculine cultures, sex roles were sharply differentiated, and traditional “masculine values,” such as
achievement and the effective exercise of power, determined cultural ideals. In feminine cultures, sex roles were
less sharply distinguished, and little differentiation was made between men and women in the same job.
e long-term versus short-term orientation dimension refers to the extent to which a culture programs its
citizens to accept delayed gratification of their material, social, and emotional needs. It captures attitudes
toward time, persistence, ordering by status, protection of face, respect for tradition, and reciprocation of gifts
and favors. e label refers to these “values” being derived from Confucian teachings.
Hofstede created an index score for each of these five dimensions that ranged from 0 to 100 and scored high
for individualism, power distance, uncertainty avoidance, masculinity, and for long-term orientation.65 By
using the company IBM, Hofstede was able to hold company constant across cultures. us, any differences
across the country cultures would by design be due to differences in the countries’ cultures and not the
company’s culture. He averaged the scores for all employees from a given country to create an index score
between 0 and 100.
A strong movement is under way to add a sixth dimension to Hofstede’s work. Geert Hofstede, working
with Michael Minkov’s analysis of the World Values Survey, added a promising new dimension called
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indulgence versus restraint (IND) in 2010.66 On January 17, 2011, Hofstede delivered a webinar for
SIETAR Europe called “New Software of the Mind” to introduce the third edition of Cultures and
Organizations, in which the results of Minkov’s analysis were included to support this sixth dimension. In
addition, in a keynote delivered at the annual meeting of the Academy of International Business
(http://aib.msu.edu) in Istanbul, Turkey, on July 6, 2013, Hofstede again presented results and theoretical
rationale to support the indulgence versus restraint dimension. Indulgence refers to a society that allows
relatively free gratification of basic and natural human drives related to enjoying life and having fun. Restraint
refers to a society that suppresses gratification of needs and regulates it by means of strict social norms.
Table 4.1 summarizes data for 15 selected countries for the five established dimensions of individualism
versus collectivism, power distance, uncertainty avoidance, masculinity versus femininity, and long-term versus
short-term orientation (the Hofstede data were collected for 50 countries and the Bond data were collected for
23 countries; numerous other researchers have also added to the country samples). Western nations such as the
United States, Canada, and United Kingdom score high on the individualism scale and low on the power
distance scale. Latin American and Asian countries emphasize collectivism over individualism and score high on
the power distance scale. Table 4.1 also reveals that Japan’s culture has strong uncertainty avoidance and high
masculinity. is characterization fits the standard stereotype of Japan as a country that is male dominant and
where uncertainty avoidance exhibits itself in the institution of lifetime employment. Sweden and Denmark
stand out as countries that have both low uncertainty avoidance and low masculinity (high emphasis on
“feminine” values).
Hofstede’s results are interesting for what they tell us in a very general way about differences among cultures.
Many of Hofstede’s findings are consistent with standard stereotypes about cultural differences. For example,
many people believe Americans are more individualistic and egalitarian than the Japanese (they have a lower
power distance), who in turn are more individualistic and egalitarian than Mexicans. Similarly, many might
agree that Latin countries place a higher emphasis on masculine value—they are machismo cultures—than the
Scandinavian countries of Denmark and Sweden. As might be expected, East Asian countries such as Japan and
ailand scored high on long-term orientation, while nations such as the United States and Canada scored low.
However, we should be careful about reading too much into Hofstede’s research. It has been criticized on a
number of points.67 First, Hofstede assumes there is a one-to-one correspondence between culture
and the nation-state, but as we discussed earlier, many countries have more than one culture. Second,
Hofstede’s research may have been culturally bound. e research team was composed of Europeans and
Americans. e questions they asked of IBM employees—and their analysis of the answers—may have been
shaped by their own cultural biases and concerns. So it is not surprising that Hofstede’s results confirm Western
stereotypes because it was Westerners who undertook the research. e later addition of the long-term versus
short-term dimension illustrates this point. ird, Hofstede’s informants worked not only within a single
industry, the computer industry, but also within one company, IBM. At the time, IBM was renowned for its
own strong corporate culture and employee selection procedures, making it possible that the employees’ values
were different in important respects from the values of the cultures from which those employees came, as we
also pointed out earlier.
How Strong Is Your National Identity?
As we have found out in this chapter, a lot of measures exist to assess cultural values and norms. Self-assessment is one of
the best ways to better know yourself, and we encourage you to take a rigorous cultural personality test such as what
Hofstede has developed. But let’s have some easy fun! How strong is your personal national identity? On a scale from 1
to 7, with 1 being “strongly disagree” and 7 being “strongly agree” (and with scores of 2, 3, 4, 5, and 6 being in between
those two extremes), rate yourself on these four questions:
1. My country has a strong historical heritage (national heritage).
2. People from my country are proud of their nationality (cultural homogeneity).
3. A true native of my country would never reject their religious beliefs (belief system).
4. It is always best to purchase products made from my home country (consumer ethnocentrism).
If you scored above 23 in total for the four questions, you have a strong “national identity”; if you scored below 9, you
have a weak “national identity.” Most people fall in between these two extremes.
Sources: B. Keillor and T. Hult, “A Five-Country Study of National Identity: Implications for International Marketing Research and Practice,”
International Marketing Review, 1999, pp. 65–82; B. Keillor, T. Hult, R. Erffmeyer, and E. Babakus, “NATID: e Development and
Application of a National Identity Measure for Use in International Marketing,” Journal of International Marketing, vol. 4, 1996.
Still, Hofstede’s work is the leading research the world has seen on culture. It represents a great starting point
for managers trying to figure out how cultures differ and what that might mean for management practices.
Also, several other scholars have found strong evidence that differences in culture affect values and practices in
the workplace, and Hofstede’s basic results have been replicated using more diverse samples of individuals in
different settings.68 Nevertheless, managers should use the results with caution. One reason for caution is the
plethora of new cultural values surveys and data points that are starting to become important additions to
Hofstede’s work. Two additional cultural values frameworks that have been examined and have been related to
work-related and/or business-related issues are the Global Leadership and Organizational Behavior Effectiveness
instrument and the World Values Survey.
e Global Leadership and Organizational Behavior Effectiveness (GLOBE) instrument is designed to address
the notion that a leader’s effectiveness is contextual.69 It is embedded in the societal and organizational norms,
values, and beliefs of the people being led. e initial GLOBE findings from 62 societies involving 17,300
middle managers from 951 organizations build on findings by Hofstede and other culture researchers. e
GLOBE research established nine cultural dimensions: power distance, uncertainty avoidance, humane
orientation, institutional collectivism, in-group collectivism, assertiveness, gender egalitarianism, future
orientation, and performance orientation.
e World Values Survey (WVS) is a research project spanning more than 100 countries that explores people’s
values and norms, how they change over time, and what impact they have in society and business.70 e WVS
includes dimensions for support for democracy; tolerance of foreigners and ethnic minorities; support for
gender equality; the role of religion and changing levels of religiosity; the impact of globalization; attitudes
toward the environment, work, family, politics, national identity, culture, diversity, and insecurity; and
subjective well-being.
As a reminder, culture is just one of many factors that might influence the economic success of a nation.
While culture’s importance should not be ignored, neither should it be overstated. e Hofstede framework is
the most significant and studied framework of culture as it relates to work values and business that we have ever
seen. But some of the newer culture frameworks (e.g., GLOBE, WVS) are also becoming popular in the
literature, and they have potential to complement and perhaps even supplant Hofstede’s work with additional
validation and connection to work-related values, business, and marketplace issues. At the same time, the
factors discussed in Chapters 2 and 3—economic, political, and legal systems—are probably more important
than culture in explaining differential economic growth rates over time.
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Cultural Change
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LO 4-5 Demonstrate an appreciation for the economic and business implications of cultural change.
An important point we want to make in this chapter on culture is that culture is not a constant; it
evolves over time.71 Changes in value systems can be slow and painful for a society. Change, however, does
occur and can often be quite profound. At the beginning of the 1960s, the idea that women might hold senior
management positions in major corporations was not widely accepted. Today, of course, it is a reality, and most
people in the United States could not fathom it any other way. For example, in 2012 Virginia (“Ginni”)
Rometty became the CEO of IBM; Mary Teresa Barra became the CEO of General Motors in 2014. Barra, as
but one of many examples (in 2018, 27 of the CEO positions at S&P 500 companies were held by women),
was named to the Time 100, and Forbes named her one of the World’s 100 Most Powerful Women. No one in
the mainstream of American society now questions the development or the capability of women in the business
world. American culture has changed.
General Motors Chair and CEO, Mary Barra, making an announcement about the Chevrolet Bolt
autonomous vehicles at a news conference in Detroit, Michigan.
©Cook/Reuters
For another illustration of cultural change, consider Japan. Some business professionals argue that a cultural
shift has been occurring in Japan, with a move toward greater individualism.72 e Japanese office worker, or
“salary person,” is characterized as being loyal to his or her boss and the organization to the point of giving up
evenings, weekends, and vacations to serve the organization. However, a new generation of office workers may
not fit this model. An individual from the new generation is likely to be more direct than the traditional
Japanese. is new-generation person acts more like a Westerner, a gaijin. He or she does not live for the
company and will move on if he or she gets an offer of a better job or has to work too much overtime.73
Several studies have suggested that economic advancement and globalization may be important factors in
societal change.74 ere is evidence that economic progress is accompanied by a shift in values away from
collectivism and toward individualism.75 As Japan has become richer, the cultural emphasis on collectivism has
declined and greater individualism is being witnessed. One reason for this shift may be that richer societies
exhibit less need for social and material support built on collectives, whether the collective is the extended
family or the company. People are better able to take care of their own needs. As a result, the importance
attached to collectivism declines, while greater economic freedoms lead to an increase in opportunities for
expressing individualism.
e culture of societies may also change as they become richer because economic progress affects a number
of other factors, which in turn influence culture. For example, increased urbanization and improvements in the
quality and availability of education are both a function of economic progress, and both can lead to declining
emphasis on the traditional values associated with poor rural societies. e World Values Survey, which we
mentioned earlier, has documented how values change. e study linked these changes in values to changes in a
country’s level of economic development.76 As countries get richer, a shift occurs away from “traditional values”
linked to religion, family, and country, and toward “secular-rational” values. Traditionalists say religion is
important in their lives. ey have a strong sense of national pride; they also think that children should be
taught to obey and that the first duty of a child is to make his or her parents proud.
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e merging or convergence of cultures can also be traced to the world today being more globalized than
ever. Advances in transportation and communication, technology, and international trade have set the tone for
global corporations (e.g., Disney, Microsoft, Google) to be part of bringing diverse cultures together into a
form of homogeneity we have not seen before.77 e examples are endless—McDonald’s hamburgers in China,
e Gap in India, iPhones in South Africa, and MTV in Sweden—of global companies helping to foster a
ubiquitous youth culture. Plus, with countries around the world climbing the ladder of economic progress,
some argue that the conditions for less cultural variation have been created. ere may be a slow but steady
convergence occurring across different cultures toward some universally accepted values and norms: is is
known as the convergence hypothesis.78
At the same time, we should not ignore important countertrends, such as the shift toward Islamic
fundamentalism in several countries; the continual separatist movement in Quebec, Canada; ethnic strains and
separatist movements in Russia; nationalist movements in the United Kingdom (Brexit); and the
election of a populist, nationally oriented Donald Trump as the 45th president of the United States.
Such countertrends are a reaction to the pressures for cultural convergence. In an increasingly modern and
materialistic world, some societies are trying to reemphasize their cultural roots and uniqueness. It is also
important to note that while some elements of culture change quite rapidly—particularly the use of material
symbols—other elements change slowly if at all. us, just because people the world over wear jeans, eat at
McDonald’s, use smartphones, watch their national version of American Idol, and drive Ford cars to work, we
should not assume that they have also adopted American (or Western) values—for often they have not.79 us,
a distinction needs to be made between the visible material aspects of culture and the deep structure,
particularly core social values and norms. e deep structure changes only slowly, and differences are often far
more persistent.
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Focus on Managerial Implications
CULTURAL LITERACY AND COMPETITIVE ADVANTAGE
International business is different from national business because countries and societies are different. Societies
differ because their cultures vary. eir cultures vary because of differences in social structure, religion,
language, education, economic philosophy, and political philosophy. ree important implications for
international business flow from these differences. e first is the need to develop cross-cultural literacy. ere is
a need not only to appreciate that cultural differences exist but also to appreciate what such differences mean
for international business. A second implication centers on the connection between culture and national
competitive advantage. A third implication looks at the connection between culture and ethics in decision
making. In this section, we explore the first two of these issues in depth. e connection between culture and
ethics is explored in Chapter 5.
Cross-Cultural Literacy One of the biggest dangers confronting a company that goes abroad for the first time is the danger of being ill-informed. International businesses that are ill-informed about another culture are
likely to fail. Doing business in different cultures requires adaptation to conform to the value systems and
norms of that culture. Adaptation can embrace all aspects of an international firm’s operations in a foreign
country. e way in which deals are negotiated, appropriate incentive pay systems for salespeople, the structure
of the organization, name of a product, tenor of relations between management and labor, the manner in which
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the product is promoted, and so on, are all sensitive to cultural differences. What works in one culture might
not work in another.
To combat the danger of being ill-informed, international businesses should consider employing local
citizens to help them do business in a particular culture. ey must also ensure that home-country executives
are well-versed enough to understand how differences in culture affect the practice of business. Transferring
executives globally at regular intervals to expose them to different cultures will help build a cadre of
knowledgeable executives. An international business must also be constantly on guard against the dangers of
ethnocentric behavior. Ethnocentrism is a belief in the superiority of one’s own ethnic group or culture. Hand
in hand with ethnocentrism goes a disregard or contempt for the culture of other countries. Unfortunately,
ethnocentrism is all too prevalent; many Americans are guilty of it, as are many French people, Japanese people,
British people, and so on.
Anthropologist Edward T. Hall has described how Americans, who tend to be informal in nature, react
strongly to being corrected or reprimanded in public.80 is can cause problems in Germany, where a cultural
tendency toward correcting strangers can shock and offend most Americans. For their part, Germans can be a
bit taken aback by the tendency of Americans to call people by their first name. is is uncomfortable enough
among executives of the same rank, but it can be seen as insulting when a junior American executive addresses a
more senior German manager by his or her first name without having been invited to do so. Hall concludes it
can take a long time to get on a first-name basis with a German; if you rush the process, you will be perceived
as over friendly and rude—and that may not be good for business.
Hall also notes that cultural differences in attitude to time can cause myriad problems. He notes that in the
United States, giving a person a deadline is a way of increasing the urgency or relative importance of a task.
However, in the Middle East, giving a deadline can have exactly the opposite effect. e American who insists
an Arab business associate make his mind up in a hurry is likely to be perceived as overly demanding and
exerting undue pressure. e result may be exactly the opposite, with the Arab going slow as a reaction to the
American’s rudeness. e American may believe that an Arab associate is being rude if he shows up late to a
meeting because he met a friend in the street and stopped to talk. e American, of course, is very concerned
about time and scheduling. But for the Arab, finishing the discussion with a friend is more important than
adhering to a strict schedule. Indeed, the Arab may be puzzled as to why the American attaches so much
importance to time and schedule.
Culture and Competitive Advantage One theme that surfaces in this chapter is the relationship between culture and national competitive advantage.81 Put simply, the value systems and norms of a country
influence the costs of doing business in that country. e costs of doing business in a country influence the
ability of firms to establish a competitive advantage. We have seen how attitudes toward cooperation between
management and labor, toward work, and toward the payment of interest are influenced by social structure and
religion. It can be argued that the class-based conflict between workers and management in class-conscious
societies raises the costs of doing business. Similarly, some sociologists have argued that the ascetic “other-
worldly” ethics of Hinduism may not be as supportive of capitalism as the ethics embedded in Protestantism
and Confucianism. Islamic laws banning interest payments may raise the costs of doing business by
constraining a country’s banking system.
Some scholars have argued that the culture of modern Japan lowers the costs of doing business relative to the
costs in most Western nations. Japan’s emphasis on group affiliation, loyalty, reciprocal obligations, honesty, and
education all boost the competitiveness of Japanese companies—at least that is the argument. e emphasis on
group affiliation and loyalty encourages individuals to identify strongly with the companies in which they work.
is tends to foster an ethic of hard work and cooperation between management and labor “for the good of the
company.” In addition, the availability of a pool of highly skilled labor, particularly engineers, has helped
Japanese enterprises develop cost-reducing process innovations that have boosted their productivity.82 us,
cultural factors may help explain the success enjoyed by many Japanese businesses. Most notably, it has been
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argued that the rise of Japan as an economic power during the second half of the twentieth century may be in
part attributed to the economic consequences of its culture.83
It also has been argued that the Japanese culture is less supportive of entrepreneurial activity than, say,
American society. In many ways, entrepreneurial activity is a product of an individualistic mindset, not a classic
characteristic of the Japanese. is may explain why American enterprises, rather than Japanese corporations,
dominate industries where entrepreneurship and innovation are highly valued, such as computer software and
biotechnology. Of course, exceptions to this generalization exist. Masayoshi Son recognized the potential of
software far faster than any of Japan’s corporate giants; set up his company, Softbank, in 1981; and over the past
30 years has built it into Japan’s top software distributor. Similarly, dynamic entrepreneurial individuals
established major Japanese companies such as Sony and Matsushita.
For international business, the connection between culture and competitive advantage is important for two
reasons. First, the connection suggests which countries are likely to produce the most viable competitors. For
example, we might argue that U.S. enterprises are likely to see continued growth in aggressive, cost-efficient
competitors from those Pacific Rim nations where a combination of free-market economics, Confucian
ideology, group-oriented social structures, and advanced education systems can all be found (e.g., South Korea,
Taiwan, Japan, and, increasingly, China). Second, the connection between culture and competitive advantage
has important implications for the choice of countries in which to locate production facilities and do business.
Consider a hypothetical case where a company has to choose between two countries, A and B, for locating a
production facility. Both countries are characterized by low labor costs and good access to world markets. Both
countries are of roughly the same size (in terms of population), and both are at a similar stage of
economic development. In country A, the education system is underdeveloped, the society is
characterized by a marked stratification between the upper and lower classes, and there are six major linguistic
groups. In country B, the education system is well developed, social stratification is lacking, group
identification is valued by the culture, and there is only one linguistic group. Which country makes the best
investment site?
Country B probably does. In country A, the conflict between management and labor, and between different
language groups, can be expected to lead to social and industrial disruption, thereby raising the costs of doing
business.84 e lack of a good education system also can be expected to work against the attainment of business
goals. e same kind of comparison could be made for an international business trying to decide where to push
its products, country A or B. Again, country B would be the logical choice because cultural factors suggest that
in the long run, country B is the nation most likely to achieve the greatest level of economic growth.
But as important as culture is to people, companies, and society, it is probably less important than
economic, political, and legal systems in explaining differential economic growth between nations. Cultural
differences are significant, but we should not overemphasize their importance in the economic sphere. For
example, earlier we noted that Max Weber argued that the ascetic principles embedded in Hinduism do not
encourage entrepreneurial activity. While this is an interesting academic thesis, recent years have seen an
increase in entrepreneurial activity in India, particularly in the information technology sector, where India is
rapidly becoming an important global player. e ascetic principles of Hinduism and caste-based social
stratification have apparently not held back entrepreneurial activity in this sector.
Key Terms
cross-cultural literacy, p. 89
culture, p. 90
values, p. 90
norms, p. 90
society, p. 90
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folkways, p. 91
mores, p. 92
social structure, p. 93
group, p. 94
social strata, p. 96
social mobility, p. 96
caste system, p. 96
class system, p. 96
class consciousness, p. 98
religion, p. 98
ethical system, p. 98
power distance, p. 110
individualism versus collectivism, p. 110
uncertainty avoidance, p. 110
masculinity versus femininity, p. 110
long-term versus short-term orientation, p. 110
ethnocentrism, p. 114
Summary
is chapter has looked at the nature of culture and discussed a number of implications for business practice.
e chapter made the following points:
1. Culture is a complex phenomenon that includes knowledge, beliefs, art, morals, law, customs, and other
capabilities acquired by people as members of society.
2. Values and norms are the central components of a culture. Values are abstract ideals about what a society
believes to be good, right, and desirable. Norms are social rules and guidelines that prescribe appropriate
behavior in particular situations.
3. Values and norms are influenced by political forces, economic philosophy, social structure, religion,
language, and education. And, the value systems and norms of a country can affect the costs of doing
business in that country.
4. e social structure of a society refers to its basic social organization. Two main dimensions along which
social structures differ are the individual–group dimension and the stratification dimension.
5. In some societies, the individual is the basic building block of a social organization. ese societies
emphasize individual achievements above all else. In other societies, the group is the basic building block
of the social organization. ese societies emphasize group membership and group achievements above
all else.
6. Virtually all societies are stratified into different classes. Class-conscious societies are characterized by low
social mobility and a high degree of stratification. Less class-conscious societies are characterized by high
social mobility and a low degree of stratification.
7. Religion may be defined as a system of shared beliefs and rituals that is concerned with the
realm of the sacred. Ethical systems refer to a set of moral principles, or values, that are used to guide and
shape behavior. e world’s major religions are Christianity, Islam, Hinduism, and Buddhism. e value
systems of different religious and ethical systems have different implications for business practice.
8. Language is one defining characteristic of a culture. It has both spoken and unspoken dimensions. In
countries with more than one spoken language, we tend to find more than one culture.
9. Formal education is the medium through which individuals learn knowledge and skills as well as become
socialized into the values and norms of a society. Education plays an important role in the determination
of national competitive advantage.
10. Geert Hofstede studied how culture relates to values in the workplace. He isolated five dimensions that
summarized different cultures: power distance, uncertainty avoidance, individualism versus collectivism,
masculinity versus femininity, and long-term versus short-term orientation.
11. Culture is not a constant; it evolves. Economic progress and globalization are two important engines of
cultural change.
12. One danger confronting a company that goes abroad is being ill-informed. To develop cross-cultural
literacy, companies operating globally should consider employing host-country nationals, build a cadre of
cosmopolitan executives, and guard against the dangers of ethnocentric behavior.
Critical inking and Discussion Questions
1. Outline why the culture of a country might influence the costs of doing business in that country.
Illustrate your answer with examples.
2. Do you think that business practices in an Islamic country are likely to differ from business practices in a
Christian country? If so, how?
3. Choose two countries that appear to be culturally diverse. Compare the cultures of those countries, and
then indicate how cultural differences influence (a) the costs of doing business in each country, (b) the
likely future economic development of that country, and (c) business practices.
4. Reread the Country Focus “Turkey, Its Religion, and Politics.” en answer the following questions:
a. Can you see anything in the values and norms of Islam that is hostile to business? Explain.
b. What does the experience of the region around Kayseri teach about the relationship between Islam and
business?
c. What are the implications of Islamic values toward business for the participation of a country such as
Turkey in the global economy or becoming a member of the European Union?
5. Reread the Management Focus “China and Its Guanxi” and answer the follow questions:
a. Why do you think it is so important to cultivate guanxi and guanxiwang in China?
b. What does the experience of DMG tell us about the way things work in China? What would likely
happen to a business that obeyed all the rules and regulations, rather than trying to find a way around
them as Dan Mintz does?
c. What ethical issues might arise when drawing on guanxiwang to get things done in China? What does
this suggest about the limits of using guanxiwang for a Western business committed to high ethical
standards?
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. You are preparing for a business trip to Chile, where you will need to interact extensively with local
professionals. As a result, you want to collect information about the local culture and business practices
prior to your departure. A colleague from Latin America recommends that you visit the Centre for
Intercultural Learning and read through the country insights provided for Chile. Prepare a short
description of the most striking cultural characteristics that may affect business interactions in this
country.
2. Typically, cultural factors drive the differences in business etiquette encountered during international
business travel. In fact, Middle Eastern cultures exhibit significant differences in business etiquette when
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compared to Western cultures. Prior to leaving for your first business trip to the region, a colleague
informed you that a guide named Business Etiquette around the World may help you. Identify five tips
regarding business etiquette in the Middle Eastern country of your choice.
T h e S w a t c h G r o u p a n d C u l t u r a l U n i q u e n e s s
c l o s i n g c a s e
e Swatch Group (swatchgroup.com) with its headquarters in Biel, Switzerland (Europe), is a manufacturer of watches
and jewelry. e company was founded in 1983 by Lebanese-born Nicolas Hayek from the merging of Allgemeine
Gesellschaft der Schweizerischen Uhrenindustrie and Société Suisse pour l’Industrie Horlogère. It is now the world’s
biggest watchmaker.
©PSL Images/Alamy Stock Photo
Nicolas’s daughter, Nayla Hayek, has been chair of the board of directors of the Swatch Group since her father’s death
in 2010, and she is also CEO of the luxury jeweler Harry Winston Inc., which was acquired by the Swatch Group in
2013. Georges Nicolas “Nick” Hayek Jr. has been the CEO and president of the Swatch Group since 2003. Today, the
Hayek family controls nearly 40 percent of the company.
Swatch and its 37 global subsidiaries employ about 37,000 people, and the company’s revenue is about 9 billion
Swiss francs (CHF), or about $9 billion in U.S. dollars. e company’s headquarters in Biel sits on the language border
between French- and German-speaking parts of Switzerland and is, by design, bilingual and culturally diverse. In fact,
everything that Swatch engages in is based on diversity and culture. is cultural diversity is embedded in its overall
brand and global strategizing.
For example, many of the Swatch brands have become cultural icons among a strong core following of customers in
the global marketplace. Some even talk about the “Swatch Revolution” that began when Nicolas Hayek founded the
company. It was the combination of legendary Swiss watch making (with the Swiss being famous for watch brands such
as Patek Philippe, Rolex, Jaeger-LeCoultre) and the unexpected appearance of an affordable plastic watch that turned
the watch world upside down.
Suddenly, a watch was more than a way to measure time. It was a new individualized culture, a new language, and a
way to speak from the heart without words. By definition, “swatch” means a sample of material or color, oftentimes
referring to a small piece of fabric. It is remarkable how Swatch has been able to develop culturally unique watches while
also building the fabric for a globally integrated world by its watch making.
e Swatch Group’s brands go far beyond the iconic Swatch watches, though. ey also include top Swiss brands like
Blancpain, Breguet, and Omega along with unique and classic products such as Balmain, Calvin Klein watches and
jewelry, Certina, Flik Flak, Glashütte, Hamilton, Harry Winston, Jaquet Droz, Léon Hatot, Longines, Mido, Original,
Rado, Tissot, Tourbillon, and Union Glashütte. ese brands form the “art” of Swatch—a focus that is almost always
emphasized upfront in the company’s annual report and something the Swatch Group nurtures in various ways, such as
via its Instagram account.
On Swatch’s Instagram (instagram.com/swatch), the storyline is clear. Swatch wants you to create your own unique
way of accessorizing by the use of a Swatch watch. A person can showcase his or her individualized Swatch use by
Page 119
tagging #MySwatch. e new line of “Skin” watches also helps users “dance with the unknown,” break down barriers,
and make #YourMove with Skin. e product is minimalist in style but unique, stylish, yet culturally diverse—much
like Swatch has created its cultural uniqueness for decades in the global marketplace. Swatch’s own description of its
brand captures this cultural uniqueness:
Everyone knows a Swatch when they see one. ere’s clearly something that makes Swatch different from every
other watch brand. What is it? e look, the colors, the plastic? e design, perhaps, or the fact that it’s Swiss made
and versatile enough to be worn with almost anything. ere are Swatch watches for people of all ages, and a Swatch
for every occasion. But there’s more to Swatch than market coverage. Swatch is an attitude, an approach to life, a
way of seeing. e sight of a Swatch excites emotion. Wearing one is a way to communicate, to speak without
speaking. Heart to heart.
e Swatch Group is not just about being culturally diverse, or a company marketing products globally to customers
of different cultures. In many respects the company is actually creating the values, beliefs, norms, and artifacts that form
a globally unique culture worldwide. So, Swatch’s large-scale production of watches and jewelry is used to help create
individually and culturally based customer uniqueness.
Sources: Corinne Gretler, “Swatch CEO Nick Hayek Sees Swiss Watch Turnaround in 2017,” Bloomberg BusinessWeek, February 2, 2017; Silke
Koltrowitz, “Swatch Group Seeing Strong Demand So Far in 2017,” Reuters, March 16, 2017 (www.reuters.com/article/us-swatch-results-
idUSKBN16N15B); “e Amazing Adventures of the Second Watch,” Swatch History 2017 (www.swatch.com/en_us/explore/history); “Swatch
Is Challenging Google and Apple with Its Own Operating System,” Fortune, March 16, 2017.
CASE DISCUSSION QUESTIONS
1. With the Hayek family controlling nearly 40 percent of e Swatch Group, how do you think the
family influence impacts the type of corporate culture in the company? What about the company’s
international culture being impacted by the Hayek family?
2. Many of the Swatch brands have become cultural icons among a strong core following of customers in
the global marketplace. Some even talk about the “Swatch Revolution” that began when Nicolas
Hayek founded the company. Why do you think Swatch has such a strong cultural following?
3. Swatch wants you to create your own unique way of accessorizing by the use of a Swatch watch. A
person can showcase his or her individualized Swatch use by tagging #MySwatch. Is a watch a way to
show who a person is culturally? Does a watch get embedded into a person’s culture? Can a watch
create a cultural image?
4. According to the company, “ Swatch is an attitude, an approach to life, a way of seeing. e sight of a
Swatch excites emotion. Wearing one is a way to communicate, to speak without speaking. Heart to
heart.” Do you buy this overarching “branding” of a Swatch watch as a cultural icon?
Endnotes
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2. is is a point made effectively by K. Leung, R. S. Bhagat, N. R. Buchan, M. Erez, and C. B. Gibson,
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Journal of International Business Studies, 2005, pp. 357–78. Several research articles and books also
support the notion that significant cultural differences still exist in the world; for example, T. Hult, D.
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3. M. Y. Brannen, “When Micky Loses Face: Recontextualization, Semantic Fit, and the Semiotics of
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4. See R. Dore, Taking Japan Seriously (Stanford, CA: Stanford University Press, 1987).
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10. J. Z. Namenwirth and R. B. Weber, Dynamics of Culture (Boston: Allen & Unwin, 1987), p. 8.
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23. Global Innovation Barometer 2018 is a product by Ideas Lab and supported by General Electric (GE).
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environment. It is the largest global survey of business executives dedicated to innovation. GE is now
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27. For an excellent historical treatment of the evolution of the English class system, see E. P. ompson, e
Making of the English Working Class (London: Vintage Books, 1966). See also R. Miliband, e State in
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28. Adonis and Pollard, A Class Act.
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35. M. Weber, e Protestant Ethic and the Spirit of Capitalism, 1905, p. 35.
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39. Dekmejian, Islam in Revolution.
40. M. K. Nydell, Understanding Arabs (Yarmouth, ME: Intercultural Press, 1987).
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42. e material in this section is based largely on Abbasi et al., “Islamic Economics.”
43. “Sharia Calling,” e Economist, November 12, 2010; N. Popper, “Islamic Banks, Stuffed with Cash,
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44. “Forced Devotion,” e Economist, February 17, 2001, pp. 76–77.
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46. See, for example, the views expressed in “A Survey of India: e Tiger Steps Out,” e Economist, January
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47. “High-Tech Entrepreneurs Flock to India,” PBS News Hour, February 9, 2014,
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48. H. Norberg-Hodge, “Buddhism in the Global Economy,” International Society for Ecology and Culture,
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52. See Dore, Taking Japan Seriously; C. W. L. Hill, “Transaction Cost Economizing as a Source of
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54. See Aoki, Information, Incentives, and Bargaining; J. P. Womack, D. T. Jones, and D. Roos, e Machine
at Changed the World (New York: Rawson Associates, 1990).
55. is hypothesis dates back to two anthropologists, Edward Sapir and Benjamin Lee Whorf. See E. Sapir,
“e Status of Linguistics as a Science,” Language 5 (1929), pp. 207–14; B. L. Whorf, Language, ought,
and Reality (Cambridge, MA: MIT Press, 1956).
56. e tendency has been documented empirically. See A. Annett, “Social Fractionalization, Political
Instability, and the Size of Government,” IMF Staff Papers 48 (2001), pp. 561–92.
57. D. A. Ricks, Big Business Blunders: Mistakes in Multinational Marketing (Homewood, IL: Dow Jones–
Irwin, 1983).
58. Goodman, An Introduction to Sociology.
59. Porter, e Competitive Advantage of Nations.
60. Porter, e Competitive Advantage of Nations, pp. 395–97.
61. G. Hofstede, “e Cultural Relativity of Organizational Practices and eories,” Journal of International
Business Studies, Fall 1983, pp. 75–89; G. Hofstede, Cultures and Organizations: Software of the Mind
(New York: McGraw-Hill USA, 1997); Hofstede, Culture’s Consequences.
62. Hofstede, “e Cultural Relativity of Organizational Practices and eories”; Hofstede, Cultures and
Organizations.
63. Hofstede, Culture’s Consequences.
64. G. Hofstede and M. Bond, “Hofstede’s Culture Dimensions: An Independent Validation Using Rokeach’s
Value Survey,” Journal of Cross-Cultural Psychology 15 (December 1984), pp. 417–33.
65. e factor scores for the long-term versus short-term orientation, using Bond’s survey, were brought into
a 0–100 range by a linear transformation (LTO = 50 × F + 50, in which F is the factor score). However,
the data for China came in after Hofstede and Bond had standardized the scale, and they put China
outside the range at LTO = 118 (which indicates a very strong long-term orientation).
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66. G. Hofstede, G. J. Hofstede, and M. Minkov, Cultures and Organizations: Software of the Mind, 3d ed.
(New York: McGraw-Hill, 2010).
67. For a more detailed critique, see Mead, International Management, pp. 73–75.
68. For example, see W. J. Bigoness and G. L. Blakely, “A Cross-National Study of Managerial
Values,” Journal of International Business Studies, December 1996, p. 739; D. H. Ralston, D. H. Holt, R.
H. Terpstra, and Y. Kai-Cheng, “e Impact of National Culture and Economic Ideology on Managerial
Work Values,” Journal of International Business Studies 28, no. 1 (1997), pp. 177–208; P. B. Smith, M. F.
Peterson, and Z. Ming Wang, “e Manager as a Mediator of Alternative Meanings,” Journal of
International Business Studies 27, no. 1 (1996), pp. 115–37; L. Tang and P. E. Koves, “A Framework to
Update Hofstede’s Cultural Value Indices,” Journal of International Business Studies 39 (2008), pp. 1045–
63.
69. R. House, P. Hanges, M. Javidan, P. Dorfman, and V. Gupta, Culture, Leadership, and Organizations: e
GLOBE Study of 62 Societies (ousand Oaks, CA: Sage, 2004); J. Chhokar, F. Brodbeck, and R. House,
Culture and Leadership across the World: e GLOBE Book of In-Depth Studies of 25 Societies (New York:
Routledge, 2012).
70. R. Inglehart, Modernization and Postmodernization: Cultural, Economic, and Political Change in 43
Societies (Princeton, NJ: Princeton University Press, 1997). Information and data on the World Values
Survey can be found at www.worldvaluessurvey.org.
71. For evidence of this, see R. Inglehart, “Globalization and Postmodern Values,” e Washington Quarterly,
Winter 2000, pp. 215–28.
72. Mead, International Management, chap. 17.
73. “Free, Young, and Japanese,” e Economist, December 21, 1991.
74. Namenwirth and Weber, Dynamics of Culture; Inglehart, “Globalization and Postmodern Values.”
75. G. Hofstede, “National Cultures in Four Dimensions,” International Studies of Management and
Organization 13, no. 1 (1983), pp. 46–74; Tang and Koves, “A Framework to Update Hofstede’s Cultural
Value Indices.”
76. See Inglehart, “Globalization and Postmodern Values.” For updates, see
www.isr.umich.edu/cps/project_wvs.html.
77. Hofstede, “National Cultures in Four Dimensions.”
78. D. A. Ralston, D. H. Holt, R. H. Terpstra, and Y. Kai-Chung, “e Impact of National Culture and
Economic Ideology on Managerial Work Values,” Journal of International Business Studies, 2007, pp. 1–
19.
79. See Leung et al., “Culture and International Business.”
80. Hall and Hall, Understanding Cultural Differences.
81. Porter, e Competitive Advantage of Nations.
82. See Aoki, Information, Incentives, and Bargaining; Dertouzos et al., Made in America; Porter, e
Competitive Advantage of Nations, pp. 395–97.
83. See Dore, Taking Japan Seriously; Hill, “Transaction Cost Economizing as a Source of Comparative
Advantage.”
84. For empirical work supporting such a view, see Annett, “Social Fractionalization, Political Instability, and
the Size of Government.”
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill
Education
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5
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Part 2 National Differences
Ethics, Corporate Social Responsibility, and Sustainability
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO5-1 Understand the ethical, corporate social responsibility, and sustainability issues faced by international
businesses.
LO5-2 Recognize an ethical, corporate social responsibility, and/or sustainability dilemma.
LO5-3 Identify the causes of unethical behavior by managers as they relate to business, corporate social
responsibility, or sustainability.
LO5-4 Describe the different philosophical approaches to business ethics that apply globally.
LO5-5 Explain how global managers can incorporate ethical considerations into their decision making in
general and for corporate social responsibility and sustainability initiatives.
Sustainability Initiatives at Natura, the Bodyshop, and Aesop
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opening case
Corporate Knights, a research firm from Toronto, Canada, puts together the Global 100, a ranking of the
world’s most sustainable companies, based on annual data analytics. Using data available publicly, Corporate
Knights rates large firms on 17 key measures, evaluating their management of resources, finances, and
employees (e.g., energy, carbon footprint, water use, waste productivity, clean air). ey consider about 4,000
companies worldwide with market values of at least $2 billion.
For several years, Natura & Co SA from Brazil has been among the world’s leaders, ranking number 14 in
the latest ranking. It is also the world’s largest cosmetics company. Natura (naturaeco.com), headquartered in
São Paulo, Brazil, was founded in 1969. It has more than 18,000 employees and revenue of about $4.4 billion
(R$15 billion Brazilian Real). Natura has three prominent subsidiaries that strive to be as sustainable in their
operations as possible. ey include Natura Cosmetics, which has become synonymous with Natura & Co SA
in general, and its more standalone brands of e Body Shop and Aesop.
Natura Cosmetics develops, produces, distributes, and sells cosmetics, fragrances, and hygiene products.
Natura’s products include creams, deodorants, lipsticks, lotions, makeup accessories, perfumes, shampoos,
shaving creams, soaps, and sunscreens, among others. Its portfolio is made up of brand names such as Amo,
Ekos, Tododia, Aguas, Chronos, Erva Doce, Homem, Horus, Seve, and Luna. Natura employs more than
7,000 people in seven countries: Brazil, Argentina, Chile, Mexico, Peru, Colombia, and France.
Sustainable development has been Natura’s guiding principle since it was founded in 1969. A passion for
Customer Relationship Management (CRM) led the company to adopt direct sales as its main commercial
strategy. To support its direct sales model, more than 1,421,000 consultants around the world (most in Brazil)
promote the company's values and products to consumers. Innovation is at the heart of Natura’s sustainable
development policy. For example, last year the company spent about $75 million on product development,
launching 164 products and achieving an innovation index of 64.8 percent (percentage of revenue from
products launched in the last two years).
e Body Shop International Limited, trading as e Body Shop, is a well-known, formerly British
cosmetics, skin care, and perfume company that was founded in 1976 by Anita and Gordon Roddick. It
currently has more than 1,000 products, which it sells in some 3,100 owned and franchised stores
internationally in 66 countries. e company is still based in East Croydon and Littlehampton, West Sussex,
United Kingdom, but was bought from French cosmetics company L'Oréal (which owned e Body Shop
from 2006 to 2017) in June 2017 for $1.2 billion (£880 million).
Famously, e Body Shop has been a leader in banning animal testing of cosmetics products worldwide.
e Body Shop has been against animal testing since the 1980s but is also tirelessly working to ban animal
testing in general in the cosmetics industry. is position also feeds into its sustainability initiatives.
Anita Roddick said that “My hope for the future of e Body Shop is primarily vested in those
people who will be the custodians of our culture and values.” is custodianship includes the pledge of being
the world’s most ethical, sustainable company. For example, in 2016, to mark its 40th anniversary, e Body
Shop unveiled a global CSR strategy—Enrich Not Exploit™—that will underpin all aspects of its operations.
e pioneering commitment reaffirmed the global cosmetics brand’s positioning as a leader in ethical and
sustainable business practices.
Aesop was founded by hairdresser Dennis Paphitis in 1987 in Melbourne, Australia. Suzanne Santos, as
Aesop’s first employee, was also instrumental in the foundation and growth of the company. Aesop is viewed
as an Australian skin care brand, owned fully by Natura since 2016 (although Natura had part ownership
since 2012). e brand has been identified as a unique way of doing marketing in today’s social media world.
In a somewhat unorthodox way, this includes not using traditional advertisements or discount sales to
promote its products. Instead, Aesop gets its promotional communication mostly by word-of-mouth for the
design of its products, stores, and events, which are a singular mix of indulgent product experiences,
thoughtful language, and modern minimalist design (compare with the Swedish furniture giant that often
receives similar reviews of minimalist but superb design in the furniture business).
Online Course Modules
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With its core subsidiaries (Natura Cosmetics, e Body Shop, and Aesop), Natura & Co SA has redefined
success in business on a global scale. In 2014, it became the first publicly traded company to become a
“Certified B Corporation.” A Certified B Corporation is a company that focuses on two specific sustainability
issues. First, it has reached a threshold standard for its impact on society and the environment. Second, the
company must have committed to consider the impact of its business decisions on its wider stakeholders, not
just its shareholders. Currently, only 2,200 B Corps exist worldwide, and their core sustainability focus is on
the interdependence between society, environment, and economy. Importantly, Natura’s actions show that it is
possible to make a positive difference for the environment while also ensuring the financial viability of the
company by profit making. is mindset also drove Natura’s purchase of e Body Shop in 2017, the first
billion-dollar B Corp acquisition by another B Corp. •
Sources: “Building for the Future,” e Body Shop Annual Report 2014/2015; Deanna Utroske, “e Body Shop Launches New
Campaign for UN Animal Testing Ban,” Cosmetics Design, March 22, 2018; Andres Schipani, “Body Shop Owner Natura Targets
Global Growth,” Financial Times, February 4, 2018; Corporate Knights, “2018 Global 100 Results,”
www.corporateknights.com/reports/2018-global-100; “e Body Shop Marks 40th Year with Pledge to Be World's Most Ethical,
Sustainable Global Company,” Sustainable Brands, February 12, 2016; Charmain Love, Katie Hill, and Marcel Fukayama, “Building
Bridges: Natura, Aesop and e Body Shop Join eir Businesses as Forces for Good,” B the Change, September 13, 2017.
Introduction
Ethics, corporate social responsibility, and sustainability are intertwined issues facing companies,
industries, countries, and regional societies worldwide. ese “social” issues arise frequently in
international business, often because business practices and regulations differ from nation to nation.
With regard to lead pollution, for example, what is allowed in Mexico is outlawed in the United
States. e tricky part is also that what is ethical, socially responsible, or sustainable often is not a legal
obligation that companies and countries face.
Instead, “doing good” is often a self-correcting measure that companies or industries place on
themselves and countries adopt as a business model (it may be a legal issue within one country but
seldom carries universally to all other countries in the world). Ultimately, differences in “sustainable”
practices can create dilemmas for businesses. Understanding the nature of these dilemmas and
deciding the course of action to pursue when confronted with them is a central theme in this chapter.
We blend a lot of business ethics with corporate social responsibility and sustainability issues to
capture a global understanding of the issues around the world.
globalEDGE™ has a series of
interactive “online course
modules”—free educational learning opportunities for businesspeople, policy officials, and students. ese
modules focus on issues that are important to international business. Each module includes a wealth of
content, a case study or anecdotes, glossary of terms, questions to consider, and a list of references. See more at
globaledge.msu.edu/reference-desk/online-course-modules. e combination of the Hill and Hult textbook
and the globalEDGE™ online course modules serves as an excellent resource that you can use to prepare for
NASBITE’s Certified Global Business Professional Credential. Achieving the industry-leading CGBP
credential ensures that employees are able to practice global business at the professional level—including
ethics, corporate social responsibility, and sustainability—required in today’s competitive global environment.
View the questions in the module as a test of your readiness to achieve the CGBP credential.
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is are not easy issues to capture, understand, or even buy into at all times. For example, we know
that some toy manufacturers have been violating safety regulations for decades, and many companies
will likewise continue to do so in the future across all product and industry categories. For the toy
industry specifically, time will tell, assuming we can track the ingredients in the materials being used
to make toys. What we do know is that about a third of the toys that are exported out of China are
currently tainted with heavy metals above the norm. Unfortunately, it is not illegal to use lead, for
example, in plastics at this time. It is an ethical issue and perhaps also a sustainability issue—and
usually a voluntary one—that some companies tackle and others choose to sidestep. e obvious
reason some companies take shortcuts is simple math or capitalism—the large size of market
opportunities in the toy industry. A basic question then is: Can it be considered unethical to
manufacture toys that include heavy metals that are bad for children to ingest and come in contact
with when using the toys in their proper way? What about corporate social responsibility among a
country’s companies or the companies’ sustainable business practices?
As the opening case illustrates, some companies tackle these issues head-on within their global
strategy of doing business. Specifically, with its core subsidiaries (Natura Cosmetics, e Body Shop,
and Aesop), Natura & Co SA has redefined success in business on a global scale, with the idea that
sustainability should be integrated throughout everything the company does. Being a “Certified B
Corporation,” the first publicly traded company to become certified, Natura has to have (1) reached a
threshold standard for its impact on society and the environment and (2) committed to consider the
impact of its business decisions on its wider stakeholders, not just its shareholders. As we stated, it is
important to note that Natura’s “positive business” actions show that it is possible to make a difference
for the environment while also ensuring that the company is profitable. is mindset drove Natura’s
purchase of e Body Shop in 2017, the first billion-dollar B Corp acquisition by another B Corp,
with e Body Shop being a longstanding advocate of no animal testing in product development.
e core starting point for this chapter is ethics. Ethics serves as the foundation for what people do
or do not do, and ultimately ethical behavior of employees results in corporate social responsibility
and sustainability practices engaged in by the company. Companies’ involvement in corporate social
responsibility practices and sustainability initiatives can be traced to the ethical foundation of its
employees and other stakeholders, such as customers, shareholders, suppliers, regulators, and
communities.1 Ethics refers to accepted principles of right or wrong that govern the conduct of a
person, the members of a profession, or the actions of an organization. Business ethics are the
accepted principles of right and wrong governing the conduct of businesspeople, and an ethical
strategy is a strategy, or course of action, that does not violate these accepted principles.
Broadly, as a start, we look at how ethical issues should be incorporated into decision making in an
international business. We also review the reasons for poor ethical decision making and discuss
different philosophical approaches to business ethics. en, using the ethical decision-making process
as our platform, we present a series of illustrations via two Management Focus boxes related
to VW and Stora Enso. e chapter closes by reviewing the different processes that
managers can adopt to make sure that ethical considerations are incorporated into decision making in
international business and how these decisions filter into corporate social responsibility and
sustainability efforts.
Ethics and International Business
LO 5-1 Understand the ethical, corporate social responsibility, and sustainability issues faced by
international businesses.
Many of the ethical issues in international business are rooted in differences in political systems, laws,
economic development, and culture across countries. What is considered normal practice in one
nation may be considered unethical in another. Also, what is illegal in one country may even be
normal ethical business practice in another.
ese unique complexities make it incredibly difficult to come up with global standards in ethics,
corporate social responsibility, and sustainability. Managers in a multinational corporation need to be
particularly sensitive to these differences when they do business throughout the world. Many
businesspeople try to advocate or even enforce their home country view on companies in other
countries without much thinking about the implications for the relationship. In the international
business setting, the most common ethical issues involve employment practices, human rights,
environmental regulations, corruption, and the moral obligation of multinational corporations.
EMPLOYMENT PRACTICES
When work conditions in another country (host nation) are inferior to those in a multinational
corporation’s home nation, which standards should be applied? ose of the home nation, those of the
host nation, or something in between? While few would suggest that pay and work conditions should
be the same across nations, how different can they be before we find it to be unacceptable? For
example, while 12-hour workdays, extremely low pay, and a failure to protect workers against toxic
chemicals may be common in some less developed and so-called emerging nations, does this mean
that it is okay for a multinational company to tolerate such working conditions in its subsidiaries or to
condone it by using local subcontractors in those countries? Without taking into account the potential
financial implications, it would be easy to simply say that every company should be as ethical, socially
responsible, and sustainable as its home-country environment dictates. But it’s not really that simple.
Some time ago, Nike found itself in the center of a storm of protests when news reports revealed
that working conditions at many of its subcontractors were poor. A 48 Hours report on CBS painted a
picture of young women who worked with toxic materials six days a week in poor conditions for only
20 cents an hour at a Vietnamese subcontractor. e report also stated that a living wage in Vietnam
was at least $3 a day, an income that could not be achieved at the subcontractor without working
substantial overtime. Nike and its subcontractors were not breaking any laws, but questions were
raised about the ethics of using “sweatshop labor” to make what were essentially fashion accessories. It
may have been legal, but was it ethical to use subcontractors who, by developed-nation standards,
clearly exploited their workforce? Nike’s critics thought not, and the company found itself the focus of
a wave of demonstrations and consumer boycotts. ese exposés surrounding Nike’s use of
subcontractors forced the company to reexamine its policies. Realizing that even though it was
breaking no law, its subcontracting policies were perceived as unethical, Nike’s management
established a code of conduct for its subcontractors and instituted annual monitoring by independent
auditors of all subcontractors.2
As the Nike case demonstrates, a strong argument can be made that it is not appropriate for a
multinational firm to tolerate poor working conditions in its foreign operations or those of
subcontractors. However, this still leaves unanswered the question of which standards should be
applied. We shall return to and consider this issue in more detail later in the chapter. For now, note
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that establishing minimal acceptable standards that safeguard the basic rights and dignity of
employees, auditing foreign subsidiaries and subcontractors on a regular basis to make sure those
standards are met, and taking corrective action if they are not up to standards are a good way to guard
against ethical abuses. For another example of problems with working practices among suppliers, read
the accompanying Management Focus, which looks at Volkswagen and the company’s staggering
public debacle regarding software used by VW to unethically lower the output data for air polluting
emissions.
m a n a g e m e n t F O C U S
“Emissionsgate” at Volkswagen
Volkswagen, often abbreviated as VW, is a German automaker that was founded by the German Labor Front.
e company is headquartered in Wolfsburg. It is the flagship marquee of the Volkswagen Group and, for the
first time ever, became the top automaker in the world in 2017 and has maintained that number one position.
Volkswagen said it delivered 10.8 million vehicles worldwide, while the nearest competitors Renault Nissan
Mitsubishi (10.3 million) and Toyota (10.3 million) had very similar global sales, some 500,000 units below
VW (with General Motors following just behind due to strong sales in China).
To go along with its car numbers, VW had sales of about $129 billion (€106 billion) and an employee
workforce of some 630,000 people. ese staggering numbers and the new ranking as the top automobile
manufacturer in the world came at the same time VW was facing perhaps its biggest challenge in its 80-year
history (the company was founded in 1937).
Sometimes referred to as “emissionsgate” or “dieselgate,” the Volkswagen emissions scandal began in September 2015 when the U.S. Environmental Protection Agency
(EPA) issued a notice of violation of the Clean Air Act to the German automaker. EPA is an agency of the
U.S. federal government that was created to protect human health and the environment by writing and
enforcing regulations based on laws passed by the U.S. Congress. e EPA has been around since 1970,
although the Trump administration has proposed a series of more than 40 cuts to the EPA (slashing the EPA
workforce by more than 3,000 people and $2 billion in funding).
In a rather astonishing finding, the EPA determined that Volkswagen had intentionally programmed
engines to activate emissions controls only during lab testing. e unethical programming by VW caused the
vehicles’ nitrogen oxide output—which is the most relevant factor for air pollution standards—to register at
lower levels to meet strict U.S. standards during the crucial laboratory regulatory testing. In reality, the
vehicles emitted up to 40 times more NOx on the streets. Volkswagen used this unethical and very
sophisticated computer programming in about 11 million cars worldwide, out of which 500,000 vehicles were
in use in the United States (for model years 2009–2015).
VW went to great lengths to make this work. e software in the cars sensed when the car was being tested
in a regulatory lab, and then the software automatically activated equipment in the vehicle that reduced
emissions. ink about that in terms of the decision making that had to go into making this unethical choice!
Additionally, the software turned the car’s equipment down during regular driving on the streets or highways,
resulting in increasing emissions way above legal limits. e only reasoning for doing this is to save fuel or to
improve the car’s torque and acceleration. us, not only were the emissions off, and unethically adjusted, the
car’s performance statistics were also affected in a positive way—which, obviously, can be seen as another
unethical decision or by-product of the emissions software.
e software was modified to adjust components such as catalytic converters or valves that were used to
recycle a portion of the exhaust gases. ese are the components that are meant to reduce emissions of
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nitrogen oxide, an air pollutant that can cause emphysema, bronchitis, and several other respiratory diseases.
e severity of this air pollution resulted in a $4.3 billion settlement with U.S. regulators. VW also agreed to
sweeping reforms, new audits, and oversight by an independent monitor for three years. Internally, VW
disciplined dozens of engineers, which is interesting because it at least implies that the top-level managers were
not aware of the software installation and unethical use.
e 2011 Volkswagen Jetta on display January 27, 2011 at the 2011 Washington Auto Show at
the Washington Convention Center in Washington, DC.
©KAREN BLEIER/AFP/Getty Images
Sources: Nathan Bomey, “Volkswagen Passes Toyota as World’s Largest Automaker Despite Scandal,” USA
Today, January 30, 2017; Bertel Schmitt, “It’s Official: Volkswagen Is World‘s Largest Automaker in 2016. Or
Maybe Toyota,” Forbes, January 30, 2017; Rob Davis, “Here Are 42 of President Donald Trump’s Planned
EPA Budget Cuts,” e Oregonian, March 2, 2017; “VW Expects to Sanction More Employees in Emissions
Scandal: Chairman,” CNBC, March 7, 2017.
HUMAN RIGHTS
Basic human rights still are not respected in a large number of nations, and several historical and
current examples exist to illustrate this point. Rights taken for granted in developed nations, such as
freedom of association, freedom of speech, freedom of assembly, freedom of movement, and freedom
from political repression, for example, are not universally accepted worldwide (see Chapter 2 for
details). One of the most obvious historical examples was South Africa during the days of white rule
and apartheid, which did not end until 1994. is may seem like a long time ago, but the effects of
the old system still linger to this day. Also, in many countries today we see an increase in authoritarian
populists who are attacking human rights principles and fueling distrust of democratic institutions.
South Africa represents an example that most people can relate to, most likely remember, and is
relatively easy to understand (compared with authoritarian populists politicians infringing on human
rights, which is often more difficult to understand and see in practice). e apartheid
system denied basic political rights to the majority nonwhite population of South Africa,
mandated segregation between whites and nonwhites, reserved certain occupations exclusively for
whites, and prohibited blacks from being placed in positions where they would manage whites.
Despite the odious nature of this system, businesses from developed nations operated in South Africa
for decades before changes started happening. In the decade prior to apartheid’s abolishment, however,
many questioned the ethics of doing so. ey argued that inward investment by foreign multinationals
supported the repressive apartheid regime, at least indirectly, by boosting the South African economy.
ankfully, several businesses started to change their policies in the 1990s and 2000s.3 Gearing up for
the 2020s and beyond, the assumption is that most businesses will follow the idea of, for example, the
United Nation’s Sustainable Development Goals 2030 (established in September 2015). In doing so,
more and more companies are now using ethical behavior as a core philosophy when competing for
work.
General Motors, which had significant activities in South Africa, was at the forefront of this trend.
GM adopted what came to be called the Sullivan principles, named after Leon Sullivan, an African
American Baptist minister and a member of GM’s board of directors. Sullivan argued that it was
ethically justified for GM to operate in South Africa so long as two conditions were fulfilled. First, the
company should not obey the apartheid laws in its own South African operations (a form of passive
resistance). Second, the company should do everything within its power to promote the abolition of
apartheid laws. As a practical matter, Sullivan’s principles ultimately became widely adopted by U.S.
firms operating in South Africa. e beginning of the end of apartheid, we think, was when these
foreign companies, like GM, violated the South African apartheid laws and the government of South
Africa did not take any action against the companies. Clearly, South Africa did not want to antagonize
important foreign investors, which then led to more and more foreign companies operating in the
country choosing to disobey the apartheid laws.
After 10 years, Leon Sullivan concluded that simply following the two principles was not sufficient
to break down the apartheid regime and that American companies, even those adhering to his
principles, could not ethically justify their continued presence in South Africa. Over the next few
years, numerous companies divested their South African operations, including Exxon, General
Motors, IBM, and Xerox. At the same time, many state pension funds signaled they would no longer
hold stock in companies that did business in South Africa, which helped persuade several companies
to divest their South African operations. ese divestments, coupled with the imposition of economic
sanctions from the United States and other governments, contributed to the abandonment of white
minority rule and apartheid in South Africa and the introduction of democratic elections in 1994.
is is when Nelson Mandela was elected president of South Africa, after having served 27 years in
prison for conspiracy and sabotage to overthrow the white government of South Africa (Mandela won
the Nobel Peace Prize in 1993 and passed away in 2013). Ultimately, adopting an ethical stance by
these large multinational corporations was argued to have helped improve human rights in South
Africa.4
Although change has come in South Africa, many repressive regimes still exist in the world. In fact,
according to the Freedom House, only about 45 percent of the world's population of 7.6 billion people are living in free democratic countries (30 percent are partly free and 25 percent are
not free). People in countries that are not considered free by the Freedom House typically face severe
consequences if they try to exercise their most basic rights, such as expressing their views, assembling
peacefully, and organizing independently of the countries in which they live.
is lack of universal freedom in many countries begs the question: Is it ethical for multinational
corporations to do business in these repressive countries? As an answer, it is often argued that inward
investment by a multinational can be a force for economic, political, and social progress that
ultimately improves the rights of people in repressive regimes. is position was first discussed in
Chapter 2, when we noted that economic progress in a nation could create pressure for
democratization. In general, this belief suggests that it is ethical for a multinational to do business in
nations that lack the democratic structures and human rights records of developed nations. Investment
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in China, for example, is frequently justified on the grounds that although China’s human rights
record is often questioned by human rights groups and although the country is not a democracy,
continuing inward investment will help boost economic growth and raise living standards.
ese developments will ultimately create pressures from the Chinese people for more
participatory government, political pluralism, and freedom of expression and speech.
ere is a limit to this argument. As in the case of South Africa, some regimes are so repressive that
investment cannot be justified on ethical grounds. Another example would be Myanmar (formerly
known as Burma). Ruled by a military dictatorship since 1962, Myanmar has one of the worst human
rights records in the world. Beginning in the mid-1990s, many companies exited Myanmar, judging
the human rights violations to be so extreme that doing business there could not be justified on ethical
grounds. However, a cynic might note that Myanmar has a small economy and that divestment carries
no great economic penalty for firms, unlike, for example, divestment from China. Interestingly, after
decades of pressure from the international community, the military government of Myanmar finally
acquiesced and allowed limited democratic elections to be held, resulting in the country being rated as
“partly free” today according to the Freedom House.
ENVIRONMENTAL POLLUTION
Ethical, social responsibility, and sustainability issues can arise when environmental regulations in host
nations are inferior to those in the home nation. Ethics drive what people decide to do, and corporate
social responsibility and sustainability drive what companies ultimately decide to do. Many developed
nations have substantial regulations governing the emission of pollutants, the dumping of toxic
chemicals, the use of toxic materials in the workplace, and so on. ose regulations are often lacking
in developing nations, and, according to critics, the result can be higher levels of pollution from the
operations of multinationals than would be allowed at home.
From a practical and moneymaking standpoint, we can ask: Should a multinational corporation
feel free to pollute in a developing nation? e answer seems simplistic: to do so hardly seems ethical.
Is there a danger that amoral management might move production to a developing nation precisely
because costly pollution controls are not required and the company is, therefore, free to despoil the
environment and perhaps endanger local people in its quest to lower production costs and gain a
competitive advantage? What is the right and moral thing to do in such circumstances: pollute to gain
an economic advantage or make sure that foreign subsidiaries adhere to common standards regarding
pollution controls?
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People wearing breathing masks walk at Tian’anmen Square in China’s capital city,
Beijing.
©Kevin Frayer/Getty Images
ese questions take on added importance because some parts of the environment are a public
good that no one owns but anyone can despoil. Even so, many companies answer illogically and say
that some degree of pollution is acceptable. If the issue becomes degree of pollution instead of
preventing as much pollution as possible, then the strategic decision has been turned around—
everyone will start arguing about the degree that is acceptable instead of what to do to prevent
pollution in the first place. e problematic part of this argument and equation for measuring
pollution is that no one owns the atmosphere or the oceans, but polluting both, no matter where the
pollution originates, harms all.5 In such cases, a phenomenon known as the tragedy of the commons
becomes applicable. e tragedy of the commons occurs when a resource held in common by all but
owned by no one is overused by individuals, resulting in its degradation. e phenomenon was first
named by Garrett Hardin when describing a particular problem in sixteenth-century England. Large
open areas, called commons, were free for all to use as pasture. e poor put out livestock on these
commons and supplemented their meager incomes. It was advantageous for each to put out more and
more livestock, but the social consequence was far more livestock than the commons could handle.
e result was overgrazing, degradation of the commons, and the loss of this much-needed
supplement.6
Corporations can contribute to the global tragedy of the commons by moving production to locations
where they are free to pump pollutants into the atmosphere or dump them in oceans or rivers, thereby
harming these valuable global commons. While such action may be legal, is it ethical? Again, such
actions seem to violate basic societal notions of ethics and corporate social responsibility. is issue is
taking on greater importance as concerns about human-induced global warming move to
center stage. Most climate scientists argue that human industrial and commercial activity is
increasing the amount of carbon dioxide in the atmosphere; carbon dioxide is a greenhouse gas, which
reflects heat back to the earth’s surface, warming the globe; and as a result, the average temperature of
the earth is increasing. e accumulated scientific evidence from numerous databases supports this
argument.7 Consequently, societies around the world are starting to restrict the amount of carbon
dioxide that can be emitted into the atmosphere as a by-product of industrial and commercial activity.
However, regulations differ from nation to nation. Given this, is it ethical for a company to try to
escape tight emission limits by moving production to a country with lax regulations, when doing so
will contribute to global warming? Again, many would argue that doing so violates basic ethical
principles.
CORRUPTION
As noted in Chapter 2, corruption has been a problem in almost every society in history, and it
continues to be one today.8 ere always have been and always will be corrupt government officials.
International businesses can gain and have gained economic advantages by making payments to those
officials. A classic example concerns a well-publicized incident involving Carl Kotchian, then president
of Lockheed. He made a $12.6 million payment to Japanese agents and government officials to secure
a large order for Lockheed’s TriStar jet from Nippon Air. When the payments were discovered, U.S.
officials charged Lockheed with falsification of its records and tax violations. Although such payments
were supposed to be an accepted business practice in Japan (they might be viewed as an exceptionally
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lavish form of gift giving), the revelations created a scandal there too. e government ministers in
question were criminally charged, one committed suicide, the government fell in disgrace, and the
Japanese people were outraged. Apparently, such a payment was not an accepted way of doing business
in Japan! e payment was nothing more than a bribe, paid to corrupt officials, to secure a large order
that might otherwise have gone to another manufacturer, such as Boeing. Kotchian clearly engaged in
unethical behavior—and to argue that the payment was an “acceptable form of doing business in
Japan” was self-serving and incorrect.
e Lockheed case was the impetus for the Foreign Corrupt Practices Act (FCPA) in the United
States, discussed in Chapter 2. e act outlawed paying of bribes to foreign government officials to
gain business, and this was the case even if other countries’ companies could do it. Some U.S.
businesses immediately objected that the act would put U.S. firms at a competitive disadvantage (there
is no evidence that has occurred).9 e act was subsequently amended to allow for “facilitating
payments.” Sometimes known as speed money or grease payments, facilitating payments are not
payments to secure contracts that would not otherwise be secured, nor are they payments to obtain
exclusive preferential treatment. Rather they are payments to ensure receiving the standard treatment
that a business ought to receive from a foreign government but might not due to the obstruction of a
foreign official.
e trade and finance ministers from the member states of the Organization for Economic Co-
operation and Development (OECD) later on followed the U.S. lead and adopted the Convention on
Combating Bribery of Foreign Public Officials in International Business Transactions.10 e
convention, which went into force in 1999, obliges member states and other signatories to make the
bribery of foreign public officials a criminal offense. e convention excludes facilitating payments
made to expedite routine government action.
While facilitating payments, or speed money, are excluded from both the Foreign Corrupt Practices
Act and the OECD convention on bribery, the ethical implications of making such payments are
unclear. From a practical standpoint, giving bribes might be the price that must be paid to do a greater
good (assuming the investment creates jobs and assuming the practice is not illegal). Several
economists advocate this reasoning, suggesting that in the context of pervasive and cumbersome
regulations in developing countries, corruption may improve efficiency and help growth! ese
economists theorize that in a country where preexisting political structures distort or limit the
workings of the market mechanism, corruption in the form of black-marketeering, smuggling, and
side payments to government bureaucrats to “speed up” approval for business investments may
enhance welfare.11 Arguments such as this persuaded the U.S. Congress to exempt facilitating
payments from the FCPA.
In contrast, other economists have argued that corruption reduces the returns on
business investment and leads to low economic growth.12 In a country where corruption is
common, unproductive bureaucrats who demand side payments for granting the enterprise permission
to operate may siphon off the profits from a business activity. is reduces businesses’ incentive to
invest and may retard a country’s economic growth rate. One study of the connection between
corruption and economic growth in 70 countries found that corruption had a significant negative
impact on a country’s growth rate.13 Another study found that firms that paid more in bribes are
likely to spend more, not less, management time with bureaucrats negotiating regulations and that this
tended to raise the costs of the firm.14
Should the United States Have Jurisdiction over Foreign Firms?
e U.S. Foreign Corrupt Practices Act (FCPA) is not just imposed on U.S. companies that operate globally.
It also has jurisdiction over foreign companies operating in the U.S. and what they do internationally. Settling
a FCPA investigation, Siemens—Europe’s largest engineering company and the largest electronics company in
the world—was fined $800 million by the U.S. Department of Justice and the U.S. Securities and Exchange
Commission. Together with various penalties imposed in Germany, Siemens’ home country, the penalties
total $1.6 billion. e settlement involved at least 4,200 allegedly corrupt payments totaling some $1.4 billion
over six years to foreign officials in numerous countries. Meetings, negotiations, and bank account transfers
were taking place in the United States between Siemens and officials from other countries. Is it appropriate
that the U.S. government can use the FCPA to investigate and fine foreign companies doing business in other
countries?
Sources: U.S. Department of Justice, www.justice.gov; “Siemens: A Giant Awakens,” e Economist, September 10, 2010; J. Ewing,
“Siemens Settlement: Relief, But Is It Over?” BusinessWeek, December 15, 2008.
Consequently, many multinationals have adopted a zero-tolerance policy. For example, the large oil
multinational BP has a zero-tolerance approach toward facilitating payments. Other corporations have
a more nuanced approach. Dow Corning used to formally state a few years ago in its Code of Conduct
that “in countries where local business practice dictates such [facilitating] payments and there is no
alternative, facilitating payments are to be for the minimum amount necessary and must be accurately
documented and recorded.”15 is statement recognized that business practices and customs differ
from country to country. At the same time, Dow Corning allowed for facilitating payments when
“there is no alternative,” although they were also stated to be strongly discouraged. More recently, the
latest version of Dow Corning’s Code of Conduct has removed the section on “international business
guidelines” altogether, so our assumption has to be that the company is taking a stronger zero-
tolerance approach.
At the same time, as with many companies, Dow Corning may have realized that the nuances
between a bribe and a facilitating payment are unclear. Many U.S. companies have sustained FCPA
violations due to facilitating payments that were made but did not fall within the general rules
allowing such payments. For example, global freight forwarder Con-way paid a $300,000 penalty for
making hundreds of what could be considered small payments to various customs officials in the
Philippines. In total, Con-way distributed some $244,000 to these officials who were induced to
violate customs regulations, settle disputes, and not enforce fines for administrative violations.16
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Ethical Dilemmas
LO 5-2 Recognize an ethical, corporate social responsibility, and/or sustainability dilemma.
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e ethical obligations of a multinational corporation toward employment conditions, human rights,
corruption, and environmental pollution are not always clear-cut. However, what is becoming clear-
cut is that managers and their companies are feeling more of the marketplace pressures from customers
and other stakeholders to be transparent in their ethical decision making. At the same time, there is no
universal worldwide agreement about what constitutes accepted ethical principles. From an
international business perspective, some argue that what is ethical depends on one’s cultural
perspective.17 In the United States, it is considered acceptable to execute murderers, but in many
cultures, this type of punishment is not acceptable—execution is viewed as an affront to human
dignity, and the death penalty is outlawed. Many Americans find this attitude strange, but, for
example, many Europeans find the American approach barbaric. For a more business-oriented
example, consider the practice of “gift giving” between the parties to a business negotiation. While this
is considered right and proper behavior in many Asian cultures, some Westerners view the practice as a
form of bribery and therefore unethical, particularly if the gifts are substantial.
International managers often confront very real ethical dilemmas where the appropriate
course of action is not clear. For example, imagine that a visiting American executive finds
that a foreign subsidiary in a poor nation has hired a 12-year-old girl to work on a factory floor.
Appalled to find that the subsidiary is using child labor in direct violation of the company’s own
ethical code, the American instructs the local manager to replace the child with an adult. e local
manager dutifully complies. e girl, an orphan, who is the only breadwinner for herself and her six-
year-old brother, is unable to find another job, so in desperation she turns to prostitution. Two years
later, she dies of AIDS. Had the visiting American understood the gravity of the girl’s situation, would
he still have requested her replacement? Would it have been better to stick with the status quo and
allow the girl to continue working? Probably not, because that would have violated the reasonable
prohibition against child labor found in the company’s own ethical code. What then would have been
the right thing to do? What was the obligation of the executive given this ethical dilemma?
A young girl making cigarettes in Bagan, Myanmar.
©Angela N Perryman/Shutterstock
ere are no easy answers to these questions. at is the nature of ethical dilemmas—situations in
which none of the available alternatives seems ethically acceptable.18 In this case, employing child
labor was not acceptable, but given that she was employed, neither was denying the child her only
source of income. What this American executive needs, what all managers need, is a moral compass, or
perhaps an ethical algorithm, to guide them through such an ethical dilemma to find an acceptable
solution. Later, we will outline what such a moral compass, or ethical algorithm, might look like. For
now, it is enough to note that ethical dilemmas exist because many real-world decisions are complex;
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difficult to frame; and involve first-, second-, and third-order consequences that are hard to quantify.
Doing the right thing, or even knowing what the right thing might be, is often far from easy.19
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Roots of Unethical Behavior
LO 5-3 Identify the causes of unethical behavior by managers as they relate to
business, corporate social responsibility, or sustainability.
Examples are plentiful of international managers behaving in a manner that might be judged unethical
in an international business setting. Why do managers behave in an unethical manner? ere is no
simple answer to this question because the causes are complex, but some generalizations can be made
and these issues are rooted in six determinants of ethical behavior: personal ethics, decision-making
processes, organizational culture, unrealistic performance goals, leadership, and societal culture (see
Figure 5.1).20
5.1 FIGURE
Determinants of ethical behavior.
PERSONAL ETHICS
Societal business ethics are not divorced from personal ethics, which are the generally accepted
principles of right and wrong governing the conduct of individuals. Personal ethics have an effect on
business ethics, which ultimately, as we will see in the Focus on Managerial Implications section of this
chapter, have an effect on a company’s socially responsibility practices and sustainability activities. As
individuals, we are typically taught that it is wrong to lie and cheat—it is unethical—and that it is
right to behave with integrity and honor and to stand up for what we believe to be right and true. is
is generally true across societies. e personal ethical code that guides our behavior comes from a
number of sources, including our parents, our schools, our religion, and the media. Our personal
ethical code exerts a profound influence on the way we behave as businesspeople. An individual with a
strong sense of personal ethics is less likely to behave in an unethical manner in a business setting. It
follows that the first step to establishing a strong sense of business ethics is for a society to emphasize
strong personal ethics.
Home-country managers working abroad in multinational firms (expatriate managers) may
experience more than the usual degree of pressure to violate their personal ethics. ey are away from
their ordinary social context and supporting culture, and they are psychologically and geographically
distant from the parent company. ey may be based in a culture that does not place the same value
on ethical norms important in the manager’s home country, and they may be surrounded by local
employees who have less rigorous ethical standards. e parent company may pressure expatriate
managers to meet unrealistic goals that can only be fulfilled by cutting corners or acting unethically.
For example, to meet centrally mandated performance goals, expatriate managers might give bribes to
win contracts or might implement working conditions and environmental controls that are below
minimal acceptable standards. Local managers might encourage the expatriate to adopt such behavior.
Due to its geographic distance, the parent company may be unable to see how expatriate managers are
meeting goals or may choose not to see how they are doing so, allowing such behavior to flourish and
persist.
DECISION-MAKING PROCESSES
Several studies of unethical behavior in a business setting have concluded that businesspeople
sometimes do not realize they are behaving unethically, primarily because they simply fail to ask, “Is
this decision or action ethical?”21 Instead, they apply a straightforward business calculus to what they
perceive to be a business decision, forgetting that the decision may also have an important ethical
dimension. e fault lies in processes that do not incorporate ethical considerations into business
decision making. is may have been the case at Nike when managers originally made subcontracting
decisions. ose decisions were probably made based on good economic logic. Subcontractors were
probably chosen based on business variables such as cost, delivery, and product quality, but the key
managers simply failed to ask, “How does this subcontractor treat its workforce?” If they thought
about the question at all, they probably reasoned that it was the subcontractor’s concern, not theirs.
To improve ethical decision making in a multinational firm, the best starting point is to better
understand how individuals make decisions that can be considered ethical or unethical in an
organizational environment.22 Two assumptions must be taken into account. First, too often it is
assumed that individuals in the workplace make ethical decisions in the same way as they would if
they were home. Second, too often it is assumed that people from different cultures make ethical
decisions following a similar process (see Chapter 4 for more on cultural differences). Both of these
assumptions are problematic. First, within an organization, there are very few individuals who have
the freedom (e.g., power) to decide ethical issues independent of pressures that may exist in an
organizational setting (e.g., should we make a facilitating payment or resort to bribery?). Second, while
the process for making an ethical decision may largely be the same in many countries, the relative
emphasis on certain issues is unlikely to be the same. Some cultures may stress organizational factors
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(Japan), while others stress individual personal factors (United States), yet some may base a decision
purely on opportunity (Myanmar) and others base it on the importance to their superiors (India).
ORGANIZATIONAL CULTURE
e culture in some businesses does not encourage people to think through the ethical consequences
of business decisions. is brings us to the third cause of unethical behavior in businesses: an
organizational culture that deemphasizes business ethics, reducing all decisions to the purely
economic. e term organizational culture refers to the values and norms that are shared
among employees of an organization. You will recall from Chapter 4 that values are abstract
ideas about what a group believes to be good, right, and desirable, while norms are the social rules and
guidelines that prescribe appropriate behavior in particular situations. Just as societies have cultures, so
do business organizations, as we discussed in Chapter 4. Together, values and norms shape the culture
of a business organization, and that culture has an important influence on the ethics of business
decision making.
For example, paying bribes to secure business contracts was long viewed as an acceptable way of
doing business within certain companies. It was, in the words of an investigator of a case against
Daimler, “standard business practice” that permeated much of the organization, including
departments such as auditing and finance that were supposed to detect and halt such behavior. It can
be argued that such a widespread practice could have persisted only if the values and norms of the
organization implicitly approved of paying bribes to secure business.
UNREALISTIC PERFORMANCE GOALS
A fourth cause of unethical behavior has already been hinted at: pressure from the parent company to
meet unrealistic performance goals that can be attained only by cutting corners or acting in an
unethical manner. In these cases, bribery may be viewed as a way to hit challenging performance goals.
e combination of an organizational culture that legitimizes unethical behavior, or at least turns a
blind eye to such behavior, and unrealistic performance goals may be particularly toxic. In such
circumstances, there is a greater than average probability that managers will violate their own personal
ethics and engage in unethical behavior. Conversely, an organization’s culture can do just the opposite
and reinforce the need for ethical behavior. At Hewlett-Packard, for example, Bill Hewlett and David
Packard, the company’s founders, propagated a set of values known as e HP Way. ese values,
which shape the way business is conducted both within and by the corporation, have an important
ethical component. Among other things, they stress the need for confidence in and respect for people,
open communication, and concern for the individual employee.
LEADERSHIP
e Hewlett-Packard example suggests a fifth root cause of unethical behavior: leadership. Leaders
help establish the culture of an organization, and they set the example, rules, and guidelines that
others follow as well as the structure and processes for operating both strategically and in daily
operations. Employees often operate and work within a defined structure with a mindset very much
similar to the overall culture of the organization that employs them.
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Additionally, employees in a business often take their cue from business leaders, and if those leaders
do not behave in an ethical manner, the employees might not either. It is not just what leaders say that
matters but what they do or do not do. What message, then, did the leaders at Daimler send about
corrupt practices? Presumably, they did very little to discourage them and may have encouraged such
behavior.
SOCIETAL CULTURE
Societal culture may well have an impact on the propensity of people and organizations to behave in
an unethical manner. One study of 2,700 firms in 24 countries found that there were significant
differences among the ethical policies of firms headquartered in different countries.23 Using Hofstede’s
dimensions of social culture (see Chapter 4), the study found that enterprises headquartered in
cultures where individualism and uncertainty avoidance are strong were more likely to emphasize the
importance of behaving ethically than firms headquartered in cultures where masculinity and power
distance are important cultural attributes. Such analysis suggests that enterprises headquartered in a
country such as Russia, which scores high on masculinity and power distance measures, and where
corruption is endemic, are more likely to engage in unethical behavior than enterprises headquartered
in Scandinavia.
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Philosophical Approaches to Ethics
LO 5-4 Describe the different philosophical approaches to business ethics that apply globally.
In this section, we look at several different philosophical approaches to business ethics in the global
marketplace. Basically, all individuals adopt a process for making ethical (or unethical) decisions. is
process is based on their personal philosophical approach to ethics—that is, the underlying moral
fabric of the individual.
We begin with what can best be described as straw men, which either deny the value of
business ethics or apply the concept in a very unsatisfactory way. Having discussed and, we
hope you agree, dismissed the straw men, we move on to consider approaches that are favored by most
moral philosophers and form the basis for current models of ethical behavior in international
businesses.
STRAW MEN
Straw men approaches to business ethics are raised by business ethics scholars primarily to demonstrate
that they offer inappropriate guidelines for ethical decision making in a multinational enterprise. Four
such approaches to business ethics are commonly discussed in the literature. ese approaches can be
characterized as the Friedman doctrine, cultural relativism, the righteous moralist, and the naive
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immoralist. All these approaches have some inherent value, but all are unsatisfactory in important
ways. Nevertheless, sometimes companies adopt these approaches.
e Friedman Doctrine e Nobel Prize–winning economist Milton Friedman wrote an article in e New York Times in 1970 that has since become a classic straw man example that business ethics
scholars outline only to then tear down.24 Friedman’s basic position is that “the social responsibility of
business is to increase profits,” so long as the company stays within the rules of law. He explicitly
rejects the idea that businesses should undertake social expenditures beyond those mandated by the
law and required for the efficient running of a business. For example, his arguments suggest that
improving working conditions beyond the level required by the law and necessary to maximize
employee productivity will reduce profits and is therefore not appropriate. His belief is that a firm
should maximize its profits because that is the way to maximize the returns that accrue to the owners
of the firm, its shareholders. If the shareholders then wish to use the proceeds to make social
investments, that is their right, according to Friedman, but managers of the firm should not make that
decision for them.
Although Friedman is talking about social responsibility and “ethical custom,” rather than business
ethics per se, many business ethics scholars equate social responsibility with ethical behavior and thus
believe Friedman is also arguing against business ethics. However, the assumption that Friedman is
arguing against ethics is not quite true, for Friedman does argue that there is only one social
responsibility of business: to increase the profitability of the enterprise so long as it stays within the
law, which is taken to mean that it engages in open and free competition without deception or
fraud.25
ere is one and only one social responsibility of business—to use its resources and engage in
activities designed to increase its profits so long as it stays within the rules of the game, which is to
say that it engages in open and free competition without deception or fraud.26
In other words, Friedman argues that businesses should behave in a socially responsible manner,
according to ethical custom and without deception and fraud.
Critics charge that Friedman’s arguments break down under examination. is is particularly true
in international business, where the “rules of the game” are not well established and differ from
country to country. Consider again the case of sweatshop labor. Child labor may not be against the
law in a developing nation, and maximizing productivity may not require that a multinational firm
stop using child labor in that country, but it is still immoral to use child labor because the practice
conflicts with widely held views about what is the right and proper thing to do. Similarly, there may
be no rules against pollution in a less developed nation and spending money on pollution control may
reduce the profit rate of the firm, but generalized notions of morality would hold that it is still
unethical to dump toxic pollutants into rivers or foul the air with gas releases. In addition to the local
consequences of such pollution, which may have serious health effects for the surrounding population,
there is also a global consequence as pollutants degrade those two global commons so important to us
all: the atmosphere and the oceans.
Cultural Relativism Another straw man often raised by business ethics scholars is cultural relativism, which is the belief that ethics are nothing more than the reflection of a culture—all ethics
are culturally determined—and that accordingly, a firm should adopt the ethics of the culture in which
it is operating.27 is approach is often summarized by the maxim when in Rome, do as the
Romans do. As with Friedman’s approach, cultural relativism does not stand up to a closer look. At its
extreme, cultural relativism suggests that if a culture supports slavery, it is okay to use slave labor in a
country. Clearly, it is not! Cultural relativism implicitly rejects the idea that universal notions of
morality transcend different cultures, but as we argue later in the chapter, some universal notions of
morality are found across cultures.
While dismissing cultural relativism in its most sweeping form, some ethicists argue there is
residual value in this approach.28 We agree. As we noted in Chapter 3, societal values and norms do
vary from culture to culture, and customs do differ, so it might follow that certain business practices
are ethical in one country but not another. Indeed, the facilitating payments allowed in the Foreign
Corrupt Practices Act can be seen as an acknowledgment that in some countries, the payment of speed
money to government officials is necessary to get business done, and, if not ethically desirable, it is at
least ethically acceptable.
“When in Rome, Behave Like a Swede,” Really?
You would think that as one of the authors of this book is from Sweden, it seemed convenient to revise the
ancient proverb “when in Rome, do as the Romans do” to “when in Rome, behave like a Swede.” But instead,
this slightly reworded saying was coined in an article in e Economist. As just one example, IKEA, the
Swedish furniture giant, as mentioned in the article, has gone to great lengths to fight corruption worldwide.
In that spirit, the argument is for the case that doing the right thing is smart business. But we all know—even
the Swedish author of this book (!)—that the global marketplace can be a jungle: It’s eat or be eaten. Now if
we go back to the ancient proverb, the meaning of it basically suggests that we should behave as those around
us and conform to the culture in the foreign society in which we are doing business. So, what is your
preference: Do you prefer “when in Rome, do as the Romans do” or “when in Rome, behave like a Swede”?
Sources: “e Corruption Eruption,” e Economist, April 29, 2010; Ethical Business Ethics, May 6, 2010,
http://ethicalbusinessethics.blogspot.com/2010/05/when-in-rome-should-you-do-as-romans-do.html.
e Righteous Moralist A righteous moralist claims that a multinational’s home-country standards of ethics are the appropriate ones for companies to follow in foreign countries. is
approach is typically associated with managers from developed nations. While this seems reasonable at
first blush, the approach can create problems. Consider the following example: An American bank
manager was sent to Italy and was appalled to learn that the local branch’s accounting department
recommended grossly underreporting the bank’s profits for income tax purposes.29 e manager
insisted that the bank report its earnings accurately, American style. When he was called by the Italian
tax department to the firm’s tax hearing, he was told the firm owed three times as much tax as it had
paid, reflecting the department’s standard assumption that each firm underreports its earnings by two-
thirds. Despite his protests, the new assessment stood. In this case, the righteous moralist has run into
a problem caused by the prevailing cultural norms in the country where he was doing business. How
should he respond? e righteous moralist would argue for maintaining the position, while a more
pragmatic view might be that in this case, the right thing to do is to follow the prevailing cultural
norms because there is a big penalty for not doing so.
e main criticism of the righteous moralist approach is that its proponents go too far. While there
are some universal moral principles that should not be violated, it does not always follow that the
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appropriate thing to do is adopt home-country standards. For example, U.S. laws set down strict
guidelines with regard to minimum wage and working conditions. Does this mean it is ethical to
apply the same guidelines in a foreign country, paying people the same as they are paid in the United
States, providing the same benefits and working conditions? Probably not, because doing so might
nullify the reason for investing in that country and therefore deny locals the benefits of inward
investment by the multinational. Clearly, a more nuanced approach is needed.
e Naive Immoralist A naive immoralist asserts that if a manager of a multinational sees that firms from other nations are not following ethical norms in a host nation, that manager should not
either. e classic example to illustrate the approach is known as the drug lord problem. In one variant
of this problem, an American manager in Colombia routinely pays off the local drug lord to guarantee
that her plant will not be bombed and that none of her employees will be kidnapped. e manager
argues that such payments are ethically defensible because everyone is doing it.
e objection is twofold. First, to say that an action is ethically justified if everyone is doing it is
not sufficient. If firms in a country routinely employ 12-year-olds and make them work 10-
hour days, is it therefore ethically defensible to do the same? Obviously not, and the
company does have a clear choice. It does not have to abide by local practices, and it can decide not to
invest in a country where the practices are particularly odious. Second, the multinational must
recognize that it does have the ability to change the prevailing practice in a country. It can use its
power for a positive moral purpose. is is what BP is doing by adopting a zero-tolerance policy with
regard to facilitating payments. BP is stating that the prevailing practice of making facilitating
payments is ethically wrong, and it is incumbent upon the company to use its power to try to change
the standard. While some might argue that such an approach smells of moral imperialism and a lack
of cultural sensitivity, if it is consistent with widely accepted moral standards in the global community,
it may be ethically justified.
UTILITARIAN AND KANTIAN ETHICS
In contrast to the straw men just discussed, most moral philosophers see value in utilitarian and
Kantian approaches to business ethics. ese approaches were developed in the eighteenth and
nineteenth centuries, and although they have been largely superseded by more modern approaches,
they form part of the tradition on which newer approaches have been constructed.
e utilitarian approach to business ethics dates to philosophers such as David Hume (1711–
1776), Jeremy Bentham (1748–1832), and John Stuart Mill (1806–1873). Utilitarian approaches to
ethics hold that the moral worth of actions or practices is determined by their consequences.30 An
action is judged desirable if it leads to the best possible balance of good consequences over bad
consequences. Utilitarianism is committed to the maximization of good and the minimization of
harm. Utilitarianism recognizes that actions have multiple consequences, some of which are good in a
social sense and some of which are harmful. As a philosophy for business ethics, it focuses attention on
the need to weigh carefully all the social benefits and costs of a business action and to pursue only
those actions where the benefits outweigh the costs. e best decisions, from a utilitarian perspective,
are those that produce the greatest good for the greatest number of people.
Many businesses have adopted specific tools such as cost–benefit analysis and risk assessment that
are firmly rooted in a utilitarian philosophy. Managers often weigh the benefits and costs of an action
before deciding whether to pursue it. An oil company considering drilling in the Alaskan wildlife
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preserve must weigh the economic benefits of increased oil production and the creation of jobs against
the costs of environmental degradation in a fragile ecosystem. An agricultural biotechnology company
such as Monsanto must decide whether the benefits of genetically modified crops that produce natural
pesticides outweigh the risks. e benefits include increased crop yields and reduced need for chemical
fertilizers. e risks include the possibility that Monsanto’s insect-resistant crops might make matters
worse over time if insects evolve a resistance to the natural pesticides engineered into Monsanto’s
plants, rendering the plants vulnerable to a new generation of superbugs.
e utilitarian philosophy does have some serious drawbacks as an approach to business ethics.
One problem is measuring the benefits, costs, and risks of a course of action. In the case of an oil
company considering drilling in Alaska, how does one measure the potential harm done to the region’s
ecosystem? e second problem with utilitarianism is that the philosophy omits the consideration of
justice. e action that produces the greatest good for the greatest number of people may result in the
unjustified treatment of a minority. Such action cannot be ethical, precisely because it is unjust. For
example, suppose that in the interests of keeping down health insurance costs, the government decides
to screen people for the HIV virus and deny insurance coverage to those who are HIV positive. By
reducing health costs, such action might produce significant benefits for a large number of people, but
the action is unjust because it discriminates unfairly against a minority.
Kantian ethics is based on the philosophy of Immanuel Kant (1724–1804). Kantian ethics holds
that people should be treated as ends and never purely as means to the ends of others. People are not
instruments, like a machine. People have dignity and need to be respected as such. Employing people
in sweatshops, making them work long hours for low pay in poor working conditions, is a violation of
ethics, according to Kantian philosophy, because it treats people as mere cogs in a machine and not as
conscious moral beings that have dignity. Although contemporary moral philosophers tend
to view Kant’s ethical philosophy as incomplete—for example, his system has no place for
moral emotions or sentiments such as sympathy or caring—the notion that people should be respected
and treated with dignity resonates in the modern world.
RIGHTS THEORIES
Developed in the twentieth century, rights theories recognize that human beings have fundamental
rights and privileges that transcend national boundaries and cultures. Rights establish a minimum
level of morally acceptable behavior. One well-known definition of a fundamental right construes it as
something that takes precedence over or “trumps” a collective good. us, we might say that the right
to free speech is a fundamental right that takes precedence over all but the most compelling collective
goals and overrides, for example, the interest of the state in civil harmony or moral consensus.31 Moral
theorists argue that fundamental human rights form the basis for the moral compass that managers
should navigate by when making decisions that have an ethical component. More precisely, they
should not pursue actions that violate these rights.
e notion that there are fundamental rights that transcend national borders and cultures was the
underlying motivation for the United Nations Universal Declaration of Human Rights, adopted in
1948, which has been ratified by almost every country on the planet and lays down basic principles
that should always be adhered to irrespective of the culture in which one is doing business.32 Echoing
Kantian ethics, Article 1 of this declaration states
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All human beings are born free and equal in dignity and rights. ey are endowed with reason and
conscience and should act towards one another in a spirit of brotherhood.33
Article 23 of this declaration, which relates directly to employment, states:
1. Everyone has the right to work, to free choice of employment, to just and favorable conditions
of work, and to protection against unemployment.
2. Everyone, without any discrimination, has the right to equal pay for equal work.
3. Everyone who works has the right to just and favorable remuneration ensuring for himself and
his family an existence worthy of human dignity, and supplemented, if necessary, by other
means of social protection.
4. Everyone has the right to form and to join trade unions for the protection of his interests.34
Clearly, the rights to “just and favorable conditions of work,” “equal pay for equal work,” and
remuneration that ensures an “existence worthy of human dignity” embodied in Article 23 imply that
it is unethical to employ child labor in sweatshop settings and pay less than subsistence wages, even if
that happens to be common practice in some countries. ese are fundamental human rights that
transcend national borders.
It is important to note that along with rights come obligations. Because we have the right to free
speech, we are also obligated to make sure that we respect the free speech of others. e notion that
people have obligations is stated in Article 29 of the Universal Declaration of Human Rights:
1. Everyone has duties to the community in which alone the free and full development of his
personality is possible.35
Within the framework of a theory of rights, certain people or institutions are obligated to provide
benefits or services that secure the rights of others. Such obligations also fall on more than one class of
moral agent (a moral agent is any person or institution that is capable of moral action such as a
government or corporation).
For example, to escape the high costs of toxic waste disposal in the West, several firms shipped their
waste in bulk to African nations, where it was disposed of at a much lower cost. At one time, five
European ships unloaded toxic waste containing dangerous poisons in Nigeria. Workers wearing
sandals and shorts unloaded the barrels for $2.50 a day and placed them in a dirt lot in a residential
area. ey were not told about the contents of the barrels.36 Who bears the obligation for protecting
the rights of workers and residents to safety in a case like this? According to rights theorists, the
obligation rests not on the shoulders of one moral agent but on the shoulders of all moral
agents whose actions might harm or contribute to the harm of the workers and residents.
us, it was the obligation not just of the Nigerian government but also of the multinational firms
that shipped the toxic waste to make sure it did no harm to residents and workers. In this case, both
the government and the multinationals apparently failed to recognize their basic obligation to protect
the fundamental human rights of others.
JUSTICE THEORIES
Justice theories focus on the attainment of a just distribution of economic goods and services. A just
distribution is one that is considered fair and equitable. ere is no one theory of justice, and several
theories of justice conflict with each other in important ways.37 Here, we focus on one particular
theory of justice that is both very influential and has important ethical implications. e theory is
attributed to philosopher John Rawls.38 Rawls argues that all economic goods and services should be
distributed equally except when an unequal distribution would work to everyone’s advantage.
Are Human Rights a Moral Compass?
e Universal Declaration of Human Rights (UDHR) was adopted by the United Nations General Assembly
on December 10, 1948, in Paris, France. e Preamble of UDHR starts by stating that “Whereas recognition
of the inherent dignity and of the equal and inalienable rights of all members of the human family is the
foundation of freedom, justice and peace in the world . . . .” e day on which UDHR was adopted,
December 10, is known as “International Human Rights Day,” and this day is also the one on which the
Nobel Peace Prize is awarded annually. One human right that we discuss in the text is the right to free speech;
by the same token, we have an obligation to respect free speech. But are there issues, situations, or reasons
where free speech should not be granted?
Sources: “e Universal Declaration of Human Rights,” United Nations, www.un.org/en/universal-declaration-human-
rights/index.html; the official site of the Nobel Prize, www.nobelprize.org.
According to Rawls, valid principles of justice are those with which all persons would agree if they
could freely and impartially consider the situation. Impartiality is guaranteed by a conceptual device
that Rawls calls the veil of ignorance. Under the veil of ignorance, everyone is imagined to be ignorant
of all of his or her particular characteristics, for example, race, sex, intelligence, nationality, family
background, and special talents. Rawls then asks what system people would design under a veil of
ignorance. Under these conditions, people would unanimously agree on two fundamental principles of
justice.
e first principle is that each person be permitted the maximum amount of basic liberty
compatible with a similar liberty for others. Rawls takes these to be political liberty (e.g., the right to
vote), freedom of speech and assembly, liberty of conscience and freedom of thought, the freedom and
right to hold personal property, and freedom from arbitrary arrest and seizure.
e second principle is that once equal basic liberty is ensured, inequality in basic social goods—
such as income and wealth distribution, and opportunities—is to be allowed only if such inequalities
benefit everyone. Rawls accepts that inequalities can be just if the system that produces inequalities is
to the advantage of everyone. More precisely, he formulates what he calls the difference principle, which
is that inequalities are justified if they benefit the position of the least-advantaged person. So, for
example, wide variations in income and wealth can be considered just if the market-based system that
produces this unequal distribution also benefits the least-advantaged members of society. One can
argue that a well-regulated, market-based economy and free trade, by promoting economic growth,
benefit the least-advantaged members of society. In principle at least, the inequalities inherent in such
systems are therefore just (in other words, the rising tide of wealth created by a market-based economy
and free trade lifts all boats, even those of the most disadvantaged).
In the context of international business ethics, Rawls’s theory creates an interesting perspective.
Managers could ask themselves whether the policies they adopt in foreign operations would be
considered just under Rawls’s veil of ignorance. Is it just, for example, to pay foreign workers less than
workers in the firm’s home country? Rawls’s theory would suggest it is, so long as the inequality
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benefits the least-advantaged members of the global society (which is what economic theory suggests).
Alternatively, it is difficult to imagine that managers operating under a veil of ignorance would design
a system where foreign employees were paid subsistence wages to work long hours in sweatshop
conditions and where they were exposed to toxic materials. Such working conditions are clearly unjust
in Rawls’s framework, and therefore, it is unethical to adopt them. Similarly, operating under a veil of
ignorance, most people would probably design a system that imparts some protection from
environmental degradation to important global commons, such as the oceans, atmosphere,
and tropical rain forests. To the extent that this is the case, it follows that it is unjust, and by
extension unethical, for companies to pursue actions that contribute toward extensive degradation of
these commons. us, Rawls’s veil of ignorance is a conceptual tool that contributes to the moral
compass that managers can use to help them navigate through difficult ethical dilemmas.
test PREP
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Focus on Managerial Implications
MAKING ETHICAL DECISIONS INTERNATIONALLY
LO 5-5 Explain how global managers can incorporate ethical considerations into their decision
making in general and for corporate social responsibility and sustainability initiatives.
What, then, is the best way for managers in a multinational firm to make sure that ethical
considerations figure into international business decisions?
How do managers decide on an ethical course of action when confronted with decisions pertaining
to working conditions, human rights, corruption, and environmental pollution? From an ethical
perspective, how do managers determine the moral obligations that flow from the power of a
multinational? In many cases, there are no easy answers to these questions: Many of the most vexing
ethical problems arise because there are very real dilemmas inherent in them and no obvious correct
action. Nevertheless, managers can and should do many things to make sure that basic ethical
principles are adhered to and that ethical issues are routinely inserted into international business
decisions.
Here, we focus on seven actions that an international business and its managers can take to make
sure ethical issues are considered in business decisions: (1) favor hiring and promoting people with a
well-grounded sense of personal ethics; (2) build an organizational culture and exemplify leadership
behaviors that place a high value on ethical behavior; (3) put decision-making processes in place that
require people to consider the ethical dimension of business decisions; (4) institute ethics officers in
the organization; (5) develop moral courage; (6) make corporate social responsibility a cornerstone of
enterprise policy; and (7) pursue strategies that are sustainable.
Hiring and Promotion It seems obvious that businesses should strive to hire people who have a strong sense of personal ethics and would not engage in unethical or illegal behavior. Similarly, you
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would expect a business to not promote people, and perhaps to fire people, whose behavior does not
match generally accepted ethical standards. However, actually doing so is very difficult. How do you
know that someone has a poor sense of personal ethics? In our society, we have an incentive to hide a
lack of personal ethics from public view. Once people realize that you are unethical, they will no
longer trust you.
Is there anything that businesses can do to make sure they do not hire people who subsequently
turn out to have poor personal ethics, particularly given that people have an incentive to hide this
from public view (indeed, the unethical person may lie about his or her nature)? Businesses can give
potential employees psychological tests to try to discern their ethical predispositions, and they can
check with prior employers or other employees regarding someone’s reputation (e.g., by asking for
letters of reference and talking to people who have worked with the prospective employee). e latter
is common and does influence the hiring process. Promoting people who have displayed poor ethics
should not occur in a company where the organizational culture values the need for ethical behavior
and where leaders act accordingly.
Not only should businesses strive to identify and hire people with a strong sense of personal ethics,
but it also is in the interests of prospective employees to find out as much as they can about the ethical
climate in an organization. Who wants to work at a multinational such as Enron, which ultimately
entered bankruptcy because unethical executives had established risky partnerships that were hidden
from public view and that existed in part to enrich those same executives?
Organizational Culture and Leadership To foster ethical behavior, businesses need to build an organizational culture that values ethical behavior. ree things are particularly important in building
an organizational culture that emphasizes ethical behavior. First, the businesses must explicitly
articulate values that emphasize ethical behavior. Many companies now do this by drafting a
code of ethics, which is a formal statement of the ethical priorities a business adheres to.
Often, the code of ethics draws heavily on documents such as the UN Universal Declaration of
Human Rights, which itself is grounded in Kantian and rights-based theories of moral philosophy.
Others have incorporated ethical statements into documents that articulate the values or mission of
the business. For example, the Academy of International Business (the top professional organization in
international business) has a Code of Ethics for its leadership (as well as a COE for its members):39
AIB’s Motivation for the Code of Ethics of the Leadership: e leadership of an organization is
ultimately responsible for the creation of the values, norms and practices that permeate the
organization and its membership. A strong ethically grounded organization is only possible when
it is governed by a strong ethical committee. e term “committee” is used for succinctness; it
includes all organizational structures that have managerial, custodial, decision-making or financial
authority within an organization.
Having articulated values in a code of ethics or some other document, leaders in the business must
give life and meaning to those words by repeatedly emphasizing their importance and then acting on
them. is means using every relevant opportunity to stress the importance of business ethics and
making sure that key business decisions not only make good economic sense but also are ethical.
Many companies have gone a step further by hiring independent auditors to make sure they are
behaving in a manner consistent with their ethical codes. Nike, for example, has hired independent
auditors to make sure that subcontractors used by the company are living up to Nike’s code of
conduct.
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Finally, building an organizational culture that places a high value on ethical behavior requires
incentive and reward systems, including promotions that reward people who engage in ethical
behavior and sanction those who do not. At General Electric, for example, the former CEO Jack
Welch has described how he reviewed the performance of managers, dividing them into several
different groups. ese included overperformers who displayed the right values and were singled out
for advancement and bonuses and overperformers who displayed the wrong values and were let go.
Welch was not willing to tolerate leaders within the company who did not act in accordance with the
central values of the company, even if they were in all other respects skilled managers.40
Decision-Making Processes In addition to establishing the right kind of ethical culture in an organization, businesspeople must be able to think through the ethical implications of decisions in a
systematic way. To do this, they need a moral compass, and both rights theories and Rawls’s theory of
justice help provide such a compass. Beyond these theories, some experts on ethics have proposed a
straightforward practical guide—or ethical algorithm—to determine whether a decision is
ethical.41 According to these experts, a decision is acceptable on ethical grounds if a businessperson
can answer yes to each of these questions:
Does my decision fall within the accepted values or standards that typically apply in the
organizational environment (as articulated in a code of ethics or some other corporate
statement)?
Am I willing to see the decision communicated to all stakeholders affected by it—for example,
by having it reported in newspapers, on television, or via social media?
Would the people with whom I have a significant personal relationship, such as family members,
friends, or even managers in other businesses, approve of the decision?
Others have recommended a five-step process to think through ethical problems (this is another
example of an ethical algorithm).42 In step 1, businesspeople should identify which stakeholders a
decision would affect and in what ways. A firm’s stakeholders are individuals or groups that have an
interest, claim, or stake in the company, in what it does, and in how well it performs.43 ey can be
divided into internal stakeholders and external stakeholders. Internal stakeholders are individuals or
groups who work for or own the business. ey include primary stakeholders such as employees, the
board of directors, and shareholders. External stakeholders are all the other individuals and groups
that have some direct or indirect claim on the firm. Typically, this group comprises primary
stakeholders such as customers, suppliers, governments, and local communities as well as
secondary stakeholders such as special-interest groups, competitors, trade associations, mass
media, and social media.44
All stakeholders are in an exchange relationship with the company.45 Each stakeholder group
supplies the organization with important resources (or contributions), and in exchange each expects its
interests to be satisfied (by inducements).46 For example, employees provide labor, skills, knowledge,
and time and in exchange expect commensurate income, job satisfaction, job security, and good
working conditions. Customers provide a company with its revenues and in exchange want quality
products that represent value for money. Communities provide businesses with local infrastructure and
in exchange want businesses that are responsible citizens and seek some assurance that the quality of
life will be improved as a result of the business firm’s existence.
Stakeholder analysis involves a certain amount of what has been called moral imagination.47 is
means standing in the shoes of a stakeholder and asking how a proposed decision might impact that
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stakeholder. For example, when considering outsourcing to subcontractors, managers might need to
ask themselves how it might feel to be working under substandard health conditions for long hours.
Step 2 involves judging the ethics of the proposed strategic decision, given the information gained
in step 1. Managers need to determine whether a proposed decision would violate the fundamental
rights of any stakeholders. For example, we might argue that the right to information about health
risks in the workplace is a fundamental entitlement of employees. Similarly, the right to know about
potentially dangerous features of a product is a fundamental entitlement of customers (something
tobacco companies violated when they did not reveal to their customers what they knew about the
health risks of smoking). Managers might also want to ask themselves whether they would allow the
proposed strategic decision if they were designing a system under Rawls’s veil of ignorance. For
example, if the issue under consideration was whether to outsource work to a subcontractor with low
pay and poor working conditions, managers might want to ask themselves whether they would allow
such action if they were considering it under a veil of ignorance, where they themselves might
ultimately be the ones to work for the subcontractor.
e judgment at this stage should be guided by various moral principles that should not be
violated. e principles might be those articulated in a corporate code of ethics or other company
documents. In addition, certain moral principles that we have adopted as members of society—for
instance, the prohibition on stealing—should not be violated. e judgment at this stage will also be
guided by the decision rule that is chosen to assess the proposed strategic decision. Although
maximizing long-run profitability is the decision rule that most businesses stress, it should be applied
subject to the constraint that no moral principles are violated—that the business behaves in an ethical
manner.
Step 3 requires managers to establish moral intent. is means the business must resolve to place
moral concerns ahead of other concerns in cases where either the fundamental rights of stakeholders or
key moral principles have been violated. At this stage, input from top management might be
particularly valuable. Without the proactive encouragement of top managers, middle-level managers
might tend to place the narrow economic interests of the company before the interests of stakeholders.
ey might do so in the (usually erroneous) belief that top managers favor such an approach.
Step 4 requires the company to engage in ethical behavior. Step 5 requires the business to audit its
decisions, reviewing them to make sure they were consistent with ethical principles, such as those
stated in the company’s code of ethics. is final step is critical and often overlooked. Without
auditing past decisions, businesspeople may not know if their decision process is working and if
changes should be made to ensure greater compliance with a code of ethics.
Ethics Officers To make sure that a business behaves in an ethical manner, firms now must have oversight by a high-ranking person or people known to respect legal and ethical standards. ese
individuals—often referred to as ethics officers—are responsible for managing their organization’s
ethics and legal compliance programs. ey are typically responsible for (1) assessing the needs and
risks that an ethics program must address; (2) developing and distributing a code of ethics; (3)
conducting training programs for employees; (4) establishing and maintaining a confidential service to
address employees’ questions about issues that may be ethical or unethical; (5) making sure that the
organization is in compliance with government laws and regulations; (6) monitoring and
auditing ethical conduct; (7) taking action, as appropriate, on possible violations; and (8)
reviewing and updating the code of ethics periodically.48 Because of these broad topics covered by the
ethics officer, in many businesses ethics officers act as an internal ombudsperson with responsibility for
handling confidential inquiries from employees, investigating complaints from employees or others,
reporting findings, and making recommendations for change.
For example, United Technologies, a multinational aerospace company with worldwide revenues of
more than $30 billion, has had a formal code of ethics since 1990.49 United Technologies has some
450 business practice officers (the company’s name for ethics officers), who are responsible for making
sure the code is followed. United Technologies also established an “ombudsperson” program in 1986
that lets employees inquire anonymously about ethics issues. e program has received some 60,000
inquiries since 1986, and more than 10,000 cases have been handled by the ombudsperson.
Moral Courage It is important to recognize that employees in an international business may need significant moral courage. Moral courage enables managers to walk away from a decision that is
profitable but unethical. Moral courage gives an employee the strength to say no to a superior who
instructs her to pursue actions that are unethical. Moral courage gives employees the integrity to go
public to the media and blow the whistle on persistent unethical behavior in a company. Moral
courage does not come easily; there are well-known cases where individuals have lost their jobs because
they blew the whistle on corporate behaviors they thought unethical, telling the media about what was
occurring.50
However, companies can strengthen the moral courage of employees by committing themselves to
not retaliate against employees who exercise moral courage, say no to superiors, or otherwise complain
about unethical actions. For example, consider the following excerpt from the Academy of
International Business Code of Ethics:
AIB Statement of Commitment by Its Leadership: In establishing policy for and on behalf of
the Academy of International Business’s members, I am a custodian in trust of the assets of this
organization. e AIB’s members recognize the need for competent and committed elected
committee members to serve their organization and have put their trust in my sincerity and
abilities. In return, the members deserve my utmost effort, dedication, and support. erefore, as a
committee member of the AIB, I acknowledge and commit that I will observe a high standard of
ethics and conduct as I devote my best efforts, skills and resources in the interest of the AIB and its
members. I will perform my duties as a committee member in such a manner that the members’
confidence and trust in the integrity, objectivity and impartiality of the AIB are conserved and
enhanced. To do otherwise would be a breach of the trust which the membership has bestowed
upon me.51
is statement ensures that all members serving in leadership positions within the Academy of
International Business adhere to and uphold the highest commitment and responsibility to be ethical
in their AIB leadership activities. A freestanding and independent AIB Ombuds Committee handles
all ethical issues and violations to ensure independence and the highest moral code.
Did You Know?
Did you know corporate social responsibility is not as new as it seems?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from
the authors.
Corporate Social Responsibility Multinational corporations have power that comes from their control over resources and their ability to move production from country to country. Although that
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power is constrained not only by laws and regulations but also by the discipline of the market and the
competitive process, it is substantial. Some moral philosophers argue that with power comes the social
responsibility for multinationals to give something back to the societies that enable them to prosper
and grow.corporate social responsibility (CSR) refers to the idea that businesspeople should consider
the social consequences of economic actions when making business decisions and that there should be
a presumption in favor of decisions that have both good economic and social consequences.52 In its
purest form, corporate social responsibility can be supported for its own sake simply because it is the
right way for a business to behave. Advocates of this approach argue that businesses, particularly large
successful businesses, need to recognize their noblesse oblige and give something back to the societies
that have made their success possible. Noblesse oblige is a French term that refers to honorable and
benevolent behavior considered the responsibility of people of high (noble) birth. In a business setting,
it is taken to mean benevolent behavior that is the responsibility of successful enterprises. is has long
been recognized by many businesspeople, resulting in a substantial and venerable history of corporate
giving to society, with businesses making social investments designed to enhance the welfare of the
communities in which they operate.
m a n a g e m e n t F O C U S
Corporate Social Responsibility at Stora Enso
Stora Enso is a Finnish pulp and paper manufacturer that was formed by the merger of Swedish mining and
forestry products company Stora and Finnish forestry products company Enso-Gutzeit Oy in 1998. e
company is headquartered in Helsinki, the capital of Finland, and it has approximately 25,000 employees. In
2000, the company bought Consolidated Papers in North America. Stora Enso also expanded into South
America, Asia, and Russia. By 2005, Stora Enso had become the world’s largest pulp and paper manufacturer
as measured by production capacity. However, the North American operations were sold in 2007 to NewPage
Corporation.
To this day, Stora Enso has a long-standing tradition of corporate social responsibility on a global scale. As
part of the company’s section “Global Responsibility in Stora Enso,” the company states that “for Stora Enso,
Global Responsibility means realizing concrete actions that will help us fulfil [sic] our Purpose, which is to do
good for the people and the planet.” Stora Enso continues to state:
Our purpose “do good for the people and the planet” is the ultimate reason why we run our business. It is
the overriding rule that guides us in all that we do: producing and selling our renewable products, buying
trees from a local forest-owner in Finland, selling electricity generated at Stora Enso Skoghall Mill, or
managing our logistics on a global scale.54
Interestingly, Stora Enso also asserts that it realizes that this statement is rather bold and perhaps not even
fully believable. But the company suggests that it makes the company accountable for its actions; that is,
setting its purpose boldly in writing. At the same time, Stora Enso positions the company as though it has
always been attending to the “socially responsible” needs of doing good for the people and the planet. It
illustrates this by maintaining that it has created and enhanced communities around its mills, developed
innovative systems to reduce the use of scarce resources, and maintained good relationships with key
stakeholders such as forest owners, their own employees, governments, and local communities near its mills.
Tracing its past and reflecting on its future, Stora Enso has adopted three lead areas for its global
responsibility strategy: people and ethics, forests and land use, and environment and efficiency. For people and
ethics, the company focuses on conducting business in a socially responsible manner throughout its global
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value chain. For forests and land use, it focuses on an innovative and responsible approach on forestry and
land use to make it a preferred partner and a good local community citizen. For the environment and
efficiency, the focus is on resource-efficient operations that help the company achieve superior environmental
performance related to its products.
While a number of companies have corporate social responsibility statements incorporated as part of their
websites, annual reports, and talking points, Stora Enso also presents clear targets and performance goals that
are assessed by established metrics. Its overall operations are guided by corporate-level targets for
environmental and social performance, aptly named Stora Enso’s Global Responsibility Key Performance
Indicators (KPIs). Targets are publicly listed in a document titled “Targets and Performance” and include two
to five basic categories of measures for each of the three lead areas. For people and ethics, the dimensions cover
health and safety, human rights, ethics and compliance, sustainable leadership, and responsible sourcing. For
forests and land use, the dimensions cover efficiency of land use and sustainable forestry. For environment and
efficiency, the dimensions cover climate and energy, material efficiency, and process water discharges. e
“Targets and Performance” document also lists performance in the prior year, targets in the current year, and
strategic objectives related to each dimension.
Sources: “Global Responsibility in Stora Enso,” www.storaenso.com; K. Vita, “Stora Enso Falls as UBS Plays
Down Merger Talk: Helsinki Mover,” Bloomberg Businessweek, September 30, 2013; M. Huuhtanen, “Paper
Maker Stora Enso Selling North American Mills,” USA Today, September 21, 2007.
Power itself is morally neutral; how power is used is what matters. It can be used in a positive way
to increase social welfare, which is ethical, or it can be used in a manner that is ethically and morally
suspect. Managers at some multinationals have acknowledged a moral obligation to use their power to
enhance social welfare in the communities where they do business. BP, one of the world’s largest oil
companies, has made it part of the company policy to undertake “social investments” in the countries
where it does business.53 In Algeria, BP has been investing in a major project to develop gas fields near
the desert town of Salah. When the company noticed the lack of clean water in Salah, it built two
desalination plants to provide drinking water for the local community and distributed containers to
residents so they could take water from the plants to their homes. ere was no economic reason for
BP to make this social investment, but the company believes it is morally obligated to use its power in
constructive ways. e action, while a small thing for BP, is a very important thing for the
local community. For another example of corporate social responsibility in practice, see the
accompanying Management Focus feature on the Finnish company Stora Enso.
Sustainability As managers in international businesses strive to translate ideas about corporate social responsibility into strategic actions, many are gravitating toward strategies that are viewed as
sustainable. By sustainable strategies, we refer to strategies that not only help the multinational
firm make good profits, but that also do so without harming the environment while simultaneously
ensuring that the corporation acts in a socially responsible manner with regard to its
stakeholders.55 e core idea of sustainability is that the organization—through its actions—does not
exert a negative impact on the ability of future generations to meet their own economic needs and that
its actions impart long-run economic and social benefits on stakeholders.56
A company pursuing a sustainable strategy would not adopt business practices that deplete the
environment for short-term economic gain because doing so would impose a cost on future
generations. In other words, international businesses that pursue sustainable strategies try to ensure
that they do not precipitate or participate in a situation that results in a tragedy of the commons us,
for example, a company pursuing a sustainable strategy would try to reduce its carbon footprint (CO2 emissions) so that it does not contribute to global warming.
Is Sustainability Bad for Profits?
Most customers prefer that the companies they buy products and services from engage in business-focused
sustainability practices. Eighty-three percent of the respondents in the Public Opinion Survey on
Sustainability said that they think companies should try to accomplish their performance goals while also
trying to improve society and the environment. At the same time, multinational firms are overwhelmed by the
varied stakeholder needs they face. And the Global Reporting Initiative, with its some 80 equally important
sustainability indicators, is not giving companies a clear set of sustainability proprieties. Meanwhile,
sustainability executives in companies have not exactly been elevated to the importance levels of other top
managers. If you had to pay more for a product, like gasoline for your automobile, how much more would
you be willing to pay to buy from a highly rated sustainability-oriented company—5 percent, 10 percent, 25
percent, 40 percent?
Sources: Epstein-Reeves, J., “e Pain of Sustainability,” Forbes, January 18, 2012; “Consumers Expect Action from Companies on
Sustainability,” Second Annual Public Opinion Survey on Sustainability; Global Reporting Initiative, www.globalreporting.org.
Nor would a company pursuing a sustainable strategy adopt policies that negatively affect the well-
being of key stakeholders such as employees and suppliers because managers would recognize that in
the long run, this would harm the company. e company that pays its employees so little that it
forces them into poverty, for example, may find it hard to recruit employees in the future and may
have to deal with high employee turnover, which imposes its own costs on an enterprise. Similarly, a
company that drives down the prices it pays to its suppliers so far that the suppliers cannot make
enough money to invest in upgrading their operations may find that in the long run, its business
suffers poor-quality inputs and a lack of innovation among its supplier base.
Starbucks has a goal of ensuring that 100 percent of its coffee is ethically sourced. By this, it means
that the farmers who grow the coffee beans it purchases use sustainable farming methods that do not
harm the environment and that they treat their employees well and pay them fairly. Starbucks
agronomists work directly with farmers in places such as Costa Rica and Rwanda to make sure that
they use environmentally responsible farming methods. e company also provides loans to farmers to
help them upgrade their production methods. As a result of these policies, some 9 percent of
Starbucks coffee beans are “fair trade” sourced and the remaining 91 percent are ethically sourced.
Key Terms
business ethics, p. 125
ethical strategy, p. 125
Foreign Corrupt Practices Act (FCPA), p. 130
Convention on Combating Bribery of Foreign Public Officials in International Business
Transactions, p. 130
ethical dilemma, p. 132
organizational culture, p. 133
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cultural relativism, p. 135
righteous moralist, p. 136
naive immoralist, p. 136
utilitarian approach to ethics, p. 137
Kantian ethics, p. 137
rights theories, p. 138
Universal Declaration of Human Rights, p. 138
just distribution, p. 139
code of ethics, p. 141
stakeholders, p. 141
internal stakeholders, p. 141
external stakeholders, p. 141
corporate social responsibility (CSR), p. 143
sustainable strategies, p. 145
Summary
is chapter discussed the source and nature of ethical issues in international businesses, the different
philosophical approaches to business ethics, the steps managers can take to ensure that ethical issues
are respected in international business decisions, and the roles of corporate social responsibility and
sustainability in practice. e chapter made the following points:
1. e term ethics refers to accepted principles of right or wrong that govern the conduct of a
person, the members of a profession, or the actions of an organization. Business ethics are the
accepted principles of right or wrong governing the conduct of businesspeople. An ethical
strategy is one that does not violate these accepted principles.
2. Ethical issues and dilemmas in international business are rooted in the variations among
political systems, law, economic development, and culture from country to country.
3. e most common ethical issues in international business involve employment practices, human
rights, environmental regulations, corruption, and social responsibility of multinational
corporations.
4. Ethical dilemmas are situations in which none of the available alternatives seems ethically
acceptable.
5. Unethical behavior is rooted in personal ethics, societal culture, psychological and geographic
distances of a foreign subsidiary from the home office, a failure to incorporate ethical issues into
strategic and operational decision making, a dysfunctional culture, and failure of leaders to act
in an ethical manner.
6. Moral philosophers contend that approaches to business ethics such as the Friedman doctrine,
cultural relativism, the righteous moralist, and the naive immoralist are unsatisfactory in
important ways.
7. e Friedman doctrine states that the only social responsibility of business is to increase profits,
as long as the company stays within the rules of law. Cultural relativism contends that one
should adopt the ethics of the culture in which one is doing business. e righteous moralist
monolithically applies home-country ethics to a foreign situation, while the naive immoralist
believes that if a manager of a multinational sees that firms from other nations are not following
ethical norms in a host nation, that manager should not either.
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8. Utilitarian approaches to ethics hold that the moral worth of actions or practices is determined
by their consequences, and the best decisions are those that produce the greatest good for the
greatest number of people.
9. Kantian ethics state that people should be treated as ends and never purely as means to the ends
of others. People are not instruments, like a machine. People have dignity and need to be
respected as such.
10. Rights theories recognize that human beings have fundamental rights and privileges that
transcend national boundaries and cultures. ese rights establish a minimum level of morally
acceptable behavior.
11. e concept of justice developed by John Rawls suggests that a decision is just and ethical if
people would allow it when designing a social system under a veil of ignorance.
12. To make sure that ethical issues are considered in international business decisions, managers
should (a) favor hiring and promoting people with a well-grounded sense of personal ethics, (b)
build an organizational culture and exemplify leadership behaviors that place a high value on
ethical behavior, (c) put decision-making processes in place that require people to consider the
ethical dimension of business decisions, (d) establish ethics officers in the organization with
responsibility for ethical decision making, (e) be morally courageous and encourage others to do
the same, (f) make corporate social responsibility a cornerstone of enterprise policy, and (g)
pursue strategies that are sustainable.
13. Multinational corporations that are practicing business-focused sustainability integrate a focus
on market orientation, addressing the needs of multiple stakeholders, and adhering to corporate
social responsibility principles.
Critical inking and Discussion Questions
1. A visiting American executive finds that a foreign subsidiary in a less developed country has
hired a 12-year-old girl to work on a factory floor, in violation of the company’s prohibition on
child labor. He tells the local manager to replace the child and tell her to go back to school. e
local manager tells the American executive that the child is an orphan with no other means of
support, and she will probably become a street child if she is denied work. What should the
American executive do?
2. Drawing on John Rawls’s concept of the veil of ignorance, develop an ethical code that will (a)
guide the decisions of a large oil multinational toward environmental protection and (b)
influence the policies of a clothing company in their potential decision of outsourcing their
manufacturing operations.
3. Under what conditions is it ethically defensible to outsource production to the
developing world where labor costs are lower when such actions also involve laying off
long-term employees in the firm’s home country?
4. Do you think facilitating payments (speed payments) should be ethical? Does it matter in which
country, or part of the world, such payments are made?
5. A manager from a developing country is overseeing a multinational’s operations in a country
where drug trafficking and lawlessness are rife. One day, a representative of a local “big man”
approaches the manager and asks for a “donation” to help the big man provide housing for the
poor. e representative tells the manager that in return for the donation, the big man will make
sure that the manager has a productive stay in his country. No threats are made, but the
manager is well aware that the big man heads a criminal organization that is engaged in drug
trafficking. He also knows that the big man does indeed help the poor in the rundown
neighborhood of the city where he was born. What should the manager do?
6. Milton Friedman stated in his famous article in e New York Times in 1970 that “the social
responsibility of business is to increase profits.”* Do you agree? If not, do you prefer that
multinational corporations adopt a focus on corporate social responsibility or sustainability
practices?
7. Can a company be good at corporate social responsibility but not be sustainability oriented? Is it
possible to focus on sustainability but not corporate social responsibility? Based on reading
the Focus on Managerial Implications section, discuss how much CSR and sustainability are
related and how much the concepts differ from each other.
*M. Friedman, “e Social Responsibility of Business Is to Increase Profits,” e New York Times
Magazine, September 13, 1970.
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. Promoting respect for universal human rights is a central dimension of many countries’ foreign
policy. As history has shown, human rights abuses are an important concern worldwide. Some
countries are more ready to work with other governments and civil society organizations to
prevent abuses of power. Begun in 1977, the annual Country Reports on Human Rights Practices
are designed to assess the state of democracy and human rights around the world, call attention
to violations, and—where needed—prompt needed changes in U.S. policies toward particular
countries. Find the latest annual Country Reports on Human Right Practices for the BRIC
countries (Brazil, Russia, India, and China), and create a table to compare the findings under
the “Worker Rights” sections. What commonalities do you see? What differences are there?
2. e use of bribery in the business setting is an important ethical dilemma many companies face
both domestically and abroad. e Bribe Payers Index is a study published every three years to
assess the likelihood of firms from 28 leading economies to win business overseas by offering
bribes. It also ranks industry sectors based on the prevalence of bribery. Compare the five
industries thought to have the largest problems with bribery with those five that have the least
problems. What patterns do you see? What factors make some industries more conducive to
bribery than others?
Wo o l w o r t h s ’ C o r p o r a t e R e s p o n s i b i l i t y S t r a t e g y
c l o s i n g c a s e
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e Woolworths Group (woolworthsgroup.com.au) is an Australian conglomerate corporation founded in
1924. e headquarters is in Bella Vista in New South Wales. Colloquially known as “Woolies,” the company
has extensive retail interests in the Oceania region, particularly in Australia and New Zealand, but it also has a
foothold in India. e Woolworths Group consists of three core businesses (Woolworths Food Group,
Endeavour Drinks, and Portfolio Businesses); employs more than 200,000 people; and has revenue of about
$60 billion Australian dollars, or $46 billion in U.S. dollars. Across the three core businesses, Woolworths has
13 different business subsidiaries.
Integrating these 13 subsidiaries into a corporate social responsibility program is a challenge for a company
with more than 200,000 employees and diverse interests. To accomplish its objective, Woolworths Group’s
Corporate Responsibility Strategy 2020 identifies 20 corporate responsibility and sustainability goals that the
company plans to implement by the year 2020. ese goals cover a broad range of Woolworths’ stakeholders
(e.g., customers, team members, suppliers, and local communities in which Woolworths operates).
Woolworths’ Corporate Responsibility Strategy is based on a framework of People, Planet, and Prosperity.
e focus on People is about encouraging diversity. e target goals include striving for gender equity by
targeting at least 40 percent of executive and senior manager positions to be held by women. Woolworths is
also setting a goal of no salary wage gap between male and female employees of equivalent positions at all
levels of the company. And rooted in Australian business, the company is embracing diversity by increasing
the number of Indigenous employees in line with the company’s stated commitments under the Australian
Federal Government’s Employment Parity Initiative.
e focus on the Planet includes two major initiatives. Woolworths is working toward zero food waste
going to landfills. According to the U.S. Environmental Protection Agency, 20 percent of what goes into
municipal landfills is food. Woolworths is also trying to reduce its carbon emissions or footprint by
10 percent. Many of our daily activities (e.g., using electricity, driving a car, or disposing of waste)
cause greenhouse gas emissions. A carbon footprint is defined as the total set of greenhouse gas emissions
caused by an individual, event, organization, or product, and it is expressed as a carbon dioxide equivalent.
Such emissions trap heat in the atmosphere, which according to most scientists contributes to disruptive
climate change.
©Takatoshi Kurikawa/Alamy Stock Photo
e focus on Prosperity is founded on trusted relationships. Woolworths’ targets are to achieve a top
quartile ranking in how the business engages fairly and equitably with its suppliers, as measured by
independent supplier surveys. Inspiration is also built into prosperity in the form of the company
implementing activities to inspire customers to consume all of Woolworths’ products in a healthy, sustainable
way. e most transparent Prosperity initiative, though, is to invest the equivalent of 1 percent of total
earnings in community partnerships and programs.
Woolworths’ People-Planet-Prosperity strategies drive how the company does business. e strategies state
that Woolworths is committed to hard work and that its integrity is resolute. e foundation is a down-to-
earth culture and family friendly values. Every aspect of Woolworths’ business exists for the purpose of making
the customers’ lives simpler, easier, and better. Underpinning Woolworths’ operations is a working
relationship built on mutual trust with suppliers. More than 80 percent of the company’s suppliers have been
strategic partners with Woolworths for a decade or longer.
Sources: Dimitri Sotiropoulos, “Woolworths Sets Sights on Sustainability,” Inside Retail (Australia), February 14, 2017; Justin
Smith, “How Woolworths Is Building Resilience in Its Food Supply Chain,” Sustainable Brands, April 11, 2016; Jason LaChappelle,
“Woolworths Sees Benefits of Working with Sustainability Standards,” Iseal Alliance, September 19, 2014; “Woolworths Group’s
Corporate Responsibility Strategy 2020,” https://woolworthsgroup.com.au/page/community-and-responsibility/group-
responsibility.
CASE DISCUSSION QUESTIONS
1. What challenges do you think a company like Woolworths Group is facing when developing
and implementing a companywide corporate social responsibility strategy that takes into
account the more than 200,000 employees, diverse interests, and stakeholders?
2. e focus on People is about encouraging diversity. e idea is to increase the number of
Indigenous employees in line with the company’s stated commitments under the Australian
Federal Government’s Employment Parity Initiative. Does such a diversity approach
enhance, or not, the company’s sustainability strategy. How?
3. Woolworths Group is trying to reduce its carbon emissions or footprint by 10 percent. Based
on where we are as a world, is 10 percent enough of a reduction? Perhaps global warming is
not real, albeit the vast majority of scientists clearly suggest it is; what do you think?
4. Woolworths’ targets are to achieve a top quartile ranking in how the business engages fairly
and equitably with its suppliers. How do supplier relationships and the fairness in dealing
with suppliers relate to sustainability and “doing good” for society (and the company)?
Endnotes
1. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!” Journal of the Academy of
Marketing Science 39 (2011), pp. 1–6; T. Hult, J. Mena, O. C. Ferrell, and L. Ferrell,
“Stakeholder Marketing: A Definition and Conceptual Framework,” AMS Review 1 (2011), pp.
44–65.
2. S. Greenhouse, “Nike Shoe Plant in Vietnam Is Called Unsafe for Workers,” e New York
Times, November 8, 1997; V. Dobnik, “Chinese Workers Abused Making Nikes, Reeboks,”
Seattle Times, September 21, 1997, p. A4.
3. R. K. Massie, Loosing the Bonds: e United States and South Africa in the Apartheid Years (New
York: Doubleday, 1997).
4. Not everyone agrees that the divestment trend had much influence on the South African
economy. For a counterview, see S. H. Teoh, I. Welch, and C. P. Wazzan, “e Effect of Socially
Activist Investing on the Financial Markets: Evidence from South Africa,” e Journal of Business
72, no. 1 (January 1999), pp. 35–60.
5. Peter Singer, One World: e Ethics of Globalization (New Haven, CT: Yale University Press,
2002).
6. Garrett Hardin, “e Tragedy of the Commons,” Science 162, no. 1 (1968), pp. 243–48.
7. For a summary of the evidence, see S. Solomon, D. Qin, M. Manning, Z. Chen, M. Marquis,
K. B. Averyt, M. Tignor, and H. L. Miller, eds., Contribution of Working Group I to the Fourth
Assessment Report of the Intergovernmental Panel on Climate Change (Cambridge, UK: Cambridge
University Press, 2007).
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8. J. Everett, D. Neu, and A. S. Rahaman, “e Global Fight against Corruption,” Journal of
Business Ethics 65 (2006), pp. 1–18.
9. R. T. De George, Competing with Integrity in International Business (Oxford, UK: Oxford
University Press, 1993).
10. Details can be found at www.oecd.org/corruption/oecdantibriberyconvention.htm.
11. B. Pranab, “Corruption and Development,” Journal of Economic Literature 36 (September
1997), pp. 1320–46.
12. A. Shleifer and R. W. Vishny, “Corruption,” Quarterly Journal of Economics 108 (1993), pp.
599–617; I. Ehrlich and F. Lui, “Bureaucratic Corruption and Endogenous Economic Growth,”
Journal of Political Economy 107 (December 1999), pp. 270–92.
13. P. Mauro, “Corruption and Growth,” Quarterly Journal of Economics 110 (1995), pp. 681–712.
14. D. Kaufman and S. J. Wei, “Does Grease Money Speed up the Wheels of
Commerce?” World Bank policy research working paper, January 11, 2000.
15. Center for the Study of Ethics in the Professions, http://ethics.iit.edu.
16. B. Vitou, R. Kovalevsky, and T. Fox, “Time to Call a Spade a Spade. Facilitation Payments and
Why Neither Bans Nor Exemption Work,” http://thebriberyact.com/2011/02/03/time-to-call-a-
spade-a-spade-facilitation-payments-why-neither-bans-nor-exemptions-work, accessed March 8,
2014.
17. is is known as the “when in Rome perspective.” T. Donaldson, “Values in Tension: Ethics
Away from Home,” Harvard Business Review, September–October 1996.
18. De George, Competing with Integrity in International Business.
19. For a discussion of the ethics of using child labor, see J. Isern, “Bittersweet Chocolate: e
Legacy of Child Labor in Cocoa Production in Cote d’Ivoire,” Journal of Applied Management
and Entrepreneurship 11 (2006), pp. 115–32.
20. S. W. Gellerman, “Why Good Managers Make Bad Ethical Choices,” in Ethics in Practice:
Managing the Moral Corporation, ed. K. R. Andrews (Cambridge, MA: Harvard Business School
Press, 1989).
21. D. Messick and M. H. Bazerman, “Ethical Leadership and the Psychology of Decision Making,”
Sloan Management Review 37 (Winter 1996), pp. 9–20.
22. O. C. Ferrell, J. Fraedrich, and L. Ferrell, Business Ethics, 9th ed. (Mason, OH: Cengage, 2013).
23. B. Scholtens and L. Dam, “Cultural Values and International Differences in Business Ethics,”
Journal of Business Ethics, 2007.
24. M. Friedman, “e Social Responsibility of Business Is to Increase Profits,” e New York Times
Magazine, September 13, 1970. Reprinted in T. L. Beauchamp and N. E. Bowie, Ethical eory
and Business, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).
25. Friedman, “e Social Responsibility of Business Is to Increase Profits.”
26. Friedman, “e Social Responsibility of Business Is to Increase Profits.”
27. For example, see Donaldson, “Values in Tension: Ethics Away from Home.” See also N. Bowie,
“Relativism and the Moral Obligations of Multinational Corporations,” in T. L. Beauchamp and
N. E. Bowie, Ethical eory and Business, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).
28. For example, see De George, Competing with Integrity in International Business.
29. is example is often repeated in the literature on international business ethics. It was first
outlined by A. Kelly in “Case Study—Italian Style Mores,” in T. Donaldson and P. Werhane,
Ethical Issues in Business (Englewood Cliffs, NJ: Prentice Hall, 1979).
30. See Beauchamp and Bowie, Ethical eory and Business.
31. T. Donaldson, e Ethics of International Business (Oxford: Oxford University Press, 1989).
32. Found at www.un.org/Overview/rights.html.
33. UN Universal Declaration of Human Rights, Article 1.
34. UN Universal Declaration of Human Rights, Article 23.
35. UN Universal Declaration of Human Rights, Article 29.
36. Donaldson, e Ethics of International Business.
37. See Chapter 10 in Beauchamp and Bowie, Ethical eory and Business.
38. J. Rawls, A eory of Justice, rev. ed. (Cambridge, MA: Belknap Press, 1999).
39. https://aib.msu.edu/aboutleadership.asp.
40. J. Bower and J. Dial, “Jack Welch: General Electric’s Revolutionary,” Harvard Business School
Case 9–394–065, April 1994.
41. For example, see R. E. Freeman and D. Gilbert, Corporate Strategy and the Search for Ethics
(Englewood Cliffs, NJ: Prentice Hall, 1988); T. Jones, “Ethical Decision Making by Individuals
in Organizations,” Academy of Management Review 16 (1991), pp. 366–95; J. R. Rest, Moral
Development: Advances in Research and eory (New York: Praeger, 1986).
42. Freeman and Gilbert, Corporate Strategy and the Search for Ethics; Jones, “Ethical Decision
Making by Individuals in Organizations”; Rest, Moral Development.
43. See E. Freeman, Strategic Management: A Stakeholder Approach (Boston: Pitman Press, 1984); C.
W. L. Hill and T. M. Jones, “Stakeholder-Agency eory,” Journal of Management Studies 29
(1992), pp. 131–54; J. G. March and H. A. Simon, Organizations (New York: Wiley, 1958).
44. Hult et al., “Stakeholder Marketing.”
45. Hult, “Market-Focused Sustainability: Market Orientation Plus!”; Hult et al., “Stakeholder
Marketing.”
46. Hill and Jones, “Stakeholder-Agency eory”; March and Simon, Organizations.
47. De George, Competing with Integrity in International Business.
48. “Our Principles,” Unilever, www.unilever.com.
49. e code can be accessed at the United Technologies website, www.utc.com.
50. C. Grant, “Whistle Blowers: Saints of Secular Culture,” Journal of Business Ethics, September
2002, pp. 391–400.
51. “Statement of Commitment,” Academy of International Business Code of Ethics,
https://aib.msu.edu/aboutleadership.asp.
52. S. A. Waddock and S. B. Graves, “e Corporate Social Performance–Financial Performance
Link,” Strategic Management Journal 8 (1997), pp. 303–19; I. Maignan, O. C. Ferrell, and
T. Hult, “Corporate Citizenship: Cultural Antecedents and Business Benefits,” Journal of the
Academy of Marketing Science 27 (1999), pp. 455–69.
53. Details can be found at BP’s website, www.bp.com.
54. Hult, T., “Market-Focused Sustainability: Market Orientation Plus!” Journal of the Academy of
Marketing Science, vol. 39, no.1, 2011.
55. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!”
56. M. Clarkson, “A Stakeholder Framework for Analyzing and Evaluating Corporate Social
Performance,” Academy of Management Review 20 (1995), pp. 92–117; R. Freeman, Strategic
Management: A Stakeholder Approach(Marshfield, MA: Pitman, 1984); T. Hult, J. Mena, O.
Ferrell, and L. Ferrell, “Stakeholder Marketing: A Definition and Conceptual Framework,” AMS
Review 1 (2011), pp. 44–65.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-
Hill Education
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Part 3 e Global Trade and Investment Environment
International Trade eory
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO6-1 Understand why nations trade with each other.
LO6-2 Summarize the different theories explaining trade flows between nations.
LO6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the
economic welfare of countries that participate in a free trade system.
LO6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting
national competitive advantage in certain industries.
LO6-5 Understand the important implications that international trade theory holds for management practice.
“Trade Wars Are Good and Easy to Win”
opening case
Page 152
At 3:50 a.m. on March 2, 2018, Donald Trump, the 45th President of the United States, took to Twitter to
espouse his view on an important policy issue: international trade. He tweeted “When a country (USA) is
losing many billions of dollars on trade with virtually every country it does business with, trade wars are good,
and easy to win. When we are down $100 billion with a certain country and they get cute, don’t trade
anymore—we win big. It’s easy!”
Trump’s tweet was a response to backlash over his decision to impose a 25 percent tariff on imports of steel,
and a 10 percent tariff on imports of aluminum. e Trump administration claimed that these tariffs were
necessary to protect two industries that were important for national security. His critics had a different take.
ey argued that the tariffs would raise input costs for consumers of steel and aluminum, which included
construction companies, manufacturers of construction equipment, appliance makers, auto manufacturers,
makers of containers and packaging (e.g. beer cans), and aerospace companies. Among those hit by higher
costs due to these tariffs would be two of America's largest exporters, Boeing and Caterpillar Tractor. e
critics also noted that there are only 140,000 people employed in the steel and aluminum industries, whereas
6.5 million Americans are employed in industries that use steel and aluminum, where input prices have just
gone up.
Trump’s actions should not have been a surprise. In contrast to all U.S. presidents since World War II,
Donald Trump has long voiced strong opposition to trade deals designed to lower tariff barriers and foster the
free flow of goods and services between the United States and its trading partners. During the presidential
election campaign, he called the North American Free Trade Agreement (NAFTA) “the worst trade deal
maybe ever signed anywhere.” Upon taking office, his administration launched a renegotiation of NAFTA
with the aim of making the treaty more favorable to America. As a candidate, he vowed to “kill” the Trans
Pacific Partnership (TPP), a free trade deal among 12 Pacific Rim countries, including the United States (but
excluding China), negotiated by the Obama administration. In his first week in office, he signed an executive
order formally withdrawing the United States from the TPP. He has even threatened to pull the United States
out of the World Trade Organization (WTO) if the global trade body interferes with his plans to impose
tariffs.
Trump’s position seems to be based on a belief that trade is a game that America needs to win. He appears
to equate winning with running a trade surplus. He sees the persistent U.S. trade deficit as a sign of American
weakness. In his words, “you only have to look at our trade deficit to see that we are being taken to the
cleaners by our trading partners.” He believes that other countries have taken advantage of the United States
in trade deals, and the result has been a sharp decline in manufacturing jobs in the United States.
China and Mexico have been frequent targets of his criticisms. He has argued that China’s trade
surplus with the United States is a result of that country’s currency manipulation, which has made Chinese
exports artificially cheap. He seems to think that America can win at the trade game by becoming a tougher
negotiator and extracting favorable terms from foreign nations that want access to the U.S. market. He has
even characterized previous American trade negotiators as “stupid people,” “political hacks and diplomats,”
and “saps” and suggested that he should become “negotiator in chief.”
In contrast to Donald Trump’s espoused position, the pro trade policies of the last 70 years were based
upon a substantial body of economic theory and evidence that suggests free trade has a positive impact on the
economic growth rate of all nations that participate in a free trade system. According to this work, free trade
doesn’t destroy jobs; it creates jobs and raises national income. To be sure, some sectors will lose jobs when a
nation moves to a free trade regime, but the argument is that jobs created elsewhere in the economy will more
than compensate for such losses, and in aggregate, the nation will be better off.
e United States has long been the world’s largest economy, largest foreign investor, and one of the three
largest exporters (along with China and Germany). As a result of America’s economic power, Americans’ long
adherence to free trade policies has helped to set the tone for the world trading system. In large part, the post–
World War II international trading system, with its emphasis on lowering barriers to international trade and
investment, was only possible because of vigorous American leadership. Now with the ascendancy of Donald
Trump to the presidency, that seems to be changing. Pro–free traders argue that if Trump continues to push
for more protectionist trade policies—and his rhetoric and cabinet picks suggest he will—the unintended
consequences could include retaliation from America’s trading partners, a trade war characterized by higher
tariffs, a decline in the volume of world trade, substantial job losses in the United States, and lower economic
Page 153
growth around the world. As evidence, they point to the last time such protectionist policies were
implemented. at was in the early 1930s, when a trade war between nations deepened the Great Depression.
•
Sources: “Donald Trump on Free Trade,” On the Issues, www.ontheissues.org/2016/Donald_Trump_Free_Trade.htm; Keith
Bradsher, “Trump’s Pick on Trade Could Put China in a Difficult Spot,” e New York Times, January 13, 2017; William Mauldin,
“Trump reatens to Pull U.S. Out of World Trade Organization,” e Wall Street Journal, July 24, 2016; “Trump’s Antitrade
Warriors,” e Wall Street Journal, January 16, 2017; “Donald Trump’s Trade Bluster,” e Economist, December 10, 2016; and
Chad Brown, “Trump’s Steel and Aluminum Tariffs Are Counterproductive,” Peterson Institute for International Economics, March
7, 2018.
Introduction
As discussed in the opening case of this chapter, thanks to the rise of Donald Trump, trade policy is
currently at the center of political discourse in the United States and elsewhere. President Trump has
made statements and taken actions that suggest he may be the most protectionist president in modern
history. His administration could upend 70 years of American-led policy designed to lower barriers to
the free flow of goods and services between and among nations. at policy was founded on the belief
that free trade promotes economic growth in all nations that participate in a free trade system. Free
trade is what economists call a positive-sum game; it is a policy under which all nations win. e
Trump administration, in contrast, appears to see trade as a zero-sum game, in which there are
winners and losers.
To truly understand the debate over trade, we need to take a close look at the intellectual
foundations for trade policy; at the impact of trade policy on jobs, income, and economic growth; and
at how global trade policy has evolved over the last 70 years. We should also consider the reasons for
foreign direct investment (FDI) by corporations because FDI may be a substitute for trade (i.e.,
exports), or it may support greater global trade. For example, many car companies invest in
production facilities in Mexico because that is a good base from which to export finished cars to many
other countries.
is is the first of four chapters that deal with the global trade and investment environment. In this
chapter, we focus on the theoretical foundations of trade policy. We will also look at what the
economic evidence tells us about the relationship between trade policies and economic growth. In
Chapter 7, we chart the development of the world trading system, discuss different aspects
of trade policy, and look at how trade policy is managed by national and global institutions.
In Chapter 8, we discuss the reasons for foreign direct investment and the government policies
adopted to manage foreign investment. In Chapter 9, we look at the reasons for creating trading
blocks such as the European Union and NAFTA, and we discuss how these transnational agreements
have worked out in practice. By the time you have finished these four chapters, you should have a very
solid understanding of the international trade and investment environment, and you should be able to
analyze in depth and critique the policy positions taken both by free traders and by people who share
Donald Trump’s views. You will also understand the extremely important impact that trade and
investment policies have upon the practice of international business.
An Overview of Trade eory
We open this chapter with a discussion of mercantilism. Propagated in the sixteenth and seventeenth
centuries, mercantilism advocated that countries should simultaneously encourage exports and
discourage imports. Although mercantilism is an old and largely discredited doctrine, its echoes
remain in modern political debate and in the trade policies of many countries. Indeed, some have
argued that Donald Trump espouses mercantilist views. Next, we look at Adam Smith’s theory of
absolute advantage. Proposed in 1776, Smith’s theory was the first to explain why unrestricted free
trade is beneficial to a country. Free trade refers to a situation in which a government does not
attempt to influence through quotas or duties what its citizens can buy from another country or what
they can produce and sell to another country. Smith argued that the invisible hand of the market
mechanism, rather than government policy, should determine what a country imports and what it
exports. His arguments imply that such a laissez-faire stance toward trade was in the best interests of a
country. Building on Smith’s work are two additional theories that we review. One is the theory of
comparative advantage, advanced by the nineteenth-century English economist David Ricardo. is
theory is the intellectual basis of the modern argument for unrestricted free trade. In the twentieth
century, Ricardo’s work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin,
whose theory is known as the Heckscher–Ohlin theory.
THE BENEFITS OF TRADE
LO 6-1 Understand why nations trade with each other.
e great strength of the theories of Smith, Ricardo, and Heckscher–Ohlin is that they identify with
precision the specific benefits of international trade. Common sense suggests that some international
trade is beneficial. For example, nobody would suggest that Iceland should grow its own oranges.
Iceland can benefit from trade by exchanging some of the products that it can produce at a low cost
(fish) for some products that it cannot produce at all (oranges). us, by engaging in international
trade, Icelanders are able to add oranges to their diet of fish.
e theories of Smith, Ricardo, and Heckscher–Ohlin go beyond this commonsense notion,
however, to show why it is beneficial for a country to engage in international trade even for products it
is able to produce for itself. is is a difficult concept for people to grasp. For example, many people in
the United States believe that American consumers should buy products made in the United States by
American companies whenever possible to help save American jobs from foreign competition. e
same kind of nationalistic sentiments can be observed in many other countries.
However, the theories of Smith, Ricardo, and Heckscher–Ohlin tell us that a country’s economy
may gain if its citizens buy certain products from other nations that could be produced at home. e
gains arise because international trade allows a country to specialize in the manufacture and export of
products that can be produced most efficiently in that country, while importing products that can be
produced more efficiently in other countries.
Did You Know?
Did you know that sugar prices in the United States are much higher than sugar prices in the rest of the world?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from
the authors.
Trade Tutorials
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us, it may make sense for the United States to specialize in the production and export of
commercial jet aircraft because the efficient production of commercial jet aircraft requires resources
that are abundant in the United States, such as a highly skilled labor force and cutting-edge
technological know-how. On the other hand, it may make sense for the United States to import
textiles from Bangladesh because the efficient production of textiles requires a relatively cheap labor
force—and cheap labor is not abundant in the United States.
In this chapter, we discuss
benefits and costs associated
with free trade, discuss the benefits of international trade, and explain the pattern of international trade in
today’s world economy. e general idea is that international trade theories explain why it can be beneficial for
a country to engage in trade across country borders, even though countries are at different stages of
development, have different product needs, and produce different types of products. International trade
theory assumes that countries—through their governments, laws, and regulations—engage in more or less
trade across borders. In reality, the vast majority of trade happens across borders by companies from different
countries. As related to this chapter, check out globalEDGE™’s “trade tutorials” section, where lots of
information, data, and tools are compiled related to trading internationally (globaledge.msu.edu/global-
resources/trade-tutorials). e potpourri of trade resources includes export tutorials, online course modules, a
glossary, a free trade agreement tariff tool, and much more. e glossary includes lots of terms related to trade.
For example, “trade surplus” is defined as a situation in which a country’s exports exceeds its imports (i.e., it
represents a net inflow of domestic currency from foreign markets). e opposite is called trade deficit and is
considered a net outflow, but how is it really defined? e globalEDGE™ glossary can help.
Of course, this economic argument is often difficult for segments of a country’s population to
accept. With their future threatened by imports, U.S. textile companies and their employees have tried
hard to persuade the government to limit the importation of textiles by demanding quotas and tariffs.
Although such import controls may benefit particular groups, such as textile businesses and their
employees, the theories of Smith, Ricardo, and Heckscher–Ohlin suggest that the economy as a whole
is hurt by such action. One of the key insights of international trade theory is that limits on imports
are often in the interests of domestic producers but not domestic consumers.
THE PATTERN OF INTERNATIONAL TRADE
e theories of Smith, Ricardo, and Heckscher–Ohlin help explain the pattern of international trade
that we observe in the world economy. Some aspects of the pattern are easy to understand. Climate
and natural resource endowments explain why Ghana exports cocoa, Brazil exports coffee, Saudi
Arabia exports oil, and China exports crawfish. However, much of the observed pattern
of international trade is more difficult to explain. For example, why does Japan export automobiles,
consumer electronics, and machine tools? Why does Switzerland export chemicals, pharmaceuticals,
watches, and jewelry? Why does Bangladesh export garments? David Ricardo’s theory of comparative
advantage offers an explanation in terms of international differences in labor productivity. e more
sophisticated Heckscher–Ohlin theory emphasizes the interplay between the proportions in which the
factors of production (such as land, labor, and capital) are available in different countries and the
proportions in which they are needed for producing particular goods. is explanation rests on the
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assumption that countries have varying endowments of the various factors of production. Tests of this
theory, however, suggest that it is a less powerful explanation of real-world trade patterns than once
thought.
One early response to the failure of the Heckscher–Ohlin theory to explain the observed pattern of
international trade was the product life-cycle theory. Proposed by Raymond Vernon, this theory
suggests that early in their life cycle, most new products are produced in and exported from the
country in which they were developed. As a new product becomes widely accepted internationally,
however, production starts in other countries. As a result, the theory suggests, the product
may ultimately be exported back to the country of its original innovation.
A Rolex Group logo sits on display above a luxury wristwatch store in Vienna, Austria.
©Bloomberg/Getty Images
In a similar vein, during the 1980s, economists such as Paul Krugman developed what has come to
be known as the new trade theory. New trade theory (for which Krugman won the Nobel Prize in
economics in 2008) stresses that in some cases, countries specialize in the production and export of
particular products not because of underlying differences in factor endowments but because in certain
industries the world market can support only a limited number of firms. (is is argued to be the case
for the commercial aircraft industry.) In such industries, firms that enter the market first are able to
build a competitive advantage that is subsequently difficult to challenge. us, the observed pattern of
trade between nations may be due in part to the ability of firms within a given nation to capture first-
mover advantages. e United States is a major exporter of commercial jet aircraft because American
firms such as Boeing were first movers in the world market. Boeing built a competitive advantage that
has subsequently been difficult for firms from countries with equally favorable factor endowments to
challenge (although Europe’s Airbus has succeeded in doing that). In a work related to the new trade
theory, Michael Porter developed a theory referred to as the theory of national competitive advantage.
is attempts to explain why particular nations achieve international success in particular industries.
In addition to factor endowments, Porter points out the importance of country factors such as
domestic demand and domestic rivalry in explaining a nation’s dominance in the production and
export of particular products.
TRADE THEORY AND GOVERNMENT POLICY
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Although all these theories agree that international trade is beneficial to a country, they lack agreement
in their recommendations for government policy. Mercantilism makes a case for government
involvement in promoting exports and limiting imports (one could argue that Donald Trump seems
to advocate such policies). e theories of Smith, Ricardo, and Heckscher–Ohlin form part of the case
for unrestricted free trade. e argument for unrestricted free trade is that both import controls and
export incentives (such as subsidies) are self-defeating and result in wasted resources. Both the new
trade theory and Porter’s theory of national competitive advantage can be interpreted as justifying
some limited government intervention to support the development of certain export-oriented
industries. We discuss the pros and cons of this argument, known as strategic trade policy, as well as
the pros and cons of the argument for unrestricted free trade, in Chapter 7.
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Mercantilism
LO 6-2 Summarize the different theories explaining trade flows between nations.
e first theory of international trade, mercantilism, emerged in England in the mid-sixteenth
century. e principle assertion of mercantilism was that gold and silver were the mainstays of
national wealth and essential to vigorous commerce. At that time, gold and silver were the currency of
trade between countries; a country could earn gold and silver by exporting goods. Conversely,
importing goods from other countries would result in an outflow of gold and silver from those
countries. e main tenet of mercantilism was that it was in a country’s best interests to maintain a
trade surplus, to export more than it imported. By doing so, a country would accumulate gold and
silver and, consequently, increase its national wealth, prestige, and power. As the English mercantilist
writer omas Mun put it in 1630:
e ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we
must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value.1
Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve
a surplus in the balance of trade. e mercantilists saw no virtue in a large volume of trade. Rather,
they recommended policies to maximize exports and minimize imports. To achieve this, imports were
limited by tariffs and quotas, while exports were subsidized.
e classical economist David Hume pointed out an inherent inconsistency in the mercantilist
doctrine in 1752. According to Hume, if England had a balance-of-trade surplus with France (it
exported more than it imported), the resulting inflow of gold and silver would swell the
domestic money supply and generate inflation in England. In France, however, the outflow
of gold and silver would have the opposite effect. France’s money supply would contract, and its prices
would fall. is change in relative prices between France and England would encourage the French to
buy fewer English goods (because they were becoming more expensive) and the English to buy more
French goods (because they were becoming cheaper). e result would be a deterioration in the
English balance of trade and an improvement in France’s trade balance, until the English surplus was
eliminated. Hence, according to Hume, in the long run, no country could sustain a surplus on the
balance of trade and so accumulate gold and silver as the mercantilists had envisaged.
e flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one
in which a gain by one country results in a loss by another.) It was left to Adam Smith and David
Ricardo to show the limitations of this approach and to demonstrate that trade is a positive-sum game,
or a situation in which all countries can benefit. Despite this, the mercantilist doctrine is by no means
dead. Donald Trump appears to advocate neo-mercantilist policies.2 Neo-mercantilists equate political
power with economic power and economic power with a balance-of-trade surplus. Critics argue that
several nations have adopted a neo-mercantilist strategy that is designed to simultaneously boost
exports and limit imports.3 For example, critics charge that China long pursued a neo-mercantilist
policy, deliberately keeping its currency value low against the U.S. dollar in order to sell more goods to
the United States and other developed nations, and thus amass a trade surplus and foreign exchange
reserves (see the accompanying Country Focus).
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c o u n t r y F O C U S
Is China Manipulating Its Currency in Pursuit of a Neo-Mercantilist Policy?
China’s rapid rise in economic power has been built on export-led growth. For decades, the country’s exports
have been growing faster than its imports. is has led some critics to claim that China is pursuing a neo-
mercantilist policy, trying to amass record trade surpluses and foreign currency that will give it economic
power over developed nations. By the end of 2014, its foreign exchange reserves exceeded $3.8 trillion, some
60 percent of which were held in U.S.-denominated assets such as U.S. Treasury bills. Observers worried that
if China ever decided to sell its holdings of U.S. currency, that would depress the value of the dollar against
other currencies and increase the price of imports into America.
America’s trade deficit with China has been a particular cause for concern. In 2017, this reached a record
$375 billion. At the same time, China has long resisted attempts to let its currency float freely against the U.S.
dollar. Many have claimed that China’s currency has been too cheap and that this keeps the prices of China’s
goods artificially low, which fuels the country’s exports. China, the critics charge, is guilty of currency
manipulation.
So is China manipulating the value of its currency to keep exports artificially cheap? e facts of the matter
are less clear than the rhetoric. China actually started to allow the value of the yuan (China’s currency) to
appreciate against the dollar in July 2005, albeit at a slow pace. In July 2005, one U.S. dollar purchased 8.11
yuan. By January 2014 one U.S. dollar purchased 6.05 yuan, which implied a 25 percent increase in the price
of Chinese exports, not what one would expect from a country that was trying to keep the price of its exports
low through currency manipulation.
Moreover, in 2015 and 2016, the rate of growth in China started to slow significantly. China’s stock
market fell sharply, and capital started to leave the country, with investors selling yuan and buying U.S.
dollars. To stop the yuan from declining in value against the U.S. dollar, China began to spend about $100
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billion of its foreign exchange reserves every month to buy yuan on the open market. Far from allowing its
currency to decline against the U.S. dollar, thereby giving a boost to its exports, China was trying to prop up
its value, running down its foreign exchange reserves by $2 trillion in the process. is action seems
inconsistent with the charges that the country is pursuing a neo-mercantilist policy by artificially depressing
the value of its currency. In recognition of these developments, in late 2017 the U.S. Treasury Department
declined to name China a currency manipulator and moderated its criticism of the country’s foreign exchange
policies. On the other hand, e Treasury said that it remained concerned by the lack of progress in reducing
China’s bilateral trade surplus with the United States.
Sources: S. H. Hanke, “Stop the Mercantilists,” Forbes, June 20, 2005, p. 164; G. Dyer and A. Balls, “Dollar
reat as China Signals Shift,” Financial Times, January 6, 2006; Richard Silk, “China’s Foreign Exchange
Reserves Jump Again,” e Wall Street Journal, October 15, 2013; Terence Jeffrey, “U.S. Merchandise Trade
Deficit with China Hit Record in 2015,” cnsnews.com, February 9, 2016; “Trump’s Chinese Currency
Manipulation,” e Wall Street Journal, December 7, 2016; Elena Holodny, “e Treasury Department Backs
Down on Some of Its Criticisms of China’s Currency Policies,” Business Insider, October 18, 2017; and Ana
Swanson,“U.S.-China Trade Deficit Hits Record, Fueling Trade Fight,” e New York Times, February 6,
2018.
Absolute Advantage
LO 6-2 Summarize the different theories explaining trade flows between nations.
In his 1776 landmark book e Wealth of Nations, Adam Smith attacked the mercantilist
assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to
produce goods efficiently. In his time, the English, by virtue of their superior manufacturing processes,
were the world’s most efficient textile manufacturers. Due to the combination of favorable climate,
good soils, and accumulated expertise, the French had the world’s most efficient wine industry. e
English had an absolute advantage in the production of textiles, while the French had an absolute
advantage in the production of wine. us, a country has an absolute advantage in the production of
a product when it is more efficient than any other country at producing it.
According to Smith, countries should specialize in the production of goods for which they have an
absolute advantage and then trade these goods for those produced by other countries. In Smith’s time,
this suggested the English should specialize in the production of textiles, while the French should
specialize in the production of wine. England could get all the wine it needed by selling its textiles to
France and buying wine in exchange. Similarly, France could get all the textiles it needed by selling
wine to England and buying textiles in exchange. Smith’s basic argument, therefore, is that a country
should never produce goods at home that it can buy at a lower cost from other countries. Smith
demonstrates that by specializing in the production of goods in which each has an absolute advantage,
both countries benefit by engaging in trade.
Consider the effects of trade between two countries, Ghana and South Korea. e production of
any good (output) requires resources (inputs) such as land, labor, and capital. Assume that Ghana and
South Korea both have the same amount of resources and that these resources can be used to produce
either rice or cocoa. Assume further that 200 units of resources are available in each country. Imagine
that in Ghana it takes 10 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of
rice. us, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some
combination of rice and cocoa between these two extremes. e different combinations that Ghana
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could produce are represented by the line GG′ in Figure 6.1. is is referred to as Ghana’s production possibility frontier (PPF). Similarly, imagine that in South Korea it takes 40 resources to produce 1 ton
of cocoa and 10 resources to produce 1 ton of rice. us, South Korea could produce 5 tons of cocoa
and no rice, 20 tons of rice and no cocoa, or some combination between these two extremes. e
different combinations available to South Korea are represented by the line KK′ in Figure 6.1, which is South Korea’s PPF. Clearly, Ghana has an absolute advantage in the production of cocoa. (More
resources are needed to produce a ton of cocoa in South Korea than in Ghana.) By the same token,
South Korea has an absolute advantage in the production of rice.
6.1 FIGURE
e theory of absolute advantage.
Now consider a situation in which neither country trades with any other. Each country devotes half
its resources to the production of rice and half to the production of cocoa. Each country must also
consume what it produces. Ghana would be able to produce 10 tons of cocoa and 5 tons of rice (point
A in Figure 6.1), while South Korea would be able to produce 10 tons of rice and 2.5 tons of cocoa
(point B in Figure 6.1). Without trade, the combined production of both countries would be 12.5
tons of cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons in Ghana
and 10 tons in South Korea). If each country were to specialize in producing the good for which it had
an absolute advantage and then trade with the other for the good it lacks, Ghana could produce 20
tons of cocoa, and South Korea could produce 20 tons of rice. us, by specializing, the
production of both goods could be increased. Production of cocoa would increase from
12.5 tons to 20 tons, while production of rice would increase from 15 tons to 20 tons. e increase in
production that would result from specialization is therefore 7.5 tons of cocoa and 5 tons of rice.
Table 6.1 summarizes these figures.
6.1 TABLE
Absolute Advantage and the Gains from Trade
Which Products Should Always Be Produced at Home?
One of the key insights of international trade theory is that limits on imports are often in the interests of
domestic producers but not domestic consumers. is is especially true if Adam Smith’s theory of absolute
advantage is in play, where one country is better at producing a product than another country. e reason is
that consumers typically want the best products they can get for the amount of money they are willing to pay.
But what about the comparative advantage theory that was originally conceptualized by David Ricardo and
then refined by Eli Heckscher and Bertil Ohlin? Comparative advantage theory argues that a country should
consider not producing products that it can actually produce reasonably well if the country can produce
something else even more efficiently. In reality, not a single country has stopped all production of products
they produce less efficiently than some other country. e reason is that countries always engage in a strategic
balancing act! ey prefer to be as efficient as possible (engage in international trade when advantageous)
while also being as self-sufficient as possible (produce inside their country). So, what types of products should
always be produced in the home country and which products should always be considered for importing if
other countries can produce them more efficiently?
By engaging in trade and swapping 1 ton of cocoa for 1 ton of rice, producers in both countries
could consume more of both cocoa and rice. Imagine that Ghana and South Korea swap cocoa and
rice on a one-to-one basis; that is, the price of 1 ton of cocoa is equal to the price of 1 ton of rice. If
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Ghana decided to export 6 tons of cocoa to South Korea and import 6 tons of rice in return, its final
consumption after trade would be 14 tons of cocoa and 6 tons of rice. is is 4 tons more cocoa than
it could have consumed before specialization and trade and 1 ton more rice. Similarly, South Korea’s
final consumption after trade would be 6 tons of cocoa and 14 tons of rice. is is 3.5 tons more
cocoa than it could have consumed before specialization and trade and 4 tons more rice. us, as a
result of specialization and trade, output of both cocoa and rice would be increased, and consumers in
both nations would be able to consume more. us, we can see that trade is a positive-sum game; it
produces net gains for all involved.
Comparative Advantage
LO 6-2 Summarize the different theories explaining trade flows between nations.
David Ricardo took Adam Smith’s theory one step further by exploring what might happen when one
country has an absolute advantage in the production of all goods.4 Smith’s theory of absolute
advantage suggests that such a country might derive no benefits from international trade. In his 1817
book Principles of Political Economy, Ricardo showed that this was not the case. According to Ricardo’s
theory of comparative advantage, it makes sense for a country to specialize in the production of those
goods that it produces most efficiently and to buy the goods that it produces less efficiently from other
countries, even if this means buying goods from other countries that it could produce more efficiently
itself.5 While this may seem counterintuitive, the logic can be explained with a simple example.
Assume that Ghana is more efficient in the production of both cocoa and rice; that is, Ghana has
an absolute advantage in the production of both products. In Ghana it takes 10 resources to produce 1
ton of cocoa and 13.33 resources to produce 1 ton of rice. us, given its 200 units of resources,
Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or any combination in
between on its PPF (the line GG′ in Figure 6.2). In South Korea, it takes 40 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. us, South Korea can produce 5 tons of
cocoa and no rice, 10 tons of rice and no cocoa, or any combination on its PPF (the line KK′ in Figure 6.2). Again assume that without trade, each country uses half its resources to produce rice and
half to produce cocoa. us, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice
(point A in Figure 6.2), while South Korea will produce 2.5 tons of cocoa and 5 tons of rice (point B
in Figure 6.2).
6.2 FIGURE
e theory of comparative advantage.
In light of Ghana’s absolute advantage in the production of both goods, why should it trade with
South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it
has a comparative advantage only in the production of cocoa: Ghana can produce 4 times as much
cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at
producing cocoa than it is at producing rice.
Without trade the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in
South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5
tons in South Korea). Without trade each country must consume what it produces. By engaging in
trade, the two countries can increase their combined production of rice and cocoa, and consumers in
both nations can consume more of both goods.
THE GAINS FROM TRADE
Imagine that Ghana exploits its comparative advantage in the production of cocoa to increase its
output from 10 tons to 15 tons. is uses up 150 units of resources, leaving the remaining 50 units of
resources to use in producing 3.75 tons of rice (point C in Figure 6.2). Meanwhile, South Korea
specializes in the production of rice, producing 10 tons. e combined output of both cocoa and rice
has now increased. Before specialization, the combined output was 12.5 tons of cocoa and 12.5 tons
of rice. Now it is 15 tons of cocoa and 13.75 tons of rice (3.75 tons in Ghana and 10 tons in South
Korea). e source of the increase in production is summarized in Table 6.2.
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6.2 TABLE
Comparative Advantage and the Gains from Trade
Not only is output higher, but both countries also can now benefit from trade. If Ghana and South
Korea swap cocoa and rice on a one-to-one basis, with both countries choosing to exchange 4 tons of
their export for 4 tons of the import, both countries are able to consume more cocoa and rice than
they could before specialization and trade (see Table 6.2). us, if Ghana exchanges 4 tons
of cocoa with South Korea for 4 tons of rice, it is still left with 11 tons of cocoa, which is 1
ton more than it had before trade. e 4 tons of rice it gets from South Korea in exchange for its 4
tons of cocoa, when added to the 3.75 tons it now produces domestically, leave it with a total of 7.75
tons of rice, which is 0.25 ton more than it had before specialization. Similarly, after swapping 4 tons
of rice with Ghana, South Korea still ends up with 6 tons of rice, which is more than it had before
specialization. In addition, the 4 tons of cocoa it receives in exchange is 1.5 tons more than it
produced before trade. us, consumption of cocoa and rice can increase in both countries as a result
of specialization and trade.
e basic message of the theory of comparative advantage is that potential world production is
greater with unrestricted free trade than it is with restricted trade. Ricardo’s theory suggests that
consumers in all nations can consume more if there are no restrictions on trade. is occurs even in
countries that lack an absolute advantage in the production of any good. In other words, to an even
greater degree than the theory of absolute advantage, the theory of comparative advantage suggests that
trade is a positive-sum game in which all countries that participate realize economic gains. is theory
provides a strong rationale for encouraging free trade. So powerful is Ricardo’s theory that it remains a
major intellectual weapon for those who argue for free trade.
QUALIFICATIONS AND ASSUMPTIONS
LO 6-3 Recognize why many economists believe that unrestricted free trade between nations will
raise the economic welfare of countries that participate in a free trade system.
e conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple
model. Our simple model includes many unrealistic assumptions:
1. We have assumed a simple world in which there are only two countries and two goods. In the
real world, there are many countries and many goods.
2. We have assumed away transportation costs between countries.
3. We have assumed away differences in the prices of resources in different countries. We have said
nothing about exchange rates, simply assuming that cocoa and rice could be swapped on a one-
to-one basis.
4. We have assumed that resources can move freely from the production of one good to
another within a country. In reality, this is not always the case.
5. We have assumed constant returns to scale; that is, that specialization by Ghana or South Korea
has no effect on the amount of resources required to produce one ton of cocoa or rice. In reality,
both diminishing and increasing returns to specialization exist. e amount of resources
required to produce a good might decrease or increase as a nation specializes in production of
that good.
6. We have assumed that each country has a fixed stock of resources and that free trade does not
change the efficiency with which a country uses its resources. is static assumption makes no
allowances for the dynamic changes in a country’s stock of resources and in the efficiency with
which the country uses its resources that might result from free trade.
7. We have assumed away the effects of trade on income distribution within a country.
Given these assumptions, can the conclusion that free trade is mutually beneficial be extended to the
real world of many countries, many goods, positive transportation costs, volatile exchange rates,
immobile domestic resources, nonconstant returns to specialization, and dynamic changes? Although a
detailed extension of the theory of comparative advantage is beyond the scope of this book,
economists have shown that the basic result derived from our simple model can be generalized to a
world composed of many countries producing many different goods.6 Despite the shortcomings of the
Ricardian model, research suggests that the basic proposition that countries will export the goods that
they are most efficient at producing is borne out by the data.7
However, once all the assumptions are dropped, the case for unrestricted free trade, while still
positive, has been argued by some economists associated with the “new trade theory” to lose some of
its strength.8 We return to this issue later in this chapter and in the next when we discuss the new
trade theory. In a recent and widely discussed analysis, the Nobel Prize–winning economist Paul
Samuelson argued that contrary to the standard interpretation, in certain circumstances the theory of
comparative advantage predicts that a rich country might actually be worse off by switching to a free
trade regime with a poor nation.9 We consider Samuelson’s critique in the next section.
EXTENSIONS OF THE RICARDIAN MODEL
Let us explore the effect of relaxing three of the assumptions identified earlier in the simple
comparative advantage model. Next, we relax the assumptions that resources move freely from the
production of one good to another within a country, that there are constant returns to scale, and that
trade does not change a country’s stock of resources or the efficiency with which those resources are
utilized.
Immobile Resources In our simple comparative model of Ghana and South Korea, we assumed that producers (farmers) could easily convert land from the production of cocoa to rice and vice versa.
While this assumption may hold for some agricultural products, resources do not always shift quite so
easily from producing one good to another. A certain amount of friction is involved. For example,
embracing a free trade regime for an advanced economy such as the United States often implies that
the country will produce less of some labor-intensive goods, such as textiles, and more of some
knowledge-intensive goods, such as computer software or biotechnology products. Although the
country as a whole will gain from such a shift, textile producers will lose. A textile worker in South
Carolina is probably not qualified to write software for Microsoft. us, the shift to free trade may
mean that she becomes unemployed or has to accept another less attractive job, such as working at a
fast-food restaurant.
Resources do not always move easily from one economic activity to another. e process creates
friction and human suffering too. While the theory predicts that the benefits of free trade outweigh
the costs by a significant margin, this is of cold comfort to those who bear the costs. Accordingly,
political opposition to the adoption of a free trade regime typically comes from those whose jobs are
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most at risk. In the United States, for example, textile workers and their unions have long opposed the
move toward free trade precisely because this group has much to lose from free trade. Governments
often ease the transition toward free trade by helping retrain those who lose their jobs as a result. e
pain caused by the movement toward a free trade regime is a short-term phenomenon, while the gains
from trade once the transition has been made are both significant and enduring.
Diminishing Returns e simple comparative advantage model developed above assumes constant returns to specialization. By constant returns to specialization we mean the units of
resources required to produce a good (cocoa or rice) are assumed to remain constant no matter where
one is on a country’s production possibility frontier (PPF). us, we assumed that it always took
Ghana 10 units of resources to produce 1 ton of cocoa. However, it is more realistic to assume
diminishing returns to specialization. Diminishing returns to specialization occur when more units of
resources are required to produce each additional unit. While 10 units of resources may be sufficient
to increase Ghana’s output of cocoa from 12 tons to 13 tons, 11 units of resources may be needed to
increase output from 13 to 14 tons, 12 units of resources to increase output from 14 tons to 15 tons,
and so on. Diminishing returns imply a convex PPF for Ghana (see Figure 6.3), rather than the
straight line depicted in Figure 6.2.
6.3 FIGURE
Ghana’s PPF under diminishing returns.
It is more realistic to assume diminishing returns for two reasons. First, not all resources are of the
same quality. As a country tries to increase its output of a certain good, it is increasingly likely to draw
on more marginal resources whose productivity is not as great as those initially employed. e result is
that it requires ever more resources to produce an equal increase in output. For example, some land is
more productive than other land. As Ghana tries to expand its output of cocoa, it might have to utilize
increasingly marginal land that is less fertile than the land it originally used. As yields per acre decline,
Ghana must use more land to produce 1 ton of cocoa.
A second reason for diminishing returns is that different goods use resources in different
proportions. For example, imagine that growing cocoa uses more land and less labor than growing rice
and that Ghana tries to transfer resources from rice production to cocoa production. e rice industry
will release proportionately too much labor and too little land for efficient cocoa production. To
absorb the additional resources of labor and land, the cocoa industry will have to shift toward more
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labor-intensive methods of production. e effect is that the efficiency with which the cocoa industry
uses labor will decline, and returns will diminish.
Diminishing returns show that it is not feasible for a country to specialize to the degree suggested
by the simple Ricardian model outlined earlier. Diminishing returns to specialization suggest that the
gains from specialization are likely to be exhausted before specialization is complete. In reality, most
countries do not specialize, but instead produce a range of goods. However, the theory predicts that it
is worthwhile to specialize until that point where the resulting gains from trade are outweighed by
diminishing returns. us, the basic conclusion that unrestricted free trade is beneficial still holds,
although because of diminishing returns, the gains may not be as great as suggested in the constant
returns case.
LO 6-3 Recognize why many economists believe that unrestricted free trade between nations will
raise the economic welfare of countries that participate in a free trade system.
Dynamic Effects and Economic Growth e simple comparative advantage model assumed that trade does not change a country’s stock of resources or the efficiency with which it utilizes those
resources. is static assumption makes no allowances for the dynamic changes that might result from
trade. If we relax this assumption, it becomes apparent that opening an economy to trade is likely to
generate dynamic gains of two sorts.10 First, free trade might increase a country’s stock of resources as
increased supplies of labor and capital from abroad become available for use within the country. For
example, this has been occurring in eastern Europe since the early 1990s, with many western
businesses investing significant capital in the former communist countries.
Second, free trade might also increase the efficiency with which a country uses its resources. Gains
in the efficiency of resource utilization could arise from a number of factors. For example, economies
of large-scale production might become available as trade expands the size of the total market available
to domestic firms. Trade might make better technology from abroad available to domestic firms; better
technology can increase labor productivity or the productivity of land. (e so-called green revolution
had this effect on agricultural outputs in developing countries.) Also, opening an economy to foreign
competition might stimulate domestic producers to look for ways to increase their efficiency. Again,
this phenomenon has arguably been occurring in the once-protected markets of eastern Europe, where
many former state monopolies have had to increase the efficiency of their operations to survive in the
competitive world market.
Dynamic gains in both the stock of a country’s resources and the efficiency with which resources
are utilized will cause a country’s PPF to shift outward. is is illustrated in Figure 6.4, where the shift
from PPF1 to PPF2 results from the dynamic gains that arise from free trade. As a consequence of this
outward shift, the country in Figure 6.4 can produce more of both goods than it did before
introduction of free trade. e theory suggests that opening an economy to free trade not only results
in static gains of the type discussed earlier but also results in dynamic gains that stimulate economic
growth. If this is so, then one might think that the case for free trade becomes stronger still, and in
general it does. However, as noted, one of the leading economic theorists of the twentieth century,
Paul Samuelson, argued that in some circumstances, dynamic gains can lead to an outcome that is not
so beneficial.
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6.4 FIGURE
e influence of free trade on the PPF.
Trade, Jobs and Wages: e Samuelson Critique Paul Samuelson’s critique looks at what happens when a rich country—the United States—enters into a free trade agreement with a poor
country—China—that rapidly improves its productivity after the introduction of a free trade regime
(i.e., there is a dynamic gain in the efficiency with which resources are used in the poor country).
Samuelson’s model suggests that in such cases, the lower prices that U.S. consumers pay for goods
imported from China following the introduction of a free trade regime may not be enough to produce
a net gain for the U.S. economy if the dynamic effect of free trade is to lower real wage rates in the
United States. As he stated in a New York Times interview, “Being able to purchase groceries 20
percent cheaper at Wal-Mart (due to international trade) does not necessarily make up for the wage
losses (in America).”11
Samuelson was particularly concerned about the ability to offshore service jobs that traditionally
were not internationally mobile, such as software debugging, call-center jobs, accounting jobs, and
even medical diagnosis of MRI scans (see the accompanying Country Focus for details). Advances in
communications technology since the development of the World Wide Web in the early 1990s have
made this possible, effectively expanding the labor market for these jobs to include educated people in
places such as India, the Philippines, and China. When coupled with rapid advances in the
productivity of foreign labor due to better education, the effect on middle-class wages in the United
States, according to Samuelson, may be similar to mass inward migration into the country: It will
lower the market clearing wage rate, perhaps by enough to outweigh the positive benefits of
international trade.
c o u n t r y F O C U S
Moving U.S. White-Collar Jobs Offshore
Economists have long argued that free trade produces gains for all countries that participate in a free trading
system. As globalization continues to sweep through the U.S. economy, many people are wondering if this is
true. During the 1980s and 1990s, free trade was associated with the movement of low-skill, blue-collar
manufacturing jobs out of rich countries such as the United States and toward low-wage countries—textiles to
Costa Rica, athletic shoes to the Philippines, steel to Brazil, electronic products to ailand, and so on. While
many observers bemoaned the “hollowing out” of U.S. manufacturing, economists stated that high-skill and
high-wage white-collar jobs associated with the knowledge-based economy would stay in the United States.
Computers might be assembled in ailand, so the argument went, but they would continue to be designed
in Silicon Valley by highly skilled U.S. engineers, and software applications would be written in the United
States by programmers at Apple, Microsoft, Adobe, Oracle, and the like.
Developments over the past several decades have people questioning this assumption. Many American
companies have been moving white-collar, knowledge-based jobs to developing nations where they can be
performed for a fraction of the cost. For example, a few years ago Bank of America cut nearly 5,000 jobs from
its 25,000-strong, U.S.-based information technology workforce. Some of these jobs were transferred to India,
where work that costs $100 an hour in the United States could be done for $20 an hour. One beneficiary of
Bank of America’s downsizing is Infosys Technologies Ltd., a Bangalore, India, information technology firm
where 250 engineers now develop information technology applications for the bank. Other Infosys employees
are busy processing home loan applications for U.S. mortgage companies. Nearby in the offices of another
Indian firm, Wipro Ltd., radiologists interpret 30 CT scans a day for Massachusetts General Hospital that are
sent over the Internet. At yet another Bangalore business, engineers earn $10,000 a year designing leading-
edge semiconductor chips for Texas Instruments. Nor is India the only beneficiary of these changes.
Some architectural work also is being outsourced to lower-cost locations. Flour Corp., a Texas-based
construction company, employs engineers and drafters in the Philippines, Poland, and India to turn layouts of
industrial facilities into detailed specifications. For a Saudi Arabian chemical plant Flour designed, 200 young
engineers based in the Philippines earning less than $3,000 a year collaborated in real time over the Internet
with elite U.S. and British engineers who make up to $100,000 a year. Why did Flour do this? According to
the company, the answer was simple. Doing so reduces the prices of a project by 15 percent, giving the
company a cost-based competitive advantage in the global market for construction design. Also troubling for
future job growth in the United States, some high-tech start-ups are outsourcing significant work right from
inception. For example, Zoho Corporation, a California-based start-up offering online web applications for
small businesses, has about 20 employees in the United States and more than 1,000 in India!
Employees walk below the Infosys Ltd. logo at the company’s campus in Electronics City in
Bangalore, India.
©Vivek Prakash/Bloomberg/Getty Images
Sources: P. Engardio, A. Bernstein, and M. Kripalani, “Is Your Job Next?” BusinessWeek, February 3, 2003, pp.
50–60; “America’s Pain, India’s Gain,” e Economist, January 11, 2003, p. 57; M. Schroeder and T. Aeppel,
“Skilled Workers Mount Opposition to Free Trade, Swaying Politicians,” e Wall Street Journal, October 10,
2003, pp. A1, A11; D. Clark,“New U.S. Fees on Visas Irk Outsources,” e Wall Street Journal, August 16,
Page 165
2010, p. 6; and J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” e Wall Street Journal,
January 18, 2012, p. B1.
Having said this, it should be noted that Samuelson concedes that free trade has historically
benefited rich countries (as data discussed later seem to confirm). Moreover, he notes that introducing
protectionist measures (e.g., trade barriers) to guard against the theoretical possibility that free trade
may harm the United States in the future may produce a situation that is worse than the disease they
are trying to prevent. To quote Samuelson: “Free trade may turn out pragmatically to be still best for
each region in comparison to lobbyist-induced tariffs and quotas which involve both a perversion of
democracy and non-subtle deadweight distortion losses.”12
One notable recent study by MIT economist David Autor and his associates found evidence in
support of Samuelson’s thesis. e study has been widely quoted in the media and cited by politicians.
Autor and his associates looked at every county in the United States for its manufacturers’ exposure to
competition from China.13 e researchers found that regions most exposed to China tended not only
to lose more manufacturing jobs, but also to see overall employment decline. Areas with higher
exposure to China also had larger increases in workers receiving unemployment insurance,
food stamps, and disability payments. e costs to the economy from the increased
government payments amounted to two-thirds of the gains from trade with China. In other words,
many of the ways trade with China has helped the United States—such as providing inexpensive
goods to U.S. consumers—have been wiped out. Even so, like Samuelson the authors of this study
argued that in the long run, free trade is a good thing. ey note, however, that the rapid rise of China
has resulted in some large adjustment costs that, in the short run, significantly reduce the gains from
trade.
Other economists have dismissed Samuelson’s fears.14 While not questioning his analysis, they note
that as a practical matter, developing nations are unlikely to be able to upgrade the skill level of their
workforce rapidly enough to give rise to the situation in Samuelson’s model. In other words, they will
quickly run into diminishing returns. However, such rebuttals are at odds with data suggesting that
Asian countries are rapidly upgrading their educational systems. For example, about 56 percent of the
world’s engineering degrees awarded in 2008 were in Asia, compared with 4 percent in the United
States!15
Evidence for the Link between Trade and Growth Many economic studies have looked at the relationship between trade and economic growth.16 In general, these studies suggest that as
predicted by the standard theory of comparative advantage, countries that adopt a more open stance
toward international trade enjoy higher growth rates than those that close their economies to trade.
Jeffrey Sachs and Andrew Warner created a measure of how “open” to international trade an economy
was and then looked at the relationship between “openness” and economic growth for a sample of
more than 100 countries from 1970 to 1990.17 Among other findings, they reported
We find a strong association between openness and growth, both within the group of developing
and the group of developed countries. Within the group of developing countries, the open
economies grew at 4.49 percent per year, and the closed economies grew at 0.69 percent per year.
Within the group of developed economies, the open economies grew at 2.29 percent per year, and
the closed economies grew at 0.74 percent per year.18
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A study by Wacziarg and Welch updated the Sachs and Warner data through the late 1990s. ey
found that over the period 1950–1998, countries that liberalized their trade regimes experienced, on
average, increases in their annual growth rates of 1.5–2.0 percent compared to preliberalization
times.19 An exhaustive survey of 61 studies published between 1967 and 2009 concluded: “e
macroeconomic evidence provides dominant support for the positive and significant effects of trade on
output and growth.”20
e message seems clear: Adopt an open economy and embrace free trade, and your nation will be
rewarded with higher economic growth rates. Higher growth will raise income levels and living
standards. is last point has been confirmed by a study that looked at the relationship between trade
and growth in incomes. e study, undertaken by Jeffrey Frankel and David Romer, found that on
average, a 1 percentage point increase in the ratio of a country’s trade to its gross domestic product
increases income per person by at least 0.5 percent.21 For every 10 percent increase in the importance
of international trade in an economy, average income levels will rise by at least 5 percent. Despite the
short-term adjustment costs associated with adopting a free trade regime, which can be significant,
trade would seem to produce greater economic growth and higher living standards in the long run,
just as the theory of Ricardo would lead us to expect.22
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Heckscher–Ohlin eory
LO 6-2 Summarize the different theories explaining trade flows between nations.
Ricardo’s theory stresses that comparative advantage arises from differences in productivity. us,
whether Ghana is more efficient than South Korea in the production of cocoa depends on how
productively it uses its resources. Ricardo stressed labor productivity and argued that differences in
labor productivity between nations underlie the notion of comparative advantage. Swedish economists
Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of
comparative advantage. ey argued that comparative advantage arises from differences in
national factor endowments.23 By factor endowments they meant the extent to which a
country is endowed with such resources as land, labor, and capital. Nations have varying factor
endowments, and different factor endowments explain differences in factor costs; specifically, the more
abundant a factor, the lower its cost. e Heckscher–Ohlin theory predicts that countries will export
those goods that make intensive use of factors that are locally abundant, while importing goods that
make intensive use of factors that are locally scarce. us, the Heckscher–Ohlin theory attempts to
explain the pattern of international trade that we observe in the world economy. Like Ricardo’s theory,
the Heckscher–Ohlin theory argues that free trade is beneficial. Unlike Ricardo’s theory, however, the
Heckscher–Ohlin theory argues that the pattern of international trade is determined by differences in
factor endowments, rather than differences in productivity.
e Heckscher–Ohlin theory has commonsense appeal. For example, the United States has long
been a substantial exporter of agricultural goods, reflecting in part its unusual abundance of arable
land. In contrast, China has excelled in the export of goods produced in labor-intensive
manufacturing industries. is reflects China’s relative abundance of low-cost labor. e United States,
which lacks abundant low-cost labor, has been a primary importer of these goods. Note that it is
relative, not absolute, endowments that are important; a country may have larger absolute amounts of
land and labor than another country but be relatively abundant in one of them.
THE LEONTIEF PARADOX
e Heckscher–Ohlin theory has been one of the most influential theoretical ideas in international
economics. Most economists prefer the Heckscher–Ohlin theory to Ricardo’s theory because it makes
fewer simplifying assumptions. Because of its influence, the theory has been subjected to many
empirical tests. Beginning with a famous study published in 1953 by Wassily Leontief (winner of the
Nobel Prize in economics in 1973), many of these tests have raised questions about the validity of the
Heckscher–Ohlin theory.24 Using the Heckscher–Ohlin theory, Leontief postulated that because the
United States was relatively abundant in capital compared to other nations, the United States would
be an exporter of capital-intensive goods and an importer of labor-intensive goods. To his surprise,
however, he found that U.S. exports were less capital intensive than U.S. imports. Because this result
was at variance with the predictions of the theory, it has become known as the Leontief paradox.
No one is quite sure why we observe the Leontief paradox. One possible explanation is that the
United States has a special advantage in producing new products or goods made with innovative
technologies. Such products may be less capital intensive than products whose technology has had
time to mature and become suitable for mass production. us, the United States may be exporting
goods that heavily use skilled labor and innovative entrepreneurship, such as computer software, while
importing heavy manufacturing products that use large amounts of capital. Some empirical studies
tend to confirm this.25 Still, tests of the Heckscher–Ohlin theory using data for a large number of
countries tend to confirm the existence of the Leontief paradox.26
Should Factor Endowments or Productivity Drive Trade?
Ricardo’s theory of trade suggests that it makes sense for a country to specialize in production of those
products that it produces most efficiently and to buy the products that it produces less efficiently from other
countries, even if this means that the country is buying products that in reality it could produce more
efficiently itself. is means that Ricardo showed that a country can derive advantages by trade even though it
has an absolute advantage in producing all products. e Heckscher-Ohlin theory of trade suggests that
comparative advantage for a country arises from differences in national factor endowments (i.e., the extent to
which a country is endowed with such resources as land, labor, and capital). Ricardo’s argument focused on
relative productivity, while Heckscher-Ohlin’s argument focused on having important resources. If you can
only have one of the two—better relative productivity or lots of resources such as land, labor, and capital—
which would you prefer, and why?
is leaves economists with a difficult dilemma. ey prefer the Heckscher–Ohlin theory on
theoretical grounds, but it is a relatively poor predictor of real-world international trade patterns. On
the other hand, the theory they regard as being too limited, Ricardo’s theory of comparative
Page 167
advantage, actually predicts trade patterns with greater accuracy. e best solution to this dilemma
may be to return to the Ricardian idea that trade patterns are largely driven by international
differences in productivity. us, one might argue that the United States exports commercial aircraft
and imports textiles not because its factor endowments are especially suited to aircraft manufacture
and not suited to textile manufacture, but because the United States is relatively more efficient at
producing aircraft than textiles. A key assumption in the Heckscher–Ohlin theory is that
technologies are the same across countries. is may not be the case. Differences in
technology may lead to differences in productivity, which in turn, drives international trade
patterns.27 us, Japan’s success in exporting automobiles from the 1970s onward has been based not
only on the relative abundance of capital but also on its development of innovative manufacturing
technology that enabled it to achieve higher productivity levels in automobile production than other
countries that also had abundant capital. Empirical work suggests that this theoretical explanation may
be correct.28 e new research shows that once differences in technology across countries are
controlled for, countries do indeed export those goods that make intensive use of factors that are
locally abundant, while importing goods that make intensive use of factors that are locally scarce. In
other words, once the impact of differences of technology on productivity is controlled for, the
Heckscher–Ohlin theory seems to gain predictive power.
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e Product Life-Cycle eory
LO 6-2 Summarize the different theories explaining trade flows between nations.
Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s.29 Vernon’s theory
was based on the observation that for most of the twentieth century, a very large proportion of the
world’s new products had been developed by U.S. firms and sold first in the U.S. market (e.g., mass-
produced automobiles, televisions, instant cameras, photocopiers, personal computers, and
semiconductor chips). To explain this, Vernon argued that the wealth and size of the U.S. market gave
U.S. firms a strong incentive to develop new consumer products. In addition, the high cost of U.S.
labor gave U.S. firms an incentive to develop cost-saving process innovations.
Just because a new product is developed by a U.S. firm and first sold in the U.S. market, it does not
follow that the product must be produced in the United States. It could be produced abroad at some
low-cost location and then exported back into the United States. However, Vernon argued that most
new products were initially produced in America. Apparently, the pioneering firms believed it was
better to keep production facilities close to the market and to the firm’s center of decision making,
given the uncertainty and risks inherent in introducing new products. Also, the demand for most new
products tends to be based on nonprice factors. Consequently, firms can charge relatively high prices
for new products, which obviates the need to look for low-cost production sites in other countries.
Vernon went on to argue that early in the life cycle of a typical new product, while demand is
starting to grow rapidly in the United States, demand in other advanced countries is limited to high-
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income groups. e limited initial demand in other advanced countries does not make it worthwhile
for firms in those countries to start producing the new product, but it does necessitate some exports
from the United States to those countries.
Over time, demand for the new product starts to grow in other advanced countries (e.g., Great
Britain, France, Germany, and Japan). As it does, it becomes worthwhile for foreign producers to
begin producing for their home markets. In addition, U.S. firms might set up production facilities in
those advanced countries where demand is growing. Consequently, production within other advanced
countries begins to limit the potential for exports from the United States.
As the market in the United States and other advanced nations matures, the product becomes more
standardized, and price becomes the main competitive weapon. As this occurs, cost considerations
start to play a greater role in the competitive process. Producers based in advanced countries where
labor costs are lower than in the United States (e.g., Italy and Spain) might now be able to export to
the United States. If cost pressures become intense, the process might not stop there. e cycle by
which the United States lost its advantage to other advanced countries might be repeated once more,
as developing countries (e.g., ailand) begin to acquire a production advantage over advanced
countries. us, the locus of global production initially switches from the United States to other
advanced nations and then from those nations to developing countries.
e consequence of these trends for the pattern of world trade is that over time, the United States
switches from being an exporter of the product to an importer of the product as production becomes
concentrated in lower-cost foreign locations.
PRODUCT LIFE-CYCLE THEORY IN THE TWENTY-FIRST CENTURY
Historically, the product life-cycle theory seems to be an accurate explanation of international trade
patterns. Consider photocopiers: e product was first developed in the early 1960s by Xerox in the
United States and sold initially to U.S. users. Originally, Xerox exported photocopiers from the United
States, primarily to Japan and the advanced countries of Western Europe. As demand began to grow in
those countries, Xerox entered into joint ventures to set up production in Japan (Fuji-Xerox) and
Great Britain (Rank-Xerox). In addition, once Xerox’s patents on the photocopier process expired,
other foreign competitors began to enter the market (e.g., Canon in Japan and Olivetti in Italy). As a
consequence, exports from the United States declined, and U.S. users began to buy some photocopiers
from lower-cost foreign sources, particularly Japan. More recently, Japanese companies found that
manufacturing costs are too high in their own country, so they have begun to switch production to
developing countries such as ailand. us, initially the United States and now other advanced
countries (e.g., Japan and Great Britain) have switched from being exporters of photocopiers to
importers. is evolution in the pattern of international trade in photocopiers is consistent with the
predictions of the product life-cycle theory that mature industries tend to go out of the United States
and into low-cost assembly locations.
However, the product life-cycle theory is not without weaknesses. Viewed from an Asian or
European perspective, Vernon’s argument that most new products are developed and introduced in the
United States seems ethnocentric and dated. Although it may be true that during U.S. dominance of
the global economy (from 1945 to 1975), most new products were introduced in the United States,
there have always been important exceptions. ese exceptions appear to have become more common
Page 169
in recent years. Many new products are now first introduced in Japan (e.g., video-game consoles) or
South Korea (e.g., Samsung smartphones). Moreover, with the increased globalization and integration
of the world economy discussed in Chapter 1, an increasing number of new products (e.g., tablet
computers, smartphones, and digital cameras) are now introduced simultaneously in the United States
and many European and Asian nations. is may be accompanied by globally dispersed production,
with particular components of a new product being produced in those locations around the globe
where the mix of factor costs and skills is most favorable (as predicted by the theory of comparative
advantage). In sum, although Vernon’s theory may be useful for explaining the pattern of international
trade during the period of American global dominance, its relevance in the modern world seems more
limited.
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New Trade eory
LO 6-2 Summarize the different theories explaining trade flows between nations.
e new trade theory began to emerge in the 1970s when a number of economists pointed out that
the ability of firms to attain economies of scale might have important implications for international
trade.30 Economies of scale are unit cost reductions associated with a large scale of output.
Economies of scale have a number of sources, including the ability to spread fixed costs over a large
volume and the ability of large-volume producers to utilize specialized employees and equipment that
are more productive than less specialized employees and equipment. Economies of scale are a major
source of cost reductions in many industries, from computer software to automobiles and from
pharmaceuticals to aerospace. For example, Microsoft realizes economies of scale by spreading the
fixed costs of developing new versions of its Windows operating system, which runs to about $10
billion, over the 2 billion or so personal computers on which each new system is ultimately installed.
Similarly, automobile companies realize economies of scale by producing a high volume of
automobiles from an assembly line where each employee has a specialized task.
New trade theory makes two important points: First, through its impact on economies of scale,
trade can increase the variety of goods available to consumers and decrease the average cost of those
goods. Second, in those industries in which the output required to attain economies of scale represents
a significant proportion of total world demand, the global market may be able to support only a small
number of enterprises. us, world trade in certain products may be dominated by countries whose
firms were first movers in their production.
INCREASING PRODUCT VARIETY AND REDUCING COSTS
LO 6-3 Recognize why many economists believe that unrestricted free trade between nations will
raise the economic welfare of countries that participate in a free trade system.
Imagine first a world without trade. In industries where economies of scale are important, both the
variety of goods that a country can produce and the scale of production are limited by the size of the
market. If a national market is small, there may not be enough demand to enable producers to realize
economies of scale for certain products. Accordingly, those products may not be produced, thereby
limiting the variety of products available to consumers. Alternatively, they may be produced but at
such low volumes that unit costs and prices are considerably higher than they might be if economies of
scale could be realized.
Now consider what happens when nations trade with each other. Individual national markets are
combined into a larger world market. As the size of the market expands due to trade, individual firms
may be able to better attain economies of scale. e implication, according to new trade theory, is that
each nation may be able to specialize in producing a narrower range of products than it would in the
absence of trade, yet by buying goods that it does not make from other countries, each nation can
simultaneously increase the variety of goods available to its consumers and lower the costs of those
goods; thus, trade offers an opportunity for mutual gain even when countries do not differ in their
resource endowments or technology.
Suppose there are two countries, each with an annual market for 1 million automobiles. By trading
with each other, these countries can create a combined market for 2 million cars. In this combined
market, due to the ability to better realize economies of scale, more varieties (models) of cars can be
produced, and cars can be produced at a lower average cost, than in either market alone. For example,
demand for a sports car may be limited to 55,000 units in each national market, while a total output
of at least 100,000 per year may be required to realize significant scale economies. Similarly, demand
for a minivan may be 80,000 units in each national market, and again a total output of at least
100,000 per year may be required to realize significant scale economies. Faced with limited domestic
market demand, firms in each nation may decide not to produce a sports car, because the costs of
doing so at such low volume are too great. Although they may produce minivans, the cost of doing so
will be higher, as will prices, than if significant economies of scale had been attained. Once the two
countries decide to trade, however, a firm in one nation may specialize in producing sports cars, while
a firm in the other nation may produce minivans. e combined demand for 110,000 sports cars and
160,000 minivans allows each firm to realize scale economies. Consumers in this case benefit from
having access to a product (sports cars) that was not available before international trade and from the
lower price for a product (minivans) that could not be produced at the most efficient scale before
international trade. Trade is thus mutually beneficial because it allows the specialization of production,
the realization of scale economies, the production of a greater variety of products, and lower prices.
Can We Continue to Rely on Economies of Scale?
Economies of scale are unit cost reductions associated with a large scale of output. As we discuss in the text,
economies of scale have a number of sources, including the ability to spread fixed costs over a large volume
and the ability of large-volume producers to utilize specialized employees and equipment that are more
productive than less specialized employees and equipment. Economies of scale have been a major source of
cost reductions in many industries—from computer software to automobiles and from pharmaceuticals to
aerospace. But some of these economies of scale advantages were realized when production platforms for
computers, automobiles, and so on were used for years and spread across large numbers of customers. With
more and more innovations coming on the market faster and faster every year and more and more customers
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wanting customized products (even if the customization is small), how can companies continue to rely on
economies of scale as a strategic advantage? Will large, mass market–type companies that are selling large
quantities of specific products always have economies of scale advantages vis-à-vis small and medium-sized
companies?
ECONOMIES OF SCALE, FIRST-MOVER ADVANTAGES, AND THE PATTERN OF TRADE
A second theme in new trade theory is that the pattern of trade we observe in the world economy may
be the result of economies of scale and first-mover advantages. First-mover advantages are the
economic and strategic advantages that accrue to early entrants into an industry.31 e ability to
capture scale economies ahead of later entrants, and thus benefit from a lower cost structure, is an
important first-mover advantage. New trade theory argues that for those products where economies of
scale are significant and represent a substantial proportion of world demand, the first movers in an
industry can gain a scale-based cost advantage that later entrants find almost impossible to match.
us, the pattern of trade that we observe for such products may reflect first-mover advantages.
Countries may dominate in the export of certain goods because economies of scale are
important in their production and because firms located in those countries were the first to
capture scale economies, giving them a first-mover advantage.
For example, consider the commercial aerospace industry. In aerospace, there are substantial scale
economies that come from the ability to spread the fixed costs of developing a new jet aircraft over a
large number of sales. It has cost Airbus some $15 billion to develop its superjumbo jet, the 550-seat
A380. To recoup those costs and break even, Airbus will have to sell at least 250 A380 planes. If
Airbus can sell more than 350 A380 planes, it will apparently be a profitable venture. Total demand
over the next 20 years for this class of aircraft is estimated to be between 400 and 600 units. us, the
global market can probably profitably support only one producer of jet aircraft in the superjumbo
category. It follows that the European Union might come to dominate in the export of very large jet
aircraft, primarily because a European-based firm, Airbus, was the first to produce a superjumbo jet
aircraft and realize scale economies. Other potential producers, such as Boeing, might be shut out of
the market because they will lack the scale economies that Airbus will enjoy. By pioneering this market
category, Airbus may have captured a first-mover advantage based on scale economies that will be
difficult for rivals to match, and that will result in the European Union becoming the leading exporter
of very large jet aircraft.
IMPLICATIONS OF NEW TRADE THEORY
New trade theory has important implications. e theory suggests that nations may benefit from trade
even when they do not differ in resource endowments or technology. Trade allows a nation to
specialize in the production of certain products, attaining scale economies and lowering the costs of
producing those products, while buying products that it does not produce from other nations that
specialize in the production of other products. By this mechanism, the variety of products available to
consumers in each nation is increased, while the average costs of those products should fall, as should
their price, freeing resources to produce other goods and services.
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e theory also suggests that a country may predominate in the export of a good simply because it
was lucky enough to have one or more firms among the first to produce that good. Because they are
able to gain economies of scale, the first movers in an industry may get a lock on the world market
that discourages subsequent entry. First-movers’ ability to benefit from increasing returns creates a
barrier to entry. In the commercial aircraft industry, the fact that Boeing and Airbus are already in the
industry and have the benefits of economies of scale discourages new entry and reinforces the
dominance of America and Europe in the trade of midsize and large jet aircraft. is dominance is
further reinforced because global demand may not be sufficient to profitably support another producer
of midsize and large jet aircraft in the industry. So although Japanese firms might be able to compete
in the market, they have decided not to enter the industry but to ally themselves as major
subcontractors with primary producers (e.g., Mitsubishi Heavy Industries is a major subcontractor for
Boeing on the 777 and 787 programs).
New trade theory is at variance with the Heckscher–Ohlin theory, which suggests a country will
predominate in the export of a product when it is particularly well endowed with those factors used
intensively in its manufacture. New trade theorists argue that the United States is a major exporter of
commercial jet aircraft not because it is better endowed with the factors of production required to
manufacture aircraft, but because one of the first movers in the industry, Boeing, was a U.S. firm. e
new trade theory is not at variance with the theory of comparative advantage. Economies of scale
increase productivity. us, the new trade theory identifies an important source of comparative
advantage.
is theory is quite useful in explaining trade patterns. Empirical studies seem to support the
predictions of the theory that trade increases the specialization of production within an industry,
increases the variety of products available to consumers, and results in lower average prices.32 With
regard to first-mover advantages and international trade, a study by Harvard business historian Alfred
Chandler suggests the existence of first-mover advantages is an important factor in explaining the
dominance of firms from certain nations in specific industries.33 e number of firms is very limited
in many global industries, including the chemical industry, the heavy construction-equipment
industry, the heavy truck industry, the tire industry, the consumer electronics industry, the jet engine
industry, and the computer software industry.
Perhaps the most contentious implication of the new trade theory is the argument that it generates
for government intervention and strategic trade policy.34 New trade theorists stress the role of luck,
entrepreneurship, and innovation in giving a firm first-mover advantages. According to this argument,
the reason Boeing was the first mover in commercial jet aircraft manufacture—rather than firms such
as Great Britain’s De Havilland and Hawker Siddeley or Holland’s Fokker, all of which could have
been—was that Boeing was both lucky and innovative. One way Boeing was lucky is that De
Havilland shot itself in the foot when its Comet jet airliner, introduced two years earlier than Boeing’s
first jet airliner, the 707, was found to be full of serious technological flaws. Had De Havilland not
made some serious technological mistakes, Great Britain might have become the world’s leading
exporter of commercial jet aircraft. Boeing’s innovativeness was demonstrated by its independent
development of the technological know-how required to build a commercial jet airliner. Several new
trade theorists have pointed out, however, that Boeing’s research and development (R&D) was largely
paid for by the U.S. government; the 707 was a spin-off from a government-funded military program
(the entry of Airbus into the industry was also supported by significant government subsidies). Herein
is a rationale for government intervention: By the sophisticated and judicious use of subsidies, could a
government increase the chances of its domestic firms becoming first movers in newly emerging
industries, as the U.S. government apparently did with Boeing (and the European Union did with
Airbus)? If this is possible, and the new trade theory suggests it might be, we have an economic
rationale for a proactive trade policy that is at variance with the free trade prescriptions of the trade
theories we have reviewed so far. We consider the policy implications of this issue in Chapter 7.
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National Competitive Advantage: Porter’s Diamond
LO 6-2 Summarize the different theories explaining trade flows between nations.
Michael Porter, the famous Harvard strategy professor, has also written extensively on international
trade.35 Porter and his team looked at 100 industries in 10 nations. Like the work of the new trade
theorists, Porter’s work was driven by a belief that existing theories of international trade told only part
of the story. For Porter, the essential task was to explain why a nation achieves international success in
a particular industry. Why does Japan do so well in the automobile industry? Why does Switzerland
excel in the production and export of precision instruments and pharmaceuticals? Why do Germany
and the United States do so well in the chemical industry? ese questions cannot be answered easily
by the Heckscher–Ohlin theory, and the theory of comparative advantage offers only a partial
explanation. e theory of comparative advantage would say that Switzerland excels in the production
and export of precision instruments because it uses its resources very productively in these industries.
Although this may be correct, this does not explain why Switzerland is more productive in this
industry than Great Britain, Germany, or Spain. Porter tries to solve this puzzle.
Porter theorizes that four broad attributes of a nation shape the environment in which local firms
compete, and these attributes promote or impede the creation of competitive advantage (see Figure
6.5). ese attributes are
6.5 FIGURE
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e determinants of national competitive advantage: Porter’s diamond.
Source: Michael E. Porter, e Competitive Advantage of Nations (New York: Free Press, 1990; republished with a new
introduction, 1998), p. 72.
Factor endowments—a nation’s position in factors of production, such as skilled labor or the
infrastructure necessary to compete in a given industry.
Demand conditions—the nature of home demand for the industry’s product or service.
Related and supporting industries—the presence or absence of supplier industries and related
industries that are internationally competitive.
Firm strategy, structure, and rivalry—the conditions governing how companies are created,
organized, and managed and the nature of domestic rivalry.
Porter speaks of these four attributes as constituting the diamond. He argues that firms are most likely
to succeed in industries or industry segments where the diamond is most favorable. He also argues that
the diamond is a mutually reinforcing system. e effect of one attribute is contingent on the state of
others. For example, Porter argues favorable demand conditions will not result in
competitive advantage unless the state of rivalry is sufficient to cause firms to respond to
them.
Porter maintains that two additional variables can influence the national diamond in important
ways: chance and government. Chance events, such as major innovations, can reshape industry
structure and provide the opportunity for one nation’s firms to supplant another’s. Government, by its
choice of policies, can detract from or improve national advantage. For example, regulation can alter
home demand conditions, antitrust policies can influence the intensity of rivalry within an industry,
and government investments in education can change factor endowments.
FACTOR ENDOWMENTS
Factor endowments lie at the center of the Heckscher–Ohlin theory. While Porter does not propose
anything radically new, he does analyze the characteristics of factors of production. He recognizes
hierarchies among factors, distinguishing between basic factors (e.g., natural resources, climate,
location, and demographics) and advanced factors (e.g., communication infrastructure, sophisticated
and skilled labor, research facilities, and technological know-how). He argues that advanced factors are
the most significant for competitive advantage. Unlike the naturally endowed basic factors, advanced
factors are a product of investment by individuals, companies, and governments. us, government
investments in basic and higher education, by improving the general skill and knowledge level of the
population and by stimulating advanced research at higher education institutions, can upgrade a
nation’s advanced factors.
e relationship between advanced and basic factors is complex. Basic factors can provide an initial
advantage that is subsequently reinforced and extended by investment in advanced factors. Conversely,
disadvantages in basic factors can create pressures to invest in advanced factors. An obvious example of
this phenomenon is Japan, a country that lacks arable land and mineral deposits and yet through
investment has built a substantial endowment of advanced factors. Porter notes that Japan’s large pool
of engineers (reflecting a much higher number of engineering graduates per capita than almost any
other nation) has been vital to Japan’s success in many manufacturing industries.
DEMAND CONDITIONS
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Porter emphasizes the role home demand plays in upgrading competitive advantage. Firms are
typically most sensitive to the needs of their closest customers. us, the characteristics of home
demand are particularly important in shaping the attributes of domestically made products and in
creating pressures for innovation and quality. Porter argues that a nation’s firms gain competitive
advantage if their domestic consumers are sophisticated and demanding. Such consumers pressure
local firms to meet high standards of product quality and to produce innovative products. For
example, Porter notes that Japan’s sophisticated and knowledgeable buyers of cameras helped stimulate
the Japanese camera industry to improve product quality and to introduce innovative models.
RELATED AND SUPPORTING INDUSTRIES
e third broad attribute of national advantage in an industry is the presence of suppliers or related
industries that are internationally competitive. e benefits of investments in advanced factors of
production by related and supporting industries can spill over into an industry, thereby helping it
achieve a strong competitive position internationally. Swedish strength in fabricated steel products
(e.g., ball bearings and cutting tools) has drawn on strengths in Sweden’s specialty steel industry.
Technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in
personal computers and several other technically advanced electronic products. Similarly, Switzerland’s
success in pharmaceuticals is closely related to its previous international success in the technologically
related dye industry.
One consequence of this process is that successful industries within a country tend to be grouped
into clusters of related industries. is was one of the most pervasive findings of Porter’s study. One
such cluster Porter identified was in the German textile and apparel sector, which included high-
quality cotton, wool, synthetic fibers, sewing machine needles, and a wide range of textile machinery.
Such clusters are important because valuable knowledge can flow between the firms within a
geographic cluster, benefiting all within that cluster. Knowledge flows occur when employees move
between firms within a region and when national industry associations bring employees from different
companies together for regular conferences or workshops.36
FIRM STRATEGY, STRUCTURE, AND RIVALRY
e fourth broad attribute of national competitive advantage in Porter’s model is the strategy,
structure, and rivalry of firms within a nation. Porter makes two important points here. First, different
nations are characterized by different management ideologies, which either help them or do not help
them build national competitive advantage. For example, Porter noted the predominance of engineers
in top management at German and Japanese firms. He attributed this to these firms’ emphasis on
improving manufacturing processes and product design. In contrast, Porter noted a predominance of
people with finance backgrounds leading many U.S. firms. He linked this to U.S. firms’ lack of
attention to improving manufacturing processes and product design. He argued that the dominance of
finance led to an overemphasis on maximizing short-term financial returns. According to Porter, one
consequence of these different management ideologies was a relative loss of U.S. competitiveness in
those engineering-based industries where manufacturing processes and product design issues are all-
important (e.g., the automobile industry).
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How Important Is Education?
Both the Heckscher-Ohlin and Michael Porter theories of trade focus to a large degree on “factor
endowments.” e Heckscher-Ohlin theory specifies endowments such as resources as land, labor, and capital
as being critical, while the Porter theory recognizes hierarchies among these factor endowments. Education-
related endowments such as skilled labor, research facilities, and technological know-how are what Porter calls
“advanced factors.” A long-standing argument across multiple governmental organizations, research studies,
and prominent individuals is that education drives economic, social, and environmental well-being of
countries (i.e., countries adopt sustainability principles the more educated the people in the country are
relative to people in the global marketplace—see Chapter 5). e extension of this argument is that education
helps people become better citizens of a country. But what do you think education does to a customer’s
product needs and wants? Do they want more foreign products if they have more years of education (e.g.,
graduate degree) compared with fewer years of education (e.g., high school)? Or does education not influence
the type of products bought by customers (i.e., foreign-made or home-country made)?
Sources: T. Healy and S. Cote, “e Well-Being of Nations: e Role of Human and Social Capital,” Organisation for Economic
Cooperation and Development (OECD) (2001); S. Samuel, “Importance of Education in a Country’s Progress,” HowToLearn.com,
March 13, 2013; K. Matsui, “e Economic Benefits of Educating Women,” Bloomberg Businessweek, March 7, 2013.
Porter’s second point is that there is a strong association between vigorous domestic rivalry and the
creation and persistence of competitive advantage in an industry. Vigorous domestic rivalry induces
firms to look for ways to improve efficiency, which makes them better international competitors.
Domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in
upgrading advanced factors. All this helps create world-class competitors. Porter cites the case of Japan:
Nowhere is the role of domestic rivalry more evident than in Japan, where it is all-out warfare in
which many companies fail to achieve profitability. With goals that stress market share, Japanese
companies engage in a continuing struggle to outdo each other. Shares fluctuate markedly. e
process is prominently covered in the business press. Elaborate rankings measure which companies
are most popular with university graduates. e rate of new product and process development is
breathtaking.37
EVALUATING PORTER’S THEORY
LO 6-4 Explain the arguments of those who maintain that government can play a proactive role
in promoting national competitive advantage in certain industries.
Porter contends that the degree to which a nation is likely to achieve international success in a certain
industry is a function of the combined impact of factor endowments, domestic demand conditions,
related and supporting industries, and domestic rivalry. He argues that the presence of all four
components is usually required for this diamond to boost competitive performance (although there are
exceptions). Porter also contends that government can influence each of the four components of the
diamond—either positively or negatively. Factor endowments can be affected by subsidies, policies
toward capital markets, policies toward education, and so on. Government can shape domestic
demand through local product standards or with regulations that mandate or influence buyer needs.
Government policy can influence supporting and related industries through regulation and influence
firm rivalry through such devices as capital market regulation, tax policy, and antitrust laws.
If Porter is correct, we would expect his model to predict the pattern of international trade that we
observe in the real world. Countries should be exporting products from those industries where all four
components of the diamond are favorable, while importing in those areas where the components are
not favorable. Is he correct? We simply do not know. Porter’s theory has not been subjected to detailed
empirical testing. Much about the theory rings true, but the same can be said for the new trade theory,
the theory of comparative advantage, and the Heckscher–Ohlin theory. It may be that each of these
theories, which complement each other, explains something about the pattern of international trade.
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Focus on Managerial Implications
LOCATION, FIRST-MOVER ADVANTAGES, AND GOVERNMENT POLICY
LO 6-5 Understand the important implications that international trade theory holds for
management practice.
Why does all this matter for business? ere are at least three main implications for international
businesses of the material discussed in this chapter: location implications, first-mover implications,
and government policy implications.
Location Underlying most of the theories we have discussed is the notion that different countries have particular advantages in different productive activities. us, from a profit perspective, it makes
sense for a firm to disperse its productive activities to those countries where, according to the theory of
international trade, they can be performed most efficiently. If design can be performed most efficiently
in France, that is where design facilities should be located; if the manufacture of basic components can
be performed most efficiently in Singapore, that is where they should be manufactured; and if final
assembly can be performed most efficiently in China, that is where final assembly should be
performed. e result is a global web of productive activities, with different activities being performed
in different locations around the globe depending on considerations of comparative advantage, factor
endowments, and the like. If the firm does not do this, it may find itself at a competitive disadvantage
relative to firms that do.
First-Mover Advantages According to the new trade theory, firms that establish a first-mover advantage with regard to the production of a particular new product may subsequently dominate
global trade in that product. is is particularly true in industries where the global market can
profitably support only a limited number of firms, such as the aerospace market, but early
commitments may also seem to be important in less concentrated industries. For the individual firm,
the clear message is that it pays to invest substantial financial resources in trying to build a first-mover,
or early mover, advantage, even if that means several years of losses before a new venture becomes
profitable. e idea is to preempt the available demand, gain cost advantages related to volume, build
an enduring brand ahead of later competitors, and, consequently, establish a long-term sustainable
competitive advantage. Although the details of how to achieve this are beyond the scope of this book,
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many publications offer strategies for exploiting first-mover advantages and for avoiding the traps
associated with pioneering a market (first-mover disadvantages).38
Government Policy e theories of international trade also matter to international businesses because firms are major players on the international trade scene. Business firms produce exports, and
business firms import the products of other countries. Because of their pivotal role in international
trade, businesses can exert a strong influence on government trade policy, lobbying to promote free
trade or trade restrictions. e theories of international trade claim that promoting free trade is
generally in the best interests of a country, although it may not always be in the best interest of an
individual firm. Many firms recognize this and lobby for open markets.
For example, when the U.S. government announced its intention to place a tariff on Japanese
imports of liquid crystal display (LCD) screens in the 1990s, IBM and Apple Computer protested
strongly. Both IBM and Apple pointed out that (1) Japan was the lowest-cost source of LCD screens;
(2) they used these screens in their own laptop computers; and (3) the proposed tariff, by increasing
the cost of LCD screens, would increase the cost of laptop computers produced by IBM and Apple,
thus making them less competitive in the world market. In other words, the tariff, designed to protect
U.S. firms, would be self-defeating. In response to these pressures, the U.S. government reversed its
posture.
Unlike IBM and Apple, however, businesses do not always lobby for free trade. In the United
States, for example, restrictions on imports of steel have periodically been put into place in response to
direct pressure by U.S. firms on the government (the latest example being in March 2018 when the
Trump administration placed a 25 percent tariff on imports of foreign steel). In some cases, the
government has responded to pressure from domestic companies seeking protection by getting foreign
companies to agree to “voluntary” restrictions on their imports, using the implicit threat of more
comprehensive formal trade barriers to get them to adhere to these agreements (historically, this has
occurred in the automobile industry). In other cases, the government used what are called
“antidumping” actions to justify tariffs on imports from other nations (these mechanisms will be
discussed in detail in Chapter 7).
As predicted by international trade theory, many of these agreements have been self-defeating, such
as the voluntary restriction on machine tool imports agreed to in 1985. Shielded from international
competition by import barriers, the U.S. machine tool industry had no incentive to increase its
efficiency. Consequently, it lost many of its export markets to more efficient foreign competitors.
Because of this misguided action, the U.S. machine tool industry shrunk during the period when the
agreement was in force. For anyone schooled in international trade theory, this was not surprising.39
Finally, Porter’s theory of national competitive advantage also contains policy implications. Porter’s
theory suggests that it is in the best interest of business for a firm to invest in upgrading advanced
factors of production (for example, to invest in better training for its employees) and to increase its
commitment to research and development. It is also in the best interests of business to lobby the
government to adopt policies that have a favorable impact on each component of the national
diamond. us, according to Porter, businesses should urge government to increase investment in
education, infrastructure, and basic research (because all these enhance advanced factors) and to adopt
policies that promote strong competition within domestic markets (because this makes firms stronger
international competitors, according to Porter’s findings).
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Key Terms
free trade, p. 153
new trade theory, p. 155
mercantilism, p. 155
zero-sum game, p. 156
absolute advantage, p. 157
constant returns to specialization, p. 162
factor endowments, p. 166
economies of scale, p. 168
first-mover advantages, p. 169
balance-of-payments accounts, p. 179
current account, p. 180
current account deficit, p. 180
current account surplus, p. 180
capital account, p. 180
financial account, p. 180
Summary
is chapter reviewed a number of theories that explain why it is beneficial for a country to engage in
international trade and explained the pattern of international trade observed in the world economy.
e theories of Smith, Ricardo, and Heckscher–Ohlin all make strong cases for unrestricted free trade.
In contrast, the mercantilist doctrine and, to a lesser extent, the new trade theory can be interpreted to
support government intervention to promote exports through subsidies and to limit imports through
tariffs and quotas.
In explaining the pattern of international trade, this chapter shows that, with the exception of
mercantilism, which is silent on this issue, the different theories offer largely complementary
explanations. Although no one theory may explain the apparent pattern of international trade, taken
together, the theory of comparative advantage, the Heckscher–Ohlin theory, the product life-cycle
theory, the new trade theory, and Porter’s theory of national competitive advantage do suggest which
factors are important. Comparative advantage tells us that productivity differences are important;
Heckscher–Ohlin tells us that factor endowments matter; the product life-cycle theory tells us that
where a new product is introduced is important; the new trade theory tells us that increasing returns
to specialization and first-mover advantages matter; Porter tells us that all these factors may be
important insofar as they affect the four components of the national diamond. e chapter made the
following points:
1. Mercantilists argued that it was in a country’s best interests to run a balance-of-trade surplus.
ey viewed trade as a zero-sum game, in which one country’s gains cause losses for other
countries.
2. e theory of absolute advantage suggests that countries differ in their ability to produce goods
efficiently. e theory suggests that a country should specialize in producing goods in areas
where it has an absolute advantage and import goods in areas where other countries have
absolute advantages.
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3. e theory of comparative advantage suggests that it makes sense for a country to specialize in
producing those goods that it can produce most efficiently, while buying goods that it can
produce relatively less efficiently from other countries—even if that means buying goods from
other countries that it could produce more efficiently itself.
4. e theory of comparative advantage suggests that unrestricted free trade brings about increased
world production—that is, that trade is a positive-sum game.
5. e theory of comparative advantage also suggests that opening a country to free trade
stimulates economic growth, which creates dynamic gains from trade. e empirical evidence
seems to be consistent with this claim.
6. e Heckscher–Ohlin theory argues that the pattern of international trade is determined by
differences in factor endowments. It predicts that countries will export those goods that make
intensive use of locally abundant factors and will import goods that make intensive use of factors
that are locally scarce.
7. e product life-cycle theory suggests that trade patterns are influenced by where a new product
is introduced. In an increasingly integrated global economy, the product life-cycle theory seems
to be less predictive than it once was.
8. New trade theory states that trade allows a nation to specialize in the production of certain
goods, attaining scale economies and lowering the costs of producing those goods, while buying
goods that it does not produce from other nations that are similarly specialized. By this
mechanism, the variety of goods available to consumers in each nation is increased, while the
average costs of those goods should fall.
9. New trade theory also states that in those industries where substantial economies of scale
imply that the world market will profitably support only a few firms, countries may
predominate in the export of certain products simply because they had a firm that was a first
mover in that industry.
10. Some new trade theorists have promoted the idea of strategic trade policy. e argument is that
government, by the sophisticated and judicious use of subsidies, might be able to increase the
chances of domestic firms becoming first movers in newly emerging industries.
11. Porter’s theory of national competitive advantage suggests that the pattern of trade is influenced
by four attributes of a nation: (a) factor endowments, (b) domestic demand conditions, (c)
related and supporting industries, and (d) firm strategy, structure, and rivalry.
12. eories of international trade are important to an individual business firm primarily because
they can help the firm decide where to locate its various production activities.
13. Firms involved in international trade can and do exert a strong influence on government policy
toward trade. By lobbying government, business firms can promote free trade or trade
restrictions.
Critical inking and Discussion Questions
1. Mercantilism is a bankrupt theory that has no place in the modern world. Discuss.
2. Is free trade fair? Discuss.
3. Unions in developed nations often oppose imports from low-wage countries and advocate trade
barriers to protect jobs from what they often characterize as “unfair” import competition. Is such
competition “unfair”? Do you think that this argument is in the best interests of (a) the unions,
(b) the people they represent, and/or (c) the country as a whole?
4. What are the potential costs of adopting a free trade regime? Do you think governments should
do anything to reduce these costs? Why?
5. Reread the Country Focus “Is China Manipulating Its Currency in Pursuit of a Neo-
Mercantilist Policy?”
a. Do you think China is pursuing a currency policy that can be characterized as neo-
mercantilist?
b. What should the United States, and other countries, do about this?
6. Reread the Country Focus “Moving U.S. White-Collar Jobs Offshore.”
a. Who benefits from the outsourcing of skilled white-collar jobs to developing nations? Who
are the losers?
b. Will developed nations like the United States suffer from the loss of high-skilled and high-
paying jobs?
c. Is there a difference between the transference of high-paying white-collar jobs, such as
computer programming and accounting, to developing nations, and low-paying blue-collar
jobs? If so, what is the difference, and should government do anything to stop the flow of
white-collar jobs out of the country to countries such as India?
7. Drawing upon the new trade theory and Porter’s theory of national competitive advantage,
outline the case for government policies that would build national competitive advantage in
biotechnology. What kinds of policies would you recommend that the government adopt? Are
these policies at variance with the basic free trade philosophy?
8. e world’s poorest countries are at a competitive disadvantage in every sector of their
economies. ey have little to export; they have no capital; their land is of poor quality; they
often have too many people given available work opportunities; and they are poorly educated.
Free trade cannot possibly be in the interests of such nations. Discuss.
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. e World Trade Organization International Trade Statistics is an annual report that provides
comprehensive, comparable, and updated statistics on trade in merchandise and commercial
services. e report allows an assessment of world trade flows by country, region, and main
product or service categories. Using the most recent statistics available, identify the top 10
countries that lead in the export and import of merchandise trade, respectively. Which countries
appear in the top 10 in both exports and imports? Can you explain why these countries appear
at the top of both lists?
2. Food is an integral part of understanding different countries, cultures, and lifestyles. You run a
chain of high-end premium restaurants in the United States, and you are looking for unique
Australian wines you can import. However, you must first identify which Australian suppliers can
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provide you with premium wines. After searching through the Australian supplier directory,
identify three to four companies that can be potential suppliers. en develop a list of criteria
you would need to ask these companies about to select which one to work with.
T h e Tr a n s P a c i f i c P a r t n e r s h i p ( T P P ) I s D e a d ; L o n g L i v e t h e C P T P P !
c l o s i n g c a s e
On February 4, 2016, ministers from 12 governments signed off on the Trans Pacific Partnership (TPP), a free
trade deal among 12 countries, including the United States, Japan, Australia, New Zealand, Chile, Canada,
Mexico, and Vietnam. China was not part of the deal. Together, these countries accounted for 36 percent of
the world’s GDP and 26 percent of world trade. In the United States, critics of the deal were quick to register
their opposition. Donald Trump, now president of the United States, said that the “TPP is a terrible deal.”
Bernie Sanders, one of the leading Democratic contenders, called it “disastrous” and “a victory for Wall Street
and other big corporations.” Many other politicians, wary of the fact that 2016 was a general
election year in the United States, were also quick to criticize the deal. In contrast, the
administration of Barack Obama heralded the TPP as a historic deal of major importance. Editorials in
influential publications such as e Wall Street Journal and e Economist urged the U.S. Congress to ratify the
deal.
e TPP planned to eliminate or reduce about 18,000 tariffs, taxes, and nontariff barriers such as quotas
on trade between and among the member countries. By expanding market access and lowering prices for
consumers, economists claimed that the deal would boost economic growth rates among TPP countries and
add about $285 billion to global GDP by 2025. Because the United States already has very low tariff barriers,
most of the tariff reductions would occur in other countries.
U.S. agriculture would have been a big beneficiary. e TPP would eliminate import tariffs as high as 40
percent on U.S. poultry products and fruit and 35 percent on soybeans—all products where the United States
has a comparative advantage in production. Cargill Inc., a giant U.S. grain exporter and meat producer, urged
lawmakers to support the pact. A number of large, efficient U.S. manufacturers also came out in support of
the deal, which would eliminate import tariffs as high as 59 percent on U.S. machinery exports to TPP
countries. Boeing, the country’s largest exporter, said that the deal would help it compete overseas, where it
gets 70 percent of its revenue. Several technology companies, including Intel, voiced support for the deal,
pointing out that it would eliminate import taxes as high as 35 percent on the sale of information and
communication technology to some other TPP countries.
Some U.S. companies urged Congress to vote against the deal. Ford opposed the deal because it would
phase out a 2.5 percent tariff on imports of Japanese cars into the United States and a 25 percent tariff on
imports of light trucks—even though under the agreement, those tariffs would be phased down over 30 years.
Labor unions opposed the deal, arguing that it would result in further losses of U.S. manufacturing jobs and
lead to lower wages. e tobacco company Philip Morris opposed the deal because it would prevent tobacco
companies from suing foreign governments over antismoking measures that restrict tobacco companies from
using their logos and brands to market tobacco products. Several big drug companies also opposed the deal
because it only protected new biotechnology products from generic competition for 5 years, rather than the
12 years they had before.
Data supporting these various claims and counterclaims was offered by a number of independent studies,
including those from the World Bank, the Institute of International Economics (IIE), and Tufts University.
Both the World Bank and the IIE concluded that by creating more overseas demand for American goods and
services, by 2030 the TPP would raise U.S. wages slightly above what they would have been without the deal.
e IIE study estimated that the TPP would increase annual U.S. exports by $357 billion, or 9 percent, by
2030. e IIE study also calculated that overall, there would be no job losses in the United States. Although
some sectors would see job losses, the IIE suggested that these would be offset by job gains elsewhere. e
study from Tufts University was the most pessimistic, estimating that the deal would result in the loss of
450,000 jobs in the United States over 10 years. To put this in context, between 2010 and 2015, the U.S.
economy created 13 million new jobs, so the worst-case estimate of losses amounted to no more than two
months of job growth during the 2010–2015 period.
Just three days into his administration, President Donald Trump withdrew the United States from the TPP,
calling it a “ridiculous trade deal.” Many predicted that without the United States, the deal would quickly
collapse—but that did not happen. Instead, led by Japan, the remaining 11 nations pressed ahead with a
revamped deal. Renamed the Comprehensive and Progressive Trans Pacific Partnership (CPTPP)—or TPP for
short—the deal signed in Chile on March 8, 2018, will dramatically lower tariffs and other trade barriers
between the 11 nations. e revised agreement, which still excludes China, covers 500 million people in
nations that produce more than 13 percent of global gross domestic product. According to David Parker, New
Zealand’s Trade Minister:
©Fiona Goodall/Getty Images
I think this agreement serves as an antidote to the protectionist trend we’re seeing in the world. I think
the CPTPP is more important than it was a year ago. is rise of protectionism is worrisome. . . .
Countries that are in the agreement have got a different route where they can club together in a friendly
manner, and facilitate the growth of their own economies for the benefit of their people.
Although the United States is no longer party to this deal, several leaders of the signatory nations have
indicated that they would welcome the U.S. back into the fold, although this seems unlikely to happen so
long as Donald Trump is president. ere are also indications that a post-Brexit Britain might seek to join the
CPTPP.
Sources: Caitlin McGee, “Controversial TPP Pact Signed amid New Zealand Protests,” Aljazeera, February 4, 2016; Catherine Ho,
“Fact Checking the Campaigns for and against the TPP Trade Deal,” Washington Post, February 11, 2016; Tripp Mickle and eo
Francis, “Trade Pact Sealed,” e Wall Street Journal, October 6, 2015; Peter Petri, and Michael Plummer, “e Economic Effects of
the Trans Pacific Partnership: New Estimates,” Peterson Institute for International Economics, working paper 16-2, January 1,
2016; “China Picks Up the U.S. Trade Fumble,” e Wall Street Journal, November 17, 2016; “e New TPP Trade Deal: Going
Ahead without Trump,” Aljazeera News, March 24, 2018; and “Japan Approves Bill to Ratify Successor to TPP Free Trade
Pact,” Japan Times, March 24, 2018.
CASE DISCUSSION QUESTIONS
1. What were the proposed benefits of the TPP?
2. What were the potential drawbacks of the U.S. entering the TPP? What would be the
drawbacks to other nations?
3. Why do you think that Donald Trump was so adamantly opposed to the TPP?
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4. Why do you think the 11 remaining signatories went ahead with a revised deal after the
United States withdrew?
5. Is the CPTTP a threat to American economic interests?
6. What is the opportunity cost to the United States of withdrawing from the TPP?
appendix
International Trade and the Balance of Payments International trade involves the sale of goods and services to residents in other countries (exports) and
the purchase of goods and services from residents in other countries (imports). A country’s balance-
of-payments accounts keep track of the payments to and receipts from other countries for a particular
time period. ese include payments to foreigners for imports of goods and services, and receipts from
foreigners for goods and services exported to them. A summary copy of the U.S. balance-of-payments
accounts for 2017 is given in Table A.1. In this appendix, we briefly describe the form of the balance-
of-payments accounts, and we discuss whether a current account deficit, often a cause of much
concern in the popular press, is something to worry about.
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A.1 TABLE
U.S. Balance-of-Payments Accounts, 2017
BALANCE-OF-PAYMENTS ACCOUNTS
Balance-of-payments accounts are divided into three main sections: the current account, the capital
account, and the financial account (to confuse matters, what is now called the capital account until
recently was part of the current account, and the financial account used to be called the capital
account). e current account records transactions that pertain to four categories, all of which can be
seen in Table A.1. e first category, goods, refers to the export or import of physical goods (e.g.,
agricultural foodstuffs, autos, computers, chemicals). e second category is the export or import of
services (e.g., intangible products such as banking and insurance services, royalty payments on
intellectual property, and earnings from foreign tourists who visit the U.S.). e third category,
primary income receipts or payments, refers to income from foreign investments or payments to
foreign investors (e.g., interest and dividend receipts or payments). e third category also includes
payments that foreigners have made to U.S. residents for work performed outside the United States
and payments that U.S. entities make to foreign residents. e fourth category, secondary income
receipts or payments, refers to the transfer of a good, service, or asset to the U.S. government or U.S.
private entities, or the transfer to a foreign government or entity in the case of payments (this includes
tax payments, foreign pension payments, cash transfers, etc.).
A current account deficit occurs when a country imports more goods, services, and income than it
exports. A current account surplus occurs when a country exports more goods, services, and income
than it imports. Table A.1 shows that in 2017 the United States ran a current account deficit of
$466.25 billion. is is often a headline-grabbing figure and is widely reported in the news media.
e U.S. current account deficit reflects the fact that America imports far more physical goods than it
exports. (e United States typically runs a surplus on trade in services and on income payments.)
e 2006 current account deficit of $803 billion was the largest on record and was equivalent to
about 6.5 percent of the country’s GDP. e deficit has shrunk since then. e 2017 current account
deficit represented just 2.4 percent of GDP. Many people find the fact that the United States runs a
persistent deficit on its current account to be disturbing, the common assumption being that high
import of goods displaces domestic production, causes unemployment, and reduces the growth of the
U.S. economy. However, the issue is more complex than this. Fully understanding the implications of
a large and persistent deficit requires that we look at the rest of the balance-of-payments accounts.
e capital account records one-time changes in the stock of assets. As noted earlier, until recently
this item was included in the current account. e capital account includes capital transfers, such as
debt forgiveness and migrants’ transfers (the goods and financial assets that accompany migrants as
they enter or leave the country). In the big scheme of things, this is a relatively small figure amounting
to $24.8 billion in 2017.
e financial account (formerly the capital account) records transactions that involve the purchase
or sale of assets. us, when a German firm purchases stock in a U.S. company or buys a U.S. bond,
the transaction enters the U.S. balance of payments as a credit on the financial account. is is because
capital is flowing into the country. When capital flows out of the United States, it enters the financial
account as a debit.
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e financial account is comprised of a number of elements. e net U.S. acquisition of financial
assets includes the change in foreign assets owned by the U.S. government (e.g., U.S. official reserve
assets) and the change in foreign assets owned by private individuals and corporations (including
changes in assets owned through foreign direct investment). As can be seen from Table A.1, in 2017
there was a $1.212 trillion increase in U.S. ownership of foreign assets, which tells us that the U.S.
government and U.S. private entities were purchasing more foreign assets than they were selling. e
net U.S. incurrence of liabilities refers to the change in U.S. assets owned by foreigners. In 2017
foreigners increased their holdings of U.S. assets by $1.587 trillion, signifying that foreigners were net
acquirers of U.S. stocks, bonds (including Treasury bills), and physical assets such as real estate.
A basic principle of balance-of-payments accounting is double-entry bookkeeping. Every
international transaction automatically enters the balance of payments twice—once as a credit and
once as a debit. Imagine that you purchase a car produced in Japan by Toyota for $20,000.
Because your purchase represents a payment to another country for goods, it will enter the balance
of payments as a debit on the current account. Toyota now has the $20,000 and must do
something with it. If Toyota deposits the money at a U.S. bank, Toyota has purchased a
U.S. asset—a bank deposit worth $20,000—and the transaction will show up as a $20,000 credit on
the financial account. Or Toyota might deposit the cash in a Japanese bank in return for Japanese yen.
Now the Japanese bank must decide what to do with the $20,000. Any action that it takes will
ultimately result in a credit for the U.S. balance of payments. For example, if the bank lends the
$20,000 to a Japanese firm that uses it to import personal computers from the United States, then the
$20,000 must be credited to the U.S. balance-of-payments current account. Or the Japanese bank
might use the $20,000 to purchase U.S. government bonds, in which case it will show up as a credit
on the U.S. balance-of-payments financial account.
us, any international transaction automatically gives rise to two offsetting entries in the balance
of payments. Because of this, the sum of the current account balance, the capital account, and the
financial account balance should always add up to zero. In practice, this does not always occur due to
the existence of “statistical discrepancies,” the source of which need not concern us here (note that in
2017, the statistical discrepancy amounted to $92.2 billion).
DOES THE CURRENT ACCOUNT DEFICIT MATTER?
As discussed earlier, there is some concern when a country is running a deficit on the current account
of its balance of payments.40 In recent years, a number of rich countries, including most notably the
United States, have run persistent current account deficits. When a country runs a current account
deficit, the money that flows to other countries can then be used by those countries to purchase assets
in the deficit country. us, when the United States runs a trade deficit with China, the Chinese use
the money that they receive from U.S. consumers to purchase U.S. assets such as stocks, bonds, and
the like. Put another way, a deficit on the current account is financed by selling assets to other
countries—that is, by increasing liabilities on the financial account. us, the persistent U.S. current
account deficit is being financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole
corporations) to other countries. In short, countries that run current account deficits become net
debtors.
For example, as a result of financing its current account deficit through asset sales, the United States
must deliver a stream of interest payments to foreign bondholders, rents to foreign landowners, and
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dividends to foreign stockholders. One might argue that such payments to foreigners drain resources
from a country and limit the funds available for investment within the country. Because investment
within a country is necessary to stimulate economic growth, a persistent current account deficit can
choke off a country’s future economic growth. is is the basis of the argument that persistent deficits
are bad for an economy. However, things are not this simple. For one thing, in an era of global capital
markets, money is efficiently directed toward its highest value uses, and over the past quarter of a
century, many of the highest value uses of capital have been in the United States. So even though
capital is flowing out of the United States in the form of payments to foreigners, much of that capital
finds its way right back into the country to fund productive investments in the United States. In short,
it is not clear that the current account deficit chokes off U.S. economic growth. In fact,
notwithstanding the 2008–2009 recession, the U.S. economy has grown substantially over the past 30
years, despite running a persistent current account deficit and despite financing that deficit by selling
U.S. assets to foreigners. is is precisely because foreigners reinvest much of the income earned from
U.S. assets and from exports to the United States right back into the United States. is revisionist
view, which has gained in popularity in recent years, suggests that a persistent current account deficit
might not be the drag on economic growth it was once thought to be.41
Having said this, there is still a nagging fear that at some point, the appetite that foreigners have for
U.S. assets might decline. If foreigners suddenly reduced their investments in the United States, what
would happen? In short, instead of reinvesting the dollars that they earn from exports and investment
in the United States back into the country, they would sell those dollars for another currency,
European euros, Japanese yen, or Chinese yuan, for example, and invest in euro-, yen-, and yuan-
denominated assets instead. is would lead to a fall in the value of the dollar on foreign exchange
markets, and that in turn would increase the price of imports and lower the price of U.S. exports,
making them more competitive, which should reduce the overall level of the current account deficit.
us, in the long run, the persistent U.S. current account deficit could be corrected via a reduction in
the value of the U.S. dollar. e concern is that such adjustments may not be smooth.
Rather than a controlled decline in the value of the dollar, the dollar might suddenly lose a
significant amount of its value in a very short time, precipitating a “dollar crisis.”42 Because the U.S.
dollar is the world’s major reserve currency and is held by many foreign governments and banks, any
dollar crisis could deliver a body blow to the world economy and at the very least trigger a global
economic slowdown. at would not be a good thing.
Endnotes
1. H.W. Spiegel, e Growth of Economic ought (Durham, NC: Duke University Press, 1991).
2. Binyamin Applebaum, “On Trade, Donald Trump Breaks with 200 Years of Economic
Orthodoxy,” e New York Times, March 10, 2016.
3. M. Solis, “e Politics of Self-Restraint: FDI Subsidies and Japanese Mercantilism,” e World
Economy 26 (February 2003), pp. 153–70; Kevin Hamlin, “China Is a Growing reat to
Global Competitors, Kroeber Says,” Bloomberg News, June 28, 2016.
4. S. Hollander, e Economics of David Ricardo (Buffalo: University of Toronto Press, 1979).
5. D. Ricardo, e Principles of Political Economy and Taxation (Homewood, IL: Irwin, 1967, first
published in 1817).
6. For example, R. Dornbusch, S. Fischer, and P. Samuelson, “Comparative Advantage: Trade and
Payments in a Ricardian Model with a Continuum of Goods,” American Economic Review 67
(December 1977), pp. 823–39.
7. B. Balassa, “An Empirical Demonstration of Classic Comparative Cost eory,” Review of
Economics and Statistics, 1963, pp. 231–38.
8. See P. R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1 (Fall 1987), pp.
131–44.
9. P. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream
Economists Supporting Globalization,” Journal of Economic Perspectives 18, no. 3 (Summer
2004), pp. 135–46.
10. P. Samuelson, “e Gains from International Trade Once Again,” Economic Journal 72 (1962),
pp. 820–29.
11. S. Lohr, “An Elder Challenges Outsourcing’s Orthodoxy,” e New York Times, September 9,
2004, p. C1.
12. P. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream
Economists Supporting Globalization,” Journal of Economic Perspectives 18, no. 3 (Summer
2004), p. 143.
13. D. H. Autor, D. Dorn, and Gordon H. Hanson, “e China Syndrome: Local Labor Market
Effects of Import Competition in the United States,” American Economic Review 103, no. 6
(October 2013).
14. See A. Dixit and G. Grossman, “Samuelson Says Nothing about Trade Policy,” Princeton
University, 2004, accessed from
http://depts.washington.edu/teclass/inkEcon/readings/Kalles/Dixit%20and%20Grossman%2
0on%20Samuelson.pdf.
15. J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” e Wall Street Journal,
January 18, 2012, p. B1.
16. For example, J. D. Sachs and A. Warner, “Economic Reform and the Process of Global
Integration,” Brookings Papers on Economic Activity, 1995, pp. 1–96; J. A. Frankel and D.
Romer, “Does Trade Cause Growth?” American Economic Review 89, no. 3 (June 1999), pp.
379–99; D. Dollar and A. Kraay, “Trade, Growth and Poverty,” working paper, Development
Research Group, World Bank, June 2001. Also, for an accessible discussion of the relationship
between free trade and economic growth, see T. Taylor, “e Truth about Globalization,” Public
Interest, Spring 2002, pp. 24–44; D. Acemoglu, S. Johnson, and J. Robinson, “e Rise of
Europe: Atlantic Trade, Institutional Change and Economic Growth,” American Economic
Review 95, no. 3 (2005), pp. 547–79; T. Singh, “Does International Trade Cause Economic
Growth?” e World Economy 33, no. 11 (2010), pp. 1517–64.
17. Sachs and Warner, “Economic Reform and the Process of Global Integration.”
18. Sachs and Warner, “Economic Reform and the Process of Global Integration,” pp. 35–36.
19. R. Wacziarg and K. H. Welch, “Trade Liberalization and Growth: New Evidence,” World Bank
Economic Review 22, no. 2 (June 2008).
20. T. Singh, “Does International Trade Cause Economic Growth?” e World Economy 33, no. 11
(November 2010), pp. 1517–64.
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21. J. A. Frankel and D. H. Romer, “Does Trade Cause Growth?” American Economic Review 89,
no. 3 (June 1999), pp. 370–99.
22. A recent skeptical review of the empirical work on the relationship between trade and growth
questions these results. See F. Rodriguez and D. Rodrik, “Trade Policy and Economic Growth: A
Skeptic’s Guide to the Cross-National Evidence,” National Bureau of Economic Research Working
Paper Series, working paper no. 7081 (April 1999). Even these authors, however, cannot find any
evidence that trade hurts economic growth or income levels.
23. B. Ohlin, Interregional and International Trade (Cambridge, MA: Harvard University Press,
1933). For a summary, see R. W. Jones and J. P. Neary, “e Positive eory of International
Trade,” in Handbook of International Economics, R. W. Jones and P. B. Kenen, eds. (Amsterdam:
North Holland, 1984).
24. W. Leontief, “Domestic Production and Foreign Trade: e American Capital Position Re-
examined,” Proceedings of the American Philosophical Society 97 (1953), pp. 331–49.
25. R. M. Stern and K. Maskus, “Determinants of the Structure of U.S. Foreign Trade,” Journal of
International Economics 11 (1981), pp. 207–44.
26. See H. P. Bowen, E. E. Leamer, and L. Sveikayskas, “Multicountry, Multifactor Tests of the
Factor Abundance eory,” American Economic Review 77 (1987), pp. 791–809.
27. D. Trefler, “e Case of the Missing Trade and Other Mysteries,” American Economic
Review 85 (December 1995), pp. 1029–46.
28. D. R. Davis and D. E. Weinstein, “An Account of Global Factor Trade,” American Economic
Review 91, no. 5 (December 2001), pp. 1423–52.
29. R. Vernon, “International Investments and International Trade in the Product Life Cycle,”
Quarterly Journal of Economics, May 1966, pp. 190–207; R. Vernon and L. T. Wells, e
Economic Environment of International Business, 4th ed. (Englewood Cliffs, NJ: Prentice Hall,
1986).
30. For a good summary of this literature, see E. Helpman and P. Krugman, Market Structure and
Foreign Trade: Increasing Returns, Imperfect Competition, and the International Economy (Boston:
MIT Press, 1985). Also see P. Krugman, “Does the New Trade eory Require a New Trade
Policy?” World Economy 15, no. 4 (1992), pp. 423–41.
31. M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,” Strategic Management
Journal 9 (Summer 1988), pp. 41–58; W. T. Robinson and Sungwook Min, “Is the First to
Market the First to Fail?” Journal of Marketing Research 29 (2002), pp. 120–28.
32. J. R. Tybout, “Plant and Firm Level Evidence on New Trade eories,” National Bureau of
Economic Research Working Paper Series, working paper no. 8418 (August 2001), www.nber.org;
S. Deraniyagala and B. Fine, “New Trade eory versus Old Trade Policy: A Continuing
Enigma,” Cambridge Journal of Economics 25 (November 2001), pp. 809–25.
33. A. D. Chandler, Scale and Scope (New York: Free Press, 1990).
34. Krugman, “Does the New Trade eory Require a New Trade Policy?”
35. M. E. Porter, e Competitive Advantage of Nations (New York: Free Press, 1990). For a good
review of this book, see R. M. Grant, “Porter’s Competitive Advantage of Nations: An
Assessment,” Strategic Management Journal 12 (1991), pp. 535–48.
36. B. Kogut, ed., Country Competitiveness: Technology and the Organizing of Work (New York:
Oxford University Press, 1993).
37. Porter, e Competitive Advantage of Nations, p. 121.
38. Lieberman and Montgomery, “First-Mover Advantages.” See also Robinson and Min, “Is the
First to Market the First to Fail?”; W. Boulding and M. Christen, “First-Mover Disadvantage,”
Harvard Business Review, October 2001, pp. 20–21; R. Agarwal and M. Gort, “First-Mover
Advantage and the Speed of Competitive Entry,” Journal of Law and Economics 44 (2001), pp.
131–59.
39. C. A. Hamilton, “Building Better Machine Tools,” Journal of Commerce, October 30, 1991, p.
8; “Manufacturing Trouble,” e Economist, October 12, 1991, p. 71.
40. P. Krugman, e Age of Diminished Expectations (Cambridge, MA: MIT Press, 1990); J.
Bernstein and Dean Baker, “Why Trade Deficits Matter,” e Atlantic, December 8, 2016.
41. D. Griswold, “Are Trade Deficits a Drag on U.S. Economic Growth?” Free Trade Bulletin,
March 12, 2007; O. Blanchard, “Current Account Deficits in Rich Countries,” National Bureau
of Economic Research Working Paper Series, working paper no. 12925, February 2007.
42. S. Edwards, “e U.S. Current Account Deficit: Gradual Correction or Abrupt Adjustment?”
National Bureau of Economic Research Working Paper Series, working paper no. 12154, April
2006.
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Hill Education
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Part 3 e Global Trade and Investment Environment
Government Policy and International Trade
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO7-1 Identify the policy instruments used by governments to influence international trade flows.
LO7-2 Understand why governments sometimes intervene in international trade.
LO7-3 Summarize and explain the arguments against strategic trade policy.
LO7-4 Describe the development of the world trading system and the current trade issue.
LO7-5 Explain the implications for managers of developments in the world trading system.
U.S. and South Korea Strike a Revised Trade Deal
opening case
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In 2012, a free trade deal between the United States and South Korea went into effect. In 2016, the United
States exported $63.8 billion in goods and services to South Korea, and imported $80.8 billion, resulting in a
trade deficit of $17 billion. During the U.S. election campaign in 2016, Donald Trump, who became
President in 2017, called the deal “horrible” and a “job killer.”
Given Trump’s hostility to the free trade deal, it was no surprise when in January 2018, the U.S.
announced that it was entering into negotiations with South Korea to revise the terms of the agreement.
Complicating matters were two factors. First, in early March 2018, the Trump administration placed a 25
percent tariff on imports of steel. As the third largest supplier of foreign steel to the United States, these tariffs
threatened to harm the South Korean steel industry. Moreover, the global tariffs were technically in violation
of the World Trade Organization treaty, to which both the United States and South Korea were
signatories. Second, South Korea is an important U.S. ally. e country’s support was crucial in putting
pressure on North Korea to halt its nuclear weapons program. Given this, many observers wondered why the
Trump Administration was pressuring South Korea at a time when it needed to work together with the nation
to keep North Korea in check.
Perhaps because of geopolitical considerations, the negotiations proceeded very quickly. Trade in
automobiles was central to the negotiations, since the Trump Administration saw that as a primary cause of
the trade deficit. In 2017, the United States imported nearly $16 billion worth of South Korean passenger
cars, but exported only $1.5 billion worth to South Korea. It should also be noted that significant automobile
production in the U.S. is concentrated in swing states such as Michigan and Ohio, which helped elect Trump
to the presidency.
In late March, the two countries announced that they had reached a revised deal. Under the terms of this
deal, South Korea would be exempt from the 25 percent tariff on steel imports into the United States. Instead,
South Korea agreed to a quota which would limit its steel exports to the U.S. to about 70 percent of what
they had been in 2017.
In return, South Korea made two concessions. First, the deal extended for 20 years a 25 percent tariff on
exports of South Korean light trucks to the United States (under the original agreement, the 25 percent tariff
was set to expire in 2021). is will likely be a significant boon to U.S. auto manufactures, since the light
truck segment is one that they dominate. Second, the Koreans agreed to lift their annual quota on imports of
U.S. cars into the country from 25,000 per manufacturer to 50,000 per manufacturer. Beyond that, U.S. cars
sold in South Korea would have to adhere to Korea’s stringent safety and environmental standards, which the
Trump Administration has characterized as “burdensome regulations” designed to make it difficult
for U.S. companies to sell vehicles in Korea. at being said, the reality is that U.S. auto companies
were not even close to reaching the old quota limit of 25,000 cars a year, so lifting the cap may be primarily
symbolic.
e deal will also establish a side agreement between the United States and South Korea that is intended to
deter “competitive devaluation” of both countries’ currencies—which can artificially lower the cost of imports
bought by consumers—and to create more transparency on issues of monetary policy. Administration officials
suggested that this new type of arrangement was likely to be replicated in other trade deals, though they
acknowledged that it was not enforceable.
e deal allows President Trump to claim that his “get tough” approach to trade negotiations works. For
their part, the South Koreans were reportedly pleased that they didn’t have to give ground on opening up their
agricultural industry to U.S. imports, where administrative tariff barriers have limited importation of some
low-priced American foodstuffs such as rice and potatoes. •
Sources: Michael Shear and Alan Rappeport, “Trump Secures Trade Deal with South Korea Ahead of Nuclear Talks,” e New York
Times, March 27, 2018; Scott Horsley, “Trump Administration Strikes Trade Deal with South Korea,” NPR Politics, March 27,
2018; Patrick Gillespie, “New US Deal with South Korea: What You Need to Know,” CNN Money, March 28, 2018.
Introduction
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e review of the classical trade theories of Smith, Ricardo, and Heckscher–Ohlin in Chapter 6
showed that in a world without trade barriers, trade patterns are determined by the relative
productivity of different factors of production in different countries. Countries will specialize in
products they can make most efficiently, while importing products they can produce less efficiently.
Chapter 6 also laid out the intellectual case for free trade. Remember, free trade refers to a situation in
which a government does not attempt to restrict what its citizens can buy from or sell to another
country. As we saw in Chapter 6, the theories of Smith, Ricardo, and Heckscher–Ohlin predict that
the consequences of free trade include both static economic gains (because free trade supports a higher
level of domestic consumption and more efficient utilization of resources) and dynamic economic
gains (because free trade stimulates economic growth and the creation of wealth).
is chapter looks at the political reality of international trade. Although many nations are
nominally committed to free trade, they tend to intervene in international trade to protect the
interests of politically important groups or promote the interests of key domestic producers. For
example, the opening case suggests that the United States renegotiated a free trade deal with South
Korea in order to protect the interests of U.S. automobile companies, particularly in the profitable
light truck segment where Korean imports will face a 25 percent tariff for another 20 years (the tariff
was set to expire in 2021). is chapter explores the political and economic reasons that governments
have for intervening in international trade. When governments intervene, they often do so by
restricting imports of goods and services into their nation while adopting policies that promote
domestic production and exports (one could argue that this was the case with the South Korean trade
deal). Normally, their motives are to protect domestic producers (in this case, U.S. steel and auto
producers). In recent years, social issues have also intruded into the decision-making calculus. In the
United States, for example, a movement is growing to ban imports of goods from countries that do
not abide by the same labor, health, and environmental regulations as the United States.
is chapter starts by describing the range of policy instruments that governments use to intervene
in international trade. A detailed review of governments’ various political and economic motives for
intervention follows. In the third section of this chapter, we consider how the case for free trade stands
up in view of the various justifications given for government intervention in international trade. en
we look at the emergence of the modern international trading system, which is based on the General
Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization. e
GATT and WTO are the creations of a series of multinational treaties. e final section of this chapter
discusses the implications of this material for management practice.
Instruments of Trade Policy
LO 7-1 Identify the policy instruments used by governments to influence international trade
flows.
Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary export restraints,
local content requirements, administrative policies, and antidumping duties. Tariffs are the oldest and
simplest instrument of trade policy. As we shall see later in this chapter, they are also the instrument
that the GATT and WTO have been most successful in limiting. A fall in tariff barriers in recent
decades has been accompanied by a rise in nontariff barriers, such as subsidies, quotas, voluntary
export restraints, and antidumping duties.
TARIFFS
A tariff is a tax levied on imports (or exports). Tariffs fall into two categories. Specific tariffs are levied
as a fixed charge for each unit of a good imported (e.g., $3 per barrel of oil). Ad valorem tariffs are
levied as a proportion of the value of the imported good. In most cases, tariffs are placed on imports to
protect domestic producers from foreign competition by raising the price of imported goods.
However, tariffs also produce revenue for the government. Until the income tax was introduced, for
example, the U.S. government received most of its revenues from tariffs.
Did You Know?
Did you know that the high price of SUVs in the United States is the result of the “chicken tariff”?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from
the authors.
e important thing to understand about an import tariff is who suffers and who gains. e
government gains because the tariff increases government revenues. Domestic producers gain because
the tariff affords them some protection against foreign competitors by increasing the cost of imported
foreign goods. Consumers lose because they must pay more for certain imports. For example, in 2002
the U.S. government placed an ad valorem tariff of 8 to 30 percent on imports of foreign steel. e
idea was to protect domestic steel producers from cheap imports of foreign steel. In this case, however,
the effect was to raise the price of steel products in the United States between 30 and 50 percent. A
number of U.S. steel consumers, ranging from appliance makers to automobile companies, objected
that the steel tariffs would raise their costs of production and make it more difficult for them to
compete in the global marketplace. Whether the gains to the government and domestic producers
exceed the loss to consumers depends on various factors, such as the amount of the tariff, the
importance of the imported good to domestic consumers, the number of jobs saved in the protected
industry, and so on. In the steel case, many argued that the losses to steel consumers apparently
outweighed the gains to steel producers. In November 2003, the World Trade Organization declared
that the tariffs represented a violation of the WTO treaty, and the United States removed them in
December of that year. Interestingly, this ruling did not stop Donald Trump from imposing a 25
percent tariff on imports of foreign steel in March 2018. If the tariffs are challenged, as seems likely,
the WTO will in all probability reach a similar conclusion.
In general, two conclusions can be derived from economic analysis of the effect of import tariffs.1
First, tariffs are generally pro-producer and anticonsumer. While they protect producers from foreign
competitors, this restriction of supply also raises domestic prices. For example, a study by Japanese
economists calculated that tariffs on imports of foodstuffs, cosmetics, and chemicals into Japan cost
the average Japanese consumer about $890 per year in the form of higher prices. Almost all studies
find that import tariffs impose significant costs on domestic consumers in the form of higher prices.
Second, import tariffs reduce the overall efficiency of the world economy. ey reduce efficiency
because a protective tariff encourages domestic firms to produce products at home that could be
produced more efficiently abroad. e consequence is an inefficient utilization of resources.2
Which Country Is Really the Most Globally Competitive?
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e World Economic Forum is an independent international organization committed to improving the state
of the world by engaging business, political, academic, and other leaders of society to shape global, regional,
and industry agendas. e World Economic Forum also conducts global economic research and annually
publishes country competitive rankings. Over the years, northern and western European countries have
dominated the top 10 most globally competitive nations. e United States and Japan typically also hold
strong positions. But is it really fair that the “global competitiveness” ranking indicates that relatively small
Nordic countries such as Finland and Sweden are viewed as being as competitive as the United States and
Japan? Should larger countries, with more people and a larger economy be given preferential treatment in
ranking such as when the topic is on “global competitiveness”?
Source: www.weforum.org.
Sometimes tariffs are levied on exports of a product from a country. Export tariffs are less common
than import tariffs. In general, export tariffs have two objectives: first, to raise revenue for the
government, and second, to reduce exports from a sector, often for political reasons. For example, in
2004 China imposed a tariff on textile exports. e primary objective was to moderate the growth in
exports of textiles from China, thereby alleviating tensions with other trading partners.
China also had tariffs on steel exports but removed many of those in late 2015.
SUBSIDIES
A subsidy is a government payment to a domestic producer. Subsidies take many forms, including
cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. By
lowering production costs, subsidies help domestic producers in two ways: (1) competing against
foreign imports and (2) gaining export markets. Agriculture tends to be one of the largest beneficiaries
of subsidies in most countries. e European Union has been paying out about €44 billion annually
($55 billion) in farm subsidies. e farm bill that passed the U.S. Congress in 2007 contained
subsidies of $289 billion for the next 10 years. e Japanese also have a long history of supporting
inefficient domestic producers with farm subsidies. According to the World Trade Organization, in
mid-2000 countries spent some $300 billion on subsidies, $250 billion of which was spent by 21
developed nations.3 In response to a severe sales slump following the global financial crisis, between
mid-2008 and mid-2009, some developed nations gave $45 billion in subsidies to their automobile
makers. While the purpose of the subsidies was to help them survive a very difficult economic climate,
one of the consequences was to give subsidized companies an unfair competitive advantage in the
global auto industry. Somewhat ironically, given the government bailouts of U.S. auto companies
during the global financial crisis, in 2012 the Obama administration filed a complaint with the WTO
arguing that the Chinese were illegally subsidizing exports of autos and auto parts. Details are given in
the accompanying Country Focus feature.
c o u n t r y F O C U S
Are the Chinese Illegally Subsidizing Auto Exports?
In late 2012, during that year’s presidential election campaign, the Obama administration filed a complaint
against China with the World Trade Organization. e complaint claimed that China was providing export
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subsidies to its auto and auto parts industries. e subsidies included cash grants for exporting, grants for
R&D, subsidies to pay interest on loans, and preferential tax treatment.
e United States estimated the value of the subsidies to be at least $1 billion between 2009 and 2011. e
complaint also pointed out that in the years 2002 through 2011, the value of China’s exports of autos and
auto parts increased more than ninefold from $7.4 billion to $69.1 billion. e United States was China’s
largest market for exports of auto parts during this period. e United States asserted that, to some degree,
this growth may have been helped by subsidies. e complaint went on to claim that these subsidies hurt
producers of automobiles and auto parts in the United States. is is a large industry in the United States,
employing more than 800,000 people and generating some $350 billion in sales.
While some in the labor movement applauded the move, the response from U.S. auto companies and auto
parts producers was muted. One reason for this is that many U.S. producers do business in China and, in all
probability, want to avoid retaliation from the Chinese government. GM, for example, has a joint venture and
two wholly owned subsidiaries in China and is doing very well there. In addition, some U.S. producers benefit
by purchasing cheap Chinese auto parts, so any retaliatory tariffs imposed on those imports might actually
raise their costs.
More cynical observers saw the move as nothing more than political theater. e week before the
complaint was filed, the Republican presidential candidate, Mitt Romney, had accused the Obama
administration of “failing American workers” by not labeling China a currency manipulator. So perhaps the
complaint was in part simply another move on the presidential campaign chessboard.
In February 2014, the United States expanded its complaint with the WTO against China, arguing that
the country had an illegal export subsidy program that includes not only auto parts, but also textiles, apparel
and footwear, advanced materials and metals, speciality chemicals, medical products and agriculture. In 2016,
after pressure from the WTO and U.S., China agreed to eliminate a wide range of subsidies for its
exporters. Michael Froman, the U.S. Trade Representative, announced the deal, calling it “a win for
Americans employed in seven diverse sectors that run the gamut from agriculture to textiles.”
Sources: James Healey, “U.S. Alleges Unfair China Auto Subsidies in WTO Action,” USA Today, September
17, 2012; M. A. Memoli, “Obama to Tell WTO at China Illegally Subsidizes Auto Imports,” Los Angeles
Times, September 17, 2012; Vicki Needham, “US Launches Trade Case against China’s Export Subsidy
Program,” e Hill, February 11, 2014; and David J. Lynch, “China Eliminates Subsidies for Its Exporters,”
Financial Times, April 14, 2016.
e main gains from subsidies accrue to domestic producers, whose international competitiveness
is increased as a result. Advocates of strategic trade policy (which, as you will recall from Chapter 6, is
an outgrowth of the new trade theory) favor subsidies to help domestic firms achieve a dominant
position in those industries in which economies of scale are important and the world
market is not large enough to profitably support more than a few firms (aerospace and
semiconductors are two such industries). According to this argument, subsidies can help a firm achieve
a first-mover advantage in an emerging industry. If this is achieved, further gains to the domestic
economy arise from the employment and tax revenues that a major global company can generate.
However, government subsidies must be paid for, typically by taxing individuals and corporations.
Whether subsidies generate national benefits that exceed their national costs is debatable. In
practice, many subsidies are not that successful at increasing the international competitiveness of
domestic producers. Rather, they tend to protect the inefficient and promote excess production. One
study estimated that if advanced countries abandoned subsidies to farmers, global trade in agricultural
products would be 50 percent higher and the world as a whole would be better off by $160 billion.4
Another study estimated that removing all barriers to trade in agriculture (both subsidies and tariffs)
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would raise world income by $182 billion.5 is increase in wealth arises from the more efficient use
of agricultural land.
IMPORT QUOTAS AND VOLUNTARY EXPORT RESTRAINTS
An import quota is a direct restriction on the quantity of some good that may be imported into a
country. e restriction is usually enforced by issuing import licenses to a group of individuals or
firms. For example, the United States has a quota on cheese imports. e only firms allowed to import
cheese are certain trading companies, each of which is allocated the right to import a maximum
number of pounds of cheese each year. In some cases, the right to sell is given directly to the
governments of exporting countries. Similarly, under the terms of a new trade agreement, South Korea
has agreed to a quota on exports of its steel to the United States (see the opening case).
A common hybrid of a quota and a tariff is known as a tariff rate quota. Under a tariff rate quota,
a lower tariff rate is applied to imports within the quota than those over the quota. For example, as
illustrated in Figure 7.1, an ad valorem tariff rate of 10 percent might be levied on 1 million tons of
rice imports into South Korea, after which an out-of-quota rate of 80 percent might be applied. us,
South Korea might import 2 million tons of rice, 1 million at a 10 percent tariff rate and another 1
million at an 80 percent tariff. Tariff rate quotas are common in agriculture, where their goal is to
limit imports over quota.
7.1 FIGURE
Hypothetical tariff rate quota.
A variant on the import quota is the voluntary export restraint. A voluntary export restraint
(VER) is a quota on trade imposed by the exporting country, typically at the request of the importing
country’s government. For example, in 2012 Brazil imposed what amounts to voluntary export
restraints on shipments of vehicles from Mexico to Brazil. e two countries have a decade-
old free trade agreement, but a surge in vehicles heading to Brazil from Mexico prompted
Brazil to raise its protectionist walls. Mexico has agreed to quotas on Brazil-bound vehicle exports for
the next three years.6 Foreign producers agree to VERs because they fear more damaging punitive
tariffs or import quotas might follow if they do not. Agreeing to a VER is seen as a way to make the
best of a bad situation by appeasing protectionist pressures in a country.
As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting
import competition. As with all restrictions on trade, quotas do not benefit consumers. An import
quota or VER always raises the domestic price of an imported good. When imports are limited to a
low percentage of the market by a quota or VER, the price is bid up for that limited foreign supply.
e extra profit that producers make when supply is artificially limited by an import quota is referred
to as a quota rent.
If a domestic industry lacks the capacity to meet demand, an import quota can raise prices for both
the domestically produced and the imported good. is happened in the U.S. sugar industry, in which
a tariff rate quota system has long limited the amount foreign producers can sell in the U.S. market.
According to one study, import quotas have caused the price of sugar in the United States to be as
much as 40 percent greater than the world price.7 ese higher prices have translated into greater
profits for U.S. sugar producers, which have lobbied politicians to keep the lucrative agreement. ey
argue U.S. jobs in the sugar industry will be lost to foreign producers if the quota system is scrapped.
EXPORT TARIFFS AND BANS
An export tariff is a tax placed on the export of a good. e goal behind an export tariff is to
discriminate against exporting in order to ensure that there is sufficient supply of a good within a
country. For example, in the past, China has placed an export tariff on the export of grain to ensure
that there is sufficient supply in China. Similarly, during its infrastructure building boom, China had
an export tariff in place on certain kinds of steel products to ensure that there was sufficient supply of
steel within the country. e steel tariffs were removed in late 2015. Because most countries try to
encourage exports, export tariffs are relatively rare.
An export ban is a policy that partially or entirely restricts the export of a good. One well-known
example was the ban on exports of U.S. crude oil production that was enacted by Congress in 1975.
At the time, Organization of the Petroleum Exporting Countries (OPEC) was restricting the supply of
oil in order to drive up prices and punish Western nations for their support of Israel during conflicts
between Arab nations and Israel. e export ban in the United States was seen as a way of ensuring a
sufficient supply of domestic oil at home, thereby helping to keep the domestic price down and
boosting national security. e ban was lifted in 2015 after lobbying from American oil producers,
who believed that they could get higher prices for some of their output if they were allowed to sell on
world markets.
LOCAL CONTENT REQUIREMENTS
A local content requirement (LCR) is a requirement that some specific fraction of a good be
produced domestically. e requirement can be expressed either in physical terms (e.g., 75 percent of
component parts for this product must be produced locally) or in value terms (e.g., 75 percent of the
value of this product must be produced locally). Local content regulations have been widely used by
developing countries to shift their manufacturing base from the simple assembly of products whose
parts are manufactured elsewhere into the local manufacture of component parts. ey have also been
used in developed countries to try to protect local jobs and industry from foreign competition. For
example, a little-known law in the United States, the Buy America Act, specifies that government
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agencies must give preference to American products when putting contracts for equipment out to bid
unless the foreign products have a significant price advantage. e law specifies a product as
“American” if 51 percent of the materials by value are produced domestically. is amounts to a local
content requirement. If a foreign company, or an American one for that matter, wishes to
win a contract from a U.S. government agency to provide some equipment, it must ensure
that at least 51 percent of the product by value is manufactured in the United States.
Local content regulations provide protection for a domestic producer of parts in the same way an
import quota does: by limiting foreign competition. e aggregate economic effects are also the same;
domestic producers benefit, but the restrictions on imports raise the prices of imported components.
In turn, higher prices for imported components are passed on to consumers of the final product in the
form of higher final prices. So as with all trade policies, local content regulations tend to benefit
producers and not consumers.
Is Having a Local Content Requirement a Good Idea?
Local content requirements refer to a specific fraction of a product that needs to be manufactured
domestically. Basically, LCRs establish a minimum level of local content required under trade law when giving
foreign companies the right to manufacture in a particular place. In the wake of the economic downturn in
2008, many economists feared that some governments would institute protectionist policies similar to the
tariff escalations during the Great Depression of the 1930s. However, most public policy officials avoided
traditional forms of protection (e.g., tariffs, quotas). is led some observers to underestimate the degree of
protectionism. Instead, what had happened was that so-called nontariff barriers in the form of local content
requirements had become increasingly popular. As a (1) citizen of a specific country and (2) as a global
customer, do you think local content requirements help you as a citizen of a country, as a global customer, as
both, or as neither?
Source: G. C. Hufbauer and J. J. Scott, “Local Content Requirements: A Global Problem,” Washington,
D.C., Peterson Institute for Global Economics, 2013.
ADMINISTRATIVE POLICIES
In addition to the formal instruments of trade policy, governments of all types sometimes use informal
or administrative policies to restrict imports and boost exports. Administrative trade policies are
bureaucratic rules designed to make it difficult for imports to enter a country. It has been argued that
the Japanese are the masters of this trade barrier. In recent decades, Japan’s formal tariff and nontariff
barriers have been among the lowest in the world. However, critics charge that the country’s informal
administrative barriers to imports more than compensate for this. For example, Japan’s car market has
been hard for foreigners to crack. In 2016, only 6 percent of the 4.9 million cars sold in Japan were
foreign, and only 1 percent were U.S. cars. American car makers have argued for decades that Japan
makes it difficult to compete by setting up regulatory hurdles, such as vehicle parts standards, that
don’t exist anywhere else in the world. Ironically, the Trans Pacific Partnership (TPP) addressed this
issue. America would have reduced tariffs on imports of Japanese light trucks in return for Japan
adopting U.S. standards on auto parts, which would have made it easier to import and sell American
cars in Japan. However, President Donald Trump pulled America out of the TPP in January 2017.8
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ANTIDUMPING POLICIES
In the context of international trade, dumping is variously defined as selling goods in a foreign market
at below their costs of production or as selling goods in a foreign market at below their “fair” market
value. ere is a difference between these two definitions; the fair market value of a good is normally
judged to be greater than the costs of producing that good because the former includes a “fair” profit
margin. Dumping is viewed as a method by which firms unload excess production in foreign markets.
Some dumping may be the result of predatory behavior, with producers using substantial profits from
their home markets to subsidize prices in a foreign market with a view to driving indigenous
competitors out of that market. Once this has been achieved, so the argument goes, the predatory firm
can raise prices and earn substantial profits.
Antidumping policies are designed to punish foreign firms that engage in dumping. e ultimate
objective is to protect domestic producers from unfair foreign competition. Although antidumping
policies vary from country to country, the majority are similar to those used in the United States. If a
domestic producer believes that a foreign firm is dumping production in the U.S. market, it can file a
petition with two government agencies, the Commerce Department and the International Trade
Commission (ITC). If a complaint has merit, the Commerce Department may impose an
antidumping duty on the offending foreign imports (antidumping duties are often called
countervailing duties). ese duties, which represent a special tariff, can be fairly substantial and stay
in place for up to five years. e accompanying Management Focus discusses how a firm, U.S.
Magnesium, used antidumping legislation to gain protection from unfair foreign competitors.
test PREP
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m a n a g e m e n t F O C U S
Protecting U.S. Magnesium
In February 2004, U.S. Magnesium, the sole surviving U.S. producer of magnesium, a metal that is primarily
used in the manufacture of certain automobile parts and aluminum cans, filed a petition with the U.S.
International Trade Commission (ITC) contending that a surge in imports had caused material damage to the
U.S. industry’s employment, sales, market share, and profitability. According to U.S. Magnesium, Russian and
Chinese producers had been selling the metal at prices significantly below market value. During 2002 and
2003, imports of magnesium into the United States rose 70 percent, while prices fell by 40 percent, and the
market share accounted for by imports jumped to 50 percent from 25 percent.
“e United States used to be the largest producer of magnesium in the world,” a U.S. Magnesium
spokesperson said at the time of the filing. “What’s really sad is that you can be state of the art and have
modern technology, and if the Chinese, who pay people less than 90 cents an hour, want to run you out of
business, they can do it. And that’s why we are seeking relief.”
During a yearlong investigation, the ITC solicited input from various sides in the dispute. Foreign
producers and consumers of magnesium in the United States argued that falling prices for magnesium during
2002 and 2003 simply reflected an imbalance between supply and demand due to additional capacity coming
on stream not from Russia or China but from a new Canadian plant that opened in 2001 and from a planned
Australian plant. e Canadian plant shut down in 2003, the Australian plant never came on stream, and
prices for magnesium rose again in 2004.
Magnesium consumers in the United States also argued to the ITC that imposing antidumping duties on
foreign imports of magnesium would raise prices in the United States significantly above world levels. A
spokesperson for Alcoa, which mixes magnesium with aluminum to make alloys for cans, predicted that if
antidumping duties were imposed, high magnesium prices in the United States would force Alcoa to move
some production out of the United States. Alcoa also noted that in 2003, U.S. Magnesium was unable to
supply all of Alcoa’s needs, forcing the company to turn to imports. Consumers of magnesium in the
automobile industry asserted that high prices in the United States would drive engineers to design magnesium
out of automobiles or force manufacturing elsewhere, which would ultimately hurt everyone.
e six members of the ITC were not convinced by these arguments. In March 2005, the ITC ruled that
both China and Russia had been dumping magnesium in the United States. e government decided to
impose duties ranging from 50 percent to more than 140 percent on imports of magnesium from China.
Russian producers faced duties ranging from 19 percent to 22 percent. e duties were to be levied for five
years, after which the ITC would revisit the situation. e ITC revoked the antidumping order on Russia in
February 2011 but decided to continue placing the duties on Chinese producers. ey were finally removed
by the ITC in 2014.
According to U.S. Magnesium, the initial favorable ruling allowed the company to reap the benefits of
nearly $50 million in investments made in its manufacturing plant and enabled the company to boost its
capacity by 28 percent by the end of 2005. Commenting on the favorable ruling, a U.S. Magnesium
spokesperson noted, “Once unfair trade is removed from the marketplace we’ll be able to compete with
anyone.”
U.S. Magnesium’s customers and competitors, however, did not view the situation as one of unfair trade.
While the imposition of antidumping duties no doubt helped to protect U.S. Magnesium and the 400 people
it employed from foreign competition, magnesium consumers in the United States felt they were the ultimate
losers, a view that seemed to be confirmed by price data. In early 2010, the price for magnesium alloy in the
United States was $2.30 per pound, compared to $1.54 in Mexico, $1.49 in Europe, and $1.36 in China.
Sources: D. Anderton, “U.S. Magnesium Lands Ruling on Unfair Imports,” Deseret News, October 1, 2004, p.
D10; “U.S. Magnesium and Its Largest Consumers Debate before U.S. ITC,” Platt’s Metals Week, February
28, 2005, p. 2; S. Oberbeck, “U.S. Magnesium Plans Big Utah Production Expansion,” Salt Lake Tribune,
March 30, 2005; “US to Keep Anti-dumping Duty on China Pure Magnesium,” Chinadaily.com, September
13, 2012.; Lance Duronl, “No Duties for Chinese Magnesium Exporter, CIT Affirms,” Law360, June 2,
2015; and Dan Ikenson, “Death by Antidumping,” Forbes, January 3, 2011.
e Case for Government Intervention
LO 7-2 Understand why governments sometimes intervene in international trade.
Now that we have reviewed the various instruments of trade policy that governments can use, it is
time to look at the case for government intervention in international trade. Arguments for government
intervention take two paths: political and economic. Political arguments for intervention are
concerned with protecting the interests of certain groups within a nation (normally producers), often
at the expense of other groups (normally consumers), or with achieving some political objective that
Page 193
lies outside the sphere of economic relationships, such as protecting the environment or human rights.
Economic arguments for intervention are typically concerned with boosting the overall wealth of a
nation (to the benefit of all, both producers and consumers).
POLITICAL ARGUMENTS FOR INTERVENTION
Political arguments for government intervention cover a range of issues, including preserving jobs,
protecting industries deemed important for national security, retaliating against unfair foreign
competition, protecting consumers from “dangerous” products, furthering the goals of foreign policy,
and advancing the human rights of individuals in exporting countries.
Protecting Jobs and Industries Perhaps the most common political argument for government intervention is that it is necessary for protecting jobs and industries from unfair
foreign competition. Competition is most often viewed as unfair when producers in an exporting
country are subsidized in some way by their government. For example, it has been repeatedly claimed
that Chinese enterprises in several industries, including aluminum, steel, and auto parts, have
benefited from extensive government subsidies. Such logic was behind the complaint that the Obama
administration filed with the WTO against Chinese auto parts producers in 2012 (see the Country
Focus “Are the Chinese Illegally Subsidizing Auto Exports?” in this chapter). More generally, Robert
Scott of the Economic Policy Institute has claimed that the growth in the U.S.–China trade deficit
between 2001 and 2015 was, to a significant degree, the result of unfair competition, including direct
subsidies to Chinese producers and currency manipulations. Scott estimated that as many as 3.4
million U.S. jobs were lost as a consequence.9 Donald Trump tapped into anxiety about job losses due
to unfair trade from China during his successful 2016 presidential run.
On the other hand, critics charge that claims of unfair competition are often overstated for political
reasons. For example, President George W. Bush placed tariffs on imports of foreign steel in 2002 as a
response to “unfair competition,” but critics were quick to point out that many of the U.S. steel
producers that benefited from these tariffs were located in states that Bush needed to win reelection in
2004. A political motive also underlay establishment of the Common Agricultural Policy (CAP) by
the European Union. e CAP was designed to protect the jobs of Europe’s politically powerful
farmers by restricting imports and guaranteeing prices. However, the higher prices that resulted from
the CAP have cost Europe’s consumers dearly. is is true of many attempts to protect jobs and
industries through government intervention. For example, the imposition of steel tariffs in 2002 raised
steel prices for American consumers, such as automobile companies, making them less competitive in
the global marketplace.
Protecting National Security Countries sometimes argue that it is necessary to protect certain industries because they are important for national security. Defense-related industries often get this
kind of attention (e.g., aerospace, advanced electronics, and semiconductors). Although now
uncommon, this argument is still made sometimes. When the Trump Administration announced
tariffs on imports of foreign steel and aluminum on March 1, 2018, national security issues were cited
as a primary justification. is was the first time since 1986 that a national security threat was used to
justify tariffs imposed by the United States. In 2017, the United States was importing about 30
percent of steel used in the country, with the largest source of imports being Canada and Mexico.
Interestingly, and counter to the argument of the Trump Administration, critics argued that by raising
input prices for many U.S. defense contractors, who tend to be big consumers of steel and aluminum,
Trade Law
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the tariffs would actually harm the U.S. defense industry and have a negative impact on national
security.10
Government policy and
international trade is the core
focus of this chapter. is topic area has far-ranging implications, such as trade policy, free trade, and the
world’s international trading system. Basically, we are talking about a lot of legalistic aspects starting at the
government level and moving all the way to what organizations and even individuals can and cannot do
globally when trading. e globalEDGE™ section “Trade Law” (globaledge.msu.edu/global-resources/trade-
law) is a unique compilation of globalEDGE™ partner-designed “compendiums of trade laws,” country- and
region-specific trade law, free online learning modules created for globalEDGE™ on various aspects of trade
law, and much more. One fascinating resource related to trade law is the Anti-Counterfeiting and Product
Protection Program (A-CAPPP). A-CAPPP includes counterfeiting-related webinars, presentations, and
research-related materials and working papers. Do you know what counterfeiting is? Take a look at the “Trade
Law” section of globalEDGE™ and especially the A-CAPPP site to become more familiar with the topic. (Is
China really as bad as many in the international community think?)
Retaliating Some argue that governments should use the threat to intervene in trade policy as a bargaining tool to help open foreign markets and force trading partners to “play
by the rules of the game.” e U.S. government has used the threat of punitive trade sanctions to try
to get the Chinese government to enforce its intellectual property laws. Lax enforcement of these laws
had given rise to massive copyright infringements in China that had been costing U.S. companies such
as Microsoft hundreds of millions of dollars per year in lost sales revenues. After the United States
threatened to impose 100 percent tariffs on a range of Chinese imports and after harsh words between
officials from the two countries, the Chinese agreed to tighter enforcement of intellectual property
regulations.11
If it works, such a politically motivated rationale for government intervention may liberalize trade
and bring with it resulting economic gains. It is a risky strategy, however. A country that is being
pressured may not back down and instead may respond to the imposition of punitive tariffs by raising
trade barriers of its own. is is exactly what the Chinese government threatened to do when
pressured by the United States, although it ultimately did back down. If a government does not back
down, the results could be higher trade barriers all around and an economic loss to all involved.
Protecting Consumers Many governments have long had regulations to protect consumers from unsafe products. e indirect effect of such regulations often is to limit or ban the importation of such
products. For example, in 2003 several countries, including Japan and South Korea, decided to ban
imports of American beef after a single case of mad cow disease was found in Washington State. e
ban was designed to protect consumers from what was seen to be an unsafe product. Together, Japan
and South Korea accounted for about $2 billion of U.S. beef sales, so the ban had a significant impact
on U.S. beef producers. After two years, both countries lifted the ban, although they placed stringent
requirements on U.S. beef imports to reduce the risk of importing beef that might be tainted by mad
cow disease (e.g., Japan required that all beef must come from cattle under 21 months of age).
Furthering Foreign Policy Objectives Governments sometimes use trade policy to support their foreign policy objectives.12 A government may grant preferential trade terms to a country with
which it wants to build strong relations. Trade policy has also been used several times to pressure or
punish “rogue states” that do not abide by international law or norms. Iraq labored under extensive
trade sanctions after the UN coalition defeated the country in the 1991 Gulf War until the 2003
invasion of Iraq by U.S.-led forces. e theory is that such pressure might persuade the rogue state to
mend its ways, or it might hasten a change of government. In the case of Iraq, the sanctions were seen
as a way of forcing that country to comply with several UN resolutions. e United States has
maintained long-running trade sanctions against Cuba (despite the move by the Obama
administration to “normalize” relations with Cuba, these sanctions are still in place). eir principal
function is to impoverish Cuba in the hope that the resulting economic hardship will lead to the
downfall of Cuba’s communist government and its replacement with a more democratically inclined
(and pro-U.S.) regime. e United States has also had trade sanctions in place against Libya and Iran,
both of which were accused of supporting terrorist action against U.S. interests and building weapons
of mass destruction. In late 2003, the sanctions against Libya seemed to yield some returns when that
country announced it would terminate a program to build nuclear weapons. e U.S. government
responded by relaxing those sanctions. Similarly, the U.S. government used trade sanctions to pressure
the Iranian government to halt its alleged nuclear weapons program. Following a 2015 agreement to
limit Iran’s nuclear program, it relaxed some of those sanctions.
Other countries can undermine unilateral trade sanctions. e U.S. sanctions against Cuba, for
example, did not stop other Western countries from trading with Cuba. e U.S. sanctions have done
little more than help create a vacuum into which other trading nations, such as Canada and Germany,
have stepped.
e famous cigar maker Jose Castelar Cairo, better known as El Cueto, about to roll a
cigar, in Havana, Cuba.
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Protecting Human Rights Protecting and promoting human rights in other countries is an important element of foreign policy for many democracies. Governments sometimes
use trade policy to try to improve the human rights policies of trading partners. For example, as
discussed in Chapter 5, the U.S. government long had trade sanctions in place against the nation of
Myanmar, in no small part due to the poor human rights practices in that nation. In late 2012, the
United States said that it would ease trade sanctions against Myanmar in response to democratic
reforms in that country. Similarly, in the 1980s and 1990s, Western governments used trade sanctions
against South Africa as a way of pressuring that nation to drop its apartheid policies, which were seen
as a violation of basic human rights.
ECONOMIC ARGUMENTS FOR INTERVENTION
With the development of the new trade theory and strategic trade policy (see Chapter 6), the
economic arguments for government intervention have undergone a renaissance in recent years. Until
the early 1980s, most economists saw little benefit in government intervention and strongly advocated
a free trade policy. is position has changed at the margins with the development of strategic trade
policy, although as we will see in the next section, there are still strong economic arguments for
sticking to a free trade stance.
e Infant Industry Argument e infant industry argument is by far the oldest economic argument for government intervention. Alexander Hamilton proposed it in 1792. According to this
argument, many developing countries have a potential comparative advantage in manufacturing, but
new manufacturing industries cannot initially compete with established industries in developed
countries. To allow manufacturing to get a toehold, the argument is that governments should
temporarily support new industries (with tariffs, import quotas, and subsidies) until they have grown
strong enough to meet international competition.
is argument has had substantial appeal for the governments of developing nations during the
past 50 years, and the GATT has recognized the infant industry argument as a legitimate reason for
protectionism. Nevertheless, many economists remain critical of this argument for two main reasons.
First, protection of manufacturing from foreign competition does no good unless the protection helps
make the industry efficient. In case after case, however, protection seems to have done little more than
foster the development of inefficient industries that have little hope of ever competing in the world
market. Brazil, for example, built the world’s 10th-largest auto industry behind tariff barriers and
quotas. Once those barriers were removed in the late 1980s, however, foreign imports soared, and the
industry was forced to face up to the fact that after 30 years of protection, the Brazilian auto industry
was one of the world’s most inefficient.13
Second, the infant industry argument relies on an assumption that firms are unable to make
efficient long-term investments by borrowing money from the domestic or international capital
market. Consequently, governments have been required to subsidize long-term investments. Given the
development of global capital markets over the past 20 years, this assumption no longer looks as valid
as it once did. Today, if a developing country has a potential comparative advantage in a
manufacturing industry, firms in that country should be able to borrow money from the capital
markets to finance the required investments. Given financial support, firms based in countries with a
potential comparative advantage have an incentive to endure the necessary initial losses in order to
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make long-run gains without requiring government protection. Many Taiwanese and South Korean
firms did this in industries such as textiles, semiconductors, machine tools, steel, and shipping. us,
given efficient global capital markets, the only industries that would require government protection
would be those that are not worthwhile.
Strategic Trade Policy Some new trade theorists have proposed the strategic trade policy argument.14 We reviewed the basic argument in Chapter 6 when we considered the new trade theory.
e new trade theory argues that in industries in which the existence of substantial economies of scale
implies that the world market will profitably support only a few firms, countries may predominate in
the export of certain products simply because they have firms that were able to capture first-mover
advantages. e long-term dominance of Boeing in the commercial aircraft industry has been
attributed to such factors.
e strategic trade policy argument has two components. First, it is argued that by appropriate
actions, a government can help raise national income if it can somehow ensure that the firm or firms
that gain first-mover advantages in an industry are domestic rather than foreign enterprises. us,
according to the strategic trade policy argument, a government should use subsidies to support
promising firms that are active in newly emerging industries. Advocates of this argument point out
that the substantial R&D grants that the U.S. government gave Boeing in the 1950s and 1960s
probably helped tilt the field of competition in the newly emerging market for passenger jets in
Boeing’s favor. (Boeing’s first commercial jet airliner, the 707, was derived from a military plane.)
Similar arguments have been made with regard to Japan’s rise to dominance in the production of
liquid crystal display screens (used in computers). Although these screens were invented in the United
States, the Japanese government, in cooperation with major electronics companies, targeted this
industry for research support in the late 1970s and early 1980s. e result was that Japanese firms, not
U.S. firms, subsequently captured first-mover advantages in this market.
e second component of the strategic trade policy argument is that it might pay a government to
intervene in an industry by helping domestic firms overcome the barriers to entry created by foreign
firms that have already reaped first-mover advantages. is argument underlies government support of
Airbus, Boeing’s major competitor (see the opening case). Formed in 1966 as a consortium of four
companies from Great Britain, France, Germany, and Spain, Airbus had less than 5 percent of the
world commercial aircraft market when it began production in the mid-1970s. By 2017, it was
splitting the market with Boeing. How did Airbus achieve this? According to the U.S. government, the
answer is an $18 billion subsidy from the governments of Great Britain, France, Germany, and
Spain.15 Without this subsidy, Airbus would never have been able to break into the world market.
If these arguments are correct, they support a rationale for government intervention in
international trade. Governments should target technologies that may be important in the future and
use subsidies to support development work aimed at commercializing those technologies.
Furthermore, government should provide export subsidies until the domestic firms have established
first-mover advantages in the world market. Government support may also be justified if it can help
domestic firms overcome the first-mover advantages enjoyed by foreign competitors and emerge as
viable competitors in the world market (as in the Airbus and semiconductor examples). In this case, a
combination of home-market protection and export-promoting subsidies may be needed.
test PREP
Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go
to learnsmartadvantage.com for help.
e Revised Case for Free Trade
LO 7-3 Summarize and explain the arguments against strategic trade policy.
e strategic trade policy arguments of the new trade theorists suggest an economic justification for
government intervention in international trade. is justification challenges the rationale for
unrestricted free trade found in the work of classic trade theorists such as Adam Smith and David
Ricardo. In response to this challenge to economic orthodoxy, a number of economists—including
some of those responsible for the development of the new trade theory, such as Paul Krugman—point
out that although strategic trade policy looks appealing in theory, in practice it may be unworkable.
is response to the strategic trade policy argument constitutes the revised case for free trade.16
RETALIATION AND TRADE WAR
Krugman argues that a strategic trade policy aimed at establishing domestic firms in a dominant
position in a global industry is a beggar-thy-neighbor policy that boosts national income at the
expense of other countries. A country that attempts to use such policies will probably provoke
retaliation. In many cases, the resulting trade war between two or more interventionist governments
will leave all countries involved worse off than if a hands-off approach had been adopted in the first
place. If the U.S. government were to respond to the Airbus subsidy by increasing its own subsidies to
Boeing, for example, the result might be that the subsidies would cancel each other out. In the
process, both European and U.S. taxpayers would end up supporting an expensive and pointless trade
war, and both Europe and the United States would be worse off.
Krugman may be right about the danger of a strategic trade policy leading to a trade war. e
problem, however, is how to respond when one’s competitors are already being supported by
government subsidies; that is, how should Boeing and the United States respond to the subsidization
of Airbus? According to Krugman, the answer is probably not to engage in retaliatory action but to
help establish rules of the game that minimize the use of trade-distorting subsidies. is is what the
World Trade Organization seeks to do. It should also be noted that antidumping policies can be used
to target competitors supported by subsidies who are selling goods at prices that are below their costs
of production.
DOMESTIC POLICIES
Governments do not always act in the national interest when they intervene in the economy;
politically important interest groups often influence them. e European Union’s support for the
Common Agricultural Policy (CAP), which arose because of the political power of French and
German farmers, is an example. e CAP benefits inefficient farmers and the politicians who rely on
the farm vote but not consumers in the EU, who end up paying more for their foodstuffs. us, a
further reason for not embracing strategic trade policy, according to Krugman, is that such a policy is
almost certain to be captured by special-interest groups within the economy, which will distort it to
their own ends. Krugman concludes that in the United States,
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To ask the Commerce Department to ignore special-interest politics while formulating detailed
policy for many industries is not realistic; to establish a blanket policy of free trade, with
exceptions granted only under extreme pressure, may not be the optimal policy according to the
theory but may be the best policy that the country is likely to get.17
test PREP
Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go
to learnsmartadvantage.com for help.
Development of the World Trading System
LO 7-4 Describe the development of the world trading system and the current trade issue.
Economic arguments support unrestricted free trade. While many governments have recognized the
value of these arguments, they have been unwilling to unilaterally lower their trade barriers for fear
that other nations might not follow suit. Consider the problem that two neighboring countries, say,
Brazil and Argentina, face when deciding whether to lower trade barriers between them. In principle,
the government of Brazil might favor lowering trade barriers, but it might be unwilling to do so for
fear that Argentina will not do the same. Instead, the government might fear that the Argentineans
will take advantage of Brazil’s low barriers to enter the Brazilian market while continuing to shut
Brazilian products out of their market through high trade barriers. e Argentinean government
might believe that it faces the same dilemma. e essence of the problem is a lack of trust. Both
governments recognize that their respective nations will benefit from lower trade barriers between
them, but neither government is willing to lower barriers for fear that the other might not follow.18
Such a deadlock can be resolved if both countries negotiate a set of rules to govern cross-border
trade and lower trade barriers. But who is to monitor the governments to make sure they are playing
by the trade rules? And who is to impose sanctions on a government that cheats? Both governments
could set up an independent body to act as a referee. is referee could monitor trade between the
countries, make sure that no side cheats, and impose sanctions on a country if it does cheat in the
trade game.
While it might sound unlikely that any government would compromise its national sovereignty by
submitting to such an arrangement, since World War II an international trading framework has
evolved that has exactly these features. For its first 50 years, this framework was known as the General
Agreement on Tariffs and Trade (GATT). Since 1995, it has been known as the World Trade
Organization (WTO). Here, we look at the evolution and workings of the GATT and WTO.
FROM SMITH TO THE GREAT DEPRESSION
As noted in Chapter 5, the theoretical case for free trade dates to the late eighteenth century and the
work of Adam Smith and David Ricardo. Free trade as a government policy was first officially
embraced by Great Britain in 1846, when the British Parliament repealed the Corn Laws. e Corn
Laws placed a high tariff on imports of foreign corn. e objectives of the Corn Laws tariff were to
raise government revenues and to protect British corn producers. ere had been annual motions in
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Parliament in favor of free trade since the 1820s, when David Ricardo was a member. However,
agricultural protection was withdrawn only as a result of a protracted debate when the effects of a
harvest failure in Great Britain were compounded by the imminent threat of famine in Ireland. Faced
with considerable hardship and suffering among the populace, Parliament narrowly reversed its long-
held position.
During the next 80 years or so, Great Britain, as one of the world’s dominant trading powers,
pushed the case for trade liberalization, but the British government was a voice in the wilderness. Its
major trading partners did not reciprocate the British policy of unilateral free trade. e only reason
Britain kept this policy for so long was that as the world’s largest exporting nation, it had far more to
lose from a trade war than did any other country.
Do You Believe in Free Trade Agreements?
e benefits of free trade agreements are often hard to see. At the same time, the benefits of protecting certain
industries and/or companies from foreign competition are often very visible. Given these scenarios, many
people often argue that free trade agreements are bad for their country. Perhaps as a result, many governments
impose many tariffs, quotas, and other nontariff barriers to trade. For example, the common perception is that
by establishing trade barriers, a country keeps the jobs at home instead of jobs being shipped overseas. But is
this really true?
Source: D. J. Boudreaux, e Benefits of Free Trade: Addressing the Myths (Washington, DC: Mercatus Center,
George Mason University, 2013).
By the 1930s, the British attempt to stimulate free trade was buried under the economic rubble of
the Great Depression. Economic problems were compounded in 1930, when the U.S. Congress
passed the Smoot–Hawley tariff. Aimed at avoiding rising unemployment by protecting domestic
industries and diverting consumer demand away from foreign products, the Smoot–Hawley Act
erected an enormous wall of tariff barriers. Almost every industry was rewarded with its “made-to-
order” tariff. e Smoot–Hawley Act had a damaging effect on employment abroad. Other
countries reacted by raising their own tariff barriers. U.S. exports tumbled in response, and
the world slid further into the Great Depression.19
1947–1979: GATT, TRADE LIBERALIZATION, AND ECONOMIC GROWTH
Economic damage caused by the beggar-thy-neighbor trade policies that the Smoot–Hawley Act
ushered in exerted a profound influence on the economic institutions and ideology of the post–World
War II world. e United States emerged from the war both victorious and economically dominant.
After the debacle of the Great Depression, opinion in the U.S. Congress had swung strongly in favor
of free trade. Under U.S. leadership, the GATT was established in 1947.
e GATT was a multilateral agreement whose objective was to liberalize trade by eliminating
tariffs, subsidies, import quotas, and the like. From its foundation in 1947 until it was superseded by
the WTO, the GATT’s membership grew from 19 to more than 120 nations. e GATT did not
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attempt to liberalize trade restrictions in one fell swoop; that would have been impossible. Rather,
tariff reduction was spread over eight rounds.
In its early years, the GATT was by most measures very successful. For example, the average tariff
declined by nearly 92 percent in the United States between the Geneva Round of 1947 and the Tokyo
Round of 1973–1979. Consistent with the theoretical arguments first advanced by Ricardo and
reviewed in Chapter 5, the move toward free trade under the GATT appeared to stimulate economic
growth.
1980–1993: PROTECTIONIST TRENDS
During the 1980s and early 1990s, the trading system erected by the GATT came under strain as
pressures for greater protectionism increased around the world. ere were three reasons for the rise in
such pressures during the 1980s. First, the economic success of Japan during that time strained the
world trading system (much as the success of China has created strains today). Japan was in ruins
when the GATT was created. By the early 1980s, however, it had become the world’s second-largest
economy and its largest exporter. Japan’s success in such industries as automobiles and semiconductors
might have been enough to strain the world trading system. ings were made worse by the
widespread perception in the West that despite low tariff rates and subsidies, Japanese markets were
closed to imports and foreign investment by administrative trade barriers.
Second, the world trading system was strained by the persistent trade deficit in the world’s largest
economy, the United States. e consequences of the U.S. deficit included painful adjustments in
industries such as automobiles, machine tools, semiconductors, steel, and textiles, where domestic
producers steadily lost market share to foreign competitors. e resulting unemployment gave rise to
renewed demands in the U.S. Congress for protection against imports.
A third reason for the trend toward greater protectionism was that many countries found ways to
get around GATT regulations. Bilateral voluntary export restraints (VERs) circumvented GATT
agreements, because neither the importing country nor the exporting country complained to the
GATT bureaucracy in Geneva—and without a complaint, the GATT bureaucracy could do nothing.
Exporting countries agreed to VERs to avoid more damaging punitive tariffs. One of the best-known
examples was the automobile VER between Japan and the United States, under which Japanese
producers promised to limit their auto imports into the United States as a way of defusing growing
trade tensions. According to a World Bank study, 16 percent of the imports of industrialized countries
in 1986 were subjected to nontariff trade barriers such as VERs.20
THE URUGUAY ROUND AND THE WORLD TRADE ORGANIZATION
Against the background of rising pressures for protectionism, in 1986, GATT members embarked on
their eighth round of negotiations to reduce tariffs, the Uruguay Round (so named because it occurred
in Uruguay). is was the most ambitious round of negotiations yet. Until then, GATT rules had
applied only to trade in manufactured goods and commodities. In the Uruguay Round, member
countries sought to extend GATT rules to cover trade in services. ey also sought to write
rules governing the protection of intellectual property, to reduce agricultural subsidies, and
to strengthen the GATT’s monitoring and enforcement mechanisms.
e Uruguay Round dragged on for seven years before an agreement was reached on December 15,
1993. It went into effect July 1, 1995. e Uruguay Round contained the following provisions:
1. Tariffs on industrial goods were to be reduced by more than one-third, and tariffs were to be
scrapped on more than 40 percent of manufactured goods.
2. Average tariff rates imposed by developed nations on manufactured goods were to be reduced to
less than 4 percent of value, the lowest level in modern history.
3. Agricultural subsidies were to be substantially reduced.
4. GATT fair trade and market access rules were to be extended to cover a wide range of services.
5. GATT rules also were to be extended to provide enhanced protection for patents, copyrights,
and trademarks (intellectual property).
6. Barriers on trade in textiles were to be significantly reduced over 10 years.
7. e World Trade Organization was to be created to implement the GATT agreement.
e World Trade Organization e WTO acts as an umbrella organization that encompasses the GATT along with two new sister bodies, one on services and the other on intellectual property.
e WTO’s General Agreement on Trade in Services (GATS) has taken the lead in extending free
trade agreements to services. e WTO’s Agreement on Trade-Related Aspects of Intellectual Property
Rights (TRIPS) is an attempt to narrow the gaps in the way intellectual property rights are protected
around the world and to bring them under common international rules. WTO has taken over
responsibility for arbitrating trade disputes and monitoring the trade policies of member countries.
While the WTO operates on the basis of consensus as the GATT did, in the area of dispute
settlement, member countries are no longer able to block adoption of arbitration reports. Arbitration
panel reports on trade disputes between member countries are automatically adopted by the WTO
unless there is a consensus to reject them. Countries that have been found by the arbitration panel to
violate GATT rules may appeal to a permanent appellate body, but its verdict is binding. If offenders
fail to comply with the recommendations of the arbitration panel, trading partners have the right to
compensation or, in the last resort, to impose (commensurate) trade sanctions. Every stage of the
procedure is subject to strict time limits. us, the WTO has something that the GATT never had—
teeth.21
WTO: EXPERIENCE TO DATE
By 2017, the WTO had 164 members, including China, which joined at the end of 2001, and Russia,
which joined in 2012. WTO members collectively account for 98 percent of world trade. Since its
formation, the WTO has remained at the forefront of efforts to promote global free trade. Its creators
expressed the belief that the enforcement mechanisms granted to the WTO would make it more
effective at policing global trade rules than the GATT had been. e great hope was that the WTO
might emerge as an effective advocate and facilitator of future trade deals, particularly in areas such as
services. e experience so far has been mixed. After a strong early start, since the late 1990s the WTO
has been unable to get agreements to further reduce barriers to international trade and trade and
investment. ere has been very slow progress with the current round of trade talks (the Doha
Round). ere was also a shift back toward some limited protectionism following the global financial
crisis of 2008–2009. More recently, the 2016 vote by the British to leave the European Union (Brexit)
and the election of Donald Trump to the presidency in the United States have suggested that the
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world may be shifting back toward greater protectionism. ese developments have raised a number of
questions about the future direction of the WTO.
WTO as Global Police e first two decades in the life of the WTO suggest that its policing and enforcement mechanisms are having a positive effect.22 Between 1995 and 2017, more than 500 trade
disputes between member countries were brought to the WTO.23 is record compares with a total of
196 cases handled by the GATT over almost half a century. Of the cases brought to the WTO, three-
fourths have been resolved by informal consultations between the disputing countries. Resolving the
remainder has involved more formal procedures, but these have been largely successful. In
general, countries involved have adopted the WTO’s recommendations. e fact that
countries are using the WTO represents an important vote of confidence in the organization’s dispute
resolution procedures.
Expanded Trade Agreements As explained earlier, the Uruguay Round of GATT negotiations extended global trading rules to cover trade in services. e WTO was given the role of brokering
future agreements to open up global trade in services. e WTO was also encouraged to extend its
reach to encompass regulations governing foreign direct investment, something the GATT had never
done. Two of the first industries targeted for reform were the global telecommunication and financial
services industries.
In February 1997, the WTO brokered a deal to get countries to agree to open their
telecommunication markets to competition, allowing foreign operators to purchase ownership stakes
in domestic telecommunication providers and establishing a set of common rules for fair competition.
Most of the world’s biggest markets—including the United States, European Union, and Japan—were
fully liberalized by January 1, 1998, when the pact went into effect. All forms of basic
telecommunication service are covered, including voice telephone, data, and satellite and radio
communications. Many telecommunication companies responded positively to the deal, pointing out
that it would give them a much greater ability to offer their business customers one-stop shopping—a
global, seamless service for all their corporate needs and a single bill.
Should a Standard Process Be in Place for Import Licenses?
Import licenses are permits granted before a product is imported. e administrative procedures for obtaining
the licenses should be simple, neutral, equitable, and transparent. Where possible, they should be given
automatically and quickly, and even if they are nonautomatic, they should not obstruct trade unnecessarily.
Australia, Turkey, the European Union, Norway, ailand, the United States, New Zealand, Costa Rica,
Colombia, Peru, Chinese Taipei, Japan, the Republic of Korea, Switzerland, and Canada said their producers
and traders reported that exports to Argentina have declined or been delayed by Argentina’s licensing processes
and requirements, which some described as “protectionist.” Should there be a standardized process and
timeline for processing import licenses in member countries of the World Trade Organization?
Source: World Trade Organization, “Members Continue to Criticize Argentina’s Import Licensing,” 2012,
www.wto.org/english/news_e/news12_e/impl_27apr12_e.htm.
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is was followed in December 1997 with an agreement to liberalize cross-border trade in financial
services. e deal covered more than 95 percent of the world’s financial services market. Under the
agreement, which took effect at the beginning of March 1999, 102 countries pledged to open (to
varying degrees) their banking, securities, and insurance sectors to foreign competition. In common
with the telecommunication deal, the accord covers not just cross-border trade but also foreign direct
investment. Seventy countries agreed to dramatically lower or eradicate barriers to foreign direct
investment in their financial services sector. e United States and the European Union (with minor
exceptions) are fully open to inward investment by foreign banks, insurance, and securities companies.
As part of the deal, many Asian countries made important concessions that allow significant foreign
participation in their financial services sectors for the first time.
THE FUTURE OF THE WTO: UNRESOLVED ISSUES AND THE DOHA ROUND
Since the successes of the 1990s, the World Trade Organization has struggled to make progress on the
international trade front. Confronted by a slower growing world economy after 2001, many national
governments have been reluctant to agree to a fresh round of policies designed to reduce trade barriers.
Political opposition to the WTO has been growing in many nations. As the public face of
globalization, some politicians and nongovernmental organizations blame the WTO for a variety of
ills, including high unemployment, environmental degradation, poor working conditions in
developing nations, falling real wage rates among the lower paid in developed nations, and rising
income inequality. e rapid rise of China as a dominant trading nation has also played a role here.
Reflecting sentiments like those toward Japan 25 years ago, many perceive China as failing to play by
the international trading rules, even as it embraces the WTO.
Against this difficult political backdrop, much remains to be done on the international trade front.
Four issues at the forefront of the agenda of the WTO are antidumping policies, the high level of
protectionism in agriculture, the lack of strong protection for intellectual property rights in many
nations, and continued high tariff rates on nonagricultural goods and services in many nations. We
shall look at each in turn before discussing the latest round of talks between WTO members aimed at
reducing trade barriers, the Doha Round, which began in 2001 and now seem to be stalled.
Antidumping Actions Antidumping actions proliferated during the 1990s and 2000s. WTO rules allow countries to impose antidumping duties on foreign goods that are being sold cheaper than
at home or below their cost of production when domestic producers can show that they are being
harmed. Unfortunately, the rather vague definition of what constitutes “dumping” has proved to be a
loophole that many countries are exploiting to pursue protectionism.
Between 1995 and mid-2016, WTO members had reported implementation of some 5,132
antidumping actions to the WTO. India initiated the largest number of antidumping actions, some
818; the EU initiated 485 over the same period, and the United States, 593. China accounted for
1,170 complaints, South Korea for 384, the United States for 273, Taipei for 279, and Japan for 202.
Antidumping actions seem to be concentrated in certain sectors of the economy, such as basic metal
industries (e.g., aluminum and steel), chemicals, plastics, and machinery and electrical
equipment.24 ese sectors account for approximately 70 percent of all antidumping actions reported
to the WTO. Since 1995, these four sectors have been characterized by periods of intense competition
and excess productive capacity, which have led to low prices and profits (or losses) for firms in those
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industries. It is not unreasonable, therefore, to hypothesize that the high level of antidumping actions
in these industries represents an attempt by beleaguered manufacturers to use the political process in
their nations to seek protection from foreign competitors, which they claim are engaging in unfair
competition. While some of these claims may have merit, the process can become very politicized as
representatives of businesses and their employees lobby government officials to “protect domestic jobs
from unfair foreign competition,” and government officials, mindful of the need to get votes in future
elections, oblige by pushing for antidumping actions. e WTO is clearly worried by the use of
antidumping policies, suggesting that it reflects persistent protectionist tendencies and pushing
members to strengthen the regulations governing the imposition of antidumping duties.
Protectionism in Agriculture Another focus of the WTO has been the high level of tariffs and subsidies in the agricultural sector of many economies. Tariff rates on agricultural products are
generally much higher than tariff rates on manufactured products or services. For example, the average
tariff rates on nonagricultural products among developed nations are around 4 percent. On
agricultural products, however, the average tariff rates are 15.4 percent for Canada, 11.9 percent for
the European Union, 17.4 percent for Japan, and 4.8 percent for the United States.25 e
implication is that consumers in countries with high tariffs are paying significantly higher
prices than necessary for agricultural products imported from abroad, which leaves them with less
money to spend on other goods and services.
Production operations at J.M. Larson Dairy.
©Bloomberg/Getty Images
e historically high tariff rates on agricultural products reflect a desire to protect domestic
agriculture and traditional farming communities from foreign competition. In addition to high tariffs,
agricultural producers also benefit from substantial subsidies. According to estimates from the
Organisation for Economic Co-operation and Development (OECD), government subsidies on
average account for about 17 percent of the cost of agricultural production in Canada, 21 percent in
the United States, 35 percent in the European Union, and 59 percent in Japan.26 OECD countries
spend more than $300 billion a year in agricultural subsidies.
Not surprisingly, the combination of high tariff barriers and subsidies introduces significant
distortions into the production of agricultural products and international trade of those products. e
net effect is to raise prices to consumers, reduce the volume of agricultural trade, and encourage the
overproduction of products that are heavily subsidized (with the government typically buying the
surplus). Because global trade in agriculture currently amounts to around 10 percent of total
merchandized trade, the WTO argues that removing tariff barriers and subsidies could significantly
boost the overall level of trade, lower prices to consumers, and raise global economic growth by freeing
consumption and investment resources for more productive uses. According to estimates from the
International Monetary Fund, removal of tariffs and subsidies on agricultural products would raise
global economic welfare by $128 billion annually.27 Others suggest gains as high as $182 billion.28
e biggest defenders of the existing system have been the advanced nations of the world, which
want to protect their agricultural sectors from competition by low-cost producers in developing
nations. In contrast, developing nations have been pushing hard for reforms that would allow their
producers greater access to the protected markets of the developed nations. Estimates suggest that
removing all subsidies on agricultural production alone in OECD countries could return to the
developing nations of the world three times more than all the foreign aid they currently receive from
the OECD nations.29 In other words, free trade in agriculture could help jump-start economic growth
among the world’s poorer nations and alleviate global poverty.
Protection of Intellectual Property Another issue that has become increasingly important to the WTO has been protecting intellectual property. e 1995 Uruguay agreement that established the
WTO also contained an agreement to protect intellectual property (the Trade-Related Aspects of
Intellectual Property Rights, or TRIPS, agreement). e TRIPS regulations oblige WTO members to
grant and enforce patents lasting at least 20 years and copyrights lasting 50 years. Rich countries had
to comply with the rules within a year. Poor countries, in which such protection was generally much
weaker, had five years’ grace, and the very poorest had 10 years.’ e basis for this agreement was a
strong belief among signatory nations that the protection of intellectual property through patents,
trademarks, and copyrights must be an essential element of the international trading system.
Inadequate protections for intellectual property reduce the incentive for innovation. Because
innovation is a central engine of economic growth and rising living standards, the argument has been
that a multilateral agreement is needed to protect intellectual property.
Without such an agreement, it is feared that producers in a country—let’s say, India—might
market imitations of patented innovations pioneered in a different country—say, the United States.
is can affect international trade in two ways. First, it reduces the export opportunities in India for
the original innovator in the United States. Second, to the extent that the Indian producer is able to
export its pirated imitation to additional countries, it also reduces the export opportunities in those
countries for the U.S. inventor. Also, one can argue that because the size of the total world market for
the innovator is reduced, its incentive to pursue risky and expensive innovations is also reduced. e
net effect would be less innovation in the world economy and less economic growth.
Market Access for Nonagricultural Goods and Services Although the WTO and the GATT have made big strides in reducing the tariff rates on nonagricultural products, much work
remains. Although most developed nations have brought their tariff rates on industrial products down
Page 204to an average of 3.8 percent of value, exceptions still remain. In particular, while average
tariffs are low, high tariff rates persist on certain imports into developed nations, which limit
market access and economic growth. For example, Australia and South Korea, both OECD countries,
still have bound tariff rates of 15.1 percent and 24.6 percent, respectively, on imports of transportation
equipment (bound tariff rates are the highest rate that can be charged, which is often, but not always,
the rate that is charged). In contrast, the bound tariff rates on imports of transportation equipment
into the United States, European Union, and Japan are 2.7 percent, 4.8 percent, and 0 percent,
respectively. A particular area for concern is high tariff rates on imports of selected goods from
developing nations into developed nations.
In addition, tariffs on services remain higher than on industrial goods. e average tariff on
business and financial services imported into the United States, for example, is 8.2 percent, into the
EU it is 8.5 percent, and into Japan it is 19.7 percent.30 Given the rising value of cross-border trade in
services, reducing these figures can be expected to yield substantial gains.
e WTO would like to bring down tariff rates still further and reduce the scope for the selective
use of high tariff rates. e ultimate aim is to reduce tariff rates to zero. Although this might sound
ambitious, 40 nations have already moved to zero tariffs on information technology goods, so a
precedent exists. Empirical work suggests that further reductions in average tariff rates toward zero
would yield substantial gains. One estimate by economists at the World Bank suggests that a broad
global trade agreement coming out of the Doha negotiations could increase world income by $263
billion annually, of which $109 billion would go to poor countries.31 Another estimate from the
OECD suggests a figure closer to $300 billion annually.32 See the accompanying Country Focus for
estimates of the benefits to the American economy from free trade.
Looking farther out, the WTO would like to bring down tariff rates on imports of nonagricultural
goods into developing nations. Many of these nations use the infant industry argument to justify the
continued imposition of high tariff rates; however, ultimately these rates need to come down for these
nations to reap the full benefits of international trade. For example, the bound tariff rates of 53.9
percent on imports of transportation equipment into India and 33.6 percent on imports into Brazil,
by raising domestic prices, help protect inefficient domestic producers and limit economic growth by
reducing the real income of consumers who must pay more for transportation equipment and related
services.
c o u n t r y F O C U S
Estimating the Gains from Trade for America
A study published by the Institute for International Economics tried to estimate the gains to the American
economy from free trade. According to the study, due to reductions in tariff barriers under the GATT and
WTO since 1947, by 2003 the gross domestic product (GDP) of the United States was 7.3 percent higher
than would otherwise be the case. e benefits of that amounted to roughly $1 trillion a year, or $9,000 extra
income for each American household per year.
e same study tried to estimate what would happen if America concluded free trade deals with all its
trading partners, reducing tariff barriers on all goods and services to zero. Using several methods to estimate
the impact, the study concluded that additional annual gains of between $450 billion and $1.3 trillion could
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be realized. is final march to free trade, according to the authors of the study, could safely be expected to
raise incomes of the average American household by an additional $4,500 per year.
e authors also tried to estimate the scale and cost of employment disruption that would be caused by a
move to universal free trade. Jobs would be lost in certain sectors and gained in others if the country abolished
all tariff barriers. Using historical data as a guide, they estimated that 226,000 jobs would be lost every year
due to expanded trade, although some two-thirds of those losing jobs would find reemployment after a year.
Reemployment, however, would be at a wage that was 13 to 14 percent lower. e study concluded that the
disruption costs would total some $54 billion annually, primarily in the form of lower lifetime wages to those
whose jobs were disrupted as a result of free trade. Offset against this, however, must be the higher economic
growth resulting from free trade, which creates many new jobs and raises household incomes, creating another
$450 billion to $1.3 trillion annually in net gains to the economy. In other words, the estimated annual gains
from trade are far greater than the estimated annual costs associated with job disruption, and more people
benefit than lose as a result of a shift to a universal free trade regime.
Source: S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “e Payoff to America from Global
Integration,” in e United States and the World Economy: Foreign Policy for the Next Decade, C. F. Bergsten, ed.
(Washington, DC: Institute for International Economics, 2005).
A New Round of Talks: Doha In 2001, the WTO launched a new round of talks between member states aimed at further liberalizing the global trade and investment
framework. For this meeting, it picked the remote location of Doha in the Persian Gulf state of Qatar.
e talks were originally scheduled to last three years, although they have already gone on for 15 years
and are currently stalled.
e Doha agenda includes cutting tariffs on industrial goods and services, phasing out subsidies to
agricultural producers, reducing barriers to cross-border investment, and limiting the use of
antidumping laws. e talks are currently ongoing. ey have been characterized by halting progress
punctuated by significant setbacks and missed deadlines. A September 2003 meeting in Cancún,
Mexico, broke down, primarily because there was no agreement on how to proceed with reducing
agricultural subsidies and tariffs; the EU, United States, and India, among others, proved less than
willing to reduce tariffs and subsidies to their politically important farmers, while countries such as
Brazil and certain West African nations wanted free trade as quickly as possible. In 2004, both the
United States and the EU made a determined push to start the talks again. Since then, however, little
progress has been made, and the talks are in deadlock, primarily because of disagreements over how
deep the cuts in subsidies to agricultural producers should be. As of 2017, the goal was to reduce
tariffs for manufactured and agricultural goods by 60 to 70 percent and to cut subsidies to half of their
current level—but getting nations to agree to these goals was proving exceedingly difficult.
MULTILATERAL AND BILATERAL TRADE AGREEMENTS
In response to the apparent failure of the Doha Round to progress, many nations have pushed forward
with multilateral or bilateral trade agreements, which are reciprocal trade agreements between two
or more partners. For example, in 2014 Australia and China entered into a bilateral free trade
agreement. Similarly, in March 2012 the United States entered into a bilateral free trade agreement
with South Korea. Under this agreement, 80 percent of U.S. exports of consumer and industrial
products became duty free, and 95 percent of bilateral trade in industrial and consumer products will
be duty free by 2017 (this agreement was revised in 2018, see the opening case). e agreement is
estimated to boost U.S. GDP by some $10 to $12 billion. Under the Obama Administration the
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United States was pursuing two major multilateral trade agreements, one with 11 other Pacific Rim
countries including Australia, New Zealand, Japan, Malaysia, and Chile (the TPP), and another with
the European Union. However, following the accession of Donald Trump to the presidency in the
United States, the U.S. withdrew from the TPP (although the remaining 11 nations went ahead with a
revised agreement) and the trade agreement being negotiated with the EU was put on ice.
Multilateral and bilateral trade agreements are designed to capture gain from trade beyond those
agreements currently attainable under WTO treaties. Multilateral and bilateral trade agreements are
allowed under WTO rules, and countries entering into these agreements are required to notify the
WTO. As of 2017, more than 440 regional or bilateral trade agreements were in force. Reflecting the
lack of progress on the Doha Round, the number of such agreements has increased significantly since
the early 2000s, when fewer than 100 were in force.
THE WORLD TRADING SYSTEM UNDER THREAT
In 2016, two events challenged the long-held belief that there was a global consensus behind the 70-
year push to embrace free trade and lower barriers to the cross-border flow of goods and services. e
first was the decision by the British to withdraw from the European Union following a national
referendum (Brexit). We discuss Brexit in more detail in Chapter 9, but it is worth noting that the
British intention to withdraw from what is arguably one of the most successful free trade zones in the
world is a big setback for those who argue that free trade is a good thing. e second event was the
victory of Donald Trump in the 2016 U.S. presidential election. As discussed in Chapter 6, Trump
appears to hold mercantilist views on trade. He seems opposed to many free trade deals. Indeed, one
of his first actions was to pull the United States out of the Trans Pacific Partnership, a 12-
nation free trade zone that was close to ratification. In early 2018, he placed tariffs on
imports of solar panels, washing machines, steel, and aluminum into the United States, in all
probability in violation of WTO rules. Trump also initiated the renegotiation of NAFTA and has
expressed hostility to the WTO. e significance of these developments is that heretofore both Britain
and America have been leaders in the global push toward greater free trade. While Britain still seems
committed to free trade, despite the Brexit decision, the position of the United States, the world’s
largest economy, is less clear. If the U.S. continues to turn its back on new free trade deals (such as the
TPP) and dismantles existing ones (as Trump has threatened to do with NAFTA), other nations could
follow. If this happens, the impact on the world economy will almost certainly be negative, resulting in
greater protectionism, slower economic growth, and higher unemployment around the globe.
test PREP
Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go
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Focus on Managerial Implications
TRADE BARRIERS, FIRM STRATEGY, AND POLICY IMPLICATIONS
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LO 7-5 Explain the implications for managers of developments in the world trading system.
What are the implications for business practice? Why should the international manager care about the
political economy of free trade or about the relative merits of arguments for free trade and
protectionism? ere are two answers to this question. e first concerns the impact of trade barriers
on a firm’s strategy. e second concerns the role that business firms can play in promoting free trade
or trade barriers.
Trade Barriers and Firm Strategy To understand how trade barriers affect a firm’s strategy, consider first the material in Chapter 6. Drawing on the theories of international trade, we discussed
how it makes sense for the firm to disperse its various production activities to those countries around
the globe where they can be performed most efficiently. us, it may make sense for a firm to design
and engineer its product in one country, to manufacture components in another, to perform final
assembly operations in yet another country, and then export the finished product to the rest of the
world.
Clearly, trade barriers constrain a firm’s ability to disperse its productive activities in such a manner.
First and most obvious, tariff barriers raise the costs of exporting products to a country (or of
exporting partly finished products between countries). is may put the firm at a competitive
disadvantage relative to indigenous competitors in that country. In response, the firm may then find it
economical to locate production facilities in that country so that it can compete on even footing.
Second, quotas may limit a firm’s ability to serve a country from locations outside that country. Again,
the response by the firm might be to set up production facilities in that country—even though it may
result in higher production costs.
Such reasoning was one of the factors behind the rapid expansion of Japanese automaking capacity
in the United States during the 1980s and 1990s. is followed the establishment of a VER agreement
between the United States and Japan that limited U.S. imports of Japanese automobiles. Today,
Donald Trump’s threat to impose high tariffs on companies that shift their production to other
nations in order to reduce costs—and then export goods back to the United States—is forcing some
enterprises to rethink their outsourcing strategy. In particular, a number of automobile companies,
including Ford and General Motors, have modified their plans to shift some production to factories in
Mexico and have announced plans to expand U.S. production in order to appease the Trump
administration.33
ird, to conform to local content regulations, a firm may have to locate more production activities
in a given market than it would otherwise. Again, from the firm’s perspective, the consequence might
be to raise costs above the level that could be achieved if each production activity were dispersed to the
optimal location for that activity. And finally, even when trade barriers do not exist, the firm may still
want to locate some production activities in a given country to reduce the threat of trade barriers
being imposed in the future.
All these effects are likely to raise the firm’s costs above the level that could be achieved in a world
without trade barriers. e higher costs that result need not translate into a significant
competitive disadvantage relative to other foreign firms, however, if the countries imposing
trade barriers do so to the imported products of all foreign firms, irrespective of their national origin.
But when trade barriers are targeted at exports from a particular nation, firms based in that nation are
at a competitive disadvantage to firms of other nations. e firm may deal with such targeted trade
barriers by moving production into the country imposing barriers. Another strategy may be to move
production to countries whose exports are not targeted by the specific trade barrier.
Finally, the threat of antidumping action limits the ability of a firm to use aggressive pricing to gain
market share in a country. Firms in a country also can make strategic use of antidumping measures to
limit aggressive competition from low-cost foreign producers. For example, the U.S. steel industry has
been very aggressive in bringing antidumping actions against foreign steelmakers, particularly in times
of weak global demand for steel and excess capacity. For example, in 1998 and 1999, the United States
faced a surge in low-cost steel imports as a severe recession in Asia left producers there with excess
capacity. e U.S. producers filed several complaints with the International Trade Commission. One
argued that Japanese producers of hot rolled steel were selling it at below cost in the United States. e
ITC agreed and levied tariffs ranging from 18 to 67 percent on imports of certain steel products from
Japan (these tariffs are separate from the steel tariffs discussed earlier).34
Policy Implications As noted in Chapter 6, business firms are major players on the international trade scene. Because of their pivotal role in international trade, firms can and do exert a strong
influence on government policy toward trade. is influence can encourage protectionism, or it can
encourage the government to support the WTO and push for open markets and freer trade among all
nations. Government policies with regard to international trade can have a direct impact on business.
Consistent with strategic trade policy, examples can be found of government intervention in the
form of tariffs, quotas, antidumping actions, and subsidies helping firms and industries establish a
competitive advantage in the world economy. In general, however, the arguments contained in this
chapter and in Chapter 6 suggest that government intervention has three drawbacks. Intervention can
be self-defeating because it tends to protect the inefficient rather than help firms become efficient
global competitors. Intervention is dangerous; it may invite retaliation and trigger a trade war. Finally,
intervention is unlikely to be well executed, given the opportunity for such a policy to be captured by
special-interest groups. Does this mean that business should simply encourage government to adopt a
laissez-faire free trade policy?
Most economists would probably argue that the best interests of international business are served
by a free trade stance but not a laissez-faire stance. It is probably in the best long-run interests of the
business community to encourage the government to aggressively promote greater free trade by, for
example, strengthening the WTO. Business probably has much more to gain from government efforts
to open protected markets to imports and foreign direct investment than from government efforts to
support certain domestic industries in a manner consistent with the recommendations of strategic
trade policy.
is conclusion is reinforced by a phenomenon we touched on in Chapter 1—the increasing
integration of the world economy and internationalization of production that has occurred over the
past two decades. We live in a world where many firms of all national origins increasingly depend on
globally dispersed production systems for their competitive advantage. Such systems are the result of
freer trade. Freer trade has brought great advantages to firms that have exploited it and to consumers
who benefit from the resulting lower prices. Given the danger of retaliatory action, business firms that
lobby their governments to engage in protectionism must realize that by doing so, they may be
denying themselves the opportunity to build a competitive advantage by constructing a globally
dispersed production system. By encouraging their governments to engage in protectionism, their own
activities and sales overseas may be jeopardized if other governments retaliate. is does not mean a
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firm should never seek protection in the form of antidumping actions and the like, but it should
review its options carefully and think through the larger consequences.
Key Terms
free trade, p. 186
General Agreement on Tariffs and Trade (GATT), p. 186
tariff, p. 187
specific tariff, p. 187
ad valorem tariff, p. 187
subsidy, p. 188
import quota, p. 189
tariff rate quota, p. 189
voluntary export restraint (VER), p. 189
quota rent, p. 190
export tariff, p. 190
export ban, p. 190
local content requirement (LCR), p. 190
administrative trade policies, p. 191
dumping, p. 191
antidumping policies, p. 191
countervailing duties, p. 191
infant industry argument, p. 195
strategic trade policy, p. 196
Smoot-Hawley Act, p. 198
multilateral or bilateral trade agreements, p. 205
Summary
is chapter described how the reality of international trade deviates from the theoretical ideal of
unrestricted free trade reviewed in Chapter 6. In this chapter, we reported the various instruments of
trade policy, reviewed the political and economic arguments for government intervention in
international trade, reexamined the economic case for free trade in light of the strategic trade policy
argument, and looked at the evolution of the world trading framework. While a policy of free trade
may not always be the theoretically optimal policy (given the arguments of the new trade theorists), in
practice it is probably the best policy for a government to pursue. In particular, the long-run interests
of business and consumers may be best served by strengthening international institutions such as the
WTO. Given the danger that isolated protectionism might escalate into a trade war, business probably
has far more to gain from government efforts to open protected markets to imports and foreign direct
investment (through the WTO) than from government efforts to protect domestic industries from
foreign competition. e chapter made the following points:
1. Trade policies such as tariffs, subsidies, antidumping regulations, and local content requirements
tend to be pro-producer and anticonsumer. Gains accrue to producers (who are protected from
foreign competitors), but consumers lose because they must pay more for imports.
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2. ere are two types of arguments for government intervention in international trade: political
and economic. Political arguments for intervention are concerned with protecting the interests
of certain groups, often at the expense of other groups, or with promoting goals with regard to
foreign policy, human rights, consumer protection, and the like. Economic arguments for
intervention are about boosting the overall wealth of a nation.
3. A common political argument for intervention is that it is necessary to protect jobs. However,
political intervention often hurts consumers, and it can be self-defeating. Countries sometimes
argue that it is important to protect certain industries for reasons of national security. Some
argue that government should use the threat to intervene in trade policy as a bargaining tool to
open foreign markets. is can be a risky policy; if it fails, the result can be higher trade barriers.
4. e infant industry argument for government intervention contends that to let manufacturing
get a toehold, governments should temporarily support new industries. In practice, however,
governments often end up protecting the inefficient.
5. Strategic trade policy suggests that with subsidies, government can help domestic firms gain
first-mover advantages in global industries where economies of scale are important. Government
subsidies may also help domestic firms overcome barriers to entry into such industries.
6. e problems with strategic trade policy are twofold: (a) Such a policy may invite retaliation, in
which case all will lose, and (b) strategic trade policy may be captured by special-interest groups,
which will distort it to their own ends.
7. e GATT was a product of the postwar free trade movement. e GATT was successful in
lowering trade barriers on manufactured goods and commodities. e move toward greater free
trade under the GATT appeared to stimulate economic growth.
8. e completion of the Uruguay Round of GATT talks and the establishment of the World
Trade Organization have strengthened the world trading system by extending GATT rules to
services, increasing protection for intellectual property, reducing agricultural subsidies, and
enhancing monitoring and enforcement mechanisms.
9. Trade barriers act as a constraint on a firm’s ability to disperse its various production activities to
optimal locations around the globe. One response to trade barriers is to establish more
production activities in the protected country.
10. Business may have more to gain from government efforts to open protected markets to imports
and foreign direct investment than from government efforts to protect domestic industries from
foreign competition.
Critical inking and Discussion Questions
1. Do you think governments should consider human rights when granting preferential trading
rights to countries? What are the arguments for and against taking such a position?
2. Whose interests should be the paramount concern of government trade policy: the interests of
producers (businesses and their employees) or those of consumers?
3. Given the arguments relating to the new trade theory and strategic trade policy, what kind of
trade policy should business be pressuring government to adopt?
4. You are an employee of a U.S. firm that produces personal computers in ailand and then
exports them to the United States and other countries for sale. e personal computers were
originally produced in ailand to take advantage of relatively low labor costs and a skilled
workforce. Other possible locations considered at the time were Malaysia and Hong Kong. e
U.S. government decides to impose punitive 100 percent ad valorem tariffs on imports of
computers from ailand to punish the country for administrative trade barriers that restrict
U.S. exports to ailand. How should your firm respond? What does this tell you about the use
of targeted trade barriers?
5. Reread the Management Focus “Protecting U.S. Magnesium.” Who gains most from the
antidumping duties levied by the United States on imports of magnesium from China and
Russia? Who are the losers? Are these duties in the best national interests of the United States?
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. You work for a pharmaceutical company that hopes to provide products and services in New
Zealand. Yet management’s current knowledge of this country’s trade policies and barriers is
limited. After searching a resource that summarizes the import and export regulations, outline the
most important foreign trade barriers your firm’s managers must keep in mind while developing
a strategy for entry into New Zealand’s pharmaceutical market.
2. e number of member nations of the World Trade Organization has increased considerably in
recent years. In addition, some nonmember countries have observer status in the WTO. Such
status requires accession negotiations to begin within five years of attaining this preliminary
position. Visit the WTO’s website to identify a list of current members and observers. Identify
the last five countries that joined the WTO as members. Also, examine the list of current
observer countries. Do you notice anything in particular about the countries that have recently
joined or have observer status?
B o e i n g a n d A i r b u s a r e i n a D o g f i g h t o v e r I l l e g a l S u b s i d i e s
c l o s i n g c a s e
Boeing (boeing.com) and Airbus (airbus.com) are the dominant players in the global market for large
commercial jet aircraft of 100 seats or more. e two companies are locked in a relentless battle for market
share. For decades, these two companies have been accusing each other of benefiting from government
subsidies. In its early years, Airbus received 100 percent of the funds it needed to develop new aircraft from
the governments of four European countries where Airbus’s operations were based: Germany, France, Spain,
and the United Kingdom. ese funds were provided in the form of loans at below-market interest rates. For
its part, Airbus claimed that Boeing has long been the recipient of R&D grants from the U.S. Department of
Defense and NASA, which amount to indirect subsidies. For example, Boeing’s first commercial jet aircraft,
the 707, was a derivative of an aerial refueling tanker, the KC-135, originally developed for the United States
Air Force under a Pentagon contract.
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e two companies reached an agreement on phasing out subsidies back in 1992, but Boeing walked away
from that deal in 2004, claiming that Airbus was still benefiting from billions in illegal development subsidies.
In 2006, the U.S. government filed a case with the World Trade Organization (WTO) alleging that Airbus
had received $25 billion in illegal subsidies, mostly in the form of launch aid for developing new aircraft. In
2010, the WTO ruled that Airbus had benefited from $18 billion in illegal government subsidies,
including $15 billion in launch aid. e WTO gave the European governments until December
2011 to remove the harmful effects of the subsidies.
©Bloomberg/Getty Images
In September 2016, the WTO issued another ruling criticizing the Europeans for failing to comply with its
2010 ruling and, moreover, for giving another $5 billion to Airbus in the form of noncommercial loans to
help develop its latest aircraft, the A350. In this latest ruling, the WTO stated that “it is apparent that the
A350 could not have been launched and brought to market in the absence of launch aid.” In total, the WTO
calculated that Boeing had lost 104 wide-bodied jet orders and 271 narrow-bodied jet orders as a result of
Airbus launch subsidies. is latest ruling opens the door for the United States to apply retaliatory trade
sanctions against noncompliant European governments.
However, it seems unlikely that the United States will apply retaliatory sanctions any time soon. Part of the
reason is the the United States itself has been countersued by the EU through the WTO for providing illegal
subsidies to Boeing. In November 2016, the WTO ruled that Boeing would receive around $5.7 billion in
illegal tax breaks from Washington State, where Boeing’s main production facilities are located. e State of
Washington had promised to give Boeing these tax breaks between 2020 and 2040 on the condition that the
company kept the production of the wings for the wide-bodied 777X aircraft in the state. According to
Airbus, these tax breaks give the 777X an unfair advantage against its rival aircraft, an assessment that the
WTO seems to agree with.
In 2017, the WTO issued a report largely clearing the United States of maintaining unfair support for
Boeing. However, the WTO noted that the U.S. had failed to withdraw tax breaks offered by Washington
State where most of its planes are assembled, and it continued to suggest that those tax breaks have adverse
effects. It remains to be seen what the final outcome will be. e WTO has yet to rule on how much damage
the tax breaks Boeing has received for the 777X program might impose upon Airbus. For its part, Boeing
claims that the benefits from the subsidies to the 777X program only amount to $50 million a year, an
assessment that Airbus vigorously disagrees with. A final ruling isn’t expected until at least 2018.
Sources: Dominic Gates, “Airbus Scoffs, Boeing Crows as WTO Slams EU for Failing to Address Illegal Subsidies,” Seattle Times,
September 22, 2016; “Boeing Illegally Given $5.7 Billion in Tax Breaks by Washington State, WTO Rules,” Associated Press,
November 28, 2016; Robert Wall and Doug Cameron, “EU Failed to Cut Off Illegal Subsidies to Airbus, WTO Rules,” e Wall
Street Journal, September 22, 2016; and Tom Miles, “WTO Largely Backs Boeing in Trade Row, Faults Tax Breaks,” Reuters, June 9,
2017.
CASE DISCUSSION QUESTIONS
1. Are there any circumstances under which the subsidies that Airbus received in its early years
might be justified?
2. Do you think that Boeing originally benefited from subsidies? If they did, could they be
justified?
3. Boeing and Airbus have allegedly been receiving subsidies for decades. How might ongoing
subsidies distort the market for large commercial jet aircraft?
4. Who benefits from government subsidies to Boeing and Airbus? Who loses?
5. Under what circumstances, if any, should national governments subsidize the development of
new technologies?
6. What would be the optimal outcome (in terms of economic welfare) of the ongoing trade
dispute between the U.S. and the EU countries backing Airbus? How might such an
agreement be enforced?
Endnotes
1. For a detailed welfare analysis of the effect of a tariff, see P. R. Krugman and M. Obstfeld,
International Economics: eory and Policy (New York: HarperCollins, 2000), ch. 8.
2. Christian Henn and Brad McDonald, “Crisis Protectionism: e Observed Trade Impact,” IMF
Economic Review 62, no. 1 (April 2014), pp. 77–118.
3. World Trade Organization, World Trade Report 2006 (Geneva: WTO, 2006).
4. e study was undertaken by Kym Anderson of the University of Adelaide. See “A Not So
Perfect Market,” e Economist: Survey of Agriculture and Technology, March 25, 2000, pp. 8–10.
5. K. Anderson, W. Martin, and D. van der Mensbrugghe, “Distortions to World Trade: Impact
on Agricultural Markets and Farm Incomes,” Review of Agricultural Economics 28 (Summer
2006), pp. 168–94.
6. J. B. Teece, “Voluntary Export Restraints Are Back; ey Didn’t Work the Last Time,”
Automotive News, April 23, 2012.
7. G. Hufbauer and Z. A. Elliott, Measuring the Costs of Protectionism in the United States
(Washington, DC: Institute for International Economics, 1993).
8. Sean McLain, “American Cars in Japan: Lost in Translation,” e Wall Street Journal, January 26,
2017.
9. Robert E. Scott. “Growth in US-China Trade Deficit Between 2001–2015 Cost 3.4 Million
Jobs,” Economic Policy Institute, January 31, 2017.
10. Alan Goldstein, “Sematech Members Facing Dues Increase; 30% Jump to Make Up for Loss of
Federal Funding,” Dallas Morning News, July 27, 1996, p. 2F.
11. N. Dunne and R. Waters, “U.S. Waves a Big Stick at Chinese Pirates,” Financial Times, January
6, 1995, p. 4.
12. Peter S. Jordan, “Country Sanctions and the International Business Community,” American
Society of International Law Proceedings of the Annual Meeting 20, no. 9 (1997), pp. 333–42.
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13. “Brazil’s Auto Industry Struggles to Boost Global Competitiveness,” Journal of Commerce,
October 10, 1991, p. 6A.
14. For reviews, see J. A. Brander, “Rationales for Strategic Trade and Industrial Policy,” in Strategic
Trade Policy and the New International Economics, P. R. Krugman, ed. (Cambridge, MA: MIT
Press, 1986); P. R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1 (1987), pp.
131–44; P. R. Krugman, “Does the New Trade eory Require a New Trade Policy?” World
Economy 15, no. 4 (1992), pp. 423–41.
15. “Airbus and Boeing: e Jumbo War,” e Economist, June 15, 1991, pp. 65–66.
16. For details, see Krugman, “Is Free Trade Passé?”; Brander, “Rationales for Strategic Trade and
Industrial Policy.”
17. Krugman, “Is Free Trade Passe?”
18. is dilemma is a variant of the famous prisoner’s dilemma, which has become a classic
metaphor for the difficulty of achieving cooperation between self-interested and mutually
suspicious entities. For a good general introduction, see A. Dixit and B. Nalebuff, inking
Strategically: e Competitive Edge in Business, Politics, and Everyday Life (New York: Norton,
1991).
19. Note that the Smoot-Hawley Act did not cause the Great Depression. However, the beggar-thy-
neighbor trade policies that it ushered in certainly made things worse. See J. Bhagwati,
Protectionism (Cambridge, MA: MIT Press, 1988).
20. World Bank, World Development Report (New York: Oxford University Press, 1987).
21. Frances Williams, “WTO—New Name Heralds New Powers,” Financial Times, December 16,
1993, p. 5; Frances Williams, “GATT’s Successor to Be Given Real Clout,” Financial Times,
April 4, 1994, p. 6.
22. W. J. Davey, “e WTO Dispute Settlement System: e First Ten Years,” Journal of
International Economic Law, March 2005, pp. 17–28; WTO Annual Report, 2016, archived at
www.wto.org/english/res_e/publications_e/anrep16_e.htm.
23. Information provided on WTO website,
www.wto.org/english/tratop_e/dispu_e/dispu_status_e.htm.
24. Data at www.wto.org/english/tratop_e/adp_e/adp_e.htm.
25. World Trade Organization, World Tariff Profiles 2017 (Geneva: WTO, 2017).
26. World Trade Organization, Annual Report by the Director General 2003 (Geneva: WTO, 2003).
27. World Trade Organization, Annual Report by the Director General 2003 (Geneva: WTO, 2003).
28. Anderson et al., “Distortions to World Trade.”
29. World Trade Organization, Annual Report 2002 (Geneva: WTO, 2002).
30. S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “e Payoff to America from Global
Integration,” in e United States and the World Economy: Foreign Policy for the Next Decade, C.
F. Bergsten, ed. (Washington, DC: Institute for International Economics, 2005).
31. World Bank, Global Economic Prospects 2005 (Washington, DC: World Bank, 2005).
32. “Doha Development Agenda,” OECD Observer, September 2006, pp. 64–67.
33. Peter Nicholas, “Trump Warns Auto Executive on Moving Business Overseas,” e Wall Street
Journal, January 24, 2017.
34. “Punitive Tariffs Are Approved on Imports of Japanese Steel,” e New York Times, June 12,
1999, p. A3.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-
Hill Education
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Part 3 e Global Trade and Investment Environment
Foreign Direct Investment
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO8-1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.
LO8-2 Explain the different theories of FDI.
LO8-3 Understand how political ideology shapes a government’s attitudes toward FDI.
LO8-4 Describe the benefits and costs of FDI to home and host countries.
LO8-5 Explain the range of policy instruments that governments use to influence FDI.
LO8-6 Identify the implications for managers of the theory and government policies associated with FDI.
Geely Goes Global
opening case
Zhejiang Geely Holding Group Co., Ltd (zgh.com)—or Geely for short—is a Chinese auto manufacturer that
started in 1986 as a manufacturer of refrigerators. Founded by Li Shufu, an energetic entrepreneur and car
enthusiast, the Hangzhou-based company did not enter the automobile business until 1997. Today, it is the
second largest private automobile manufacturer in China’s booming car market.
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Li Shufu reportedly has a great appreciation for design. He scrapped three batches of poorly designed and
built models before finally arriving at one that met his expectations, a four-door subcompact sedan introduced
in 2002 known as the Ziyoujian (Free Cruiser in English). In a clear sign that Geely had yet to develop its own design and engineering skills, the car was actually designed by the South Korean firm Daewoo Motors.
It was around this time that Li started to think about owning Volvo, his personal favorite car maker. Based
in Sweden, Volvo had been acquired by Ford Motor Company in 1999 for $6.45 billion. Li got his chance in
2009 when Ford, battered by the great recession that had hammered the auto market in the United States and
Europe, announced that it would sell many of its specialty car brands, including Volvo. In 2010, Geely
reached an agreement to purchase Volvo for $1.8 billion. At the time this was the largest overseas acquisition
by a Chinese automobile maker.
Many observers had low expectations for the acquisition, but they have been proved wrong. e marriage
of Volvo’s brand and engineering design skills with Geely’s manufacturing capabilities has proved to be a
winning combination. Today Volvo cars are still engineered, designed, and tested in Gothenburg Sweden, but
they are manufactured at three plants in China and one in South Carolina.
China has emerged as a major market for the Volvo, where the brand is valued for its safety and elegance.
e company’s aim is to produce the safest car on the road that handles well under any roadside conditions.
Geely has pledge to produce a “death-proof ” car by 2020, with a commitment that no one should be seriously
injured or killed in a new Volvo. e technologies required to achieve this include auto steering, adaptive
cruise control, and pedestrian and animal detection for collision warnings and avoidance, all technologies that
are being developed in Gothenburg.
e proof of the strategy is in the sales figures. In 2017, sales rose 7 percent year-on-year to a new record
high. All regions contributed to the nearly 600,000 units sold, with performance in the Asia Pacific region
growing by more than 20 percent on the back of record sales in China, now the largest market for the Volvo
brand.
Emboldened by its success with Volvo, Geely is now making more foreign investments. In 2017, it
acquired a controlling stake in the British sports car manufacturer Lotus Cars, a 49.9 percent stake in Proton,
Malaysia’s largest car company, and minority stakes in the Swedish Truck Company, the Volvo Group (the one
time parent of Volvo Cars), and Daimler Benz. •
Sources: Pamela Ambler, “Volvo and Geely: e Unlikely Marriage of Swedish Tech and Chinese Manufacturing,” Forbes, January
23, 2018; Sui-Lee Wee, “Geely Buys Stake in Volvo Trucks,” e New York Times, December 27, 2017; “Volvo Cars Sales Rise to
Fresh Record,” Reuters, January 4, 2018.
Introduction
Foreign direct investment (FDI) occurs when a firm invests directly in facilities to produce or market a
good or service in a foreign country. According to the U.S. Department of Commerce, FDI occurs
whenever a U.S. citizen, organization, or affiliated group takes an interest of 10 percent or more in a
foreign business entity. Once a firm undertakes FDI, it becomes a multinational enterprise. e
investment by Geely in Volvo discussed in the opening case is an example of FDI. While much FDI
takes the form greenfield ventures—building up subsidiaries from scratch—acquisitions are also an
important vehicle for foreign investment.
is chapter begins by looking at the importance of FDI in the world economy. Next, we review
the theories that have been used to explain why enterprises undertake foreign direct investment. ese
theories can explain why Geely acquired Volvo. Geely needed Volvo’s engineering design skills and
access to a powerful brand like Volvo. Although Geely perhaps could have built these skills and the
associated brand equity internally, it was quicker (and probably cheaper in this instance) to acquire
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Volvo. e foreign investment, by combining Geely’s manufacturing capabilities with Volvo’s design
engineering skills and brand, has enabled Geely to transform itself from a little-known Chinese
automobile company into a global player in the luxury car segment. After discussing theories of FDI,
the chapter moves on to look at government policy toward foreign direct investment. e chapter
closes with a section on implications of the material discussed in the chapter for management practice.
Foreign Direct Investment in the World Economy
LO 8-1 Recognize current trends regarding foreign direct investment (FDI) in the world
economy.
When discussing foreign direct investment, it is important to distinguish between the flow of FDI and
the stock of FDI. e flow of FDI refers to the amount of FDI undertaken over a given time period
(normally a year). e stock of FDI refers to the total accumulated value of foreign-owned assets at a
given time. We also talk of outflows of FDI, meaning the flow of FDI out of a country, and inflows
of FDI, the flow of FDI into a country.
TRENDS IN FDI
e past 25 years have seen a marked increase in both the flow and stock of FDI in the world
economy. e average yearly outflow of FDI increased from $250 billion in 1990 to $1.43 trillion in
2017 (see Figure 8.1).1 Over the past 25 years, the flow of FDI has accelerated faster than the growth
in world trade and world output. For example, between 1990 and 2017, the total flow of FDI from all
countries increased around sixfold, while world trade by value grew fourfold and world output by
around 60 percent.2 As a result of the strong FDI flows, by 2017 the global stock of FDI was about
$32 trillion. e foreign affiliates of multinationals had $31 trillion in global sales in 2017,
compared to $22.5 trillion in global exports, and accounted for more than one-third of all
cross-border trade in goods and services.3 Clearly, by any measure, FDI is a very important
phenomenon in the global economy.
8.1 FIGURE
FDI outflows, 1990–2017 ($ billions).
Source: UNCTAD statistical data set, http://unctadstat.unctad.org.
FDI has grown more rapidly than world trade and world output for several reasons. First, despite
the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures.
Executives see FDI as a way of circumventing future trade barriers. Given the rising pressures for
protectionism associated with the election of Donald Trump as president in the United States and the
decision by the British to leave the European Union, this seems likely to continue for some time.
Second, much of the increase in FDI has been driven by the political and economic changes that have
been occurring in many of the world’s developing nations. e general shift toward democratic
political institutions and free market economies that we discussed in Chapter 3 has encouraged FDI.
Across much of Asia, eastern Europe, and Latin America, economic growth, economic deregulation,
privatization programs that are open to foreign investors, and removal of many restrictions on FDI
have made these countries more attractive to foreign multinationals. According to the United Nations,
some 90 percent of the 2,700 changes made worldwide between 1992 and 2009 in the laws governing
foreign direct investment created a more favorable environment for FDI.4
e globalization of the world economy is also having a positive effect on the volume of FDI.
Many firms see the whole world as their market, and they are undertaking FDI in an attempt to make
sure they have a significant presence in many regions of the world. For example, a third of the
revenues and as much as 40 percent of the profits of firms in the S&P 500 index are generated abroad.
For reasons that we explore later in this book, many firms now believe it is important to have
production facilities close to their major customers. is too creates pressure for greater FDI.
THE DIRECTION OF FDI
Historically, most FDI has been directed at the developed nations of the world as firms based in
advanced countries invested in the others’ markets (see Figure 8.2). During the 1980s and 1990s, the
United States was often the favorite target for FDI inflows. e United States has been an attractive
target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a
favorable political environment, and the openness of the country to FDI. Investors include firms based
in Great Britain, Japan, Germany, Holland, and France. Inward investment into the United States
remained high during the 2000s and stood at $275 billion in 2017. e developed nations of Europe
have also been recipients of significant FDI inflows, principally from the United States and other
European nations. In 2017, inward investment into Europe was $334 billion. e United Kingdom
and France have historically been the largest recipients of inward FDI.5
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8.2 FIGURE
FDI inflows by region, 1995–2017 ($ billions).
Source: UNCTAD statistical data set, http://unctadstat.unctad.org.
Even though developed nations still account for the largest share of FDI inflows, FDI into
developing nations and the transition economies of eastern Europe and the old Soviet Union has
increased markedly (see Figure 8.2). Most recent inflows into developing nations have been
targeted at the emerging economies of Southeast Asia. Driving much of the increase has
been the growing importance of China as a recipient of FDI, which attracted about $60 billion of FDI
in 2004 and rose steadily to hit a record $136 billion in 2017.6 e reasons for the strong flow of
investment into China are discussed in the accompanying Country Focus. Latin America is the next
most important region in the developing world for FDI inflows. In 2017, total inward investments
into this region reached $151 billion. Brazil has historically been the top recipient of inward FDI in
Latin America. In Central America, Mexico has been a big recipient of inward investment thanks to its
proximity to the United States and to NAFTA. In 2017, some $27 billion of investments were made
by foreigners in Mexico. At the other end of the scale, Africa has long received the smallest amount of
inward investment, $42 billion in 2017. In recent years, Chinese enterprises have emerged as major
investors in Africa, particularly in extraction industries, where they seem to be trying to ensure future
supplies of valuable raw materials. e inability of Africa to attract greater investment is in part a
reflection of the political unrest, armed conflict, and frequent changes in economic policy in the
region.7
THE SOURCE OF FDI
Since World War II, the United States has consistently been the largest source country for FDI. Other
important source countries include the United Kingdom, France, Germany, the Netherlands, and
Japan. Collectively, these six countries accounted for 60 percent of all FDI outflows for 1998–2018
(see Figure 8.3). As might be expected, these countries also predominate in rankings of the world’s
largest multinationals.8 ese nations dominate primarily because they were the most
developed nations with the largest economies during much of the postwar period and
therefore home to many of the largest and best-capitalized enterprises. Many of these countries also
had a long history as trading nations and naturally looked to foreign markets to fuel their economic
expansion. us, it is no surprise that enterprises based there have been at the forefront of foreign
investment trends.
8.3 FIGURE
Cumulative FDI outflows, 1998–2017 ($ billions).
Source: UNCTAD statistical data set, http://unctadstat.unctad.org.
c o u n t r y F O C U S
Foreign Direct Investment in China
Beginning in late 1978, China’s leadership decided to move the economy away from a centrally planned
socialist system to one that was more market driven. e result has been 40 years of sustained high economic
growth rates of around 6–10 percent, compounded annually. is growth attracted substantial foreign
investment. Starting from a tiny base, foreign investment increased to an annual average rate of $2.7 billion
between 1985 and 1990 and then surged to $40 billion annually in the late 1990s, making China the second-
biggest recipient of FDI inflows in the world after the United States. e growth has continued, with inward
investments into China hitting $133 billion in 2016 (with another $108 billion going into Hong Kong).
Over the past 20 years, this inflow has resulted in the establishment of more than 300,000 foreign-funded
enterprises in China. e total stock of FDI in mainland China grew from almost nothing in 1978 to $1.35
trillion in 2016 (another $1.6 trillion of FDI stock was in Hong Kong).
e reasons for this investment are fairly obvious. With a population of more than 1.3 billion people,
China represents the world’s largest market. Historically, import tariffs made it difficult to serve this market
via exports, so FDI was required if a company wanted to tap into the country’s huge potential. China joined
the World Trade Organization in 2001. As a result, average tariff rates on imports have fallen from 15.4
percent to about 8 percent today. Even so, avoiding the tariff on imports is still a motive for investing in
China (at 8 percent, tariffs are still above the average of 3.5 percent found in many developed nations).
Notwithstanding tariff rates, many foreign firms believe that doing business in China requires a substantial
presence in the country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combination of relatively inexpensive labor and tax incentives, particularly for enterprises that
establish themselves in special economic zones, makes China an attractive base from which to serve Asian or
world markets with exports (although rising labor costs in China are now making this less important).
Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China.
For one thing, despite decades of growth, China still lags far behind developed nations in the wealth and
sophistication of its consumer market. is limits opportunities for Western firms. e average annual wage
in 2014 was only $8,655. Moreover, half of the 770 million labor force works in rural areas and only earns
around $2,000 a year. e middle class, which accounts for about 20 percent of the workforce, has an average
income of $12,000 a year, still way below Western levels. Only 0.2 percent of the population earns more than
$50,000 a year.
Other problems include a highly regulated environment, which can make it problematic to conduct
business transactions, and shifting tax and regulatory regimes. en there are problems with local joint-
venture partners that are inexperienced, opportunistic, or simply operate according to different goals. One
U.S. manager explained that when he laid off 200 people to reduce costs, his Chinese partner hired them all
back the next day. When he inquired why they had been hired back, the Chinese partner, which was
government owned, explained that as an agency of the government, it had an “obligation” to reduce
unemployment. Western firms also need to be concerned about protecting their intellectual property because
there is a history of intellectual property not being respected in China, although this may now be starting to
change.
Sources: Interviews by the author while in China; United Nations, World Investment Report, 2017; Linda Ng and C. Tuan, “Building a Favorable Investment Environment: Evidence for the Facilitation of FDI in China,”
e World Economy, 2002, pp. 1095–114; S. Chan and G. Qingyang, “Investment in China Migrates Inland,” Far Eastern Economic Review, May 2006, pp. 52–57; Rachel Chang, “Here’s What China’s Middle Classes Really Earn—and Spend,” Bloomberg, March 9, 2016; Gordon Orr, “A Pocket Guide to Doing Business in China,” McKinsey, October 2014, archived at www.mckinsey.com/business-functions/strategy-and-corporate- finance/our-insights/a-pocket-guide-to-doing-business-in-china.
Did You Know?
Did you know that America is the world’s largest foreign investor and the largest recipient of foreign investment?
Visit your instructor’s Connect® course and click on your eBook or Smartbook® to view a short video explanation from
the authors.
at being said, it is noteworthy that Chinese firms have started to emerge as major foreign
investors. In 2005, Chinese firms invested some $12 billion internationally. Since then, the figure has
risen steadily, reaching a record $196 billion in 2016 before declining to $125 billion in 2017. Firms
based in Hong Kong accounted for another $60 billion of outward FDI in 2016 and $83 billion in
2017. Much of the outward investment by Chinese firms has been directed at extractive industries in
less developed nations (e.g., China has been a major investor in African countries). A major motive for
these investments has been to gain access to raw materials, of which China is one of the world’s largest
consumers. ere are signs, however, that Chinese firms are starting to turn their attention to more
advanced nations. In 2017, Chinese firms invested $25 billion in the United States, up from $146
million in 2003.9
THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS
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FDI takes two main forms. e first is a greenfield investment, which involves the establishment of a
new operation in a foreign country. e second involves acquiring or merging with an existing firm in
the foreign country. UN estimates indicate that some 40 to 80 percent of all FDI inflows were in the
form of mergers and acquisitions between 1998 and 2017.10 However, FDI flows into developed
nations differ markedly from those into developing nations. In the case of developing nations, only
about one-third or less of FDI is in the form of cross-border mergers and acquisitions. e lower
percentage of mergers and acquisitions may simply reflect the fact that there are fewer target firms to
acquire in developing nations.
Which Is Better, an Acquisition or a Greenfield Investment?
A greenfield investment is an establishment of a new operation in a foreign country (i.e., a parent company
starts a new venture in a foreign country by building new production facilities from the ground up). e
acquisition approach refers to buying or merging operations with an existing firm in a foreign country. In this
chapter and Chapter 13, we discuss reasons for greenfield and acquisition-based investments in a foreign
country. While mergers and acquisitions (M&A) are typically quicker to execute than building something
from literally the ground up, M&A often fails to gain the advantages expected. e failure rate of M&A is
somewhere between 50 and 83 percent. At the same time, the trend shows that both the number of mergers
and acquisitions and the sums of money spent on M&A are increasingly consistently every year. If you were
making the decision, would you prefer to make a greenfield investment or to engage in either a merger or
acquisition in a foreign country?
Source: Y. Weber, C. Oberg, and S. Tarba, “e M&A Paradox: Factors of Success and Failure in Mergers and
Acquisitions,” Comprehensive Guide to Mergers & Acquisitions, A: Managing the Critical Success Factors Across Every Stage of the M&A Process (Upper Saddle River, NJ: FT Press, 2013).
When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake
greenfield investments? We consider this question in depth in Chapter 15. For now, we can make a
few basic observations. First, mergers and acquisitions are quicker to execute than greenfield
investments. is is an important consideration in the modern business world where
markets evolve very rapidly. Many firms apparently believe that if they do not acquire a desirable target
firm, then their global rivals will. Second, foreign firms are acquired because those firms have valuable
strategic assets, such as brand loyalty, customer relationships, trademarks or patents, distribution
systems, production systems, and the like (this was clearly a factor in the acquisition of Volvo by Geely
—see the opening case). It is easier and perhaps less risky for a firm to acquire those assets than to
build them from the ground up through a greenfield investment. ird, firms make acquisitions
because they believe they can increase the efficiency of the acquired unit by transferring capital,
technology, or management skills. However, as we discuss in Chapter 15, there is evidence that many
mergers and acquisitions fail to realize their anticipated gains.11
test PREP
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Page 219
eories of Foreign Direct Investment
LO 8-2 Explain the different theories of FDI.
In this section, we review several theories of foreign direct investment. ese theories approach the
various phenomena of foreign direct investment from three complementary perspectives. One set of
theories seeks to explain why a firm will favor direct investment as a means of entering a foreign
market when two other alternatives, exporting and licensing, are open to it. Another set of theories
seeks to explain why firms in the same industry often undertake foreign direct investment at the same
time and why they favor certain locations over others as targets for foreign direct investment. Put
differently, these theories attempt to explain the observed pattern of foreign direct investment flows. A third theoretical perspective, known as the eclectic paradigm, attempts to combine the two other
perspectives into a single holistic explanation of foreign direct investment (this theoretical perspective
is eclectic because the best aspects of other theories are taken and combined into a single explanation).
WHY FOREIGN DIRECT INVESTMENT?
Why do firms go to the trouble of establishing operations abroad through foreign direct investment
when two alternatives, exporting and licensing, are available to them for exploiting the profit
opportunities in a foreign market? Exporting involves producing goods at home and then shipping
them to the receiving country for sale. Licensing involves granting a foreign entity (the licensee) the
right to produce and sell the firm’s product in return for a royalty fee on every unit sold. e question
is important, given that a cursory examination of the topic suggests that foreign direct investment may
be both expensive and risky compared with exporting and licensing. FDI is expensive because a firm
must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign
enterprise. FDI is risky because of the problems associated with doing business in a different culture
where the rules of the game may be very different. Relative to indigenous firms, there is a greater
probability that a foreign firm undertaking FDI in a country for the first time will make costly
mistakes due to its ignorance. When a firm exports, it need not bear the costs associated with FDI,
and it can reduce the risks associated with selling abroad by using a native sales agent. Similarly, when
a firm allows another enterprise to produce its products under license, the licensee bears the costs or
risks (e.g., fashion retailer Burberry originally entered Japan via a licensing contract with a Japanese
retailer—see the accompanying Management Focus). So why do so many firms apparently prefer FDI
over either exporting or licensing? e answer can be found by examining the limitations of exporting
and licensing as means for capitalizing on foreign market opportunities.
Limitations of Exporting e viability of exporting physical goods is often constrained by transportation costs and trade barriers. When transportation costs are added to production costs, it
becomes unprofitable to ship some products over a large distance. is is particularly true of products
that have a low value-to-weight ratio and that can be produced in almost any location. For such
products, the attractiveness of exporting decreases, relative to either FDI or licensing. is is the case,
for example, with cement. us, Cemex, the large Mexican cement maker, has expanded
internationally by pursuing FDI, rather than exporting. For products with a high value-to-weight
ratio, however, transportation costs are normally a minor component of total landed cost (e.g.,
electronic components, personal computers, medical equipment, computer software, etc.)
and have little impact on the relative attractiveness of exporting, licensing, and FDI.
m a n a g e m e n t F O C U S
Burberry Shifts Its Entry Strategy in Japan
Burberry, the icon British luxury apparel company best known for its high-fashion outerwear, has been
operating in Japan for nearly half a century. Until recently, its branded products were sold under a licensing
agreement with Sanyo Shokai. e Japanese company had considerable discretion as to how it utilized the
Burberry brand. It sold everything from golf bags to miniskirts and Burberry-clad Barbie dolls in its 400 stores
around the country, typically at prices significantly below those Burberry charged for its high-end products in
the United Kingdom.
For a long time, it looked like a good deal for Burberry. Sanyo Shokai did all of the market development in
Japan, generating revenues of around $800 million a year and paying Burberry $80 million in annual royalty
payments. However, by 2007, Burberry’s CEO, Angela Ahrendts, was becoming increasingly dissatisfied with
the Japanese licensing deal and 22 others like it in countries around the world. In Ahrendts’s view, the
licensing deals were diluting Burberry’s core brand image. Licensees such as Sanyo Shokai were selling a wide
range of products at a much lower price point than Burberry charged for products in its own stores. “In
luxury,” Ahrendts once remarked, “ubiquity will kill you—it means that you’re not really luxury
anymore.” Moreover, with an increasing number of customers buying Burberry products online and on trips
to Britain, where the brand was considered very upmarket, Ahrendts felt that it was crucial for Burberry to
tightly control its global brand image.
Ahrendts was determined to rein in licensees and regain control of Burberry’s sales in foreign markets, even
if it meant taking a short-term hit to sales. She started off the process of terminating licensees before leaving
Burberry to run Apple’s retail division in 2014. Her hand-picked successor as CEO, Christopher Bailey, who
rose through the design function at Burberry, has continued to pursue this strategy.
In Japan, the license was terminated in 2015. Sanyo Shokai was required to close nearly 400 licensed
Burberry stores. Burberry is not giving up on Japan, however. After all, Japan is the world’s second-largest
market for luxury goods. Instead, the company will now sell products through a limited number of wholly
owned stores. e goal is to have 35 to 50 stores in the most exclusive locations in Japan by 2018. ey will
offer only high-end products, such as Burberry’s classic $1,800 trench coat. In general, the price point will be
10 times higher than was common for most Burberry products in Japan. e company realizes the move is
risky and fully expects sales to initially fall before rising again as it rebuilds its brand, but CEO Bailey argues
that the move is absolutely necessary if Burberry is to have a coherent global brand image for its luxury
products.
Sources: Kathy Chu and Megumi Fujikawa, “Burberry Gets a Grip on Brand in Japan,” e Wall Street Journal, August 15–16, 2015; Angela Ahrendts, “Burberry’s CEO on Turning an Aging British Icon into a Global Luxury Brand,” Harvard Business Review, January–February 2013; Tim Blanks, “e Designer Who Would be CEO,” e Wall Street Journal Magazine, June 18, 2015; and G. Fasol, “Burberry Solves Its ‘Japan Problem,’ at Least for Now,” Japan Strategy, August 19, 2015.
Transportation costs aside, some firms undertake foreign direct investment as a response to actual
or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods,
governments can increase the cost of exporting relative to foreign direct investment and licensing.
Similarly, by limiting imports through quotas, governments increase the attractiveness of FDI and
licensing. For example, the wave of FDI by Japanese auto companies in the United States that started
in the mid 1980s and continues to this day has been partly driven by protectionist threats from
Congress and by tariffs on the importation of Japanese vehicles, particularly light trucks (SUVs),
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Rankings
which still face a 25 percent import tariff into the United States. For Japanese auto
companies, these factors decreased the profitability of exporting and increased that of
foreign direct investment. In this context, it is important to understand that trade barriers do not have
to be physically in place for FDI to be favored over exporting. Often, the desire to reduce the threat
that trade barriers might be imposed is enough to justify foreign direct investment as an alternative to
exporting.
Cross-border investments
have been ramped up to a
relatively large degree in the last decade. Even with the economic downturn that started in 2008, the world
continued to see a great deal of foreign direct investment by companies in the last decade. Now, when the
economic prosperity is likely to be better, given that we are removed from those downturn days, the
expectation is that more foreign direct investment will be considered by companies. On globalEDGE™, there
are myriad opportunities to gain more knowledge about foreign direct investment (FDI). e “Rankings”
section is a great starting point (globaledge.msu.edu/global-resources/rankings). In this section, globalEDGE™
features several reports by A.T. Kearney—with one of them squarely centered on foreign direct investment
and a “confidence index” for FDI. e companies that participate in the regular study account for more than
$2 trillion in annual global revenue! Which countries are in the top three in the investment confidence index,
and do you agree that the three countries are the best ones to invest in if you were running a company?
Limitations of Licensing A branch of economic theory known as internalization theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering
foreign markets (this approach is also known as the market imperfections approach).12 According to
internalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market
opportunities. First, licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor. In a classic example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the
time, RCA saw licensing as a way to earn a good return from its technological know-how in the
Japanese market without the costs and risks associated with foreign direct investment. However,
Matsushita and Sony quickly assimilated RCA’s technology and used it to enter the U.S. market to
compete directly against RCA. As a result, RCA was relegated to being a minor player in its home
market, while Matsushita and Sony went on to have a much bigger market share.
A second problem is that licensing does not give a firm the tight control over production, marketing, and strategy in a foreign country that may be required to maximize its profitability. With licensing, control over production (of a good or a service), marketing, and strategy are granted to a licensee in
return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain
control over these functions. One reason for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a
foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept
such an imposition because it would likely reduce the licensee’s profit, or it might even cause the
licensee to take a loss. Another reason for wanting control over the strategy of a foreign entity is to make sure that the entity does not damage the firm’s brand. is was the primary reason fashion
retailer Burberry recently terminated its licensing agreement in Japan and switched to a strategy of
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direct ownership of its own retail stores in the Japanese market (see the Management Focus about
Burberry above for details).
One reason for wanting control over the operations of a foreign entity is that the firm might wish to take advantage of differences in factor costs across countries, producing only part of its final product in
a given country, while importing other parts from where they can be produced at lower cost. Again, a
licensee would be unlikely to accept such an arrangement because it would limit the licensee’s
autonomy. For reasons such as these, when tight control over a foreign entity is desirable, foreign
direct investment is preferable to licensing.
A third problem with licensing arises when the firm’s competitive advantage is based not as much
on its products as on the management, marketing, and manufacturing capabilities that produce those
products. e problem here is that such capabilities are often not amenable to licensing. While a foreign licensee may be able to physically reproduce the firm’s product under license, it often may not be able
to do so as efficiently as the firm could itself. As a result, the licensee may not be able to fully exploit
the profit potential inherent in a foreign market.
For example, consider Toyota, a company whose competitive advantage in the global auto industry
is acknowledged to come from its superior ability to manage the overall process of designing,
engineering, manufacturing, and selling automobiles—that is, from its management and
organizational capabilities. Indeed, Toyota is credited with pioneering the development of a new
production process, known as lean production, that enables it to produce higher-quality automobiles at
a lower cost than its global rivals.13 Although Toyota could license certain products, its real
competitive advantage comes from its management and process capabilities. ese kinds of skills are
difficult to articulate or codify; they certainly cannot be written down in a simple licensing contract.
ey are organizationwide and have been developed over the years. ey are not embodied in any one
individual but instead are widely dispersed throughout the company. Put another way, Toyota’s skills
are embedded in its organizational culture, and culture is something that cannot be
licensed. us, if Toyota were to allow a foreign entity to produce its cars under license, the
chances are that the entity could not do so as efficiently as could Toyota. In turn, this would limit the
ability of the foreign entity to fully develop the market potential of that product. Such reasoning
underlies Toyota’s preference for direct investment in foreign markets, as opposed to allowing foreign
automobile companies to produce its cars under license.
All of this suggests that when one or more of the following conditions holds, markets fail as a
mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has
valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm
needs tight control over a foreign entity to maximize its market share and earnings in that country,
and (3) when a firm’s skills and know-how are not amenable to licensing.
Advantages of Foreign Direct Investment It follows that a firm will favor foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make
exporting unattractive. Furthermore, the firm will favor foreign direct investment over licensing (or
franchising) when it wishes to maintain control over its technological know-how, or over its operations
and business strategy, or when the firm’s capabilities are simply not amenable to licensing, as may
often be the case.
Beyond this, FDI has other “strategic” advantages that are difficult to achieve through licensing or
exporting/importing. For example, the opening case describes how the Chinese automobile
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manufacturer Geely acquired the assets of Volvo from Ford in 2010 in order to gain access to Volvo’s
design engineering skills and brand equity. In theory, Geely could have licensed in design know-how
from Volvo, and/or produced Volvo cars in China under license. In practice, design knowledge might
not be easy to license. As with Toyota’s lean production knowledge, such skills are difficult to articulate
or codify and cannot be written down in a simple licensing contract. us, acquisition presents itself
as a better option. Moreover, the acquisition gave Geely the tight operational control that it wanted
over Volvo’s manufacturing activities, enabling it to relocate significant production to China, and
using that as an export base to serve much of the world market outside of North America (North
American demand is served from a production facility in South Carolina).
More generally, gaining technology, productive assets, market share, brand equity, distribution
systems, and the like through FDI by purchasing the assets of an established company can all speed up
market entry, improve production in the firm’s home base, and facilitate the transfer of technology
from the acquired company to the acquiring company. We return to this topic in Chapter 13 when we
discuss different entry strategies.
THE PATTERN OF FOREIGN DIRECT INVESTMENT
Observation suggests that firms in the same industry often undertake foreign direct investment at
about the same time. Also, firms tend to direct their investment activities toward the same target
markets. e two theories we consider in this section attempt to explain the patterns that we observe
in FDI flows.
Strategic Behavior One theory is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F.
T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic
industries.14 An oligopoly is an industry composed of a limited number of large firms (e.g., an
industry in which four firms control 80 percent of a domestic market would be defined as an
oligopoly). A critical competitive feature of such industries is interdependence of the major players:
What one firm does can have an immediate impact on the major competitors, forcing a response in
kind. By cutting prices, one firm in an oligopoly can take market share away from its competitors,
forcing them to respond with similar price cuts to retain their market share. us, the interdependence
between firms in an oligopoly leads to imitative behavior; rivals often quickly imitate what a firm does
in an oligopoly.
Imitative behavior can take many forms in an oligopoly. One firm raises prices, and the others
follow; one expands capacity, and the rivals imitate lest they be left at a disadvantage in the future.
Knickerbocker argued that the same kind of imitative behavior characterizes FDI. Consider an
oligopoly in the United States in which three firms—A, B, and C—dominate the market. Firm A
establishes a subsidiary in France. Firms B and C decide that if successful, this new
subsidiary may knock out their export business to France and give a first-mover advantage
to firm A. Furthermore, firm A might discover some competitive asset in France that it could
repatriate to the United States to torment firms B and C on their native soil. Given these possibilities,
firms B and C decide to follow firm A and establish operations in France.
Studies that have looked at FDI by U.S. firms show that firms based in oligopolistic industries
tended to imitate each other’s FDI.15 e same phenomenon has been observed with regard to FDI
undertaken by Japanese firms.16 For example, Toyota and Nissan responded to investments by Honda
in the United States and Europe by undertaking their own FDI in the United States and Europe.
Research has also shown that models of strategic behavior in a global oligopoly can explain the pattern
of FDI in the global tire industry.17
Knickerbocker’s theory can be extended to embrace the concept of multipoint competition.
Multipoint competition arises when two or more enterprises encounter each other in different
regional markets, national markets, or industries.18 Economic theory suggests that rather like chess
players jockeying for advantage, firms will try to match each other’s moves in different markets to try
to hold each other in check. e idea is to ensure that a rival does not gain a commanding position in
one market and then use the profits generated there to subsidize competitive attacks in other markets.
Although Knickerbocker’s theory and its extensions can help explain imitative FDI behavior by
firms in oligopolistic industries, it does not explain why the first firm in an oligopoly decides to
undertake FDI rather than to export or license. Internalization theory addresses this phenomenon.
e imitative theory also does not address the issue of whether FDI is more efficient than exporting or
licensing for expanding abroad. Again, internalization theory addresses the efficiency issue. For these
reasons, many economists favor internalization theory as an explanation for FDI, although most
would agree that the imitative explanation tells an important part of the story.
THE ECLECTIC PARADIGM
e eclectic paradigm has been championed by the late British economist John Dunning.19 Dunning
argues that in addition to the various factors discussed earlier, location-specific advantages are also of
considerable importance in explaining both the rationale for and the direction of foreign direct
investment. By location-specific advantages, Dunning means the advantages that arise from utilizing
resource endowments or assets that are tied to a particular foreign location and that a firm finds
valuable to combine with its own unique assets (such as the firm’s technological, marketing, or
management capabilities). Dunning accepts the argument of internalization theory that it is difficult
for a firm to license its own unique capabilities and know-how. erefore, he argues that combining
location-specific assets or resource endowments with the firm’s own unique capabilities often requires
foreign direct investment. at is, it requires the firm to establish production facilities where those
foreign assets or resource endowments are located.
An obvious example of Dunning’s arguments are natural resources, such as oil and other minerals,
which are—by their character—specific to certain locations. Dunning suggests that to exploit such
foreign resources, a firm must undertake FDI. Clearly, this explains the FDI undertaken by many of
the world’s oil companies, which have to invest where oil is located in order to combine their
technological and managerial capabilities with this valuable location-specific resource. Another
obvious example is valuable human resources, such as low-cost, highly skilled labor. e cost and skill
of labor varies from country to country. Because labor is not internationally mobile, according to
Dunning it makes sense for a firm to locate production facilities in those countries where the cost and
skills of local labor are most suited to its particular production processes.
However, Dunning’s theory has implications that go beyond basic resources such as minerals and
labor. Consider Silicon Valley, which is the world center for the computer and semiconductor
industry. Many of the world’s major computer and semiconductor companies—such as Apple
Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon
Valley region of California. As a result, much of the cutting-edge research and product development in
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computers and semiconductors occurs there. According to Dunning’s arguments, knowledge being
generated in Silicon Valley with regard to the design and manufacture of computers and
semiconductors is available nowhere else in the world. To be sure, that knowledge is
commercialized as it diffuses throughout the world, but the leading edge of knowledge
generation in the computer and semiconductor industries is to be found in Silicon Valley. In
Dunning’s language, this means that Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from
the sheer concentration of intellectual talent in this area, and in part, it arises from a network of
informal contacts that allows firms to benefit from each other’s knowledge generation. Economists
refer to such knowledge “spillovers” as externalities, and there is a well-established theory suggesting
that firms can benefit from such externalities by locating close to their source.20
Google Headquarters in Mountain View, California, USA.
©Phillip Bond/Alamy Stock Photo
Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in
research and, perhaps, production facilities so they too can learn about and utilize valuable new
knowledge before those based elsewhere, thereby giving them a competitive advantage in the global
marketplace.21 Evidence suggests that European, Japanese, South Korean, and Taiwanese computer
and semiconductor firms are investing in the Silicon Valley region precisely because they wish to
benefit from the externalities that arise there.22 Others have argued that direct investment by foreign
firms in the U.S. biotechnology industry has been motivated by desire to gain access to the unique
location-specific technological knowledge of U.S. biotechnology firms.23 Dunning’s theory, therefore,
seems to be a useful addition to those outlined previously because it helps explain how location factors
affect the direction of FDI.24
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Political Ideology and Foreign Direct Investment
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LO 8-3 Understand how political ideology shapes a government’s attitudes toward FDI.
Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance
that is hostile to all inward FDI at one extreme to an adherence to the noninterventionist principle of
free market economics at the other. Between these two extremes is an approach that might be called
pragmatic nationalism.
THE RADICAL VIEW
e radical view traces its roots to Marxist political and economic theory. Radical writers argue that
the multinational enterprise (MNE) is an instrument of imperialist domination. ey see the MNE as
a tool for exploiting host countries to the exclusive benefit of their capitalist–imperialist home
countries. ey argue that MNEs extract profits from the host country and take them to their home
country, giving nothing of value to the host country in exchange. ey note, for example, that key
technology is tightly controlled by the MNE and that important jobs in the foreign subsidiaries of
MNEs go to home-country nationals rather than to citizens of the host country. Because of this,
according to the radical view, FDI by the MNEs of advanced capitalist nations keeps the less
developed countries of the world relatively backward and dependent on advanced capitalist nations for
investment, jobs, and technology. us, according to the extreme version of this view, no country
should ever permit foreign corporations to undertake FDI because they can never be instruments of
economic development, only of economic domination. Where MNEs already exist in a country, they
should be immediately nationalized.25
Are ey Friends or Not—India and Pakistan?
For many years, since the partition of British India in 1947 and the creation of India and Pakistan, these two
South Asian countries have been involved in numerous wars, border skirmishes, and military stand-offs. e
dispute for Kashmir has been the main reason in most interactions, with a notable exception being the Indo-
Pakistani War of 1971, when the conflict started because of turmoil in East Pakistan (now called Bangladesh).
However, in trying to improve the economic ties between the two nations, India recently announced that it
will allow FDI from Pakistan, paving the way for industries from the neighboring country to set up businesses
in the growing Indian market. While this is a prime example of how free markets are promoting trade
between countries that have not traditionally enjoyed stable political relationships with each other, the
question is also on what grounds cross-border interaction is founded. What do you think? Can countries that
have been long-standing enemies normalize their relationship simply based on foreign direct investment
opportunities?
Source: www.hindustantimes.com.
From 1945 until the 1980s, the radical view was very influential in the world economy. Until the
collapse of communism between 1989 and 1991, the countries of eastern Europe were
opposed to FDI. Similarly, communist countries elsewhere—such as China, Cambodia, and
Cuba—were all opposed in principle to FDI (although, in practice, the Chinese started to allow FDI
in mainland China in the 1970s). Many socialist countries—particularly in Africa, where one of the
first actions of many newly independent states was to nationalize foreign-owned enterprises—also
embraced the radical position. Countries whose political ideology was more nationalistic than
socialistic further embraced the radical position. is was true in Iran and India, for example, both of
which adopted tough policies restricting FDI and nationalized many foreign-owned enterprises. Iran is
a particularly interesting case because its Islamic government, while rejecting Marxist theory,
essentially embraced the radical view that FDI by MNEs is an instrument of imperialism.
By the early 1990s, the radical position was in retreat. ere seem to be three reasons for this: (1)
the collapse of communism in eastern Europe; (2) the generally abysmal economic performance of
those countries that embraced the radical position, in addition to a growing belief by many of these
countries that FDI can be an important source of technology and jobs and can stimulate economic
growth; and (3) the strong economic performance of those developing countries that embraced
capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan). Despite this, the
radical view lingers on in some countries, such as Venezuela, where the government of Hugo Cha´vez
and that of his successor Nicola´s Maduro have both viewed foreign multinationals as an instrument
of domination.
THE FREE MARKET VIEW
e free market view traces its roots to classical economics and the international trade theories of
Adam Smith and David Ricardo (see Chapter 6). e intellectual case for this view has been
strengthened by the internalization explanation of FDI. e free market view argues that international
production should be distributed among countries according to the theory of comparative advantage.
Countries should specialize in the production of those goods and services that they can produce most
efficiently. Within this framework, the MNE is an instrument for dispersing the production of goods
and services to the most efficient locations around the globe. Viewed this way, FDI by the MNE
increases the overall efficiency of the world economy.
Imagine that Dell decided to move assembly operations for many of its personal computers from
the United States to Mexico to take advantage of lower labor costs in Mexico. According to the free
market view, moves such as this can be seen as increasing the overall efficiency of resource utilization
in the world economy. Mexico, due to its lower labor costs, has a comparative advantage in the
assembly of PCs. By moving the production of PCs from the United States to Mexico, Dell frees U.S.
resources for use in activities in which the United States has a comparative advantage (e.g., the design
of computer software, the manufacture of high value-added components such as microprocessors, or
basic R&D). Also, consumers benefit because the PCs cost less than they would if they were produced
domestically. In addition, Mexico gains from the technology, skills, and capital that the computer
company transfers with its FDI. Contrary to the radical view, the free market view stresses that such
resource transfers benefit the host country and stimulate its economic growth. us, the free market
view argues that FDI is a benefit to both the source country and the host country.
PRAGMATIC NATIONALISM
In practice, many countries have adopted neither a radical policy nor a free market policy toward FDI
but, instead, a policy that can best be described as pragmatic nationalism.26 e pragmatic nationalist
view is that FDI has both benefits and costs. FDI can benefit a host country by bringing capital, skills,
technology, and jobs, but those benefits come at a cost. When a foreign company rather than a
domestic company produces products, the profits from that investment go abroad. Many countries are
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also concerned that a foreign-owned manufacturing plant may import many components from its
home country, which has negative implications for the host country’s balance-of-payments position.
Recognizing this, countries adopting a pragmatic stance pursue policies designed to maximize the
national benefits and minimize the national costs. According to this view, FDI should be allowed so
long as the benefits outweigh the costs. Japan offers an example of pragmatic nationalism. Until the
1980s, Japan’s policy was probably one of the most restrictive among countries adopting a pragmatic
nationalist stance. is was due to Japan’s perception that direct entry of foreign (especially U.S.) firms
with ample managerial resources into the Japanese markets could hamper the development
and growth of its own industry and technology.27 is belief led Japan to block the
majority of applications to invest in Japan. However, there were always exceptions to this policy. Firms
that had important technology were often permitted to undertake FDI if they insisted that they would
neither license their technology to a Japanese firm nor enter into a joint venture with a Japanese
enterprise. IBM and Texas Instruments were able to set up wholly owned subsidiaries in Japan by
adopting this negotiating position. From the perspective of the Japanese government, the benefits of
FDI in such cases—the stimulus that these firms might impart to the Japanese economy—outweighed
the perceived costs.
Another aspect of pragmatic nationalism is the tendency to aggressively court FDI believed to be in
the national interest by, for example, offering subsidies to foreign MNEs in the form of tax breaks or
grants. e countries of the European Union often seem to be competing with each other to attract
U.S. and Japanese FDI by offering large tax breaks and subsidies. Britain has been the most successful
at attracting Japanese investment in the automobile industry. Nissan, Toyota, and Honda now have
major assembly plants in Britain and use the country as their base for serving the rest of Europe—with
obvious employment and balance-of-payments benefits for Britain (what happens to these investments
if and when Britian exits from the EU remains to be seen). Similarly, within the United States,
individual states often compete with each other to attract FDI, offering generous financial incentives
in the form of tax breaks to foreign companies looking to set up operations in the country.
SHIFTING IDEOLOGY
Recent years have seen a marked decline in the number of countries that adhere to a radical ideology.
Although few countries have adopted a pure free market policy stance, an increasing number of
countries are gravitating toward the free market end of the spectrum and have liberalized their foreign
investment regime. is includes many countries that 30 years ago were firmly in the radical camp
(e.g., the former communist countries of eastern Europe, many of the socialist countries of Africa, and
India) and several countries that until recently could best be described as pragmatic nationalists with
regard to FDI (e.g., Japan, South Korea, Italy, Spain, and most Latin American countries). One result
has been the surge in the volume of FDI worldwide, which, as we noted earlier, has been growing
faster than world trade. Another result has been an increase in the volume of FDI directed at countries
that have liberalized their FDI regimes in the last 20 years, such as China, India, and Vietnam.
As a counterpoint, there is some evidence of a shift to a more hostile approach to foreign direct
investment in some nations. Venezuela and Bolivia have become increasingly hostile to foreign direct
investment. In 2005 and 2006, the governments of both nations unilaterally rewrote contracts for oil
and gas exploration, raising the royalty rate that foreign enterprises had to pay the government for oil
and gas extracted in their territories. Following his election victory in 2006, Bolivian president Evo
Morales nationalized the nation’s gas fields and stated that he would evict foreign firms unless they
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agreed to pay about 80 percent of their revenues to the state and relinquish production oversight. In
some developed nations, there is increasing evidence of hostile reactions to inward FDI as well. In
Europe in 2006, there was a hostile political reaction to the attempted takeover of Europe’s largest steel
company, Arcelor, by Mittal Steel, a global company controlled by the Indian entrepreneur Lakshmi
Mittal. In mid-2005, China National Offshore Oil Company withdrew a takeover bid for Unocal of
the United States after highly negative reaction in Congress about the proposed takeover of a “strategic
asset” by a Chinese company.
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Benefits and Costs of FDI
LO 8-4 Describe the benefits and costs of FDI to home and host countries.
To a greater or lesser degree, many governments can be considered pragmatic nationalists when it
comes to FDI. Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI.
Here, we explore the benefits and costs of FDI, first from the perspective of a host (receiving) country
and then from the perspective of the home (source) country. In the next section, we look at the policy
instruments governments use to manage FDI.
HOST-COUNTRY BENEFITS
e main benefits of inward FDI for a host country arise from resource-transfer effects, employment
effects, balance-of-payments effects, and effects on competition and economic growth.
Resource-Transfer Effects Foreign direct investment can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be
available and thus boost that country’s economic growth rate.
With regard to capital, many MNEs, by virtue of their large size and financial strength, have access
to financial resources not available to host-country firms. ese funds may be available from internal
company sources, or, because of their reputation, large MNEs may find it easier to borrow money
from capital markets than host-country firms would.
Does Foreign Direct Investment Promote Growth?
ere are multiple reasons for companies to make foreign direct investments. Lowering the cost of
production, increasing capacity (volume) of production, and strategically locating production facilities to serve
world regions are some of the many reasons for FDI by a company. For the host countries that receive the
investment by multinational corporations, the logic is that the influx of capital and increase in tax revenues
will benefit the host country in the form of new infrastructure, increased knowledge, and general economic
development. However, the evidence so far is very mixed on the value of FDI to the host, ranging from
beneficial to detrimental. What do you think? Does FDI promote growth in the host country?
Source: L. Alfaro, A. Chanda, S. Kalemli-Ozcan, and S. Sayek, Does Foreign Direct Investment Promote Growth? Exploring the Role of Financial Markets on Linkages (Cambridge, MA: Harvard Business School, 2009), www.people.hbs.edu/lalfaro/fdiandlinkages.pdf.
As for technology, you will recall from Chapter 3 that technology can stimulate economic
development and industrialization. Technology can take two forms, both of which are valuable.
Technology can be incorporated in a production process (e.g., the technology for discovering,
extracting, and refining oil), or it can be incorporated in a product (e.g., personal computers).
However, many countries lack the research and development resources and skills required to develop
their own indigenous product and process technology. is is particularly true in less developed
nations. Such countries must rely on advanced industrialized nations for much of the technology
required to stimulate economic growth, and FDI can provide it.
Research supports the view that multinational firms often transfer significant technology when they
invest in a foreign country.28 For example, a study of FDI in Sweden found that foreign firms
increased both the labor and total factor productivity of Swedish firms that they acquired, suggesting
that significant technology transfers had occurred (technology typically boosts productivity).29 Also, a
study of FDI by the Organisation for Economic Co-operation and Development (OECD) found that
foreign investors invested significant amounts of capital in R&D in the countries in which they had
invested, suggesting that not only were they transferring technology to those countries but they may
also have been upgrading existing technology or creating new technology in those countries.30
Foreign management skills acquired through FDI may also produce important benefits for the host
country. Foreign managers trained in the latest management techniques can often help improve the
efficiency of operations in the host country, whether those operations are acquired or greenfield
developments. Beneficial spin-off effects may also arise when local personnel who are trained to
occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm
and help establish indigenous firms. Similar benefits may arise if the superior management skills of a
foreign MNE stimulate local suppliers, distributors, and competitors to improve their own
management skills.
An employee uses a robotic arm to fit a wheel onto a Volkswagen AG Vento automobile
on the production line at the Volkswagen India Pvt. plant in Chakan, Maharashtra, India.
©Bloomberg/Getty Images
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Employment Effects Another beneficial employment effect claimed for FDI is that it brings jobs to a host country that would otherwise not be created there. e effects of FDI on employment are
both direct and indirect. Direct effects arise when a foreign MNE employs a number of host-country
citizens. Indirect effects arise when jobs are created in local suppliers as a result of the investment and
when jobs are created because of increased local spending by employees of the MNE. e indirect
employment effects are often as large as, if not larger than, the direct effects. For example, when
Toyota decided to open a new auto plant in France, estimates suggested the plant would create 2,000
direct jobs and perhaps another 2,000 jobs in support industries.31
Cynics argue that not all the “new jobs” created by FDI represent net additions in employment. In
the case of FDI by Japanese auto companies in the United States, some argue that the jobs
created by this investment have been more than offset by the jobs lost in U.S.-owned auto
companies, which have lost market share to their Japanese competitors. As a consequence of such
substitution effects, the net number of new jobs created by FDI may not be as great as initially
claimed by an MNE. e issue of the likely net gain in employment may be a major negotiating point
between an MNE wishing to undertake FDI and the host government.
When FDI takes the form of an acquisition of an established enterprise in the host economy as
opposed to a greenfield investment, the immediate effect may be to reduce employment as the
multinational tries to restructure the operations of the acquired unit to improve its operating
efficiency. However, even in such cases, research suggests that once the initial period of restructuring is
over, enterprises acquired by foreign firms tend to increase their employment base at a faster rate than
domestic rivals. An OECD study found that foreign firms created new jobs at a faster rate than their
domestic counterparts.32
Balance-of-Payments Effects FDI’s effect on a country’s balance-of-payments accounts is an important policy issue for most host governments. A country’s balance-of-payments accounts track
both its payments to and its receipts from other countries. Governments normally are concerned when
their country is running a deficit on the current account of their balance of payments. e current
account tracks the export and import of goods and services. A current account deficit, or trade deficit as it is often called, arises when a country is importing more goods and services than it is exporting.
Governments typically prefer to see a current account surplus rather than a deficit. e only way in
which a current account deficit can be supported in the long run is by selling off assets to foreigners
(for a detailed explanation of why this is the case, see the appendix to Chapter 6). For example, the
persistent U.S. current account deficit since the 1980s has been financed by a steady sale of U.S. assets
(stocks, bonds, real estate, and whole corporations) to foreigners. Because national governments
invariably dislike seeing the assets of their country fall into foreign hands, they prefer their nation to
run a current account surplus. ere are two ways in which FDI can help a country achieve this goal.
First, if the FDI is a substitute for imports of goods or services, the effect can be to improve the
current account of the host country’s balance of payments. Much of the FDI by Japanese automobile
companies in the United States and Europe, for example, can be seen as substituting for imports from
Japan. us, the current account of the U.S. balance of payments has improved somewhat because
many Japanese companies are now supplying the U.S. market from production facilities in the United
States, as opposed to facilities in Japan. Insofar as this has reduced the need to finance a current
account deficit by asset sales to foreigners, the United States has clearly benefited.
A second potential benefit arises when the MNE uses a foreign subsidiary to export goods and
services to other countries. According to a UN report, inward FDI by foreign multinationals has been
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a major driver of export-led economic growth in a number of developing and developed nations.33
For example, in China exports increased from $26 billion in 1985 to around $3 trillion in 2017.
Much of this dramatic export growth was due to the presence of foreign multinationals that invested
heavily in China.
Effect on Competition and Economic Growth Economic theory tells us that the efficient functioning of markets depends on an adequate level of competition between producers. When FDI
takes the form of a greenfield investment, the result is to establish a new enterprise, increasing the
number of players in a market and thus consumer choice. In turn, this can increase the level of
competition in a national market, thereby driving down prices and increasing the economic welfare of
consumers. Increased competition tends to stimulate capital investments by firms in plant, equipment,
and R&D as they struggle to gain an edge over their rivals. e long-term results may include
increased productivity growth, product and process innovations, and greater economic growth.34 Such
beneficial effects seem to have occurred in the South Korean retail sector following the liberalization of
FDI regulations in 1996. FDI by large Western discount stores—including Walmart, Costco,
Carrefour, and Tesco—seems to have encouraged indigenous discounters such as E-Mart to
improve the efficiency of their own operations. e results have included more competition
and lower prices, which benefit South Korean consumers. In a similar vein, the Indian government has
been opening up that country’s retail sector to FDI, partly because it believes that inward investment
by efficient global retailers such as Walmart, Carrefour, and IKEA will provide the competitive
stimulus that is necessary to improve the efficiency of India’s fragmented retail system.
FDI’s impact on competition in domestic markets may be particularly important in the case of
services, such as telecommunications, retailing, and many financial services, where exporting is often
not an option because the service has to be produced where it is delivered.35 For example, under a
1997 agreement sponsored by the World Trade Organization, 68 countries accounting for more than
90 percent of world telecommunications revenues pledged to start opening their markets to foreign
investment and competition and to abide by common rules for fair competition in
telecommunications. Before this agreement, most of the world’s telecommunications markets were
closed to foreign competitors, and in most countries, the market was monopolized by a single carrier,
which was often a state-owned enterprise. e agreement has dramatically increased the level of
competition in many national telecommunications markets, producing two major benefits. First,
inward investment has increased competition and stimulated investment in the modernization of
telephone networks around the world, leading to better service. Second, the increased competition has
resulted in lower prices.
HOST-COUNTRY COSTS
ree costs of FDI concern host countries. ey arise from possible adverse effects on competition
within the host nation, adverse effects on the balance of payments, and the perceived loss of national
sovereignty and autonomy.
Adverse Effects on Competition Host governments sometimes worry that the subsidiaries of foreign MNEs may have greater economic power than indigenous competitors. If it is part of a larger
international organization, the foreign MNE may be able to draw on funds generated elsewhere to
subsidize its costs in the host market, which could drive indigenous companies out of business and
allow the firm to monopolize the market. Once the market is monopolized, the foreign MNE could
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raise prices above those that would prevail in competitive markets, with harmful effects on the
economic welfare of the host nation. is concern tends to be greater in countries that have few large
firms of their own (generally, less developed countries). It tends to be a relatively minor concern in
most advanced industrialized nations.
In general, while FDI in the form of greenfield investments should increase competition, it is less
clear that this is the case when the FDI takes the form of acquisition of an established enterprise in the
host nation. Because an acquisition does not result in a net increase in the number of players in a
market, the effect on competition may be neutral. When a foreign investor acquires two or more firms
in a host country and subsequently merges them, the effect may be to reduce the level of competition
in that market, create monopoly power for the foreign firm, reduce consumer choice, and raise prices.
For example, in India, Hindustan Lever Ltd., the Indian subsidiary of Unilever, acquired its main local
rival, Tata Oil Mills, to assume a dominant position in the bath soap (75 percent) and detergents (30
percent) markets. Hindustan Lever also acquired several local companies in other markets, such as the
ice cream makers Dollops, Kwality, and Milkfood. By combining these companies, Hindustan Lever’s
share of the Indian ice cream market went from zero to 74 percent.36 However, although such cases
are of obvious concern, there is little evidence that such developments are widespread. In many
nations, domestic competition authorities have the right to review and block any mergers or
acquisitions that they view as having a detrimental impact on competition. If such institutions are
operating effectively, this should be sufficient to make sure that foreign entities do not monopolize a
country’s markets.
Adverse Effects on the Balance of Payments e possible adverse effects of FDI on a host country’s balance-of-payments position are twofold. First, set against the initial capital
inflow that comes with FDI must be the subsequent outflow of earnings from the foreign
subsidiary to its parent company. Such outflows show up as capital outflow on balance-of-payments
accounts. Some governments have responded to such outflows by restricting the amount of earnings
that can be repatriated to a foreign subsidiary’s home country. A second concern arises when a foreign
subsidiary imports a substantial number of its inputs from abroad, which results in a debit on the
current account of the host country’s balance of payments. One criticism leveled against Japanese-
owned auto assembly operations in the United States, for example, is that they tend to import many
component parts from Japan. Because of this, the favorable impact of this FDI on the current account
of the U.S. balance-of-payments position may not be as great as initially supposed. e Japanese auto
companies responded to these criticisms by pledging to purchase 75 percent of their component parts
from U.S.-based manufacturers (but not necessarily U.S.-owned manufacturers). When the Japanese
auto company Nissan invested in the United Kingdom, Nissan responded to concerns about local
content by pledging to increase the proportion of local content to 60 percent and subsequently raising
it to more than 80 percent.
Possible Effects on National Sovereignty and Autonomy Some host governments worry that FDI is accompanied by some loss of economic independence. e concern is that key decisions
that can affect the host country’s economy will be made by a foreign parent that has no real
commitment to the host country and over which the host country’s government has no real control.
Most economists dismiss such concerns as groundless and irrational. Political scientist Robert Reich
has noted that such concerns are the product of outmoded thinking because they fail to account for
the growing interdependence of the world economy.37 In a world in which firms from all advanced
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nations are increasingly investing in each other’s markets, it is not possible for one country to hold
another to “economic ransom” without hurting itself.
HOME-COUNTRY BENEFITS
e benefits of FDI to the home (source) country arise from three sources. First, the home country’s
balance of payments benefits from the inward flow of foreign earnings. FDI can also benefit the home
country’s balance of payments if the foreign subsidiary creates demands for home-country exports of
capital equipment, intermediate goods, complementary products, and the like.
Second, benefits to the home country from outward FDI arise from employment effects. As with
the balance of payments, positive employment effects arise when the foreign subsidiary creates demand
for home-country exports. us, Toyota’s investment in auto assembly operations in Europe has
benefited both the Japanese balance-of-payments position and employment in Japan, because Toyota
imports some component parts for its European-based auto assembly operations directly from Japan.
ird, benefits arise when the home-country MNE learns valuable skills from its exposure to
foreign markets that can subsequently be transferred back to the home country. is amounts to a
reverse resource-transfer effect. rough its exposure to a foreign market, an MNE can learn about
superior management techniques and superior product and process technologies. ese resources can
then be transferred back to the home country, contributing to the home country’s economic growth
rate.38
Is FDI a Form of Colonialism or Ethical Investing?
Some critics of globalization suggest that FDI is an advanced form of colonialism that destroys local cultures
in developing countries. What these critics say may have some limited validity, but it isn’t the whole picture.
Take Freeport McMoRan, a U.S.-based mining company with operations in West Papua (the former Irian
Jaya), Indonesia, where the world’s largest gold, mineral, and copper reserves have been found. Freeport
formed a joint venture with the Indonesian government to mine a concession, an isolated tract of land the size
of Massachusetts on a remote island, half of which is the country of Papua New Guinea. Freeport has brought
education, Internet connections, world-class health care, and the modern world to the isolated local tribes in
West Papua, nomadic peoples who wear loincloths and hunt in the forest. eir traditional, subsistence way of
life is threatened, while at the same time, they gain from their share of the operation’s profits, from their
increased health care and education, and from local employment opportunities with FCX. Is this colonialism
or a kind of ethical investing?
Source: www.corpwatch.org.
HOME-COUNTRY COSTS
Against these benefits must be set the apparent costs of FDI for the home (source) country. e most
important concerns center on the balance-of-payments and employment effects of outward FDI. e
home country’s balance of payments may suffer in three ways. First, the balance of
payments suffers from the initial capital outflow required to finance the FDI. is effect,
however, is usually more than offset by the subsequent inflow of foreign earnings. Second, the current
account of the balance of payments suffers if the purpose of the foreign investment is to serve the
home market from a low-cost production location. ird, the current account of the balance of
payments suffers if the FDI is a substitute for direct exports. us, insofar as Toyota’s assembly
operations in the United States are intended to substitute for direct exports from Japan, the current
account position of Japan will deteriorate.
With regard to employment effects, the most serious concerns arise when FDI is seen as a
substitute for domestic production. is was the case with Toyota’s investments in the United States
and Europe. One obvious result of such FDI is reduced home-country employment. If the labor
market in the home country is already tight, with little unemployment, this concern may not be that
great. However, if the home country is suffering from unemployment, concern about the export of
jobs may arise. For example, one objection frequently raised by U.S. labor leaders to the free trade pact
among the United States, Mexico, and Canada (see Chapter 9) is that the United States would lose
hundreds of thousands of jobs as U.S. firms invest in Mexico to take advantage of cheaper labor and
then export back to the United States.39
INTERNATIONAL TRADE THEORY AND FDI
When assessing the costs and benefits of FDI to the home country, keep in mind the lessons of
international trade theory (see Chapter 6). International trade theory tells us that home-country
concerns about the negative economic effects of offshore production may be misplaced. e term
offshore production refers to FDI undertaken to serve the home market. An example would be U.S.
automobile companies investing in auto parts production facilities in Mexico. Far from reducing
home-country employment, such FDI may actually stimulate economic growth (and hence
employment) in the home country by freeing home-country resources to concentrate on activities
where the home country has a comparative advantage. In addition, home-country consumers benefit if
the price of the particular product falls as a result of the FDI. Also, if a company were prohibited from
making such investments on the grounds of negative employment effects while its international
competitors reaped the benefits of low-cost production locations, it would undoubtedly lose market
share to its international competitors. Under such a scenario, the adverse long-run economic effects for
a country would probably outweigh the relatively minor balance-of-payments and employment effects
associated with offshore production.
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Government Policy Instruments and FDI
LO 8-5 Explain the range of policy instruments that governments use to influence FDI.
We have reviewed the costs and benefits of FDI from the perspective of both home country and host
country. We now turn our attention to the policy instruments that home (source) countries and host
countries can use to regulate FDI.
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HOME-COUNTRY POLICIES
rough their choice of policies, home countries can both encourage and restrict FDI by local firms.
We look at policies designed to encourage outward FDI first. ese include foreign risk insurance,
capital assistance, tax incentives, and political pressure. en we look at policies designed to restrict
outward FDI.
Encouraging Outward FDI Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. e types of risks insurable through these
programs include the risks of expropriation (nationalization), war losses, and the inability to transfer
profits back home. Such programs are particularly useful in encouraging firms to undertake
investments in politically unstable countries.40 In addition, several advanced countries also have
special funds or banks that make government loans to firms wishing to invest in developing countries.
As a further incentive to encourage domestic firms to undertake FDI, many countries have eliminated
double taxation of foreign income (i.e., taxation of income in both the host country and the home
country). Last, and perhaps most significant, a number of investor countries (including the United
States) have used their political influence to persuade host countries to relax their
restrictions on inbound FDI. For example, in response to direct U.S. pressure, Japan relaxed
many of its formal restrictions on inward FDI. In response to further U.S. pressure, Japan relaxed its
informal barriers to inward FDI. One beneficiary of this trend was Toys “R” Us, which, after five years
of intensive lobbying by company and U.S. government officials, opened its first retail stores in Japan
in December 1991. By 2012, Toys “R” Us had more than 170 stores in Japan, and its Japanese
operation, in which Toys “R” Us retained a controlling stake, had a listing on the Japanese stock
market. Interestingly, although Toys “R” Us ceased operations in the United States in 2017 due to
bankruptcy, it continues to operate in Japan.
Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One policy has been to limit capital
outflows out of concern for the country’s balance of payments. From the early 1960s until 1979, for
example, Britain had exchange-control regulations that limited the amount of capital a firm could take
out of the country. Although the main intent of such policies was to improve the British balance of
payments, an important secondary intent was to make it more difficult for British firms to undertake
FDI.
In addition, countries have occasionally manipulated tax rules to try to encourage their firms to
invest at home. e objective behind such policies is to create jobs at home rather than in other
nations. At one time, Britain adopted such policies. e British advanced corporation tax system taxed
British companies’ foreign earnings at a higher rate than their domestic earnings. is tax code created
an incentive for British companies to invest at home.
Finally, countries sometimes prohibit national firms from investing in certain countries for political
reasons. Such restrictions can be formal or informal. For example, formal U.S. rules prohibited U.S.
firms from investing in countries such as Cuba and Iran, whose political ideology and actions are
judged to be contrary to U.S. interests. Similarly, during the 1980s, informal pressure was applied to
dissuade U.S. firms from investing in South Africa. In this case, the objective was to pressure South
Africa to change its apartheid laws, which happened during the early 1990s.
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HOST-COUNTRY POLICIES
Host countries adopt policies designed both to restrict and to encourage inward FDI. As noted earlier
in this chapter, political ideology has determined the type and scope of these policies in the past. In
the last decade of the twentieth century, many countries moved quickly away from adhering to some
version of the radical stance and prohibiting much FDI toward a situation where a combination of
free market objectives and pragmatic nationalism took hold.
Encouraging Inward FDI It is common for governments to offer incentives to foreign firms to invest in their countries. Such incentives take many forms, but the most common are tax concessions,
low-interest loans, and grants or subsidies. Incentives are motivated by a desire to gain from the
resource-transfer and employment effects of FDI. ey are also motivated by a desire to capture FDI
away from other potential host countries. For example, in the mid-1990s, the governments of Britain
and France competed with each other on the incentives they offered Toyota to invest in their
respective countries. In the United States, state governments often compete with each other to attract
FDI. For example, Kentucky offered Toyota an incentive package worth $147 million to persuade it to
build its U.S. automobile assembly plants there. e package included tax breaks, new state spending
on infrastructure, and low-interest loans.41
Restricting Inward FDI Host governments use a wide range of controls to restrict FDI in one way or another. e two most common are ownership restraints and performance requirements.
Ownership restraints can take several forms. In some countries, foreign companies are excluded from
specific fields. ey are excluded from tobacco and mining in Sweden and from the development of
certain natural resources in Brazil, Finland, and Morocco. In other industries, foreign ownership may
be permitted although a significant proportion of the equity of the subsidiary must be owned by local
investors. Foreign ownership is restricted to 25 percent or less of an airline in the United
States. In India, foreign firms were prohibited from owning media businesses until 2001,
when the rules were relaxed, allowing foreign firms to purchase up to 26 percent of an Indian
newspaper.
e rationale underlying ownership restraints seems to be twofold. First, foreign firms are often
excluded from certain sectors on the grounds of national security or competition. Particularly in less
developed countries, the feeling seems to be that local firms might not be able to develop unless
foreign competition is restricted by a combination of import tariffs and controls on FDI. is is a
variant of the infant industry argument discussed in Chapter 7.
Second, ownership restraints seem to be based on a belief that local owners can help maximize the
resource-transfer and employment benefits of FDI for the host country. Until the 1980s, the Japanese
government prohibited most FDI but allowed joint ventures between Japanese firms and foreign
MNEs if the MNE had a valuable technology. e Japanese government clearly believed such an
arrangement would speed up the subsequent diffusion of the MNE’s valuable technology throughout
the Japanese economy.
Performance requirements can also take several forms. Performance requirements are controls over
the behavior of the MNE’s local subsidiary. e most common performance requirements are related
to local content, exports, technology transfer, and local participation in top management. As with
certain ownership restrictions, the logic underlying performance requirements is that such rules help
maximize the benefits and minimize the costs of FDI for the host country. Many countries employ
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some form of performance requirements when it suits their objectives. However, performance
requirements tend to be more common in less developed countries than in advanced industrialized
nations.42
INTERNATIONAL INSTITUTIONS AND THE LIBERALIZATION OF FDI
Until the 1990s, there was no consistent involvement by multinational institutions in the governing of
FDI. is changed with the formation of the World Trade Organization in 1995. e WTO embraces
the promotion of international trade in services. Because many services have to be produced where
they are sold, exporting is not an option (e.g., one cannot export McDonald’s hamburgers or
consumer banking services). Given this, the WTO has become involved in regulations governing FDI.
As might be expected for an institution created to promote free trade, the thrust of the WTO’s efforts
has been to push for the liberalization of regulations governing FDI, particularly in services. Under the
auspices of the WTO, two extensive multinational agreements were reached in 1997 to liberalize trade
in telecommunications and financial services. Both these agreements contained detailed clauses that
require signatories to liberalize their regulations governing inward FDI, essentially opening their
markets to foreign telecommunications and financial services companies. e WTO has had less
success trying to initiate talks aimed at establishing a universal set of rules designed to promote the
liberalization of FDI. Led by Malaysia and India, developing nations have so far rejected efforts by the
WTO to start such discussions.
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Focus on Managerial Implications
FDI AND GOVERNMENT POLICY
LO 8-6 Identify the implications for managers of the theory and government policies associated
with FDI.
Several implications for business are inherent in the material discussed in this chapter. In this section,
we deal first with the implications of the theory and then turn our attention to the implications of
government policy.
e eory of FDI e implications of the theories of FDI for business practice are straightforward. First, the location-specific advantages argument associated with John Dunning does
help explain the direction of FDI. However, the location-specific advantages argument does not explain why firms prefer FDI to licensing or to exporting. In this regard, from both an explanatory and a business perspective, perhaps the most useful theories are those that focus on the limitations of
exporting and licensing—that is, internalization theories. ese theories are useful because
they identify with some precision how the relative profitability of foreign direct investment, exporting,
and licensing varies with circumstances. e theories suggest that exporting is preferable to licensing
and FDI so long as transportation costs are minor and trade barriers are trivial. As transportation costs
or trade barriers increase, exporting becomes unprofitable, and the choice is between FDI and
licensing. Because FDI is more costly and more risky than licensing, other things being equal, the
theories argue that licensing is preferable to FDI. Other things are seldom equal, however. Although
licensing may work, it is not an attractive option when one or more of the following conditions exist:
(1) the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2)
the firm needs tight control over a foreign entity to maximize its market share and earnings in that
country, and (3) a firm’s skills and capabilities are not amenable to licensing. Figure 8.4 presents these
considerations as a decision tree.
8.4 FIGURE
A decision framework.
Firms for which licensing is not a good option tend to be clustered in three types of industries:
1. High-technology industries in which protecting firm-specific expertise is of paramount
importance and licensing is hazardous.
2. Global oligopolies, in which competitive interdependence requires that multinational firms
maintain tight control over foreign operations so that they have the ability to launch
coordinated attacks against their global competitors.
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3. Industries in which intense cost pressures require that multinational firms maintain tight control
over foreign operations (so that they can disperse production to locations around the globe
where factor costs are most favorable in order to minimize costs and maximize value).
Although empirical evidence is limited, the majority of studies seem to support these
conjectures.43 In addition, licensing is not a good option if the competitive advantage of a
firm is based upon managerial or marketing knowledge that is embedded in the routines of the firm or
the skills of its managers and that is difficult to codify in a “book of blueprints.” is would seem to
be the case for firms based in a fairly wide range of industries.
Firms for which licensing is a good option tend to be in industries whose conditions are opposite to
those just specified. at is, licensing tends to be more common, and more profitable, in fragmented,
low-technology industries in which globally dispersed manufacturing is not an option. A good
example is the fast-food industry. McDonald’s has expanded globally by using a franchising strategy.
Franchising is essentially the service-industry version of licensing, although it normally involves much
longer-term commitments than licensing. With franchising, the firm licenses its brand name to a
foreign firm in return for a percentage of the franchisee’s profits. e franchising contract specifies the
conditions that the franchisee must fulfill if it is to use the franchisor’s brand name. us, McDonald’s
allows foreign firms to use its brand name so long as they agree to run their restaurants on exactly the
same lines as McDonald’s restaurants elsewhere in the world. is strategy makes sense for
McDonald’s because (1) like many services, fast food cannot be exported; (2) franchising economizes
the costs and risks associated with opening up foreign markets; (3) unlike technological know-how,
brand names are relatively easy to protect using a contract; (4) there is no compelling reason for
McDonald’s to have tight control over franchisees; and (5) McDonald’s know-how, in terms of how to
run a fast-food restaurant, is amenable to being specified in a written contract (e.g., the contract
specifies the details of how to run a McDonald’s restaurant).
Finally, it should be noted that the product life-cycle theory and Knickerbocker’s theory of FDI
tend to be less useful from a business perspective. e problem with these two theories is that they are
descriptive rather than analytical. ey do a good job of describing the historical evolution of FDI,
but they do a relatively poor job of identifying the factors that influence the relative profitability of
FDI, licensing, and exporting. Indeed, the issue of licensing as an alternative to FDI is ignored by
both these theories.
Government Policy A host government’s attitude toward FDI should be an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct
investment. Other things being equal, investing in countries that have permissive policies toward FDI
is clearly preferable to investing in countries that restrict FDI.
However, often the issue is not this straightforward. Despite the move toward a free market stance
in recent years, many countries still have a rather pragmatic stance toward FDI. In such cases, a firm
considering FDI must often negotiate the specific terms of the investment with the country’s
government. Such negotiations center on two broad issues. If the host government is trying to attract
FDI, the central issue is likely to be the kind of incentives the host government is prepared to offer to
the MNE and what the firm will commit in exchange. If the host government is uncertain about the
benefits of FDI and might choose to restrict access, the central issue is likely to be the concessions that
the firm must make to be allowed to go forward with a proposed investment.
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To a large degree, the outcome of any negotiated agreement depends on the relative bargaining
power of both parties. Each side’s bargaining power depends on three factors:
e value each side places on what the other has to offer.
e number of comparable alternatives available to each side.
Each party’s time horizon.
From the perspective of a firm negotiating the terms of an investment with a host government, the
firm’s bargaining power is high when the host government places a high value on what the firm has to
offer, the number of comparable alternatives open to the firm is greater, and the firm has a long time
in which to complete the negotiations. e converse also holds. e firm’s bargaining power is low
when the host government places a low value on what the firm has to offer, the number of comparable
alternatives open to the firm is fewer, and the firm has a short time in which to complete the
negotiations.44
Key Terms
flow of FDI, p. 214
stock of FDI, p. 214
outflows of FDI, p. 214
inflows of FDI, p. 214
greenfield investment, p. 217
eclectic paradigm, p. 218
exporting, p. 218
licensing, p. 218
internalization theory, p. 220
market imperfections, p. 220
oligopoly, p. 221
multipoint competition, p. 222
location-specific advantages, p. 222
externalities, p. 223
balance-of-payments accounts, p. 227
current account, p. 227
offshore production, p. 230
Summary
is chapter reviewed theories that attempt to explain the pattern of FDI between countries and to
examine the influence of governments on firms’ decisions to invest in foreign countries. e chapter
made the following points:
1. Any theory seeking to explain FDI must explain why firms go to the trouble of acquiring or
establishing operations abroad when the alternatives of exporting and licensing are available to
them.
2. High transportation costs or tariffs imposed on imports help explain why many firms prefer FDI
or licensing over exporting.
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3. Firms often prefer FDI to licensing when (a) a firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) a firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country, and (c) a firm’s skills and capabilities are not amenable to licensing.
4. Knickerbocker’s theory suggests that much FDI is explained by imitative behavior by rival firms
in an oligopolistic industry.
5. Dunning has argued that location-specific advantages are of considerable importance in
explaining the nature and direction of FDI. According to Dunning, firms undertake FDI to
exploit resource endowments or assets that are location-specific.
6. Political ideology is an important determinant of government policy toward FDI. Ideology
ranges from a radical stance that is hostile to FDI to a noninterventionist, free market stance.
Between the two extremes is an approach best described as pragmatic nationalism.
7. Benefits of FDI to a host country arise from resource-transfer effects, employment effects, and
balance-of-payments effects.
8. e costs of FDI to a host country include adverse effects on competition and balance of
payments and a perceived loss of national sovereignty.
9. e benefits of FDI to the home (source) country include improvement in the balance of
payments as a result of the inward flow of foreign earnings, positive employment effects when
the foreign subsidiary creates demand for home-country exports, and benefits from a reverse
resource-transfer effect. A reverse resource-transfer effect arises when the foreign subsidiary
learns valuable skills abroad that can be transferred back to the home country.
10. e costs of FDI to the home country include adverse balance-of-payments effects that arise
from the initial capital outflow and from the export substitution effects of FDI. Costs also arise
when FDI exports jobs abroad.
11. Home countries can adopt policies designed to both encourage and restrict FDI. Host countries
try to attract FDI by offering incentives and try to restrict FDI by dictating ownership restraints
and requiring that foreign MNEs meet specific performance requirements.
Critical inking and Discussion Questions
1. In 2008, inward FDI accounted for some 63.7 percent of gross fixed capital formation in
Ireland but only 4.1 percent in Japan (gross fixed capital formation refers to investments in fixed assets such as factories, warehouses, and retail stores). What do you think explains this difference
in FDI inflows into the two countries?
2. Compare and contrast these explanations of FDI: internalization theory and Knickerbocker’s
theory of FDI. Which theory do you think offers the best explanation of the historical pattern of
FDI? Why?
3. What are the strengths of the eclectic theory of FDI? Can you see any shortcomings? How does
the eclectic theory influence management practice?
4. Read the Management Focus “Burberry Shifts Its Entry Strategy in Japan” and then answer the
following questions:
a. Why did Burberry initially choose a licensing strategy to expand its presence in Japan?
b. What limitations of licensing became apparent over time? Should Burberry have
expected these drawbacks to arise?
c. Was terminating the Japanese licensing agreement and opening wholly owned stores the
correct strategy for Burberry? What are the risks here?
5. You are the international manager of a U.S. business that has just developed a revolutionary new
personal computer that can perform the same functions as existing PCs but costs only half as
much to manufacture. Several patents protect the unique design of this computer. Your CEO
has asked you to formulate a recommendation for how to expand into Western Europe. Your
options are (a) to export from the United States, (b) to license a European firm to manufacture and market the computer in Europe, or (c) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative, and suggest a course of action to your CEO.
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. e World Investment Report published annually by UNCTAD provides a summary of recent trends in FDI as well as quick access to comprehensive investment statistics. Identify the table of
largest transnational corporations from developing and transition countries. e ranking is based on the foreign assets each corporation owns. Based only on the top 20 companies, provide a
summary of the countries and industries represented. Do you notice any common traits from
your analysis? Did any industries or countries in the top 20 surprise you? Why?
2. An integral part of successful foreign direct investment is to understand the target market
opportunities as well as the nature of the risk inherent in possible investment projects,
particularly in developing countries. You work for a company that builds wastewater and
sanitation infrastructure in such countries. e Multilateral Investment Guarantee Agency (MIGA) provides insurance for risky projects in these markets. Identify the sector brief for the water and
wastewater sector, and prepare a report to identify the major risks projects in this sector tend to
face and how MIGA can assist in such projects.
F D I i n t h e I n d i a n R e t a i l S e c t o r
c l o s i n g c a s e
Historically, the structure of retailing in India was very fragmented with a large number of very small stores
serving most of the market. Supply chains were also very poorly developed and fragmented. As recently as
2010, larger format big box stores, chain stores, and supermarkets only accounted for 4 percent of retail sales
in the country (compared to 85 percent in the United States). is might sound like an ideal opportunity for
efficient foreign retailers such as Walmart, IKEA, Tesco, and Carrefour. In theory, these multinational
enterprises could enter the market and transform India’s retail space, making it more efficient and bringing
modern retail formats, technology, and supply chains to the country. is would benefit consumers and
producers from farmers to manufacturers. For example, it has been estimated that up to 40 percent of the
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food produced by Indian farmers is currently wasted because chronically underdeveloped supply chains mean
that food rots before it reaches the market.
In practice, small store owners in India have a long history of using their political power to lobby the
government to impose restrictions on direct investment by foreigners in the retail space. Like incumbents
everywhere, their goal has been to limit competition and protect their businesses and jobs. Until 2011, foreign
multi-brand retailers such as Costco, Tesco, and Walmart were forbidden from owning retail outlets in the
country. Even single-brand retailers such as IKEA and Nike had to partner with a local retailer, were limited to
a 51 percent ownership stake, and had to go through a lengthy bureaucratic approval process.
Chinese customers visit and exit a supermarket of Walmart in Hangzhou city, east China’s
Zhejiang province
©Imaginechina/AP Images
By 2011, the Indian federal government had come to the conclusion that foreign investment in
retailing was needed to improve India’s supply chain, increase consumer choice, and help farmers
bring their products to market. is view was supported by much of Indian industry, which saw the
modernization of the retailing sector as an important condition for continued economic development. Clearly,
the government believed that greater foreign capital and technology would help India grow its economy.
In late 2011, the Indian government announced a plan to reform foreign direct investment regulations.
e plan was to allow foreign multi-brand retailers such as Walmart and Tesco to open retail stores, although
they would be limited to a 51 percent ownership stake. At the same time, the government stated its intention
to allow single-brand retailers to set up wholly owned stores, although anything over a 49 percent foreign
ownership stake would still require formal government approval. ese plans were greeted with strong
opposition from small retailers and rival political parties, and the government was forced to temporarily shelve
them.
In early 2012, the Indian government managed to secure approval for plans to allow foreign single-brand
retailers to open wholly owned stores, but imposed the requirement that a single-brand retailer had to source
30 percent of its inventory from India. One of the first retailers to respond to these changes was IKEA, which
announced that it would invest $1.9 billion and set up 25 stores in the country. More generally though, many
analysts viewed the 30 percent sourcing requirement as a major impediment to entering India. Both Apple
and Nike, for example, would have to establish significant production facilities in the country in order to meet
that requirement and set up their own brand stores.
In early 2018, the government modified the 30 percent requirement, giving single-brand retailers five years
after their initial entry to reach the 30 percent figure. e government also allowed single-brand retailers to
establish wholly owned subsidiaries without having to go through the cumbersome government approval
process.
In late 2012, the federal Indian government allowed foreign investors to open multi-brand retail stores in
India, but limited ownership to 51 percent. Moreover, in a nod to the strength of the political opposition, the
federal government made this requirement subject to approval by individual states within the country,
allowing some to opt out. Several states have done so, which reduces the attractiveness of India as a market for
foreign retailers.
At the same time, India has allowed 100 percent ownership of online retail marketplaces in India. Amazon
took advantage of this to enter the country in 2014 and has committed to invest $5 billion in India. Unlike in
the United States, however, Amazon does not sell goods that it has taken ownership of because that would
classify the company as a multi-brand retailer, limit its ownership stake in Indian operation to 51 percent, and
require it to take an Indian partner. Instead, Amazon only sells goods offered through its marketplace platform
by third parties. However, Amazon is investing heavily in fulfillment centers and logistics infrastructure to
enable it to deliver goods efficiently to Indian customers. Its investment may help to boost the efficiency of
supply chains in the country.
Sources: Greg Bensinger, “Amazon Plans $3 Billion Indian Investment,” e Wall Street Journal, June 7, 2016; Vibhuto Agarwal and
Megha Bahree, “India Retreats on Retail,” e Wall Street Journal, December 8, 2011; “India Online,” e Economist, May 5, 2016;
Newley Purnell, “Jeff Bezos Invests Billions to Make Amazon a Top E-Commerce Player in India,” e Wall Street Journal,
November 19, 2016; and K.R. Srivats, “Cabinet Okays 100% FDI in Single Brand Retailing via Automatic Route,” Business Line,
January 10, 2018.
CASE DISCUSSION QUESTIONS
1. What explains the fragmented nature of India’s retail sector? What are the benefits of this
system? What are the costs?
2. How might investment by foreign retailers change retailing in India? What are the potential
benefits of such FDI?
3. Who stands to lose from FDI into India’s retail sector? Who stands to gain?
4. Why has India been so slow to change its laws regarding foreign ownership of retailers?
What, if anything, can foreign retailers do to influence the laws in a way that benefits entry?
5. Given the political and economic realities in India, what is the best entry strategy for a
foreign retailer?
Endnotes
1. United Nations, Conference on Trade and Development, Statistical Database, accessed July
2018, http://unctadstat.unctad.org.
2. World Trade Organization, International Trade Statistics, 2017 (Geneva: WTO, 2017); United Nations, World Investment Report, 2018.
3. United Nations, World Investment Report, 2018.
4. United Nations, World Investment Report, 2010 (New York and Geneva: United Nations, 2010).
5. United Nations, Conference on Trade and Development, Statistical Database.
6. United Nations, Conference on Trade and Development, Statistical Database.
7. United Nations, Conference on Trade and Development, Statistical Database.
8. United Nations, World Investment Report, 2018.
9. American Enterprise Institute, Chinese Investments in the United States, archived online
at http://www.aei.org/feature/china-tracker/
10. United Nations, World Investment Report, 2018.
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11. See D. J. Ravenscraft and F. M. Scherer, Mergers, Selloffs and Economic Efficiency (Washington, DC: Brookings Institution, 1987); A. Seth, K. P. Song, and R. R. Pettit, “Value Creation and
Destruction in Cross-Border Acquisitions,” Strategic Management Journal 23 (2002), pp. 921– 40; B. Ayber and A. Ficici, “Cross-Border Acquisitions and Firm Value,” Journal of International Business Studies, 40 (2009), pp. 1317–38.
12. For example, see S. H. Hymer, e International Operations of National Firms: A Study of Direct Foreign Investment (Cambridge, MA: MIT Press, 1976); A. M. Rugman, Inside the Multinationals: e Economics of Internal Markets (New York: Columbia University Press, 1981); D. J. Teece, “Multinational Enterprise, Internal Governance, and Industrial Organization,”
American Economic Review 75 (May 1983), pp. 233–38; C. W. L. Hill and W. C. Kim, “Searching for a Dynamic eory of the Multinational Enterprise: A
Transaction Cost Model,” Strategic Management Journal 9 (special issue, 1988), pp. 93–104; A. Verbeke, “e Evolutionary View of the MNE and the Future of Internalization eory,”
Journal of International Business Studies 34 (2003), pp. 498–501; J. H. Dunning, “Some Antecedents of Internalization eory,” Journal of International Business Studies 34 (2003), pp. 108–28; A. H. Kirca, W. D. Fernandez, and S.K. Kundu, “An Empirical Analysis of
Internalization eory in Emerging Markets,” Journal of World Business 51 (2016), pp. 628–40.
13. J. P. Womack, D. T. Jones, and D. Roos, e Machine at Changed the World (New York: Rawson Associates, 1990).
14. e argument is most often associated with F. T. Knickerbocker, Oligopolistic Reaction and Multinational Enterprise (Boston: Harvard Business School Press, 1973). See also K. Head, T. Mayer, and J. Ries, “Revisiting Oligopolistic Reaction: Are Decisions on Foreign Direct
Investment Strategic Complements?” Journal of Economics and Management Strategy 11 (2002), pp. 453–72.
15. e studies are summarized in R. E. Caves, Multinational Enterprise and Economic Analysis, 2nd ed. (Cambridge, UK: Cambridge University Press, 1996).
16. See R. E. Caves, “Japanese Investment in the US: Lessons for the Economic Analysis of Foreign
Investment,” e World Economy 16 (1993), pp. 279–300; B. Kogut and S. J. Chang, “Technological Capabilities and Japanese Direct Investment in the United States,” Review of Economics and Statistics 73 (1991), pp. 401–43; J. Anand and B. Kogut, “Technological Capabilities of Countries, Firm Rivalry, and Foreign Direct Investment,” Journal of International Business Studies, 1997, pp. 445–65.
17. K. Ito and E. L. Rose, “Foreign Direct Investment Location Strategies in the Tire Industry,”
Journal of International Business Studies 33 (2002), pp. 593–602.
18. H. Haveman and L. Nonnemaker, “Competition in Multiple Geographical Markets,”
Administrative Science Quarterly 45 (2000), pp. 232–67; L. Fuentelsaz and J. Gomez, “Multipoint Competition, Strategic Similarity and Entry into Geographic Markets,” Strategic Management Journal 27 (2006), pp. 447–57.
19. J. H. Dunning, Explaining International Production (London: Unwin Hyman, 1988); J. H. Dunning, “Reappraising the Eclectic Paradigm in an Age of Alliance Capital,” in J. H.
Dunning, ed., e Eclectic Paradigm: A Framework for Synthesizing and Comparing eories of International Business from Different Disciplines or Perspectives (London: Palgrave McMillian, 2015).
20. P. Krugman, “Increasing Returns and Economic Geography,” Journal of Political Economy 99, no. 3 (1991), pp. 483–99.
21. J. M. Shaver and F. Flyer, “Agglomeration Economies, Firm Heterogeneity, and Foreign Direct
Investment in the United States,” Strategic Management Journal 21 (2000), pp. 1175–93.
22. J. H. Dunning and R. Narula, “Transpacific Foreign Direct Investment and the Investment
Development Path,” South Carolina Essays in International Business, May 1995.
23. W. Shan and J. Song, “Foreign Direct Investment and the Sourcing of Technological Advantage:
Evidence from the Biotechnology Industry,” Journal of International Business Studies, 1997, pp. 267–84.
24. For some additional evidence, see L. E. Brouthers, K. D. Brouthers, and S. Warner, “Is
Dunning’s Eclectic Framework Descriptive or Normative?” Journal of International Business Studies 30 (1999), pp. 831–44.
25. For elaboration, see S. Hood and S. Young, e Economics of the Multinational Enterprise (London: Longman, 1979); P. M. Sweezy and H. Magdoff, “e Dynamics of U.S. Capitalism,”
Monthly Review Press, 1972.
26. For an example of this policy as practiced in China, see L. G. Branstetter and R. C. Freenstra,
“Trade and Foreign Direct Investment in China: A Political Economy Approach,” Journal of International Economics 58 (December 2002), pp. 335–58.
27. M. Itoh and K. Kiyono, “Foreign Trade and Direct Investment,” in Industrial Policy of Japan, R. Komiya, M. Okuno, and K. Suzumura, eds. (Tokyo: Academic Press, 1988).
28. E. Borensztein and J. De Gregorio, “How Does Foreign Direct Investment Affect Economic
Growth?” Journal of International Economics 45 (June 1998), pp. 115–35; X. J. Zhan and T. Ozawa, Business Restructuring in Asia: Cross-Border M&As in Crisis Affected Countries (Copenhagen: Copenhagen Business School, 2000); I. Costa, S. Robles, and R. de Queiroz,
“Foreign Direct Investment and Technological Capabilities,” Research Policy 31 (2002), pp. 1431–43; B. Potterie and F. Lichtenberg, “Does Foreign Direct Investment Transfer Technology
across Borders?” Review of Economics and Statistics 83 (2001), pp. 490–97; K. Saggi, “Trade, Foreign Direct Investment and International Technology Transfer,” World Bank Research Observer 17 (2002), pp. 191–235; W. N. W. Azman-Saini, A. Z. Baharumshah and S. Hook Law, “Foreign Direct Investment, Economic Freedom and Economic Growth: International
Evidence,” Economic Modelling 27 (2010), pp. 1079–89.
29. K. M. Moden, “Foreign Acquisitions of Swedish Companies: Effects on R&D and
Productivity,” Research Institute of International Economics, 1998, mimeo.
30. “Foreign Friends,” e Economist, January 8, 2000, pp. 71–72.
31. A. Jack, “French Go into Overdrive to Win Investors,” Financial Times, December 10, 1997, p. 6.
32. “Foreign Friends.”
33. United Nations, World Investment Report, 2014 (New York and Geneva: United Nations, 2014).
34. R. Ram and K. H. Zang, “Foreign Direct Investment and Economic Growth,” Economic Development and Cultural Change 51 (2002), pp. 205–25.
35. United Nations, World Investment Report, 2014.
36. United Nations, World Investment Report, 2000 (New York and Geneva: United Nations, 2000).
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37. R. B. Reich, e Work of Nations: Preparing Ourselves for the 21st Century (New York: Knopf, 1991).
38. is idea has been articulated, although not quite in this form, by C. A. Bartlett and S. Ghoshal,
Managing across Borders: e Transnational Solution (Boston: Harvard Business School Press, 1989).
39. P. Magnusson, “e Mexico Pact: Worth the Price?” BusinessWeek, May 27, 1991, pp. 32–35.
40. C. Johnston, “Political Risk Insurance,” in Assessing Corporate Political Risk, D. M. Raddock, ed. (Totowa, NJ: Rowman & Littlefield, 1986).
41. M. Tolchin and S. Tolchin, Buying into America: How Foreign Money Is Changing the Face of Our Nation (New York: Times Books, 1988).
42. L. D. Qiu and Z. Tao, “Export, Foreign Direct Investment and Local Content Requirements,”
Journal of Development Economics 66 (October 2001), pp. 101–25.
43. See R. E. Caves, Multinational Enterprise and Economic Analysis (Cambridge, UK: Cambridge University Press, 1982); A. H. Kirca et al., “Firm-Specific Assets, Multinationality, and Financial
Performance: A Meta-Analytic Review and eoretical Integration,” Academy of Management Journal 54 (2011), pp. 47–72.
44. For a good general introduction to negotiation strategy, see M. H. Bazerman and M. A. Neale,
Negotiating Rationally (New York: Free Press, 1992); A. Dixit and B. Nalebuff, inking Strategically: e Competitive Edge in Business, Politics, and Everyday Life (New York: Norton, 1991); H. Raiffa, e Art and Science of Negotiation (Cambridge, MA: Harvard University Press, 1982).
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-
Hill Education
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9
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Part 3 e Global Trade and Investment Environment
Regional Economic Integration
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO9-1 Describe the different levels of regional economic integration.
LO9-2 Understand the economic and political arguments for regional economic integration.
LO9-3 Understand the economic and political arguments against regional economic integration.
LO9-4 Explain the history, current scope, and future prospects of the world’s most important regional economic
agreements.
LO9-5 Understand the implications for management practice that are inherent in regional economic integration
agreements.
NAFTA 2.0: e USMCA
opening case
In his 2016 presidential campaign, Donald Trump repeatedly criticized the North American Free Trade Agreement
(NAFTA) as an unfair deal in which Americans had been taken to the cleaners by Mexico. Trump claimed that NAFTA
had cost American manufacturers millions of jobs, even though there is scant evidence to suggest that this is the case.
After becoming president, Trump stuck to his word and initiated a renegotiation of NAFTA.
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Trump's anti-NAFTA stance sent shockwaves through industry on both sides of the border. Since NAFTA was signed
in 1994, trade between the United States, Canada, and Mexico has tripled to $1.3 trillion. In 2017, the United States
exported $342 billion of goods and services to Canada and $277 billion to Mexico, while importing $339 billion from
Canada and $355 billion from Mexico. e U.S. ran a $2.8 billion surplus in trade with Canada, and a $69 billion
deficit with Mexico. Canada and Mexico are now the largest export markets for the United States, accounting for a third
of all U.S. exports, and the largest sources of imports behind China.
e renegotiation of NAFTA was complicated by the fact that multilayered supply chains now span both sides of the
U.S.–Mexican border. Nowhere is this more the case than in the automobile industry. Auto parts manufactured in the
United States may be shipped to plants in Mexico, where finished cars are assembled and then shipped back to the
United States for final sale (the converse also occurs, with parts manufactured in Mexico being shipped to U.S. final
assembly plants). In 2017, U.S. producers exported $21 billion of finished automobiles and automotive parts to Mexico
but imported $84 billion in autos and parts from Mexico. Without that $63 billion trade deficit in autos and auto parts,
the United States would be running only a $6 billion trade deficit with Mexico.
Perhaps because he recognizes the lopsided nature of trade in auto and auto parts between the United States and
Mexico, President Trump has taken it upon himself to criticize auto producers that have moved production to Mexico
or are planning to do so. Following criticism from Trump, Ford canceled plans to build a $1.6 billion auto assembly
plant in Mexico. President Trump has also criticized General Motors, Toyota, and BMW for their plans to invest in
Mexican assembly operations. Jawboning aside, as part of the NAFTA renegotiations, the Trump administration was
looking at different options for restructuring trade with Mexico. ese include placing tariffs on imports of autos from
Mexico.
In the event, on September 30th, 2018, the Trump Administration reached agreement with Mexico and Canada on a
revised version of NAFTA. Known as the United States-Mexico-Canada Agreement, or USMCA for short, this
agreement must now be ratified by legislators in all three countries. e USMCA does make some changes to the 25-
year-old NAFTA agreement. Most significantly, NAFTA required automakers to produce 62.5 percent of a
vehicle’s content in North America to qualify for zero tariffs. e USMCA raises that threshold to 75%.
at’s meant to force automakers to source fewer parts for a car assembled in North America from Germany, Japan,
South Korea or China. e new agreement also mandates that by 2023, 40% of parts for any tariff-free vehicle must
come from a so-called “high wage” factory. ose factories must pay a minimum of $16 an hour in average salaries for
production workers, which is about triple the average wage in a Mexican factory right now.
e Trump Administration clearly hopes these provisions will increase the production of automobiles and
component parts in the United States. at may occur, but critics also note that the consequences may include higher
costs to North American automobile producers, and higher prices for consumers. •
Sources: U.S. Census Bureau, www.census.gov/foreign-trade/index.html, accessed April 10, 2018; Robbie Whelan, “Gloom Descends on
Mexico’s NAFTA Capital,” e Wall Street Journal, January 26, 2017; Dudley Althaus and Christina Rogers, “Donald Trump’s NAFTA Plan
Would Confront Globalized Auto Industry,” e Wall Street Journal, November 10, 2016; William Mauldin and David Luhnow, “Donald
Trump Posed to Pressure Mexico on Trade,” e Wall Street Journal, November 21, 2016; and Siobhan Hughes et al., “Trump Tariffs Spark
GOP Rift,” e Wall Street Journal, March 5, 2018.
Introduction
e past two decades have witnessed a proliferation of regional trade blocs that promote regional economic
integration. World Trade Organization (WTO) members are required to notify the WTO of any regional trade
agreements in which they participate. By 2018, all members had notified the WTO of participation in one or
more regional trade agreements. As of early 2018, there were 284 regional trade agreements in force.1
Consistent with the predictions of international trade theory and particularly the theory of comparative
advantage (see Chapter 6), agreements designed to promote freer trade within regions are believed by
economists to produce gains from trade for all member countries. e General Agreement on Tariffs and Trade
(GATT) and its successor, the World Trade Organization, also seek to reduce trade barriers. However, the
WTO has a global perspective and 164 members, which can make reaching an agreement extremely difficult.
By entering into regional agreements, groups of countries aim to reduce trade barriers more rapidly than can be
achieved under the auspices of the WTO. is has become an increasingly important policy approach in recent
years, given the failure of the WTO to make any progress with its latest round of trade talks, the Doha Round,
Regional Trade Agreements
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initiated in 2001 but currently in limbo (see Chapter 7). Given the failure of the Doha Round, national
governments have felt that they can better advance their trade agenda through multilateral agreements than
through the WTO.
Nowhere has the movement toward regional economic integration been more ambitious than in Europe. On
January 1, 1993, the European Union formally removed many barriers to doing business across borders within
the EU in an attempt to create a single market with 340 million consumers. Today, the EU has a population of
more than 500 million and a gross domestic product of more than $17 trillion, making it slightly smaller than
the United States in economic terms. at being said, the 2016 vote by the British to negotiate an exit from the
EU (Brexit) has cast a cloud over the future of the European project (the British are set to exit the EU in March
2019).
Similar moves toward regional integration are being pursued elsewhere in the world. Canada, Mexico, and
the United States entered into the NAFTA on January 1, 1994. Ultimately, NAFTA aimed to remove all
barriers to the free flow of goods and services among the three countries. While the implementation of NAFTA
has resulted in job losses in some sectors of the U.S. economy, in aggregate and consistent with the predictions
of international trade theory, most economists argue that the benefits of greater regional trade outweigh any
costs. As noted in the opening case, however, the administration of President Donald Trump criticized NAFTA,
blaming it for significant job losses in the United States, and has negotiated a new agreement.
Regional economic integration is
the focus of Chapter 9, and the
value-added portion of globalEDGE™ that captures the ongoing development of major trade agreements worldwide is
called “Regional Trade Agreements” (globaledge.msu.edu/global-resources/regional-trade-agreements). In this section of
globalEDGE™, the most critical agreements of the some 300 that exist today are included, with direct access to the
home pages for each agreement. e landing page for “Regional Trade Agreements” also includes globalEDGE’s own
“Trade Bloc Insights,” which takes the user to a wealth of information and data (e.g., overview of each agreement, its
history, countries included in the membership, related agreements, online resources, statistics, and an executive
summary of what the agreement entails). In Chapter 9, we cover several of the trade agreements to provide an overview
of the global marketplace. But which agreements are not covered in detail in the book, and which ones are covered on
globalEDGE? What do you know, for example, about ECOWAS and SADC? How many members are in ECOWAS
and SADC, respectively, and are any of these agreements overlapping? When were the treaties of ECOWAS and SADC
started?
South America, too, has moved toward regional integration. For example, in 1991, Argentina, Brazil,
Paraguay, and Uruguay implemented an agreement known as Mercosur to start reducing barriers to trade
between each other, and although progress within Mercosur has been halting, the institution is still in place.
ere are also ongoing attempts at regional economic integration in Africa, where 26 countries signed an
agreement to try and reduce tariffs and costly customs processes in order to stimulate economic growth in the
region.
is chapter explores the economic and political debate surrounding regional economic integration, paying
particular attention to the economic and political benefits and costs of integration; reviews progress toward
regional economic integration around the world; and maps the important implications of regional economic
integration for the practice of international business. We will discuss current developments that threatened the
future of the EU and NAFTA. Before tackling these objectives, we first need to examine the levels of
integration that are theoretically possible.
Levels of Economic Integration
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LO 9-1 Describe the different levels of regional economic integration.
Several levels of economic integration are possible in theory (see Figure 9.1). From least integrated to most
integrated, they are a free trade area, a customs union, a common market, an economic union, and, finally, a
full political union.
9.1 Figure
Levels of economic integration
In a free trade area, all barriers to the trade of goods and services among member countries are
removed. In the theoretically ideal free trade area, no discriminatory tariffs, quotas, subsidies, or
administrative impediments are allowed to distort trade between members. Each country, however, is allowed to
determine its own trade policies with regard to nonmembers. us, for example, the tariffs placed on the
products of nonmember countries may vary from member to member. Free trade agreements are the most
popular form of regional economic integration, accounting for almost 90 percent of regional agreements.2
e most enduring free trade area in the world is the European Free Trade Association (EFTA).
Established in January 1960, the EFTA currently joins four countries—Norway, Iceland, Liechtenstein, and
Switzerland—down from seven in 1995 (three EFTA members—Austria, Finland, and Sweden—joined the EU
on January 1, 1996). e EFTA was founded by those western European countries that initially decided not to
be part of the European Community (the forerunner of the EU). Its original members included Austria, Great
Britain, Denmark, Finland, and Sweden, all of which are now members of the EU. e emphasis of the EFTA
has been on free trade in industrial goods. Agriculture was left out of the arrangement, each member being
allowed to determine its own level of support. Members are also free to determine the level of protection
applied to goods coming from outside the EFTA. Other free trade areas include the North American Free Trade
Agreement, which we discuss in depth later in the chapter.
e customs union is one step farther along the road to full economic and political integration. A customs
union eliminates trade barriers between member countries and adopts a common external trade policy.
Establishment of a common external trade policy necessitates significant administrative machinery to oversee
trade relations with nonmembers. Most countries that enter into a customs union desire even greater economic
integration down the road. e EU began as a customs union, but it has now moved beyond this stage. Other
customs unions include the current version of the Andean Community (formerly known as the Andean Pact)
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among Bolivia, Colombia, Ecuador, and Peru. e Andean Community established free trade between member
countries and imposes a common tariff, of 5 to 20 percent, on products imported from outside.3
e next level of economic integration, a common market, has no barriers to trade among member
countries, includes a common external trade policy, and allows factors of production to move freely among
members. Labor and capital are free to move because there are no restrictions on immigration, emigration, or
cross-border flows of capital among member countries. Establishing a common market demands a significant
degree of harmony and cooperation on fiscal, monetary, and employment policies. Achieving this degree of
cooperation has proved very difficult. For years, the European Union functioned as a common market,
although it has now moved beyond this stage. Mercosur—the South American grouping of Argentina, Brazil,
Paraguay, and Uruguay—hopes to eventually establish itself as a common market. Venezuela was accepted as a
full member of Mercosur subject to ratification by the governments of the four existing members. As of early
2016, Paraguay has yet to ratify Venezuela’s membership.
Should Regional Economic Integration Be Based on Culture?
A free trade area is a group of countries committed to removing all barriers to the free flow of goods and services while at
the same time pursuing independent external trade policies. A free trade area can be of the form of a customs union,
common market, economic union, or political union. e European Union is an economic union—although some
would say that the EU is striving for the approach of a political union as well. e EU, in reality, is an imperfect
economic union because not all members of the EU have adopted the common currency, the euro, and countries differ
in a variety of economic measures (e.g., taxes, regulations). But the most obvious reason the EU is an imperfect market
is that the cultures of the independent countries in many cases are very different, from the Nordic countries to the
southern European countries to the former eastern bloc European countries, and so on. Do you think regional economic
integration should be more based on similarity in culture of the nations involved, or are market-based economic
indicators the most appropriate?
An economic union entails even closer economic integration and cooperation than a common market. Like
the common market, an economic union involves the free flow of products and factors of production among
member countries and the adoption of a common external trade policy, but it also requires a common currency,
harmonization of members’ tax rates, and a common monetary and fiscal policy. Such a high degree
of integration demands a coordinating bureaucracy and the sacrifice of significant amounts of national
sovereignty to that bureaucracy. e EU is an economic union, although an imperfect one because not all
members of the EU have adopted the euro, the currency of the EU; differences in tax rates and regulations
across countries still remain; and some markets, such as the market for energy, are still not fully deregulated.
e move toward economic union raises the issue of how to make a coordinating bureaucracy
accountable to the citizens of member nations. e answer is through political union in which a central
political apparatus coordinates the economic, social, and foreign policy of the member states. e EU is on the
road toward at least partial political union. e European Parliament, which plays an important role in the EU,
has been directly elected by citizens of the EU countries since the late 1970s. In addition, the Council of
Ministers (the controlling, decision-making body of the EU) is composed of government ministers from each
EU member. e United States provides an example of even closer political union; in the United States,
independent states are effectively combined into a single nation.
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Page 246
e Case for Regional Integration
LO 9-2 Understand the economic and political arguments for regional economic integration.
e case for regional integration is both economic and political, and it is typically not accepted by many groups
within a country, which explains why most attempts to achieve regional economic integration have been
contentious and halting. In this section, we examine the economic and political cases for integration and two
impediments to integration. In the next section, we look at the case against integration.
THE ECONOMIC CASE FOR INTEGRATION
e economic case for regional integration is straightforward. We saw in Chapter 6 how economic theories of
international trade predict that unrestricted free trade will allow countries to specialize in the production of
goods and services that they can produce most efficiently. e result is greater world production than would be
possible with trade restrictions. at chapter also revealed how opening a country to free trade stimulates
economic growth, which creates dynamic gains from trade. Chapter 8 detailed how foreign direct investment
(FDI) can transfer technological, marketing, and managerial know-how to host nations. Given the central role
of knowledge in boosting economic growth, opening a country to FDI also is likely to stimulate economic
growth. In sum, economic theories suggest that free trade and investment is a positive-sum game, in which all
participating countries stand to gain.
Given this, the theoretical ideal is an absence of barriers to the free flow of goods, services, and factors of
production among nations. However, as we saw in Chapters 7 and 8, a case can be made for government
intervention in international trade and FDI. Because many governments have accepted part or all of the case
for intervention, unrestricted free trade and FDI have proved to be only an ideal. Although international
institutions such as the WTO have been moving the world toward a free trade regime, success has been less
than total. In a world of many nations and many political ideologies, it is very difficult to get all countries to
agree to a common set of rules.
Against this background, regional economic integration can be seen as an attempt to achieve additional
gains from the free flow of trade and investment between countries beyond those attainable under global
agreements such as the WTO. It is easier to establish a free trade and investment regime among a limited
number of adjacent countries than among the world community. Coordination and policy harmonization
problems are largely a function of the number of countries that seek agreement. e greater the number of
countries involved, the more perspectives that must be reconciled, and the harder it will be to reach agreement.
us, attempts at regional economic integration are motivated by a desire to exploit the gains from free trade
and investment.
THE POLITICAL CASE FOR INTEGRATION
e political case for regional economic integration also has loomed large in several attempts to establish free
trade areas, customs unions, and the like. Linking neighboring economies and making them increasingly
dependent on each other creates incentives for political cooperation between the neighboring states and reduces
the potential for violent conflict. In addition, by grouping their economies, the countries can enhance their
political weight in the world.
ese considerations underlay the 1957 establishment of the European Community (EC), the forerunner of
the EU. Europe had suffered two devastating wars in the first half of the twentieth century, both arising out of
the unbridled ambitions of nation-states. ose who have sought a united Europe have always had a desire to
make another war in Europe unthinkable. Many Europeans also believed that after World War II, the European
nation-states were no longer large enough to hold their own in world markets and politics. e need
for a united Europe to deal with the United States and the politically alien Soviet Union loomed large in the
minds of many of the EC’s founders.4 A long-standing joke in Europe is that the European Commission should
erect a statue to Joseph Stalin, for without the aggressive policies of the former dictator of the old Soviet Union,
the countries of western Europe may have lacked the incentive to cooperate and form the EC.
e establishment of NAFTA also had a political aspect to it. Many NAFTA supporters felt that the trade
agreement would help promote democracy and economic growth in Mexico. is, they argued, would be good
for the United States, since it would reduce the flow of illegal immigration from Mexico. In fact, illegal
immigration from Mexico rose from 2.9 million in 1995 to almost 7 million in 2007. However, since then, the
strong Mexican economy has indeed led to a reduction in illegal immigration from Mexico. By 2017 the
number Mexican illegal immigrants living in the United States had fallen to 5.8 million.5
IMPEDIMENTS TO INTEGRATION
Despite the strong economic and political arguments in support, integration has never been easy to achieve or
sustain for two main reasons. First, although economic integration aids the majority, it has its costs. While a
nation as a whole may benefit significantly from a regional free trade agreement, certain groups will lose, at least
in the short to medium term. Moving to a free trade regime can involve painful adjustments. Due to the
establishment of NAFTA, some Canadian and U.S. workers in such industries as textiles—which employ low-
cost, low-skilled labor—lost their jobs as Canadian and U.S. firms moved production to Mexico. e promise
of significant net benefits to the Canadian and U.S. economies as a whole is little comfort to those who lose as a
result of NAFTA. Such groups have been at the forefront of opposition to NAFTA and will continue to oppose
any widening of the agreement.
A second impediment to integration arises from concerns over national sovereignty. For example, Mexico’s
concerns about maintaining control of its oil interests resulted in an agreement with Canada and the United
States to exempt the Mexican oil industry from any liberalization of foreign investment regulations achieved
under NAFTA. Concerns about national sovereignty arise because close economic integration demands that
countries give up some degree of control over such key issues as monetary policy, fiscal policy (e.g., tax policy),
and trade policy. is has been a major stumbling block in the EU. To achieve full economic union, the EU
introduced a common currency, the euro, controlled by a central EU bank. Although most member states have
signed on, Great Britain remained an important holdout. A politically important segment of public opinion in
that country opposed a common currency on the grounds that it would require relinquishing control of the
country’s monetary policy to the EU, which many British perceive as a bureaucracy run by foreigners. In 1992,
the British won the right to opt out of any single currency agreement. In 2016, the British held a referendum
on their continuing membership of the EU and voted to leave the EU (discussed later in the chapter).
Concerns over national sovereignty, particularly with regard to immigration policy, were the major factor
persuading the British government that a referendum was necessary.
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e Case against Regional Integration
LO 9-3 Understand the economic and political arguments against regional economic integration.
Although the tide has been running in favor of regional free trade agreements, some economists have expressed
concern that the benefits of regional integration have been oversold, while the costs have often been ignored.6
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ey point out that the benefits of regional integration are determined by the extent of trade creation, as
opposed to trade diversion. Trade creation occurs when high-cost domestic producers are replaced by low-cost
producers within the free trade area. It may also occur when higher-cost external producers are replaced by
lower-cost external producers within the free trade area. Trade diversion occurs when lower-cost external
suppliers are replaced by higher-cost suppliers within the free trade area. A regional free trade agreement will
benefit the world only if the amount of trade it creates exceeds the amount it diverts.
Suppose the United States and Mexico imposed tariffs on imports from all countries and then set up a free
trade area, scrapping all trade barriers between themselves but maintaining tariffs on imports from the rest of
the world. If the United States began to import textiles from Mexico, would this change be for the better? If the
United States previously produced all its own textiles at a higher cost than Mexico, then the free
trade agreement has shifted production to the cheaper source. According to the theory of
comparative advantage, trade has been created within the regional grouping, and there would be no decrease in
trade with the rest of the world. Clearly, the change would be for the better. If, however, the United States
previously imported textiles from Costa Rica, which produced them more cheaply than either Mexico or the
United States, then trade has been diverted from a low-cost source—a change for the worse.
In theory, WTO rules should ensure that a free trade agreement does not result in trade diversion. ese
rules allow free trade areas to be formed only if the members set tariffs that are not higher or more restrictive to
outsiders than the ones previously in effect. However, as we saw in Chapter 7, GATT and the WTO do not
cover some nontariff barriers. As a result, regional trade blocs could emerge whose markets are protected from
outside competition by high nontariff barriers. In such cases, the trade diversion effects might outweigh the
trade creation effects. e only way to guard against this possibility, according to those concerned about this
potential, is to increase the scope of the WTO so it covers nontariff barriers to trade. ere is no sign that this is
going to occur any time soon, however, so the risk remains that regional economic integration will result in
trade diversion.
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Regional Economic Integration in Europe
LO 9-4 Explain the history, current scope, and future prospects of the world’s most important regional
economic agreements.
Europe has two trade blocs—the European Union and the European Free Trade Association. Of the two, the
EU is by far the more significant, not just in terms of membership (the EU currently has 28 members, although
the British have voted to exit the union and is scheduled to do so on March 29, 2019; the EFTA has four), but
also in terms of economic and political influence in the world economy. e EU has been viewed as an
emerging economic and political superpower of the same order as the United States, although the exit of Britain
may alter this perception. Accordingly, we will concentrate our attention on the EU.7
EVOLUTION OF THE EUROPEAN UNION
e European Union (EU) is the product of two political factors: (1) the devastation of western Europe during
two world wars and the desire for a lasting peace and (2) the European nations’ desire to hold their own on the
world’s political and economic stage. In addition, many Europeans were aware of the potential economic
benefits of closer economic integration of the countries.
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e forerunner of the EU, the European Coal and Steel Community, was formed in 1951 by Belgium,
France, West Germany, Italy, Luxembourg, and the Netherlands. Its objective was to remove barriers to
intragroup shipments of coal, iron, steel, and scrap metal. With the signing of the Treaty of Rome in 1957, the
European Community (EC) was established. e name changed again in 1993 when the European
Community became the European Union following the ratification of the Maastricht Treaty (discussed later).
e Treaty of Rome provided for the creation of a common market. Article 3 of the treaty laid down the key
objectives of the new community, calling for the elimination of internal trade barriers and the creation of a
common external tariff and requiring member states to abolish obstacles to the free movement of factors of
production among the members. To facilitate the free movement of goods, services, and factors of production,
the treaty provided for any necessary harmonization of the member states’ laws. Furthermore, the treaty
committed the EC to establish common policies in agriculture and transportation.
e community grew in 1973, when Great Britain, Ireland, and Denmark joined. ese three were followed
in 1981 by Greece; in 1986 by Spain and Portugal; and in 1995 by Austria, Finland, and Sweden—bringing
the total membership to 15 (East Germany became part of the EC after the reunification of Germany in 1990).
Another 10 countries joined the EU on May 1, 2004—eight of them from eastern Europe plus the small
Mediterranean nations of Malta and Cyprus. Bulgaria and Romania joined in 2007 and Croatia in 2013,
bringing the total number of member states to 28 (see Map 9.1). rough these enlargements, the EU has
become a global economic power. Right now, it looks as if the the number of members will fall to 27 in 2019
when Britain exits the EU.
9.1 MAP
Member states of the European Union in 2017.
Source: European Union, 1995-2017
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POLITICAL STRUCTURE OF THE EUROPEAN UNION
e economic policies of the EU are formulated and implemented by a complex and still-evolving political
structure. e four main institutions in this structure are the European Commission, the Council of the
European Union, the European Parliament, and the Court of Justice.8
e European Commission is responsible for proposing EU legislation, implementing it, and monitoring
compliance with EU laws by member states. Headquartered in Brussels, Belgium, it is run by a group of
commissioners appointed by each member country for five-year renewable terms. Currently, there are 28
commissioners, one from each member state. A president of the commission is chosen by member states, and
the president then chooses other members in consultation with the states. e entire commission has to be
approved by the European Parliament before it can begin work. e commission has a monopoly in proposing
European Union legislation. e commission makes a proposal, which goes to the Council of the European
Union and then to the European Parliament. e council cannot legislate without a commission proposal in
front of it. e commission is also responsible for implementing aspects of EU law, although in practice much
of this must be delegated to member states. Another responsibility of the commission is to monitor member
states to make sure they are complying with EU laws. In this policing role, the commission will normally ask a
state to comply with any EU laws that are being broken. If this persuasion is not sufficient, the commission can
refer a case to the Court of Justice.
e European Commission’s role in competition policy has become increasingly important to business in
recent years. Since 1990, when the office was formally assigned a role in competition policy, the EU’s
competition commissioner has been steadily gaining influence as the chief regulator of competition
policy in the member nations of the EU. As with antitrust authorities in the United States, which
include the Federal Trade Commission and the Department of Justice, the role of the competition
commissioner is to ensure that no one enterprise uses its market power to drive out competitors and
monopolize markets. In 2009, for example, the commission fined Intel a record €1.06 billion for abusing its
market power in the computer chip market. (See the accompanying Management Focus for details.) e
previous record for a similar abuse was €497 million imposed on Microsoft in 2004 for blocking competition
in markets for server computers and media software. e commissioner also reviews proposed mergers and
acquisitions to make sure they do not create a dominant enterprise with substantial market power.9 For
example, in 2000 a proposed merger between Time Warner of the United States and EMI of the United
Kingdom, both music recording companies, was withdrawn after the commission expressed concerns that the
merger would reduce the number of major record companies from five to four and create a dominant player in
the $40 billion global music industry.
m a n a g e m e n t F O C U S
e European Commission and Intel
In May 2009, the European Commission announced that it had imposed a record €1.06 billion ($1.45 billion) fine on
Intel for anticompetitive behavior. is fine was the result of an investigation into Intel’s competitive conduct during the
period from October 2002 to December 2007. During this period, Intel’s market share of microprocessor sales to
personal computer manufacturers consistently exceeded 70 percent. According to the commission, Intel illegally used its
market power to ensure that its major rival, AMD, was at a competitive disadvantage, thereby harming “millions of
European consumers.”
e commission charged that Intel granted major rebates to PC manufacturers—including Acer, Dell, Hewlett-
Packard, Lenovo, and NEC—on the condition that they purchased all or almost all their supplies from Intel. Intel also
made payments to some manufacturers in exchange for them postponing, canceling, or putting restrictions on the
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introduction or distribution of AMD-based products. Intel also apparently made payments to Media Saturn Holdings,
the owner of Media Markt chain of superstores, for selling only Intel-based computers in Germany, Belgium, and other
countries.
Under the order, Intel had to change its practices immediately, pending any appeal. e company was also required
to write a bank guarantee for the fine, although that guarantee is held in a bank until the appeal process is exhausted.
For its part, Intel immediately appealed the ruling. e company insisted that it had never coerced computer makers
and retailers with inducements and maintained that it had never paid to stop AMD products from reaching the market
in Europe. Although Intel acknowledges that it did offer rebates, it claimed that they were never conditional on specific
actions by manufacturers and retailers aimed to limit AMD. In June 2014, an EU court rejected Intel’s appeal and
upheld the judgment against the company.
Sources: M. Hachman, “EU Hits Intel with $1.45 Billion Fine for Antitrust Violations,” PCMAG.com, May 13, 2009;
J. Kanter, “Europe Fines Intel $1.45 Billion in Antitrust Case,” e New York Times, May 14, 2009; T. Fairless, “EU
Court Upholds Record Fine against Intel,” e Wall Street Journal, June 12, 2014.
e European Council represents the interests of member states. It is clearly the ultimate controlling
authority within the EU because draft legislation from the commission can become EU law only if the council
agrees. e council is composed of one representative from the government of each member state. e
membership, however, varies depending on the topic being discussed. When agricultural issues are being
discussed, the agriculture ministers from each state attend council meetings; when transportation is being
discussed, transportation ministers attend; and so on. Before 1987, all council issues had to be decided by
unanimous agreement among member states. is often led to marathon council sessions and a failure to make
progress or reach agreement on commission proposals. In an attempt to clear the resulting logjams, the Single
European Act formalized the use of majority voting rules on issues “which have as their object the establishment
and functioning of a single market.” Most other issues, however, such as tax regulations and immigration policy,
still require unanimity among council members if they are to become law. e votes that a country gets in the
council are related to the size of the country. For example, Germany, a large country, has 29 votes, whereas
Denmark, a much smaller state, has seven votes.
As of 2016, the European Parliament has 751 members and is directly elected by the populations of the
member states. e parliament, which meets in Strasbourg, France, is primarily a consultative rather than
legislative body. It debates legislation proposed by the commission and forwarded to it by the
council. It can propose amendments to that legislation, which the commission and ultimately the
council are not obliged to take up but often will. e power of the parliament recently has been increasing,
although not by as much as parliamentarians would like. e European Parliament now has the right to vote on
the appointment of commissioners as well as veto some laws (such as the EU budget and single-market
legislation).
One major debate waged in Europe during the past few years is whether the council or the parliament
should ultimately be the most powerful body in the EU. Some in Europe expressed concern over the
democratic accountability of the EU bureaucracy. One side argued that the answer to this apparent democratic
deficit lay in increasing the power of the parliament, while others think that true democratic legitimacy lies
with elected governments, acting through the Council of the European Union.10 After significant debate, in
December 2007, the member states signed a new treaty, the Treaty of Lisbon, under which the power of the
European Parliament was increased. When it took effect in December 2009, for the first time in history the
European Parliament was the co-equal legislator for almost all European laws.11 e Treaty of Lisbon also
created a new position, a president of the European Council, who serves a 30-month term and represents the
nation-states that make up the EU.
e Court of Justice, which is composed of one judge from each country, is the supreme appeals court for
EU law. Like commissioners, the judges are required to act as independent officials, rather than as
representatives of national interests. e commission or a member country can bring other members to the
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court for failing to meet treaty obligations. Similarly, member countries, member companies, or member
institutions can bring the commission or council to the court for failure to act according to an EU treaty.
THE SINGLE EUROPEAN ACT
e Single European Act was born of a frustration among members that the community was not living up to its
promise. By the early 1980s, it was clear that the EC had fallen short of its objectives to remove barriers to the
free flow of trade and investment among member countries and to harmonize the wide range of technical and
legal standards for doing business. Against this background, many of the EC’s prominent businesspeople
mounted an energetic campaign in the early 1980s to end the EC’s economic divisions. e EC responded by
creating the Delors Commission. Under the chairperson Jacques Delors, the commission proposed that all
impediments to the formation of a single market be eliminated by December 31, 1992. e result was the
Single European Act, which became EC law in 1987.
e Objectives of the Act e purpose of the Single European Act was to have one market in place by December 31, 1992. e act proposed the following changes:12
Remove all frontier controls among EC countries, thereby abolishing delays and reducing the resources
required for complying with trade bureaucracy.
Apply the principle of “mutual recognition” to product standards. A standard developed in one EC
country should be accepted in another, provided it met basic requirements in such matters as health and
safety.
Institute open public procurement to nonnational suppliers, reducing costs directly by allowing lower-
cost suppliers into national economies and indirectly by forcing national suppliers to compete.
Lift barriers to competition in the retail banking and insurance businesses, which should drive down the
costs of financial services, including borrowing, throughout the EC.
Remove all restrictions on foreign exchange transactions between member countries by the end of 1992.
Abolish restrictions on cabotage—the right of foreign truckers to pick up and deliver goods within
another member state’s borders—by the end of 1992. Estimates suggested this would reduce the cost of
haulage within the EC by 10 to 15 percent.
All those changes were expected to lower the costs of doing business in the EC, but the single-market
program was also expected to have more complicated supply-side effects. For example, the expanded market
was predicted to give EC firms greater opportunities to exploit economies of scale. In addition, it was thought
that the increase in competitive intensity brought about by removing internal barriers to trade and
investment would force EC firms to become more efficient. To signify the importance of the Single
European Act, the European Community also decided to change its name to the European Union once the act
took effect.
Impact e Single European Act has had an impact on the EU economy.13 e act provided the impetus for the restructuring of substantial sections of European industry. Many firms have shifted from national to pan-
European production and distribution systems in an attempt to realize scale economies and better compete in a
single market. e results have included faster economic growth than would otherwise have been the case.
According to empirical research, the single market raised GDP by between 2 and 5 percent in its first 15 years
(different empirical studies generated different results, although all pointed to a positive impact).14 However,
25 years after the formation of a single market, there is little doubt that the reality still falls short of the ideal.
Although the EU is undoubtedly moving toward a single marketplace, long-established legal, cultural, and
language differences among nations mean that implementation has been uneven.
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Is Greece a Good Member of the European Union?
In April 2014, Greece held its first bond sale since 2010, raising about $4.2 billion as investors flocked to secure bonds
from the hard-hit country. Greece stopped issuing bonds in 2010 amid the country’s economic crisis. e 2014 bond
sale was hailed as a sign that Greece is recovering and heading in the right direction. As most observers agree, Greece has
struggled to deal with its financial crisis, and has, among many measures, taken on more than $330 billion worth of
bailouts and implemented various austerity measures to fix the country’s finances. e government’s bond sale is a return
to international markets for Greece and a step toward the country reducing its dependence on foreign aid—a crucial
step to regain confidence from investors and other countries. e bond sale’s success is a reason for optimism in Greece
and throughout Europe, especially the European Union countries, as it not only shows investors’ renewed confidence in
the Greek economy, but perhaps also in the euro zone’s recovery in general. Do you think that the European Union is
only as strong as its weakest link or as strong as its strongest country?
Source: T. Ford, “globalEDGE Blog: High Demand for Greece’s Return to Bond Market,” April 11, 2014,
http://globalEDGE.msu.edu.
THE ESTABLISHMENT OF THE EURO
In February 1992, EC members signed the Maastricht Treaty, which committed them to adopting a common
currency by January 1, 1999.15 e euro is now used by 19 of the 28 member states of the European Union;
these 19 states are members of what is often referred to as the euro zone. It encompasses 330 million EU citizens
and includes the powerful economies of Germany and France. Many of the countries that joined the EU on
May 1, 2004, and the two that joined in 2007 originally planned to adopt the euro when they fulfilled certain
economic criteria—a high degree of price stability, a sound fiscal situation, stable exchange rates, and converged
long-term interest rates (the current members had to meet the same criteria). However, the events surrounding
the EU sovereign debt crisis of 2010–2012 persuaded many of these countries to put their plans on hold, at
least for the time being (further details provided later).
Establishment of the euro was a remarkable political feat with few historical precedents. It required
participating national governments to give up their own currencies and national control over monetary policy.
Governments do not routinely sacrifice national sovereignty for the greater good, indicating the importance
that the Europeans attach to the euro. By adopting the euro, the EU has created the second most widely traded
currency in the world after the U.S. dollar. Some believe that the euro could come to rival the dollar as the most
important currency in the world.
ree long-term EU members—Great Britain, Denmark, and Sweden—decided to sit on the sidelines. e
countries agreeing to the euro locked their exchange rates against each other January 1, 1999. Euro notes and
coins were not actually issued until January 1, 2002. In the interim, national currencies circulated in each
participating state. However, in each country, the national currency stood for a defined amount of euros. After
January 1, 2002, euro notes and coins were issued and the national currencies were taken out of circulation. By
mid-2002, all prices and routine economic transactions within the euro zone were in euros.
Benefits of the Euro Europeans decided to establish a single currency in the EU for a number of reasons. First, they believe that businesses and individuals realize significant savings from having to handle one currency,
rather than many. ese savings come from lower foreign exchange and hedging costs. For example, people
going from Germany to France no longer have to pay a commission to a bank to change German deutsche
marks into French francs. Instead, they are able to use euros. According to the European Commission, such
savings amount to 0.5 percent of the European Union’s GDP.
Second, and perhaps more important, the adoption of a common currency makes it easier to compare prices
across Europe. is has been increasing competition because it has become easier for consumers to shop
around. For example, if a German finds that cars sell for less in France than Germany, he may be tempted to
purchase from a French car dealer rather than his local car dealer. Alternatively, traders may engage in arbitrage
to exploit such price differentials, buying cars in France and reselling them in Germany. e only way that
German car dealers will be able to hold onto business in the face of such competitive pressures will be to reduce
the prices they charge for cars. As a consequence of such pressures, the introduction of a common currency has
led to lower prices, which translates into substantial gains for European consumers.
ird, faced with lower prices, European producers have been forced to look for ways to reduce their
production costs to maintain their profit margins. e introduction of a common currency, by increasing
competition, has produced long-run gains in the economic efficiency of European companies.
Fourth, the introduction of a common currency has given a boost to the development of a highly liquid
pan-European capital market. Over time, the development of such a capital market should lower the cost of
capital and lead to an increase in both the level of investment and the efficiency with which investment funds
are allocated. is could be especially helpful to smaller companies that have historically had difficulty
borrowing money from domestic banks. For example, the capital market of Portugal is very small and illiquid,
which makes it extremely difficult for bright Portuguese entrepreneurs with a good idea to borrow money at a
reasonable price. However, in theory, such companies can now tap a much more liquid pan-European capital
market.
Finally, the development of a pan-European, euro-denominated capital market will increase the range of
investment options open to both individuals and institutions. For example, it will now be much easier for
individuals and institutions based in, let’s say, Holland to invest in Italian or French companies. is will enable
European investors to better diversify their risk, which again lowers the cost of capital, and should also increase
the efficiency with which capital resources are allocated.16
Costs of the Euro e drawback, for some, of a single currency is that national authorities have lost control over monetary policy. us, it is crucial to ensure that the EU’s monetary policy is well managed. e
Maastricht Treaty called for establishment of the independent European Central Bank (ECB), similar in some
respects to the U.S. Federal Reserve, with a clear mandate to manage monetary policy so as to ensure price
stability. e ECB, based in Frankfurt, is meant to be independent from political pressure—although critics
question this. Among other things, the ECB sets interest rates and determines monetary policy across the euro
zone.
e implied loss of national sovereignty to the ECB underlies the decision by Great Britain, Denmark, and
Sweden to stay out of the euro zone. Many in these countries are suspicious of the ECB’s ability to remain free
from political pressure and to keep inflation under tight control.
Can the Euro Survive?
It seems like experts and interested observers are always debating the merits of the euro and its likelihood of survival.
e answers lie in examining several interesting facts of the European Union. First, the lack of a European treasury is a
missing piece of the puzzle. Without it, the ECB is limited in the assistance it can provide to euro zone member-states.
In theory, the European Central Bank (ECB) could bail out those member-states burdened with excessive debt by
printing more money. However, that would require the approval of all of the EU member countries (not just the
countries that use the euro as their national currency). Germany is typically opposed to any measure that may light the
fires of inflation. Some of the EU members also think it is unfair to bail out those states that have lived beyond their
means for many years. It is difficult to compare the difficulties within the EU to those of other nations that have faced
similar problems and survived. But the basic question remains, will the euro survive?
Source: http://seekingalpha.com.
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In theory, the design of the ECB should ensure that it remains free of political pressure. e ECB is modeled
on the German Bundesbank, which historically has been the most independent and successful central bank in
Europe. e Maastricht Treaty prohibits the ECB from taking orders from politicians. e executive board of
the bank, which consists of a president, vice president, and four other members, carries out policy by issuing
instructions to national central banks. e policy itself is determined by the governing council, which consists
of the executive board plus the central bank governors from the euro zone countries. e governing council
votes on interest rate changes. Members of the executive board are appointed for eight-year nonrenewable
terms, insulating them from political pressures to get reappointed. So far, the ECB has established a solid
reputation for political independence.
According to critics, another drawback of the euro is that the EU is not what economists would call an
optimal currency area. In an optimal currency area, similarities in the underlying structure of economic
activity make it feasible to adopt a single currency and use a single exchange rate as an instrument of
macroeconomic policy. Many of the European economies in the euro zone, however, are very dissimilar. For
example, Finland and Portugal have different wage rates, tax regimes, and business cycles, and they may react
very differently to external economic shocks. A change in the euro exchange rate that helps Finland may hurt
Portugal. Obviously, such differences complicate macroeconomic policy. For example, when euro economies are
not growing in unison, a common monetary policy may mean that interest rates are too high for depressed
regions and too low for booming regions.
One way of dealing with such divergent effects within the euro zone is for the EU to engage in fiscal
transfers, taking money from prosperous regions and pumping it into depressed regions. Such a move, however,
opens a political can of worms. Would the citizens of Germany forgo their “fair share” of EU funds to create
jobs for underemployed Greece workers? Not surprisingly, there is strong political opposition to such practices.
e Euro Experience Since its establishment January 1, 1999, the euro has had a volatile trading history against the world’s major currency, the U.S. dollar. After starting life in 1999 at €1 = $1.17, the euro stood at a
robust all-time high of €1 = $1.54 in early March 2008. One reason for the rise in the value of the euro was
that the flow of capital into the United States stalled as the U.S. financial markets fell during 2007 and 2008.
Many investors took money out of the United States, selling dollar-denominated assets such as U.S. stocks and
bonds, and purchasing euro-denominated assets. Falling demand for U.S. dollars and rising demand for euros
translated into a fall in the value of the dollar against the euro. Furthermore, in a vote of confidence in both the
euro and the ability of the ECB to manage monetary policy within the euro zone, many foreign central banks
added more euros to their supply of foreign currencies. In the first three years of its life, the euro never reached
the 13 percent of global reserves made up by the deutsche mark and other former euro zone currencies. e
euro didn’t jump that hurdle until early 2002 and hit 28 percent in 2009. By the end of 2017, the euro
accounted for about 20 percent of global foreign exchange reserves.17
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Euro sign sculpture.
©Bloomberg/Getty Images
Since 2008 however, the euro has weakened against a basket of currencies, reflecting persistent
concerns over slow economic growth and large budget deficits among several EU member states,
particularly Greece, Portugal, Ireland, Italy, and Spain. During the 2000s, all these governments had sharply
increased their government debt to finance public spending. Government debt as a percentage of GDP hit
record levels in many of these nations. By 2010, private investors became increasingly concerned that these
nations would not be able to service their sovereign debt, particularly given the economic slowdown following
the 2008–2009 global financial crisis. ey sold off government bonds of troubled nations, driving down bond
prices and driving up the cost of government borrowing (bond prices and interest rates are inversely related).
is led to fears that several national governments, particularly Greece, might default on their sovereign debt,
plunging the euro zone into an economic crisis.
To try to stave off such a sovereign debt crisis, in May 2010, the euro zone nations and the International
Monetary Fund (IMF) agreed to a €110 billion bailout package to help rescue Greece. In November 2010, the
EU and IMF agreed to a bailout package for Ireland of €85 billion; in May 2011, euro zone countries and the
IMF instituted a €78 billion bailout plan for Portugal. In return for these loans, all three countries had to agree
to sharp reductions in government spending, which meant slower economic growth and high unemployment
until government debt was reduced to more sustainable levels. While Italy and Spain did not request bailout
packages, both countries were forced by falling bond prices to institute austerity programs that required big
reductions in government spending. e euro zone nations also set up a permanent bailout fund—the
European Stability Mechanism—worth about €500 billion, which was designed to restore confidence in the
euro. As detailed in the accompanying Country Focus, by 2012 Greece had been granted two more bailout
packages in an attempt to forestall a full-blown default on payment of its sovereign debt. As might be expected,
economic turmoil within the EU led to a decline in the value of the euro. By early 2018, the dollar-euro
exchange rate stood at €1 = $1.23, below its 2008 value. e euro also declined by 20 to 30 percent against
most of the world’s other major currencies between late 2008 and early 2017, but has staged a partial recovery
since then largely on stronger economic growth in the EU.
Potentially troubling for the long-run success of the euro, many of the newer EU nations that had
committed to adopting the euro put their plans on hold. Countries like Poland and the Czech Republic had no
desire to join the euro zone and then have their taxpayers help bail out the profligate governments of countries
like Italy and Greece. To compound matters, the sovereign debt crisis had exposed a deep flaw in the euro zone:
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It was difficult for fiscally more conservative nations like Germany to limit profligate spending by the
governments of other nations that might subsequently create strains and impose costs on the entire euro zone.
e Germans in particular found themselves in the unhappy position of having to underwrite loans to bail out
the governments of Greece, Portugal, and Ireland. is started to erode support for the euro in the stronger EU
states. To try to correct this flaw, 25 of the then 27 countries in the EU signed a fiscal pact in January 2012 that
made it more difficult for member states to break tight new rules on government deficits (the United Kingdom
and Czech Republic abstained; Croatia joined in 2013).
ENLARGEMENT OF THE EUROPEAN UNION
Enlargement of the EU into eastern Europe has been discussed since the collapse of communism at the end of
the 1980s. By the end of the 1990s, 13 countries had applied to become EU members. To qualify for EU
membership, the applicants had to privatize state assets, deregulate markets, restructure industries, and tame
inflation. ey also had to enshrine complex EU laws into their own systems, establish stable democratic
governments, and respect human rights.18 In December 2002, the EU formally agreed to accept the
applications of 10 countries, and they joined May 1, 2004. e new members included the Baltic countries, the
Czech Republic, and the larger nations of Hungary and Poland. e only new members not in eastern Europe
were the Mediterranean island nations of Malta and Cyprus. eir inclusion in the EU expanded the union to
25 states, stretching from the Atlantic to the borders of Russia; added 23 percent to the landmass of the EU;
brought 75 million new citizens into the EU, building an EU with a population of 450 million people; and
created a single continental economy with a GDP of close to €11 trillion. In 2007, Bulgaria and Romania
joined, and in 2013, Croatia joined, bringing total membership to 28 nations.
c o u n t r y F O C U S
e Greek Sovereign Debt Crisis
When the euro was established, some critics worried that free-spending countries in the euro zone (such as Italy and
Greece) might borrow excessively, running up large public-sector deficits that they could not finance. is would then
rock the value of the euro, requiring their more sober brethren, such as Germany or France, to step in and bail out the
profligate nation. In 2010, this worry became a reality as a financial crisis in Greece hit the value of the euro.
e financial crisis had its roots in a decade of free spending by the Greek government, which ran up a high level of
debt to finance extensive spending in the public sector. Much of the spending increase could be characterized as an
attempt by the government to buy off powerful interest groups in Greek society, from teachers and farmers to public-
sector employees, rewarding them with high pay and extensive benefits. To make matters worse, the government misled
the international community about the level of its indebtedness. In October 2009, a new government took power and
quickly announced that the 2009 public-sector deficit, which had been projected to be around 5 percent, would actually
be 12.7 percent. e previous government had apparently been cooking the books.
is shattered any faith that international investors might have had in the Greek economy. Interest rates on Greek
government debt quickly surged to 7.1 percent, about 4 percentage points higher than the rate on German bonds. Two
of the three international rating agencies also cut their ratings on Greek bonds and warned that further downgrades were
likely. e main concern now was that the Greek government might not be able to refinance some €20 billion of debt
that would mature in April or May 2010. A further concern was that the Greek government might lack the political
willpower to make the large cuts in public spending necessary to bring down the deficit and restore investor confidence.
Nor was Greece alone in having large public-sector deficits. ree other euro zone countries—Spain, Portugal, and
Ireland—also had large debt loads, and interest rates on their bonds surged as investors sold out. is raised the specter
of financial contagion, with large-scale defaults among the weaker members of the euro zone. If this did occur, the EU
and IMF would most certainly have to step in and rescue the troubled nations. With this possibility, once considered
very remote, investors started to move money out of euros, and the value of the euro started to fall on the foreign
exchange market.
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Recognizing that the unthinkable might happen—and that without external help, Greece might default on its
government debt, pushing the EU and the euro into a major crisis—in May 2010, the euro zone countries, led by
Germany, along with the IMF agreed to lend Greece up to €110 billion. ese loans were judged sufficient to cover
Greece’s financing needs for three years. In exchange, the Greek government agreed to implement a series of strict
austerity measures. ese included tax increases, major cuts in public-sector pay, reductions in benefits enjoyed by
public-sector employees (e.g., the retirement age was increased to 65 from 61, and limits were placed on pensions), and
reductions in the number of public-sector enterprises from 6,000 to 2,000. However, the Greek economy contracted so
fast in 2010 and 2011 that tax revenues plunged. By the end of 2011, the Greek economy was almost 29 percent smaller
than it had been in 2005, while unemployment approached 20 percent. e contracting tax base limited the ability of
the government to pay down debt. By early 2012, yields on 10-year Greek government debt reached 34 percent,
indicating that many investors now expected Greece to default on its sovereign debt. is forced the Greek government
to seek further aid from the euro zone countries and the IMF. As a condition for a fresh €130 billion bailout plan, the
Greek government had to get holders of Greek government bonds to agree to the biggest sovereign debt restructuring in
history, In effect, bondholders agreed to write off 53.5 percent of the debt they held.
While the Greek government did not technically default on its sovereign debt, to many it seemed as if the EU and
IMF had orchestrated an orderly partial default. By early 2014, it looked as if the Greek economy had finally turned a
corner and was on the way to recovery. Yields on 10-year bonds had fallen below 8 percent, and the government was
running a budget surplus before interest payments.
Unfortunately, things took a turn for the worse in 2014, when it became clear that despite economic progress, Greece
did not have the funds to repay its creditors on time and would have to issue new bonds in order to do so. Following a
decision to call a snap election, in January 2015, a radical left-wing “anti-bailout” party was swept into power. e
financial minister of the new government suggested that Greece should default on its scheduled debt repayments to its
largest creditor, Germany. is initiated a crisis in the euro zone and helped precipitate a sharp decline in the value of
the euro against the U.S. dollar. Following further negotiations, Greece’s creditors agreed to a third bailout in late 2015
—but only after Greece agreed to implement further austerity measures and economic reforms. Whether this will prove
to be any more successful than the prior two bailouts remains to be seen.
Sources: “A Very European Crisis,” e Economist, February 6, 2010, pp. 75–77; L. omas, “Is Debt Trashing the
Euro?” e New York Times, February 7, 2010, pp. 1, 7; “Bite the Bullet,” e Economist, January 15, 2011, pp. 77–79;
“e Wait Is Over,” e Economist, March 17, 2012, pp. 83–84; “Aegean Stables,” e Economist, January 11, 2014; Liz
Alderman, “Greece’s Debt Crisis Explained,” e New York Times, November 8, 2015.
e new members were not able to adopt the euro for several years, and free movement of labor among the
new and existing members was prohibited until then. Consistent with theories of free trade, the enlargement
should create added benefits for all members. However, given the small size of the eastern European economies
(together they amount to only 5 percent of the GDP of current EU members), the initial impact will probably
be small. e biggest notable change might be in the EU bureaucracy and decision-making processes, where
budget negotiations among 28 nations are bound to prove more problematic than negotiations among 15
nations.
Left standing at the door is Turkey. Turkey, which has long lobbied to join the union, presents the EU with
some difficult issues. e country has had a customs union with the EU since 1995, and about half its
international trade is already with the EU. However, full membership has been denied because of concerns over
human rights issues (particularly Turkish policies toward its Kurdish minority). In addition, some on the
Turkish side suspect the EU is not eager to let a primarily Muslim nation of 74 million people, which has one
foot in Asia, join the EU. e EU formally indicated in December 2002 that it would allow the Turkish
application to proceed with no further delay in December 2004 if the country improved its human rights
record to the satisfaction of the EU. In December 2004, the EU agreed to allow Turkey to start accession talks
in October 2005, but in late 2016, the European Parliament voted to suspend negotiations following Turkish
government purges of opposition groups and a belief that Turkey was tilting towards authoritarianism.
Welcome sign to Croatia when the country joined the European Union.
©FREDERICK FLORIN/AFP/Getty Images
BRITISH EXIT FROM THE EUROPEAN UNION (BREXIT)
On June 23, 2016, and by a narrow margin, the British electorate voted in a national referendum to leave the
EU. In early 2017, the British government formally notified the EU of its intention to exit the EU. Under the
Treaty of Lisbon, it had two years to negotiate the terms of exit with the EU, which was scheduled to occur on
March 29, 2019. While the British have enjoyed the benefits of free trade within Europe, a segment of the
population has never been comfortable with the loss of national sovereignty implied by membership within the
EU. e British have often railed against regulations imposed by the EU bureaucracy in Brussels, and more
recently, immigration has become a key issue. Immigration from within the EU hit record levels in 2015. Much
of that immigration has been from eastern Europe. Many of the immigrants have been low skilled and work in
restaurants, hotels, and retail stores. e campaign for leaving the EU claimed that exit would allow the British
to “take back control” of immigration. In the referendum, London, Scotland, and Northern Ireland voted to
stay in the EU, whereas most of the rest of the country voted for exit. e vote was also split by age and
education. e younger and more educated voted to stay in the EU, while the older and less educated voted to
leave.
e impending exit of Britain creates an existential problem for the EU. Britain is the EU’s second largest
national economy. It is seen by many smaller member countries as an important counterweight to the economic
power of Germany. In the aftermath of the British vote, right-wing politicians in Holland, Denmark, and
France also called for referendums on continuing EU membership, raising fears that the British vote might
trigger a “rush for the exits.” While this seems unlikely to occur, there is little doubt that an EU without Britain
will lose some of its economic and political clout on the world stage, and the EU itself will be diminished.
Given the importance of immigration in the British vote, further expansion of the EU now seems unlikely,
particularly with regard to Turkey.
As for Britain, most experts predict that the country will bear short- to medium-term costs as a result of this
decision.19 Britain is now less likely to attract inward investment from foreign multinationals, some
multinationals may move operations to other EU countries to maintain access to the single market, exports to
the EU may fall, London risks losing its position as the financial capital of Europe, and economic growth may
be lower than it otherwise might have been. Furthermore, given that the Scots voted by a large margin to stay
in the EU, this once again raises the possibility of Scottish independence from the United Kingdom. In the
long run, whether Britain benefits from exit depends on its ability to negotiate trade deals with the EU and
other major economic powers—including the United States, Japan, and China—to replace the benefits it will
lose by exiting from the EU. In a world that is becoming increasingly resistant to free trade deals, there is no
guarantee that the British will be able to do this. e British government would certainly like to extract
favorable trade terms wth the EU as part of its exit negotiations, but the EU is likely to insist that in order to
get full access to the single market, the British adopt EU regulations permitting the free movement of labor.
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is is something that the British are unlikely to accept given how important an issue immigration was in the
referendum.
test PREP
Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to
learnsmartadvantage.com for help.
Regional Economic Integration in the Americas
No other attempt at regional economic integration comes close to the EU in its boldness or its potential
implications for the world economy, but there have been significant attempts at regional economic integration
in the Americas. e most notable is the North American Free Trade Agreement which at the time of writing is
in the process of being superseded by the USMCA (see the Opening Case). In addition to NAFTA, several
other trade blocs are in the offing in the Americas (see Map 9.2), the most significant of which appear to be the
Andean Community and Mercosur.
9.2 MAP
Economic integration in the Americas.
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THE NORTH AMERICAN FREE TRADE AGREEMENT
e governments of the United States and Canada in 1988 agreed to enter into a free trade agreement, which
took effect January 1, 1989. e goal of the agreement was to eliminate all tariffs on bilateral trade between
Canada and the United States by 1998. is was followed in 1991 by talks among the United States, Canada,
and Mexico aimed at establishing a North American Free Trade Agreement (NAFTA) for the three countries.
e talks concluded in August 1992 with an agreement in principle, and the following year, the agreement was
ratified by the governments of all three countries. e agreement became law January 1, 1994.20
NAFTA’S Contents e contents of NAFTA include the following:
Abolition by 2004 of tariffs on 99 percent of the goods traded among Mexico, Canada, and the United
States.
Removal of most barriers on the cross-border flow of services, allowing financial institutions, for example,
unrestricted access to the Mexican market by 2000.
Protection of intellectual property rights.
Removal of most restrictions on foreign direct investment among the three member countries, although
special treatment (protection) will be given to Mexican energy and railway industries, American airline
and radio communications industries, and Canadian culture.
Application of national environmental standards, provided such standards have a scientific basis.
Lowering of standards to lure investment is described as being inappropriate.
Establishment of two commissions with the power to impose fines and remove trade privileges when
environmental standards or legislation involving health and safety, minimum wages, or child labor are
ignored.
e Case for NAFTA Proponents of NAFTA have argued that the free trade area should be viewed as an opportunity to create an enlarged and more efficient productive base for the entire region. Advocates
acknowledge that one effect of NAFTA would be that some U.S. and Canadian firms would move production
to Mexico to take advantage of lower labor costs. (In 2015, the average hourly labor cost in Mexican
automobile factories was $8–$10 an hour including benefits, compared to $42–$58 an hour in the United
States.21) Movement of production to Mexico, they argued, was most likely to occur in lower-skilled, labor-
intensive manufacturing industries in which Mexico might have a comparative advantage. Advocates of
NAFTA argued that many would benefit from such a trend. Mexico would benefit from much-needed inward
investment and employment. e United States and Canada would benefit because the increased incomes of
the Mexicans would allow them to import more U.S. and Canadian goods, thereby increasing demand and
making up for the jobs lost in industries that moved production to Mexico. U.S. and Canadian consumers
would benefit from the lower prices of products made in Mexico. In addition, the international competitiveness
of U.S. and Canadian firms that moved production to Mexico to take advantage of lower labor costs would be
enhanced, enabling them to better compete with Asian and European rivals.
Did You Know?
Did you know that NAFTA was thought to produce a “giant sucking sound”?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
e Case against NAFTA ose who opposed NAFTA claimed that ratification would be followed by a mass exodus of jobs from the United States and Canada into Mexico as employers sought to profit from
Mexico’s lower wages and less strict environmental and labor laws. According to one extreme opponent, Ross
Perot, up to 5.9 million U.S. jobs would be lost to Mexico after NAFTA in what he famously characterized as a
“giant sucking sound.” Most economists, however, dismissed these numbers as being absurd and alarmist. ey
argued that Mexico would have to run a bilateral trade surplus with the United States of close to $300 billion
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for job loss on such a scale to occur—and $300 billion was the size of Mexico’s GDP. In other words, such a
scenario seemed implausible.
More sober estimates of the impact of NAFTA ranged from a net creation of 170,000 jobs in the United
States (due to increased Mexican demand for U.S. goods and services) and an increase of $15 billion per year to
the joint U.S. and Mexican GDP to a net loss of 490,000 U.S. jobs. To put these numbers in perspective,
employment in the U.S. economy was predicted to grow by 18 million from 1993 to 2003. As most economists
repeatedly stressed, NAFTA would have a small impact on both Canada and the United States. It could hardly
be any other way, because the Mexican economy was only 5 percent of the size of the U.S. economy. Signing
NAFTA required the largest leap of economic faith from Mexico rather than Canada or the United States.
Falling trade barriers would expose Mexican firms to highly efficient U.S. and Canadian competitors that, when
compared to the average Mexican firm, had far greater capital resources, access to highly educated and skilled
workforces, and much greater technological sophistication. e short-run outcome was likely to be painful
economic restructuring and unemployment in Mexico. But advocates of NAFTA claimed there
would be long-run dynamic gains in the efficiency of Mexican firms as they adjusted to the rigors of
a more competitive marketplace. To the extent that this occurred, they argued, Mexico’s economic growth rate
would accelerate, and Mexico might become a major market for Canadian and U.S. firms.22
Environmentalists also voiced concerns about NAFTA. ey pointed to the sludge in the Rio Grande and
the smog in the air over Mexico City and warned that Mexico could degrade clean air and toxic waste standards
across the continent. ey pointed out that the lower Rio Grande was the most polluted river in the United
States and that, with NAFTA, chemical waste and sewage would increase along its course from El Paso, Texas,
to the Gulf of Mexico.
ere was also opposition in Mexico to NAFTA from those who feared a loss of national sovereignty.
Mexican critics argued that their country would be dominated by U.S. firms that would not really contribute to
Mexico’s economic growth but instead would use Mexico as a low-cost assembly site while keeping their high-
paying, high-skilled jobs north of the border.
As NAFTA Nurtures Mexican Economy, Illegal Immigration Dwindles?
e large wave of immigration from Mexico to the United States that began four decades ago, most of it unauthorized,
has to a large degree ended. As a report from the Pew Hispanic Center confirms, net migration from Mexico to the
United States sank to about zero in the past five years. Did the North American Free Trade Agreement (NAFTA) play a
role? Yes and no. Actually, the number of Mexicans living illegally in the United States shot up from 2.5 million in
1995, the year after NAFTA took effect, to 11 million in 2013. e main reason was the booming U.S. economy, which
generated huge demands for labor just as the share of Mexico’s population aged 15 to 39, prime migration years, was
peaking at about 75 percent. Migration plummeted after 2005 because of reduced U.S. demand for labor and the
slowing of Mexican population growth but also because NAFTA started to pay off in the form of dynamic new export
industries in Mexico, such as automobile manufacturing. Do you think there will be continued decline in immigration
of people from Mexico to the United States in future years because of the NAFTA agreement, or will the immigration
decline (or potential increase) be due to factors that are not tied to NAFTA?
Source: www.lehighvalleylive.com.
NAFTA: e Results Studies of NAFTA’s impact suggest its initial effects muted, and both advocates and detractors may have been guilty of exaggeration.23 On average, studies indicate that NAFTA’s overall impact
has been small but positive.24 NAFTA was meant to increase trade among the three member states, and it
appears to have done so.
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In 1990, U.S. trade with Canada and Mexico accounted for about 25 percent of total U.S. trade. By 2017,
the figure was over 40 percent. Canada and Mexico are now among the top three trading partners of the United
States (the other is China), accounting for $1.3 trillion in cross-border trade in goods and services in 2017, up
from $290 billion in 1993.25 All three countries also experienced strong productivity growth in the first 10
years NAFTA was in place. In Mexico, labor productivity has increased by 50 percent. e passage of NAFTA
may well have contributed to this.
Estimates suggest that employment effects of NAFTA have been moderate to small. e most pessimistic
estimate of job losses comes from a study published by the left-leaning Economic Policy Institute. is study
suggests that the United States lost about 850,000 jobs between 1993 and 2013 due to NAFTA, or 42,500 jobs
a year on average. To put this loss in context, between 1992 and 2000, the U.S. economy created 2.86 million
jobs every year on average. Other studies suggest that NAFTA had a far more moderate job impact in the
United States. One recent study concluded that at most, 5 percent of U.S. job losses per year can be traced to
NAFTA, and most of those who lose jobs find work elsewhere. Similarly, a review of empirical studies by the
OECD concluded that “the net employment effects were relatively small, although there were adjustments
across sectors displacing workers.”26
A study of the welfare effects of NAFTA, which take into account its impact on national income, suggest
that Mexico and the United States saw small welfare gains of 1.31 percent and 0.08 percent, respectively, while
Canada suffered a welfare loss of 0.06 percent. e same study noted that real wages increased for all NAFTA
members, with Mexico registering the largest gain. Similarly, a study by the Peterson Institute for International
Economics concluded that the United States was $127 billion richer every year thanks to NAFTA. ese
studies support the general conclusion that contrary to political rhetoric, the impact of NAFTA has been quite
small.27
NAFTA and the USMCA Despite data suggesting that NAFTA has had a small positive impact on U.S. national income and, at worse, a small negative impact on employment, the trade deal continues to
be the target of criticism. Politicians on both the right (Donald Trump) and the left (Bernie Sanders)
have taken aim at NAFTA, claiming that the free trade area has been responsible for significant job losses in the
United States. While the economic data does not offer support for these assertions, anecdotal evidence of job
layoffs due to NAFTA can be found in some sectors, such as the automobile industry where Mexico has made
major gains in recent years.
Despite the muted impact of NAFTA, following the accession of Donald Trump to the U.S. presidency,
NAFTA has been renegotiated. Known as the United States-Mexico-Canada Agreement, or USMCA for
short, this new agreement does make some changes to the 25-year-old NAFTA treaty. Most significantly,
NAFTA required automakers to produce 62.5 percent of a vehicle’s content in North America to qualify for
zero tariffs. e USMCA raises that threshold to 75%. e idea is the compel automakers to source fewer parts
for a car assembled in North America from Germany, Japan, South Korea or China.
e USMCA agreement also mandates that by 2023, 40% of parts for any tariff-free vehicle must come
from a so-called “high wage” factory. ose factories must pay a minimum of $16 an hour in average salaries
for production workers, which is about triple the average wage in a Mexican factory right now.
e Trump Administration clearly hopes these provisions will increase the production of automobiles and
component parts in the United States. Critics see the USMCA as likely to result in trade diversion rather than
trade creation, and argue that the consequences may include higher costs to North American automobile
producers, and higher prices for consumers.
THE ANDEAN COMMUNITY
Bolivia, Chile, Ecuador, Colombia, and Peru signed an agreement in 1969 to create the Andean Pact. e
Andean Community was largely based on the EU model but was far less successful at achieving its stated goals.
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e integration steps begun in 1969 included an internal tariff reduction program, a common external tariff, a
transportation policy, a common industrial policy, and special concessions for the smallest members, Bolivia
and Ecuador.
By the mid-1980s, the Andean Pact had all but collapsed and had failed to achieve any of its stated
objectives. ere was no tariff-free trade among member countries, no common external tariff, and no
harmonization of economic policies. Political and economic problems seem to have hindered cooperation
among member countries. e countries of the Andean Pact have had to deal with low economic growth,
hyperinflation, high unemployment, political unrest, and crushing debt burdens. In addition, the dominant
political ideology in many of the Andean countries during this period tended toward the radical-socialist end of
the political spectrum. Because such an ideology is hostile to the free market economic principles on which the
Andean Pact was based, progress toward closer integration could not be expected.
e tide began to turn in the late 1980s when, after years of economic decline, the governments of Latin
America began to adopt free market economic policies. In 1990, the heads of the five current members of the
Andean Community—Bolivia, Ecuador, Peru, Colombia, and Venezuela—met in the Galápagos Islands. e
resulting Galápagos Declaration effectively relaunched the Andean Pact, which was renamed the Andean
Community in 1997. e declaration’s objectives included the establishment of a free trade area by 1992, a
customs union by 1994, and a common market by 1995. is last milestone has not been reached. A customs
union was implemented in 1995—although Peru opted out and Bolivia received preferential treatment until
2003. e Andean Community now operates as a customs union. In December 2005, it signed an agreement
with Mercosur to restart stalled negotiations on the creation of a free trade area between the two trading blocs.
ose negotiations are proceeding at a slow pace. In late 2006, Venezuela withdrew from the Andean
Community as part of that country’s attempts to join Mercosur.
MERCOSUR
Mercosur originated in 1988 as a free trade pact between Brazil and Argentina. e modest reductions in tariffs
and quotas accompanying this pact reportedly helped bring about an 80 percent increase in trade between the
two countries in the late 1980s.28 is success encouraged the expansion of the pact in March 1990
to include Paraguay and Uruguay as full members. In 2012, the pact was further expanded when
Venezuela joined Mercosur. However, in 2016 Venezuela was suspended from Mercosur for violating the pact’s
democratic principles and engaging in widespread human rights violations.
e initial aim of Mercosur was to establish a full free trade area by the end of 1994 and a common market
sometime thereafter. In December 1995, Mercosur’s members agreed to a five-year program under which they
hoped to perfect their free trade area and move toward a full customs union—something that has yet to be
achieved.29 For its first eight years or so, Mercosur seemed to be making a positive contribution to the
economic growth rates of its member states. Trade among the four core members quadrupled between 1990
and 1998. e combined GDP of the four member states grew at an annual average rate of 3.5 percent between
1990 and 1996, a performance that is significantly better than the four attained during the 1980s.30
However, Mercosur had its critics, including Alexander Yeats, a senior economist at the World Bank, who
wrote a stinging critique.31 According to Yeats, the trade diversion effects of Mercosur outweigh its trade
creation effects. Yeats pointed out that the fastest-growing items in intra-Mercosur trade were cars, buses,
agricultural equipment, and other capital-intensive goods that are produced relatively inefficiently in the four
member countries. In other words, Mercosur countries, insulated from outside competition by tariffs that run
as high as 70 percent of value on motor vehicles, are investing in factories that build products that are too
expensive to sell to anyone but themselves. e result, according to Yeats, is that Mercosur countries might not
be able to compete globally once the group’s external trade barriers come down. In the meantime, capital is
being drawn away from more efficient enterprises. In the near term, countries with more efficient
manufacturing enterprises lose because Mercosur’s external trade barriers keep them out of the market.
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Mercosur hit a significant roadblock in 1998, when its member states slipped into recession and intrabloc
trade slumped. Trade fell further in 1999, following a financial crisis in Brazil that led to the devaluation of the
Brazilian real, which immediately made the goods of other Mercosur members 40 percent more expensive in
Brazil, their largest export market. At this point, progress toward establishing a full customs union all but
stopped. ings deteriorated further in 2001, when Argentina, beset by economic stresses, suggested the
customs union be temporarily suspended. Argentina wanted to suspend Mercosur’s tariff so that it could abolish
duties on imports of capital equipment, while raising those on consumer goods to 35 percent (Mercosur had
established a 14 percent import tariff on both sets of goods). Brazil agreed to this request, effectively halting
Mercosur’s quest to become a fully functioning customs union.32 Hope for a revival arose in 2003, when new
Brazilian President Lula da Silva announced his support for a revitalized and expanded Mercosur modeled after
the EU with a larger membership, a common currency, and a democratically elected Mercosur parliament.33 In
2010, the members of Mercosur did agree on a common customs code to avoid outside goods having to pay
tariffs more than once, an important step toward achieving a full customs union. Since 2010, however,
Mercosur has made little forward progress, and the jury is still out on whether it will become a fully
functioning customs union.
CENTRAL AMERICAN COMMON MARKET, CAFTA, AND CARICOM
Two other trade pacts in the Americas have not made much progress. In the early 1960s, Costa Rica, El
Salvador, Guatemala, Honduras, and Nicaragua attempted to set up a Central American Common Market. It
collapsed in 1969, when war broke out between Honduras and El Salvador after a riot at a soccer match
between teams from the two countries. Since then, the member countries have made some progress toward
reviving their agreement (the five founding members were joined by the Dominican Republic). e proposed
common market was given a boost in 2003, when the United States signaled its intention to enter into bilateral
free trade negotiations with the group. ese culminated in a 2004 agreement to establish a free trade
agreement between the six countries and the United States. Known as the Central America Free Trade
Agreement (CAFTA), the aim is to lower trade barriers between the United States and the six countries for
most goods and services.
A customs union was to have been created in 1991 among the English-speaking Caribbean countries under
the auspices of the Caribbean Community. Referred to as CARICOM, it was established in 1973. However, it
repeatedly failed to progress toward economic integration. A formal commitment to economic and monetary
union was adopted by CARICOM’s member states in 1984, but since then, little progress has been made. In
October 1991, the CARICOM governments failed, for the third consecutive time, to meet a deadline for
establishing a common external tariff. Despite this, CARICOM expanded to 15 members by 2005. In early
2006, six CARICOM members established the Caribbean Single Market and Economy (CSME). Modeled
on the EU’s single market, CSME’s goal is to lower trade barriers and harmonize macroeconomic and monetary
policy between member states.34
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Regional Economic Integration Elsewhere
Numerous attempts at regional economic integration have been tried throughout Asia, Africa, and elsewhere.
One of the most significant is the Association of Southeast Asian Nations (ASEAN), although there have been
numerous attempts to establish free trade agreements in Africa (see the closing case in this chapter), and there
are ongoing efforts to establish free trade agreements between the United States and 11 other nations bordering
the Pacific (the Trans Pacific Partnership, or TPP) and the United States and the European Union (the
Transatlantic Trade and Investment Partnership, or TTIP).
ASSOCIATION OF SOUTHEAST ASIAN NATIONS
Formed in 1967, the Association of Southeast Asian Nations (ASEAN) includes Brunei, Cambodia,
Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, ailand, and Vietnam. Laos, Myanmar,
Vietnam, and Cambodia have all joined recently, creating a regional grouping of 600 million people with a
combined GDP of some $2 trillion (see Map 9.3). e basic objective of ASEAN is to foster freer trade among
member countries and to achieve cooperation in their industrial policies. Progress so far has been limited,
however.
9.3 MAP
ASEAN countries.
Until recently, only 5 percent of intra-ASEAN trade consisted of goods whose tariffs had been reduced
through an ASEAN preferential trade arrangement. is may be changing. In 2003, an ASEAN Free Trade
Area (AFTA) among the six original members of ASEAN came into full effect. e AFTA has cut tariffs on
manufacturing and agricultural products to less than 5 percent. However, there are some significant exceptions
to this tariff reduction. Malaysia, for example, refused to bring down tariffs on imported cars until 2005 and
then agreed to lower the tariff only to 20 percent, not the 5 percent called for under the AFTA. Malaysia
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wanted to protect Proton, an inefficient local carmaker, from foreign competition. Similarly, the Philippines has
refused to lower tariff rates on petrochemicals, and rice, the largest agricultural product in the region, will
remain subject to higher tariff rates until at least 2020.35
Notwithstanding such issues, ASEAN and AFTA are at least progressing toward establishing a free trade
zone. Vietnam joined the AFTA in 2006, Laos and Myanmar in 2008, and Cambodia in 2010. e goal was to
reduce import tariffs among the six original members to zero by 2010 and to do so by 2015 for the newer
members (although important exceptions to that goal, such as tariffs on rice, will persist).
ASEAN signed a free trade agreement with China that removes tariffs on 90 percent of traded goods. is
went into effect January 1, 2010. Trade between China and ASEAN members more than tripled during the first
decade of the twenty-first century, and this agreement should spur further growth.36
REGIONAL TRADE BLOCS IN AFRICA
African countries have been experimenting with regional trade blocs for half a century. Nominally there are
now 19 trade blocs on the African continent. Many countries are members of more than one group. Although
the number of trade groups is impressive, progress toward the establishment of meaningful trade blocs has been
slow.
Many of these groups have been dormant for years. Significant political turmoil in several African
nations has persistently impeded any meaningful progress. Also, deep suspicion of free trade exists in
several African countries. e argument most frequently heard is that because these countries have less
developed and less diversified economies, they need to be “protected” by tariff barriers from unfair foreign
competition. Given the prevalence of this argument, it has been hard to establish free trade areas or customs
unions.
A meaningful attempt to reenergize the free trade movement in Africa occurred in early 2001, when Kenya,
Uganda, and Tanzania, member states of the East African Community (EAC), committed themselves to
relaunching their bloc, 24 years after it collapsed. e three countries, with 80 million inhabitants, intend to
establish a customs union, regional court, legislative assembly, and, eventually, a political federation.
eir program includes cooperation on immigration, road and telecommunication networks, investment,
and capital markets. However, while local business leaders welcomed the relaunch as a positive step, they were
critical of the EAC’s failure in practice to make progress on free trade. At the EAC treaty’s signing in November
1999, members gave themselves four years to negotiate a customs union, with a draft slated for the end of
2001. But that fell far short of earlier plans for an immediate free trade zone, shelved after Tanzania and
Uganda, fearful of Kenyan competition, expressed concerns that the zone could create imbalances similar to
those that contributed to the breakup of the first community.37 Nevertheless, in 2005 the EAC did start to
implement a customs union. In 2007, Burundi and Rwanda joined the EAC. e EAC established a common
market in 2010 and is now striving toward an eventual goal of monetary union.
In 2015, in what is a promising sign, representatives from 26 African nations signed an agreement pledging
to work together to establish a free trade area that would remove or reduce many tariffs and eliminate time-
consuming customs procedures between them. Known as the Tripartite Free Trade Area (TFTA), this common
market would encompass more than 630 million people and link together three existing regional trading blocks
in Southern and Eastern Africa with a combined gross domestic product of $1.2 trillion and more than $102
billion in trade among member states (see this chapter’s closing case for further details). is was followed up by
an even more ambitious free trade pact, known as the Continental Free Trade Area (CAFTA), which 44
countries signed onto in March of 2018 (again, see this chapter’s closing case for further details). Whether these
pacts will be more meaningful than prior attempts to liberalize trade in Africa remains to be seen, but African
leaders do seem to be actively embracing free trade like never before so there are reasons for optimism.
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OTHER TRADE AGREEMENTS
As noted in Chapter 7, following the failure of the Doha Round of talks to extend the WTO, the United States
and many other nations have placed renewed emphasis on bilateral and multilateral trade agreements. Under
President Obama, the United States was pursuing two major multilateral trade agreements: the Trans Pacific
Partnership (TPP) with 11 other Pacific Rim countries (including Australia, New Zealand, Japan, South Korea,
Malaysia, and Chile) and the Transatlantic Trade and Investment Partnership (TTIP) with the European
Union. However, President Trump pulled the United States out of the TPP and negotiations on the TTIP have
been put on hold.
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Focus on Managerial Implications
REGIONAL ECONOMIC INTEGRATION THREATS
LO 9-5 Understand the implications for management practice that are inherent in regional economic
integration agreements.
Currently, the most significant developments in regional economic integration are occurring in the EU and
NAFTA. Although some of the Latin American trade blocs and ASEAN may have economic significance in the
future, developments in the EU and NAFTA currently have more profound implications for business practice.
Accordingly, in this section, we concentrate on the business implications of those two groups. Similar
conclusions, however, could be drawn with regard to the creation of a single market anywhere in the world.
Opportunities Regional economic integration has created significant opportunities for businesses to grow the market for their goods and services and lower their factor costs. Markets that were formerly protected from
foreign competition have become more open, and the costs of doing business have fallen. e latter is
particularly true in the case of the EU’s single market and, to a lesser extent, NAFTA (and its successor the
USMCA). In these zones, free movement of goods and services across borders, harmonized product standards,
simplified tax regimes, and in the case of the euro zone a single currency, have made it increasingly possible for
businesses to realize potentially significant cost economies by centralizing production of products, or
component parts, in those EU and NAFTA/UMSCA locations where the mix of factor costs and skills is
optimal. Rather than producing a product in each of the 28 EU countries (27 after the British exit) or the three
NAFTA/USMCA countries, a firm may be able to serve the whole EU or North American market from a single
location. is location must be chosen carefully, of course, with an eye on local factor costs and skills. Pursuit of
such gain has led to the establishment of extensive cross border supply chains in both the EU and North
America, which in turn implies that the economies of these regions have become more tightly integrated.
at being said, it is important to recognize that even after the removal of barriers to trade and
investment, enduring differences in culture and competitive practices might limit the ability of companies to
realize cost economies by centralizing production in key locations and producing a standardized product for a
single multiple-country market. Consider the case of Atag Holdings NV, a Dutch maker of kitchen
appliances.38 Atag thought it was well placed to benefit from the single market but found it tough going. Atag’s
plant is just one mile from the German border and near the center of the EU’s population. e company
thought it could cater to both the “potato” and “spaghetti” belts—marketers’ terms for consumers in northern
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and southern Europe—by producing two main product lines and selling these standardized “euro-products” to
“euro-consumers.” e main benefit of doing so is the economy of scale derived from mass production of a
standardized range of products. Atag quickly discovered that the “euro-consumer” was a myth. Consumer
preferences vary much more across nations than Atag had thought. Consider ceramic cooktops: Atag planned
to market just two varieties throughout the EU but found it needed 11. Belgians, who cook in huge pots,
require extra-large burners. Germans like oval pots and burners to fit. e French need small burners and very
low temperatures for simmering sauces and broths. Germans like oven knobs on the top; the French want them
on the front. Most Germans and French prefer black and white ranges; the British demand a range of colors,
including peach, pigeon blue, and mint green.
reats Just as the emergence of single markets creates opportunities for business, it also presents a number of threats. For one thing, the business environment within each grouping has become more competitive. e
lowering of barriers to trade and investment among countries has led to increased price competition throughout
the EU and NAFTA/USMCA.
Over time, price differentials across nations will decline in a single market. is is a direct threat to any firm
doing business in EU or NAFTA/USMCA countries. To survive in the tougher single-market environment,
firms must take advantage of the opportunities offered by the creation of a single market to rationalize their
production and reduce their costs. Otherwise, they will be at a severe disadvantage.
A further threat to firms outside these trading blocs arises from the likely long-term improvement in the
competitive position of many firms within the areas. is is particularly relevant in the EU, where many firms
have historically been limited by a high-cost structure in their ability to compete globally with North American
and Asian firms. e creation of a single market and the resulting increased competition in the EU produced
serious attempts by many EU firms to reduce their cost structure by rationalizing production. is transformed
many EU companies into more efficient global competitors. e message for non-EU businesses is that they
need to respond to the emergence of more capable European competitors by reducing their own cost structures.
Another threat to firms outside of trading areas is the threat of being shut out of the single market by the
creation of a “trade fortress.” e charge that regional economic integration might lead to a fortress mentality is
most often leveled at the EU. Although the free trade philosophy underpinning the EU theoretically argues
against the creation of any fortress in Europe, occasional signs indicate the EU may raise barriers to imports and
investment in certain “politically sensitive” areas, such as autos. Non-EU firms might be well advised, therefore,
to set up their own EU operations. is could also occur in the NAFTA countries, but it seems less likely.
e emerging role of the European Commission in competition policy suggests the EU is increasingly
willing and able to intervene and impose conditions on companies proposing mergers and acquisitions. is is a
threat insofar as it limits the ability of firms to pursue the corporate strategy of their choice. e commission
may require significant concessions from businesses as a precondition for allowing proposed mergers and
acquisitions to proceed. While this constrains the strategic options for firms, it should be remembered that in
taking such action, the commission is trying to maintain the level of competition in Europe’s single market,
which should benefit consumers.
Finally, there is a clear threat to business in the growing opposition to free trade areas. We have seen this in
the United States, where President Trump pulled the U.S. out of the TPP and initiated a contentious
renegotiation of NAFTA. We have also seen it in the European Union, where the scheduled exit of the British
in March 2019 (Brexit) might result in the weakening of the EU. If the EU and NAFTA/UMSCA are
diminished, some of the gains from trade will be lost, and many of the benefits that businesses enjoyed will
disappear as well.
Key Terms
regional economic integration, p. 242
free trade area, p. 244
European Free Trade Association (EFTA), p. 244
customs union, p. 244
common market, p. 244
economic union, p. 244
political union, p. 245
trade creation, p. 246
trade diversion, p. 246
European Union (EU), p. 247
Treaty of Rome, p. 247
European Commission, p. 248
European Council, p. 249
European Parliament, p. 249
Treaty of Lisbon, p. 250
Court of Justice, p. 250
Maastricht Treaty, p. 251
optimal currency area, p. 253
North American Free Trade Agreement (NAFTA), p. 257
United States-Mexico-Canada Agreement (USMCA), p. 260
Andean Community, p. 260
Mercosur, p. 260
Central American Common Market, p. 261
Central America Free Trade Agreement (CAFTA), p. 261
CARICOM, p. 262
Caribbean Single Market and Economy (CSME), p. 262
Association of Southeast Asian Nations (ASEAN), p. 262
Summary
is chapter pursued three main objectives: to examine the economic and political debate surrounding regional
economic integration; to review the progress toward regional economic integration in Europe, the Americas,
and elsewhere; and to distinguish the important implications of regional economic integration for the practice
of international business. e chapter made the following points:
1. A number of levels of economic integration are possible in theory. In order of increasing integration, they
include a free trade area, a customs union, a common market, an economic union, and full political
union.
2. In a free trade area, barriers to trade among member countries are removed, but each country determines
its own external trade policy. In a customs union, internal barriers to trade are removed, and a common
external trade policy is adopted. A common market is similar to a customs union, except that a common
market also allows factors of production to move freely among countries. An economic union involves
even closer integration, including the establishment of a common currency and the harmonization of tax
rates. A political union is the logical culmination of attempts to achieve ever-closer economic integration.
3. Regional economic integration is an attempt to achieve economic gains from the free flow of trade and
investment between neighboring countries.
4. Integration is not easily achieved or sustained. Although integration brings benefits to the majority, it is
never without costs for the minority. Concerns over national sovereignty often slow or stop integration
attempts. In 2016, these concerns resulted in Britain voting for exit from the EU.
5. Regional integration will not increase economic welfare if the trade creation effects in the free trade area
are outweighed by the trade diversion effects.
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6. e Single European Act sought to create a true single market by abolishing administrative barriers to the
free flow of trade and investment among EU countries.
7. Seventeen EU members now use a common currency, the euro. e economic gains from a common
currency come from reduced exchange costs, reduced risk associated with currency fluctuations, and
increased price competition within the EU.
8. Increasingly, the European Commission is taking an activist stance with regard to competition policy,
intervening to restrict mergers and acquisitions that it believes will reduce competition in the EU.
9. Although no other attempt at regional economic integration comes close to the EU in terms of potential
economic and political significance, various other attempts are being made in the world. e most
notable include NAFTA in North America, the Andean Community and Mercosur in Latin America,
and ASEAN in Southeast Asia.
10. e creation of single markets in the EU and North America means that many markets that were
formerly protected from foreign competition are now more open. is creates major investment and
export opportunities for firms within and outside these regions.
11. e free movement of goods across borders, the harmonization of product standards, and the
simplification of tax regimes make it possible for firms based in a free trade area to realize potentially
enormous cost economies by centralizing production in those locations within the area where the mix of
factor costs and skills is optimal.
12. e lowering of barriers to trade and investment among countries within a trade group will probably be
followed by increased price competition.
Critical inking and Discussion Questions
1. NAFTA produced significant net benefits for the Canadian, Mexican, and U.S. economies. Discuss.
2. What are the economic and political arguments for regional economic integration? Given these
arguments, why don’t we see more substantial examples of integration in the world economy?
3. What in general was the effect of the creation of a single market and a single currency within the EU on
competition within the EU? Why?
4. Do you think it is correct for the European Commission to restrict mergers between American companies
that do business in Europe? (For example, the European Commission vetoed the proposed merger
between WorldCom and Sprint, both U.S. companies, and it carefully reviewed the merger between AOL
and Time Warner, again both U.S. companies.)
5. What were the causes of the 2010–2012 sovereign debt crisis in the EU? What does this crisis tell us
about the weaknesses of the euro? Do you think the euro will survive the sovereign debt crisis?
6. How should a U.S. firm that currently exports only to ASEAN countries respond to the creation of a
single market in this regional grouping?
7. How should a firm with self-sufficient production facilities in several ASEAN countries respond to the
creation of a single market? What are the constraints on its ability to respond in a manner that minimizes
production costs?
8. After a promising start, Mercosur, the major Latin American trade agreement, has faltered and made little
progress since 2000. What problems are hurting Mercosur? What can be done to solve these problems?
Research Task http://globalEDGE.msu.edu
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Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. e World Trade Organization maintains a database of regional trade agreements. You can search this
database to identify all agreements that a specific country participates in. Search the database to identify
the trade agreements that Japan currently participates in. What patterns do you see? Which region (or
regions) of the world does Japan seem to be focusing on in its trade endeavors?
2. Your company has assigned you the task of investigating the various trade blocs in Africa to see if your
company can benefit from these trade agreements while expanding into African markets. e first trade
bloc you come across is COMESA. Prepare a short executive summary for your company, explaining the
level of integration the bloc has currently achieved, the level it aspires to accomplish, and the
relationships it has with other African trade blocs.
F r e e Tr a d e i n A f r i c a : T F TA a n d C F TA
c l o s i n g c a s e
On June 10, 2015, representatives from 26 African nations signed an agreement pledging to work together to establish a
free trade area that would remove or reduce many tariffs and eliminate time-consuming customs procedures between
them. Known as the Tripartite Free Trade Area (TFTA), this common market would encompass more than 630 million
people and link together three existing regional trading blocks in Southern and Eastern Africa with a combined gross
domestic product of $1.2 trillion and more than $102 billion in trade between member states.
e existing regional trading blocks are the East African Community, created in 2000; the Southern African
Development Community, created in 1980; and an overlapping Common Market for Eastern and Southern Africa,
which also took shape in the 1980s. e East Africa Community has made some progress fostering trade between its
member countries, which include Kenya, Tanzania, and Uganda. Countries in the Southern African Development
Community have a common set of external tariffs, and several member states use the South African rand, the most
liquid and widely traded currency on the continent.
However, the existing patchwork of African trading blocks—there are some 17 in all, with many countries being
members of more than one—has made it difficult to realize the gains from trade that could flow from an expanded
single market. An African firm selling goods on the continent still faces an average tariff of 8.7 percent, compared with a
2.5 percent tariff on goods sold overseas. Other costs of intra-African trade include often-lengthy stops at borders for
customs inspection, excessive customs-related bureaucracy and red tape, and a lack of adequate physical infrastructure,
including roads and railways. As a consequence of such factors, it can take three weeks for a shipping container to travel
the 700 miles from the Kenyan port of Mombasa to Kampala, the capital of Uganda. ere are also some
vexing local content requirements. e South African Development Community, for example, requires that
clothes traded within the region are both manufactured and sourced there to qualify for lower tariffs. However, because
few textiles are produced in the region, the rules have stifled trade in garments.
For all these reasons, African countries are more likely to trade with Europe and America than they are with each
other. Only 19 percent of Africa’s $930 billion in trade is with other countries on the continent. By comparison, some
60 percent of Europe’s trade is within its own continent, as is 40 percent of North American trade. Other factors
contributing to the lack of intra-African trade include low industrialization levels, restricted movement of labor, poor
infrastructure, and a high dependence on exporting unprocessed commodities in many countries.
e thinking behind the TFTA is that harmonizing rules, reducing tariffs, and streamlining or removing customs
procedures will allow African firms to sell more goods and services to their neighbors, enabling them to achieve greater
economies of scale and lower costs, which would benefit all parties to the agreement. On the other hand, such
agreements may prove difficult to reach and, if the past is any guide, even more difficult to implement, given political
realities on the ground. Some observers think that the TFTA is too ambitious an undertaking and that focusing effort
on improving the three existing regional groups would yield more gains. It’s easier, they argue, to reach an agreement
between five adjacent member states, as in the case of the East African Community, than 26 very different countries
scattered over the entire continent.
Despite the skepticism surrounding TFTA, Africa nations have even bigger ambitions. In 2016, African leaders
committed themselves to establishing a Continental Free Trade Area (CFTA) that encompasses all African countries.
Two years later, in March 2018, 44 of those nations signed an agreement to create a CFTA. e pact will eliminate
tariffs on 90 percent of products, liberalize services, and reduce nontariff barriers. A second phase of negotiations, to
begin later this year, will focus on investment, competition, and intellectual property rights. Proponents of the deal
believe that it will merge Africa’s fragmented markets into one large continental market, ignite industrialization, boost
economic growth, and create jobs. However, 11 African nations have yet to sign onto the deal, including Nigeria and
South Africa, the two largest African economies. While both countries seem to agree with the pact in principle, they
view the pact as incomplete. ey point out that countries have not yet decided which goods will be excluded from the
tariff reductions. Nor have they finalized key annexes to the text. For example, the chapter on “rules of origin” is
incomplete, raising the possibility that goods from outside Africa could be imported, have African labels placed on
them, and then be traded within the bloc as African goods. ere is also strong opposition to the pact from labor unions
within Nigeria, who have called the trade deal a “radioactive neoliberal policy initiative.”
Egyptian, President Sisi in Kenya
©Andrew Wasike/Anadolu Agency/Getty Images
Sources: “Intra-African Trade: e Road Less Travelled,” e Economist, April 17, 2013; Martin Stevis and Patrick McGroarty, “African Leaders
Pledge to Create a Free Trade Zone,” e Wall Street Journal, June 10, 2015; “Trade Within Africa: Tear Down ese Walls,” e Economist,
February 27, 2016; John Aglionby, “Africa Looks to Boost Growth and Jobs with Free Trade Area,” Financial Times, December 1, 2016; “Why
Africa’s Two Biggest Economies Did Not Sign Its Landmark Trade Deal,” e Economist, March 29, 2018.
CASE DISCUSSION QUESTIONS
1. Why are African countries more likely to trade with Europe and America than they are with each
other?
2. What are the likely gains from trade to be had from TFTA if it is fully implemented as a common
market?
3. Why do you think free trade areas established so far in Africa have not lived up to their expectations?
4. What will African countries need to do to make the TFTA a success? What are the likely impediments
to doing this?
5. What could the impact of CFTA be on Africa?
Endnotes
1. Information taken from World Trade Organization website and current as of April 2018, www.wto.org.
2. Information taken from World Trade Organization website and current as of April 2016, www.wto.org.
3. e Andean Community has been through a number of changes since its inception. e latest version
was established in 1991. See “Free-Trade Free for All,” e Economist, January 4, 1991, p. 63.
4. D. Swann, e Economics of the Common Market, 6th ed. (London: Penguin Books, 1990).
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5. Pew Research Center, “What We Know about Illegal Immigration from Mexico,” March 2, 2017.
6. See J. Bhagwati, “Regionalism and Multilateralism: An Overview,” Columbia University Discussion
Paper 603, Department of Economics, Columbia University, New York; A. de la Torre and M.
Kelly, “Regional Trade Arrangements,” International Monetary Fund Occasional Paper 93,
March 1992; J. Bhagwati, “Fast Track to Nowhere,” e Economist, October 18, 1997, pp. 21–24;
Jagdish Bhagwati, Free Trade Today (Princeton and Oxford: Princeton University Press, 2002); B. K.
Gordon, “A High Risk Trade Policy,” Foreign Affairs 82 no. 4 (July–August 2003), pp. 105–15; M. Dai,
Y. Votov, and T. Zylkin, “On the Trade Diversion Effects of Free Trade Agreements,” Economic Letters
122 (2014), pp. 321–25.
7. N. Colchester and D. Buchan, Europower: e Essential Guide to Europe’s Economic Transformation in
1992 (London: e Economist Books, 1990); Swann, Economics of the Common Market.
8. Swann, Economics of the Common Market; Colchester and Buchan, Europower; “e European Union: A
Survey,” e Economist, October 22, 1994; “e European Community: A Survey,” e Economist, July 3,
1993; European Union website at http://europa.eu.
9. E. J. Morgan, “A Decade of EC Merger Control,” International Journal of Economics and Business,
November 2001, pp. 451–73.
10. “e European Community: A Survey,” 1993.
11. Tony Barber, “e Lisbon Reform Treaty,” FT.com, December 13, 2007.
12. “One Europe, One Economy,” e Economist, November 30, 1991, pp. 53–54; “Market Failure: A
Survey of Business in Europe,” e Economist, June 8, 1991, pp. 6–10.
13. Alan Riley, “e Single Market Ten Years On,” European Policy Analyst, December 2002, pp. 65–72.
14. Deutsche Bank, “e Single European Market 20 Years On,” EU Monitor, October 31, 2013.
15. See C. Wyploze, “EMU: Why and How It Might Happen,” Journal of Economic Perspectives 11 (1997),
pp. 3–22; M. Feldstein, “e Political Economy of the European Economic and Monetary Union,”
Journal of Economic Perspectives 11 (1997), pp. 23–42.
16. “One Europe, One Economy”; Feldstein, “e Political Economy of the European Economic and
Monetary Union.”
17. Richard Leong, “Dollar Share of Global FX Reserves Shrinks to Lowest Since 2014,” Reuters, December
29, 2017.
18. Details regarding conditions of membership and the progression of enlargement negotiations can be
found at http://europa.eu/pol/enlarg/index_en.htm.
19. Chris Giles, “Brexit in Seven Charts—e Economic Impact,” Financial Times, June 27, 2016.
20. “What Is NAFTA?” Financial Times, November 17, 1993, p. 6; S. Garland, “Sweet Victory,”
BusinessWeek, November 29, 1993, pp. 30–31.
21. Bernie Woodall, “U.S. Autoworkers Face reat as Car Makers Drawn to Mexico,” Reuters, March 26,
2015.
22. “NAFTA: e Showdown,” e Economist, November 13, 1993, pp. 23–36.
23. N. C. Lustog, “NAFTA: Setting the Record Straight,” e World Economy, 1997, pp. 605–14; G. C.
Hufbauer and J. J. Schott, NAFTA Revisited: Achievements and Challenges (Washington, DC: Institute for
International Economics, 2005).
24. W. orbecke and C. Eigen-Zucchi, “Did NAFTA Cause a Giant Sucking Sound?” Journal of Labor
Research, Fall 2002, pp. 647–58; G. Gagne, “North American Free Trade, Canada, and U.S. Trade
Remedies: An Assessment after Ten Years,” e World Economy, 2000, pp. 77–91; Hufbauer and Schott,
NAFTA Revisited; J. Romalis, “NAFTA’s and Custfa’s Impact on International Trade,” Review of Economics
and Statistics 98, no. 3 (2007), pp. 416–35; “NAFTA at 20: Ready to Take Off Again?” e Economist,
January 4, 2014. G. C. Hufbauer, C. Cimno, and T. Moran, “NAFTA at 20: Misleading Charges and
Positive Achievements,” Peterson Institute for International Economics, May 2014.
25. Data from the U.S. Census Bureau.
26. C. J. O’Leary, R. W. Eberts, and B. M. Pittelko, “Effects of NAFTA on US Employment and Policy
Responses: A Product of the International Collaborative Initiative on Trade and Employment (ICITE),”
OECD Trade Policy Papers, no. 131 (Paris: OECD Publishing, 2012); Hufbauer, Cimno, and Moran,
“NAFTA at 20: Misleading Charges and Positive Achievements.”
27. L. Caliendo and F. Parro, “Estimates of the Trade and Welfare Effects of NAFTA,” Review of Economic
Studies, July 2014; Hufbauer, Cimno, and Moran, “NAFTA at 20: Misleading Charges and Positive
Achievements.”
28. “e Business of the American Hemisphere,” e Economist, August 24, 1991, pp. 37–38.
29. “NAFTA Is Not Alone,” e Economist, June 18, 1994, pp. 47–48.
30. “Murky Mercosur,” e Economist, July 26, 1997, pp. 66–67.
31. See M. Philips, “South American Trade Pact under Fire,” e Wall Street Journal, October 23, 1996, p.
A2; A. J. Yeats, Does Mercosur’s Trade Performance Justify Concerns about the Global Welfare-Reducing
Effects of Free Trade Arrangements? Yes! (Washington, DC: World Bank, 1996); D. M. Leipziger et al.,
“Mercosur: Integration and Industrial Policy,” e World Economy, 1997, pp. 585–604.
32. “Another Blow to Mercosur,” e Economist, March 31, 2001, pp. 33–34.
33. “Lula Lays Out Mercosur Rescue Mission,” Latin America Newsletters, February 4, 2003, p. 7.
34. “CARICOM Single Market Begins,” EIU Views, February 3, 2006.
35. “Every Man for Himself: Trade in Asia,” e Economist, November 2, 2002, pp. 43–44.
36. L. Gooch, “Asian Free-Trade Zone Raises Hopes,” e New York Times, January 1, 2010, p. B3.
37. M. Turner, “Trio Revives East African Union,” Financial Times, January 16, 2001, p. 4.
38. T. Horwitz, “Europe’s Borders Fade,” e Wall Street Journal, May 18, 1993, pp. A1, A12; “A Singular
Market,” e Economist, October 22, 1994, pp. 10–16; “Something Dodgy in Europe’s Single Market,”
e Economist, May 21, 1994, pp. 69–70.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill
Education
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10
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Part 4 e Global Monetary System
e Foreign Exchange Market
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO10-1 Describe the functions of the foreign exchange market.
LO10-2 Understand what is meant by spot exchange rates.
LO10-3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.
LO10-4 Understand the different theories explaining how currency exchange rates are determined and their
relative merits.
LO10-5 Identify the merits of different approaches toward exchange rate forecasting.
LO10-6 Compare and contrast the differences among translation, transaction, and economic exposure, and
explain the implications for management practice.
e Fluctuating Value of the Yuan gives Chinese Business a Lesson in Foreign Exchange Risk
opening case
Between 2015 and early 2018, the Chinese currency, the yuan, fluctuated significantly in value against the
U.S. dollar, giving Chinese businesses an object lesson in the importance of managing for foreign exchange
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risk.
From August 2015 through to December 2016, the value of the yuan in dollars depreciated by 12 percent from 6.2 to the dollar to 6.95 to the dollar. is depreciation was triggered by a slowdown in the Chinese
economy, which led to an outflow of capital from China. Even though the Chinese government spent heavily
to try to prop up the value of the yuan, using $1.5 trillion of dollar-denominated foreign exchange reserves to
purchase yuan, they could not halt the decline in its value against the dollar.
While the depreciation in the yuan boosted exports, it also resulted in an unanticipated increase in the
yuan price of key imports, which raised costs for a number of Chinese companies. About 980 listed Chinese
companies reported combined foreign-exchange losses of 48.7 billion yuan in 2015, almost 13 times higher
than 2014, according to data compiled by Bloomberg. Hardest hit were Chinese airlines, many of which
imported aviation fuel that was paid for in dollars. As the cost of fuel in terms of yuan went up, their profits
slumped. In total, the Chinese airline sector registered foreign exchange losses of 17.9 billion yuan for 2015,
compared with 951.7 million a year earlier. e big three state-owned airlines—China Southern Airlines Co,
China Eastern Airlines Corp, and Air China Ltd—suffered 15.85 billion yuan in foreign-exchange currency
losses in 2015.
In 2017, conditions reversed. Between January 2017 and April 2018 the yuan appreciated in value by 10 percent against the dollar, increasing from 6.95 to the dollar to 6.27 to the dollar. e appreciation was due to
a number of factors, including a return to stronger growth in China and the election of Donald Trump in the
United States. e latter event seems to have reduced the confidence that foreign investors had in the United
States and resulted in an outflow of capital as they sought to diversify their holdings of foreign assets and
currency. e dollar also fell after members of the Trump administration made statements suggesting that they
were happy to see it decline, since that boosted U.S. exports.
e appreciation in the value of the yuan against the dollar from January 2017 onward reduced the yuan
costs for Chinese companies that imported goods priced in dollars, such as aviation fuel. us Air China
noted in its 2017 annual report that a 1 percent gain in the yuan against the greenback can boost its net
profits by about 280 million yuan, primarily due to reductions in the cost of aviation fuel.
On the other hand, the appreciation of the yuan raised the dollar price of Chinese exports. Many exporters
saw their profits squeezed as a result. In early February 2018, Guangdong Goworld, a supplier to Apple, said
in a stock exchange filing that it had suffered an estimated foreign exchange loss of 45 million yuan
(US$7.2 million) in January 2018 owing to a stronger yuan. e January figure alone was equal to
94 percent of its foreign exchange losses for the first three quarters of 2017. It also translated into 34 percent
of its net profits in the first nine months of 2017. e Shenzhen-listed company manufactures and sells
printed circuit boards, liquid crystal displays (LCDs), and ultrasonic electronic measuring instruments to
developed markets including the U.S., Europe, Australia, and Japan.
In another example, a spokesperson for Zhejiang NHU Co, a producer of vitamins, said that even as the
vitamin export market experienced a boom in 2017, the company suffered millions of yuan in foreign
exchange losses. e basic problem was that the company negotiated dollar prices for its vitamins in 2016, but
by the end of 2017, each dollar of sales was yielding less revenues when translated back into yuan (thanks to
the appreciation of the yuan). To deal with this problem, the company set up a team to discuss the issue and
employed means such as hedging and forward exchange transactions to try to minimize foreign exchange
risks. •
Sources: Maggie Zhang and Daniel Ren, “It Has Dealt Us Heavy Blow,” South China Morning Post, April 7, 2018; Xie Yu, “Chinese
Companies Foreign Exchange Losses Soared Last Year,” South China Morning Post, April 6, 2016; and “Exporters Feel the Bite of a
Stronger Yuan,” Global Times, April 2, 2018.
Introduction
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globalEDGE Database of International Business Statistics
Like many enterprises in the global economy, the Chinese enterprises discussed in the opening case are
affected by changes in the value of currencies on the foreign exchange market. As the yuan depreciated
in value against the dollar during 2015 and 2016, the profits of big Chinese importers fell due to
foreign exchange losses. In contrast, as the yuan appreciated in value against the dollar during 2017,
some Chinese exporters saw their profits hurt by foreign exchange losses. e case illustrates that what
happens in the foreign exchange market can have a fundamental impact on the sales profits of an
enterprise. Accordingly, it is very important for managers to understand how the foreign exchange
works and what the impact of changes in currency exchange rates might be for their enterprise and its
strategy.
is chapter has three main objectives. e first is to explain how the foreign exchange market
works. e second is to examine the forces that determine exchange rates and to discuss the degree to
which it is possible to predict future exchange rate movements. e third objective is to map the
implications for international business of exchange rate movements. is chapter is the first of three
that deal with the international monetary system and its relationship to international business.
Chapter 11 explores the institutional structure of the international monetary system. e institutional
structure is the context within which the foreign exchange market functions. As we shall see, changes
in the institutional structure of the international monetary system can exert a profound influence on
the development of foreign exchange markets.
e foreign exchange market is a market for converting the currency of one country into that of
another country. An exchange rate is simply the rate at which one currency is converted into another.
For example, Toyota uses the foreign exchange market to convert the dollars it earns from selling cars
in the United States into Japanese yen. Without the foreign exchange market, international trade and
international investment on the scale that we see today would be impossible; companies would have to
resort to barter. e foreign exchange market is the lubricant that enables companies based in
countries that use different currencies to trade with each other.
We know from earlier chapters that international trade and investment have their risks. Some of
these risks exist because future exchange rates cannot be perfectly predicted. e rate at which one
currency is converted into another can change over time. For example, at the start of 2001, 1 U.S.
dollar bought 1.065 euros, but by early 2014, 1 U.S. dollar bought only 0.74 euro. e dollar had
fallen sharply in value against the euro. is made American goods cheaper in Europe, boosting export
sales. At the same time, it made European goods more expensive in the United States, which hurt the
sales and profits of European companies that sold goods and services to the United States. e pricing
advantage enjoyed by U.S. companies, however, disappeared during 2015 and 2016 as economic
weakness in Europe and a stronger U.S. economy resulted in a sharp fall in the value of the
euro. By early 2017, 1 U.S. dollar bought 0.93 euro, meaning that American exports to the
euro zone had become more expensive. Rapid changes in currency values such as these often take
managers by surprise, and if they have not hedged against the possible risk, sales and profits can be
significantly affected.
e “global money system”
can have a significant effect
on how companies operate
globally. Often companies have to deal with exchange rates, monetary systems, and the capital market on both
country and regional levels. But the influences of countries on the regional and global money system are
significant (i.e., countries set the tone for the parameters of the foreign exchange market and the international
monetary system). e globalEDGE™ Database of International Business Statistics (DIBS) includes time-
series data beginning in the 1990s until today and covers more than 200 countries and more than 5,000 data
variables. Countries, regions, and the world use these types of data points to drive the global money system,
and everyone who is interested in better understanding the global capital market needs to know about them!
Register free on globalEDGE™ to gain access to the DIBS database right now; students have free access to
DIBS, and DIBS can be found at globaledge.msu.edu/tools-and-data/dibs.
One function of the foreign exchange market is to provide some insurance against the risks that
arise from such volatile changes in exchange rates, commonly referred to as foreign exchange risk.
Although the foreign exchange market offers some insurance against foreign exchange risk, it cannot
provide complete insurance. It is not unusual for international businesses to suffer losses (or gains)
because of unpredicted changes in exchange rates. Currency fluctuations can make seemingly
profitable trade and investment deals unprofitable, and vice versa.
We begin this chapter by looking at the functions and the form of the foreign exchange market.
is includes distinguishing among spot exchanges, forward exchanges, and currency swaps. en we
consider the factors that determine exchange rates. We also look at how foreign trade is conducted
when a country’s currency cannot be exchanged for other currencies, that is, when its currency is not
convertible. e chapter closes with a discussion of these things in terms of their implications for
business.
e Functions of the Foreign Exchange Market
LO 10-1 Describe the functions of the foreign exchange market.
e foreign exchange market serves two main functions. e first is to convert the currency of one
country into the currency of another. e second is to provide some insurance against foreign
exchange risk, or the adverse consequences of unpredictable changes in exchange rates.1
CURRENCY CONVERSION
Each country has a currency in which the prices of goods and services are quoted. In the United
States, it is the dollar ($); in Great Britain, the pound (£); in France, Germany, and the other 17
members of the euro zone, it is the euro (€); in Japan, the yen (¥); and so on. In general, within the
borders of a particular country, one must use the national currency. A U.S. tourist cannot walk into a
store in Edinburgh, Scotland, and use U.S. dollars to buy a bottle of Scotch whisky. Dollars are not
recognized as legal tender in Scotland; the tourist must use British pounds. Fortunately, the tourist can
go to a bank and exchange her dollars for pounds. en she can buy the whisky.
When a tourist changes one currency into another, she is participating in the foreign exchange
market. e exchange rate is the rate at which the market converts one currency into another. For
example, an exchange rate of €1 = $1.07 specifies that 1 euro buys 1.07 U.S. dollars. e exchange
rate allows us to compare the relative prices of goods and services in different countries. A U.S. tourist
wishing to buy a bottle of Scotch whisky in Edinburgh may find that she must pay £30 for the bottle,
knowing that the same bottle costs $35 in the United States. Is this a good deal? Imagine the current
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pound/dollar exchange rate is £1.00 = $1.25 (i.e., 1 British pound buys $1.25). Our intrepid tourist
takes out her calculator and converts £30 into dollars. (e calculation is 30 × 1.25.) She
finds that the bottle of Scotch costs the equivalent of $37.50. She is surprised that a bottle
of Scotch whisky could cost less in the United States than in Scotland despite shipping costs (alcohol
is taxed heavily in Great Britain).
Tourists are minor participants in the foreign exchange market; companies engaged in international
trade and investment are major ones. International businesses have four main uses of foreign exchange
markets. First, the payments a company receives for its exports, the income it receives from foreign
investments, or the income it receives from licensing agreements with foreign firms may be in foreign
currencies. To use those funds in its home country, the company must convert them to its home
country’s currency. Consider the Scotch distillery that exports its whisky to the United States. e
distillery is paid in dollars, but because those dollars cannot be spent in Great Britain, they must be
converted into British pounds. Similarly, Toyota sells its cars in the United States for dollars; it must
convert the U.S. dollars it receives into Japanese yen to use them in Japan.
Tourists exchanging currency in Istanbul, Turkey.
©Muratart/Shutterstock
Second, international businesses use foreign exchange markets when they must pay a foreign
company for its products or services in its country’s currency. For example, Dell buys many of the
components for its computers from Malaysian firms. e Malaysian companies must be paid in
Malaysia’s currency, the ringgit, so Dell must convert money from dollars into ringgit to pay them.
ird, international businesses also use foreign exchange markets when they have spare cash that
they wish to invest for short terms in money markets. For example, consider a U.S. company that has
$10 million it wants to invest for three months. e best interest rate it can earn on these funds in the
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United States may be 2 percent. Investing in a South Korean money market account, however, may
earn 6 percent. us, the company may change its $10 million into Korean won and invest it in South
Korea. Note, however, that the rate of return it earns on this investment depends not only on the
Korean interest rate but also on the changes in the value of the Korean won against the dollar in the
intervening period.
Currency speculation is the fourth use of foreign exchange markets. Currency speculation
typically involves the short-term movement of funds from one currency to another in the hopes of
profiting from shifts in exchange rates. Consider again a U.S. company with $10 million to invest for
three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese
yen. at is, the company expects the value of the dollar to depreciate (fall) against that of the yen.
Imagine the current dollar/yen exchange rate is $1 = ¥120. e company exchanges its $10 million
into yen, receiving ¥1.2 billion ($10 million × 120 = ¥1.2 billion). Over the next three months, the
value of the dollar depreciates against the yen until $1 = ¥100. Now the company exchanges its ¥1.2
billion back into dollars and finds that it has $12 million. e company has made a $2 million profit
on currency speculation in three months on an initial investment of $10 million! In general, however,
companies should beware, for speculation by definition is a very risky business. e company cannot
know for sure what will happen to exchange rates. While a speculator may profit handsomely if his
speculation about future currency movements turns out to be correct, he can also lose vast amounts of
money if it turns out to be wrong.
A kind of speculation that has become more common in recent years is known as the carry trade.
e carry trade involves borrowing in one currency where interest rates are low and then using the
proceeds to invest in another currency where interest rates are high.2 For example, if the interest rate
on borrowings in Japan is 1 percent but the interest rate on deposits in American banks is 6 percent, it
can make sense to borrow in Japanese yen, convert the money into U.S. dollars, and deposit it in an
American bank. e trader can make a 5 percent margin by doing so, minus the transaction costs
associated with changing one currency into another. e speculative element of this trade is that its
success is based on a belief that there will be no adverse movement in exchange rates (or interest rates
for that matter) that will make the trade unprofitable. However, if the yen were to rapidly increase in
value against the dollar, then it would take more U.S. dollars to repay the original loan, and the trade
could fast become unprofitable. e dollar/yen carry trade was actually very significant
during the mid-2000s, peaking at more than $1 trillion in 2007, when some 30 percent of
trade on the Tokyo foreign exchange market was related to the carry trade.3 is carry trade declined
in importance during 2008–2009 because interest rate differentials were falling as U.S. rates came
down, making the trade less profitable. By late 2016, there were signs that the dollar/yen carry trade
was becoming important again as negative interest rates in Japan, coupled with rising interest rates in
the United States, were making it profitable to borrow in yen again and convert the money into U.S.
dollars.4
INSURING AGAINST FOREIGN EXCHANGE RISK
A second function of the foreign exchange market is to provide insurance against foreign exchange
risk, which is the possibility that unpredicted changes in future exchange rates will have adverse
consequences for the firm. When a firm insures itself against foreign exchange risk, it is engaging in
hedging. To explain how the market performs this function, we must first distinguish among spot
exchange rates, forward exchange rates, and currency swaps.
LO 10-2 Understand what is meant by spot exchange rates.
Spot Exchange Rates When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as a spot exchange. Exchange rates governing such “on the
spot” trades are referred to as spot exchange rates. e spot exchange rate is the rate at which a
foreign exchange dealer converts one currency into another currency on a particular day. us, when
our U.S. tourist in Edinburgh goes to a bank to convert her dollars into pounds, the exchange rate is
the spot rate for that day.
Spot exchange rates are reported on a real-time basis on many financial websites. An exchange rate
can be quoted in two ways: as the amount of foreign currency one U.S. dollar will buy or as the value
of a dollar for one unit of foreign currency. us, on February 6, 2016, at 12:30 p.m., Eastern
Standard Time, 1 U.S. dollar bought €0.93, and 1 euro bought $1.08.
Spot rates change continually, often on a minute-by-minute basis (although the magnitude of
changes over such short periods is usually small). e value of a currency is determined by the
interaction between the demand and supply of that currency relative to the demand and supply of
other currencies. For example, if lots of people want U.S. dollars and dollars are in short supply, and
few people want British pounds and pounds are in plentiful supply, the spot exchange rate for
converting dollars into pounds will change. e dollar is likely to appreciate against the pound (or the
pound will depreciate against the dollar). Imagine the spot exchange rate is £1 = $1.25 when the
market opens. As the day progresses, dealers demand more dollars and fewer pounds. By the end of
the day, the spot exchange rate might be £1 = $1.23. Each pound now buys fewer dollars than at the
start of the day. e dollar has appreciated, and the pound has depreciated.
Forward Exchange Rates Changes in spot exchange rates can be problematic for an international business. For example, a U.S. company that imports high-end cameras from Japan knows that in 30
days it must pay yen to a Japanese supplier when a shipment arrives. e company will pay the
Japanese supplier ¥200,000 for each camera, and the current dollar/yen spot exchange rate is $1 =
¥120. At this rate, each camera costs the importer $1,667 (i.e., 1,667 = 200,000/120). e importer
knows she can sell the cameras the day they arrive for $2,000 each, which yields a gross profit of $333
on each ($2,000 − $1,667). However, the importer will not have the funds to pay the Japanese
supplier until the cameras are sold. If, over the next 30 days, the dollar unexpectedly depreciates
against the yen, say, to $1 = ¥95, the importer will still have to pay the Japanese company ¥200,000
per camera but in dollar terms that would be equivalent to $2,105 per camera, which is more than she
can sell the cameras for. A depreciation in the value of the dollar against the yen from $1 = ¥120 to $1
= ¥95 would transform a profitable deal into an unprofitable one.
LO 10-3 Recognize the role that forward exchange rates play in insuring against foreign exchange
risk.
m a n a g e m e n t F O C U S
Embraer and the Gyrations of the Brazilian Real
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For many years, Brazil was a country battered by persistently high inflation. As a result, the value of its
currency, the real, depreciated steadily against the U.S. dollar. is changed in the early 2000s, when the
Brazilian government was successful in bringing down annual inflation rates into the single digits. Lower
inflation, coupled with policies that paved the way for the expansion of the Brazilian economy, resulted in a
steady appreciation of the real against the U.S. dollar. In May 2004, 1 real bought $0.3121; by August 2008,
1 real bought $0.65, an appreciation of more than 100 percent.
e appreciation of the real against the dollar was a mixed bag for Embraer, the world’s largest
manufacturer of regional jets of up to 110 seats and one of Brazil’s most prominent industrial companies.
Embraer purchases many of the parts that go into its jets, including the engines and electronics, from U.S.
manufacturers. As the real appreciated against the dollar, these parts cost less when translated into reals, which
benefited Embraer’s profit margins. However, the company also prices its aircraft in U.S. dollars, as do all
manufacturers in the global market for commercial jet aircraft. So, as the real appreciated against the dollar,
Embraer’s dollar revenues were compressed when exchanged back into reals.
To try to deal with the impact of currency appreciation on its revenues, in the mid-2000s, Embraer started
to hedge against future appreciation of the real by buying forward contracts (forward contracts give the holder
the right to exchange one currency—in this case, dollars—for another—in this case, reals—at some point in
the future at a predetermined exchange rate). If the real had continued to appreciate, this would have been a
great strategy for Embraer because the company could have locked in the rate at which sales made in dollars
were exchanged back into reals. Unfortunately for Embraer, as the global financial crisis unfolded in 2008,
investors fled to the dollar, which they viewed as a safe haven, and the real depreciated against the dollar. Between August 2008 and November 2008, the value of the real fell by almost 40 percent against the dollar.
But for the hedging, this depreciation would have actually increased Embraer’s revenues in reals. Embraer,
however, had locked itself into a much higher real/dollar exchange rate, and the company was forced to take a
$121 million loss on what was essentially a bad currency bet.
Since the shock of 2008, Embraer has cut back on currency hedging, and most of its dollar sales and
purchases are not hedged. is makes Embraer’s sales revenues very sensitive to the real/dollar exchange rate.
By 2010, the Brazilian real was once more appreciating against the U.S. dollar, which pressured Embraer’s
revenues. By 2012, however, the Brazilian economy was stagnating, while inflation was starting to increase
again. is led to a sustained fall in the value of the real, which fell from 1 real = $0.644 in July 2011 to 1 real
= $0.32 by February 2017, a depreciation of 50 percent. What was bad for the Brazilian currency, however,
was good for Embraer, whose stock price surged to the highest price since February 2008 on speculation that
the decline on the real would lead to a boost in Embraer’s revenues when expressed in reals.
Sources: D. Godoy, “Embraer Rallies as Brazilian Currency Weakens,” Bloomberg, May 31, 2013; K. Kroll, “Embraer Fourth Quarter Profits Plunge 44% on Currency Woes,” Cleveland.com, March 27, 2009; “A Fall from Grace: Brazil’s Mediocre Economy,” e Economist, June 8, 2013; and “Brazil’s Economy: e Deterioration,” e Economist, December 7, 2013.
To insure or hedge against this risk, the U.S. importer might want to engage in a forward exchange.
A forward exchange occurs when two parties agree to exchange currency and execute the deal at some
specific date in the future. Exchange rates governing such future transactions are referred to as forward
exchange rates. For most major currencies, forward exchange rates are quoted for 30 days, 90 days,
and 180 days into the future. In some cases, it is possible to get forward exchange rates for several
years into the future. Returning to our camera importer example, let us assume the 30-day forward
exchange rate for converting dollars into yen is $1 = ¥110. e importer enters into a 30-day forward
exchange transaction with a foreign exchange dealer at this rate and is guaranteed that she will have to
pay no more than $1,818 for each camera (1,818 = 200,000/110). is guarantees her a profit of
$182 per camera ($2,000 − $1,818). She also insures herself against the possibility that an
unanticipated change in the dollar/yen exchange rate will turn a profitable deal into an unprofitable
one.
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In this example, the spot exchange rate ($1 = ¥120) and the 30-day forward rate ($1 = ¥110) differ.
Such differences are normal; they reflect the expectations of the foreign exchange market about future
currency movements. In our example, the fact that $1 bought more yen with a spot exchange than
with a 30-day forward exchange indicates foreign exchange dealers expected the dollar to depreciate
against the yen in the next 30 days. When this occurs, we say the dollar is selling at a discount on the
30-day forward market (i.e., it is worth less than on the spot market). Of course, the opposite can also
occur. If the 30-day forward exchange rate were $1 = ¥130, for example, $1 would buy more yen with
a forward exchange than with a spot exchange. In such a case, we say the dollar is selling at a premium
on the 30-day forward market. is reflects the foreign exchange dealers’ expectations that the dollar
will appreciate against the yen over the next 30 days.
In sum, when a firm enters into a forward exchange contract, it is taking out insurance against the
possibility that future exchange rate movements will make a transaction unprofitable by the time that
transaction has been executed. Although many firms routinely enter into forward exchange contracts
to hedge their foreign exchange risk, sometimes this can work against the company. An example is
given in the accompanying Management Focus, which explains how the hedging strategy adopted by
the Brazilian regional jet manufacturer, Embraer, backfired.
Currency Swaps e preceding discussion of spot and forward exchange rates might lead you to conclude that the option to buy forward is very important to companies engaged in international
trade—and you would be right. According to the most recent data, forward instruments account for
almost two-thirds of all foreign exchange transactions, while spot exchanges account for about one-
third.5 However, the vast majority of these forward exchanges are not forward exchanges of the type
we have been discussing but rather a more sophisticated instrument known as currency swaps.
A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for
two different value dates. Swaps are transacted between international businesses and their banks,
between banks, and between governments when it is desirable to move out of one currency into
another for a limited period without incurring foreign exchange risk. A common kind of swap is spot
against forward. Consider a company such as Apple. Imagine Apple assembles laptop computers in the
United States, but the screens are made in Japan. Apple also sells some of the finished laptops in Japan.
So, like many companies, Apple both buys from and sells to Japan. Imagine Apple needs to change $1
million into yen to pay its supplier of laptop screens today. Apple knows that in 90 days it will be paid
¥120 million by the Japanese importer that buys its finished laptops. It will want to convert these yen
into dollars for use in the United States. Let us say today’s spot exchange rate is $1 = ¥120 and the 90-
day forward exchange rate is $1 = ¥110. Apple sells $1 million to its bank in return for ¥120 million.
Now Apple can pay its Japanese supplier. At the same time, Apple enters into a 90-day forward
exchange deal with its bank for converting ¥120 million into dollars. us, in 90 days Apple will
receive $1.09 million (¥120 million/110 = $1.09 million). Because the yen is trading at a premium on
the 90-day forward market, Apple ends up with more dollars than it started with (although the
opposite could also occur). e swap deal is just like a conventional forward deal in one important
respect: It enables Apple to insure itself against foreign exchange risk. By engaging in a swap, Apple
knows today that the ¥120 million payment it will receive in 90 days will yield $1.09 million.
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Page 278
e Nature of the Foreign Exchange Market
e foreign exchange market is not located in any one place. It is a global network of banks, brokers,
and foreign exchange dealers connected by electronic communications systems. When companies wish
to convert currencies, they typically go through their own banks rather than entering the market
directly. e foreign exchange market has been growing at a rapid pace, reflecting a general growth in
the volume of cross-border trade and investment (see Chapter 1). In March 1986, the average total
value of global foreign exchange trading was about $200 billion per day. By April 2016, the last date
for which we have solid data, it had hit $5.1 trillion a day.6 e most important trading centers are
London (37 percent of activity); New York (18 percent of activity); and Zurich, Tokyo, and Singapore
(all with around 5 to 6 percent of activity).7 Major secondary trading centers include Frankfurt, Paris,
Hong Kong, and Sydney.
London’s dominance in the foreign exchange market is due to both history and geography. As the
capital of the world’s first major industrial trading nation, London had become the world’s largest
center for international banking by the end of the nineteenth century, a position it has retained.
Today, London’s central position between Tokyo and Singapore to the east and New York to the west
has made it the critical link between the East Asian and New York markets. Due to the particular
differences in time zones, London opens soon after Tokyo closes for the night and is still open for the
first few hours of trading in New York. It is an open question, however, as to how the decision to exit
from the EU (Brexit) will affect London’s position as a global trading center.8
Two features of the foreign exchange market are of particular note. e first is that the market
never sleeps. Tokyo, London, and New York are all shut for only three hours out of every 24. During
these three hours, trading continues in a number of minor centers, particularly San Francisco and
Sydney, Australia. e second feature of the market is the integration of the various trading centers.
High-speed computer linkages among trading centers around the globe have effectively created a single
market. e integration of financial centers implies there can be no significant difference in exchange
rates quoted in the trading centers. For example, if the yen/dollar exchange rate quoted in London at 3
p.m. is ¥120 = $1, the yen/dollar exchange rate quoted in New York at the same time (10 a.m. New
York time) will be identical. If the New York yen/dollar exchange rate were ¥125 = $1, a
dealer could make a profit through arbitrage, buying a currency low and selling it high. For
example, if the prices differed in London and New York as given, a dealer in New York could take $1
million and use that to purchase ¥125 million. She could then immediately sell the ¥125 million for
dollars in London, where the transaction would yield $1.041666 million, allowing the trader to book
a profit of $41,666 on the transaction. If all dealers tried to cash in on the opportunity, however, the
demand for yen in New York would rise, resulting in an appreciation of the yen against the dollar such
that the price differential between New York and London would quickly disappear. Because foreign
exchange dealers are always watching their computer screens for arbitrage opportunities, the few that
arise tend to be small, and they disappear in minutes.
Another feature of the foreign exchange market is the important role played by the U.S. dollar.
Although a foreign exchange transaction can involve any two currencies, most transactions involve
dollars on one side. is is true even when a dealer wants to sell a non-dollar currency and buy
another. A dealer wishing to sell Mexican pesos for Japanese yen, for example, will usually sell the
pesos for dollars and then use the dollars to buy yen. Although this may seem a roundabout way of
doing things, it is actually cheaper than trying to find a holder of pesos who wants to buy yen. Because
the volume of international transactions involving dollars is so great, it is not hard to find dealers who
wish to trade dollars for pesos or yen.
Due to its central role in so many foreign exchange deals, the dollar is a vehicle currency. In 2013,
87 percent of all foreign exchange transactions involved dollars on one side of the transaction. After
the dollar, the most important vehicle currencies were the euro (33 percent), the Japanese yen (23
percent), and the British pound (12 percent)—reflecting the historical importance of these trading
entities in the world economy.
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Economic eories of Exchange Rate Determination
LO 10-4 Understand the different theories explaining how currency exchange rates are
determined and their relative merits.
At the most basic level, exchange rates are determined by the demand and supply of one currency
relative to the demand and supply of another. For example, if the demand for dollars outstrips the
supply of them and if the supply of Japanese yen is greater than the demand for them, the dollar/yen
exchange rate will change (see the opening case). e dollar will appreciate against the yen (and the
yen will depreciate against the dollar). However, while differences in relative demand and supply
explain the determination of exchange rates, they do so only in a superficial sense. is simple
explanation does not reveal what factors underlie the demand for and supply of a currency. Nor does it
tell us when the demand for dollars will exceed the supply (and vice versa) or when the supply of
Japanese yen will exceed demand for them (and vice versa). Neither does it show under what
conditions a currency is in demand or under what conditions it is not demanded. In this section, we
will review economic theory’s answers to these questions. is will give us a deeper understanding of
how exchange rates are determined.
If we understand how exchange rates are determined, we may be able to forecast exchange rate
movements. Because future exchange rate movements influence export opportunities, the profitability
of international trade and investment deals, and the price competitiveness of foreign imports, this is
valuable information for an international business. Unfortunately, there is no simple explanation. e
forces that determine exchange rates are complex, and no theoretical consensus exists, even among
academic economists who study the phenomenon every day. Nonetheless, most economic theories of
exchange rate movements seem to agree that three factors have an important impact on future
exchange rate movements in a country’s currency: the country’s price inflation, its interest rate, and
market psychology.9
PRICES AND EXCHANGE RATES
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To understand how prices are related to exchange rate movements, we first need to discuss an
economic proposition known as the law of one price. en we will discuss the theory of purchasing
power parity (PPP), which links changes in the exchange rate between two countries’ currencies to
changes in the countries’ price levels.
e Law of One Price e law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries
must sell for the same price when their price is expressed in terms of the same currency.10 For
example, if the exchange rate between the British pound and the dollar is £1 = $2, a jacket that retails
for $80 in New York should sell for £40 in London (because $80/$2 = £40). Consider what would
happen if the jacket cost £30 in London ($60 in U.S. currency). At this price, it would pay a trader to
buy jackets in London and sell them in New York (an example of arbitrage). e company initially
could make a profit of $20 on each jacket by purchasing it for £30 ($60) in London and selling it for
$80 in New York (we are assuming away transportation costs and trade barriers). However, the
increased demand for jackets in London would raise their price in London, and the increased supply
of jackets in New York would lower their price there. is would continue until prices were equalized.
us, prices might equalize when the jacket cost £35 ($70) in London and $70 in New York
(assuming no change in the exchange rate of £1 = $2).
Purchasing Power Parity If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By
comparing the prices of identical products in different currencies, it would be possible to determine
the “real,” or PPP, exchange rate that would exist if markets were efficient. (An efficient market has no
impediments to the free flow of goods and services, such as trade barriers.)
A less extreme version of the PPP theory states that given relatively efficient markets—that is,
markets in which few impediments to international trade exist—the price of a “basket of goods”
should be roughly equivalent in each country. To express the PPP theory in symbols, let P$ be the U.S.
dollar price of a basket of particular goods and P¥ be the price of the same basket of goods in Japanese
yen. e PPP theory predicts that the dollar/yen exchange rate, E$/¥, should be equivalent to
us, if a basket of goods costs $200 in the United States and ¥20,000 in Japan, PPP theory predicts
that the dollar/yen exchange rate should be $200/¥20,000 or $0.01 per Japanese yen (i.e., $1 = ¥100).
Every year, the news magazine e Economist publishes its own version of the PPP theorem, which
it refers to as the “Big Mac Index.” e Economist has selected McDonald’s Big Mac as a proxy for a
“basket of goods” because it is produced according to more or less the same recipe in about 120
countries. e Big Mac PPP is the exchange rate that would have hamburgers costing the same in each
country. According to e Economist, comparing a country’s actual exchange rate with the one
predicted by the PPP theorem based on relative prices of Big Macs is a test of whether a currency is
undervalued or not. is is not a totally serious exercise, as e Economist admits, but it does provide a
useful illustration of the PPP theorem.
To calculate the index, e Economist converts the price of a Big Mac in a country into dollars at
current exchange rates and divides that by the average price of a Big Mac in America. According to the
PPP theorem, the prices should be the same. If they are not, it implies that the currency is either
overvalued against the dollar or undervalued. For example, in January 2017, the average price of a Big
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Mac in the United States was $5.06, while it was $2.83 in China, and $5.67 in Norway. is suggests
that the Chinese yuan is undervalued by 44 percent, while the Norwegian krona is overvalued by 12
percent!
e next step in the PPP theory is to argue that the exchange rate will change if relative prices
change. For example, imagine there is no price inflation in the United States, while prices in Japan are
increasing by 10 percent a year. At the beginning of the year, a basket of goods costs $200 in the
United States and ¥20,000 in Japan, so the dollar/yen exchange rate, according to PPP theory, should
be $1 = ¥100. At the end of the year, the basket of goods still costs $200 in the United States, but it
costs ¥22,000 in Japan. PPP theory predicts that the exchange rate should change as a result. More
precisely, by the end of the year
us, ¥1 = $0.0091 (or $1 = ¥110). Because of 10 percent price inflation, the Japanese
yen has depreciated by 10 percent against the dollar. One dollar will buy 10 percent more
yen at the end of the year than at the beginning.
Money Supply and Price Inflation In essence, PPP theory predicts that changes in relative prices will result in a change in exchange rates. eoretically, a country in which price inflation is
running wild should expect to see its currency depreciate against that of countries in which inflation
rates are lower. If we can predict what a country’s future inflation rate is likely to be, we can also
predict how the value of its currency relative to other currencies—its exchange rate—is likely to
change. e growth rate of a country’s money supply determines its likely future inflation rate.11
us, in theory at least, we can use information about the growth in money supply to forecast
exchange rate movements.
Inflation is a monetary phenomenon. It occurs when the quantity of money in circulation rises
faster than the stock of goods and services—that is, when the money supply increases faster than
output increases. Imagine what would happen if everyone in the country was suddenly given $10,000
by the government. Many people would rush out to spend their extra money on those things they had
always wanted—new cars, new furniture, better clothes, and so on. ere would be a surge in demand
for goods and services. Car dealers, department stores, and other providers of goods and services
would respond to this upsurge in demand by raising prices. e result would be price inflation.
A government increasing the money supply is analogous to giving people more money. An increase
in the money supply makes it easier for banks to borrow from the government and for individuals and
companies to borrow from banks. e resulting increase in credit causes increases in demand for goods
and services. Unless the output of goods and services is growing at a rate similar to that of the money
supply, the result will be inflation. is relationship has been observed time after time in country after
country.
So now we have a connection between the growth in a country’s money supply, price inflation, and
exchange rate movements. Put simply, when the growth in a country’s money supply is faster than the
growth in its output, price inflation is fueled. e PPP theory tells us that a country with a high inflation
rate will see depreciation in its currency exchange rate. In one of the clearest historical examples, in the
mid-1980s, Bolivia experienced hyperinflation—an explosive and seemingly uncontrollable price
inflation in which money loses value very rapidly. Table 10.1 presents data on Bolivia’s money supply,
inflation rate, and its peso’s exchange rate with the U.S. dollar during the period of hyperinflation. e
exchange rate is actually the “black market” exchange rate because the Bolivian government prohibited
converting the peso to other currencies during the period. e data show that the growth in money
supply, the rate of price inflation, and the depreciation of the peso against the dollar all moved in step
with each other. is is just what PPP theory and monetary economics predict. Between April 1984
and July 1985, Bolivia’s money supply increased by 17,433 percent, prices increased by 22,908
percent, and the value of the peso against the dollar fell by 24,662 percent! In October 1985, the
Bolivian government instituted a dramatic stabilization plan—which included the introduction of a
new currency and tight control of the money supply—and by 1987, the country’s annual inflation rate
was down to 16 percent.12
10.1 TABLE
Macroeconomic Data for Bolivia, April 1984 to October 1985
Source: Juan-Antonio Morales, “Inflation Stabilization in Bolivia,” Inflation Stabilization: e Experience of Israel,
Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge, MA: MIT Press, 1988).
Another way of looking at the same phenomenon is that an increase in a country’s money supply,
which increases the amount of currency available, changes the relative demand-and-supply conditions
in the foreign exchange market. If the U.S. money supply is growing more rapidly than U.S. output,
dollars will be relatively more plentiful than the currencies of countries where monetary growth is
closer to output growth. As a result of this relative increase in the supply of dollars, the dollar will
depreciate on the foreign exchange market against the currencies of countries with slower monetary
growth.
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Government policy determines whether the rate of growth in a country’s money supply is greater
than the rate of growth in output. A government can increase the money supply simply by telling the
country’s central bank to issue more money. Governments tend to do this to finance public
expenditure (building roads, paying government workers, paying for defense, etc.). A government
could finance public expenditure by raising taxes, but because nobody likes paying more
taxes and because politicians do not like to be unpopular, they have a natural preference for
expanding the money supply. Unfortunately, there is no magic money tree. e result of excessive
growth in money supply is typically price inflation. However, this has not stopped governments
around the world from expanding the money supply, with predictable results. If an international
business is attempting to predict future movements in the value of a country’s currency on the foreign
exchange market, it should examine that country’s policy toward monetary growth. If the government
seems committed to controlling the rate of growth in money supply, the country’s future inflation rate
may be low (even if the current rate is high) and its currency should not depreciate too much on the
foreign exchange market. If the government seems to lack the political will to control the rate of
growth in money supply, the future inflation rate may be high, which is likely to cause its currency to
depreciate. Historically, many Latin American governments have fallen into this latter category,
including Argentina, Bolivia, and Brazil. More recently, many of the newly democratic states of eastern
Europe made the same mistake. In late 2010, when the U.S. Federal Reserve decided to promote
growth by expanding the U.S. money supply using a technique known as quantitative easing, critics
charged that this too would lead to inflation and a decline in the value of the U.S. dollar on foreign
exchange markets, but are they right? For a discussion of this, see the accompanying Country Focus.
An outdoor market in Bolivia.
©Noah Friedman-Rudovsky/Bloomberg/Getty Images
c o u n t r y F O C U S
Quantitative Easing, Inflation, and the Value of the U.S. Dollar
In fall 2010, the U.S. Federal Reserve (the Fed) decided to expand the U.S. money supply by entering the
open market and purchasing $600 billion in U.S. government bonds from bondholders, a technique known
as quantitative easing. Where did the $600 billion come from? e Fed simply created new bank reserves and used this cash to pay for the bonds. It had, in effect, printed money. e Fed took this action in an attempt to
stimulate the U.S. economy, which, in the aftermath of the 2008–2009 global financial crisis, was struggling
with low economic growth and high unemployment rates. e Fed had already tried to stimulate the
economy by lowering short-term interest rates, but these were already close to zero, so it decided to lower
medium- to longer-term rates; its tool for doing this was to pump $600 billion into the economy, increasing
the supply of money and lowering its price, the interest rate. e Fed pursued further rounds of quantitative
easing in 2011 through to 2013. In 2014, with the U.S. economy getting stronger and unemployment falling
below 6 percent, the Fed progressively reduced its bond buying program. It ended the program in October
2014. By that time, the Fed had effectively pumped more than $3.5 trillion into the U.S. economy.
Critics were quick to attack the Fed’s moves. Many claimed that the policy of expanding the money supply
would fuel inflation and lead to a decline in the value of the U.S. dollar on the foreign exchange market.
Some even called the policy a deliberate attempt by the Fed to debase the value of the U.S. currency, thereby
driving down its value and promoting U.S. exports, which, if true, would be a form of mercantilism.
However, these charges may be unfounded for two reasons. First, at the time, the core U.S. inflation rate
was the lowest in 50 years. In fact, the Fed actually feared the risk of deflation (a persistent fall in prices),
which is a very damaging phenomenon. When prices are falling, people hold off their purchases because they
know that goods will be cheaper tomorrow than they are today. is can result in a collapse in aggregate
demand and high unemployment. e Fed felt that a little inflation—say, 2 percent per year—might be a
good thing. Second, U.S. economic growth had been weak, unemployment was high, and there was excess
productive capacity in the economy. Consequently, if the injection of money into the economy did stimulate
demand, this would not translate into price inflation because the first response of businesses would be to
expand output to utilize their excess capacity. Defenders of the Fed argued that the important point, which
the critics seemed to be missing, was that expanding the money supply leads to only higher price inflation
when unemployment is relatively low and there is not much excess capacity in the economy, a situation that
did not exist in fall 2010. As for the currency market, its reaction was muted. At the beginning of November
2010, just before the Fed announced its policy, a trade-weighted index of the value of the dollar against a
basket of other major currencies stood at 72. At the end of January 2014, it stood at 78—a slight
appreciation. In short, currency traders did not seem to be selling off the dollar or reflecting worries about
high inflation rates.
By March 2016, with the program over, there was no sign of a surge in price inflation in the U.S. economy.
Indeed, inflation rates remained near historic lows. Moreover, far from weakening, the U.S. dollar had
increased in value against most currencies, and the index value stood at 92. e Fed, it would seem, had been
right and the critics were wrong.
Sources: P. Wallsten and S. Reddy, “Fed’s Bond Buying Plan Ignites Growing Criticism,” e Wall Street Journal, November 15, 2010; S. Chan, “Under Attack, the Fed Defends Policy of Buying Bonds,” International Herald Tribune, November 17, 2010; “What QE Means for the World; Positive Sum Currency Wars,” e Economist, February 14, 2013.
Empirical Tests of PPP eory PPP theory predicts that exchange rates are determined by relative prices and that changes in relative prices will result in a change in exchange rates. A country in
which price inflation is running wild should expect to see its currency depreciate against that of
countries with lower inflation rates. is is intuitively appealing, but is it true in practice? ere are
several good examples of the connection between a country’s price inflation and exchange rate position
(such as Bolivia). However, extensive empirical testing of PPP theory has yielded mixed results.13
While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to
be a strong predictor of short-run movements in exchange rates covering time spans of five years or
less.14 In addition, the theory seems to best predict exchange rate changes for countries with high rates
of inflation and underdeveloped capital markets. e theory is less useful for predicting short-term
exchange rate movements between the currencies of advanced industrialized nations that have
relatively small differentials in inflation rates.
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e failure to find a strong link between relative inflation rates and exchange rate movements has
been referred to as the purchasing power parity puzzle. Several factors may explain the failure of PPP
theory to predict exchange rates more accurately.15 PPP theory assumes away transportation costs and
barriers to trade. In practice, these factors are significant, and they tend to create significant price
differentials between countries. Transportation costs are certainly not trivial for many goods.
Moreover, as we saw in Chapter 7, governments routinely intervene in international trade, creating
tariff and nontariff barriers to cross-border trade. Barriers to trade limit the ability of traders to use
arbitrage to equalize prices for the same product in different countries, which is required for the law of
one price to hold. Government intervention in cross-border trade, by violating the assumption of
efficient markets, weakens the link between relative price changes and changes in exchange rates
predicted by PPP theory.
PPP theory may not hold if many national markets are dominated by a handful of multinational
enterprises that have sufficient market power to be able to exercise some influence over prices, control
distribution channels, and differentiate their product offerings between nations.16 In fact, this
situation seems to prevail in a number of industries. In such cases, dominant enterprises may be able
to exercise a degree of pricing power, setting different prices in different markets to reflect varying
demand conditions. is is referred to as price discrimination. For price discrimination to work,
arbitrage must be limited. According to this argument, enterprises with some market power may be
able to control distribution channels and therefore limit the unauthorized resale (arbitrage) of
products purchased in another national market. ey may also be able to limit resale (arbitrage) by
differentiating otherwise identical products among nations along some line, such as design or
packaging.
For example, even though the version of Microsoft Office sold in China may be less expensive than
the version sold in the United States, the use of arbitrage to equalize prices may be limited because few
Americans would want a version that was based on Chinese characters. e design differentiation
between Microsoft Office for China and for the United States means that the law of one price would
not work for Microsoft Office, even if transportation costs were trivial and tariff barriers between the
United States and China did not exist. If the inability to practice arbitrage were widespread enough, it
would break the connection between changes in relative prices and exchange rates predicted by the
PPP theorem and help explain the limited empirical support for this theory.
Another factor of some importance is that governments also intervene in the foreign exchange
market in attempting to influence the value of their currencies. We look at why and how they do this
in Chapter 11. For now, the important thing to note is that governments regularly intervene in the
foreign exchange market, and this further weakens the link between price changes and changes in
exchange rates. One more factor explaining the failure of PPP theory to predict short-term movements
in foreign exchange rates is the impact of investor psychology and other factors on currency
purchasing decisions and exchange rate movements. We discuss this issue in more detail later in this
chapter.
INTEREST RATES AND EXCHANGE RATES
Economic theory tells us that interest rates reflect expectations about likely future inflation rates. In
countries where inflation is expected to be high, interest rates also will be high, because investors want
compensation for the decline in the value of their money. is relationship was first formalized by
economist Irvin Fisher and is referred to as the Fisher effect. e Fisher effect states that a country’s
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“nominal” interest rate (i) is the sum of the required “real” rate of interest (r) and the expected rate of
inflation over the period for which the funds are to be lent (I). More formally,
For example, if the real rate of interest in a country is 5 percent and annual inflation is expected to be
10 percent, the nominal interest rate will be 15 percent. As predicted by the Fisher effect, a strong
relationship seems to exist between inflation rates and interest rates.17
We can take this one step further and consider how it applies in a world of many countries and
unrestricted capital flows. When investors are free to transfer capital between countries, real interest
rates will be the same in every country. If differences in real interest rates did emerge between
countries, arbitrage would soon equalize them. For example, if the real interest rate in Japan was 10
percent and only 6 percent in the United States, it would pay investors to borrow money in the
United States and invest it in Japan. e resulting increase in the demand for money in the United
States would raise the real interest rate there, while the increase in the supply of foreign money in
Japan would lower the real interest rate there. is would continue until the two sets of real interest
rates were equalized.
It follows from the Fisher effect that if the real interest rate is the same worldwide, any difference in
interest rates between countries reflects differing expectations about inflation rates. us, if the
expected rate of inflation in the United States is greater than that in Japan, U.S. nominal interest rates
will be greater than Japanese nominal interest rates.
Because we know from PPP theory that there is a link (in theory, at least) between inflation and
exchange rates and because interest rates reflect expectations about inflation, it follows that there must
also be a link between interest rates and exchange rates. is link is known as the international Fisher
effect. e international Fisher effect (IFE) states that for any two countries, the spot exchange rate
should change in an equal amount but in the opposite direction to the difference in
nominal interest rates between the two countries. Stated more formally, the change in the
spot exchange rate between the United States and Japan, for example, can be modeled as follows:
where i$ and i¥ are the respective nominal interest rates in the United States and Japan, S1 is the spot
exchange rate at the beginning of the period, and S2 is the spot exchange rate at the end of the period.
If the U.S. nominal interest rate is higher than Japan’s, reflecting greater expected inflation rates, the
value of the dollar against the yen should fall by that interest rate differential in the future. So if the
interest rate in the United States is 10 percent and in Japan it is 6 percent, we would expect the value
of the dollar to depreciate by 4 percent against the Japanese yen.
Do interest rate differentials help predict future currency movements? e evidence is mixed; as in
the case of PPP theory, in the long run, there seems to be a relationship between interest rate
differentials and subsequent changes in spot exchange rates. However, considerable short-run
deviations occur. Like PPP, the international Fisher effect is not a good predictor of short-run changes
in spot exchange rates.18
INVESTOR PSYCHOLOGY AND BANDWAGON EFFECTS
Page 285
Empirical evidence suggests that neither PPP theory nor the international Fisher effect is particularly
good at explaining short-term movements in exchange rates. One reason may be the impact of
investor psychology on short-run exchange rate movements. Evidence reveals that various
psychological factors play an important role in determining the expectations of market traders as to
likely future exchange rates.19 In turn, expectations have a tendency to become self-fulfilling
prophecies.
A particularly famous example of this mechanism occurred in September 1992, when the
international financier George Soros made a huge bet against the British pound. Soros borrowed
billions of pounds, using the assets of his investment funds as collateral, and immediately sold those
pounds for German deutsche marks (this was before the advent of the euro). is technique, known as
short selling, can earn the speculator enormous profits if he can subsequently buy back the pounds he
sold at a much better exchange rate and then use those pounds, purchased cheaply, to repay his loan.
By selling pounds and buying deutsche marks, Soros helped start pushing down the value of the
pound on the foreign exchange markets. More importantly, when Soros started shorting the British
pound, many foreign exchange traders, knowing Soros’s reputation, jumped on the bandwagon and
did likewise. is triggered a classic bandwagon effect with traders moving as a herd in the same
direction at the same time. As the bandwagon effect gained momentum, with more traders selling
British pounds and purchasing deutsche marks in expectation of a decline in the pound, their
expectations became a self-fulfilling prophecy. Massive selling forced down the value of the pound
against the deutsche mark. In other words, the pound declined in value not so much because of any
major shift in macroeconomic fundamentals but because investors followed a bet placed by a major
speculator, George Soros.
According to a number of studies, investor psychology and bandwagon effects play an important
role in determining short-run exchange rate movements.20 However, these effects can be hard to
predict. Investor psychology can be influenced by political factors and by microeconomic events, such
as the investment decisions of individual firms, many of which are only loosely linked to
macroeconomic fundamentals, such as relative inflation rates. Also, bandwagon effects can be both
triggered and exacerbated by the idiosyncratic behavior of politicians. Something like this seems to
have occurred in Southeast Asia during 1997 when, one after another, the currencies of ailand,
Malaysia, South Korea, and Indonesia lost between 50 and 70 percent of their value against the U.S.
dollar in a few months.
SUMMARY OF EXCHANGE RATE THEORIES
Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all
moderately good predictors of long-run changes in exchange rates. ey are poor predictors of short-
run changes in exchange rates, however, perhaps because of the impact of psychological factors,
investor expectations, and bandwagon effects on short-term currency movements. is information is
useful for an international business. Insofar as the long-term profitability of foreign investments,
export opportunities, and the price competitiveness of foreign imports are all influenced by long-term
movements in exchange rates, international businesses would be advised to pay attention to countries’
differing monetary growth, inflation, and interest rates. International businesses that engage
in foreign exchange transactions on a day-to-day basis could benefit by knowing some
predictor s of short-term foreign exchange rate movements. Unfortunately, short-term exchange rate
movements are difficult to predict.
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Exchange Rate Forecasting
LO 10-5 Identify the merits of different approaches toward exchange rate forecasting.
A company’s need to predict future exchange rate variations raises the issue of whether it is worthwhile
for the company to invest in exchange rate forecasting services to aid decision making. Two schools of
thought address this issue. e efficient market school argues that forward exchange rates do the best
possible job of forecasting future spot exchange rates and, therefore, investing in forecasting services
would be a waste of money. e other school of thought, the inefficient market school, argues that
companies can improve the foreign exchange market’s estimate of future exchange rates (as contained
in the forward rate) by investing in forecasting services. In other words, this school of thought does
not believe the forward exchange rates are the best possible predictors of future spot exchange rates.
THE EFFICIENT MARKET SCHOOL
Did You Know?
Did you know that the U.S. dollar has been one of the strongest currencies in the world since the great recession of
2008–2009?
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the authors.
Forward exchange rates represent market participants’ collective predictions of likely spot exchange
rates at specified future dates. If forward exchange rates are the best possible predictor of future spot
rates, it would make no sense for companies to spend additional money trying to forecast short-run
exchange rate movements. Many economists believe the foreign exchange market is efficient at setting
forward rates.21 An efficient market is one in which prices reflect all available public information. (If
forward rates reflect all available information about likely future changes in exchange rates, a company
cannot beat the market by investing in forecasting services.)
If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of
future spot rates. is does not mean the predictions will be accurate in any specific situation. It
means inaccuracies will not be consistently above or below future spot rates; they will be random.
Many empirical tests have addressed the efficient market hypothesis. Although most of the early work
seems to confirm the hypothesis (suggesting that companies should not waste their money on
forecasting services), some studies have challenged it.22 ere is some evidence that forward rates are
not unbiased predictors of future spot rates and that more accurate predictions of future spot rates can
be calculated from publicly available information.23
THE INEFFICIENT MARKET SCHOOL
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Citing evidence against the efficient market hypothesis, some economists believe the foreign exchange
market is inefficient. An inefficient market is one in which prices do not reflect all available
information. In an inefficient market, forward exchange rates will not be the best possible predictors of
future spot exchange rates.
If this is true, it may be worthwhile for international businesses to invest in forecasting services (as
many do). e belief is that professional exchange rate forecasts might provide better predictions of
future spot rates than forward exchange rates do. However, the track record of professional forecasting
services is not that good.24 For example, forecasting services did not predict the 1997 currency crisis
that swept through Southeast Asia, nor did they predict the rise in the value of the dollar that occurred
during late 2008, a period when the United States fell into a deep financial crisis that some thought
would lead to a decline in the value of the dollar (it appears that the dollar rose because it was seen as a
relatively safe currency in a time when many nations were experiencing economic trouble).
APPROACHES TO FORECASTING
Assuming the inefficient market school is correct that the foreign exchange market’s estimate of future
spot rates can be improved, on what basis should forecasts be prepared? Here again, there are two
schools of thought. One adheres to fundamental analysis, while the other uses technical analysis.
Fundamental Analysis Fundamental analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. e variables contained in
these models typically include those we have discussed, such as relative money supply growth rates,
inflation rates, and interest rates. In addition, they may include variables related to balance-of-
payments positions.
Running a deficit on a balance-of-payments current account (a country is importing more goods
and services than it is exporting) creates pressures that may result in the depreciation of the country’s
currency on the foreign exchange market.25 Consider what might happen if the United States were
running a persistent current account balance-of-payments deficit (as it has been). Because the United
States would be importing more than it was exporting, people in other countries would be increasing
their holdings of U.S. dollars. If these people were willing to hold their dollars, the dollar’s exchange
rate would not be influenced. However, if these people converted their dollars into other currencies,
the supply of dollars in the foreign exchange market would increase (as would demand for the other
currencies). is shift in demand and supply would create pressures that could lead to the depreciation
of the dollar against other currencies.
is argument hinges on whether people in other countries are willing to hold dollars. is
depends on such factors as U.S. interest rates, the return on holding other dollar-denominated assets
such as stocks in U.S. companies, and, most important, inflation rates. So, in a sense, the balance-of-
payments situation is not a fundamental predictor of future exchange rate movements. But what
makes financial assets such as stocks and bonds attractive? e answer is prevailing interest rates and
inflation rates, both of which affect underlying economic growth and the real return to holding U.S.
financial assets. Given this, we are back to the argument that the fundamental determinants of
exchange rates are monetary growth, inflation rates, and interest rates.
Technical Analysis Technical analysis uses price and volume data to determine past trends, which are expected to continue into the future. is approach does not rely on a consideration of economic
Page 287
fundamentals. Technical analysis is based on the premise that there are analyzable market trends and
waves and that previous trends and waves can be used to predict future trends and waves. Since there is
no theoretical rationale for this assumption of predictability, many economists compare technical
analysis to fortune-telling. Despite this skepticism, technical analysis has gained favor in recent
years.26
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Currency Convertibility
Until this point, we have assumed that the currencies of various countries are freely convertible into
other currencies. Due to government restrictions, a significant number of currencies are not freely
convertible into other currencies. A country’s currency is said to be freely convertible when the
country’s government allows both residents and nonresidents to purchase unlimited amounts of a
foreign currency with it. A currency is said to be externally convertible when only nonresidents may
convert it into a foreign currency without any limitations. A currency is nonconvertible when neither
residents nor nonresidents are allowed to convert it into a foreign currency.
Free convertibility is not universal. Many countries place some restrictions on their residents’ ability
to convert the domestic currency into a foreign currency (a policy of external convertibility).
Restrictions range from the relatively minor (such as restricting the amount of foreign currency they
may take with them out of the country on trips) to the major (such as restricting domestic businesses’
ability to take foreign currency out of the country). External convertibility restrictions can limit
domestic companies’ ability to invest abroad, but they present few problems for foreign companies
wishing to do business in that country. For example, even if the Japanese government tightly
controlled the ability of its residents to convert the yen into U.S. dollars, all U.S. businesses with
deposits in Japanese banks may at any time convert all their yen into dollars and take them out of the
country. us, a U.S. company with a subsidiary in Japan is assured that it will be able to convert the
profits from its Japanese operation into dollars and take them out of the country.
Serious problems arise, however, under a policy of nonconvertibility. is was the practice of the
former Soviet Union, and it continued to be the practice in Russia for several years after the collapse of
the Soviet Union. When strictly applied, nonconvertibility means that although a U.S. company
doing business in a country such as Russia may be able to generate significant ruble profits, it may not
convert those rubles into dollars and take them out of the country. Obviously, this is not desirable for
international business.
Governments limit convertibility to preserve their foreign exchange reserves. A country needs an
adequate supply of these reserves to service its international debt commitments and to purchase
imports. Governments typically impose convertibility restrictions on their currency when they fear
that free convertibility will lead to a run on their foreign exchange reserves. is occurs
when residents and nonresidents rush to convert their holdings of domestic currency into a
foreign currency—a phenomenon generally referred to as capital flight. Capital flight is most likely to
occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or
when a country’s economic prospects are shaky in other respects. Under such circumstances, both
residents and nonresidents tend to believe that their money is more likely to hold its value if it is
converted into a foreign currency and invested abroad. Not only will a run on foreign exchange
reserves limit the country’s ability to service its international debt and pay for imports, but it will also
lead to a precipitous depreciation in the exchange rate as residents and nonresidents unload their
holdings of domestic currency on the foreign exchange markets (thereby increasing the market supply
of the country’s currency). Governments fear that the rise in import prices resulting from currency
depreciation will lead to further increases in inflation. is fear provides another rationale for limiting
convertibility.
Companies can deal with the nonconvertibility problem by engaging in countertrade.
Countertrade refers to a range of barter-like agreements by which goods and services can be traded for
other goods and services. Countertrade can make sense when a country’s currency is nonconvertible.
For example, consider the deal that General Electric struck with the Romanian government when that
country’s currency was nonconvertible. When General Electric won a contract for a $150 million
generator project in Romania, it agreed to take payment in the form of Romanian goods that could be
sold for $150 million on international markets. In a similar case, the Venezuelan government
negotiated a contract with Caterpillar under which Venezuela would trade 350,000 tons of iron ore
for Caterpillar heavy construction equipment. Caterpillar subsequently traded the iron ore to
Romania in exchange for Romanian farm products, which it then sold on international markets for
dollars.27
How important is countertrade? Twenty years ago, a large number of nonconvertible currencies
existed in the world, and countertrade was quite significant. However, in recent years, many
governments have made their currencies freely convertible, and the percentage of world trade that
involves countertrade is probably significantly below 5 percent.28
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Focus on Managerial Implications
FOREIGN EXCHANGE RATE RISK
LO 10-6 Compare and contrast the differences among translation, transaction, and economic
exposure, and explain the implications for management practice.
is chapter contains a number of clear implications for business. First, it is critical that international
businesses understand the influence of exchange rates on the profitability of trade and investment
deals. Adverse changes in exchange rates can make apparently profitable deals unprofitable. As noted,
the risk introduced into international business transactions by changes in exchange rates is referred to
as foreign exchange risk. Foreign exchange risk is usually divided into three main categories:
transaction exposure, translation exposure, and economic exposure.
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Transaction Exposure Transaction exposure ure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes
obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing
or lending of funds in foreign currencies. For example, suppose in 2004, an American airline agreed to
purchase 10 Airbus 330 aircraft for €120 million each for a total price of €1.20 billion, with delivery
scheduled for 2008 and payment due then. When the contract was signed in 2004, the dollar/euro
exchange rate stood at $1 = €1.10, so the American airline anticipated paying $1.09 billion for the 10
aircraft when they were delivered (€1.2 billion/1.1 = $1.09 billion). However, imagine that the value
of the dollar depreciates against the euro over the intervening period, so that a dollar buys only €0.80
in 2008 when payment was due ($1 = €0.80). Now the total cost in U.S. dollars is $1.5 billion (€1.2
billion/0.80 = $1.5 billion), an increase of $0.41 billion! e transaction exposure here is $0.41
billion, which is the money lost due to an adverse movement in exchange rates between the time when
the deal was signed and when the aircraft were paid for.
Translation Exposure Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Translation exposure is concerned with the present
measurement of past events. e resulting accounting gains or losses are said to be
unrealized—they are “paper” gains and losses—but they are still important. Consider a U.S.
firm with a subsidiary in Mexico. If the value of the Mexican peso depreciates significantly against the
dollar, this would substantially reduce the dollar value of the Mexican subsidiary’s equity. In turn, this
would reduce the total dollar value of the firm’s equity reported in its consolidated balance sheet. is
would raise the apparent leverage of the firm (its debt ratio), which could increase the firm’s cost of
borrowing and potentially limit its access to the capital market. Similarly, if an American firm has a
subsidiary in the European Union and the value of the euro depreciates rapidly against that of the
dollar over a year, this will reduce the dollar value of the euro profit made by the European subsidiary,
resulting in negative translation exposure. In fact, many U.S. firms suffered from significant negative
translation exposure in Europe during 2000, precisely because the euro did depreciate rapidly against
the dollar. In 2002–2007, the euro rose in value against the dollar. is positive translation exposure
boosted the dollar profits of American multinationals with significant operations in Europe. Between
mid-2014 and early 2015, the euro slumped in value against the dollar, compressing the dollar profits
of American multinationals with significant European exposure.
Economic Exposure Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the
long-run effect of changes in exchange rates on future prices, sales, and costs. is is distinct from
transaction exposure, which is concerned with the effect of exchange rate changes on individual
transactions, most of which are short-term affairs that will be executed within a few weeks or months.
Consider the effect of wide swings in the value of the dollar on many U.S. firms’ international
competitiveness. e rapid rise in the value of the dollar on the foreign exchange market in the 1990s
hurt the price competitiveness of many U.S. producers in world markets. U.S. manufacturers that
relied heavily on exports saw their export volume and world market share decline. e reverse
phenomenon occurred in 2000–2009, when the dollar declined against most major currencies. e
fall in the value of the dollar helped increase the price competitiveness of U.S. manufacturers in world
markets. Between mid-2014 and early 2015, the dollar increased significantly in value against most
major currencies, decreasing the price competitiveness of U.S. exporters. Since early 2017 the opposite
has occurred, with the dollar falling in value, increasing the price competitiveness of U.S. exporters.
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REDUCING TRANSLATION AND TRANSACTION EXPOSURE
A number of tactics can help firms minimize their transaction and translation exposure. ese tactics
primarily protect short-term cash flows from adverse changes in exchange rates. We have already
discussed two of these tactics at length in the chapter, entering into forward exchange rate contracts
and buying swaps. In addition to buying forward and using swaps, firms can minimize their foreign
exchange exposure through leading and lagging payables and receivables—that is, paying suppliers and
collecting payment from customers early or late depending on expected exchange rate movements. A
lead strategy involves attempting to collect foreign currency receivables (payments from customers)
early when a foreign currency is expected to depreciate and paying foreign currency payables (to
suppliers) before they are due when a currency is expected to appreciate. A lag strategy involves
delaying collection of foreign currency receivables if that currency is expected to appreciate and
delaying payables if the currency is expected to depreciate. Leading and lagging involve accelerating
payments from weak-currency to strong-currency countries and delaying inflows from strong-currency
to weak-currency countries.
Lead and lag strategies can be difficult to implement, however. e firm must be in a position to
exercise some control over payment terms. Firms do not always have this kind of bargaining power,
particularly when they are dealing with important customers who are in a position to dictate payment
terms. Also, because lead and lag strategies can put pressure on a weak currency, many governments
limit leads and lags. For example, some countries set 180 days as a limit for receiving payments for
exports or making payments for imports.
REDUCING ECONOMIC EXPOSURE
Reducing economic exposure requires strategic choices that go beyond the realm of financial
management. e key to reducing economic exposure is to distribute the firm’s productive assets to
various locations so the firm’s long-term financial well-being is not severely affected by adverse changes
in exchange rates. is is a strategy that firms both large and small sometimes pursue. For example,
during the 2000s, fearing that the euro would continue to strengthen against the U.S. dollar, some
European firms that did significant business in the United States set up local production facilities in
that market to ensure that a rising euro did not put them at a competitive disadvantage relative to
their local rivals. Similarly, Toyota has production plants distributed around the world in part to make
sure that a rising yen does not price Toyota cars out of local markets. Caterpillar has also pursued this
strategy, setting up factories around the world that can act as a hedge against the possibility that a
strong dollar will price Caterpillar’s exports out of foreign markets. In 2008, 2009, and 2014–2015, all
periods of dollar strength, this real hedge proved to be very useful.
OTHER STEPS FOR MANAGING FOREIGN EXCHANGE RISK
A firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and
strategies for minimizing its foreign exchange exposure. Although there is no universal agreement as to
the components of this mechanism, a number of common themes stand out.29 First, central control of
exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix
Page 290
of tactics and strategies. Many companies have set up in-house foreign exchange centers. Although
such centers may not be able to execute all foreign exchange deals—particularly in large, complex
multinationals where myriad transactions may be pursued simultaneously—they should at least set
guidelines for the firm’s subsidiaries to follow.
Second, firms should distinguish between, on one hand, transaction and translation exposure and,
on the other, economic exposure. Many companies seem to focus on reducing their transaction and
translation exposure and pay scant attention to economic exposure, which may have more profound
long-term implications.30 Firms need to develop strategies for dealing with economic exposure. For
example, Stanley Black & Decker, the maker of power tools, has a strategy for actively managing its
economic risk. e key to Stanley Black & Decker’s strategy is flexible sourcing. In response to foreign
exchange movements, Stanley Black & Decker can move production from one location to another to
offer the most competitive pricing. Stanley Black & Decker manufactures in more than a dozen
locations around the world—in Europe, Australia, Brazil, Mexico, and Japan. More than 50 percent of
the company’s productive assets are based outside North America. Although each of Stanley Black &
Decker’s factories focuses on one or two products to achieve economies of scale, there is considerable
overlap. On average, the company runs its factories at no more than 80 percent capacity, so most are
able to switch rapidly from producing one product to producing another or to add a product. is
allows a factory’s production to be changed in response to foreign exchange movements. For example,
if the dollar depreciates against other currencies, the amount of imports into the United States from
overseas subsidiaries can be reduced and the amount of exports from U.S. subsidiaries to other
locations can be increased.31
ird, the need to forecast future exchange rate movements cannot be overstated, although as we
saw earlier in the chapter this is a tricky business. No model comes close to perfectly predicting future
movements in foreign exchange rates. e best that can be said is that in the short run, forward
exchange rates provide the best predictors of exchange rate movements, and in the long run,
fundamental economic factors—particularly relative inflation rates—should be watched because they
influence exchange rate movements. Some firms attempt to forecast exchange rate movements in-
house; others rely on outside forecasters. However, all such forecasts are imperfect attempts to predict
the future.
Fourth, firms need to establish good reporting systems so the central finance function (or in-house
foreign exchange center) can regularly monitor the firm’s exposure positions. Such reporting systems
should enable the firm to identify any exposed accounts, the exposed position by currency of each
account, and the time periods covered.
Finally, on the basis of the information it receives from exchange rate forecasts and its own regular
reporting systems, the firm should produce monthly foreign exchange exposure reports. ese reports
should identify how cash flows and balance sheet elements might be affected by forecasted changes in
exchange rates. e reports can then be used by management as a basis for adopting tactics and
strategies to hedge against undue foreign exchange risks.
Surprisingly, some of the largest and most sophisticated firms don’t take such precautionary steps,
exposing themselves to very large foreign exchange risks.
Key Terms
foreign exchange market p. 272
exchange rate p. 272
foreign exchange risk p. 273
currency speculation p. 274
carry trade p. 274
spot exchange rate p. 275
forward exchange p. 275
forward exchange rate p. 275
currency swap p. 277
arbitrage p. 278
law of one price p. 279
efficient market p. 279
Fisher effect p. 283
international Fisher effect (IFE) p. 284
bandwagon effect p. 284
inefficient market p. 285
freely convertible currency p. 286
externally convertible currency p. 286
nonconvertible currency p. 286
capital flight p. 287
countertrade p. 287
transaction exposure p. 287
translation exposure p. 287
economic exposure p. 288
lead strategy p. 288
lag strategy p. 288
Summary
is chapter explained how the foreign exchange market works, examined the forces that determine
exchange rates, and then discussed the implications of these factors for international business. Given
that changes in exchange rates can dramatically alter the profitability of foreign trade and investment
deals, this is an area of major interest to international business. e chapter made the following points:
1. One function of the foreign exchange market is to convert the currency of one country into the
currency of another. A second function of the foreign exchange market is to provide insurance
against foreign exchange risk.
2. e spot exchange rate is the exchange rate at which a dealer converts one currency into another
currency on a particular day.
3. Foreign exchange risk can be reduced by using forward exchange rates. A forward exchange rate
is an exchange rate governing future transactions. Foreign exchange risk can also be reduced by
engaging in currency swaps. A swap is the simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
4. e law of one price holds that in competitive markets that are free of transportation costs and
barriers to trade, identical products sold in different countries must sell for the same price when
their price is expressed in the same currency.
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5. Purchasing power parity (PPP) theory states the price of a basket of particular goods should be
roughly equivalent in each country. PPP theory predicts that the exchange rate will change if
relative prices change.
6. e rate of change in countries’ relative prices depends on their relative inflation rates. A
country’s inflation rate seems to be a function of the growth in its money supply.
7. e PPP theory of exchange rate changes yields relatively accurate predictions of long-term
trends in exchange rates but not of short-term movements. e failure of PPP theory to predict
exchange rate changes more accurately may be due to transportation costs, barriers to trade and
investment, and the impact of psychological factors such as bandwagon effects on market
movements and short-run exchange rates.
8. Interest rates reflect expectations about inflation. In countries where inflation is expected to be
high, interest rates also will be high.
9. e international Fisher effect states that for any two countries, the spot exchange rate should
change in an equal amount but in the opposite direction to the difference in nominal interest
rates.
10. e most common approach to exchange rate forecasting is fundamental analysis. is relies on
variables such as money supply growth, inflation rates, nominal interest rates, and balance-of-
payments positions to predict future changes in exchange rates.
11. In many countries, the ability of residents and nonresidents to convert local currency into a
foreign currency is restricted by government policy. A government restricts the
convertibility of its currency to protect the country’s foreign exchange reserves and to
halt any capital flight.
12. Nonconvertibility of a currency makes it very difficult to engage in international trade and
investment in the country. One way of coping with the nonconvertibility problem is to engage
in countertrade—to trade goods and services for other goods and services.
13. e three types of exposure to foreign exchange risk are transaction exposure, translation
exposure, and economic exposure.
14. Tactics that insure against transaction and translation exposure include buying forward, using
currency swaps, and leading and lagging payables and receivables.
15. Reducing a firm’s economic exposure requires strategic choices about how the firm’s productive
assets are distributed around the globe.
Critical inking and Discussion Questions
1. e interest rate on South Korean government securities with one-year maturity is 4 percent,
and the expected inflation rate for the coming year is 2 percent. e interest rate on U.S.
government securities with one-year maturity is 7 percent, and the expected rate of inflation is 5
percent. e current spot exchange rate for Korean won is $1 = W1,200. Forecast the spot
exchange rate one year from today. Explain the logic of your answer.
2. Two countries, Great Britain and the United States, produce just one good: beef. Suppose the
price of beef in the United States is $2.80 per pound and in Britain it is £3.70 per pound.
a. According to PPP theory, what should the dollar/pound spot exchange rate be?
b. Suppose the price of beef is expected to rise to $3.10 in the United States and to £4.65 in
Britain. What should the one-year forward dollar/pound exchange rate be?
c. Given your answers to parts a and b, and given that the current interest rate in the United
States is 10 percent, what would you expect the current interest rate to be in Britain?
3. Reread the Management Focus “Embraer and the Gyrations of the Brazilian Real,” and then
answer the following questions:
a. What does the recent economic history of Brazil tell you about the relationship between price
inflation and exchange rates? What other factors might determine exchange rates for the
Brazilian real?
b. Is a decline in value of the real against the U.S. dollar good for Embraer, bad for Embraer, or
a mixed bag? Explain your answer.
c. What kind of foreign exchange rate risks is Embraer exposed to? Can Embraer reduce these
risks? How?
d. Do you think Embraer’s decision to try to hedge against further appreciation of the real in the
early 2000s was a good decision? What was the alternative?
e. Since 2008, Embraer has significantly reduced its dollar hedging operations. Is this wise?
f. Between mid-2014 and early 2015, the real depreciated significantly against the U.S. dollar.
What do you think the impact was on Embraer?
4. You manufacture wine goblets. In mid-June, you receive an order for 10,000 goblets from Japan.
Payment of ¥400,000 is due in mid-December. You expect the yen to rise from its present rate
of $1 = ¥130 to $1 = ¥100 by December. You can borrow yen at 6 percent a year. What should
you do?
5. You are the CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures
component parts for your U.S. assembly operations. e subsidiary has been financed by bank
borrowings in the United States. One of your analysts told you that the Mexican peso is
expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the
next year. What actions, if any, should you take?
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. One of your company’s essential suppliers is located in Japan. Your company needs to make a 1
million Japanese yen payment in six months. Considering that your company primarily operates
in U.S. dollars, you are assigned the task of deciding on a strategy to minimize your transaction
exposure. Identify the spot and forward exchange rates between the two currencies. What factors
influence your decision to use each? Which one would you choose? How many dollars must you
spend to acquire the amount of yen required?
2. Sometimes analysts use the price of specific products in different locations to compare currency
valuation and purchasing power. For example, e Economist’s Big Mac Index compares the
purchasing power parity of many countries based on the price of a Big Mac. Using Google,
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locate the latest edition of this index that is accessible. Identify the five countries (and their
currencies) with the lowest purchasing power parity according to this classification. Which
currencies, if any, are overvalued?
T h e M e x i c a n Pe s o , t h e J a p a n e s e Ye n , a n d P o k e m o n G o
c l o s i n g c a s e
Nintendo’s hit game Pokemon Go is a lot less lucrative in Mexico than the Japanese company originally thought it would be. is is because Mexicans purchase the “Pokecoins” they need to navigate the game in
Mexican pesos, and the peso has been falling in value against the Japanese yen. Back in early 2015, 1 Mexican
peso bought 8 Japanese yen. By September-2016, 1 peso was only worth about 5.1 Japanese yen. is meant
that when pesos spent on Pokemon Go were translated back into Japanese yen, they were worth less in yen, which negatively affected Nintendo’s profits from Mexico.
e diverging values on the yen and peso are a function of their exchange rates against the U.S. dollar.
Most trades between the yen and the peso are converted through the U.S. dollar, rather than traded directly.
is is because the U.S. dollar is the world’s most widely traded and liquid currency. It’s easier to trade dollars
for yen, and dollars for pesos, than it is to trade yen for pesos. For much of 2016, the yen gained against the
dollar, while the Mexican peso fell, leading to a fall in the peso/yen exchange rate.
Guests Play Nintendo Co.’s Pokemon Go Inside A Six Flags Entertainment Corp. Amusement
Park
©Bloomberg/Getty Images
e strength of the yen reflected the belief that Japan is a safe haven in which to park cash. Although the
Japanese economy has been stagnant for decades, inflation is low and the yen has been a strong currency. e
Mexican peso is the most liquid emerging market currency, which makes it an easy one to sell when investors
worry about the economic strength of developing economies, which they did in 2015 and 2016. To
compound matters, worries about the health of the Mexican economy following the election of Donald
Trump to the U.S. presidency put further pressure on the peso. Trump threatened to pull the United States
out of NAFTA—the regional trade deal that has been a major boon for Mexico. e Mexican peso hit a
record low against the U.S. dollar following the election of Mr. Trump.
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In addition to Nintendo, the fall in the value of the peso against the yen has created problems for other
Japanese firms. Japanese automakers have significant assembly operations in Mexico. Companies such as
Toyota and Mazda import a large number of specialty electronic components from suppliers in Japan. e
price of these components has gone up when translated into pesos, raising costs for their Mexican operations
and making them less profitable.
On the other hand, the weak peso has boosted demand for some Mexican products in Japan. For example,
Japan imports a large quantity of frozen Mexican pork. e price has fallen when translated into yen and
demand has surged. Mexico dices up the pork and exports it to Japanese convenience stores, where it is sold in
bento boxes. e dicing process is labor intensive—and one less step they have to perform in Japan. Mexico
can do it cheaper, and the currency moves have only added to the cost savings, which is good for Japanese
consumers.
Sources: Julie Wernau, “Pokeman Go Illustrates a Currency Problem,” e Wall Street Journal, August 11, 2016; Elena Holodny
and Portia Crowe, “Mexican Peso Crashes to Record Low,” Business Insider, November 8, 2016; and “Peso Falls to Session Lows after
Meeting between US and Mexico Presidents Falls rough,” Reuters, January 26, 2017.
CASE DISCUSSION QUESTIONS
1. Why are most trades between the Japanese yen and the Mexican peso made through U.S.
dollars?
2. Explain why the peso fell in value against the Japanese yen during 2016. How predictable
was this fall?
3. What were the benefits of the fall in the value of the peso against the yen for Mexican
companies? What were the costs?
4. What were the benefits of the fall in the value of the peso against the yen for Japanese
companies? What were the costs?
5. Should Japanese companies such as Nintendo and Toyota with business in Mexico have
hedged against adverse changes in the peso/yen exchange rate? How might they have done
that?
Endnotes
1. For a good general introduction to the foreign exchange market, see R. Weisweiller, How the
Foreign Exchange Market Works (New York: New York Institute of Finance, 1990). A detailed
description of the economics of foreign exchange markets can be found in P. R. Krugman and
M. Obstfeld, International Economics: eory and Policy (New York: HarperCollins, 1994).
2. Oscar Jorda and Alan Taylor, “e Carry Trade and Fundamentals: Nothing to Fear but FEER
Itself,” Journal of International Economics 88 (2012), pp. 74–90.
3. “e Domino Effect,” e Economist, July 5, 2008, p. 85.
4. Leo Lewis, “Speculations of a Yen Carry Trade Revival Grow,” Financial Times, December 22,
2016.
5. Bank for International Settlements, Tri-annual Central Bank Survey of Foreign
Exchange and Derivatives Market Activity, April 2016 (Basle, Switzerland: BIS, December 11,
2016).
6. Bank for International Settlements, Tri-annual Central Bank Survey of Foreign Exchange and
Derivatives Market Activity, April 2016 (Basle, Switzerland: BIS, December 11, 2016).
7. Bank for International Settlements, Tri-annual Central Bank Survey of Foreign Exchange and
Derivatives Market Activity, April 2016 (Basle, Switzerland: BIS, December 11, 2016).
8. M. Dickson, “Capital Gain: How London Is riving as It Takes on the Global Competition,”
Financial Times, March 27, 2006, p. 11; Patrick Jenkins, “e City of London Faces the Future
Beyond Brexit,” Financial Times, October 3, 2016.
9. For a comprehensive review, see M. Taylor, “e Economics of Exchange Rates,” Journal of
Economic Literature 33 (1995), pp. 13–47.
10. Krugman and Obstfeld, International Economics.
11. M. Friedman, Studies in the Quantity eory of Money (Chicago: University of Chicago Press,
1956). For an accessible explanation, see M. Friedman and R. Friedman, Free to Choose
(London: Penguin Books, 1979), chap. 9.
12. Juan-Antonio Morales, “Inflation Stabilization in Bolivia,” in Inflation Stabilization: e
Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge,
MA: MIT Press, 1988); e Economist, World Book of Vital Statistics (New York: Random
House, 1990).
13. For reviews and various articles, see H. J. Edison, J. E. Gagnon, and W. R. Melick,
“Understanding the Empirical Literature on Purchasing Power Parity,” Journal of International
Money and Finance 16 (February 1997), pp. 1–18; J. R. Edison, “Multi-Country Evidence on
the Behavior of Purchasing Power Parity under the Current Float,” Journal of International
Money and Finance 16 (February 1997), pp. 19–36; K. Rogoff, “e Purchasing Power Parity
Puzzle,” Journal of Economic Literature 34 (1996), pp. 647–68; D. R. Rapach and M. E. Wohar,
“Testing the Monetary Model of Exchange Rate Determination: New Evidence from a Century
of Data,” Journal of International Economics, December 2002, pp. 359–85; M. P. Taylor,
“Purchasing Power Parity,” Review of International Economics, August 2003, pp. 436–56; H. Kim
and YK Moh, “A Century of Purchasing Power Parity Confirmed,” Journal of International
Money and Finance 29 (2010), pp. 1398–1405.
14. M. Obstfeld and K. Rogoff, “e Six Major Puzzles in International Economics,” National
Bureau of Economic Research Working Paper Series, paper no. 7777, July 2000.
15. M. Obstfeld and K. Rogoff, “e Six Major Puzzles in International Economics,” National
Bureau of Economic Research Working Paper Series, paper no. 7777, July 2000.
16. See M. Devereux and C. Engel, “Monetary Policy in the Open Economy Revisited: Price Setting
and Exchange Rate Flexibility,” National Bureau of Economic Research Working Paper Series, paper
no. 7665, April 2000. See also P. Krugman, “Pricing to Market When the Exchange Rate
Changes,” in Real Financial Economics, ed. S. Arndt and J. Richardson (Cambridge, MA: MIT
Press, 1987).
17. For a summary of the evidence, see the survey by Taylor, “e Economics of Exchange Rates.”
18. R. E. Cumby and M. Obstfeld, “A Note on Exchange Rate Expectations and Nominal Interest
Differentials: A Test of the Fisher Hypothesis,” Journal of Finance, June 1981, pp. 697–703; L.
Coppock and M. Poitras, “Evaluating the Fisher Effect in Long Term Cross Country Averages,”
International Review of Economics and Finance 9 (2000), pp. 181–203.
19. Taylor, “e Economics of Exchange Rates.” See also R. K. Lyons, e Microstructure Approach
to Exchange Rates (Cambridge, MA: MIT Press, 2002); P. De Grauwe and M. Grimaldi, e
Exchange Rate in a Behavioral Finance Framework (Princeton, NJ: Princeton University Press,
2006).
20. See H. L. Allen and M. P. Taylor, “Charts, Noise, and Fundamentals in the Foreign Exchange
Market,” Economic Journal 100 (1990), pp. 49–59; T. Ito, “Foreign Exchange Rate Expectations:
Micro Survey Data,” American Economic Review 80 (1990), pp. 434–49; T. F. Rotheli,
“Bandwagon Effects and Run Patterns in Exchange Rates,” Journal of International Financial
Markets, Money and Institutions 12, no. 2 (2002), pp. 157–66.
21. For example, see E. Fama, “Forward Rates as Predictors of Future Spot Rates,” Journal of
Financial Economics, October 1976, pp. 361–77.
22. L. Kilian and M. P. Taylor, “Why Is It So Difficult to Beat the Random Walk Forecast of
Exchange Rates?” Journal of International Economics 20 (May 2003), pp. 85–103; R. M. Levich,
“e Efficiency of Markets for Foreign Exchange,” in International Finance, ed. G. D. Gay and
R. W. Kold (Richmond, VA: Robert F. Dane, 1983).
23. J. Williamson, e Exchange Rate System (Washington, DC: Institute for International
Economics, 1983); R. H. Clarida, L. Sarno, M. P. Taylor, and G. Valente, “e Out of Sample
Success of Term Structure Models as Exchange Rate Predictors,” Journal of International
Economics 60 (May 2003), pp. 61–84.
24. Kilian and Taylor, “Why Is It So Difficult to Beat the Random Walk Forecast of Exchange
Rates?”
25. Rogoff, “e Purchasing Power Parity Puzzle.”
26. C. Engel and J. D. Hamilton, “Long Swings in the Dollar: Are ey in the Data and Do
Markets Know It?” American Economic Review, September 1990, pp. 689–713.
27. J. R. Carter and J. Gagne, “e Do’s and Don’ts of International Countertrade,” Sloan
Management Review, Spring 1988, pp. 31–37.
28. D. S. Levine, “Got a Spare Destroyer Lying Around?” World Trade 10 (June 1997), pp. 34–35;
Dan West, “Countertrade,” Business Credit, April 2001, pp. 64–67.
29. For details on how various firms manage their foreign exchange exposure, see the articles
contained in the special foreign exchange issue of Business International Money Report, December
18, 1989, pp. 401–12.
30. See Business International Money Report, December 18, 1989, pp. 401–12.
31. S. Arterian, “How Black & Decker Defines Exposure,” Business International Money Report,
December 18, 1989, pp. 404, 405, 409.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-
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Part 4 e Global Monetary System
e International Monetary System
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO11-1 Describe the historical development of the modern global monetary system.
LO11-2 Explain the role played by the World Bank and the IMF in the international monetary system.
LO11-3 Compare and contrast the differences between a fixed and a floating exchange rate system.
LO11-4 Identify exchange rate regimes used in the world today and why countries adopt different exchange rate regimes.
LO11-5 Understand the debate surrounding the role of the IMF in the management of financial crises.
LO11-6 Explain the implications of the global monetary system for management practice.
Can Dollarization Save Venezuela?
opening case
Venezuela is in deep trouble. Although the country boasts the largest oil reserves on the planet, a fact that should make
it rich, poor governance has created an economic crisis of historic proportions and turned the country into the poorest
in Latin America. e economy contracted by 16.5 percent in 2016, and another 12 percent in 2017, while
unemployment surged to over 26 percent. Due to food shortages, some two-thirds of the population have reported
significant weight loss.
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e country’s economic decline dates back to the rule of Hugo Chavez, who took power in 1999. Chavez
significantly raised the royalty rate that foreign oil companies had to pay the government. Oil companies responded by
not investing in Venezuela and looking for oil elsewhere. Chavez then compounded the problem by pushing out the
professional management of the state-run oil company and replacing them with his own political appointees. e results
included underinvestment in exploration and extraction infrastructure and falling oil output. By 2017, oil output had
fallen by 50 percent from its peak in 1998, a major problem for a country where crude oil makes up about 95 percent of
exports.
Early in his rule, Chavez spent oil revenues liberally on social programs, including price controls and fuel subsidies.
ese initially helped the poor and boosted his popularity. However, by 2012 significant strains were showing up in the
economy, including declining oil production and exports, rising unemployment, high inflation, and ballooning
government deficits.
In 2013, Chavez died and was succeeded by Nicolas Maduro. Maduro continued on the trajectory set by Chavez.
Unfortunately for him, oil prices and output both fell sharply, reducing government revenue. Rather than abandon
social programs and subsidies, Maduro simply expanded the government budget deficit, raising it to a staggering 38
percent of GDP by 2017. He financed that deficit by printing money. Predictably, the result has been hyperinflation.
e inflation rate surged to 250 percent in 2016, and then to around 2700 percent per year in 2017, the highest in the
world. is made the country’s currency, the bolivar, virtually worthless, stifling commerce, which depends upon a stable currency.
On the foreign exchange market, the value of the bolivar collapsed, falling from 64 per U.S. dollar in 2014 to 960
per dollar by early 2016, and around 100,000 per USD by early 2018! It should be noted that this was the exchange rate
on the black market. e official exchange rate set by the Venezuelan government, which no one pays any attention to,
is 10 bolivars per USD. With the bolivar viewed as worthless, no one wants to trade with Venezuela unless they get paid
in U.S. dollars. With not enough dollars in Venezuela to finance international transactions, that means a shortage of
many goods.
When a country experiences this kind of currency crisis, the normal response is to call in the International Monetary
Fund (IMF). In return for a loan of funds, the IMF will often advocate austerity programs to reduce the
government budget deficit, along with high interest rates and tight controls over the growth in money supply
to reduce inflation. Other policies advocated by the IMF include the removal of price controls and subsidies and the
privatization of state-owned enterprises. However, all of these actions are an anathema to Maduro, who continues to
adhere to a hard line socialist ideology and blame foreign and domestic capitalists for the country’s ills.
Opposition figures in Venezuela have suggested another solution to the country’s currency problems—dollarization.
e process would involve abandoning the bolivar, and the government introducing cash denominated in U.S. dollars to
keep commerce moving. In fact, de facto dollarization is already under way in Venezuela. Increasingly, merchants are ignoring price controls and pricing goods in U.S. dollars at their free market value. Unfortunately, Venezuela’s economic
collapse has been so severe that most Venezuelans only earn the equivalent of a few dollars per month, so this doesn’t
help them. For dollarization to work, the government would have to purchase about $10 billion worth of U.S. notes
and coins and put those in circulation.
ere are precedents for dollarization. Ecuador adopted the U.S. dollar in 2000 in order to overcome soaring
inflation and a collapse in the value of that country’s currency, the sucre. While the switch was painful—salaries initially fell by 40 percent and savings and pension accounts were ravaged—wages and prices stabilized and the economy
recovered and started to grow again. However, Maduro has long vilified the United States, so it is difficult to see him
backing a similar dollarization effort for Venezuela. •
Sources: John Otis and Kejal Vyas, “e Dollar Rescued Ecuador: Can It Save Venezuela?” e Wall Street Journal, March 27, 2018; Matt
O’Brian, “Venezuela Should Be Rich, but Its Government Has Destroyed Its Economy,” e Washington Post, January 21, 2015; and Patricia
Laya, “One Dollar Now Buys 103,000 Bolivars in Venezuela’s Black Market,” Bloomberg Markets, December 1, 2017.
Introduction
In this chapter, we look at the international monetary system and its role in determining exchange rates. e
international monetary system refers to the institutional arrangements that govern exchange rates. In Chapter
10, we assumed the foreign exchange market was the primary institution for determining exchange rates and
the impersonal market forces of demand and supply determined the relative value of any two currencies (i.e.,
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their exchange rate). Furthermore, we explained that the demand and supply of currencies are influenced by
their respective countries’ relative inflation rates and interest rates. When the foreign exchange market
determines the relative value of a currency, we say that the country is adhering to a floating exchange rate
regime. Four of the world’s major trading currencies—the U.S. dollar, the European Union’s euro, the Japanese
yen, and the British pound—are all free to float against each other. us, their exchange rates are determined by
market forces and fluctuate against each other day to day, if not minute to minute. However, the exchange rates
of many currencies are not determined by the free play of market forces; other institutional arrangements are
adopted.
Many of the world’s developing nations peg their currencies, primarily to the dollar or the euro. A pegged
exchange rate means the value of the currency is fixed relative to a reference currency, such as the U.S. dollar,
and then the exchange rate between that currency and other currencies is determined by the reference currency
exchange rate.
Other countries, while not adopting a formal pegged rate, try to hold the value of their currency within
some range against an important reference currency such as the U.S. dollar or a “basket” of currencies. is is
often referred to as a managed-float system or a dirty-float system. It is a float because, in theory, the value of
the currency is determined by market forces, but it is a managed (or dirty) float (as opposed to a clean float)
because the central bank of a country will intervene in the foreign exchange market to try to maintain the value
of its currency if it depreciates (or appreciates) too rapidly against an important reference currency. is has
been the policy adopted by the Chinese since July 2005. e value of the Chinese currency, the yuan, has been
linked to a basket of other currencies—including the dollar, yen, and euro—and it is allowed to vary in value
against individual currencies, but only within limits.
e international monetary
system captures our attention
because here we are talking about the institutional arrangements that govern exchange rates, and this is a tricky business
in which countries have leverage to influence their country’s currency value but do not necessarily always use it. e
options for how the value, or “rate,” is set for a currency are many: floating exchange rate, pegged exchange rate, dirty
float, and fixed exchange rate are the ones covered in Chapter 11. We start the chapter with some history related to the
“gold standard,” a practice that takes us back to ancient times. Technically, no country uses the gold standard any longer
but many, including the United States, hold substantial gold reserves. e international monetary system depends on a
lot of variables (see the globalEDGE™ Database of International Business Statistics, which we covered in Chapter 10);
today, these variables also include “behavioral” (perception) issues in addition to hard, concrete data. e globalEDGE™
Blog has been a favored “international business” vehicle to stay current on important topics, often related to monetary
issues. Check out the globalEDGE™ Blog (globaledge.msu.edu/blog), see what is covered on monetary issues, and
engage with people from around the world on issues that are of interest to you.
Still other countries have operated with a fixed exchange rate, in which the values of a set of currencies are
fixed against each other at some mutually agreed-on exchange rate. Before the introduction of the euro in 1999,
several member states of the European Union operated with fixed exchange rates within the context of the
European Monetary System (EMS). For a quarter of a century after World War II, the world’s major
industrial nations participated in a fixed exchange rate system. Although this system collapsed in 1973, some
still argue that the world should attempt to reestablish it.
Another option is for a country to abandon its own currency and instead adopt another currency (typically
the U.S. dollar—a process referred to as dollarization). Dollarization is sometimes used when a country is
suffering from severe macroeconomic problems, such as high inflation, that are making its own currency
worthless. is was the case with Ecuador in 2000, which abandoned its own currency in favor of the U.S.
dollar after suffering from hyperinflation. As discussed in the opening case, dollarization is now being
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considered as an option for Venezuela, a country whose currency has been rendered worthless by
hyperinflation.
is chapter explains how the international monetary system works and points out its implications for
international business. To understand how the system works, we must review its evolution. We begin with a
discussion of the gold standard and its breakup during the 1930s. en we discuss the 1944 Bretton Woods
conference. e Bretton Woods conference created two major international institutions that play a role in the
international monetary system—the International Monetary Fund (IMF) and the World Bank. e IMF was
given the task of maintaining order in the international monetary system; the World Bank’s role was to promote
development. Today, both these institutions continue to play major roles in the world economy and in the
international monetary system. For example, in 2016 the IMF stepped in to help Egypt navigate its way
through a currency crisis caused by poor economic policies, terrorism, and political turmoil. e Bretton
Woods system of fixed exchange rates collapsed in 1973. Since then, the world has operated with a mixed
system in which some currencies are allowed to float freely, but many are either managed by government
intervention or pegged to another currency.
Finally, we discuss the implications of all this material for international business. We will see how the
exchange rate policy adopted by a government can have an important impact on the outlook for business
operations in a given country. We also look at how the policies adopted by the IMF can have an impact on the
economic outlook for a country and, accordingly, on the costs and benefits of doing business in that country.
e Gold Standard
LO 11-1 Describe the historical development of the modern global monetary system.
e gold standard had its origin in the use of gold coins as a medium of exchange, unit of account, and store of
value—a practice that dates to ancient times. When international trade was limited in volume, payment for
goods purchased from another country was typically made in gold or silver. However, as the volume of
international trade expanded in the wake of the Industrial Revolution, a more convenient means of
financing international trade was needed. Shipping large quantities of gold and silver around the
world to finance international trade seemed impractical. e solution adopted was to arrange for payment in
paper currency and for governments to agree to convert the paper currency into gold on demand at a fixed rate.
MECHANICS OF THE GOLD STANDARD
Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. By 1880, most of the
world’s major trading nations, including Great Britain, Germany, Japan, and the United States, had adopted the
gold standard. Given a common gold standard, the value of any currency in units of any other currency (the
exchange rate) was easy to determine.
For example, under the gold standard, 1 U.S. dollar was defined as equivalent to 23.22 grains of “fine”
(pure) gold. us, one could, in theory, demand that the U.S. government convert that one dollar into 23.22
grains of gold. Because there are 480 grains in an ounce, one ounce of gold cost $20.67 (480/23.22). e
amount of a currency needed to purchase one ounce of gold was referred to as the gold par value. e British
pound was valued at 113 grains of fine gold. In other words, one ounce of gold cost £4.25 (480/113). From the
gold par values of pounds and dollars, we can calculate what the exchange rate was for converting pounds into
dollars; it was £1 = $4.87 (i.e., $20.67/£4.25).
STRENGTH OF THE GOLD STANDARD
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e great strength claimed for the gold standard was that it contained a powerful mechanism for achieving
balance-of-trade equilibrium by all countries.1 A country is said to be in balance-of-trade equilibrium when
the income its residents earn from exports is equal to the money its residents pay to other countries for imports
(the current account of its balance of payments is in balance). Suppose there are only two countries in the
world, Japan and the United States. Imagine Japan’s trade balance is in surplus because it exports more to the
United States than it imports from the United States. Japanese exporters are paid in U.S. dollars, which they
exchange for Japanese yen at a Japanese bank. e Japanese bank submits the dollars to the U.S. government
and demands payment of gold in return. (is is a simplification of what would occur, but it will make our
point.)
Under the gold standard, when Japan has a trade surplus, there is a net flow of gold from the United States
to Japan. ese gold flows automatically reduce the U.S. money supply and swell Japan’s money supply. As we
saw in Chapter 10, there is a close connection between money supply growth and price inflation. An increase in
money supply will raise prices in Japan, while a decrease in the U.S. money supply will push U.S. prices
downward. e rise in the price of Japanese goods will decrease demand for these goods, while the fall in the
price of U.S. goods will increase demand for these goods. us, Japan will start to buy more from the United
States, and the United States will buy less from Japan, until a balance-of-trade equilibrium is achieved.
is adjustment mechanism seems so simple and attractive that even today, nearly 80 years after the final
collapse of the gold standard, some people believe the world should return to a gold standard.
THE PERIOD BETWEEN THE WARS: 1918–1939
e gold standard worked reasonably well from the 1870s until the start of World War I in 1914, when it was
abandoned. During the war, several governments financed part of their massive military expenditures by
printing money. is resulted in inflation, and by the war’s end in 1918, price levels were higher everywhere.
e United States returned to the gold standard in 1919, Great Britain in 1925, and France in 1928.
Great Britain returned to the gold standard by pegging the pound to gold at the prewar gold parity level of
£4.25 per ounce, despite substantial inflation between 1914 and 1925. is priced British goods out of foreign
markets, which pushed the country into a deep depression. When foreign holders of pounds lost confidence in
Great Britain’s commitment to maintaining its currency’s value, they began converting their holdings of pounds
into gold. e British government saw that it could not satisfy the demand for gold without seriously depleting
its gold reserves, so it suspended convertibility in 1931.
e United States followed suit and left the gold standard in 1933 but returned to it in 1934, raising the
dollar price of gold from $20.67 per ounce to $35.00 per ounce. Because more dollars were needed to buy an
ounce of gold than before, the implication was that the dollar was worth less. is effectively amounted to a
devaluation of the dollar relative to other currencies. us, before the devaluation, the pound/dollar exchange
rate was £1 = $4.87, but after the devaluation it was £1 = $8.24. By reducing the price of U.S. exports and
increasing the price of imports, the government was trying to create employment in the United States by
boosting output (the U.S. government was basically using the exchange rate as an instrument of trade policy—
something it now accuses China of doing). However, a number of other countries adopted a similar tactic, and
in the cycle of competitive devaluations that soon emerged, no country could win.
e net result was the shattering of any remaining confidence in the system. With countries devaluing their
currencies at will, one could no longer be certain how much gold a currency could buy. Instead of holding onto
another country’s currency, people often tried to change it into gold immediately, lest the country devalue its
currency in the intervening period. is put pressure on the gold reserves of various countries, forcing them to
suspend gold convertibility. By the start of World War II in 1939, the gold standard was dead.
test PREP
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Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to
learnsmartadvantage.com for help.
e Bretton Woods System
LO 11-2 Explain the role played by the World Bank and the IMF in the international monetary system.
In 1944, at the height of World War II, representatives from 44 countries met at Bretton Woods, New
Hampshire, to design a new international monetary system. With the collapse of the gold standard and the
Great Depression of the 1930s fresh in their minds, these statesmen were determined to build an enduring
economic order that would facilitate postwar economic growth. ere was consensus that fixed exchange rates
were desirable. In addition, the conference participants wanted to avoid the senseless competitive devaluations
of the 1930s, and they recognized that the gold standard would not ensure this. e major problem with the
gold standard as previously constituted was that no multinational institution could stop countries from
engaging in competitive devaluations.
e agreement reached at Bretton Woods established two multinational institutions—the International
Monetary Fund (IMF) and the World Bank. e task of the IMF would be to maintain order in the
international monetary system and that of the World Bank would be to promote general economic
development. e Bretton Woods agreement also called for a system of fixed exchange rates that would be
policed by the IMF. Under the agreement, all countries were to fix the value of their currency in terms of gold
but were not required to exchange their currencies for gold. Only the dollar remained convertible into gold—at
a price of $35 per ounce. Each country decided what it wanted its exchange rate to be vis-à-vis the dollar and
then calculated the gold par value of the currency based on that selected dollar exchange rate. All participating
countries agreed to try to maintain the value of their currencies within 1 percent of the par value by buying or
selling currencies (or gold) as needed. For example, if foreign exchange dealers were selling more of a country’s
currency than demanded, that country’s government would intervene in the foreign exchange markets, buying
its currency in an attempt to increase demand and maintain its gold par value.
Another aspect of the Bretton Woods agreement was a commitment not to use devaluation as a weapon of
competitive trade policy. However, if a currency became too weak to defend, a devaluation of up to 10 percent
would be allowed without any formal approval by the IMF. Larger devaluations required IMF approval.
THE ROLE OF THE IMF
e IMF Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive
devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic
disintegration that occurred between the two world wars. e aim of the Bretton Woods agreement, of which
the IMF was the main custodian, was to try to avoid a repetition of that chaos through a combination of
discipline and flexibility.
Discipline A fixed exchange rate regime imposes discipline in two ways. First, the need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment.
Second, a fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price
inflation. For example, consider what would happen under a fixed exchange rate regime if Great Britain rapidly
increased its money supply by printing pounds. As explained in Chapter 10, the increase in money supply
would lead to price inflation. Given fixed exchange rates, inflation would make British goods uncompetitive in
world markets, while the prices of imports would become more attractive in Great Britain. e result would be
a widening trade deficit in Great Britain, with the country importing more than it exports. To correct this trade
imbalance under a fixed exchange rate regime, Great Britain would be required to restrict the rate of growth in
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its money supply to bring price inflation back under control. us, fixed exchange rates are seen as a
mechanism for controlling inflation and imposing economic discipline on countries.
Flexibility Although monetary discipline was a central objective of the Bretton Woods agreement, it was recognized that a rigid policy of fixed exchange rates would be too inflexible. It would probably break down just
as the gold standard had. In some cases, a country’s attempts to reduce its money supply growth and correct a
persistent balance-of-payments deficit could force the country into recession and create high unemployment.
e architects of the Bretton Woods agreement wanted to avoid high unemployment, so they built limited
flexibility into the system. Two major features of the IMF Articles of Agreement fostered this flexibility: IMF
lending facilities and adjustable parities.
e IMF stood ready to lend foreign currencies to members to tide them over during short periods of
balance-of-payments deficits, when a rapid tightening of monetary or fiscal policy would hurt domestic
employment. A pool of gold and currencies contributed by IMF members provided the resources for these
lending operations. A persistent balance-of-payments deficit can lead to a depletion of a country’s reserves of
foreign currency, forcing it to devalue its currency. By providing deficit-laden countries with short-term foreign
currency loans, IMF funds would buy time for countries to bring down their inflation rates and reduce their
balance-of-payments deficits. e belief was that such loans would reduce pressures for devaluation and allow
for a more orderly and less painful adjustment.
Countries were to be allowed to borrow a limited amount from the IMF without adhering to any specific
agreements. However, extensive drawings from IMF funds would require a country to agree to increasingly
stringent IMF supervision of its macroeconomic policies. Heavy borrowers from the IMF must agree to
monetary and fiscal conditions set down by the IMF, which typically included IMF-mandated targets on
domestic money supply growth, exchange rate policy, tax policy, government spending, and so on.
e system of adjustable parities allowed for the devaluation of a country’s currency by more than 10
percent if the IMF agreed that a country’s balance of payments was in “fundamental disequilibrium.” e term
fundamental disequilibrium was not defined in the IMF’s Articles of Agreement, but it was intended to apply to
countries that had suffered permanent adverse shifts in the demand for their products. Without devaluation,
such a country would experience high unemployment and a persistent trade deficit until the domestic price
level had fallen far enough to restore a balance-of-payments equilibrium. e belief was that devaluation could
help sidestep a painful adjustment process in such circumstances.
THE ROLE OF THE WORLD BANK
e official name for the World Bank is the International Bank for Reconstruction and Development (IBRD).
When the Bretton Woods participants established the World Bank, the need to reconstruct the war-torn
economies of Europe was foremost in their minds. e bank’s initial mission was to help finance the building of
Europe’s economy by providing low-interest loans. As it turned out, the World Bank was overshadowed in this
role by the Marshall Plan, under which the United States lent money directly to European nations to help them
rebuild. So the bank turned its attention to development and began lending money to third-world nations. In
the 1950s, the bank concentrated on public-sector projects. Power stations, road building, and other
transportation investments were much in favor. During the 1960s, the bank also began to lend
heavily in support of agriculture, education, population control, and urban development.
e bank lends money under two schemes. Under the IBRD scheme, money is raised through bond sales in
the international capital market. Borrowers pay what the bank calls a market rate of interest—the bank’s cost of
funds plus a margin for expenses. is “market” rate is lower than commercial banks’ market rate. Under the
IBRD scheme, the bank offers low-interest loans to risky customers whose credit rating is often poor, such as
the governments of underdeveloped nations.
A second scheme is overseen by the International Development Association (IDA), an arm of the bank
created in 1960. Resources to fund IDA loans are raised through subscriptions from wealthy members such as
the United States, Japan, and Germany. IDA loans go only to the poorest countries. Borrowers have up to 50
years to repay at an interest rate of less than 1 percent a year. e world’s poorest nations receive grants and
interest-free loans.
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e Collapse of the Fixed Exchange Rate System
LO 11-3 Compare and contrast the differences between a fixed and a floating exchange rate system.
e system of fixed exchange rates established at Bretton Woods worked well until the late 1960s, when it
began to show signs of strain. e system finally collapsed in 1973, and since then, we have had a managed-
float system. To understand why the system collapsed, one must appreciate the special role of the U.S. dollar in
the system. As the only currency that could be converted into gold and as the currency that served as the
reference point for all others, the dollar occupied a central place in the system. Any pressure on the dollar to
devalue could wreak havoc with the system, and that is what occurred.
Most economists trace the breakup of the fixed exchange rate system to the U.S. macroeconomic policy
package of 1965–1968.2 To finance both the Vietnam conflict and his welfare programs, President Lyndon
Johnson backed an increase in U.S. government spending that was not financed by an increase in taxes. Instead,
it was financed by an increase in the money supply, which led to a rise in price inflation from less than 4
percent in 1966 to close to 9 percent by 1968. At the same time, the rise in government spending had
stimulated the economy. With more money in their pockets, people spent more—particularly on imports—and
the U.S. trade balance began to deteriorate.
e increase in inflation and the worsening of the U.S. foreign trade position gave rise to speculation in the
foreign exchange market that the dollar would be devalued. ings came to a head in spring 1971, when U.S.
trade figures showed that for the first time since 1945, the United States was importing more than it was
exporting. is set off massive purchases of German deutsche marks in the foreign exchange market by
speculators who guessed that the mark would be revalued against the dollar. On a single day, May 4, 1971, the
Bundesbank (Germany’s central bank) had to buy $1 billion to hold the dollar/deutsche mark exchange rate at
its fixed exchange rate, given the great demand for deutsche marks. On the morning of May 5, the Bundesbank
purchased another $1 billion during the first hour of foreign exchange trading! At that point, the Bundesbank
faced the inevitable and allowed its currency to float.
In the weeks following the decision to float the deutsche mark, the foreign exchange market became
increasingly convinced that the dollar would have to be devalued. However, devaluation of the dollar was no
easy matter. Under the Bretton Woods provisions, any other country could change its exchange rates against all
currencies simply by fixing its dollar rate at a new level. But as the key currency in the system, the dollar could
be devalued only if all countries agreed to simultaneously revalue against the dollar. Many countries did not
want this, because it would make their products more expensive relative to U.S. products.
To force the issue, President Richard Nixon announced in August 1971 that the dollar was no longer
convertible into gold. He also announced that a new 10 percent tax on imports would remain in effect until
U.S. trading partners agreed to revalue their currencies against the dollar. is brought the trading partners to
the bargaining table, and in December 1971, an agreement was reached to devalue the dollar by about 8
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percent against foreign currencies. e import tax was then removed. e problem was not solved, however.
e U.S. balance-of-payments position continued to deteriorate throughout 1973, while the nation’s money
supply continued to expand at an inflationary rate. Speculation continued to grow that the dollar was still
overvalued and that a second devaluation would be necessary. In anticipation, foreign exchange
dealers began converting dollars to deutsche marks and other currencies. After a massive wave of
speculation in February 1973, which culminated with European central banks spending $3.6 billion on March
1 to try to prevent their currencies from appreciating against the dollar, the foreign exchange market was closed.
When the foreign exchange market reopened March 19, the currencies of Japan and most European countries
were floating against the dollar, although many developing countries continued to peg their currency to the
dollar, and many do to this day. At that time, the switch to a floating system was viewed as a temporary
response to unmanageable speculation in the foreign exchange market. But it is now more than 40 years since
the Bretton Woods system of fixed exchange rates collapsed, and the temporary solution looks permanent.
e Bretton Woods system had an Achilles’ heel: e system could not work if its key currency, the U.S.
dollar, was under speculative attack. e Bretton Woods system could work only as long as the U.S. inflation
rate remained low and the United States did not run a balance-of-payments deficit. Once these things occurred,
the system soon became strained to the breaking point.
e Floating Exchange Rate Regime
e floating exchange rate regime that followed the collapse of the fixed exchange rate system was formalized in
January 1976, when IMF members met in Jamaica and agreed to the rules for the international monetary
system that are in place today.
THE JAMAICA AGREEMENT
e Jamaica meeting revised the IMF’s Articles of Agreement to reflect the new reality of floating exchange
rates. e main elements of the Jamaica agreement include the following:
Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange
market to even out “unwarranted” speculative fluctuations.
Gold was abandoned as a reserve asset. e IMF returned its gold reserves to members at the current
market price, placing the proceeds in a trust fund to help poor nations. IMF members were permitted to
sell their own gold reserves at the market price.
Total annual IMF quotas—the amount member countries contribute to the IMF—were increased to $41
billion. (Since then, they have been increased to $767 billion, while the membership of the IMF has been
expanded to include 188 countries. Non-oil-exporting, less developed countries were given greater access
to IMF funds.)
EXCHANGE RATES SINCE 1973
Since March 1973, exchange rates have become much more volatile and less predictable than they were between
1945 and 1973.3 is volatility has been partly due to a number of unexpected shocks to the world monetary
system, including:
e oil crisis in 1971, when the Organization of the Petroleum Exporting Countries (OPEC) quadrupled
the price of oil. e harmful effect of this on the U.S. inflation rate and trade position resulted in a
further decline in the value of the dollar.
e loss of confidence in the dollar that followed a sharp rise in the U.S. inflation rate in 1977–1978.
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e oil crisis of 1979, when OPEC once again increased the price of oil dramatically: this time, it was
doubled.
e unexpected rise in the dollar between 1980 and 1985, despite a deteriorating balance-of-payments
picture.
e rapid fall of the U.S. dollar against the Japanese yen and German deutsche mark between 1985 and
1987, and against the yen between 1993 and 1995.
e partial collapse of the European Monetary System in 1992.
e 1997 Asian currency crisis, when the Asian currencies of several countries—including South Korea,
Indonesia, Malaysia, and ailand—lost between 50 and 80 percent of their value against the U.S. dollar
in a few months.
e global financial crisis of 2008–2010 and the sovereign debt crisis in the European Union during
2010–2011.
Figure 11.1 summarizes how the value of the U.S. dollar has fluctuated against an index of trading
currencies between January 1973 and March 2018. (e index, which was set equal to 100 in March 1973, is a
weighted average of the foreign exchange values of the U.S. dollar against a basket of other currencies.) An
interesting phenomenon in Figure 11.1 is the rapid rise in the value of the dollar between 1980 and 1985 and
its subsequent fall between 1985 and 1988. A similar, though less pronounced, rise and fall in the value of the
dollar occurred between 1995 and 2012. You will also notice a sharp uptick in the value of the dollar between
mid-2014 and early 2017. We briefly discuss the rise and fall of the dollar during these periods, because this
tells us something about how the international monetary system has operated in recent years.4
11.1 FIGURE
Major currencies dollar index, 1973–2018.
Source: Data from www.federalreserve.gov.
e rise in the value of the dollar between 1980 and 1985 occurred when the United States was running a
large and growing trade deficit, importing substantially more than it exported. Conventional wisdom would
suggest that the increased supply of dollars in the foreign exchange market as a result of the trade deficit should
lead to a reduction in the value of the dollar, but as shown in Figure 11.1, it increased in value. Why?
A number of favorable factors overcame the unfavorable effect of a trade deficit. Strong economic growth in
the United States attracted heavy inflows of capital from foreign investors seeking high returns on capital assets.
High real interest rates attracted foreign investors seeking high returns on financial assets. At the same time,
political turmoil in other parts of the world, along with relatively slow economic growth in the developed
countries of Europe, helped create the view that the United States was a good place to invest. ese inflows of
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capital increased the demand for dollars in the foreign exchange market, which pushed the value of the dollar
upward against other currencies.
e fall in the value of the dollar between 1985 and 1988 was caused by a combination of government
intervention and market forces. e rise in the dollar, which priced U.S. goods out of foreign markets and
made imports relatively cheap, had contributed to a dismal trade picture. In 1985, the United States posted a
then-record-high trade deficit of more than $160 billion. is led to growth in demands for protectionism in
the United States. In September 1985, the finance ministers and central bank governors of the so-called Group
of Five major industrial countries (Great Britain, France, Japan, Germany, and the United States) met at the
Plaza Hotel in New York City and reached what was later referred to as the Plaza Accord. ey announced that
it would be desirable for most major currencies to appreciate vis-à-vis the U.S. dollar and pledged to intervene
in the foreign exchange markets, selling dollars, to encourage this objective. e dollar had already
begun to weaken during summer 1985, and this announcement further accelerated the decline.
e dollar continued to decline until 1987. e governments of the Group of Five began to worry that the
dollar might decline too far, so the finance ministers of the Group of Five met in Paris in February 1987 and
reached a new agreement known as the Louvre Accord. ey agreed that exchange rates had been realigned
sufficiently and pledged to support the stability of exchange rates around their current levels by intervening in
the foreign exchange markets when necessary to buy and sell currency. Although the dollar continued to decline
for a few months after the Louvre Accord, the rate of decline slowed, and by early 1988, the decline had ended.
Except for a brief speculative flurry around the time of the Persian Gulf War in 1991, the dollar was
relatively stable for the first half of the 1990s. However, in the late 1990s, the dollar again began to appreciate
against most major currencies, including the euro after its introduction, even though the United States was still
running a significant balance-of-payments deficit. Once again, the driving force for the appreciation in the
value of the dollar was that foreigners continued to invest in U.S. financial assets, primarily stocks and bonds,
and the inflow of money drove up the value of the dollar on foreign exchange markets. e inward investment
was due to a belief that U.S. financial assets offered a favorable rate of return.
By 2002, foreigners had started to lose their appetite for U.S. stocks and bonds, and the inflow of money
into the United States slowed. Instead of reinvesting dollars earned from exports to the United States in U.S.
financial assets, they exchanged those dollars for other currencies, particularly euros, to invest them in non-
dollar-denominated assets. One reason for this was the continued growth in the U.S. trade deficit, which hit a
record $791 billion in 2005 (by 2016, it had fallen to $502 billion). Although the U.S. trade deficits had been
setting records for decades, this deficit was the largest ever when measured as a percentage of the country’s GDP
(6.3 percent of GDP in 2005).
e record deficit meant that even more dollars were flowing out of the United States into foreign hands,
and those foreigners were less inclined to reinvest those dollars in the United States at a rate required to keep
the dollar stable. is growing reluctance of foreigners to invest in the United States was in turn due to several
factors. First, there was a slowdown in U.S. economic activity during 2001–2002. Second, the U.S.
government’s budget deficit expanded rapidly after 2001. is led to fears that ultimately the budget deficit
would be financed by an expansionary monetary policy that could lead to higher price inflation. ird, from
2003 onward, U.S. government officials began to “talk down” the value of the dollar, in part because the
administration believed that a cheaper dollar would increase exports and reduce imports, thereby improving the
U.S. balance-of-trade position.5 Foreigners saw this as a signal that the U.S. government would not intervene in
the foreign exchange markets to prop up the value of the dollar, which increased their reluctance to reinvest
dollars earned from export sales in U.S. financial assets. As a result of these factors, demand for dollars
weakened, and the value of the dollar slid on the foreign exchange markets—hitting an index value of 80.5 in
June 2011, the lowest value since the index began in 1973. Some believed that the dollar would have fallen
even further had not oil-producing states recycled the dollars they were earning from sales of crude oil back into
the U.S. economy. At the time, these states were benefiting from high oil prices (oil is priced in U.S. dollars),
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and they chose to invest the dollars they earned back into the United States, rather than selling them for
another currency.
Interestingly, from mid-2008 through early 2009, the dollar staged a moderate rally against major
currencies, despite the fact that the American economy was suffering from a serious financial crisis. e reason
seems to be that despite America’s problems, things were even worse in many other countries, and foreign
investors saw the dollar as a safe haven and put their money in low-risk U.S. assets, particularly low-yielding
U.S. government bonds. is rally faltered in mid-2009 as investors became worried about the level of U.S.
indebtedness. However, between 2014 and early 2017, the dollar yet again increased significantly in value,
primarily because of the strength of the U.S. economy, which had emerged from the great financial crisis of
2008–2009 in better shape than any other major developed nation, with higher economic growth rates and
lower levels of unemployment.
Did You Know?
Did you know that China has recently been trying to stop its currency from falling in value on foreign exchange markets?
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is review tells us that in recent history, both market forces and government intervention have determined
the value of the dollar. Under a floating exchange rate regime, market forces have produced a volatile dollar
exchange rate. Governments have sometimes responded by intervening in the market—buying and selling
dollars—in an attempt to limit the market’s volatility and to correct what they see as overvaluation
(in 1985) or potential undervaluation (in 1987) of the dollar. In addition to direct intervention,
statements from government officials have frequently influenced the value of the dollar. e dollar may not
have declined by as much as it did in 2004, for example, had not U.S. government officials publicly ruled out
any action to stop the decline. Paradoxically, a signal not to intervene can affect the market. e frequency of
government intervention in the foreign exchange market explains why the current system is sometimes thought
of as a managed-float system or a dirty-float system.
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Fixed versus Floating Exchange Rates
e breakdown of the Bretton Woods system has not stopped the debate about the relative merits of fixed
versus floating exchange rate regimes. Disappointment with the system of floating rates in recent years has led
to renewed debate about the merits of fixed exchange rates. is section reviews the arguments for fixed and
floating exchange rate regimes.6 We discuss the case for floating rates before studying why many critics are
disappointed with the experience under floating exchange rates and yearn for a system of fixed rates.
THE CASE FOR FLOATING EXCHANGE RATES
e case in support of floating exchange rates has three main elements: monetary policy autonomy, automatic
trade balance adjustments, and economic recovery following a severe economic crisis.
Monetary Policy Autonomy It is argued that under a fixed system, a country’s ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity. Monetary
expansion can lead to inflation, which puts downward pressure on a fixed exchange rate (as predicted by the
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PPP theory; see Chapter 10). Similarly, monetary contraction requires high interest rates (to reduce the demand
for money). Higher interest rates lead to an inflow of money from abroad, which puts upward pressure on a
fixed exchange rate. us, to maintain exchange rate parity under a fixed system, countries were limited in their
ability to use monetary policy to expand or contract their economies.
Advocates of a floating exchange rate regime argue that removal of the obligation to maintain exchange rate
parity would restore monetary control to a government. If a government faced with unemployment wanted to
increase its money supply to stimulate domestic demand and reduce unemployment, it could do so
unencumbered by the need to maintain its exchange rate. While monetary expansion might lead to inflation,
this would lead to a depreciation in the country’s currency. If PPP theory is correct, the resulting currency
depreciation on the foreign exchange markets should offset the effects of inflation. Although under a floating
exchange rate regime, domestic inflation would have an impact on the exchange rate, it should have no impact
on businesses’ international cost competitiveness due to exchange rate depreciation. e rise in domestic costs
should be exactly offset by the fall in the value of the country’s currency on the foreign exchange markets.
Similarly, a government could use monetary policy to contract the economy without worrying about the need
to maintain parity.
Trade Balance Adjustments Under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade (importing more than it exported) that could not be corrected by domestic policy, this
would require the IMF to agree to currency devaluation. Critics of this system argue that the adjustment
mechanism works much more smoothly under a floating exchange rate regime. ey argue that if a country is
running a trade deficit, the imbalance between the supply and demand of that country’s currency in the foreign
exchange markets (supply exceeding demand) will lead to depreciation in its exchange rate. In turn, by making
its exports cheaper and its imports more expensive, exchange rate depreciation should correct the trade deficit.
Crisis Recovery Advocates of floating exchange rates also argue that exchange rate adjustments can help a country to deal with economic crises. When a country is hit by a severe economic crisis, its currency typically
declines on foreign exchange markets. e reason for this is that investors respond to the crisis by taking their
money out of the country, selling the local currency, and driving down its value. At some point,
however, the currency becomes so cheap that it starts to stimulate exports. is is what occurred in
Iceland after the krona lost 50 percent of its value against the U.S. dollar and euro following a banking crisis in
2008. By 2009, exports of fish and aluminum from Iceland were booming, which helped pull the Icelandic
economy out of a recession. A similar process occurred in South Korean after the 1997 Asian banking crisis.
e value of the South Korean won plunged to 1,700 per dollar from around 800. In turn, the cheap won
helped South Korea increase its exports and resulted in an export-led economic recovery. On the other hand, in
both countries, the declining value of the currency did raise import prices and led to an increase in inflation, so
there is a price that has to be paid for an export-led recovery due to falling currency values.
A contrast can be drawn with the recent situation in Greece, where the economy imploded following the
2008–2009 global financial crisis and has struggled to recover. Part of the problem in Greece is that it gave up
its own currency to adopt the euro in 2001, and the euro has remained quite strong; thus, Greece cannot rely
on a falling local currency to boost exports and stimulate economic recovery.
THE CASE FOR FIXED EXCHANGE RATES
e case for fixed exchange rates rests on arguments about monetary discipline, speculation, uncertainty, and
the lack of connection between the trade balance and exchange rates.
Monetary Discipline We have already discussed the nature of monetary discipline inherent in a fixed exchange rate system when we discussed the Bretton Woods system. e need to maintain fixed exchange rate
parity ensures that governments do not expand their money supplies at inflationary rates. While advocates of
floating rates argue that each country should be allowed to choose its own inflation rate (the monetary
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autonomy argument), advocates of fixed rates argue that governments all too often give in to political pressures
and expand the monetary supply far too rapidly, causing unacceptably high price inflation. A fixed exchange
rate regime would ensure that this does not occur.
Speculation Critics of a floating exchange rate regime also argue that speculation can cause fluctuations in exchange rates. ey point to the dollar’s rapid rise and fall during the 1980s, which they claim had nothing to
do with comparative inflation rates and the U.S. trade deficit but everything to do with speculation. ey argue
that when foreign exchange dealers see a currency depreciating, they tend to sell the currency in the expectation
of future depreciation, regardless of the currency’s longer-term prospects. As more traders jump on the
bandwagon, the expectations of depreciation are realized. Such destabilizing speculation tends to accentuate the
fluctuations around the exchange rate’s long-run value. It can damage a country’s economy by distorting export
and import prices. us, advocates of a fixed exchange rate regime argue that such a system will limit the
destabilizing effects of speculation.
Uncertainty Speculation also adds to the uncertainty surrounding future currency movements that characterizes floating exchange rate regimes. e unpredictability of exchange rate movements in the post–
Bretton Woods era has made business planning difficult, and it adds risk to exporting, importing, and foreign
investment activities. Given a volatile exchange rate, international businesses do not know how to react to the
changes—and often they do not react. Why change plans for exporting, importing, or foreign investment after
a 6 percent fall in the dollar this month, when the dollar may rise 6 percent next month? is uncertainty,
according to the critics, dampens the growth of international trade and investment. ey argue that a fixed
exchange rate, by eliminating such uncertainty, promotes the growth of international trade and investment.
Advocates of a floating system reply that the forward exchange market ensures against the risks associated with
exchange rate fluctuations (see Chapter 10), so the adverse impact of uncertainty on the growth of international
trade and investment has been overstated.
Trade Balance Adjustments and Economic Recovery ose in favor of floating exchange rates argue that floating rates help adjust trade imbalances and can assist with economic recovery after a crisis. Critics
question the closeness of the link between the exchange rate, the trade balance, and economic
growth. ey claim trade deficits are determined by the balance between savings and investment in a
country, not by the external value of its currency.7 ey argue that depreciation in a currency will lead to
inflation (due to the resulting increase in import prices). is inflation, they state, will wipe out any apparent
gains in cost competitiveness that arise from currency depreciation. In other words, a depreciating exchange rate
will not boost exports and reduce imports, as advocates of floating rates claim; it will simply boost price
inflation. In support of this argument, those who favor fixed rates point out that the 40 percent drop in the
value of the dollar between 1985 and 1988 did not correct the U.S. trade deficit. In reply, advocates of a
floating exchange rate regime argue that between 1985 and 1992, the U.S. trade deficit fell from more than
$160 billion to about $70 billion, and they attribute this in part to the decline in the value of the dollar.
Moreover, the experience of countries like South Korea and Iceland seems to suggest that floating rates can help
a country recover from a severe economic crisis.
WHO IS RIGHT?
Which side is right in the vigorous debate between those who favor a fixed exchange rate and those who favor a
floating exchange rate? Economists cannot agree. Business, as a major player on the international trade and
investment scene, has a large stake in the resolution of the debate. Would international business be better off
under a fixed regime, or are flexible rates better? e evidence is not clear.
However, a fixed exchange rate regime modeled along the lines of the Bretton Woods system probably will
not work. Speculation ultimately broke the system, a phenomenon that advocates of fixed rate regimes claim is
associated with floating exchange rates! Nevertheless, a different kind of fixed exchange rate system might be
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more enduring and might foster the stability that would facilitate more rapid growth in international trade and
investment. In the next section, we look at potential models for such a system and the problems with such
systems.
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Exchange Rate Regimes in Practice
LO 11-4 Identify exchange rate regimes used in the world today and why countries adopt different
exchange rate regimes.
Governments around the world pursue a number of different exchange rate policies. ese range from a pure
“free float” in which the exchange rate is determined by market forces to a pegged system that has some aspects
of the pre-1973 Bretton Woods system of fixed exchange rates. Some 21 percent of the IMF’s members allow
their currency to float freely. Another 23 percent intervene in only a limited way (the so-called “managed float”
as practiced by China, among other nations—see the accompanying Country Focus for details). A further 5
percent of IMF members now have no separate legal tender of their own (this figure excludes the European
Union countries that have adopted the euro). ese are typically smaller states, mostly in Africa or the
Caribbean, that have no domestic currency and have adopted a foreign currency as legal tender within their
borders, typically the U.S. dollar or the euro (see the opening case). e remaining countries use more inflexible
systems, including a fixed peg arrangement (43 percent) under which they peg their currencies to other
currencies, such as the U.S. dollar or the euro, or to a basket of currencies. Other countries have adopted a
system under which their exchange rate is allowed to fluctuate against other currencies within a target zone (an
adjustable peg system). In this section, we look more closely at the mechanics and implications of exchange rate
regimes that rely on a currency peg or target zone.
PEGGED EXCHANGE RATES
Under a pegged exchange rate regime, a country will peg the value of its currency to that of a major currency so
that, for example, as the U.S. dollar rises in value, its own currency rises too. Pegged exchange rates are popular
among many of the world’s smaller nations. As with a full fixed exchange rate regime, the great virtue claimed
for a pegged exchange rate is that it imposes monetary discipline on a country and leads to low inflation. For
example, if Belize pegs the value of the Belizean dollar to that of the U.S. dollar so that US$1 = B$1.97, then
the Belizean government must make sure the inflation rate in Belize is similar to that in the United States. If the
Belizean inflation rate is greater than the U.S. inflation rate, this will lead to pressure to devalue the Belizean
dollar (i.e., to alter the peg). To maintain the peg, the Belizean government would be required to rein in
inflation. Of course, for a pegged exchange rate to impose monetary discipline on a country, the country whose
currency is chosen for the peg must also pursue sound monetary policy.
c o u n t r y F O C U S
China’s Exchange Rate Regime
For years, there have been claims from politicians in the United States that the Chinese actively manipulate their
currency, the yuan, keeping its value low against the dollar and other major currencies in order to boost Chinese exports.
In November 2015, for example, presidential hopeful Donald Trump claimed that “the wanton manipulation of China’s
currency” is “robbing Americans of billions of dollars in capital and millions of jobs.” But is this claim true? Would it
even be possible for China to manipulate the foreign exchange markets to artificially depress the value of their currency?
To answer these questions, one needs to look at the history of exchange rate determination for China and understand
something about how the international monetary system actually works.
For most of its history, the Chinese yuan was pegged to the U.S. dollar at a fixed exchange rate. When China started
to open up its economy to foreign trade and investment in the 1980s, the yuan was devalued by the Chinese
government in order to improve the competitiveness of Chinese exports. us, the official yuan/USD pegged exchange
rate was increased from 1.50 yuan per U.S. dollar in 1980 to 8.62 yuan per U.S. dollar in 1994. With China’s exports
growing and the country running a growing current account trade surplus, pressure began to increase for China to let its
currency appreciate. In response, between 1997 and 2005, the exchange rate was fixed at 8.27 yuan per U.S. dollar,
which represented a small appreciation. One could argue that during this period, China’s currency was indeed
undervalued and that this was the result of government policy.
By the 2000s, China’s growing importance in the global economy and the rise of its export-led economy led to calls
for the country to reevaluate its fixed exchange rate policy. In response, in July 2005, the country adopted a managed
floating exchange rate system. Under this system, the exchange rate for the yuan was set with reference to a basket of
foreign currencies that included the U.S. dollar, the euro, the Japanese yen, and the British pound. e daily exchange
rate was allowed to float within a narrow band of 0.3 percent around the central parity. e daily band was extended to
0.5 percent in 2007, 1 percent in 2012, and 2 percent in 2014.
Over time, this managed-float system allowed for the appreciation of the Chinese yuan. For example, against the
U.S. dollar, the exchange rate changed from 8.27 yuan per dollar in mid-2005 to 6.0875 yuan per U.S. dollar on July
20, 2015, representing an appreciation of 26 percent. More generally, the effective exchange rate index of the yuan
against a basket of more than 60 other currencies increased from 86.3 in July 2005 to 123.8 by early 2016, representing
as appreciation of 43 percent. e yuan has appreciated by less than this against the U.S. dollar primarily because the
U.S. dollar has also been relatively strong and appreciated against many other currencies over the same time period.
ese data suggest that rather than artificially trying to keep its currency undervalued, since July 2005, the Chinese
have allowed the yuan to increase in value against other currencies, albeit within the constraints imposed by the
managed float. In late 2015, this commitment was put to the test when a slowdown in the rate of growth of the Chinese
economy led to an outflow of capital from China, which put downward pressure on the yuan. e Chinese responded
by trying to maintain the value of the yuan, using its foreign exchange reserves, which are primarily held in U.S. dollars,
to buy yuan on the open market and shore up its value. Reports suggest that China spent $500 billion in 2015 to shore
up the value of the yuan and more than $1 trillion in 2016. ese actions reduced China’s foreign exchange reserves to
$3.011 trillion by January 2017, the lowest level since 2012. China appears to be trying to keep the yuan from
depreciating below 7 yuan to the U.S. dollar.
One reason for China to protect the value of the yuan against the dollar: A large number of Chinese companies have
dollar-denominated debt. If the yuan falls against the dollar, the price of serving that debt goes up when translated into
yuan. is could stress the financials of those companies (possibly pushing some into bankruptcy) and make it more
difficult for China to hit the government’s economic growth targets. Another reason: China might want to head off
charges from the Trump administration that it continues to keep the value of its currency artificially low.
Sources: T. Hult, “e U.S. Shouldn’t Fret over Cheaper Yuan,” Time, August 14, 2015; “e Yuan and the Markets,” e Economist, January 16, 2016; Madison Gesiotto, “e Negative Effects of China’s Currency Manipulation Explained,” Washington Times, November 13, 2015; Matthew Slaughter, “e Myths of China’s Currency Manipulation,” e Wall Street Journal, January 8, 2016; “e Curious Case of China’s Currency,” e Economist, August 11, 2015; and L. Wei, “China Foreign Exchange Reserves Keep Dropping,” e Wall Street Journal, January 8, 2017.
Evidence shows that adopting a pegged exchange rate regime moderates inflationary pressures in a country.
An IMF study concluded that countries with pegged exchange rates had an average annual inflation rate of 8
percent, compared with 14 percent for intermediate regimes and 16 percent for floating regimes.8 However,
many countries operate with only a nominal peg and in practice are willing to devalue their currency rather
than pursue a tight monetary policy. It can be very difficult for a smaller country to maintain a peg against
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another currency if capital is flowing out of the country and foreign exchange traders are speculating against the
currency. Something like this occurred in 1997, when a combination of adverse capital flows and currency
speculation forced several Asian countries, including ailand and Malaysia, to abandon pegs against the
U.S. dollar and let their currencies float freely. Malaysia and ailand would not have been in this position had
they dealt with a number of problems that began to arise in their economies during the 1990s, including
excessive private-sector debt and expanding current account trade deficits.
CURRENCY BOARDS
Hong Kong’s experience during the 1997 Asian currency crisis added a new dimension to the debate over how
to manage a pegged exchange rate. During late 1997, when other Asian currencies were collapsing, Hong Kong
maintained the value of its currency against the U.S. dollar at about $1 = HK$7.80 despite several concerted
speculative attacks. Hong Kong’s currency board has been given credit for this success. A country that
introduces a currency board commits itself to converting its domestic currency on demand into another
currency at a fixed exchange rate. To make this commitment credible, the currency board holds reserves of
foreign currency equal at the fixed exchange rate to at least 100 percent of the domestic currency issued. e
system used in Hong Kong means its currency must be fully backed by the U.S. dollar at the specified exchange
rate. is is still not a true fixed exchange rate regime because the U.S. dollar—and, by extension, the Hong
Kong dollar—floats against other currencies, but it has some features of a fixed exchange rate regime.
Under this arrangement, the currency board can issue additional domestic notes and coins only when there
are foreign exchange reserves to back it. is limits the ability of the government to print money and, thereby,
create inflationary pressures. Under a strict currency board system, interest rates adjust automatically. If
investors want to switch out of domestic currency into, for example, U.S. dollars, the supply of domestic
currency will shrink. is will cause interest rates to rise until it eventually becomes attractive for investors to
hold the local currency again. In the case of Hong Kong, the interest rate on three-month deposits climbed as
high as 20 percent in late 1997, as investors switched out of Hong Kong dollars and into U.S. dollars. e
dollar peg held, however, and interest rates declined again.
Since its establishment in 1983, the Hong Kong currency board has weathered several storms. is success
persuaded several other countries in the developing world to consider a similar system. Argentina introduced a
currency board in 1991 (but abandoned it in 2002), and Bulgaria, Estonia, and Lithuania have all gone down
this road in recent years. Despite interest in the arrangement, however, critics are quick to point out that
currency boards have their drawbacks.9 If local inflation rates remain higher than the inflation rate in the
country to which the currency is pegged, the currencies of countries with currency boards can become
noncompetitive and overvalued (this is what happened in the case of Argentina, which had a currency board).
Also, under a currency board system, government lacks the ability to set interest rates. Interest rates in Hong
Kong, for example, are effectively set by the U.S. Federal Reserve. In addition, economic collapse in Argentina
in 2001 and the subsequent decision to abandon its currency board dampened much of the enthusiasm for this
mechanism of managing exchange rates.
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Crisis Management by the IMF
LO 11-5 Understand the debate surrounding the role of the IMF in the management of financial crises.
Page 310
Many observers initially believed that the collapse of the Bretton Woods system in 1973 would diminish the
role of the IMF within the international monetary system. e IMF’s original function was to provide a pool of
money from which members could borrow, short term, to adjust their balance-of-payments position and
maintain their exchange rate. Some believed the demand for short-term loans would be considerably
diminished under a floating exchange rate regime. A trade deficit would presumably lead to a decline in a
country’s exchange rate, which would help reduce imports and boost exports. No temporary IMF adjustment
loan would be needed. Consistent with this, after 1973, most industrialized countries tended to let the foreign
exchange market determine exchange rates in response to demand and supply. Since the early 1970s, the rapid
development of global capital markets has generally allowed developed countries such as Great Britain and the
United States to finance their deficits by borrowing private money, as opposed to drawing on IMF funds.
Despite these developments, the activities of the IMF have expanded over the past 30 years. By 2018, the
IMF had 189 members, around 40 of which had some kind of IMF program in place. In 1997, the institution
implemented its largest rescue packages until that date, committing more than $110 billion in short-term loans
to three troubled Asian countries—South Korea, Indonesia, and ailand. is was followed by additional IMF
rescue packages in Turkey, Russia, Argentina, and Brazil. IMF loans increased again in late 2008 as the global
financial crisis took hold. Between 2008 and 2010, the IMF made more than $100 billion in loans to troubled
economies such as Latvia, Greece, and Ireland. In April 2009, in response to the growing financial crisis, major
IMF members agreed to triple the institution’s resources from $250 billion to $750 billion, thereby
giving the IMF the financial leverage to act aggressively in times of global financial crisis.
e IMF’s activities have expanded because periodic financial crises have continued to hit many economies
in the post–Bretton Woods era. e IMF has repeatedly lent money to nations experiencing financial crises,
requesting in return that the governments enact certain macroeconomic policies. Critics of the IMF claim these
policies have not always been as beneficial as the IMF might have hoped and, in some cases, may have made
things worse. Following the IMF loans to several Asian economies, these criticisms reached new levels, and a
vigorous debate was waged as to the appropriate role of the IMF. In this section, we discuss some of the main
challenges the IMF has had to deal with over the past three decades and review the ongoing debate over the role
of the IMF.
FINANCIAL CRISES IN THE POST–BRETTON WOODS ERA
A number of broad types of financial crises have occurred over the past 30 years, many of which have required
IMF involvement. A currency crisis occurs when a speculative attack on the exchange value of a currency
results in a sharp depreciation in the value of the currency or forces authorities to expend large volumes of
international currency reserves and sharply increase interest rates to defend the prevailing exchange rate. is
happened in Brazil in 2002, and the IMF stepped in to help stabilize the value of the Brazilian currency on
foreign exchange markets by lending it foreign currency. A banking crisis refers to a loss of confidence in the
banking system that leads to a run on banks, as individuals and companies withdraw their deposits. is is what
happened in Iceland in 2008. e experience of Iceland with the IMF is discussed in depth in the
accompanying Country Focus. A foreign debt crisis is a situation in which a country cannot service its foreign
debt obligations, whether private-sector or government debt. is happened to Greece, Ireland, and Portugal in
2010.
c o u n t r y F O C U S
e IMF and Iceland’s Economic Recovery
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When the global financial crisis hit in 2008, tiny Iceland suffered more than most. e country’s three biggest banks had
been expanding at a breakneck pace since 2000, when the government privatized the banking sector. With a population
of around 320,000, Iceland was too small for the banking sector’s ambitions, so the banks started to expand into other
Scandinavian countries and the United Kingdom. ey entered local mortgage markets, purchased foreign financial
institutions, and opened foreign branches—attracting depositors by offering high interest rates. e expansion was
financed by debt, much of it structured as short-term loans that had to be regularly refinanced. By early 2008, the three
banks held debts that amounted to almost six times the value of the entire economy of Iceland! So long as they could
periodically refinance this debt, it was not a problem. However, in 2008, global financial markets imploded following
the bankruptcy of Lehman Brothers and the collapse of the U.S. housing market. In the aftermath, financial markets
froze. e Icelandic banks found that they could not refinance their debt, and they faced bankruptcy.
e Icelandic government lacked the funds to bail out the banks, so it decided to let the big three fail. In quick
succession, the local stock market plunged 90 percent, and unemployment increased ninefold. e krona, Iceland’s
currency, plunged on foreign exchange markets, pushing up the price of imports, and inflation soared to 18 percent.
Iceland appeared to be in free fall. e economy shrank by almost 7 percent in 2009 and another 4 percent in 2010.
To stem the decline, the government secured $10 billion in loans from the International Monetary Fund (IMF) and
other countries. e Icelandic government stepped in to help local depositors, seizing the domestic assets of the
Icelandic banks and using IMF and other loans to backstop deposit guarantees. Far from implementing austerity
measures to solve the crisis, the Icelandic government looked for ways to shore up consumer spending. For example, the
government provided means-tested subsidies to reduce the mortgage interest expenses of borrowers. e idea was to stop
domestic consumer spending from imploding and further depressing the economy.
With the financial system stabilized, thanks to the IMF and other foreign loans, what happened next is an object
lesson in the value of having a floating currency. e fall in the value of the krona helped boost Iceland’s exports, such as
fish and aluminum, while depressing demand for costly imports, such as automobiles. By 2009, the krona was worth
half as much against the U.S. dollar and euro as it was in 2007 before the crisis. Iceland’s exports surged and imports
slumped. While the high cost of imports did stoke inflation, booming exports started to pump money back into the
Icelandic economy. In 2011, the economy grew again at a 3.1 percent annual rate. is was followed by 2.7 percent
growth in 2012 and 4 percent growth in 2013, while unemployment fell from a high of nearly 10 percent to 4.4 percent
at the end of 2013.
Sources: Charles Forelle, “In European Crisis, Iceland Emerges as an Island of Recovery,” e Wall Street Journal, May 19, 2012, pp. A1, A10; “Coming in from the Cold,” e Economist, December 16, 2010; Charles Duxbury, “Europe Gets Cold Shoulder in Iceland,” e Wall Street Journal, April 26, 2012; and “Iceland,” e World Factbook 2013 (Washington, DC: Central Intelligence Agency, 2013).
ese crises tend to have common underlying macroeconomic causes: high relative price inflation
rates, a widening current account deficit, excessive expansion of domestic borrowing, high
government deficits, and asset price inflation (such as sharp increases in stock and property prices).10 At times,
elements of currency, banking, and debt crises may be present simultaneously, as in the 1997 Asian crisis, the
2000–2002 Argentinean crisis, and the 2010 crisis in Ireland.
To assess the frequency of financial crises, the IMF looked at the macroeconomic performance of a group of
53 countries from 1975 to 1997 (22 of these countries were developed nations, and 31 were developing
countries).11 e IMF found there had been 158 currency crises, including 55 episodes in which a country’s
currency declined by more than 25 percent. ere were also 54 banking crises. e IMF’s data suggest that
developing nations were more than twice as likely to experience currency and banking crises as developed
nations. It is not surprising, therefore, that most of the IMF’s loan activities since the mid-1970s have been
targeted toward developing nations.
In 1997, several Asian currencies started to fall sharply as international investors came to the realization that
there was a speculative investment bubble in the region. ey took their money out of local currencies,
changing it into U.S. dollars, and those currencies started to fall precipitously. e currency declines started in
ailand and then, in a process of contagion, quickly spread to other countries in the region. Stabilizing those
currencies required massive help from the IMF. In the case of South Korea, local enterprises had built up huge
debt loads as they invested heavily in new industrial capacity. By 1997, they found they had too much
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industrial capacity and could not generate the income required to service their debt. South Korean banks and
companies had also made the mistake of borrowing in dollars, much of it in the form of short-term loans that
would come due within a year. us, when the Korean won started to decline in fall 1997 in sympathy with the
problems elsewhere in Asia, South Korean companies saw their debt obligations balloon. Several large
companies were forced to file for bankruptcy. is triggered a decline in the South Korean currency and stock
market that was difficult to halt.
With its economy on the verge of collapse, the South Korean government requested $20 billion in standby
loans from the IMF on November 21. As the negotiations progressed, it became apparent that South Korea was
going to need far more than $20 billion. On December 3, 1997, the IMF and South Korean
government reached a deal to lend $55 billion to the country. e agreement with the IMF called for
the South Koreans to open their economy and banking system to foreign investors. South Korea also pledged to
restrain Korea’s largest enterprises, the chaebol, by reducing their share of bank financing and requiring them to
publish consolidated financial statements and undergo annual independent external audits. On trade
liberalization, the IMF said South Korea would comply with its commitments to the World Trade Organization
to eliminate trade-related subsidies and restrictive import licensing and would streamline its import certification
procedures, all of which should open the South Korean economy to greater foreign competition.12
e IMF Managing Director Christine Lagarde addresses the Development Committee at the
World Bank Headquarters in Washington, DC.
©Stephen Jaffe/IMF/Getty Images
EVALUATING THE IMF’S POLICY PRESCRIPTIONS
By 2018, the IMF had programs in around 40 countries that were struggling with economic and/or currency
problems. All IMF loan packages come with conditions attached. Until very recently, the IMF has always
insisted on a combination of tight macroeconomic policies, including cuts in public spending, higher interest
rates, and tight monetary policy. It has also often pushed for the deregulation of sectors formerly protected
from domestic and foreign competition, privatization of state-owned assets, and better financial reporting from
the banking sector. ese policies are designed to cool overheated economies by reining in inflation and
reducing government spending and debt. is set of policy prescriptions has come in for tough criticisms from
many observers, and the IMF itself has started to modify its approach.13
Page 313
Inappropriate Policies One criticism is that the IMF’s traditional policy prescriptions represent a “one- size-fits-all” approach to macroeconomic policy that is inappropriate for many countries. In the case of the
1997 Asian crisis, critics argue that the tight macroeconomic policies imposed by the IMF were not well suited
to countries that are suffering not from excessive government spending and inflation but from a private-sector
debt crisis with deflationary undertones.14
In South Korea, for example, the government had been running a budget surplus for years (it was 4 percent
of South Korea’s GDP in 1994–1996), and inflation was low at about 5 percent. South Korea had the second-
strongest financial position of any country in the Organisation for Economic Co-operation and Development.
Despite this, critics say, the IMF insisted on applying the same policies that it applies to countries suffering
from high inflation. e IMF required South Korea to maintain an inflation rate of 5 percent. However, given
the collapse in the value of its currency and the subsequent rise in price for imports such as oil, critics claimed
inflationary pressures would inevitably increase in South Korea. So to hit a 5 percent inflation rate, the South
Koreans would be forced to apply an unnecessarily tight monetary policy. Short-term interest rates in South
Korea did jump from 12.5 to 21 percent immediately after the country signed its initial deal with the IMF.
Increasing interest rates made it even more difficult for companies to service their already excessive short-term
debt obligations, and critics used this as evidence to argue that the cure prescribed by the IMF might actually
increase the probability of widespread corporate defaults, not reduce them.
At the time, the IMF rejected this criticism. According to the IMF, the central task was to rebuild confidence
in the won. Once this was achieved, the won would recover from its oversold levels, reducing the size of South
Korea’s dollar-denominated debt burden when expressed in won and making it easier for companies to service
their debt. e IMF also argued that by requiring South Korea to remove restrictions on foreign direct
investment, foreign capital would flow into the country to take advantage of cheap assets. is, too, would
increase demand for the Korean currency and help improve the dollar/won exchange rate.
South Korea did recover fairly quickly from the crisis, supporting the position of the IMF. While the
economy contracted by 7 percent in 1998, by 2000, it had rebounded and grew at a 9 percent rate (measured
by growth in GDP). Inflation, which peaked at 8 percent in 1998, fell to 2 percent by 2000, and
unemployment fell from 7 to 4 percent over the same period. e won hit a low of $1 = W1,812 in early 1998
but by 2000 was back to an exchange rate of around $1 = W1,200, at which it seems to have stabilized.
Moral Hazard A second criticism of the IMF is that its rescue efforts are exacerbating a problem known to economists as moral hazard. Moral hazard arises when people behave recklessly because they know
they will be saved if things go wrong. Critics point out that many Japanese and Western banks were
far too willing to lend large amounts of capital to overleveraged Asian companies during the boom years of the
1990s. ese critics argue that the banks should now be forced to pay the price for their rash lending policies,
even if that means some banks must close.15 Only by taking such drastic action, the argument goes, will banks
learn the error of their ways and not engage in rash lending in the future. By providing support to these
countries, the IMF is reducing the probability of debt default and in effect bailing out the banks whose loans
gave rise to this situation.
is argument ignores two critical points. First, if some Japanese or Western banks with heavy exposure to
the troubled Asian economies were forced to write off their loans due to widespread debt default, the impact
would have been difficult to contain. e failure of large Japanese banks, for example, could have triggered a
meltdown in the Japanese financial markets. at would almost inevitably lead to a serious decline in stock
markets around the world, which was the very risk the IMF was trying to avoid by stepping in with financial
support. Second, it is incorrect to imply that some banks have not had to pay the price for rash lending policies.
e IMF insisted on the closure of banks in South Korea, ailand, and Indonesia after the 1997 Asian
financial crisis. Foreign banks with short-term loans outstanding to South Korean enterprises have been forced
by circumstances to reschedule those loans at interest rates that do not compensate for the extension of the loan
maturity.
Page 314
Lack of Accountability e final criticism of the IMF is that it has become too powerful for an institution that lacks any real mechanism for accountability.16 e IMF has determined macroeconomic policies in those
countries, yet according to critics such as noted economist Jeffrey Sachs, the IMF, with a staff of less than 1,000,
lacks the expertise required to do a good job. Evidence of this, according to Sachs, can be found in the fact that
the IMF was singing the praises of the ai and South Korean governments only months before both countries
lurched into crisis. en the IMF put together a draconian program for South Korea without having deep
knowledge of the country. Sachs’s solution to this problem is to reform the IMF so it makes greater use of
outside experts and its operations are open to greater outside scrutiny.
Observations As with many debates about international economics, it is not clear which side is correct about the appropriateness of IMF policies. ere are cases where one can argue that IMF policies had been
counterproductive or only had limited success. For example, one might question the success of the IMF’s
involvement in Turkey given that the country has had to implement some 18 IMF programs since 1958! But
the IMF can also point to some notable accomplishments, including its success in containing the Asian crisis,
which could have rocked the global international monetary system to its core, and its actions in 2008–2010 to
contain the global financial crisis, quickly stepping in to rescue Iceland, Ireland, Greece, and Latvia. Similarly,
many observers give the IMF credit for its deft handling of politically difficult situations, such as the Mexican
peso crisis, and for successfully promoting a free market philosophy.
Several years after the IMF’s intervention, the economy of Asia recovered. Certainly, the kind of catastrophic
implosion that might have occurred had the IMF not stepped in had been averted, and although some
countries still faced considerable problems, it is not clear that the IMF should take much blame for this. e
IMF cannot force countries to adopt the policies required to correct economic mismanagement. While a
government may commit to taking corrective action in return for an IMF loan, internal political problems may
make it difficult for a government to act on that commitment. In such cases, the IMF is caught between a rock
and a hard place, because if it decided to withhold money, it might trigger financial collapse and the kind of
contagion that it seeks to avoid.
Finally, it is notable that in recent years the IMF has started to change its policies. In response to the global
financial crisis of 2008–2009, the IMF began to urge countries to adopt policies that included fiscal stimulus
and monetary easing—the direct opposite of what the fund traditionally advocated. Some economists in the
fund are also now arguing that higher inflation rates might be a good thing, if the consequence is greater
growth in aggregate demand, which would help pull nations out of recessionary conditions. e IMF, in other
words, is starting to display the very flexibility in policy responses that its critics claim it lacks. While
the traditional policy of tight controls on fiscal policy and tight monetary policy targets might be
appropriate for countries suffering from high inflation rates, the Asian economic crisis and the 2008–2009
global financial crisis were caused not by high inflation rates but by excessive debt, and the IMF’s “new
approach” seems tailored to deal with this.17
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Focus on Managerial Implications
CURRENCY MANAGEMENT, BUSINESS STRATEGY, AND GOVERNMENT RELATIONS
Page 315
LO 11-6 Explain the implications of the global monetary system for management practice.
e implications for international businesses of the material discussed in this chapter fall into three main areas:
currency management, business strategy, and corporate–government relations.
Currency Management An obvious implication with regard to currency management is that companies must recognize that the foreign exchange market does not work quite as depicted in Chapter 10. e current
system is a mixed system in which a combination of government intervention and speculative activity can drive
the foreign exchange market. Companies engaged in significant foreign exchange activities need to be aware of
this and to adjust their foreign exchange transactions accordingly. For example, the currency management unit
of Caterpillar claims it made millions of dollars in the hours following the announcement of the Plaza Accord
by selling dollars and buying currencies that it expected to appreciate on the foreign exchange market following
government intervention.
Under the present system, speculative buying and selling of currencies can create very volatile movements in
exchange rates (as exhibited by the rise and fall of the dollar during the 1980s and the Asian currency crisis of
the late 1990s). Contrary to the predictions of the purchasing power parity theory (see Chapter 10), exchange
rate movements during the 1980s and 1990s often did not seem to be strongly influenced by relative inflation
rates. Insofar as volatile exchange rates increase foreign exchange risk, this is not good news for business. On the
other hand, as we saw in Chapter 10, the foreign exchange market has developed a number of instruments,
such as the forward market and swaps, that can help ensure against foreign exchange risk. Not surprisingly, use
of these instruments has increased markedly since the breakdown of the Bretton Woods system in 1973.
Business Strategy e volatility of the current global exchange rate regime presents a conundrum for international businesses. Exchange rate movements are difficult to predict, and yet their movement can have a
major impact on a business’s competitive position. For a detailed example, see the accompanying Management
Focus on Airbus. Faced with uncertainty about the future value of currencies, firms can utilize the forward
exchange market, which Airbus has done. However, the forward exchange market is far from perfect as a
predictor of future exchange rates (see Chapter 10). It is also difficult, if not impossible, to get adequate
insurance coverage for exchange rate changes that might occur several years in the future. e forward market
tends to offer coverage for exchange rate changes a few months—not years—ahead. Given this, it makes sense
to pursue strategies that will increase the company’s strategic flexibility in the face of unpredictable exchange
rate movements—that is, to pursue strategies that reduce the economic exposure of the firm (which we first
discussed in Chapter 10).
Maintaining strategic flexibility can take the form of dispersing production to different locations around the
globe as a real hedge against currency fluctuations (this seems to be what Airbus has considered). Consider the
case of Daimler-Benz, Germany’s export-oriented automobile and aerospace company. In June 1995, the
company stunned the German business community when it announced it expected to post a severe loss in 1995
of about $720 million. e cause was Germany’s strong currency, which had appreciated by 4 percent against a
basket of major currencies since the beginning of 1995 and had risen by more than 30 percent against the U.S.
dollar since late 1994. By mid-1995, the exchange rate against the dollar stood at $1 = DM1.38.
Daimler’s management believed it could not make money with an exchange rate under $1 =
DM1.60. Daimler’s senior managers concluded the appreciation of the mark against the dollar was probably
permanent, so they decided to move substantial production outside of Germany and increase purchasing of
foreign components. e idea was to reduce the vulnerability of the company to future exchange rate
movements. Even before the company’s acquisition of Chrysler Corporation in 1998, the Mercedes-Benz
division planned to produce 10 percent of its cars outside Germany by 2000, mostly in the United States.
Similarly, the move by Japanese automobile companies to expand their productive capacity in the United States
and Europe can be seen in the context of the increase in the value of the yen between 1985 and 1995, which
raised the price of Japanese exports. For the Japanese companies, building production capacity overseas was a
hedge against continued appreciation of the yen (as well as against trade barriers).
m a n a g e m e n t F O C U S
Airbus and the Euro
Airbus had reason to celebrate in 2003; for the first time in the company’s history, it delivered more commercial jet
aircraft than long-time rival Boeing. Airbus delivered 305 planes in 2003, compared to Boeing’s 281. e celebration,
however, was muted because the strength of the euro against the U.S. dollar was casting a cloud over the company’s
future. Airbus, which is based in Toulouse, France, prices planes in dollars, just as Boeing has always done. But more
than half of Airbus’s costs are in euros. So as the dollar drops in value against the euro—and it dropped by more than 50
percent between 2002 and the end of 2009—Airbus’s costs rise in proportion to its revenue, squeezing profits in the
process.
In the short run, the fall in the value of the dollar against the euro did not hurt Airbus. e company fully hedged its
dollar exposure in 2005 and was mostly hedged for 2006. However, anticipating that the dollar would stay weak against
the euro, Airbus started to take other steps to reduce its economic exposure to a strong European currency. Recognizing
that raising prices is not an option given the strong competition from Boeing, Airbus decided to focus on reducing its
costs. As a step toward doing this, Airbus gave U.S. suppliers a greater share of work on new aircraft models, such as the
A380 superjumbo and the A350. It also shifted supply work on some of its older models from European to American-
based suppliers. is increased the proportion of its costs that were in dollars, making profits less vulnerable to a rise in
the value of the euro and reducing the costs of building an aircraft when they were converted back into euros.
In addition, Airbus pushed its European-based suppliers to start pricing in U.S. dollars. Because the costs of many
suppliers were in euros, the suppliers found that to comply with Airbus’s wishes, they too had to move more work to the
United States or to countries whose currency is pegged to the U.S. dollar. us, one large French-based supplier, Zodiac,
announced that it was considering acquisitions in the United States. Not only was Airbus pushing suppliers to price
components for commercial jet aircraft in dollars, but the company was also requiring suppliers to its A400M program,
a military aircraft that will be sold to European governments and priced in euros, to price components in U.S. dollars.
Beyond these steps, the CEO of EADS, Airbus’s parent company, publicly stated it might be prepared to assemble
aircraft in the United States if that would help win important U.S. contracts. While this strategy made good sense for
years, it worked against Airbus between mid-2014 and 2015 as the dollar rose rapidly against the euro.
Aircraft factory assembly line.
©Xenotar/Getty Images
Sources: D. Michaels, “Airbus Deliveries Top Boeing’s; But Several Obstacles Remain,” e Wall Street Journal, January 16, 2004, p. A9; J. L. Gerondeau, “Airbus Eyes U.S. Suppliers as Euro Gains,” Seattle Times, February 21, 2004, p. C4; “Euro’s Gains Create Worries in Europe,” HoustonChronicle.com, January 13, 2004, 3; and K. Done, “Soft Dollar and A380 Hitches Lead to EADS Losses,” Financial Times, November 9, 2006, p. 32.
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Another way of building strategic flexibility and reducing economic exposure involves contracting out
manufacturing. is allows a company to shift suppliers from country to country in response to changes in
relative costs brought about by exchange rate movements. However, this kind of strategy may work only for
low-value-added manufacturing (e.g., textiles), in which the individual manufacturers have few if any firm-
specific skills that contribute to the value of the product. It may be less appropriate for high-value-added
manufacturing, in which firm-specific technology and skills add significant value to the product (e.g.,
the heavy equipment industry) and in which switching costs are correspondingly high. For high-
value-added manufacturing, switching suppliers will lead to a reduction in the value that is added, which may
offset any cost gains arising from exchange rate fluctuations.
e roles of the IMF and the World Bank in the current international monetary system also have
implications for business strategy. Increasingly, the IMF has been acting as the macroeconomic police of the
world economy, insisting that countries seeking significant borrowings adopt IMF-mandated macroeconomic
policies. ese policies typically include anti-inflationary monetary policies and reductions in government
spending. In the short run, such policies usually result in a sharp contraction of demand. International
businesses selling or producing in such countries need to be aware of this and plan accordingly. In the long run,
the kind of policies imposed by the IMF can promote economic growth and an expansion of demand, which
create opportunities for international business.
Corporate–Government Relations As major players in the international trade and investment environment, businesses can influence government policy toward the international monetary system. For
example, intense government lobbying by U.S. exporters helped convince the U.S. government that
intervention in the foreign exchange market was necessary. With this in mind, business can and should use its
influence to promote an international monetary system that facilitates the growth of international trade and
investment. Whether a fixed or floating regime is optimal is a subject for debate. However, exchange rate
volatility such as the world experienced during the 1980s and 1990s creates an environment less conducive to
international trade and investment than one with more stable exchange rates. erefore, it would seem to be in
the interests of international business to promote an international monetary system that minimizes volatile
exchange rate movements, particularly when those movements are unrelated to long-run economic
fundamentals.
Key Terms
international monetary system, p. 296
floating exchange rate, p. 296
pegged exchange rate, p. 296
managed-float system, p. 296
dirty-float system, p. 296
fixed exchange rate, p. 297
European Monetary System (EMS), p. 297
dollarization, p. 297
gold standard, p. 298
gold par value, p. 298
balance-of-trade equilibrium, p. 298
currency board, p. 309
currency crisis, p. 310
banking crisis, p. 310
foreign debt crisis, p. 310
moral hazard, p. 312
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Summary
is chapter explained the workings of the international monetary system and pointed out its implications for
international business. e chapter made the following points:
1. e gold standard is a monetary standard that pegs currencies to gold and guarantees convertibility to
gold. It was thought that the gold standard contained an automatic mechanism that contributed to the
simultaneous achievement of a balance-of-payments equilibrium by all countries. e gold standard
broke down during the 1930s as countries engaged in competitive devaluations.
2. e Bretton Woods system of fixed exchange rates was established in 1944. e U.S. dollar was the
central currency of this system; the value of every other currency was pegged to its value. Significant
exchange rate devaluations were allowed only with the permission of the International Monetary Fund
(IMF). e role of the IMF was to maintain order in the international monetary system (a) to avoid a
repetition of the competitive devaluations of the 1930s and (b) to control price inflation by imposing
monetary discipline on countries.
3. e fixed exchange rate system collapsed in 1973, primarily due to speculative pressure on the
dollar following a rise in U.S. inflation and a growing U.S. balance-of-trade deficit.
4. Since 1973, the world has operated with a floating exchange rate regime, and exchange rates have become
more volatile and far less predictable. Volatile exchange rate movements have helped reopen the debate
over the merits of fixed and floating systems.
5. e case for a floating exchange rate regime claims (a) such a system gives countries autonomy regarding
their monetary policy and (b) floating exchange rates facilitate smooth adjustment of trade imbalances.
6. e case for a fixed exchange rate regime claims (a) the need to maintain a fixed exchange rate imposes
monetary discipline on a country; (b) floating exchange rate regimes are vulnerable to speculative
pressure; (c) the uncertainty that accompanies floating exchange rates dampens the growth of
international trade and investment; and (d) far from correcting trade imbalances, depreciating a currency
on the foreign exchange market tends to cause price inflation.
7. In today’s international monetary system, some countries have adopted floating exchange rates; some have
pegged their currency to another currency, such as the U.S. dollar; and some have pegged their currency
to a basket of other currencies, allowing their currency to fluctuate within a zone around the basket.
8. In the post–Bretton Woods era, the IMF has continued to play an important role in helping countries
navigate their way through financial crises by lending significant capital to embattled governments and by
requiring them to adopt certain macroeconomic policies.
9. An important debate is occurring over the appropriateness of IMF-mandated macroeconomic policies.
Critics charge that the IMF often imposes inappropriate conditions on developing nations that are the
recipients of its loans.
10. e current managed-float system of exchange rate determination has increased the importance of
currency management in international businesses.
11. e volatility of exchange rates under the current managed-float system creates both opportunities and
threats. One way of responding to this volatility is for companies to build strategic flexibility and limit
their economic exposure by dispersing production to different locations around the globe by contracting
out manufacturing (in the case of low-value-added manufacturing) and other means.
Critical inking and Discussion Questions
1. Why did the gold standard collapse? Is there a case for returning to some type of gold standard? What is
it?
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2. What opportunities might current IMF lending policies to developing nations create for international
businesses? What threats might they create?
3. Do you think the standard IMF policy prescriptions of tight monetary policy and reduced government
spending are always appropriate for developing nations experiencing a currency crisis? How might the
IMF change its approach? What would the implications be for international businesses?
4. Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an
international business, what are the most important criteria in a choice between the systems? Which
system is the more desirable for an international business?
5. Imagine that Canada, the United States, and Mexico decide to adopt a fixed exchange rate system. What
would be the likely consequences of such a system for (a) international businesses and (b) the flow of
trade and investment among the three countries?
6. Reread the Country Focus “e IMF and Iceland’s Economic Recovery,” and then answer the following
questions:
a. What were the main causes of Iceland's economic troubles in 2008?
b. Was Iceland facing a classic currency crisis, or was this a banking crisis?
c. How did Iceland recover from its 2008–2009 crisis? What are the important lessons to draw from this
case?
d. Iceland did not implement the austerity policies that are so often associated with IMF loans, and yet
the economy recovered. Does this suggest that austerity policies do not work?
7. Reread the Country Focus “China’s Exchange Rate Regime,” and then answer the following questions:
a. Why do you think that the Chinese historically pegged the value of the yuan to the U.S. dollar?
b. Why did the Chinese move to a managed-float system in 2005?
c. What are the benefits that China might gain by allowing the yuan to float freely against other major
currencies such as the U.S. dollar and the euro? What are the risks? What do you think they should
do?
d. Is there any evidence that the Chinese kept the level of their currency artificially low in the past to
boost exports? Is China keeping it artificially low today?
e. What policy stance should the United States and the EU adopt toward China with regard to how it
manages the value of its currency?
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. e Global Financial Stability Report is a semiannual report published by the International Capital
Markets division of the International Monetary Fund. e report includes an assessment of the risks
facing the global financial markets. Locate and download the latest report to get an overview of the most
important issues currently under discussion. Also, download a report from five years ago. How do issues
from five years ago compare with financial issues identified in the current report?
2. An important element to understanding the international monetary system is keeping updated on current
growth trends worldwide. A German colleague told you yesterday that Deutsche Bank Research provides
an effective way to stay informed on important topics in international finance from a European
perspective. One area of focus for the site is emerging markets and economic and financial challenges
faced by these markets. Find an emerging market research report for analysis. On which emerging market
region did you choose to focus? What are the key takeaways from your chosen report?
E g y p t a n d t h e I M F
c l o s i n g c a s e
When President Abdel Fatah al-Sissi came to power in a 2013 military coup, he promised to fix Egypt’s mounting
economic problems. ree years later, those problems had only intensified. e country was struggling with low
economic growth; 13 percent unemployment; a 12 percent inflation rate; a large trade deficit, amounting to 7 percent of
GDP; a persistent budget deficit of around 12 percent of GDP; and public debt, which by 2016 stood at 92 percent of
GDP. e tourism trade, a major source of foreign currency, had collapsed in the wake of concerns about terrorism,
which included an Islamic State–linked insurgency in the Sinai Peninsula that claimed the bombing of a Russian
passenger jet in 2016. Foreign direct investment, another source of foreign currency, had also slumped in the wake of
Egypt’s economic and political problems.
One major issue was a lack of foreign currency in the country, which made it difficult to pay for imports and resulted
in shortages of key commodities. For example, Egypt imports one-third of its sugar. By mid-2016, this commodity was
in short supply due to the inability of Egyptian traders to get the foreign currency required to pay for imported sugar.
Historically, in times of trouble, the oil-rich Arab states of the Persian Gulf had loaned foreign currency to Egypt at low
interest rates, but a collapse in oil prices had left those states financially strained, and loans were not forthcoming. In an
indication of the depth of Egypt’s problems, while the official exchange rate of the Egyptian pound was pegged at 9
pounds to the U.S. dollar, the black market rate had soared to 18 pounds to the dollar.
In mid-2016, with its foreign exchange reserves being rapidly depleted, the Egyptian government applied to the IMF
for a loan. e IMF agreed to loan Egypt up to $12 billion, but only if the government undertook a number of
economic reforms. ese included liberalizing the exchange rate, letting the Egyptian pound float against other
currencies. e thinking was that the pound would immediately depreciate against major currencies such as the U.S.
dollar and the euro, making Egyptian exports cheaper and its imports more expensive. is should help the country to
improve its trade deficit and earn more foreign currency. At the same time, the IMF required the Egyptian government
to implement an austerity program that included an immediate end to energy subsidies, which had kept energy prices
artificially low; reforms to public enterprises to make them more efficient; tighter monetary policy to rein in inflation;
and the imposition of a value-added tax to raise government revenues.
©Baloncici/Shutterstock
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In November 2016, Egypt let the pound float freely. It immediately lost 50 percent of its value against the U.S.
dollar, trading at around 13 pounds to the dollar. e depreciation continued into the new year, with the pound falling
to 19 pounds to the dollar by mid-January 2017, bringing the official exchange rate and the black market rate into
equality. Egypt also moved rapidly to impose the value-added tax. In return, the IMF released the first $2.75 billion of
its loan to Egypt. Further tranches of the loan will be released as Egypt makes progress on the economic reforms
advocated by the IMF.
Only time will tell if these policies will work. In addition to a fall in the value of the pound, the immediate impact
included a surge in the annual inflation rate to around 20 percent. e IMF envisages the inflation rate falling to 7
percent within three years, while there should be sharp improvements in both the trade deficit and the budget deficit.
However, the planned austerity measures carry significant political risks for the Egyptian government. If protests
materialize over short-term hardships, the government might cave in to political pressure and pull back from the IMF-
mandated reforms. If that happens, the IMF might withhold further installments under the loan program, and the
Egyptian economy could continue to deteriorate.
Sources: Heba Mahfouz and Paul Schemm, “Struggling Egypt Devalues Currency by Almost 50% Ahead of IMF Loan,” e Washington Post,
November 3, 2016; Lin Noueihed and Ahmed Aboulenein, “Egypt on Track to Receive IMF Loan’s Second Tranche,” Reuters, January 18, 2017;
“State of Denial,” e Economist, August 6, 2016; and CIA World Fact Book, Egypt, accessed February 2017.
CASE DISCUSSION QUESTIONS
1. What was the root cause of Egypt’s economic problems?
2. Was it appropriate for Egypt to bring in the IMF? What other alternatives did they have?
3. Do you think that the policy measures required by the IMF are appropriate? What are these policy
measures designed to do? What might be the unintended consequences of these measures?
4. As a potential foreign investor, at what point would you be willing to invest in the Egyptian economy?
To what extent would policies imposed by the IMF influence your decision?
Endnotes
1. e argument goes back to eighteenth-century philosopher David Hume. See D. Hume, “On the
Balance of Trade,” reprinted in e Gold Standard in eory and in History, ed. B. Eichengreen (London:
Methuen, 1985).
2. R. Solomon, e International Monetary System, 1945–1981 (New York: Harper & Row, 1982).
3. International Monetary Fund, World Economic Outlook, 2005 (Washington, DC: IMF, May 2005).
4. For an extended discussion of the dollar exchange rate in the 1980s, see B. D. Pauls, “US Exchange Rate
Policy: Bretton Woods to the Present,” Federal Reserve Bulletin, November 1990, pp. 891–908.
5. R. Miller, “Why the Dollar Is Giving Way,” BusinessWeek, December 6, 2004, pp. 36–37.
6. For a feel for the issues contained in this debate, see P. Krugman, Has the Adjustment Process Worked?
(Washington, DC: Institute for International Economics, 1991); “Time to Tether Currencies,” e
Economist, January 6, 1990, pp. 15–16; P. R. Krugman and M. Obstfeld, International Economics: eory
and Policy (New York: HarperCollins, 1994); J. Shelton, Money Meltdown (New York: Free Press, 1994);
and S. Edwards, “Exchange Rates and the Political Economy of Macroeconomic Discipline,” American
Economic Review 86, no. 2 (May 1996), pp. 159–63.
7. e argument is made by several prominent economists, particularly Stanford University’s Robert
McKinnon. See R. McKinnon, “An International Standard for Monetary Stabilization,” Policy Analyses in
International Economics 8 (1984). e details of this argument are beyond the scope of this book. For a
relatively accessible exposition, see P. Krugman, e Age of Diminished Expectations (Cambridge, MA:
MIT Press, 1990).
8. A. R. Ghosh and A. M. Gulde, “Does the Exchange Rate Regime Matter for Inflation and Growth?”
Economic Issues, no. 2 (1997).
9. “e ABC of Currency Boards,” e Economist, November 1, 1997, p. 80.
10. International Monetary Fund, World Economic Outlook, 1998 (Washington, DC: IMF, 1998).
11. International Monetary Fund, World Economic Outlook, 1998 (Washington, DC: IMF, 1998).
12. T. S. Shorrock, “Korea Starts Overhaul; IMF Aid Hits $55 Billion,” Journal of Commerce, December 8,
1997, p. 3A.
13. See J. Sachs, “Economic Transition and Exchange Rate Regime,” American Economic Review 86, no. 92
(May 1996), pp. 147–52; and J. Sachs, “Power unto Itself,” Financial Times, December 11, 1997, p. 11.
14. Sachs, “Power unto Itself.”
15. Martin Wolf, “Same Old IMF Medicine,” Financial Times, December 9, 1997, p. 12.
16. Sachs, “Power unto Itself.”
17. “New Fund, Old Fundamentals,” e Economist, May 2, 2009, p. 78.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill
Education
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Part 5 e Strategy of International Business
e Strategy of International Business
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO12-1 Explain the concept of international business strategy.
LO12-2 Recognize how firms can increase revenue and profit by expanding globally.
LO12-3 Understand how pressures for cost reductions and local responsiveness influence strategic choice.
LO12-4 Identify the different international strategies for competing and their pros and cons.
LO12-5 Explain the pros and cons of using strategic alliances to support international strategies.
Red Bull, A Leader In International Strategy
opening case
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Where does Red Bull hail from? Many people in the United States and in many other countries as well think
that Red Bull is a local product in their country since Red Bull does such a fantastic job of marketing the
company everywhere. Red Bull plays up the amazing energy, go-getter attitude, and fun risk-taking that the
brand symbolizes in everything they do around the globe, “Red Bull gives you wings,” as their slogan says. To
support the company’s international strategy, Red Bull hosts a number of extreme sporting events around the
world. ese include the Red Bull Indianapolis Grand Prix in the United States, Red Bull Air Race in the
United Kingdom, Red Bull Soapbox Race in Jordan, Red Bull Cliff Diving World Series, Red Bull Air Race,
Red Bull Crashed Ice, and stand-out stunts such as Stratos space diving. In addition, Red Bull maintains
numerous other notable strategic placements globally of their brand.
Now, the answer to the opening question is that Red Bull is from Austria, although saying that it is an
Austrian-ai company may work also! In 1984, Austrian entrepreneur Dietrich Mateschitz and ai
businessperson Chaleo Yoovidhya founded Red Bull GmbH. While working for German manufacturer
Blendax (later acquired by Procter & Gamble), Mateschitz traveled to ailand and met Chaleo, owner of TC
Pharmaceutical. e two struck a cord and eventually started Red Bull a couple of years after they met. Today,
Red Bull is viewed as one of the world’s top companies for its international strategy, in particular for its
international marketing strategy (keep that in mind when you read Chapter 16: Global Marketing and
Business Analytics later). Worldwide, Red Bull has the highest market share of all energy drinks, with more
than 6 billion cans sold annually (that’s almost one can for every person in the world).
Why is it called Red Bull? e name reflects its founders’ backgrounds and the unique history of the
enterprise. ai company Krating Daeng had been founded by Chaleo; when Mateschitz met Chaleo, they
created Red Bull as a spinoff and modified the ingredients in the energy drink to suit the tastes of Westerners.
In ai, daeng means red and krating is a large wild bovine in Southeast Asia informally referred to in English as a bull. us Red Bull, which is sold in a tall, slim blue-silver can. Krating Daeng is in a shorter gold
can. Red Bull is viewed as an Austrian company and Krating Daeng as a ai company. While Red Bull is the
best-selling energy drink in most parts of the world, both Red Bull and Krating Daeng are sold worldwide (in
about 165 countries).
In many ways, Red Bull’s extreme-event marketing strategy is what drives their international business
strategy. e events sponsored by Red Bull exemplify the brand that Red Bull has become, that it tries to
strategically nurture, and that has built the company its reputation, really a “brand myth,” that has become a
legend. Red Bull mass markets its products in a unique way. ey don’t do regular marketing, and their overall
international business strategy is somewhat unorthodox. Contrary to most other multinational
corporations, the events and the teams they support (e.g., soccer/football clubs RB Leipzig, FC Red
Bull Salzburg, FC Liefering, Red Bull Brasil, New York Red Bulls, and Formula One teams Red Bull Racing
and Scuderia Toro Rosso) drive the company’s international business strategy.
Aside from these extreme events and sporting teams, Red Bull’s packaging also plays a significant part in its
global appeal and is core to its international business strategy. Some say that Red Bull really looks like a
product that fits the idea of a global economy. It’s not in a normal can or bottle and its design has a much
broader appeal to a wider global audience. It’s not an American product in look and content, nor is it an Asian
product in look or content, or the look and content of any other world area. By lacking a clear geographic
focus, its sleek look appeals to customers globally who can form their own connection to the product. us
the product seems adaptable to each local environment in which it is sold. Plus, Red Bull’s consistent
packaging worldwide has helped the brand go global with a very consistent international business strategy.
Red Bull has created an international business strategy by focusing on a universal product concept, unique
and standout packaging, and extreme event sponsorship without also tackling the architecture of the company
itself. Most other multinational corporations have to balance their focus on marketing strategy and
organizational infrastructure to operate a well-functioning international strategy. Red Bull drives certain
concepts hard and that works superbly well for them. ey communicate their clear and consistent messages
via their own Red Bull Media House, inspirational videos and activities on social media, and content
marketing that is uniquely customized to diverse audiences. ey focus on people having freedom and fun
and rely on user-generated content where customers share their own exciting lifestyles. •
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Sources: Hanna Fleishman, “13 Businesses with Brilliant Global Marketing Strategies,” HubSpot, February 9, 2018; Alex Siminoff,
“Red Bull Stomps All Over Global Marketing,” Art + Marketing, April 28, 2017; Nitin Pangarkar and Mohit Agarwal, “e Wind
Behind Red Bull’s Wings,” Forbes, June 24, 2013; Celine Cnossen, Yuan Li, Neha Sampath, Whitney Taylor-Maisano, and Viktor
Tsonev, “What Gives Red Bull Wings: Creating a Successful Market-Oriented Organization,” American Marketing Association,
April 24, 2018; and “Global Energy Drinks Market Opportunities 2018: Red Bull GmbH, Rockstar, Monster Energy, Amway
Global,” Market Watch, March 14, 2018.
Introduction
Up to this point in the text, we have focused on the worldwide environment in which small, medium,
and large companies—multinational corporations and SMEs (small- and medium-sized enterprises)—
compete in the global marketplace.1 ese “macro” chapters have included content on the different
political, economic, and cultural institutions found in nations; the international trade and investment
framework; and the international monetary system. Additionally, we’ve placed a strong emphasis on
managerial implications associated with each of these macro topics, with separate sections in each of
the chapters on what the macro topics mean for managerial strategy and action globally. is
managerial focus has been complemented with Management Focus and Country Focus features
throughout to capture the relevant learning in relation to running a global company.
Starting with this “strategy” chapter, our focus now shifts from the macro environment to the firm
itself and, in particular, to the actions managers can take to compete more effectively as an
international business.2 To begin the sequence of chapters on running a firm, which comprise the
remainder of the text, this chapter looks at how organizations can increase revenue (and profitability)
by expanding their operations in foreign markets: is is international business strategy. Keep in mind
that we distinguish between revenue and profit; even nonprofit companies need to make revenue to
offsets costs. Profit-focused companies, with shareholders, on the other hand, often focus on making a
profit in addition to revenue. In this context, we discuss the different strategies that firms pursue when
competing around the world, consider the pros and cons of the strategies, and elaborate on the various
factors that affect a firm’s choice of international strategy. Key issues in this chapter are value creation,
global value chains (which later on also ties to Chapter 15 on global supply chain
management),3 strategic alliances, and how small, medium, and large companies achieve superior
performance.4
e overview of the strategy of Red Bull in the opening case shows a company that has developed a
unique, energetic, and fluid approach to competing in the global marketplace. As we mentioned,
many people in the United States and elsewhere think that Red Bull is a local product, because
strategically, Red Bull does such a great job of promoting a universal brand that customers
in all countries can get attached to, buy into as their own “local” brand, and identify as
“global” by its packaging. Red Bull communicates their messaging via their own Red Bull Media
House, all the various social media, and content marketing that is customized to diverse audiences
around the world.
To complement Red Bull’s strategic uniqueness and effectiveness globally, the closing case of this
chapter is about Sony Corporation. Sony’s basic strategy is to first categorize their products and
services into 12 core business segments—whereas Red Bull focuses on a universal global brand. Sony’s
structured approach—but also its focus on “strategic curiosity”—has made Sony a global innovator for
more than seven decades. Beyond the 12 core segments that have served Sony well strategically for a
long time, the company is embarking on global initiatives to create new business opportunities. ey
are accelerating research and development (R&D) activities to bring about innovations that can, if
successful, become new strategic business segments serving customers’ needs and wants. e
differences between Red Bull and Sony in international strategy are clear: one company has an almost
universal appeal to customers and drives that point home in sponsored events and content marketing
(Red Bull), while the other has a very structurally defined approach to international strategy (Sony).
e cases of Red Bull and Sony illustrate this chapter’s themes of value creation, strategic
positioning, value chain operations, global expansion opportunities, cost pressures, and choosing a
strategy that fits with the core business model of a company in its industry. ese elements of
international business strategy have long been the core domains of companies’ strategy globally, and
something that all companies can leverage to do well in the markets they choose to engage in. Red
Bull and Sony have both been very successful in their global strategy development and
implementation but for vastly different reasons. For each company, however, value creation and
strategic positioning were the initial drivers of success, and these topics are covered in the first section
of this chapter.
Before we move on, let’s highlight the final topic in this chapter, which is the idea of entering into
strategic alliances. Strategic alliances are cooperative agreements between potential or actual
competitors. e term is often used to embrace a variety of agreements between actual or potential
competitors, including cross-shareholding deals, licensing arrangements, formal joint ventures, and
informal cooperative arrangements. e motives for entering strategic alliances are varied, but they
often include market access, which overlaps with the topic of entering foreign markets which we will
cover in detail in Chapter 13.
Strategy and the Firm
LO 12-1 Explain the concept of international business strategy.
When we talk about strategy and the firm, we refer to the firm in the most common way as a method
to organize activities. is means that the firm can also be called a multinational enterprise,
multinational corporation, international business, international organization, global company, and so
on. A unique type of firm, though, is what we call an SME—a small- or medium-sized enterprise.
SMEs are companies that have fewer than 500 employees (U.S.) or fewer than 250 employees
(Europe). roughout the text, we use a variety of terminologies in largely the same context for the
larger firms, but we specify when we talk about SMEs since these companies have global strategies that
sometimes differ from their larger counterparts.5 However, importantly, whereas most textbooks in
business focus on large companies, we take great pride and have dedicated our effort to discuss content
as it relates to small and medium-sized, as well as large, firms.
Before we discuss the strategies that managers in the multinational enterprise can pursue, we need
to review some basic principles of strategy. A firm’s strategy can be defined as the actions that
managers take to attain the goals of the firm. For most firms, the preeminent goal is to maximize the
value of the firm for its owners and its shareholders (subject to the very important constraint that the
activities undertaken are done in a legal, ethical, and socially responsible manner—see Chapter 5 for
details). To maximize the value of a firm to shareholders, managers must pursue strategies that increase
the profitability of the enterprise and its rate of profit growth over time (see Figure 12.1). Profitability
can be measured in a number of ways, but for consistency, we define it as the rate of return that the
firm makes on its invested capital (return-on-investments, abbreviated as ROI), which is calculated by
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dividing the net profits of the firm by total invested capital.6 Profit growth is measured by the
percentage increase in net profits over time. In general, higher profitability and a higher rate of profit
growth will increase the value of an enterprise and thus the returns garnered by its owners, the
shareholders.7
12.1 FIGURE
Determinants of enterprise value.
Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill Education, 2017).
Managers can increase the profitability of the firm by pursuing strategies that lower costs
or by pursuing strategies that add value to the firm’s products, which enables the firm to
raise prices. Managers can increase the rate at which the firm’s profits grow over time by pursuing
strategies to sell more products in existing markets or by pursuing strategies to enter new markets. As
we shall see, expanding internationally can help managers boost the firm’s profitability and increase the
rate of profit growth over time.
VALUE CREATION
Did You Know?
Did you know FedEx’s global strategy focuses on more than transportation?
Visit your Connect SmartBook® to view a short video explanation from the authors.
e way to increase the profitability of a firm is to create more value. e amount of value a firm
creates is measured by the difference between its costs of production and the value that consumers
perceive in its products. In general, the more value customers place on a firm’s products, the higher the
price the firm can charge for those products. However, the price a firm charges for a good or service is
typically less than the value placed on that good or service by the customer. is is because the
customer captures some of that value in the form of what economists call a consumer surplus.8 e
customer is able to do this because the firm is competing with other firms for the customer’s business,
so the firm must charge a lower price than it could were it a monopoly supplier. Also, it is normally
impossible to segment the market to such a degree that the firm can charge each customer a price that
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reflects that individual’s assessment of the value of a product, which economists refer to as a customer’s
reservation price. For these reasons, the price that gets charged tends to be less than the value placed
on the product by many customers.
Figure 12.2 illustrates these concepts. e value of a product to an average consumer is V, the
average price that the firm can charge a consumer for that product given competitive pressures and its
ability to segment the market is P, and the average unit cost of producing that product is C (C
comprises all relevant costs, including the firm’s cost of capital). e firm’s profit per unit sold (π) is
equal to P − C, while the consumer surplus per unit is equal to V − P (another way of thinking of the
consumer surplus is as “value for the money”; the greater the consumer surplus, the greater the value
for the money the consumer gets). e firm makes a profit so long as P is greater than C, and its profit
will be greater the lower C is relative to P. e difference between V and P is in part determined by the
intensity of competitive pressure in the marketplace: the lower the intensity of competitive pressure,
the higher the price charged relative to V.9 In general, the higher the firm’s profit per unit sold is, the
greater its profitability will be, all else being equal.
12.2 FIGURE
Value creation.
Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill Education, 2017).
e firm’s value creation is measured by the difference between V and C (V − C ); a company
creates value by converting inputs that cost C into a product on which consumers place a value of V. A
company can create more value (V − C ) either by lowering production costs, C, or by making the
product more attractive through superior design, styling, functionality, features, reliability, after-sales
service, and the like, so that consumers place a greater value on it (V increases) and, consequently, are
willing to pay a higher price (P increases). is discussion suggests that a firm has high profits when it
creates more value for its customers and does so at a lower cost. We refer to a strategy that
focuses primarily on lowering production costs as a low-cost strategy. We refer to a strategy
that focuses primarily on increasing the attractiveness of a product as a differentiation strategy.10
Michael Porter has argued that low cost and differentiation are two basic strategies for creating value
and attaining a competitive advantage in an industry.11 According to Porter, superior profitability goes
to those firms that can create superior value, and the way to create superior value is to drive down the
cost structure of the business and/or differentiate the product in some way so that consumers value it
more and are prepared to pay a premium price. Superior value creation relative to rivals does not
necessarily require a firm to have the lowest cost structure in an industry or to create the most valuable
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product in the eyes of consumers. However, it does require that the gap between value (V ) and cost of
production (C ) be greater than the gap attained by competitors.
STRATEGIC POSITIONING
Porter notes that it is important for a firm to be explicit about its choice of strategic emphasis with
regard to value creation (differentiation) and low cost and to configure its internal operations to
support that strategic emphasis.12 Figure 12.3 illustrates this point. e convex curve in Figure 12.3 is
what economists refer to as an efficiency frontier. e efficiency frontier shows all of the different
positions that a firm can adopt with regard to adding value to the product (V ) and low cost (C ),
assuming that its internal operations are configured efficiently to support a particular position (note
that the horizontal axis in Figure 12.3 is reverse scaled; moving along the axis to the right implies
lower costs). e efficiency frontier has a convex shape because of diminishing returns. Diminishing
returns imply that when a firm already has significant value built into its product offering, increasing
value by a relatively small amount requires significant additional costs. e converse also holds: when a
firm already has a low-cost structure, it has to give up a lot of value in its product offering to get
additional cost reductions.
12.3 FIGURE
Strategic choice in the international hotel industry.
Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill Education, 2017).
Figure 12.3 plots three hotel firms with a global presence that cater to international travelers: Four
Seasons, Marriott International, and Starwood (Starwood owns the Sheraton and Westin chains). Four
Seasons positions itself as a luxury chain and emphasizes the value of its product offering, which drives
up its costs of operations. Marriott and Starwood are positioned more in the middle of the market.
Both emphasize sufficient value to attract international business travelers but are not luxury chains like
Four Seasons. In Figure 12.3, Four Seasons and Marriott are shown to be on the efficiency
frontier, indicating that their internal operations are well configured to their strategy and
run efficiently. Starwood is inside the frontier, indicating that its operations are not running as
efficiently as they might be and that its costs are too high. is implies that Starwood is less profitable
than Four Seasons and Marriott and that its managers must take steps to improve the company’s
performance.
Porter emphasizes that it is very important for management to decide where the company wants to
be positioned with regard to value (V ) and cost (C ), to configure operations accordingly, and to
manage them efficiently to make sure the firm is operating on the efficiency frontier. However, not all
positions on the efficiency frontier are viable. In the international hotel industry, for example, there
might not be enough demand to support a chain that emphasizes very low cost and strips all the value
out of its product offering (see Figure 12.3). International travelers are relatively affluent and expect a
degree of comfort (value) when they travel away from home.
A central tenet of the basic strategy paradigm is that to maximize its profitability, a firm must do
three things: (1) pick a position on the efficiency frontier that is viable in the sense that there is
enough demand to support that choice; (2) configure its internal operations, such as manufacturing,
marketing, logistics, information systems, human resources, and so on, so that they support that
position; and (3) make sure that the firm has the right organization structure in place to execute its
strategy. e strategy, operations, and organization of the firm must all be consistent with each other if it is
to attain a competitive advantage and garner superior profitability. By operations, we mean the different
value creation activities a firm undertakes, which we shall review next. e accompanying
Management Focus provides an illustration of how AB InBev creates value in the beer industry
globally by adopting a strategy paradigm that is centered on maximizing profitability.
m a n a g e m e n t F O C U S
AB InBev, Beer Globally, and Creating Value
e company AB InBev may not sound familiar to everyone, but spelled out, its name likely becomes clearer
to most people, especially the beer-loving population of the world. Anheuser-Busch InBev originates from the
Den Hoorn brewery in Leuven, Belgium, which dates back to 1366, and the pioneering spirit of the Anheuser
& Co brewery, with origins in St. Louis, Missouri, since 1852. Today, AB InBev is the leading global brewer
and one of the world’s top consumer products companies.
AB InBev has operations in 25 countries, sales in more than 100 countries, revenue of $44 billion,
155,000 employees, and seven of the top 10 most valuable beer brands. ese seven brands are: Budweiser,
Bud Light, Stella Artois, Skol, Corona, Brahma, and Modelo Especial. Budweiser, Corona, and Stella Artois
are marketed as “global brands,” while Beck’s, Leffe, and Hoegaarden are considered “international brands” in
AB InBev’s brand portfolio. e company also has 15 “local champions,” which represent leadership in their
respective local markets. ese local brands include Jupiler (most popular beer in Belgium), Quilmes (original
Argentinean lager since 1890), and Harbin (from the oldest brewery in North China), among the portfolio.
In total, AB InBev’s portfolio consists of more than 200 brands.
With more than 200 brands and strong coverage internationally of the different brands, strategically AB
InBev is a unique and highly organized global company. Carlos Brito (CEO) and Olivier Goudet (chairman
of the board) have stated that the company’s ambition is to build a great, enduring company for the next 100
years. e core management team consists of the CEO, nine Executive Board members, and six zone
presidents. e six zone presidents have responsibility for Latin America South, Latin America North, Asia
Pacific, North America, Mexico, and Europe.
Using this management structure, AB InBev has built leading positions in the important beer profit
markets in the world through a combination of organic growth and selected, value-enhancing acquisitions.
e company follows a focused brands strategy in which the majority of the resources are devoted to those
brands that have the greatest long-term growth potential. Investment behind the brands is fueled by a
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disciplined approach to cost management and efficiency. AB InBev has a strong track record of industry-
leading margins and cash flow generation. In 2015, this led to growth of 12.6 percent of the company’s three
global brands (Budweiser, Corona, and Stella Artois), for example, and strong earnings in North America and
most of Latin America.
e foundation for AB InBev’s global strategy is the company’s “Dream-People-Culture” approach. e
goal is that despite having operations in many countries around the world, with different national cultures,
AB InBev operates as one company, with one dream and one culture uniting them. ere is also a focus on
having the right people in the right place at the right time. is culture is built on ownership, informality,
candor, transparency, and meritocracy.
Strategically, AB InBev has 10 principles driving everything they do. At the core, AB InBev is focused on a
shared dream that energizes everyone to work in the same direction to be the best beer company in the world,
bring people together, and aspire for the betterment of the world. Additional principles cover people
strengths, quality of teams, striving for increased satisfaction, consumer focus, ownership, common sense and
simplicity, cost management, leadership, and hard work and responsibility.
Sources: D. Leonard, “Can Craft Beer Survive AB InBev?” Bloomberg Business, June 25, 2015; V. Wong, “Why AB InBev and Big Brewers Are Betting on Hard Cider,” Bloomberg Business, May 13, 2013; J. Colley, “e Big Beer Merger Won’t Bring Down the Price of a Pint,” Newsweek, October 18, 2015; C. Purdy, “ere’s a Less Obvious Reason Why AB InBev Is Buying Up Craft Breweries,” Quartz, December 23, 2015; and AB InBev Annual Report 2015, http://annualreport.ab-inbev.com.
OPERATIONS: THE FIRM AS A VALUE CHAIN
e operations of a firm can be thought of as a value chain composed of a series of distinct value
creation activities, including production, marketing and sales, materials management, research and
development, human resources, information systems, and the firm infrastructure. We can categorize
these value creation activities, or operations, as primary activities and support activities (see Figure
12.4).13 As noted earlier, if a firm is to implement its strategy efficiently and position itself on the
efficiency frontier shown in Figure 12.3, it must manage these activities effectively and in a manner
that is consistent with its strategy.
12.4 FIGURE
e value chain.
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Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill Education, 2017).
Primary Activities Primary activities have to do with the design, creation, and delivery of the product; its marketing; and its support and after-sale service. Following normal practice, in the value
chain illustrated in Figure 12.4, the primary activities are divided into four functions: research and
development, production, marketing and sales, and customer service.
Research and development (R&D) is concerned with the design of products and production
processes. Although we think of R&D as being associated with the design of physical products and
production processes in manufacturing enterprises, many service companies also undertake R&D. For
example, banks compete with each other by developing new financial products and new ways of
delivering those products to customers. Online banking and smart debit cards are two examples of
product development in the banking industry. Earlier examples of innovation in the banking industry
included automated teller machines, credit cards, and debit cards. rough superior product design,
R&D can increase the functionality of products, which makes them more attractive to consumers
(raising V ). Alternatively, R&D may result in more efficient production processes, thereby cutting
production costs (lowering C). Either way, the R&D function can create value.
Production is concerned with the creation of a good or service. For physical products, when we talk
about production, we generally mean manufacturing. us, we can talk about the production of an
automobile. For services such as banking or health care, “production” typically occurs when the service
is delivered to the customer (e.g., when a bank originates a loan for a customer, it is engaged in
“production” of the loan). For a retailer such as Walmart, “production” is concerned with selecting the
merchandise, stocking the store, and ringing up the sale at the cash register. For MTV, production is
concerned with the creation, programming, and broadcasting of content, such as music videos and
thematic shows. e production activity of a firm creates value by performing its activities efficiently
so lower costs result (lower C) and/or by performing them in such a way that a higher-quality product
is produced (which results in higher V ).
e marketing and sales functions of a firm can help to create value in several ways. rough brand
positioning and advertising, the marketing function can increase the value (V) that consumers perceive
to be contained in a firm’s product. If these create a favorable impression of the firm’s product in the
minds of consumers, they increase the price that can be charged for the firm’s product. For
example, Ford produced a high-value version of its Ford Expedition SUV. Sold as the
Lincoln Navigator and priced higher, the Navigator has the same body, engine, chassis, and design as
the Expedition, but through skilled advertising and marketing, supported by some fairly minor
features changes (e.g., more accessories and the addition of a Lincoln-style engine grille and
nameplate), Ford has fostered the perception that the Navigator is a “luxury SUV.” is marketing
strategy has increased the perceived value (V) of the Navigator relative to the Expedition and enables
Ford to charge a higher price for the car (P).
Marketing and sales can also create value by discovering consumer needs and communicating them
back to the R&D function of the company, which can then design products that better match those
needs. For example, the allocation of research budgets at Pfizer, the world’s largest pharmaceutical
company, is determined by the marketing function’s assessment of the potential market size associated
with solving unmet medical needs. us, Pfizer is currently directing significant monies to R&D
efforts aimed at finding treatments for Alzheimer’s disease, principally because marketing has identified
the treatment of Alzheimer’s as a major unmet medical need in nations around the world where the
population is aging.
Business BEAT
A Caterpillar motor factory in Germany helps to ensure product after-sales and service
outside the United States.
©Bernd Wustneck/picture-alliance/dpa/AP Images
e role of the enterprise’s service activity is to provide after-sale service and support. is function
can create a perception of superior value (V ) in the minds of consumers by solving customer problems
and supporting customers after they have purchased the product. Caterpillar, the U.S.-based
manufacturer of heavy earthmoving equipment, can get spare parts to any point in the world within
24 hours, thereby minimizing the amount of downtime its customers have to suffer if their Caterpillar
equipment malfunctions. is is an extremely valuable capability in an industry where downtime is
very expensive. It has helped to increase the value that customers associate with Caterpillar products
and thus the price that Caterpillar can charge.
Support Activities e support activities of the value chain provide inputs that allow the primary activities to occur (see Figure 12.4). In terms of attaining a competitive advantage, support activities
can be as important as, if not more important than, the primary activities of the firm. Consider
information systems: these systems refer to the electronic systems for managing inventory, tracking
sales, pricing products, selling products, dealing with customer service inquiries, and so on.
Information systems, when coupled with the communications features of the Internet, can alter the
efficiency and effectiveness with which a firm manages its other value creation activities. Dell, for
example, has used its information systems to attain a competitive advantage over rivals. When
customers place an order for a Dell product over the firm’s website, that information is immediately
transmitted, via the Internet, to suppliers, who then configure their production schedules to produce
and ship that product so that it arrives at the right assembly plant at the right time. ese systems have
reduced the amount of inventory that Dell holds at assembly plants to under two days, which is a
major source of cost savings.
In Chapter 12, we are
bringing you closer to
running an international firm based on the issues we have covered on country differences, global trade and
investment environment, and the global money system. is is where many of you will “make your money” as
strategic decision makers in corporations. is also means that you need to know what is current, important,
and strategic in the global marketplace; your company’s products or services; and your company’s uniqueness
in satisfying the needs and wants of customers. e globalEDGETM Business Beat (gBB) is a radio show that
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covers discussions with a wide range of global leaders in business, government, and academe to educate the
listeners about the latest thoughts, tools, and markets to succeed globally (http://globaledge.msu.edu/get-
connected/globaledge-business-beat). Tomas Hult, coauthor of this textbook, is the host of gBB, and Charles
W. L. Hill, the textbook’s lead author, is regularly featured on the show.
e logistics function controls the transmission of physical materials through the value
chain, from procurement through production and into distribution. e efficiency with
which this is carried out can significantly reduce cost (lower C), thereby creating more value. e
combination of logistics systems and information systems is a particularly potent source of cost savings
in many enterprises, such as Dell, where information systems tell Dell on a real-time basis where in its
global logistics network parts are, when they will arrive at an assembly plant, and thus how production
should be scheduled.
e human resource function can help create more value in a number of ways. It ensures that the
company has the right mix of skilled people to perform its value creation activities effectively. e
human resource function also ensures that people are adequately trained, motivated, and compensated
to perform their value creation tasks. In a multinational enterprise, one of the things human resources
can do to boost the competitive position of the firm is to take advantage of its transnational reach to
identify, recruit, and develop a cadre of skilled managers, regardless of their nationality, who can be
groomed to take on senior management positions. ey can find the very best, wherever they are in
the world. Indeed, the senior management ranks of many multinationals are becoming increasingly
diverse, as managers from a variety of national backgrounds have ascended to senior leadership
positions.
Is Education Creating Value for You?
e concept of a value chain can be used to examine the role your education plays in your life plans, if you
look closely at your personal development plans (education, internship, work, physical and emotional fitness,
and extracurricular activities) and think about them in terms of primary and support activities. If we use the
logic that the amount of value you receive from your education is the difference between the costs (e.g.,
tuition, time, lost income) and what you receive in the form of education (e.g., knowledge, tools, networks),
how does your choice of major area of focus in your education fit into your personal development strategy?
How do your choices of how you spend your time fit into your value chain? Do you ever spend time doing
things that do not support the strategic goals of your personal value chain? But, most importantly, what is the
one thing you should do more of to drive the value higher for yourself today and in the future?
e final support activity is the company infrastructure, or the context within which all the other
value creation activities occur. e infrastructure includes the organizational structure, control
systems, and culture of the firm. Because top management can exert considerable influence in shaping
these aspects of a firm, top management should also be viewed as part of the firm’s infrastructure.
rough strong leadership, top management can consciously shape the infrastructure of a firm and
through that the performance of all its value creation activities.
Organization: e Implementation of Strategy e strategy of a firm is implemented through its organization. For a firm to have superior return on invested capital (ROIC), its
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organization must support its strategy and operations. e term organization architecture can be
used to refer to the totality of a firm’s organization, including formal organizational structure, control
systems and incentives, organizational culture, processes, and people.14 Figure 12.5 illustrates these
different elements. By organizational structure, we mean three things: first, the formal
division of the organization into subunits such as product divisions, national operations,
and functions (most organizational charts display this aspect of structure); second, the location of
decision-making responsibilities within that structure (e.g., centralized or decentralized); and third, the
establishment of integrating mechanisms to coordinate the activities of subunits including cross-
functional teams and or pan-regional committees.
12.5 FIGURE
Organization architecture.
Controls are the metrics used to measure the performance of subunits and make judgments about
how well managers are running those subunits. Incentives are the devices used to reward appropriate
managerial behavior. Incentives are very closely tied to performance metrics. For example, the
incentives of a manager in charge of a national operating subsidiary might be linked to the
performance of that company. Specifically, she might receive a bonus if her subsidiary exceeds its
performance targets.
Processes are the manner in which decisions are made and work is performed within the
organization. Examples are the processes for formulating strategy, for deciding how to allocate
resources within a firm, or for evaluating the performance of managers and giving feedback. Processes
are conceptually distinct from the location of decision-making responsibilities within an organization,
although both involve decisions. While the CEO might have ultimate responsibility for deciding what
the strategy of the firm should be (i.e., the decision-making responsibility is centralized), the process
he or she uses to make that decision might include the solicitation of ideas and criticism from lower-
level managers.
Organizational culture is the norms and value systems that are shared among the employees of an
organization. Just as societies have cultures (see Chapter 4 for details), so do organizations.
Organizations are societies of individuals who come together to perform collective tasks. ey have
their own distinctive patterns of culture and subculture.15 As we shall see, organizational culture can
have a profound impact on how a firm performs. Finally, by people we mean not just the employees
of the organization but also the strategy used to recruit, compensate, and retain those individuals and
the type of people that they are in terms of their skills, values, and orientation (discussed in depth in
Chapter 17).
As illustrated by the arrows in Figure 12.5, the various components of an organization’s architecture
are not independent of each other: Each component shapes, and is shaped by, other components of
architecture. An obvious example is the strategy regarding people. is can be used proactively to hire
individuals whose internal values are consistent with those that the firm wishes to emphasize in its
organization culture. us, the people component of architecture can be used to reinforce (or not) the
prevailing culture of the organization. If a firm is going to maximize its profitability, it must pay close
attention to achieving internal consistency among the various components of its architecture, and the
architecture must support the strategy and operations of the firm.
Strategic Fit In sum, as we have repeatedly stressed, for a firm to attain superior performance and earn a high return on capital, its strategy (as captured by its desired strategic position on the efficiency
frontier) must make sense given market conditions (there must be sufficient demand to support that
strategic choice). e operations of the firm must be configured in a way that supports the strategy of
the firm, and the organization architecture of the firm must match the operations and strategy of the
firm. In other words, as illustrated in Figure 12.6, market conditions, strategy, operations, and
organization must all be consistent with each other, or fit each other, for superior performance to be
attained.
Of course, the issue is more complex than illustrated in Figure 12.6. For example, the firm can
influence market conditions through its choice of strategy—it can create demand by leveraging core
skills to create new market opportunities. In addition, shifts in market conditions caused by new
technologies, government action such as deregulation, demographics, or social trends can mean that
the strategy of the firm no longer fits the market. In such circumstances, the firm must change its
strategy, operations, and organization to fit the new reality—which can be an extraordinarily difficult
challenge. And last but by no means least, international expansion adds another layer of complexity to
the strategic challenges facing the firm. We shall now consider this.
12.6 FIGURE
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Strategic fit.
test PREP
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Global Expansion, Profitability, and Profit Growth
LO 12-2 Recognize how firms can increase revenue and profit by expanding globally.
Expanding globally allows firms to increase their profitability and rate of profit growth in ways not
available to purely domestic enterprises.16 Firms that operate internationally are able to
1. Expand the market for their domestic product offerings by selling those products in
international markets.
2. Realize location economies by dispersing individual value creation activities to those locations
around the globe where they can be performed most efficiently and effectively.
3. Realize greater cost economies from experience effects by serving an expanded global market
from a central location, thereby reducing the costs of value creation.
4. Earn a greater return by leveraging any valuable skills developed in foreign operations and
transferring them to other entities within the firm’s global network of operations.
As we will see, however, a firm’s ability to increase its profitability and profit growth by pursuing these
strategies is constrained by the need to customize its product offering, marketing strategy, and business
strategy to differing national or regional conditions—that is, by the imperative of localization.
EXPANDING THE MARKET: LEVERAGING PRODUCTS AND COMPETENCIES
A company can increase its growth rate by taking goods or services developed at home and selling
them internationally. Almost all multinationals started out doing just this. For example, Procter &
Gamble developed most of its best-selling products (such as Pampers disposable diapers and Ivory
soap) in the United States and subsequently sold them around the world. Likewise, although
Microsoft developed its software in the United States, from its earliest days the company has always
focused on selling that software in international markets. Automobile companies such as Volkswagen
and Toyota also grew by developing products at home and then selling them in international markets.
e returns from such a strategy are likely to be greater if indigenous competitors in the nations that a
company enters lack comparable products. us, Toyota increased its profits by entering the large
automobile markets of North America and Europe, offering products that differed from those offered
by local rivals (Ford and GM) in their superior quality and reliability.
e success of many multinational companies that expand in this manner is based not just upon
the goods or services that they sell in foreign nations but also upon the core competencies that
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underlie the development, production, and marketing of those goods or services. e term core
competence refers to skills within the firm that competitors cannot easily match or imitate.17 ese
skills may exist in any of the firm’s value creation activities: production, marketing, R&D,
human resources, logistics, general management, and so on. Such skills are typically
expressed in product offerings that other firms find difficult to match or imitate. Core competencies
are the bedrock of a firm’s competitive advantage. ey enable a firm to reduce the costs of value
creation and/or to create perceived value in such a way that premium pricing is possible. For example,
Toyota has a core competence in the production of cars. It is able to produce high-quality, well-
designed cars at a lower delivered cost than any other firm in the world. e competencies that enable
Toyota to do this seem to reside primarily in the firm’s production and logistics functions.18 Similarly,
IKEA has a core competence in the design of stylish and affordable furniture that can be manufactured
at a low cost and flat-packed, McDonald’s has a core competence in managing fast-food operations (it
seems to be one of the most skilled firms in the world in this industry), and Procter & Gamble (P&G)
has a core competence in developing and marketing name-brand consumer products (it is one of the
most skilled firms in the world in this business).
Because core competencies are, by definition, the source of a firm’s competitive advantage, the
successful global expansion by manufacturing companies such as Toyota and P&G was based not just
on leveraging products and selling them in foreign markets but also on the transfer of core
competencies to foreign markets in which indigenous competitors lacked them. e same can be said
of companies engaged in the service sectors of an economy, such as financial institutions, retailers,
restaurant chains, and hotels. Expanding the market for their services often means replicating their
business model in foreign nations (albeit with some changes to account for local differences, which we
will discuss in more detail shortly). Firms such as Starbucks and IKEA, for example, expanded rapidly
outside of their home markets in the United States by taking the basic business model that they
developed at home and using that as a blueprint for establishing international operations.
P&G’s core competency in marketing is evidenced in this photo of Olay men’s skin care
products for sale in a Shanghai, China, supermarket.
©Weng lei/Imaginechina/AP Images
LOCATION ECONOMIES
Earlier chapters revealed that countries differ along a range of dimensions—including the economic,
political, legal, and cultural—and that these differences can either raise or lower the costs of doing
business in a country. e theory of international trade also teaches that due to differences in factor
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costs, certain countries have a comparative advantage in the production of certain products. Japan
might excel in the production of automobiles and consumer electronics; the United States in the
production of computer software, pharmaceuticals, biotechnology products, and financial services;
Switzerland in the production of precision instruments and pharmaceuticals; South Korea in the
production of semiconductors; and Vietnam in the production of apparel.19
For a firm that is trying to survive in a competitive global market, this implies that trade barriers
and transportation costs permitting, the firm will benefit by basing each value creation activity it
performs at that location where economic, political, and cultural conditions—including relative factor
costs—are most conducive to the performance of that activity. us, if the best designers for a product
live in France, a firm should base its design operations in France. If the most productive labor force for
assembly operations is in Mexico, assembly operations should be based in Mexico. If the best
marketers are in the United States, the marketing strategy should be formulated in the United States.
And so on.
Firms that pursue such a strategy can realize what we refer to as location economies, which are the
economies that arise from performing a value creation activity in the optimal location for that activity,
wherever in the world that might be (transportation costs and trade barriers permitting). Locating a
value creation activity in the optimal location for that activity can have one of two effects. It can lower
the costs of value creation and help the firm to achieve a low-cost position, and/or it can enable a firm to
differentiate its product offering from those of competitors. In terms of Figure 12.2, it can lower C and/or
increase V (which, in general, supports higher pricing), both of which boost the profitability of the
enterprise.
For an example of how this works in an international business, consider Clear Vision, a
manufacturer and distributor of eyewear. Started by David Glassman, the firm now generates annual
gross revenues of more than $100 million. Not exactly small, but no corporate giant either,
Clear Vision is a multinational firm with production facilities on three continents and
customers around the world. Clear Vision began its move toward becoming a multinational when its
sales were still less than $20 million. At the time, the U.S. dollar was very strong, and this made U.S.-
based manufacturing expensive. Low-priced imports were taking an ever-larger share of the U.S.
eyewear market, and Clear Vision realized it could not survive unless it also began to import. Initially,
the firm bought from independent overseas manufacturers, primarily in Hong Kong. However, the
firm became dissatisfied with these suppliers’ product quality and delivery. As Clear Vision’s volume of
imports increased, Glassman decided the best way to guarantee quality and delivery was to set up
Clear Vision’s own manufacturing operation overseas. Accordingly, Clear Vision found a Chinese
partner, and together they opened a manufacturing facility in Hong Kong, with Clear Vision being
the majority shareholder.
e choice of the Hong Kong location was influenced by its combination of low labor costs, a
skilled workforce, and tax breaks given by the Hong Kong government. e firm’s objective at this
point was to lower production costs by locating value creation activities at an appropriate location.
After a few years, however, the increasing industrialization of Hong Kong and a growing labor
shortage had pushed up wage rates to the extent that it was no longer a low-cost location. In response,
Glassman and his Chinese partner moved part of their manufacturing to a plant in mainland China to
take advantage of the lower wage rates there. Again, the goal was to lower production costs. e parts
for eyewear frames manufactured at this plant are shipped to the Hong Kong factory for final assembly
and then distributed to markets in North and South America. e Hong Kong factory employs 80
people and the China plant between 300 and 400.
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At the same time, Clear Vision was looking for opportunities to invest in foreign eyewear firms
with reputations for fashionable design and high quality. Its objective was not to reduce production
costs but to launch a line of high-quality, differentiated, “designer” eyewear. Clear Vision did not have
the design capability in-house to support such a line, but Glassman knew that certain foreign
manufacturers did. As a result, Clear Vision invested in factories in Japan, France, and Italy, holding a
minority shareholding in each case. ese factories now supply eyewear for Clear Vision’s Status Eye
division, which markets high-priced designer eyewear.20
us, to deal with a threat from foreign competition, Clear Vision adopted a strategy intended to
lower its cost structure (lower C): shifting its production from a high-cost location, the United States,
to a low-cost location, first Hong Kong and later China. en Clear Vision adopted a strategy
intended to increase the perceived value of its product (increase V ) so it could charge a premium price
(P). Reasoning that premium pricing in eyewear depended on superior design, its strategy involved
investing capital in French, Italian, and Japanese factories that had reputations for superior design. In
sum, Clear Vision’s strategies included some actions intended to reduce its costs of creating value and
other actions intended to add perceived value to its product through differentiation. e overall goal
was to increase the value created by Clear Vision and thus the profitability of the enterprise. To the
extent that these strategies were successful, the firm should have attained a higher profit margin and
greater profitability than if it had remained a U.S.-based manufacturer of eyewear.
Creating a Global Web Generalizing from the Clear Vision example, one result of this kind of thinking is the creation of a global web of value creation activities, with different stages of the value
chain being dispersed to those locations around the globe where perceived value is maximized or
where the costs of value creation are minimized.21 Consider Lenovo’s inkPad laptop computers
(Lenovo is the Chinese computer company that purchased IBM’s personal computer
operations).22 is product is designed in the United States by engineers because Lenovo believes that
the United States is the best location in the world to do the basic design work. e case, keyboard, and
hard drive are made in ailand; the display screen and memory in South Korea; the built-in wireless
card in Malaysia; and the microprocessor in the United States. In each case, these components are
manufactured and sourced from the optimal location given current factor costs. ese components are
then shipped to an assembly operation in China, where the product is assembled before being shipped
to the United States for final sale. Lenovo assembles the inkPad in Mexico because managers have
calculated that due to low labor costs, the costs of assembly can be minimized there. e marketing
and sales strategy for North America is developed by Lenovo personnel in the United States,
primarily because managers believe that due to their knowledge of the local marketplace,
U.S. personnel add more value to the product through their marketing efforts than personnel based
elsewhere.
In theory, a firm that realizes location economies by dispersing each of its value creation activities to
its optimal location should have a competitive advantage vis-à-vis a firm that bases all of its value
creation activities at a single location. It should be able to better differentiate its product offering
(thereby raising perceived value, V) and lower its cost structure (C) than its single-location competitor.
In a world where competitive pressures are increasing, such a strategy may become an imperative for
survival.
Some Caveats Introducing transportation costs and trade barriers complicates this picture. Due to favorable factor endowments, New Zealand may have a comparative advantage for automobile
assembly operations, but high transportation costs would make it an uneconomical location from
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which to serve global markets. Another caveat concerns the importance of assessing political and
economic risks when making location decisions. Even if a country looks very attractive as a production
location when measured against all the standard criteria, if its government is unstable or totalitarian,
the firm might be advised not to base production there. (Political risk is discussed in Chapter 3.)
Similarly, if the government appears to be pursuing inappropriate economic policies that could lead to
foreign exchange risk, that might be another reason for not basing production in that location, even if
other factors look favorable.
EXPERIENCE EFFECTS
e experience curve refers to systematic reductions in production costs that have been observed to
occur over the life of a product.23 A number of studies have observed that a product’s production costs
decline by some quantity about each time cumulative output doubles. e relationship was first
observed in the aircraft industry, where each time cumulative output of airframes was doubled, unit
costs typically declined to 80 percent of their previous level.24 us, production cost for the fourth
airframe would be 80 percent of production cost for the second airframe, the eighth airframe’s
production costs 80 percent of the fourth’s, the sixteenth’s 80 percent of the eighth’s, and so on. Figure
12.7 illustrates this experience curve relationship between unit production costs and cumulative output
(the relationship is for cumulative output over time and not output in any one period, such as a year).
Two things explain this: learning effects and economies of scale.
12.7 FIGURE
e experience curve.
Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill Education, 2017).
Learning Effects Learning effects refer to cost savings that come from learning by doing. Labor, for example, learns by repetition how to carry out a task, such as assembling airframes, most efficiently.
Labor productivity increases over time as individuals learn the most efficient ways to perform
particular tasks. Equally important in new production facilities, management typically learns how to
manage the new operation more efficiently over time. Hence, production costs decline due to
increasing labor productivity and management efficiency, which increases the firm’s profitability.
Learning effects tend to be more significant when a technologically complex task is
repeated because there is more that can be learned about the task. us, learning effects will be more
significant in an assembly process involving 1,000 complex steps than in one of only 100 simple steps.
No matter how complex the task, however, learning effects typically disappear after a while. It has been
suggested that they are important only during the start-up period of a new process and that they cease
after two or three years.25 Any decline in the experience curve after such a point is due to economies
of scale.
Economies of Scale Economies of scale refer to the reductions in unit cost achieved by producing a large volume of a product. Attaining economies of scale lowers a firm’s unit costs and
increases its profitability. Economies of scale have a number of sources. One is the ability to spread
fixed costs over a large volume.26 Fixed costs are the costs required to set up a production facility,
develop a new product, and the like. ey can be substantial. For example, the fixed cost of
establishing a new production line to manufacture semiconductor chips now exceeds $5 billion.
Similarly, according to one estimate, developing a new drug and bringing it to market costs about
$800 million and takes about 12 years.27 e only way to recoup such high fixed costs may be to sell
the product worldwide, which reduces average unit costs by spreading fixed costs over a larger volume.
e more rapidly that cumulative sales volume is built up, the more rapidly fixed costs can be
amortized over a large production volume and the more rapidly unit costs will fall.
Second, a firm may not be able to attain an efficient scale of production unless it serves global
markets. In the automobile industry, for example, an efficiently scaled factory is one designed to
produce about 200,000 units a year. Automobile firms would prefer to produce a single model from
each factory because this eliminates the costs associated with switching production from one model to
another. If domestic demand for a particular model is only 100,000 units a year, the inability to attain
a 200,000-unit output will drive up average unit costs. By serving international markets as well,
however, the firm may be able to push production volume up to 200,000 units a year, thereby reaping
greater scale economies, lowering unit costs, and boosting profitability. By serving domestic and
international markets from its production facilities, a firm may be able to utilize those facilities more
intensively. For example, if Intel sold microprocessors only in the United States, it might be able to
keep its factories open for only one shift five days a week. By serving international markets from the
same factories, Intel can utilize its productive assets more intensively, which translates into higher
capital productivity and greater profitability.
Finally, as global sales increase the size of the enterprise, its bargaining power with suppliers
increases as well, which may allow it to attain economies of scale in purchasing, bargaining down the
cost of key inputs and boosting profitability that way. For example, Walmart has used its enormous
sales volume as a lever to bargain down the price it pays suppliers for merchandise sold through its
stores.
Strategic Significance e strategic significance of the experience curve is clear. Moving down the experience curve allows a firm to reduce its cost of creating value (to lower C in Figure 12.2) and
increase its profitability. e firm that moves down the experience curve most rapidly will have a cost
advantage vis-á-vis its competitors. Firm A in Figure 12.7, because it is farther down the experience
curve, has a clear cost advantage over firm B.
Many of the underlying sources of experience-based cost economies are plant-based. is is true for
most learning effects as well as for the economies of scale derived by spreading the fixed costs of
building productive capacity over a large output, attaining an efficient scale of output, and utilizing a
plant more intensively. us, one key to progressing downward on the experience curve as rapidly as
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possible is to increase the volume produced by a single plant as rapidly as possible. Because global
markets are larger than domestic markets, a firm that serves a global market from a single location is
likely to build accumulated volume more quickly than a firm that serves only its home market or that
serves multiple markets from multiple production locations. us, serving a global market from a
single location is consistent with moving down the experience curve and establishing a low-cost
position. In addition, to get down the experience curve rapidly, a firm may need to price and market
aggressively so demand will expand rapidly. It will also need to build sufficient production capacity for
serving a global market. Also, the cost advantages of serving the world market from a single location
will be even more significant if that location is the optimal one for performing the particular value
creation activity.
Once a firm has established a low-cost position, it can act as a barrier to new competition.
Specifically, an established firm that is well down the experience curve, such as firm A in Figure 12.7,
can price so that it is still making a profit while new entrants, which are farther up the curve, are
suffering losses. Intel is one of the masters of this kind of strategy. e costs of building a state-of-the-
art facility to manufacture microprocessors are so large (now around $5 billion) that to make this
investment pay Intel must pursue experience curve effects, serving world markets from a limited
number of plants to maximize the cost economies that derive from scale and learning effects.
LEVERAGING SUBSIDIARY SKILLS
Implicit in our earlier discussion of core competencies is the idea that valuable skills are developed first
at home and then transferred to foreign operations. However, for more mature multinationals that
have already established a network of subsidiary operations in foreign markets, the development of
valuable skills can just as well occur in foreign subsidiaries.28 Skills can be created anywhere within a
multinational’s global network of operations, wherever people have the opportunity and incentive to
try new ways of doing things. e creation of skills that help to lower the costs of production or to
enhance perceived value and support higher product pricing is not the monopoly of the corporate
center.
Leveraging the skills created within subsidiaries and applying them to other operations within the
firm’s global network may create value. McDonald’s is increasingly finding that its foreign franchisees
are a source of valuable new ideas. Faced with slow growth in France, its local franchisees began to
experiment not only with the menu but also with the layout and theme of restaurants. Gone are the
ubiquitous golden arches; gone too are many of the utilitarian chairs and tables and other plastic
features of the fast-food giant. Many McDonald’s restaurants in France now have hardwood floors,
exposed brick walls, and even armchairs. e menu, too, has been changed to include premier
sandwiches, such as chicken on focaccia bread, priced some 30 percent higher than the average
hamburger. In France at least, the strategy seems to be working. Following the change, increases in
same-store sales rose from 1 percent annually to 3.4 percent, and France is now the second-largest
national market for McDonald’s. Impressed with the impact, McDonald’s executives are considering
similar changes at other McDonald’s restaurants in markets where same-store sales growth is sluggish,
including the United States.29
For the managers of the multinational enterprise, this phenomenon creates important new
challenges. First, they must have the humility to recognize that valuable skills that lead to
competencies can arise anywhere within the firm’s global network, not just at the corporate center.
Second, they must establish an incentive system that encourages local employees to acquire new skills.
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is is not as easy as it sounds. Creating new skills involves a degree of risk. Not all new skills add
value. For every valuable idea created by a McDonald’s subsidiary in a foreign country, there may be
several failures. e management of the multinational must install incentives that encourage
employees to take the necessary risks. e company must reward people for successes and not sanction
them unnecessarily for taking risks that did not pan out. ird, managers must have a process for
identifying when valuable new skills have been created in a subsidiary. And finally, they need to act as
facilitators, helping to transfer valuable skills within the firm.
PROFITABILITY AND PROFIT GROWTH SUMMARY
We have seen how firms that expand globally can increase their profitability and profit growth by
entering new markets where indigenous competitors lack similar competencies, by lowering costs and
adding value to their product offering through the attainment of location economies, by exploiting
experience curve effects, and by transferring valuable skills among their global network of subsidiaries.
For completeness, it should be noted that strategies that increase profitability may also expand a firm’s
business and thus enable it to attain a higher rate of profit growth. For example, by simultaneously
realizing location economies and experience effects, a firm may be able to produce a more highly
valued product at a lower unit cost, thereby boosting profitability. e increase in the perceived value
of the product may also attract more customers, thereby growing revenues and profits as well.
Furthermore, rather than raising prices to reflect the higher perceived value of the product, the firm’s
managers may elect to hold prices low in order to increase global market share and attain greater scale
economies (in other words, they may elect to offer consumers better “value for money”).
Such a strategy could increase the firm’s rate of profit growth even further, because
consumers will be attracted by prices that are low relative to value. e strategy might also increase
profitability if the scale economies that result from market share gains are substantial. In sum,
managers need to keep in mind the complex relationship between profitability and profit growth when
making strategic decisions about pricing.
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Cost Pressures and Pressures for Local Responsiveness
LO 12-3 Understand how pressures for cost reductions and local responsiveness influence
strategic choice.
Firms that compete in the global marketplace typically face two types of competitive pressure that
affect their ability to realize location economies and experience effects and to leverage products and
transfer competencies and skills within the enterprise. ey face pressures for cost reductions and
pressures to be locally responsive (see Figure 12.8).30 ese competitive pressures place conflicting
demands on a firm. Responding to pressures for cost reductions requires that a firm try to minimize its
unit costs. But responding to pressures to be locally responsive requires that a firm differentiate its
product offering and marketing strategy from country to country (or in some cases, region to region)
in an effort to accommodate the diverse demands arising from national (or regional) differences in
consumer tastes and preferences, business practices, distribution channels, competitive conditions, and
government policies. Because differentiation across countries can involve significant duplication and a
lack of product standardization, it may raise costs.
12.8 FIGURE
Pressures for cost reductions and local responsiveness.
Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill Education, 2017).
While some enterprises, such as firm A in Figure 12.8, face high pressures for cost reductions and
low pressures for local responsiveness, and others, such as firm B, face low pressures for cost reductions
and high pressures for local responsiveness, many companies are in the position of firm C. ey face
high pressures for both cost reductions and local responsiveness. Dealing with these conflicting and
contradictory pressures is a difficult strategic challenge, primarily because being locally responsive
tends to raise costs.
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PRESSURES FOR COST REDUCTIONS
In competitive global markets, international businesses often face pressures for cost reductions.
Responding to pressures for cost reduction requires a firm to try to lower the costs of value creation. A
manufacturer, for example, might mass-produce a standardized product at the optimal locations in the
world, wherever that might be, to realize economies of scale, learning effects, and location economies.
Alternatively, a firm might outsource certain functions to low-cost foreign suppliers in an attempt to
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reduce costs. us, many computer companies have outsourced their telephone-based customer
service functions to India, where qualified technicians who speak English can be hired for a lower
wage rate than in the United States. In the same manner, a retailer such as Walmart might
push its suppliers (manufacturers) to do the same. (e pressure that Walmart has placed on
its suppliers to reduce prices has been cited as a major cause of the trend among North American
manufacturers to shift production to China.31) A service business such as a bank might respond to
cost pressures by moving some back-office functions, such as information processing, to developing
nations where wage rates are lower.
Pressures for cost reduction can be particularly intense in industries producing commodity-type
products where meaningful differentiation on nonprice factors is difficult and price is the main
competitive weapon. is tends to be the case for products that serve universal needs. Universal needs
exist when the tastes and preferences of consumers in different nations or regions are similar, if not
identical. is is the case for conventional commodity products such as bulk chemicals, petroleum,
steel, sugar, and the like. It also tends to be the case for many industrial and consumer products—for
example, smartphones, semiconductor chips, personal computers, and liquid crystal display screens.
Pressures for cost reductions are also intense in industries where major competitors are based in low-
cost locations, where there is persistent excess capacity, and where consumers are powerful and face
low switching costs. e liberalization of the world trade and investment environment in recent
decades, by facilitating greater international competition, has generally increased cost pressures.32
PRESSURES FOR LOCAL RESPONSIVENESS
Pressures for local responsiveness arise from national or regional differences in consumer tastes and
preferences, infrastructure, accepted business practices, and distribution channels and from host-
government demands. Responding to pressures to be locally responsive requires a firm to differentiate
its products and marketing strategy from country to country or region to region to accommodate
these factors—all of which tends to raise the firm’s cost structure.
Differences in Customer Tastes and Preferences Strong pressures for local responsiveness emerge when customer tastes and preferences differ significantly among countries, as they often do for
deeply embedded historic or cultural reasons. In such cases, a multinational’s products and marketing
message have to be customized to appeal to the tastes and preferences of local customers. is typically
creates pressure to delegate production and marketing responsibilities and functions to a firm’s overseas
subsidiaries.
For example, the automobile industry in the 1990s moved toward the creation of “world cars.” e
idea was that global companies such as General Motors, Ford, and Toyota would be able to sell the
same basic vehicle the world over, sourcing it from centralized production locations. If successful, the
strategy would have enabled automobile companies to reap significant gains from global scale
economies. However, this strategy frequently ran aground upon the hard rocks of consumer reality.
Consumers in different automobile markets seem to have different tastes and preferences, and they
demand different types of vehicles. North American consumers show a strong demand for pickup
trucks. is is particularly true in the South and West of the United States, where many families have
a pickup truck as a second or third car. But in European countries, pickup trucks are seen purely as
utility vehicles and are purchased primarily by firms rather than individuals. As a consequence, the
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product mix and marketing message needs to be tailored to consider the different nature of demand in
North America and Europe.
Some have argued that customer demands for local customization are on the decline
worldwide.33 According to this argument, modern communications and transport technologies have
created the conditions for a convergence of the tastes and preferences of consumers from different
nations. e result is the emergence of enormous global markets for standardized consumer products.
e worldwide acceptance of McDonald’s hamburgers, Coca-Cola, Gap clothes, Apple iPhones, and
Microsoft’s Xbox—all of which are sold globally as standardized products—is often cited as evidence
of the increasing homogeneity of the global marketplace.
However, this argument may not hold in many consumer goods markets. Significant differences in
consumer tastes and preferences still exist across nations, regions, and cultures. Managers in
international businesses do not yet have the luxury of being able to ignore these differences, and they
may not for a long time to come. For an example of a company that has discovered how important
pressures on cost reductions can be, read the accompanying Management Focus on IKEA’s global
strategy.
m a n a g e m e n t f o c u s
IKEA’s Global Strategy
Walk into an IKEA store anywhere in the world, and you would recognize it instantly. Global strategy
standardization is rampant! e warehouse-type stores all sell the same broad range of affordable home
furnishings, kitchens, accessories, and food. Most of the products are instantly recognizable as IKEA
merchandise, with their clean yet tasteful lines and functional design. With a heritage from Sweden (IKEA
was founded in 1943 as a mail order company, and the first store opened in Sweden in 1958), the outside of
the store is wrapped in the blue and yellow colors of the Swedish flag. IKEA has sales of €34.2 billion annually
(about 37 billion U.S. dollars) and more than 150,000 employees. Interestingly, IKEA is responsible for about
1 percent of the world’s commercial-product wood consumption.
e IKEA name comes from its founder—the acronym consists of the founder’s initials from his first and
last names (Ingvar Kamprad) along with the first initials of the farm where he grew up (Elmtaryd) and his
hometown in Sweden (Agunnaryd). Overall, Sweden has 20 IKEA stores, which is only fewer than in
Germany (49 IKEA stores), the United States (42), France (32), and Italy (21). Spain also has 20 stores. e
largest IKEA store is in Gwangmyeong, South Korea, at some 640,000 square feet. With 351 stores in 46
countries, IKEA is the largest furniture retailer in the world. Basically, the furniture market is one of the least
global markets, with local tastes, needs, and interests much different than for many other products across
industries.
e IKEA store itself is laid out as a maze that requires customers to walk through every department before
they reach the checkout stations. e stores are often structured as a one-way layout, leading customers
counterclockwise along what IKEA calls “the long natural way.” is “way” is designed to encourage
customers to see the store in its entirety. Cut-off points and shortcuts exist but are not easy to figure out. It is
even difficult to get back out after having a meal in the famous IKEA restaurant with its Swedish food
(meatballs anyone?).
Immediately before the checkout, there is an in-store warehouse where customers can pick up the items
they purchased. e furniture is all packed flat for ease of transportation and requires assembly by the
customer. Value is stressed to a great extent (i.e., the price customers pay for the quality furniture they get). If
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you look at customers in the store, you will see that many of them are in their 20s and 30s. IKEA sells to the
same basic customers worldwide: young, upwardly mobile people who are looking for tasteful yet inexpensive
“disposable” furniture of a certain quality standard for the price they are willing to pay.
A global network of more than 1,000 suppliers based in more than 50 countries manufactures most of the
12,000 or so products that IKEA sells. IKEA itself focuses on the design of products and works closely with
suppliers to bring down manufacturing costs. Developing a new product line can be a painstaking process that
takes years. IKEA’s designers will develop a prototype design (e.g., a small couch), look at the price that rivals
charge for a similar piece, and then work with suppliers to figure out a way to cut prices by 40 percent
without compromising on quality. IKEA also manufactures about 10 percent of what it sells in-house and uses
the knowledge gained to help its suppliers improve their productivity, thereby lowering costs across the entire
supply chain.
Look a little closer, however, and you will see subtle differences among the IKEA offerings in North
America, Europe, and China. In North America, sizes are different to reflect the American demand for bigger
beds, furnishings, and kitchenware. is adaptation to local tastes and preferences was the result of a painful
learning experience for IKEA. When the company first entered the United States in the late 1980s, it thought
that consumers would flock to its stores the same way that they had in Western Europe. At first they did, but
they didn’t buy as much, and sales fell short of expectations. IKEA discovered that its European-style sofas
were not big enough, wardrobe drawers were not deep enough, glasses were too small, and kitchens didn’t fit
U.S. appliances. So the company set about redesigning its offerings to better match American tastes and was
rewarded with accelerated sales growth.
Lesson learned. When IKEA entered China in the 2000s, it made adaptations to the local market. e
store layout reflects the layout of many Chinese apartments, where most people live, and because many
Chinese apartments have balconies, IKEA’s Chinese stores include a balcony section. IKEA has also had to
shift its locations in China, where car ownership lags behind that in Europe and North America. In the West,
IKEA stores are located in suburban areas and have lots of parking space. In China, stores are located near
public transportation, and IKEA offers a delivery service so that Chinese customers can get their purchases
home.
Sources: Lindsey Rupp, “Ikea, Dollar General CEOs Lobby Republicans in Tax Showdown,” Bloomberg Businessweek, March 7, 2017; D. L. Yohn, “How IKEA Designs Its Brand Success,” Forbes, June 10, 2015; J. Kane, “e 21 Emotional Stages of Shopping at IKEA, From Optimism to Total Defeat,” e Huffington Post, May 6, 2015; J. Leland, “How the Disposable Sofa Conquered America,” e New York Times Magazine, October 5, 2005, p. 45; “e Secret of IKEA’s Success,” e Economist, February 24, 2011; B. Torekull, Leading by Design: e IKEA Story (New York: HarperCollins, 1998); and P. M. Miller, “IKEA with Chinese Characteristics,” Chinese Business Review, July–August 2004, pp. 36–69.
Differences in Infrastructure and Traditional Practices Pressures for local responsiveness arise from differences in infrastructure or traditional practices among countries, creating a need to
customize products accordingly. Fulfilling this need may require the delegation of manufacturing and
production functions to foreign subsidiaries. For example, in North America, consumer electrical
systems are based on 110 volts, whereas in some European countries, 240-volt systems are standard.
us, domestic electrical appliances have to be customized for this difference in infrastructure.
Traditional practices also often vary across nations. For example, in Britain, people drive on
the left-hand side of the road, creating a demand for right-hand-drive cars, whereas in
France (and the rest of Europe), people drive on the right-hand side of the road and therefore want
left-hand-drive cars. Obviously, automobiles have to be customized to accommodate this difference in
traditional practice.
Although many national and regional differences in infrastructure are rooted in history, some are
quite recent. For example, in the wireless telecommunications industry, different technical standards
exist in different parts of the world. A technical standard known as GSM is common in Europe, and
an alternative standard, CDMA, is more common in the United States and Russia. Equipment
designed for GSM will not work on a CDMA network and vice versa. us, companies in this
industry—such as Apple and Samsung—that manufacture smartphones or infrastructure such as
switches need to customize their product offering according to the technical standard prevailing in a
given country or region. GSM stands for Global System for Mobile Communication, and this is the
technology the majority of phones use, given it is the standard system for most of the world.
Differences in Distribution Channels A firm’s marketing strategies may have to be responsive to differences in distribution channels among countries, which may necessitate the delegation of
marketing functions to national subsidiaries. In the pharmaceutical industry, for example, the British
and Japanese distribution systems are radically different from the U.S. system. British and Japanese
doctors will not accept or respond favorably to a U.S.-style high-pressure sales force. us,
pharmaceutical companies have to adopt different marketing practices in Britain and Japan compared
with the United States—soft sell versus hard sell. Similarly, Poland, Brazil, and Russia all have similar
per capita income on a purchasing power parity basis, but there are big differences in distribution
systems across the three countries. In Brazil, supermarkets account for 36 percent of food retailing, in
Poland for 18 percent, and in Russia for less than 1 percent.34 ese differences in channels require
that companies adapt their own distribution and sales strategies.
Host-Government Demands Economic and political demands imposed by host-country governments may require local responsiveness. For example, pharmaceutical companies are subject to
local clinical testing, registration procedures, and pricing restrictions—all of which make it necessary
that the manufacturing and marketing of a drug should meet local requirements. Because governments
and government agencies control a significant proportion of the health care budget in most countries,
they are in a powerful position to demand a high level of local responsiveness.
More generally, threats of protectionism, economic nationalism, and local content rules (which
require that a certain percentage of a product should be manufactured locally) dictate that
international businesses manufacture locally. For example, consider Bombardier, the Canadian-based
manufacturer of railcars, aircraft, jet boats, and snowmobiles. Bombardier has 12 railcar factories
across Europe. Critics of the company argue that the resulting duplication of manufacturing facilities
leads to high costs and helps explain why Bombardier makes lower profit margins on its railcar
operations than on its other business lines. In reply, managers at Bombardier argue that in Europe,
informal rules with regard to local content favor people who use local workers. To sell railcars in
Germany, they claim, you must manufacture in Germany. e same goes for Belgium, Austria, and
France. To try to address its cost structure in Europe, Bombardier has centralized its engineering and
purchasing functions, but it has no plans to centralize manufacturing.35
e Rise of Regionalism Traditionally, we have tended to think of pressures for local responsiveness as being derived from national differences in tastes and preferences, infrastructure, and
the like. While this is still often the case, there is also a tendency toward the convergence of tastes,
preferences, infrastructure, distribution channels, and host-government demands within a broader
region that is composed of two or more nations.36 We tend to see this when there are strong pressures
for convergence due to, for example, a shared history and culture or the establishment of a trading
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block where there are deliberate attempts to harmonize trade policies, infrastructure, regulations, and
the like.
e most obvious example of a region is the European Union and particularly the euro zone
countries within that trade bloc, where there are institutional forces that are pushing toward
convergence (see Chapter 9 for details). e creation of a single EU market—with a single currency,
common business regulations, standard infrastructure, and so on—cannot help but result in the
reduction of certain national differences among countries within the EU and the creation of one
regional rather than several national markets. Indeed, at the economic level at least, that is the explicit
intent of the EU.
Another example of regional convergence is North America, which includes the United States,
Canada, and, to some extent in some product markets, Mexico. Canada and the United States share
history, language, and much of their culture, and both are members of NAFTA. Mexico is clearly
different in many regards, but its proximity to the United States, along with its membership in
NAFTA, implies that for some product markets (e.g., automobiles), it might be reasonable to consider
Mexico as part of a relatively homogenous regional market. We might also talk about the Latin
America region, where shared Spanish history, cultural heritage, and language (with the exception of
Brazil, which was colonized by the Portuguese) mean that national differences are somewhat
moderated. It can also be argued that greater China, which includes the city-states of Hong Kong and
Singapore along with Taiwan, is a coherent region, as is much of the Middle East, where a strong Arab
culture and shared history may limit national differences. Similarly, Russia and some of the former
states of the Soviet Union, such as Belarus and Ukraine, might be considered part of a larger regional
market, at least for some products.
Taking a regional perspective is important because it may suggest that localization at the regional
rather than the national level is the appropriate strategic response. For example, rather than produce
cars for each national market within the Europe or North America, it makes far more sense for car
manufacturers to build cars for the European or North American regions. e ability to standardize
product offering within a region allows for the attainment of greater scale economies, and hence lower
costs, than if each nation had to have its own offering. At the same time, this perspective should not
be pushed too far. ere are still deep and profound cultural differences among France, Germany, and
Italy—all members of the EU—that may in turn require some degree of local customization at the
national level. Managers must thus make a judgment call about the appropriate level of aggregation,
given (1) the product market they are looking at and (2) the nature of national differences and trends
for regional convergence. What might make sense for automobiles, for example, might not be
appropriate for packaged food products.
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Choosing a Strategy
LO 12-4 Identify the different international strategies for competing and their pros and cons.
Page 342
Pressures for local responsiveness imply that it may not be possible for a firm to realize the full benefits
from economies of scale, learning effects, and location economies. It may not be possible to serve the
global marketplace from a single low-cost location, producing a globally standardized product and
marketing it worldwide to attain the cost reductions associated with experience effects. e need to
customize the product offering to local conditions, whether national or regional, may work against the
implementation of such a strategy. For example, as noted, automobile firms have found that Japanese,
American, and European consumers demand different kinds of cars, and this necessitates producing
products that are customized for regional markets. In response, firms such as Honda, Ford, and Toyota
are pursuing a strategy of establishing top-to-bottom design and production facilities in each of these
regions so that they can better serve local demands. Although such customization brings benefits, it
also limits the ability of a firm to realize significant scale economies and location economies.
In addition, pressures for local responsiveness imply that it may not be possible to leverage skills
and products associated with a firm’s core competencies wholesale from one nation or region to
another. Concessions often have to be made to local conditions. Despite being depicted as “poster
child” for the proliferation of standardized global products, even McDonald’s has found that it has to
customize its product offerings (i.e., its menu) to account for national differences in tastes and
preferences.
How do differences in the strength of pressures for cost reductions versus those for local
responsiveness affect a firm’s choice of strategy? Firms typically choose among four main strategic
postures when competing internationally. ese can be characterized as a global
standardization strategy, a localization strategy, a transnational strategy, and an international
strategy.37 e appropriateness of each strategy varies, given the extent of pressures for cost reductions
and local responsiveness. Figure 12.9 illustrates the conditions under which each of these strategies is
most appropriate.
12.9 FIGURE
Four basic strategies.
Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill Education, 2017).
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GLOBAL STANDARDIZATION STRATEGY
Firms that pursue a global standardization strategy focus on increasing profitability and profit
growth by reaping the cost reductions that come from economies of scale, learning effects, and
location economies; that is, their strategic goal is to pursue a low-cost strategy on a global scale. e
production, marketing, and R&D activities of firms pursuing a global standardization strategy are
concentrated in a few favorable locations. Firms pursuing a global standardization strategy try not to
customize their product offering and marketing strategy to local conditions because customization
involves shorter production runs and the duplication of functions, which tends to raise costs. Instead,
they prefer to market a standardized product worldwide so that they can reap the maximum benefits
from economies of scale and learning effects. ey also tend to use their cost advantage to support
aggressive pricing in world markets.
More Customized Products in the Global Marketplace?
e Coca-Cola Company’s (TCCC) Minute Maid Pulpy became the cola giant’s 14th brand to reach $1
billion in global retail sales. As opposed to cola carbonates, which often rely on global brand recognition and
cross-generational formulas for success, Minute Maid Pulpy has relied on product development and
innovations inspired by local flavors and textures. Minute Maid Pulpy contains less than 24 percent actual
fruit juice, but Coca-Cola was able to retail the product at a much lower price point than products with a
higher content of fruit juice. In China and throughout the Asia-Pacific region, consumer notions of freshness
and health are connected much more to the consumption of actual fruit. Minute Maid Pulpy acknowledged
this by including pieces of fruit in the drink, thereby creating a thicker texture that would not appeal to most
North American consumers but has proven very popular in this region of the world. In customizing the
product, Minute Maid Pulpy went from the 10th most popular fruit/vegetable juice brand in China to first.
But isn’t the world becoming more globalized? Do we still need large multinational corporations customizing
their products to local markets?
Source: http://blog.euromonitor.com.
is strategy makes most sense when there are strong pressures for cost reductions and demands for
local responsiveness are minimal. Increasingly, these conditions prevail in many industrial goods
industries, whose products often serve universal needs. In the semiconductor industry, for example,
global standards have emerged, creating enormous demands for standardized global products.
Accordingly, companies such as Intel, Texas Instruments, and Motorola all pursue a global
standardization strategy. However, these conditions are not always found in many consumer goods
markets, where demands for local responsiveness can remain high. e strategy is inappropriate when
demands for local responsiveness are high. To focus on global strategy with local responsiveness, take a
look at the accompanying Management Focus on Unilever’s global organization.
m a n a g e m e n t f o c u s
Unilever’s Global Organization
Unilever (unilever.com) is a Dutch–British company co-headquartered in Rotterdam, Netherlands, and
London, United Kingdom. e company was founded in 1930 by the merger of the Dutch margarine
producer Margarine Unie and the British soapmaker Lever Brothers. Unilever owns more than 400 brands,
but the core of its assortment are 14 brands that have annual sales of more than €1 billion: Axe/Lynx, Dove,
Omo, Becel/Flora, Heartbrand ice creams, Hellmann’s, Knorr, Lipton, Lux, Magnum, Rama, Rexona,
Sunsilk, and Surf.
With the Dutch–British background, Unilever is a dual-listed company consisting of Unilever NV based in
Rotterdam and Unilever PLC based in London. e dual-listed company operates as a single business, with a
shared board of directors. However, Unilever NV and Unilever PLC have different shareholder constituencies,
and shareholders cannot convert or exchange the shares of one company for shares of the other.
e Unilever Group—integration of Unilever NV (Netherlands) and Unilever PLC (United Kingdom)—is
organized and made functional by a number of agreements between the parent companies of NV and PLC.
ese agreements, together with provisions in their respective articles of association, are jointly known as the
Foundation Agreements. ese Foundation Agreements enable Unilever to attain unity of management,
operations, shareholders’ rights, purpose, and mission.
Unilever’s Equalization Agreement regulates the common rights of the shareholders of both NV and PLC.
e objective of the Equalization Agreement is to ensure that the positions of these two sets of shareholders
are as similar as possible. e idea is to ensure that both groups of owners are treated as if they held shares in a
single company.
Unilever’s unity of operations is facilitated by a Deed of Mutual Covenants. is deed is an agreement
between NV and PLC that provides for the allocation of assets within the Unilever Group. Relatedly, the
Agreement for Mutual Guarantees of Borrowing also assists in the creation of the single operating platform
where the objective, again, is to attain unity of management, operations, shareholders’ rights, purpose, and
mission. In effect, this mutual guarantees agreement ensures that Unilever is financially as robust as possible,
using the combined strength of NV and PLC, when asking lenders for certain significant public borrowings.
To structure its operations and management of the more than 400 brands, Unilever is organized into four
main divisions: Foods, Refreshment (beverages and ice cream), Home Care, and Personal Care. ese
divisions employ about 170,000 people, produce sales of some €55 billion annually (about 60 billion U.S.
dollars), and have 57 percent of their business in emerging markets. On a daily basis, a staggering number of
2.5 billion people worldwide use Unilever products (out of the 7.5 billion people in the world).
Sources: “About Unilever,” March 22, 2017, www.unilever.com/about/who-we-are/about-Unilever;
“Unilever‘s Legal Structure and Foundation Agreements,” March 22, 2017, www.unilever.com/investor-
relations/agm-and-corporate-governance/legal-structure-and-foundation-agreements; Port Sunlight, “Unilever:
In Search of the Good Business,” e Economist, August 9, 2014; and Rob Davies, “Unilever Bids to Heal Shareholder Rift Amid ‘Garage Sale’ Warnings,” e Guardian, March 19, 2017.
LOCALIZATION STRATEGY
A localization strategy focuses on increasing profitability by customizing the firm’s goods or services
so that they provide a good match to tastes and preferences in different national or regional markets.
Localization is most appropriate when there are substantial differences across nations or regions with
regard to consumer tastes and preferences and where cost pressures are not too intense. By customizing
the product offering to local demands, the firm increases the value of that product in the local market.
On the downside, because it involves some duplication of functions and smaller production runs,
customization limits the ability of the firm to capture the cost reductions associated with mass-
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producing a standardized product for global consumption. e strategy may make sense, however, if
the added value associated with local customization supports higher pricing, which enables the firm to
recoup its higher costs, or if it leads to substantially greater local demand, enabling the firm to reduce
costs through the attainment of some scale economies in the local market.
At the same time, firms still have to keep an eye on costs. Firms pursuing a localization strategy still
need to be efficient and, whenever possible, to capture some scale economies from their global reach.
As noted earlier, many automobile companies have found that they have to customize some of their
product offerings to local market demands—for example, producing large pickup trucks for North
American consumers and small fuel-efficient cars for Europeans and Japanese. At the same time, these
multinationals try to get some scale economies from their global volume by using common vehicle
platforms and components across many different models and manufacturing those platforms and
components at efficiently scaled factories that are optimally located. By designing their products in this
way, these companies have been able to localize their product offerings, yet simultaneously capture
some scale economies, learning effects, and location economies.
TRANSNATIONAL STRATEGY
We have argued that a global standardization strategy makes most sense when cost pressures are
intense and demands for local responsiveness are limited. Conversely, a localization strategy makes
most sense when demands for local responsiveness are high, but cost pressures are moderate or low.
What happens, however, when the firm simultaneously faces both strong cost pressures and strong
pressures for local responsiveness? How can managers balance the competing and inconsistent
demands such divergent pressures place on the firm? According to some researchers, the answer is to
pursue what has been called a transnational strategy.
Two of these researchers, Christopher Bartlett and Sumantra Ghoshal, argue that in the modern
global environment, competitive conditions are so intense that to survive, firms must do all they can
to respond to pressures for cost reductions and local responsiveness.38 ey must try to realize location
economies and experience effects, leverage products internationally, transfer core competencies and
skills within the company, and simultaneously pay attention to pressures for local
responsiveness.39 Bartlett and Ghoshal note that in the modern multinational enterprise, core
competencies and skills do not reside just in the home country but can develop in any of the firm’s
worldwide operations. us, they maintain that the flow of skills and product offerings should not be
all one way, from home country to foreign subsidiary. Rather, the flow should also be from foreign
subsidiary to home country and from foreign subsidiary to foreign subsidiary. Transnational
enterprises, in other words, must also focus on leveraging subsidiary skills.
In essence, firms that pursue a transnational strategy are trying to simultaneously achieve low
costs through location economies, economies of scale, and learning effects; differentiate their product
offering across geographic markets to account for local differences; and foster a multidirectional flow
of skills between different subsidiaries in the firm’s global network of operations. As attractive as this
may sound in theory, the strategy is not an easy one to pursue because it places conflicting demands
on the company. Differentiating the product to respond to local demands in different geographic
markets raises costs, which runs counter to the goal of reducing costs. Companies such as 3M and
ABB (one of the world’s largest engineering conglomerates) have tried to embrace a transnational
strategy and found it difficult to implement.
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How best to implement a transnational strategy is one of the most complex questions that large
multinationals are grappling with today. Few, if any, enterprises have perfected this strategic posture.
But some clues as to the right approach can be derived from a number of companies. For an example,
consider the case of Caterpillar. e need to compete with low-cost competitors such as Komatsu of
Japan forced Caterpillar to look for greater cost economies. However, variations in construction
practices and government regulations across countries and regions mean that Caterpillar also has to be
responsive to local demands. erefore, Caterpillar confronted significant pressures for cost reductions
and for local responsiveness.
To deal with cost pressures, Caterpillar redesigned its products to use many identical components
and invested in a few large-scale component manufacturing facilities, sited at favorable locations, to fill
global demand and realize scale economies. At the same time, the company augments the centralized
manufacturing of components with assembly plants in each of its major global markets. At these
plants, Caterpillar adds local product features, tailoring the finished product to local needs. us,
Caterpillar is able to realize many of the benefits of global manufacturing while reacting to pressures
for local responsiveness by differentiating its product among national markets.40 Caterpillar started to
pursue this strategy, and a few years later it had succeeded in doubling output per employee,
significantly reducing its overall cost structure in the process. Meanwhile, Komatsu and Hitachi,
which are still wedded to a Japan-centric global strategy, have seen their cost advantages evaporate and
have been steadily losing market share to Caterpillar.
Changing a firm’s strategic posture to build an organization capable of supporting a transnational
strategy is a complex and challenging task. Some would say it is too complex because the strategy
implementation problems of creating a viable organizational structure and control systems to manage
this strategy are immense.
INTERNATIONAL STRATEGY
Sometimes it is possible to identify multinational firms that find themselves in the fortunate position
of being confronted with low cost pressures and low pressures for local responsiveness. Many of these
enterprises have pursued an international strategy, taking products first produced for their domestic
market and selling them internationally with only minimal local customization. e distinguishing
feature of many such firms is that they are selling a product that serves universal needs, but they do
not face significant competitors; thus, unlike firms pursuing a global standardization strategy, they are
not confronted with pressures to reduce their cost structure. Xerox found itself in this position in the
1960s, after its invention and commercialization of the photocopier. e technology underlying the
photocopier was protected by strong patents, so for several years, Xerox did not face competitors—it
had a monopoly. e product serves universal needs, and it was highly valued in most developed
nations. us, Xerox was able to sell the same basic product the world over, charging a relatively high
price for that product. Because Xerox did not face direct competitors, it did not have to deal with
strong pressures to minimize its cost structure.
Is Citigroup Now the Best in Financials?
Recent earnings reports of the financials showed a separation between the more internationally focused
business models of Bank of America and Citigroup from the more domestically focused growth strategies of
JP Morgan and Wells Fargo. e banking sector in the United States is heavily saturated, and the financials
that rely primarily on the domestic economy for growth continue to struggle. Today, when you look at
Citigroup’s business model, the company looks like an international bank headquartered in the United States
because the company gets nearly 70 percent of its revenue overseas. e company is strongly positioned in
almost every major emerging market economy, with bold plans for continued future growth. In Latin
America, for instance, Eduardo Cruz, one of the most respected executives in the banking industry, continues
to successfully build out Citigroup’s retail and investment banking presence. Also, in Asia, where Citigroup
has its largest international footprint, the company continues to be similarly successful in building out its core
banking business across the region, with a particularly strong retail franchise in India. Based on the material in
Chapter 12, do you think Citigroup is using a global standardization strategy, localization strategy,
transnational strategy, or international strategy? And, perhaps more interestingly, is Citigroup now the best in
financials?
Source: http://seekingalpha.com.
Enterprises pursuing an international strategy have followed a similar developmental pattern as
they expanded into foreign markets. ey tend to centralize product development functions such as
R&D at home. However, they also tend to establish manufacturing and marketing functions in each
major country or geographic region in which they do business. e resulting duplication can raise
costs, but this is less of an issue if the firm does not face strong pressures for cost reductions. Although
they may undertake some local customization of product offering and marketing strategy, this tends to
be rather limited in scope. Ultimately, in most firms that pursue an international strategy, the head
office retains fairly tight control over marketing and product strategy.
Firms that have pursued this strategy include Procter & Gamble and Microsoft. Historically,
Procter & Gamble developed innovative new products in Cincinnati and then transferred them
wholesale to local markets (see the accompanying Management Focus). Similarly, the bulk of
Microsoft’s product development work occurs in Redmond, Washington, where the company is
headquartered. Although some localization work is undertaken elsewhere, this is limited to producing
foreign-language versions of popular Microsoft programs.
THE EVOLUTION OF STRATEGY
e Achilles’ heel of the international strategy is that over time, competitors inevitably emerge, and if
managers do not take proactive steps to reduce their firm’s cost structure, it will be rapidly outflanked
by efficient global competitors. is is what happened to Xerox. Japanese companies such as Canon
ultimately invented their way around Xerox’s patents, produced their own photocopiers in very
efficient manufacturing plants, priced them below Xerox’s products, and rapidly took global market
share from Xerox. In the final analysis, Xerox’s demise was not due to the emergence of competitors—
because, ultimately, that was bound to occur—but due to its failure to proactively reduce its cost
structure in advance of the emergence of efficient global competitors. e message in this story is that
an international strategy may not be viable in the long term and to survive, firms need to shift toward
a global standardization strategy or a transnational strategy in advance of competitors (see Figure
12.10).
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12.10 FIGURE
Changes in strategy over time.
Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill Education, 2017).
m a n a g e m e n t f o c u s
Evolution of Strategy at Procter & Gamble
Founded in 1837, Cincinnati-based Procter & Gamble (P&G) has long been one of the world’s most
international companies. Today, P&G is a global colossus in the consumer products business with annual sales
in excess of $80 billion, some 54 percent of which are generated outside of the United States. P&G sells more
than 300 brands—including Ivory soap, Tide, Pampers, IAMS pet food, Crisco, and Folgers—to consumers
in 180 countries. Historically, the strategy at P&G was well established. e company developed new
products in Cincinnati and then relied on semiautonomous foreign subsidiaries to manufacture, market, and
distribute those products in different nations. In many cases, foreign subsidiaries had their own production
facilities and tailored the packaging, brand name, and marketing message to local tastes and preferences. For
years, this strategy delivered a steady stream of new products and reliable growth in sales and profits. By the
1990s, however, profit growth at P&G was slowing.
e essence of the problem was simple; P&G’s costs were too high because of extensive duplication of
manufacturing, marketing, and administrative facilities in different national subsidiaries. e duplication of
assets made sense in the world of the 1960s, when national markets were segmented from each other by
barriers to cross-border trade. Products produced in Great Britain, for example, could not be sold
economically in Germany due to high tariff duties levied on imports into Germany. By the 1980s, however,
barriers to cross-border trade were falling rapidly worldwide and fragmented national markets were merging
into larger regional or global markets. Also, the retailers through which P&G distributed its products were
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growing larger and more global, such as Walmart, Tesco from the United Kingdom, and Carrefour from
France. ese emerging global retailers were demanding price discounts from P&G.
In the 1990s, P&G embarked on a major reorganization in an attempt to control its cost structure and
recognize the new reality of emerging global markets. e company shut down some 30 manufacturing plants
around the globe, laid off 13,000 employees, and concentrated production in fewer plants that could better
realize economies of scale and serve regional markets. It wasn’t enough! Profit growth remained sluggish, so in
1999, P&G launched its second reorganization of the decade. Named “Organization 2005,” the goal was to
transform P&G into a truly global company.
e company tore up its old organization, which was based on countries and regions, and replaced it with
one based on seven self-contained global business units, ranging from baby care to food products. Each
business unit was given complete responsibility for generating profits from its products and for
manufacturing, marketing, and product development. Each business unit was told to rationalize production,
concentrating it in fewer larger facilities; to build global brands wherever possible, thereby eliminating
marketing differences among countries; and to accelerate the development and launch of new products.
P&G announced that as a result of this initiative, it would close another 10 factories and lay off 15,000
employees, mostly in Europe where there was still extensive duplication of assets. e annual cost savings were
estimated to be about $800 million. P&G planned to use the savings to cut prices and increase marketing
spending in an effort to gain market share and thus further lower costs through the attainment of scale
economies. is time, the strategy seemed to be working. P&G has now reported strong growth in both sales
and profits. Significantly, P&G’s global competitors, such as Unilever, Kimberly-Clark, and Colgate-
Palmolive, were struggling during the same time period.
Sources: J. Neff, “P&G Outpacing Unilever in Five-Year Battle,” Advertising Age, November 3, 2003, pp. 1–3; G. Strauss, “Firm Restructuring into Truly Global Company,” USA Today, September 10, 1999, p. B2; Procter & Gamble 10K Report, 2005; and M. Kolbasuk McGee, “P&G Jump-Starts Corporate Change,” Information Week, November 1, 1999, pp. 30–34.
e same can be said about a localization strategy. Localization may give a firm a
competitive edge, but if it is simultaneously facing aggressive competitors, the company will
also have to reduce its cost structure, and the only way to do that may be to shift toward a
transnational strategy. is is what Procter & Gamble has been doing (see the earlier Management
Focus). us, as competition intensifies, international and localization strategies tend to become less
viable, and managers need to orient their companies toward either a global standardization strategy or
a transnational strategy.
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Strategic Alliances
LO 12-5 Explain the pros and cons of using strategic alliances to support international strategies.
Strategic alliances refer to cooperative agreements between potential or actual competitors. In this
section, we are concerned specifically with strategic alliances between firms from different countries.
Strategic alliances run the range from formal joint ventures, in which two or more firms have equity
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stakes (e.g., Fuji Xerox), to short-term contractual agreements, in which two companies agree to
cooperate on a particular task (such as developing a new product). Collaboration between competitors
is fashionable; recent decades have seen an explosion in the number of strategic alliances.
THE ADVANTAGES OF STRATEGIC ALLIANCES
Firms ally themselves with actual or potential competitors for various strategic purposes.41 First,
strategic alliances may facilitate entry into a foreign market. For example, many firms believe that if
they are to successfully enter the Chinese market, they need a local partner who understands business
conditions and who has good connections (or guanxi—see Chapter 4). us, Warner Brothers entered
into a joint venture with two Chinese partners to produce and distribute films in China. As a foreign
film company, Warner found that if it wanted to produce films on its own for the Chinese market, it
had to go through a complex approval process for every film, and it had to farm out distribution to a
local company, which made doing business in China very difficult. Due to the participation of
Chinese firms, however, the joint-venture films will go through a streamlined approval process, and
the venture will be able to distribute any films it produces. Also, the joint venture will be able to
produce films for Chinese TV, something that foreign firms are not allowed to do.42
(L-R) Canadian actor Chris Collins, actress Jacky Cai and actress Hanna Chan arrive at
the red carpet of the premiere of film ‘Paradox’ on August 14, 2017 in Beijing, China. e
strategic alliance between Warner Brothers and their Chinese partners has helped
streamline the process for film distribution.
©VCG/VCG via Getty Images
Strategic alliances also allow firms to share the fixed costs (and associated risks) of
developing new products or processes. An alliance between Boeing and a number of
Japanese companies to build Boeing’s latest commercial jetliner, the 787, was motivated by Boeing’s
desire to share the estimated $8 billion investment required to develop the aircraft.
Was Nokia a Risky Purchase for Microsoft?
Microsoft Corporation’s acquisition of Nokia Corporation’s devices and services business was seen as a bold
but risky gamble in the software giant’s bid for a larger footprint in the fast-growing mobile market. Initially,
it relied heavily on a strategic alliance with Nokia, which in 2011 announced that it was embracing
Microsoft’s Windows Phone as its main operating system. is partnership produced Lumia, a Windows-
based Nokia phone. Nokia got caught in a tough transition from its phones based on its Symbian operating
system to Windows-based devices, and this transition has been more painful than Nokia anticipated. Despite
the somewhat rocky start to their alliance, in September 2013, Microsoft and Nokia announced that the two
companies “have decided to enter into a transaction whereby Microsoft will purchase substantially all of
Nokia’s Devices and Services business, license Nokia’s patents, and license and use Nokia’s mapping
services.” Experts, the markets, and customers were skeptical. Was Nokia a risky purchase for Microsoft? Based
on where Microsoft is today with its phone business, what do you think?
Source: “Microsoft to Acquire Nokia’s Devices and Services Business, License Nokia’s Patents and Mapping
Services,” Microsoft News Center, September 3, 2013.
ird, an alliance is a way to bring together complementary skills and assets that neither company
could easily develop on its own.43 In 2003, for example, Microsoft and Toshiba established an alliance
aimed at developing embedded microprocessors (essentially tiny computers) that can perform a variety
of entertainment functions in an automobile (e.g., run a backseat DVD player or a wireless Internet
connection). e processors run a version of Microsoft’s Windows operating system. Microsoft brings
its software engineering skills to the alliance and Toshiba its skills in developing microprocessors.44
Fourth, it can make sense to form an alliance that will help the firm establish technological
standards for the industry that will benefit the firm. For example, in 2011, Nokia, one of the leading
makers of smartphones, entered into an alliance with Microsoft under which Nokia agreed to license
and use Microsoft’s Windows Mobile operating system in Nokia’s phones. e motivation for the
alliance was in part to help establish Windows Mobile as the industry standard for smartphones as
opposed to the rival operating systems such as Apple’s iPhone and Google’s Android. Unfortunately
for Microsoft, the Nokia’s Windows phones failed to gain sufficient market share. In 2013, Microsoft
decided to acquire Nokia’s mobile phone business and bring it in house so that it could ensure a
continued aggressive push into the smartphone hardware business. But so far, it really has not worked
out to the advantage of Microsoft in the super-competitive mobile phone market.
THE DISADVANTAGES OF STRATEGIC ALLIANCES
Some have criticized strategic alliances on the grounds that they give competitors a low-cost route to
new technology and markets.45 For example, two decades ago, critics argued that many strategic
alliances between U.S. and Japanese firms were part of an implicit Japanese strategy to keep high-
paying, high-value-added jobs in Japan while gaining the project engineering and production process
skills that underlie the competitive success of many U.S. companies.46 ey argued that Japanese
success in the machine tool and semiconductor industries was built on U.S. technology acquired
through strategic alliances. And they argued that U.S. managers were aiding the Japanese by entering
alliances that channel new inventions to Japan and provide a U.S. sales and distribution network for
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the resulting products. Although such deals may generate short-term profits, so the argument goes, in
the long run, the result is to “hollow out” U.S. firms, leaving them with no competitive advantage in
the global marketplace. e same arguments are now made regarding alliances with Chinese firms.
ese critics have a point; alliances have risks. Unless a firm is careful, it can give away more than it
receives. But there are so many examples of apparently successful alliances between firms—including
alliances between U.S. and Japanese firms—that the critics’ position seems extreme. It is difficult to see
how the Microsoft–Toshiba alliance, the Boeing–Mitsubishi alliance for the 787, and the Fuji–Xerox
alliance fit the critics’ thesis. In these cases, both partners seem to have gained from the alliance. Why
do some alliances benefit both firms while others benefit one firm and hurt the other? e next section
provides an answer to this question.
MAKING ALLIANCES WORK
e failure rate for international strategic alliances seems to be high. One study of international
strategic alliances found that two-thirds of them run into serious managerial and financial troubles
within two years of their formation and that although many of these problems are solved,
33 percent are ultimately rated as failures by the parties involved.47 e success of an
alliance seems to be a function of three main factors: partner selection, alliance structure, and the
manner in which the alliance is managed.
Partner Selection One key to making a strategic alliance work is to select the right ally. A good ally, or partner, has three characteristics. First, a good partner helps the firm achieve its strategic goals,
whether they are market access, sharing the costs and risks of product development, or gaining access
to critical core competencies. e partner must have capabilities that the firm lacks and that it values.
Second, a good partner shares the firm’s vision for the purpose of the alliance. If two firms approach an
alliance with radically different agendas, the chances are great that the relationship will not be
harmonious, will not flourish, and will end in divorce. ird, a good partner is unlikely to try to
opportunistically exploit the alliance for its own ends, that is, to expropriate the firm’s technological
know-how while giving away little in return. In this respect, firms with reputations for “fair play”
probably make the best allies. For example, companies such as General Electric are involved in so
many strategic alliances that it would not pay the company to trample over individual alliance
partners.48 is would tarnish GE’s reputation of being a good ally and would make it more difficult
for GE to attract alliance partners. Because IBM attaches great importance to its alliances, it is unlikely
to engage in the kind of opportunistic behavior that critics highlight. Similarly, their reputations make
it less likely (but by no means impossible) that such Japanese firms as Sony, Toshiba, and Fuji, which
have histories of alliances with non-Japanese firms, would opportunistically exploit an alliance partner.
To select a partner with these three characteristics, a firm needs to conduct comprehensive research
on potential alliance candidates. To increase the probability of selecting a good partner, the firm
should
1. Collect as much pertinent, publicly available information on potential allies as possible.
2. Gather data from informed third parties. ese include firms that have had alliances with the
potential partners, investment bankers that have had dealings with them, and former employees.
3. Get to know the potential partner as well as possible before committing to an alliance. is
should include face-to-face meetings between senior managers (and perhaps middle-level
managers) to ensure that the chemistry is right.
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Alliance Structure A partner having been selected, the alliance should be structured so that the firm’s risks of giving too much away to the partner are reduced to an acceptable level. First, alliances
can be designed to make it difficult (if not impossible) to transfer technology not meant to be
transferred. e design, development, manufacture, and service of a product manufactured by an
alliance can be structured so as to wall off sensitive technologies to prevent their leakage to the other
participant. In a long-standing alliance between General Electric and Snecma to build commercial
aircraft engines for single-aisle commercial jet aircraft, for example, GE reduced the risk of excess
transfer by walling off certain sections of the production process. e modularization effectively cut off
the transfer of what GE regarded as key competitive technology, while permitting Snecma access to
final assembly. Formed in 1974, the alliance has been a remarkably long-term success, and it now
dominates the market for certain jet engines used by Boeing and Airbus.49 Similarly, in the alliance
between Boeing and the Japanese to build the 767, Boeing walled off research, design, and marketing
functions considered central to its competitive position, while allowing the Japanese to share in
production technology. Boeing also walled off new technologies not required for 767 production.50
Second, contractual safeguards can be written into an alliance agreement to guard against the risk
of opportunism by a partner. (Opportunism includes the theft of technology and/or markets.) For
example, TRW Inc. entered into three strategic alliances with large Japanese auto component suppliers
to produce seat belts, engine valves, and steering gears for sale to Japanese-owned auto assembly plants
in the United States. TRW put clauses in each of its alliance contracts that barred the Japanese firms
from competing with TRW to supply U.S.-owned auto companies with component parts. By doing
this, TRW protected itself against the possibility that the Japanese companies were entering into the
alliances merely to gain access to the North American market to compete with TRW in its home
market.
ird, both parties to an alliance can agree in advance to swap skills and technologies that the other
covets, thereby ensuring a chance for equitable gain. Cross-licensing agreements are one way to achieve
this goal. Fourth, the risk of opportunism by an alliance partner can be reduced if the firm extracts a
significant credible commitment from its partner in advance. e long-term alliance between Xerox
and Fuji to build photocopiers for the Asian market perhaps best illustrates this. Rather than enter
into an informal agreement or a licensing arrangement (which Fuji Photo initially wanted), Xerox
insisted that Fuji invest in a 50/50 joint venture to serve Japan and East Asia. is venture constituted
such a significant investment in people, equipment, and facilities that Fuji Photo was committed from
the outset to making the alliance work in order to earn a return on its investment. By agreeing to the
joint venture, Fuji essentially made a credible commitment to the alliance. Given this, Xerox felt
secure in transferring its photocopier technology to Fuji.51
Managing the Alliance Once a partner has been selected and an appropriate alliance structure has been agreed on, the task facing the firm is to maximize its benefits from the alliance. As in all
international business deals, an important factor is sensitivity to cultural differences (see Chapter 4).
Many differences in management style are attributable to cultural differences, and managers need to
make allowances for these in dealing with their partner. Beyond this, maximizing the benefits from an
alliance seems to involve building trust between partners and learning from partners.52
Managing an alliance successfully requires building interpersonal relationships between the firms’
managers, or what is sometimes referred to as relational capital.53 is is one lesson that can be drawn
from a successful strategic alliance between Ford and Mazda. Ford and Mazda set up a framework of
meetings within which their managers not only discuss matters pertaining to the alliance but also have
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time to get to know each other better. e belief is that the resulting friendships help build trust and
facilitate harmonious relations between the two firms. Personal relationships also foster an informal
management network between the firms. is network can then be used to help solve problems arising
in more formal contexts (such as in joint committee meetings between personnel from the two firms).
Academics have argued that a major determinant of how much acquiring knowledge a company
gains from an alliance is its ability to learn from its alliance partner.54 For example, in a five-year study
of strategic alliances between major multinationals, Gary Hamel, Yves Doz, and C. K. Prahalad
focused on a number of alliances between Japanese companies and Western (European or American)
partners.55 In every case in which a Japanese company emerged from an alliance stronger than its
Western partner, the Japanese company had made a greater effort to learn. Few Western companies
studied seemed to want to learn from their Japanese partners. ey tended to regard the alliance
purely as a cost-sharing or risk-sharing device, rather than as an opportunity to learn how a potential
competitor does business.
Consider the alliance between General Motors and Toyota constituted in 1985 to build the
Chevrolet Nova. is alliance was structured as a formal joint venture, called New United Motor
Manufacturing Inc., and each party had a 50 percent equity stake. e venture owned an auto plant in
Fremont, California. According to one Japanese manager, Toyota quickly achieved most of its
objectives from the alliance: “We learned about U.S. supply and transportation. And we got the
confidence to manage U.S. workers.”56 All that knowledge was then transferred to Georgetown,
Kentucky, where Toyota opened its own plant in 1988. Possibly all GM got was a new product, the
Chevrolet Nova. Some GM managers complained that the knowledge they gained through the alliance
with Toyota has never been put to good use inside GM. ey believe they should have been kept
together as a team to educate GM’s engineers and workers about the Japanese system. Instead, they
were dispersed to various GM subsidiaries.
To maximize the learning benefits of an alliance, a firm must try to learn from its partner and then
apply the knowledge within its own organization. It has been suggested that all operating employees
should be well briefed on the partner’s strengths and weaknesses and should understand how acquiring
particular skills will bolster their firm’s competitive position. Hamel and Prahalad note that this is
already standard practice among Japanese companies. ey made this observation:
We accompanied a Japanese development engineer on a tour through a partner’s factory. is
engineer dutifully took notes on plant layout, the number of production stages, the rate at which
the line was running, and the number of employees. He recorded all this despite the fact that he
had no manufacturing responsibility in his own company, and that the alliance did not encompass
joint manufacturing. Such dedication greatly enhances learning.57
test PREP
Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go
to learnsmartadvantage.com for help.
Key Terms
strategic alliances, p. 323
strategy, p. 323
profitability, p. 323
profit growth, p. 323
value creation, p. 324
operations, p. 327
organization architecture, p. 329
organizational structure, p. 329
controls, p. 330
incentives, p. 330
processes, p. 330
organizational culture, p. 330
people, p. 330
core competence, p. 331
location economies, p. 332
global web, p. 333
experience curve, p. 334
learning effects, p. 334
economies of scale, p. 335
universal needs, p. 338
global standardization strategy, p. 342
localization strategy, p. 343
transnational strategy, p. 344
international strategy, p. 345
Summary
is chapter reviewed basic principles of strategy and the various ways in which firms can profit from
global expansion, and it looked at the strategies that firms that compete globally can adopt. e
chapter made the following points:
1. A strategy can be defined as the actions that managers take to attain the goals of the firm. For
most firms, the preeminent goal is to maximize shareholder value. Maximizing shareholder value
requires firms to focus on increasing their profitability and the growth rate of profits over time.
2. International expansion may enable a firm to earn greater returns by transferring the product
offerings derived from its core competencies to markets where indigenous competitors lack those
product offerings and competencies.
3. It may pay a firm to base each value creation activity it performs at that location where factor
conditions are most conducive to the performance of that activity. We refer to this strategy as
focusing on the attainment of location economies.
4. By rapidly building sales volume for a standardized product, international expansion can assist a
firm in moving down the experience curve by realizing learning effects and economies of scale.
5. A multinational firm can create additional value by identifying valuable skills created within its
foreign subsidiaries and leveraging those skills within its global network of operations.
6. e best strategy for a firm to pursue often depends on a consideration of the pressures for cost
reductions and for local responsiveness.
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7. Firms pursuing an international strategy transfer the products derived from core competencies
to foreign markets, while undertaking some limited local customization.
8. Firms pursuing a localization strategy customize their product offering, marketing strategy, and
business strategy to national conditions.
9. Firms pursuing a global standardization strategy focus on reaping the cost reductions that come
from experience curve effects and location economies.
10. Many industries are now so competitive that firms must adopt a transnational strategy. is
involves a simultaneous focus on reducing costs, transferring skills and products, and boosting
local responsiveness. Implementing such a strategy may not be easy.
11. Strategic alliances are cooperative agreements between actual or potential competitors.
12. e advantages of alliances are that they facilitate entry into foreign markets, enable partners to
share the fixed costs and risks associated with new products and processes, facilitate the transfer
of complementary skills between companies, and help firms establish technical standards.
13. A disadvantage of a strategic alliance is that the firm risks giving away technological know-how
and market access to its alliance partner in return for very little.
14. e disadvantages associated with alliances can be reduced if the firm selects partners carefully,
paying close attention to the firm’s reputation and the structure of the alliance so as to avoid
unintended transfers of know-how.
15. Keys to making alliances work seem to be building trust and informal communications
networks between partners and taking proactive steps to learn from alliance partners.
Critical inking and Discussion Questions
1. In a world of zero transportation costs, no trade barriers, and nontrivial differences between
nations with regard to factor conditions, firms must expand internationally if they are to survive.
Discuss.
2. Plot the position of the following firms on Figure 12.8: Procter & Gamble, IBM, Apple, Coca-
Cola, Dow Chemical, U.S. Steel, McDonald’s. In each case, justify your answer.
3. In what kind of industries does a localization strategy make sense? When does a global
standardization strategy make most sense?
4. Reread the Management Focus: “AB InBev, Beer Globally, and Creating Value,” and then answer
the following questions:
a. With more than 200 brands and strong coverage internationally of the different brands,
strategically AB InBev is a unique and highly organized global company. Do they have too
many brands? Why or why not?
b. e company follows a focused brands strategy in which the majority of the resources are
devoted to those brands that have the greatest long-term growth potential. What positives
and negatives do you see with this approach?
c. Strategically, AB InBev has 10 principles driving everything they do. At the core, AB InBev is
focused on a shared dream that energizes everyone to work in the same direction to be the
best beer company in the world, bring people together, and aspire for the betterment of the
world. Additional principles cover people strengths, quality of teams, striving for increased
satisfaction, consumer focus, ownership, common sense and simplicity, cost management,
leadership, and hard work and responsibility. Should large multinational corporations really
be built on strong principles or do they need a more flexible structure?
5. What do you see as the main organizational problems that are likely to be associated with the
implementation of a transnational strategy?
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. Several classifications and rankings of the world’s largest companies are prepared by a variety of
sources. Find one such composite ranking system, and identify the criteria that are used to rank
the top global companies. Extract the list of the top 20 ranked companies, paying particular
attention to their home countries.
2. e top management of your company, a manufacturer and marketer of smartphones, has
decided to pursue international expansion opportunities in eastern Europe. To ensure success,
management’s goal is to enter into countries with a high level of global connectedness. Identify the
top three eastern European countries in which your company can market its current product
line. Prepare an executive summary to support your recommendations.
S o n y C o r p o r a t i o n : A n I n t e r n a t i o n a l I n n o v a t o r ?
c l o s i n g c a s e
Sony Corporation (sony.com) is one of the most well-known companies in the world. With a heritage from
Japan as a multinational conglomerate that was founded in 1946, the company is headquartered in Kōnan,
Minato, Tokyo. Sony has annual sales of about 7 trillion Japanese yen (65 billion U.S. dollars), 128,000
employees, and some 100 global subsidiaries and affiliates. e global strategy of Sony has been as an
innovator in its industries of electronics, semiconductors, computers, video games, and telecommunications
equipment.
Strategically, Sony’s products and services can be classified into 12 core business segments: TV and video,
audio, digital camera, professional products and solutions, medical, semiconductors, smartphones and
Internet, game and network services, pictures, music, and financial services. To integrate these 12 segments,
Sony has a vision of “using our unlimited passion for technology, content and services to deliver
groundbreaking new excitement and entertainment.” e mission is even clearer. Sony is “a company that
inspires and fulfills your curiosity.”
is “strategic curiosity” has served Sony well as a global innovator for more than seven decades. For
example, in 1960 Sony launched the world’s first direct-view portable transistor TV and in 1961 developed
the world’s first transistor-based videotape recorder. e strategy for the future is through the stunning reality
of visuals that can be created by big-screen TVs and dynamic sound, Sony plans to transform the viewing
experience from “watching” to “feeling.”
Behind the scenes, Sony has also spent more than 50 years honing its technological excellence in the field
of broadcasting and in the professional products. e company’s products are widely used in the production
Page 353
of movies and television shows, as well as in live sporting events. is has resulted in a high global market
share for Sony and the company receiving a number of Emmy Awards—one of the most prestigious prizes in
the broadcasting industry. Moving forward, Sony is placing a strategic emphasis on providing new value
through end-to-end solutions that meet the needs of various customers by incorporating technologies
enhanced in the area of content creation.
©Bloomberg/Getty Images
Beyond the 12 core segments that have served Sony well strategically for a long time, the company is
embarking on global initiatives to create new business opportunities. ey are accelerating research and
development (R&D) activities to bring about innovations that can, if successful, become new strategic
business segments serving customers’ needs and wants. To strategically evaluate and nurture potential
opportunities, Sony divides these into new business ventures (Life Space UX, Seed Acceleration Program, and
Sports Entertainment) and R&D opportunities (Future Lab Program and Sony Computer Science
Laboratories Inc.).
On the business venture side, Life Space UX is a concept that is defined by delivering unique experiences
and facilitating new ways to transform a person’s living space. e Seed Acceleration Program’s goal
is to gather and nurture new business ideas from beyond the boundaries of existing Sony
organizations (which is very similar to many organizations’ strategies that are innovatively new). Additionally,
with its range of products and services designed to enrich various everyday life situations, Sony is focused on a
new business venture of providing discoveries and experiences in sports.
e Future Lab Program is a part of Sony’s heavy investment in R&D. It embraces an approach to
technological R&D that emphasizes an open creative environment and direct lines of communication with
society, with the end goal being to co-create new lifestyles and customer value. At Sony Computer Science
Laboratories Inc.—often abbreviated to Sony CSL—value is assessed based on achievements that can
contribute to humanity and society, to new science and technology, to industrial progress, and to product
development.
Sources: Anousha Sakoui and Yuji Nakamura, “Sony CEO Heads to Hollywood in Push to Revive Movie Studio,” Bloomberg
Businessweek, January 31, 2017; “New Business and R&D,” March 22, 2017, www.sony.net/SonyInfo/CorporateInfo/newbusiness;
“Here’s Sony’s New Business Strategy,” e Economist, February 21, 2015; and “Sony Global Corporate Strategy,” June 29,
2016, www.sony.net/SonyInfo/IR/strategy.
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CASE DISCUSSION QUESTIONS
1. Do you see Sony as an innovator in its industries of electronics, semiconductors, computers,
video games, and telecommunications equipment? Why or why not?
2. Sony has a vision of “using our unlimited passion for technology, content and services to
deliver groundbreaking new excitement and entertainment.” e mission is even clearer.
Sony is “a company that inspires and fulfills your curiosity.” Does Sony inspire and fulfill
your curiosity?
3. Sony has 12 core segments in its business. Is this too many or not enough? Are today’s
companies diversified like they used to be a few decades ago? Can Sony’s 12-segment
business model be sustainable?
4. e Future Lab Program, which is a part of Sony’s investment in R&D, embraces an
approach to technological R&D that emphasizes an open creative environment and direct
lines of communication with society, with the end goal being to co-create new lifestyles and
customer value. Does Sony create significant customer value? Does Sony create new
lifestyles?
Endnotes
1. Sui Sui and Matthias Baum, “Internationalization Strategy, Firm Resources and the Survival of
SMEs in the Export Market,” Journal of International Business Studies 45, no. 7 (September
2014), pp. 821–41.
2. Constantine S. Katsikeas, Neil A. Morgan, Leonidas C. Leonidou, and G. Tomas M. Hult,
“Assessing Performance Outcomes in Marketing,” Journal of Marketing 80, no. 2 (2016), pp. 1–
20.
3. Tomas Hult, David Closs, and David Frayer, Global Supply Chain Management: Leveraging
Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill
Professional, 2014).
4. Katsikeas et al., “Assessing Performance Outcomes in Marketing.”
5. Gary A. Knight and Daekwan Kim, “International Business Competence and the
Contemporary Firm,” Journal of International Business Studies 40, 2 (2009), pp. 255–73.
6. For interesting empirical studies that deal with the issues of timing and resource commitments,
see T. Isobe, S. Makino, and D. B. Montgomery, “Resource Commitment, Entry Timing, and
Market Performance of Foreign Direct Investments in Emerging Economies,” Academy of
Management Journal 43, no. 3 (2000), pp. 468–84; and Y. Pan and P. S. K. Chi, “Financial
Performance and Survival of Multinational Corporations in China,” Strategic
Management Journal 20, no. 4 (1999), pp. 359–74. A complementary theoretical
perspective on this issue can be found in V. Govindarjan and A. K. Gupta, e Quest for Global
Dominance (San Francisco: Jossey-Bass, 2001). Also see F. Vermeulen and H. Barkeme, “Pace,
Rhythm and Scope: Process Dependence in Building a Profitable Multinational Corporation,”
Strategic Management Journal 23 (2002), pp. 637–54.
7. is can be reconceptualized as the resource base of the entrant, relative to indigenous
competitors. For work that focuses on this issue, see W. C. Bogner, H. omas, and J. McGee,
“A Longitudinal Study of the Competitive Positions and Entry Paths of European Firms in the
U.S. Pharmaceutical Market,” Strategic Management Journal 17 (1996), pp. 85–107; D. Collis,
“A Resource-Based Analysis of Global Competition,” Strategic Management Journal 12 (1991),
pp. 49–68; and S. Tallman, “Strategic Management Models and Resource-Based Strategies
among MNEs in a Host Market,” Strategic Management Journal 12 (1991), pp. 69–82.
8. e concept of consumer surplus is an important one in economics. For a more detailed
exposition, see D. Besanko, D. Dranove, and M. Shanley, Economics of Strategy (New York: John
Wiley & Sons, 1996).
9. However, P = V only in the special case in which the company has a perfect monopoly and in
which it can charge each customer a unique price that reflects the value of the product to that
customer (i.e., where perfect price discrimination is possible). More generally, except in the
limiting case of perfect price discrimination, even a monopolist will see most consumers capture
some of the value of a product in the form of a consumer surplus.
10. is point is central to the work of Michael Porter, Competitive Advantage (New York: Free
Press, 1985). See also chap. 4 in P. Ghemawat, Commitment: e Dynamic of Strategy (New
York: Free Press, 1991).
11. M. E. Porter, Competitive Strategy (New York: Free Press, 1980).
12. M. E. Porter, “What Is Strategy?” Harvard Business Review, On-point Enhanced Edition article,
February 1, 2000.
13. Porter, Competitive Advantage.
14. D. Naidler, M. Gerstein, and R. Shaw, Organization Architecture (San Francisco: Jossey-Bass,
1992).
15. G. Morgan, Images of Organization (Beverly Hills, CA: Sage Publications, 1986).
16. Empirical evidence does seem to indicate that, on average, international expansion is linked to
greater firm profitability. For some recent examples, see M. A. Hitt, R. E. Hoskisson, and
H. Kim, “International Diversification, Effects on Innovation and Firm Performance,” Academy
of Management Journal 40, no. 4 (1997), pp. 767–98; and S. Tallman and J. Li, “Effects of
International Diversity and Product Diversity on the Performance of Multinational Firms,”
Academy of Management Journal 39, no. 1 (1996), pp. 179–96.
17. is concept has been popularized by G. Hamel and C. K. Prahalad, Competing for the Future
(Boston: Harvard Business School Press, 1994). e concept is grounded in the resource-based
view of the firm; for a summary, see J. B. Barney, “Firm Resources and Sustained Competitive
Advantage,” Journal of Management 17 (1991), pp. 99–120; and K. R. Conner, “A Historical
Comparison of Resource-Based eory and Five Schools of ought within Industrial
Organization Economics: Do We Have a New eory of the Firm?” Journal of Management 17
(1991), pp. 121–54.
18. J. P. Womack, D. T. Jones, and D. Roos, e Machine at Changed the World (New York:
Rawson Associates, 1990).
19. M. E. Porter, e Competitive Advantage of Nations (New York: Free Press, 1990).
20. Example is based on C. S. Trager, “Enter the Mini-Multinational,” Northeast International
Business, March 1989, pp. 13–14.
21. See R. B. Reich, e Work of Nations (New York: Alfred A. Knopf, 1991); and P. J. Buckley and
N. Hashai, “A Global System View of Firm Boundaries,” Journal of International Business
Page 355
Studies, January 2004, pp. 33–50.
22. D. Barboza, “An Unknown Giant Flexes Its Muscles,” e New York Times, December 4, 2004,
pp. B1, B3.
23. G. Hall and S. Howell, “e Experience Curve from an Economist’s Perspective,” Strategic
Management Journal 6 (1985), pp. 197–212.
24. A. A. Alchain, “Reliability of Progress Curves in Airframe Production,” Econometrica 31 (1963),
pp. 697–98.
25. Hall and Howell, “e Experience Curve from an Economist’s Perspective.”
26. For a full discussion of the source of scale economies, see D. Besanko, D. Dranove, and M.
Shanley, Economics of Strategy (New York: John Wiley & Sons, 1996).
27. is estimate was provided by the Pharmaceutical Manufacturers Association.
28. See J. Birkinshaw and N. Hood, “Multinational Subsidiary Evolution: Capability and Charter
Change in Foreign Owned Subsidiary Companies,” Academy of Management Review 23
(October 1998), pp. 773–95; A. K. Gupta and V. J. Govindarajan, “Knowledge Flows within
Multinational Corporations,” Strategic Management Journal 21 (2000), pp. 473–96; V. J.
Govindarajan and A. K. Gupta, e Quest for Global Dominance (San Francisco: Jossey Bass,
2001); T. S. Frost, J. M. Birkinshaw, and P. C. Ensign, “Centers of Excellence in Multinational
Corporations,” Strategic Management Journal 23 (2002), pp. 997–1018; and U. Andersson, M.
Forsgren, and U. Holm, “e Strategic Impact of External Networks,” Strategic Management
Journal 23 (2002), pp. 979–96.
29. S. Leung, “Armchairs, TVs and Espresso: Is It McDonald’s?” e Wall Street Journal, August 30,
2002, pp. A1, A6; and E. Beardsley, “Why McDonald’s in France Doesn’t Feel Like Fast Food,”
NPR, January 24, 2012.
30. C. K. Prahalad and Yves L. Doz, e Multinational Mission: Balancing Local Demands and
Global Vision (New York: Free Press, 1987). Also see J. Birkinshaw, A. Morrison, and J. Hulland,
“Structural and Competitive Determinants of a Global Integration Strategy,” Strategic
Management Journal 16 (1995), pp. 637–55; and P. Ghemawat, Redefining Global Strategy
(Boston: Harvard Business School Press, 2007).
31. J. E. Garten, “Wal-Mart Gives Globalization a Bad Name,” BusinessWeek, March 8, 2004, p. 24.
32. Prahalad and Doz, e Multinational Mission. Prahalad and Doz actually talk about local
responsiveness rather than local customization.
33. T. Levitt, “e Globalization of Markets,” Harvard Business Review, May–June 1983,
pp. 92–102.
34. W. W. Lewis, e Power of Productivity (Chicago: University of Chicago Press, 2004).
35. C. J. Chipello, “Local Presence Is Key to European Deals,” e Wall Street Journal, June 30,
1998, p. A15.
36. For an extended discussion see G. S. Yip and G. Tomas M. Hult, Total Global Strategy (Boston:
Pearson, 2012); and A. M. Rugman and A. Verbeke, “A Perspective on Regional and Global
Strategies of Multinational Enterprises,” Journal of International Business Studies 35, no. 1
(2004), pp. 3–18.
37. C. A. Bartlett and S. Ghoshal, Managing Across Borders: e Transnational Solution (Boston:
Harvard Business School Press, 1998).
38. C. A. Bartlett and S. Ghoshal, Managing Across Borders: e Transnational Solution (Boston:
Harvard Business School Press, 1998).
39. Pankaj Ghemawat makes a similar argument, although he does not use the term transnational.
See Ghemawat, Redefining Global Strategy.
40. T. Hout, M. E. Porter, and E. Rudden, “How Global Companies Win Out,” Harvard Business
Review, September–October 1982, pp. 98–108.
41. See K. Ohmae, “e Global Logic of Strategic Alliances,” Harvard Business Review, March–April
1989, pp. 143–54; G. Hamel, Y. L. Doz, and C. K. Prahalad, “Collaborate with Your
Competitors and Win!” Harvard Business Review, January–February 1989, pp. 133–39; W.
Burgers, C. W. L. Hill, and W. C. Kim, “Alliances in the Global Auto Industry,” Strategic
Management Journal 14 (1993), pp. 419–32; and P. Kale, H. Singh, and H. Perlmutter,
“Learning and Protection of Proprietary Assets in Strategic Alliances: Building Relational
Capital,” Strategic Management Journal 21 (2000), pp. 217–37.
42. L. T. Chang, “China Eases Foreign Film Rules,” e Wall Street Journal, October 15, 2004, p.
B2.
43. B. L. Simonin, “Transfer of Marketing Know-How in International Strategic Alliances,” Journal
of International Business Studies, 1999, pp. 463–91; and J. W. Spencer, “Firms’ Knowledge
Sharing Strategies in the Global Innovation System,” Strategic Management Journal 24 (2003),
pp. 217–33.
44. C. Souza, “Microsoft Teams with MIPS, Toshiba,” EBN, February 10, 2003, p. 4.
45. Kale, Singh, and Perlmutter, “Learning and Protection of Proprietary Assets.”
46. R. B. Reich and E. D. Mankin, “Joint Ventures with Japan Give Away Our Future,” Harvard
Business Review, March–April 1986, pp. 78–90.
47. J. Bleeke and D. Ernst, “e Way to Win in Cross-Border Alliances,” Harvard Business Review,
November–December 1991, pp. 127–35.
48. C. H. Deutsch, “e Venturesome Giant,” e New York Times, October 5, 2007, pp. C1, C8.
49. “Odd Couple: Jet Engines,” e Economist, May 5, 2007, pp. 79–80.
50. W. Roehl and J. F. Truitt, “Stormy Open Marriages Are Better,” Columbia Journal of World
Business, Summer 1987, pp. 87–95.
51. B. Gomes-Casseres and K. McQuade, “Xerox and Fuji Xerox,” Cambridge, MA: Harvard
Business School Case, February 15, 1991.
52. See T. Khanna, R. Gulati, and N. Nohria, “e Dynamics of Learning Alliances: Competition,
Cooperation, and Relative Scope,” Strategic Management Journal 19 (1998), pp. 193–210; and
Kale, Singh, and Perlmutter, “Learning and Protection of Proprietary Assets in Strategic
Alliances.”
53. Kale, Singh, and Perlmutter, “Learning and Protection of Proprietary Assets in Strategic
Alliances.”
54. Hamel, Doz, and Prahalad, “Collaborate with Your Competitors and Win!”; Khanna, Gulati,
and Nohria, “e Dynamics of Learning Alliances”; and E. W. K. Tang, “Acquiring Knowledge
by Foreign Partners from International Joint Ventures in a Transition Economy: Learning by
Doing and Learning Myopia,” Strategic Management Journal 23 (2002), pp. 835–54.
55. Hamel, Doz, and Prahalad, “Collaborate with Your Competitors and Win!”
56. B. Wysocki, “Cross-Border Alliances Become Favorite Way to Crack New Markets,” e Wall
Street Journal, March 4, 1990, p. A1.
57. G. Hamel and C. K. Prahalad, Competing for the Future (Boston, MA: Harvard Business School
Press, 1994).
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-
Hill Education
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13
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Part 5 e Strategy of International Business
Entering Developed and Emerging Markets
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO13-1 Explain the three basic decisions that firms contemplating foreign expansion must make: which markets
to enter, when to enter those markets, and on what scale.
LO13-2 Compare and contrast the different modes that firms use to enter foreign markets.
LO13-3 Identify the factors that influence a firm’s choice of entry mode.
LO13-4 Recognize the pros and cons of acquisitions versus greenfield ventures as an entry strategy.
IKEA Entering India, Finally!
opening case
e Swedish home furnishings giant IKEA has finally entered India in 2018 after more than five years of
preparation (including the last two years building the stores). e question still lingers though, can IKEA
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adapt to the aesthetic wants and needs of Indian customers and can the company motivate the Indian
customers to buy into the do-it-yourself bug that is a symbol of the IKEA brand? After all, many customers
around the world think that IKEA’s success was built on the “L-shaped” metal IKEA tool used to put together
virtually all of IKEA’s furniture after you get the pieces out of the flat box. And no one knows what to call the
L-shaped tool—although there is an official IKEA emoji for it on smartphones and a keyboard app for iOS
and Android phones for IKEA emoticons (the meatball plate with a Swedish flag at the top looks interesting)!
But is this a style, emoji, emoticons, and lifestyle that will work in India? How is it working so far?
India became the 51st country that the largest furniture company in the world, IKEA, entered since its
founding in 1943. Since its founding, IKEA has become a $43 billion company in sales annually (€35
billion), which has been the envy of the furniture industry and the benchmarking model for companies across
several industries around the world. e flat packaging, high quality for the price you pay (i.e., great value),
and global supply chains make IKEA a superbly efficient company with a very effective business model.
Amazingly, the business model has been in place ever since Ingvar Kamprad founded IKEA, with very
minimal changes except for being implemented on a much larger scale—growing rapidly almost every year.
e IKEA business model and the company’s assortment of products are now on the move to take over
India like they have been doing with other countries. After all, IKEA’s market entry into China in 1998 went
reasonably well. IKEA has three stores in Shanghai, two stores in Beijing, two stores in Chengdu, and one
store each in Tianjin, Guangzhou, Shenzhen, Nanjing, Dalian, and Shenyang, along with eleven more stores
across smaller cities in China. For India, IKEA initially plans to open 25 stores but has marked some 49
Indian cities that have potential to get an IKEA store in the future. e 25-store plans call for an investment
of about $2 billion over 15 to 20 years. As we said in the opening, IKEA began its India market entry
planning in 2013 and started building in 2016. e first construction took place in Hyderabad and is a
400,000 square-foot store at a cost of $110 million.
To ease Indian customers into the IKEA model before the store opened in 2018, the company unwrapped
its first experiential center IKEA Hej (Hello) Home close to the IT hub of Hyderabad. e Hej Home small-
scale store provides some insight into IKEA products and solutions, which future Indian customers could buy
before the store opened in Hyderabad. is also eased the market entry into India and helped point out
glaring problems that IKEA management could tackle before opening the actual large-scale IKEA store. e
Hej Home, designed and built over a six-month period, highlights what IKEA stands for and what to expect.
Ikea Hej Home reflects IKEA’s understanding of life at home in India and its unique home
furnishing solutions, including food and room settings, for Indian homes.
e preparation to get to the IKEA Hej Home concept and ultimately to the first large-scale store opening
in Hyderabad was a long research-oriented endeavor. e Swedish home furnishings giant with a reputation
for being very Swedish in almost everything they do sent one of its top design executives, Marie Lundström,
to India with a mission to understand the Indian mindset and aesthetic. IKEA had decided that it needed to
learn everything it possibly could about the Indian customers in a variety of Indian homes, places, and
settings. e entry into China in 1998 went well but was also undertaken before the social media world we
now live in. India could not go wrong for IKEA; the brand depended on it.
Marie Lundström didn’t leave a single stone unturned. She visited nearly 200 Indian homes all across the
large landscape of India. She spent countless hours interacting with Indian family members. IKEA also did the
customary customer surveys with a large cross-section of the potential customers. In all, under the leadership
of Marie Lundström, IKEA found some important characteristics of the Indian customers that could be
effectively used by IKEA to make sure that their market entry into the country in 2018 was as successful as it
could possibly be. Some of the findings indicated that Indians love color. Indians’ family lives center around
the couch. ey watch TV while eating, which is not much different than Americans and many other
nationalities, but nevertheless a finding that was helpful to understand India, the country’s customers, and
their characteristics. Unfortunately, customers in India are not also big fans of the IKEA trademark of do-it-
yourself.
Taking all of this into account, IKEA could now plan accordingly. e company meticulously planned its
large-scale store design and product range for one of the largest economies in the world with one of the largest
potential customer populations. It is a remarkable journey that took IKEA through five years from initiation
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Interactive Rankings
of the idea of entering India, to three years of detailed planning and research, and a couple of years of actually
building the first store in Hyderabad. It is a fascinating story, journey, and a deviation from normal practice
for IKEA—the company that prides itself on being Swedish in its processes, product names, and food served
in its restaurants! To date, IKEA has about 400 employees in India and the company has plans to increase that
number to 15,000 employees by 2025, with half being women. •
Sources: Rathna Bhushan, “Ikea Betting on New Markets; Will Open Stores in India Next Year,” e Economic Times, April 27,
2017; Ashish Gupta, “Is India Ready for IKEA?” Fortune India, March 24, 2017; Natasha Lomas, “IKEA Does Emoji,” Tech
Crunch, February 11, 2015; V. Rishi Kumar, “IKEA Opens First Hej Home in India at Hyderabad,” Business Line, November 22,
2017; and Saurabh Singh, “IKEA’s India Plan: To Hire 15,000 Co-Workers with Equal Representation from
Women,” EnTrackr, December 7, 2017.
Introduction
is chapter is concerned with two closely related topics: (1) the decision of which foreign markets to
enter, when to enter them, and on what scale; and (2) the choice of entry mode. We covered strategic
alliances in Chapter 12 when we discussed the strategy of international business, which also has
implications for entering foreign markets. Specifically, a company can engage in a strategic alliance to
enter a foreign market, and this becomes the company’s internationalization strategy. However, most
companies are not strategic and instead choose a market entry mode that requires lower levels of
commitment and involvement. is includes choices between entering foreign markets by exporting,
licensing, or franchising. Strategic alliances, like joint ventures, which we also cover as a market entry
form in this chapter (in addition to the material we covered on strategic alliances in Chapter 12),
require greater involvement and commitment.
Did You Know?
Did you know increasingly more companies are born global?
Visit your Connect SmartBook® to view a short video explanation from the authors.
At the basic level, any firm thinking about foreign expansion must first struggle with the issue of
which foreign market or markets to enter and the timing and scale of entry. e choice of which
markets to enter should be driven by an assessment of the potential for relative long-run growth and
profit. For example, in the opening case, how to go about entering a foreign market is a major issue
with which IKEA wrestles even today. Keep in mind that IKEA is the largest furniture
manufacturer in the world, usually does most of its operations in a very Swedish way, and
seldom customizes to the foreign market it enters. However, finally, the IKEA business model and the
company’s assortment of products are now on the move to take over India like they have been doing in
other countries. IKEA’s market entry into China in 1998 went reasonably well, and the Chinese entry
was done the Swedish way, but IKEA decided that the Indian market entry needed to be done the
Indian way to reach the success the company is used to achieving.
Entering foreign markets is
the focus of Chapter 13. e
selection of country markets to choose from is getting larger for many product categories as more countries see
their populations’ purchasing power growing. With almost 200 countries in the world, the data are
overwhelming, and even the starting point for analysis is not always an easy decision. e Interactive
Rankings on globalEDGETM can serve as a great pictorial view of the world on some 50 important variables
in categories covering the economy, energy, government, health, infrastructure, labor, people, and trade and
investment (globaledge.msu.edu/tools-and-data/interactive-rankings). Active data maps such as the Interactive
Rankings maps are a good starting point for analysis to evaluate data for a specific country as well as the
countries around it in a region. is allows for a focus on entry into one market now and a strategy for
expansion later on to nearby countries with similar characteristics. Which are the top three countries for
Internet users?
e journey into India has been unique, as the opening case attests. To facilitate the Indian
customers’ mindsets before IKEA opened the store in 2018, the company unwrapped its first
experiential center IKEA Hej (Hello) Home close to the IT hub of Hyderabad. is Hej Home small-
scale store provided insight into IKEA products and solutions, which future Indian customers could
buy before the store opened in Hyderabad. But to get IKEA to the Hej Home concept and ultimately
to the first large-scale store opening in Hyderabad, the road was a long research-oriented endeavor
spanning five years. For IKEA, the market entry included a commitment to build their own stores,
hire their own Indian people, and still place a great deal of emphasis on Swedish furniture and
processes but with an Indian feel and flavor.
IKEA’s choice was to set up a wholly owned subsidiary in India but there are lots of choices for
market entry into a new country. e various modes for serving foreign markets are exporting,
licensing, or franchising to host-country firms, establishing joint ventures with a host-country firm,
setting up a new wholly owned subsidiary in a host country to serve its market, and acquiring an
established enterprise in the host nation to serve that market. Each of these options has advantages and
disadvantages. e magnitude of the advantages and disadvantages associated with each entry mode is
determined by a number of factors, including transportation costs, trade barriers, political risks,
economic risks, business risks, costs, and firm strategy.
e optimal entry mode varies by situation, depending on these factors. us, whereas some firms
may best serve a given market by exporting, other firms may better serve the market by setting up a
new wholly owned subsidiary or by acquiring an established enterprise. Starbucks, for example, has
had a preference for entering into joint ventures with local partners and then licensing its format to
the joint venture. Cutco, on the other hand, usually adopts different models for domestic and
international sales. IKEA builds their own stores and manages the operations as subsidiaries.
Basic Entry Decisions
A firm contemplating foreign expansion must make three basic decisions: which markets to enter,
when to enter those markets, and on what scale.1
WHICH FOREIGN MARKETS?
LO 13-1 Explain the three basic decisions that firms contemplating foreign expansion must
make: which markets to enter, when to enter those markets, and on what scale.
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ere are now almost 200 nations in the world (technically, there are 195 countries and 61 territories
in the world as of 2018; with an additional 6 disputed territories), and they do not all hold the same
profit potential for a firm contemplating foreign expansion. Ultimately, the choice must be
based on an assessment of a nation’s long-run revenue potential. is potential is a function
of several factors, many of which we have studied in earlier chapters. Chapters 2 and 3 looked in detail
at the economic and political factors that influence the potential attractiveness of a foreign market.
e attractiveness of a country as a potential market for an international business depends on
balancing the benefits, costs, and risks associated with doing business in that country.
Chapters 2 and 3 also noted that the long-run economic benefits of doing business in a country are
a function of factors such as the size of the market (in terms of demographics), the present wealth
(purchasing power) of consumers in that market, and the likely future wealth of consumers, which
depends on economic growth rates. While some markets are very large when measured by number of
consumers (e.g., China, India, Brazil, Russia, and Indonesia), one must also look at living standards
and economic growth. On this basis, China and India, while relatively poor, are growing so rapidly
that they are attractive targets for inward investment. Alternatively, weak growth in Indonesia implies
that this populous nation is a far less attractive target for inward investment. As we saw in Chapters 2
and 3, likely future economic growth rates appear to be a function of a free market system and a
country’s capacity for growth (which may be greater in less developed nations). Also, the costs and
risks associated with doing business in a foreign country are typically lower in economically advanced
and politically stable democratic nations, and they are greater in less developed and politically unstable
nations.
e discussion in Chapters 2 and 3 suggests that, other things being equal, the benefit–cost–risk
trade-off is likely to be most favorable in politically stable developed and developing nations that have
free market systems and where there is not a dramatic upsurge in either inflation rates or private-sector
debt. e trade-off is likely to be least favorable in politically unstable developing nations that operate
with a mixed or command economy or in developing nations where speculative financial bubbles have
led to excess borrowing.
Another important factor is the value an international business can create in a foreign market. is
depends on the suitability of its product offering to that market and the nature of indigenous
competition.2 If the international business can offer a product that has not been widely available in
that market and that satisfies an unmet need, the value of that product to consumers is likely to be
much greater than if the international business simply offers the same type of product that indigenous
competitors and other foreign entrants are already offering. Greater value translates into an ability to
charge higher prices and/or to build sales volume more rapidly. By considering such factors, a firm can
rank countries in terms of their attractiveness and long-run profit potential. Preference is then given to
entering markets that rank highly. For example, Tesco, the large British grocery chain, has been
aggressively expanding its foreign operations, primarily by focusing on emerging markets that lack
strong indigenous competitors (see the accompanying Management Focus).
TIMING OF ENTRY
Once attractive markets have been identified, it is important to consider the timing of entry. Entry is
early when an international business enters a foreign market before other foreign firms and late when
it enters after other international businesses have already established themselves. e advantages
frequently associated with entering a market early are commonly known as first-mover advantages.3
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One first-mover advantage is the ability to preempt rivals and capture demand by establishing a strong
brand name. is desire has driven the rapid expansion by Tesco into developing nations (see the
Management Focus). A second advantage is the ability to build sales volume in the country and ride
down the experience curve ahead of rivals, giving the early entrant a cost advantage over later entrants.
is cost advantage may enable the early entrant to cut prices below those of later entrants, thereby
driving them out of the market. A third advantage is the ability of early entrants to create switching
costs that tie customers into their products or services. Such switching costs make it difficult for later
entrants to win business.
ere can also be disadvantages associated with entering a foreign market before other international
businesses. ese are often referred to as first-mover disadvantages.4 ese disadvantages may give
rise to pioneering costs, costs that an early entrant has to bear that a later entrant can avoid.
Pioneering costs arise when the business system in a foreign country is so different from that in a firm’s
home market that the enterprise has to devote considerable effort, time, and expense to learning the
rules of the game. Pioneering costs include the costs of business failure if the firm, due to its ignorance
of the foreign environment, makes major mistakes. A certain liability is associated with being a
foreigner, and this liability is greater for foreign firms that enter a national market early.5 Research
seems to confirm that the probability of survival increases if an international business enters
a national market after several other foreign firms have already done so.6 e late entrant
may benefit by observing and learning from the mistakes made by early entrants.
m a n a g e m e n t F O C U S
Tesco’s International Growth Strategy
Tesco, founded in 1919 by Jack Cohen, is a British multinational grocery and merchandise retailer. It is the
largest grocery retailer in the United Kingdom, with a 28 percent share of the local market, and the second-
largest retailer in the world after Walmart measured by revenue. By 2019, Tesco had sales of more than £55
billion ($77 billion), more than 476,000 employees, and 6,553 stores.
In its home market of the United Kingdom (with a headquarters in Chestnut, Hertfordshire, England), the
company’s strengths are reputed to come from strong competencies in marketing and store site selection,
logistics and inventory management, and its own label product offerings. By the early 1990s, these
competencies had already given the company a leading position in the United Kingdom. e company was
generating strong free cash flows, and senior managers had to decide how to use that cash. One strategy they
settled on was overseas expansion.
As they looked at international markets, they soon concluded the best opportunities were not in
established markets, such as those in North America and Western Europe, where strong local competitors
already existed, but in the emerging markets of eastern Europe and Asia, where there were few capable
competitors but strong underlying growth trends. Tesco’s first international foray was into Hungary in 1994,
when it acquired an initial 51 percent stake in Global, a 43-store, state-owned grocery chain. By 2019, Tesco
was the market leader in Hungary, with more than 200 stores and additional openings planned. In 1995,
Tesco acquired 31 stores in Poland from Stavia; a year later, it added 13 stores purchased from Kmart in the
Czech Republic and Slovakia; and the following year, it entered the Republic of Ireland. Tesco now has more
than 450 stores in Poland, some 80 stores in the Czech Republic, more than 120 stores in Slovakia, and more
than 100 stores in Ireland.
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Tesco’s Asian expansion began in 1998 in ailand when it purchased 75 percent of Lotus, a local food
retailer with 13 stores. Building on that base, Tesco had more than 380 stores in ailand by 2015. In 1999,
the company entered South Korea when it partnered with Samsung to develop a chain of hypermarkets. is
was followed by entry into Taiwan in 2000, Malaysia in 2002, Japan in 2003, and China in 2004. e move
into China came after three years of careful research and discussions with potential partners. Like many other
Western companies, Tesco was attracted to the Chinese market by its large size and rapid growth. In the end,
Tesco settled on a 50–50 joint venture with Hymall, a hypermarket chain that is controlled by Ting Hsin, a
Taiwanese group, which had been operating in China for six years. In 2014, Tesco combined its 131 stores in
China in a joint venture with the state-run China Resources Enterprise (CRE) and its nearly 3,000 stores.
Tesco owns 20 percent of the joint venture.
As a result of these moves, by 2019 Tesco generated sales of $25 billion outside of the United Kingdom (its
UK annual revenues were about $52 billion). e addition of international stores has helped make Tesco the
second-largest company in the global grocery market behind only Walmart (Tesco is also behind Carrefour of
France if profits are used). Of the three, however, Tesco may be the most successful internationally. By 2019,
all its foreign ventures were making money.
Tesco is the largest grocery retailer in the United Kingdom and the second-largest retailer
worldwide after Walmart.
©Guang Niu/Getty Images
In explaining the company’s success, Tesco’s managers have detailed a number of important factors. First,
the company devotes considerable attention to transferring its core capabilities in retailing to its new ventures.
At the same time, it does not send in an army of expatriate managers to run local operations, preferring to hire
local managers and support them with a few operational experts from the United Kingdom. Second, the
company believes that its partnering strategy in Asia has been a great asset. Tesco has teamed up with good
companies that have a deep understanding of the markets in which they are participating but that lack Tesco’s
financial strength and retailing capabilities. Consequently, both Tesco and its partners have brought useful
assets to the venture, increasing the probability of success. As the venture becomes established, Tesco has
typically increased its ownership stake in its partner. For example, by 2019 Tesco owned 100 percent of
Homeplus, its South Korean hypermarket chain, but when the venture was established, Tesco owned 51
percent. ird, the company has focused on markets with good growth potential but that lack strong
indigenous competitors, which provides Tesco with ripe ground for expansion.
Sources: Ivana Kottasová, “Women in Supermarkets Want Same Pay as Warehouse Workers,” CNN Money, February 7, 2018; P. N. Child, “Taking Tesco Global,” e McKenzie Quarterly 3 (2002); H. Keers, “Global Tesco Sets Out Its Stall in China,” Daily Telegraph, July 15, 2004, p. 31; K. Burgess, “Tesco Spends Pounds 140m on Chinese Partnership,” Financial Times, July 15, 2004, p. 22; J. McTaggart, “Industry Awaits Tesco Invasion,” Progressive Grocer, March 1, 2006, pp. 8–10; Tesco’s annual reports, www.tesco.com; P. Sonne, “Five Years and $1.6 Billion Later, Tesco Decides to Quit US,” e Wall Street Journal, December 6, 2012; and “Tesco Set to Push Ahead in the United States,” e Wall Street Journal, October 6, 2010, p. 19.
Is First-Mover Advantage Always a Good ing?
Timing of entry into a foreign market is one of the most critical aspects of going international. Popularized by
Marvin Lieberman and David Montgomery in 1988, first-mover advantage was an idea that resonated with
every company. But 10 years later, in 1998, Lieberman and Montgomery actually backed off their own idea
that taking advantage of being the first mover was always a good strategy. At this time, it was too late: Venture
capitalists, companies, people, and many scholars had already latched onto the positive things about being
first in a new foreign market and stressed this approach over any other timing of entry. Now we are some 20
years into the twenty-first century, and the realization is that first-mover advantages also come with pioneering
costs. If you had a choice of being the first-mover into a new emerging foreign market (e.g., Turkey) and
being the fifth company entering that market with your product, what would you choose and why?
Sources: M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 (1988), pp. 41–58;
and M. B. Lieberman and D. B. Montgomery, “First-Mover (Dis)Advantages: Retrospective and Link with the Resource-Based
View,” Strategic Management Journal 19 (1998), pp. 1111–1125.
Pioneering costs also include the costs of promoting and establishing a product offering, including
the costs of educating customers. ese can be significant when the product being promoted is
unfamiliar to local consumers. In contrast, later entrants may be able to ride on an early entrant’s
investments in learning and customer education by watching how the early entrant proceeded in the
market, by avoiding costly mistakes made by the early entrant, and by exploiting the market potential
created by the early entrant’s investments in customer education. For example, KFC introduced the
Chinese to American-style fast food, but a later entrant, McDonald’s, has capitalized on the market in
China by correcting mistakes that KFC made and implementing a better approach.
An early entrant may be put at a severe disadvantage, relative to a later entrant, if regulations
change in a way that diminishes the value of an early entrant’s investments. is is a serious risk in
many developing nations where the rules that govern business practices are still evolving. Early
entrants can find themselves at a disadvantage if a subsequent change in regulations invalidates prior
assumptions about the best business model for operating in that country.
SCALE OF ENTRY AND STRATEGIC COMMITMENTS
Another issue that an international business needs to consider when contemplating market entry is the
scale of entry. Entering a market on a large scale involves the commitment of significant resources and
implies rapid entry. Consider the entry of the Dutch insurance company ING into the U.S. insurance
market in 1999. ING had to spend several billion dollars to acquire its U.S. operations. Not all firms
have the resources necessary to enter on a large scale, and even some large firms prefer to enter foreign
markets on a small scale and then build slowly as they become more familiar with the market.
e consequences of entering on a significant scale—entering rapidly—are associated with the
value of the resulting strategic commitments.7 A strategic commitment has a long-term impact and is
difficult to reverse. Deciding to enter a foreign market on a significant scale is a major strategic
commitment. Strategic commitments, such as rapid large-scale market entry, can have an important
influence on the nature of competition in a market. For example, by entering the U.S. financial
services market on a significant scale, ING signaled its commitment to the market. is will have
several effects. On the positive side, it will make it easier for the company to attract customers and
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distributors (such as insurance agents). e scale of entry gives both customers and distributors
reasons for believing that ING will remain in the market for the long run. e scale of entry may also
give other foreign institutions considering entry into the United States pause; now they will have to
compete not only against indigenous institutions in the United States but also against an aggressive
and successful European institution. On the negative side, by committing itself heavily to one country,
the United States, ING may have fewer resources available to support expansion in other desirable
markets, such as Japan. e commitment to the United States limits the company’s strategic flexibility.
As suggested by the ING example, significant strategic commitments are neither unambiguously
good nor bad. Rather, they tend to change the competitive playing field and unleash a number of
changes, some of which may be desirable and some of which will not be. It is important for a firm to
think through the implications of large-scale entry into a market and act accordingly. Of particular
relevance is trying to identify how actual and potential competitors might react to large-
scale entry into a market. Also, the large-scale entrant is more likely than the small-scale
entrant to be able to capture first-mover advantages associated with demand preemption, scale
economies, and switching costs.
e value of the commitments that flow from rapid large-scale entry into a foreign market must be
balanced against the resulting risks and lack of flexibility associated with significant commitments. But
strategic inflexibility can also have value. A famous example from military history illustrates the value
of inflexibility. When Hernán Cortés landed in Mexico, he ordered his men to burn all but one of his
ships. Cortés reasoned that by eliminating their only method of retreat, his men had no choice but to
fight hard to win against the Aztecs—and ultimately they did.8
Balanced against the value and risks of the commitments associated with large-scale entry are the
benefits of a small-scale entry. Small-scale entry allows a firm to learn about a foreign market while
limiting the firm’s exposure to that market. Small-scale entry is a way to gather information about a
foreign market before deciding whether to enter on a significant scale and how best to enter. By giving
the firm time to collect information, small-scale entry reduces the risks associated with a subsequent
large-scale entry. But the lack of commitment associated with small-scale entry may make it more
difficult for the small-scale entrant to build market share and to capture first-mover or early-mover
advantages. e risk-averse firm that enters a foreign market on a small scale may limit its potential
losses, but it may also miss the chance to capture first-mover advantages.
MARKET ENTRY SUMMARY
ere are no “right” decisions here, just decisions that are associated with different levels of risk and
reward. Entering a large developing nation such as China or India before most other international
businesses in the firm’s industry and entering on a large scale will be associated with high levels of risk.
In such cases, the liability of being foreign is increased by the absence of prior foreign entrants whose
experience can be a useful guide. At the same time, the potential long-term rewards associated with
such a strategy are great. e early large-scale entrant into a major developing nation may be able to
capture significant first-mover advantages that will bolster its long-run position in that market.9 In
contrast, entering developed nations such as Australia or Canada after other international businesses in
the firm’s industry and entering on a small scale to first learn more about those markets will be
associated with much lower levels of risk. However, the potential long-term rewards are also likely to
be lower because the firm is essentially forgoing the opportunity to capture first-mover advantages and
because the lack of commitment signaled by small-scale entry may limit its future growth potential.
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is section has been written largely from the perspective of a business based in a developed
country considering entry into foreign markets. Christopher Bartlett and Sumantra Ghoshal have
pointed out the ability that businesses based in emerging countries have to enter foreign markets and
become global players.10 Although such firms tend to be late entrants into foreign markets and
although their resources may be limited, Bartlett and Ghoshal argue that such late movers can still
succeed against well-established global competitors by pursuing appropriate strategies. In particular,
companies based in emerging countries should use the entry of foreign multinationals as an
opportunity to learn from these competitors by benchmarking their operations and performance
against them. Furthermore, a local company may be able to find ways to differentiate itself from a
foreign multinational, for example, by focusing on market niches that the multinational ignores or is
unable to serve effectively if it has a standardized global product offering. Having improved its
performance through learning and differentiated its product offering, the firm from an emerging
country may then be able to pursue its own international expansion strategy. Even though the firm
may be a late entrant into many countries, by benchmarking and then differentiating itself from early
movers in global markets, the firm from the emerging country may still be able to build a strong
international business presence. A good example of how this can work is given in the accompanying
Management Focus, which looks at how Jollibee, a Philippines-based fast-food chain, has started to
build a global presence in a market dominated by U.S. multinationals such as McDonald’s and KFC.
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m a n a g e m e n t F O C U S
e Jollibee Phenomenon
Jollibee Foods Corporation, abbreviated JFC and more popularly known as Jollobee, is one of the Philippines’
phenomenal business success stories. Jollibee, which stands for “Jolly Bee,” began operations in 1975 as a two-
branch ice cream parlor. It later expanded its menu to include hot sandwiches and other meals. Encouraged by
early success, Jollibee Foods Corporation was incorporated in 1978, with a network that had grown to seven
outlets. In 1981, when Jollibee had 11 stores, McDonald’s began to open stores in Manila. Many observers
thought Jollibee would have difficulty competing against McDonald’s. However, Jollibee saw this as an
opportunity to learn from a very successful global competitor. Jollibee benchmarked its performance against
that of McDonald’s and started to adopt operational systems similar to those used at McDonald’s to control
its quality, cost, and service at the store level. is helped Jollibee improve its performance.
As it came to better understand McDonald’s business model, Jollibee began to look for a weakness in
McDonald’s global strategy. Jollibee executives concluded that McDonald’s fare was too standardized for many
locals and that the local firm could gain share by tailoring its menu to local tastes. Jollibee’s hamburgers were
set apart by a secret mix of spices blended into the ground beef to make the burgers sweeter than those
produced by McDonald’s, appealing more to Philippine tastes. It also offered local fare, including various rice
dishes, pineapple burgers, and banana langka and peach mango pies for desserts. By pursuing this strategy, Jollibee maintained a leadership position over the global giant. By 2019, Jollibee had over 801 stores in the
Philippines for its Jollibee brand and some 2,040 total stores across all of its brands (e.g., Jollibee, Chowking,
Greenwich, Red Ribbon, Mang INasal, and Burger King), a market share of more than 60 percent, and
revenues in excess of $600 million. McDonald’s, in contrast, had about 400 stores.
e international expansion started in the mid-1980s. Jollibee’s initial ventures were into neighboring
Asian countries such as Indonesia, where it pursued the strategy of localizing the menu to better match local
tastes, thereby differentiating itself from McDonald’s. In 1987, Jollibee entered the Middle East, where a large
contingent of expatriate Filipino workers provided a ready-made market for the company. e strategy of
focusing on expatriates worked so well that in the late 1990s, Jollibee decided to enter another foreign market
where there was a large Filipino population—the United States.
Between 1999 and 2019, Jollibee opened 32 stores in the United States, 20 of which are in California.
Even though many believe the U.S. fast-food market is saturated, the stores have performed well. While the
initial clientele was strongly biased toward the expatriate Filipino community, where Jollibee’s brand awareness
is high, non-Filipinos increasingly are coming to the restaurant. In the San Francisco store, which has been
open the longest, more than half the customers are now non-Filipino. Today, Jollibee has some 500
international stores and a potentially bright future as a niche player in a market that has historically been
dominated by U.S. multinationals.
Sources: Tina G. Santos, “Up to 10,000 Jollibee Workers to Be Regularized,” Inquirer.net, April 6, 2018; “Jollibee Battles Burger Giants in US Market,” Philippine Daily Inquirer, July 13, 2000; M. Ballon, “Jollibee Struggling to Expand in U.S.,” Los Angeles Times, September 16, 2002, p. C1; J. Hookway, “Burgers and Beer,” Far Eastern Economic Review, December 2003, pp. 72–74; S. E. Lockyer, “Coming to America,” Nation’s Restaurant News, February 14, 2005, pp. 33–35; Erik de la Cruz, “Jollibee to Open 120 New Stores is Year, Plans India,” Inquirer Money, July 5, 2006, business.inquirer.net; and www.jollibee.com.ph.
Entry Modes
LO 13-2 Compare and contrast the different modes that firms use to enter foreign markets.
Once a firm decides to enter a foreign market, the question arises as to the best mode of entry. Firms
can use six different modes to enter foreign markets: exporting, turnkey projects, licensing,
franchising, establishing joint ventures with a host-country firm, or setting up a new wholly owned
subsidiary in the host country. Each entry mode has advantages and disadvantages. Managers need to
consider these carefully when deciding which to use.11
EXPORTING
Many manufacturing firms begin their global expansion as exporters and only later switch to another
mode for serving a foreign market. We take a close look at the mechanics of exporting in Chapter 14.
Here we focus on the advantages and disadvantages of exporting as an entry mode.
Advantages Exporting has two distinct advantages. First, it avoids the often substantial costs of establishing manufacturing operations in the host country. Second, exporting may help a firm achieve
experience curve and location economies (see Chapter 12). By manufacturing the product in a
centralized location and exporting it to other national markets, the firm may realize substantial scale
economies from its global sales volume. is is how many Japanese automakers made inroads into the
U.S. market over the last two decades (although more and more they are also setting up factories in
the United States due to the favorable tax incentives and also restrictions placed on them for SUVs).
Page 365Disadvantages Exporting has a number of drawbacks. First, exporting from the firm’s home base may not be appropriate if lower-cost locations for manufacturing the product
can be found abroad (i.e., if the firm can realize location economies by moving production elsewhere).
us, particularly for firms pursuing global or transnational strategies, it may be preferable to
manufacture where the mix of factor conditions is most favorable from a value creation perspective
and to export to the rest of the world from that location. is is not so much an argument against
exporting as an argument against exporting from the firm’s home country. Many U.S. electronics firms
have moved some of their manufacturing to the Far East because of the availability of low-cost, highly
skilled labor. ey then export from that location to the rest of the world, including the United States.
A second drawback to exporting is that high transportation costs can make exporting
uneconomical, particularly for bulk products. One way of getting around this is to manufacture bulk
products regionally. is strategy enables the firm to realize some economies from large-scale
production and at the same time to limit its transportation costs. For example, many multinational
chemical firms manufacture their products regionally, serving several countries from one facility.
Another drawback is that tariff barriers can make exporting uneconomical. Similarly, the threat of
tariff barriers by the host-country government can make it very risky. A fourth drawback to exporting
arises when a firm delegates its marketing, sales, and service in each country where it does business to
another company. is is a common approach for manufacturing firms that are just beginning to
expand internationally. e other company may be a local agent, or it may be another multinational
with extensive international distribution operations. Local agents often carry the products of
competing firms and so have divided loyalties. In such cases, the local agent may not do as good a job
as the firm would if it managed its marketing itself. Similar problems can occur when another
multinational takes on distribution.
e way around such problems is to set up wholly owned subsidiaries in foreign nations to handle
local marketing, sales, and service. By doing this, the firm can exercise tight control over marketing
and sales in the country while reaping the cost advantages of manufacturing the product in a single
location or a few choice locations.
TURNKEY PROJECTS
Firms that specialize in the design, construction, and start-up of turnkey plants are common in some
industries. In a turnkey project, the contractor agrees to handle every detail of the project for a
foreign client, including the training of operating personnel. At completion of the contract, the
foreign client is handed the “key” to a plant that is ready for full operation—hence, the term turnkey. is is a means of exporting process technology to other countries. Turnkey projects are most
common in the chemical, pharmaceutical, petroleum-refining, and metal-refining industries, all of
which use complex, expensive production technologies.
Advantages e know-how required to assemble and run a technologically complex process, such as refining petroleum or steel, is a valuable asset. Turnkey projects are a way of earning great economic
returns from that asset. e strategy is particularly useful where foreign direct investment (FDI) is
limited by host-government regulations. For example, the governments of many oil-rich countries
have set out to build their own petroleum-refining industries, so they restrict FDI in their oil-refining
sectors. But because many of these countries lack petroleum-refining technology, they gain it by
entering into turnkey projects with foreign firms that have the technology. Such deals are often
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attractive to the selling firm because without them, they would have no way to earn a return on their
valuable know-how in that country. A turnkey strategy can also be less risky than conventional FDI.
In a country with unstable political and economic environments, a longer-term investment might
expose the firm to unacceptable political and/or economic risks (e.g., the risk of nationalization or of
economic collapse).
Disadvantages ree main drawbacks are associated with a turnkey strategy. First, the firm that enters into a turnkey deal will have no long-term interest in the foreign country. is can be a
disadvantage if that country subsequently proves to be a major market for the output of the process
that has been exported. One way around this is to take a minority equity interest in the
operation. Second, the firm that enters into a turnkey project with a foreign enterprise may
inadvertently create a competitor. For example, many of the Western firms that sold oil-refining
technology to firms in Saudi Arabia, Kuwait, and other Gulf states now find themselves competing
with these firms in the world oil market. ird, if the firm’s process technology is a source of
competitive advantage, then selling this technology through a turnkey project is also selling
competitive advantage to potential and/or actual competitors.
LICENSING
A licensing agreement is an arrangement whereby a licensor grants the rights to intangible property
to another entity (the licensee) for a specified period, and in return, the licensor receives a royalty fee
from the licensee.12 Intangible property includes patents, inventions, formulas, processes, designs,
copyrights, and trademarks. For example, to enter the Japanese market, Xerox, inventor of the
photocopier, established a joint venture with Fuji Photo that is known as Fuji Xerox. Xerox then
licensed its xerographic know-how to Fuji Xerox. In return, Fuji Xerox paid Xerox a royalty fee equal
to 5 percent of the net sales revenue that Fuji Xerox earned from the sales of photocopiers based on
Xerox’s patented know-how. In the Fuji Xerox case, the license was originally granted for 10 years, and
it has been renegotiated and extended several times since. e licensing agreement between Xerox and
Fuji Xerox also limited Fuji Xerox’s direct sales to the Asian Pacific region (although Fuji Xerox does
supply Xerox with photocopiers that are sold in North America under the Xerox label).13
Advantages In the typical international licensing deal, the licensee puts up most of the capital necessary to get the overseas operation going. us, a primary advantage of licensing is that the firm
does not have to bear the development costs and risks associated with opening a foreign market.
Licensing is very attractive for firms lacking the capital to develop operations overseas. In addition,
licensing can be attractive when a firm is unwilling to commit substantial financial resources to an
unfamiliar or politically volatile foreign market. Licensing is also often used when a firm wishes to
participate in a foreign market but is prohibited from doing so by barriers to investment. is was one
of the original reasons for the formation of the Fuji Xerox joint venture. Xerox wanted to participate
in the Japanese market but was prohibited from setting up a wholly owned subsidiary by the Japanese
government. So Xerox set up the joint venture with Fuji and then licensed its know-how to the joint
venture.
Finally, licensing is frequently used when a firm possesses some intangible property that might have
business applications, but it does not want to develop those applications itself. For example, Bell
Laboratories at AT&T originally invented the transistor circuit in the 1950s, but AT&T decided it did
not want to produce transistors, so it licensed the technology to a number of other companies, such as
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TI (Texas Instruments). Similarly, Coca-Cola has licensed its famous trademark to clothing
manufacturers, which have incorporated the design into clothing. Harley-Davidson licenses its brand
to Wolverine World Wide to make footwear that embodies the spirit of the open road, which Harley-
Davidson emphasizes in its advertisements and product positioning.
Exporting or Licensing?
In Chapter 13, we discuss a series of advantages and disadvantages of exporting and licensing (as well as
turnkey projects, franchising, joint ventures, and wholly owned subsidiaries as other entry mode choices).
Exporting refers to the sale of products produced in one country to residents of another country. Licensing
refers to an arrangement in which a licensor grants the rights to intangible property to the licensee for a
specified period and receives a royalty fee in return. Both of these modes of entry into a foreign market have
unique advantages and disadvantages. Oftentimes, selecting exporting or licensing depends on myriad factors
—one being the global mindset of the business owner. Assume you have a choice to enter three emerging
markets—Bolivia, Chile, and Peru, neighboring countries in South America. You have a great product, with
lots of technological innovation and a lightweight packaging. Would you opt for exporting or licensing, and
why?
Disadvantages Licensing has three serious drawbacks. First, it does not give a firm the tight control over manufacturing, marketing, and strategy that is required for realizing experience curve and
location economies. Licensing typically involves each licensee setting up its own production
operations. is severely limits the firm’s ability to realize experience curve and location economies by
producing its product in a centralized location. When these economies are important, licensing may
not be the best way to expand overseas.
Second, competing in a global market may require a firm to coordinate strategic moves across
countries by using profits earned in one country to support competitive attacks in another. By its very
nature, licensing limits a firm’s ability to do this. A licensee is unlikely to allow
a multinational firm to use its profits (beyond those due in the form of royalty payments) to
support a different licensee operating in another country.
A third problem with licensing is one that we encountered in Chapter 8 when we reviewed the
economic theory of foreign direct investment (FDI). is is the risk associated with licensing
technological know-how to foreign companies. Technological know-how constitutes the basis of many
multinational firms’ competitive advantage. Most firms wish to maintain control over how their know-
how is used, and a firm can quickly lose control over its technology by licensing it. Many firms have
made the mistake of thinking they could maintain control over their know-how within the framework
of a licensing agreement. RCA Corporation, for example, once licensed its color TV technology to
Japanese firms including Matsushita and Sony. e Japanese firms quickly assimilated the technology,
improved on it, and used it to enter the U.S. market, taking substantial market share away from RCA
and ultimately RCA became defunct in 1986.
ere are ways of reducing this risk. One way is by entering into a cross-licensing agreement with a
foreign firm. Under a cross-licensing agreement, a firm might license some valuable intangible
property to a foreign partner, but in addition to a royalty payment, the firm might also request that
the foreign partner license some of its valuable know-how to the firm. Such agreements are believed to
reduce the risks associated with licensing technological know-how, since the licensee realizes that if it
violates the licensing contract (by using the knowledge obtained to compete directly with the
licensor), the licensor can do the same to it. Cross-licensing agreements enable firms to hold each
other hostage, which reduces the probability that they will behave opportunistically toward each
other.14 Such cross-licensing agreements are increasingly common in high-technology industries.
Another way of reducing the risk associated with licensing is to follow the Fuji Xerox model and
link an agreement to license know-how with the formation of a joint venture in which the licensor and
licensee take important equity stakes. Such an approach aligns the interests of licensor and licensee,
because both have a stake in ensuring that the venture is successful. us, the risk that Fuji Photo
might appropriate Xerox’s technological know-how and then compete directly against Xerox in the
global photocopier market was reduced by the establishment of a joint venture in which both Xerox
and Fuji Photo had an important stake.
FRANCHISING
Franchising is similar to licensing, although franchising tends to involve longer-term commitments
than licensing. Franchising is basically a specialized form of licensing in which the franchiser not only
sells intangible property (normally a trademark) to the franchisee but also insists that the franchisee
agree to abide by strict rules as to how it does business. e franchiser will also often assist the
franchisee to run the business on an ongoing basis. As with licensing, the franchiser typically receives a
royalty payment, which amounts to some percentage of the franchisee’s revenues. Whereas licensing is
pursued primarily by manufacturing firms, franchising is employed primarily by service firms.15
So, You ink You Want to Own a Franchise?
Franchising is a specialized form of licensing in which the franchiser not only sells intangible property to the
franchisee but also insists that the franchisee agree to abide by strict rules as to how it does business. Some of
the advantages of franchising include branding, advertising, reputation, and headquarters/company support
for development of the infrastructure needed to operate the franchise business. Some of the disadvantages of
franchising include restrictions on territory and pricing, not being completely independent, franchise fee and
ongoing royalty payments, and dependence on other franchise owners for nurturing the brand. Well-known
worldwide franchise systems include Subway, 7-Eleven, Pizza Hut, and McDonald’s. Assume you
are interested in being an international entrepreneur. Would franchising be your choice of starting a business?
Source: T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill Education, 2014).
Advantages McDonald’s is a good example of a firm that has grown and taken advantage of a franchising strategy (Subway is another). McDonald’s strict rules as to how franchisees should operate
a restaurant extend to control over the menu, cooking methods, staffing policies, and design and
location. McDonald’s also organizes the supply chain for its franchisees and provides management
training and financial assistance.16 Overall, the advantages of franchising as an entry mode are very
similar to those of licensing. e firm is relieved of many of the costs and risks of opening a foreign
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market on its own. Instead, the franchisee typically assumes those costs and risks. is creates a good
incentive for the franchisee to build a profitable operation as quickly as possible.
us, using a franchising strategy, a service firm can build a global presence quickly and at a
relatively low cost and risk, as McDonald’s has. Two Men and a Truck—a Lansing, Michigan–
headquartered moving company—effectively used the franchising concept to scale up from a local
company to a U.S. nationwide company almost immediately in 1989 after its inception in 1985.
Now, the company has 410 locations worldwide.
Disadvantages e disadvantages of franchising are less pronounced than with licensing. Since franchising is often used by service companies, there is no reason to consider the need for coordination
of manufacturing to achieve experience curve and location economies. But franchising may inhibit the
firm’s ability to take profits out of one country to support competitive attacks in another. A more
significant disadvantage of franchising is quality control. e foundation of franchising arrangements
is that the firm’s brand name conveys a message to consumers about the quality of the firm’s product.
us, a business traveler checking in at a Four Seasons hotel in Hong Kong can reasonably expect the
same quality of room, food, and service that she would receive in New York. e Four Seasons name is
supposed to guarantee consistent product quality. is presents a problem in that foreign franchisees
may not be as concerned about quality as they are supposed to be, and the result of poor quality can
extend beyond lost sales in a particular foreign market to a decline in the firm’s worldwide reputation.
For example, if the business traveler has a bad experience at the Four Seasons in Hong Kong, she may
never go to another Four Seasons hotel and may urge her colleagues to do likewise. e geographic
distance of the firm from its foreign franchisees can make poor quality difficult to detect. In addition,
the sheer numbers of franchisees—in the case of McDonald’s, tens of thousands—can make quality
control difficult. Due to these factors, quality problems may persist.
One way around this disadvantage is to set up a subsidiary in each country in which the firm
expands. e subsidiary might be wholly owned by the company or a joint venture with a foreign
company. e subsidiary assumes the rights and obligations to establish franchises throughout the
particular country or region. McDonald’s, for example, establishes a master franchisee in many
countries. Typically, this master franchisee is a joint venture between McDonald’s and a local firm. e
proximity and the smaller number of franchises to oversee reduce the quality control challenge. In
addition, because the subsidiary (or master franchisee) is at least partly owned by the firm, the firm
can place its own managers in the subsidiary to help ensure that it is doing a good job of monitoring
the franchises. is organizational arrangement has proven very satisfactory for McDonald’s, KFC,
and others.
JOINT VENTURES
A joint venture entails establishing a firm that is jointly owned by two or more otherwise independent
firms. Fuji Xerox, for example, was set up as a joint venture between Xerox and Fuji Photo.
Establishing a joint venture with a foreign firm has long been a popular mode for entering a new
market. e most typical joint venture is a 50–50 venture, in which there are two parties, each holding
a 50 percent ownership stake and contributing a team of managers to share operating control. is
was the case with the Fuji–Xerox joint venture until 2001; it is now a 25–75 venture with Xerox
holding 25 percent. e GM SAIC venture in China was a 50–50 venture until 2010, when it became
a 51–49 venture, with SAIC holding the 51 percent stake. Some firms, however, have sought joint
ventures in which they have a majority share and thus tighter control.17
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Advantages Joint ventures have a number of advantages. First, a firm benefits from a local partner’s knowledge of the host country’s competitive conditions, culture, language, political systems, and
business. us, for many U.S. firms, joint ventures have involved the U.S. company providing
technological know-how and products and the local partner providing the marketing expertise and the
local knowledge necessary for competing in that country. Second, when the development costs and/or
risks of opening a foreign market are high, a firm might gain by sharing these costs and or risks with a
local partner. ird, in many countries, political considerations make joint ventures the only feasible
entry mode. Research suggests joint ventures with local partners face a low risk of being subject to
nationalization or other forms of adverse government interference.18 is appears to be
because local equity partners, who may have some influence on host-government policy,
have a vested interest in speaking out against nationalization or government interference.
Disadvantages Despite these advantages, there are major disadvantages with joint ventures. First, as with licensing, a firm that enters into a joint venture risks giving control of its technology to its
partner. us, a proposed joint venture in 2002 between Boeing and Mitsubishi Heavy Industries to
build a new wide-body jet (the 787) raised fears that Boeing might unwittingly give away its
commercial airline technology to the Japanese. However, joint-venture agreements can be constructed
to minimize this risk. One option is to hold majority ownership in the venture. is allows the
dominant partner to exercise greater control over its technology. But it can be difficult to find a foreign
partner who is willing to settle for minority ownership. Another option is to “wall off” from a partner
technology that is central to the core competence of the firm, while sharing other technology.
A second disadvantage is that a joint venture does not give a firm the tight control over subsidiaries
that it might need to realize experience curve or location economies. Nor does it give a firm the tight
control over a foreign subsidiary that it might need for engaging in coordinated global attacks against
its rivals. Consider the entry of Texas Instruments (TI) into the Japanese semiconductor market.
When TI established semiconductor facilities in Japan, it did so for the dual purpose of checking
Japanese manufacturers’ market share and limiting their cash available for invading TI’s global market.
In other words, TI was engaging in global strategic coordination. To implement this strategy, TI’s
subsidiary in Japan had to be prepared to take instructions from corporate headquarters regarding
competitive strategy. e strategy also required the Japanese subsidiary to run at a loss if necessary.
Few, if any, potential joint-venture partners would have been willing to accept such conditions, since it
would have necessitated a willingness to accept a negative return on investment. Indeed, many joint
ventures establish a degree of autonomy that would make such direct control over strategic decisions
all but impossible to establish.19 us, to implement this strategy, TI set up a wholly owned
subsidiary in Japan.
A third disadvantage with joint ventures is that the shared ownership arrangement can lead to
conflicts and battles for control between the investing firms if their goals and objectives change or if
they take different views as to what the strategy should be. is was apparently not a problem with the
Fuji Xerox joint venture. According to Yotaro Kobayashi, the former chair of Fuji Xerox, a primary
reason is that both Xerox and Fuji Photo adopted an arm’s-length relationship with Fuji Xerox, giving
the venture’s management considerable freedom to determine its own strategy.20 However, much
research indicates that conflicts of interest over strategy and goals often arise in joint ventures. ese
conflicts tend to be greater when the venture is between firms of different nationalities, and they often
end in the dissolution of the venture.21 Such conflicts tend to be triggered by shifts in the relative
bargaining power of venture partners. For example, in the case of ventures between a foreign firm and
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a local firm, as a foreign partner’s knowledge about local market conditions increases, it depends less
on the expertise of a local partner. is increases the bargaining power of the foreign partner and
ultimately leads to conflicts over control of the venture’s strategy and goals.22 Some firms have sought
to limit such problems by entering into joint ventures in which one partner has a controlling interest.
WHOLLY OWNED SUBSIDIARIES
In a wholly owned subsidiary, the firm owns 100 percent of the stock. Establishing a wholly owned
subsidiary in a foreign market can be done two ways. e firm either can set up a new operation in
that country, often referred to as a greenfield venture, or it can acquire an established firm in that host
nation and use that firm to promote its products.23 For example, ING’s strategy for entering the U.S.
insurance market was to acquire established U.S. enterprises, rather than try to build an operation
from the ground floor. IKEA, as the largest furniture manufacturer in the world, always seems to build
on their large-scale stores to drive their brand, concept, and “Swedish way” of doing business. (IKEA
India is one exception to this Swedish influence! In India, the Swedish way was nicely combined with
the Indian mindset to open IKEA India in 2018. See the opening case.)
Advantages ere are several clear advantages of wholly owned subsidiaries. First, when a firm’s competitive advantage is based on technological competence, a wholly owned subsidiary will often be
the preferred entry mode because it reduces the risk of losing control over that competence. (See
Chapter 8 for more details.) Many high-tech firms prefer this entry mode for overseas expansion (e.g.,
firms in the semiconductor, electronics, and pharmaceutical industries). Second, a wholly owned
subsidiary gives a firm tight control over operations in different countries. is is necessary for
engaging in global strategic coordination (i.e., using profits from one country to support competitive
attacks in another).
ird, a wholly owned subsidiary may be required if a firm is trying to realize location and
experience curve economies (as firms pursuing global and transnational strategies try to do). As we saw
in Chapter 11, when cost pressures are intense, it may pay a firm to configure its value chain in such a
way that the value added at each stage is maximized. us, a national subsidiary may specialize in
manufacturing only part of the product line or certain components of the end product, exchanging
parts and products with other subsidiaries in the firm’s global system. Establishing such a global
production system requires a high degree of control over the operations of each affiliate. e various
operations must be prepared to accept centrally determined decisions as to how they will produce,
how much they will produce, and how their output will be priced for transfer to the next operation.
Because licensees or joint-venture partners are unlikely to accept such a subservient role, establishing
wholly owned subsidiaries may be necessary. Finally, establishing a wholly owned subsidiary gives the
firm a 100 percent share in the profits generated in a foreign market.
Disadvantages Establishing a wholly owned subsidiary is generally the most costly method of serving a foreign market from a capital investment standpoint. Firms doing this must bear the full
capital costs and risks of setting up overseas operations. e risks associated with learning to do
business in a new culture are less if the firm acquires an established host-country enterprise. However,
acquisitions raise additional problems, including those associated with trying to marry divergent
corporate cultures. ese problems may more than offset any benefits derived by acquiring an
established operation. Because the choice between greenfield ventures and acquisitions is such an
important one, we discuss it in more detail later in the chapter.
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Selecting an Entry Mode
LO 13-3 Identify the factors that influence a firm’s choice of entry mode.
As the preceding discussion demonstrated, all the entry modes have advantages and disadvantages, as
summarized in Table 13.1. us, trade-offs are inevitable when selecting an entry mode. For example,
when considering entry into an unfamiliar country with a track record for discriminating against
foreign-owned enterprises when awarding government contracts, a firm might favor a joint venture
with a local enterprise. Its rationale might be that the local partner will help it establish operations in
an unfamiliar environment and will help the company win government contracts. However, if the
firm’s core competence is based on proprietary technology, entering a joint venture might risk losing
control of that technology to the joint-venture partner, in which case the strategy may seem
unattractive. Despite the existence of such trade-offs, it is possible to make some generalizations about
the optimal choice of entry mode.24
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13.1 TABLE
Advantages and Disadvantages of Entry Modes
CORE COMPETENCIES AND ENTRY MODE
We saw in Chapter 12 that firms often expand internationally to earn greater returns from their core
competencies, transferring the skills and products derived from their core competencies to foreign
markets where indigenous competitors lack those skills. e optimal entry mode for these firms
depends to some degree on the nature of their core competencies. A distinction can be drawn between
firms whose core competency is in technological know-how and those whose core competency is in
management know-how.
Technological Know-How As was observed in Chapter 8, if a firm’s competitive advantage (its core competence) is based on control over proprietary technological know-how, licensing and joint-
venture arrangements should be avoided if possible to minimize the risk of losing control
over that technology. us, if a high-tech firm sets up operations in a foreign country to
profit from a core competency in technological know-how, it will probably do so through a wholly
owned subsidiary. is rule should not be viewed as hard and fast, however. Sometimes a licensing or
joint-venture arrangement can be structured to reduce the risk of licensees or joint-venture partners
expropriating technological know-how. Another exception exists when a firm perceives its
technological advantage to be only transitory, when it expects rapid imitation of its core technology by
competitors. In such cases, the firm might want to license its technology as rapidly as possible to
foreign firms to gain global acceptance for its technology before the imitation occurs.25 Such a strategy
has some advantages. By licensing its technology to competitors, the firm may deter them from
developing their own, possibly superior, technology. Further, by licensing its technology, the firm may
establish its technology as the dominant design in the industry. is may ensure a steady stream of
royalty payments. However, the attractions of licensing are frequently outweighed by the risks of
losing control over technology, and if this is a risk, licensing should be avoided.
Management Know-How e competitive advantage of many service firms is based on management know-how (e.g., McDonald’s, Starbucks). For such firms, the risk of losing control over
the management skills to franchisees or joint-venture partners is not that great. ese firms’ valuable
asset is their brand name, and brand names are generally well protected by international laws
pertaining to trademarks. Given this, many of the issues arising in the case of technological know-how
are of less concern here. As a result, many service firms favor a combination of franchising and master
subsidiaries to control the franchises within particular countries or regions. e master subsidiaries
may be wholly owned or joint ventures, but most service firms have found that joint ventures with
local partners work best for the master controlling subsidiaries. A joint venture is often politically
more acceptable and brings a degree of local knowledge to the subsidiary.
PRESSURES FOR COST REDUCTIONS AND ENTRY MODE
e greater the pressures for cost reductions, the more likely a firm will want to pursue some
combination of exporting and wholly owned subsidiaries. By manufacturing in those locations where
factor conditions are optimal and then exporting to the rest of the world, a firm may be able to realize
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substantial location and experience curve economies. e firm might then want to export the finished
product to marketing subsidiaries based in various countries. ese subsidiaries will typically be wholly
owned and have the responsibility for overseeing distribution in their particular countries. Setting up
wholly owned marketing subsidiaries can be preferable to joint-venture arrangements and to using
foreign marketing agents because it gives the firm tight control that might be required for
coordinating a globally dispersed value chain. (e accompanying Management Focus on General
Motors illustrates GM’s joint venture to access the Chinese market.) It also gives the firm the ability to
use the profits generated in one market to improve its competitive position in another market. In
other words, firms pursuing global standardization or transnational strategies tend to prefer
establishing wholly owned subsidiaries.
m a n a g e m e n t F O C U S
General Motors on the Upswing
e late 2000s were not kind to General Motors Corporation (GM), but the company is on a much-needed
upswing. e Chinese market, in particular, is becoming one of the most important foreign markets for GM.
General Motors, of course, is a U.S.-based multinational corporation headquartered in Detroit, Michigan.
GM was founded in 1908 in Flint, Michigan, and Mary Barra is the company’s CEO. In 2019, GM had
revenues of $149 billion and more than 180,000 employees, produced almost 10 million vehicles, and
consisted of four core divisions (Buick, Chevrolet, Cadillac, and GMC).
Hurt by a deep recession in the United States and plunging vehicle sales, GM capped off the 2000s decade,
where it had progressively lost market share to foreign rivals such as Toyota, by entering Chapter 11
bankruptcy. Between 1980, when it dominated the U.S. market, and 2009, when it entered bankruptcy
protection, GM saw its U.S. market share slip from 44 to just 19 percent. e troubled company emerged
from bankruptcy a few months later a smaller enterprise with fewer brands, and yet going forward, some
believe that the new GM could be a much more profitable enterprise. One major reason for this optimism is
the success of its joint ventures in China.
GM entered China in 1997 with a $1.6 billion investment to establish a joint venture with the state-
owned Shanghai Automotive Industry Corporation (SAIC) to build Buick sedans. At the time, the Chinese
market was tiny (fewer than 400,000 cars were sold in 1996), but GM was attracted by the enormous
potential in a country of more than 1.4 billion people that was experiencing rapid economic growth. While
the company initially recognized that it had much to learn about the Chinese market and would probably lose
money for a few years in the early years, GM executives believed it was crucial to establish operations and to
team up with SAIC (one of the early leaders in China’s emerging automobile industry) before its global rivals
did. e decision to enter a joint venture was not a hard one. Not only did GM lack knowledge and
connections in China, but Chinese government regulations made it all but impossible for a foreign automaker
to go it alone in the country.
While GM was not alone in investing in China—many of the world’s major automobile companies
entered into some kind of Chinese joint venture during this time period—it was among the largest investors.
Only Volkswagen, whose management shared GM’s view, made a similar-sized investment. Other companies
adopted a more cautious approach, investing smaller amounts and setting more limited goals.
By 2007, GM had expanded the range of its partnership with SAIC to include vehicles sold under the
names of Chevrolet, Cadillac, and Wuling. e two companies had also established the Pan-Asian Technical
Automotive Center to design cars and components not just for China but also for other Asian markets. At this
point, it was already clear that both the Chinese market and the joint venture were exceeding GM’s initial
expectations. Not only was the venture profitable, but it was also selling more than 900,000 cars and light
trucks in 2007, an 18 percent increase over 2006, placing it second only to Volkswagen in the market among
foreign nameplates. Equally impressive, some 8 million cars and light trucks were sold in China in 2007,
making China the second-largest car market in the world, ahead of Japan and behind the United States. In
2015, GM sold about 3.16 million vehicles in China, up from some 2.4 million vehicles sold in 2010.
Much of the venture’s success could be attributed to its strategy of designing vehicles explicitly for the
Chinese market. For example, together with SAIC, GM produced a tiny minivan, the Wuling Sunshine. e
van costs $3,700, has a 0.8-liter engine, hits a top speed of 60 mph, and weighs less than 1,000 kilograms—a
far cry from the heavy SUVs GM is known for in the United States. For China, the vehicle was perfect,
making it the best seller in the light truck sector.
It is the future, however, that has people excited. From a market of about 9 million passenger and
commercial vehicles sold in China in 2008 to 25 million in 2019, the Chinese vehicle market is booming
compared with those in the United States and Europe. China has now become GM’s largest market in vehicles
sold. GM also plans to expand its Chinese dealer network to more than 5,000, and it plans to have 17
assembly plants in China, more than the 12 it has in the United States. Driving this expansion are forecasts
from GM that demand in China will reach 35 million vehicles a year by 2022, a huge increase from the
25 million vehicles sold in 2019. Underlying these forecasts are the still relatively low vehicle penetration rates
in China. China has about 85 vehicles per 1,000 people compared to around 800 vehicles for every 1,000
people in the United States.
Sources: S. Schifferes, “Cracking China’s Car Market,” BBC News, May 17, 2007; N. Madden, “Led by Buick, Carmaker Learning Fine Points of Regional China Tastes,” Automotive News, September 15, 2008, pp. 186– 90; “GM Posts Record Sales in China,” Toronto Star, January 5, 2010, p. B4; “GM’s Sales in China Top US,” Investor’s Business Daily, January 25, 2011, p. A1; and K. Naughton, “GM’s China Bet Mimics Toyota’s Bet on U.S. Last Century,” Bloomberg.com, April 29, 2013.
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Greenfield Venture or Acquisition?
LO 13-4 Recognize the pros and cons of acquisitions versus greenfield ventures as an entry
strategy.
A firm can establish a wholly owned subsidiary in a country by building a subsidiary from the ground
up, the so-called greenfield strategy, or by acquiring an enterprise in the target market.26 e volume
of cross-border acquisitions has been growing at a rapid rate for two decades. Over most of the past
decades, between 40 and 80 percent of all foreign direct investment (FDI) inflows have been in the
form of mergers and acquisitions.27
PROS AND CONS OF ACQUISITIONS
Acquisitions have three major points in their favor. First, they are quick to execute. By acquiring an
established enterprise, a firm can rapidly build its presence in the target foreign market. When the
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German automobile company Daimler-Benz decided it needed a bigger presence in the U.S.
automobile market, it did not increase that presence by building new factories to serve the United
States, a process that would have taken years. Instead, it acquired the third-largest U.S. automobile
company, Chrysler, and merged the two operations to form DaimlerChrysler (Daimler spun off
Chrysler into a private equity firm in 2007). When the Spanish telecommunications service provider
Telefónica wanted to build a service presence in Latin America, it did so through a series of
acquisitions, purchasing telecommunications companies in Brazil and Argentina. In these cases, the
firms made acquisitions because they knew that was the quickest way to establish a sizable presence in
the target market.
Second, in many cases, firms make acquisitions to preempt their competitors. e need for
preemption is particularly great in markets that are rapidly globalizing, such as telecommunications,
where a combination of deregulation within nations and liberalization of regulations governing cross-
border foreign direct investment has made it much easier for enterprises to enter foreign markets
through acquisitions. Such markets may see concentrated waves of acquisitions as firms race each other
to attain global scale. In the telecommunications industry, for example, regulatory changes triggered
what can be called a feeding frenzy, with firms entering each other’s markets via acquisitions to
establish a global presence. ese included the $56 billion acquisition of AirTouch Communications
in the United States by the British company Vodafone, which was the largest acquisition ever; the $13
billion acquisition of One 2 One in Britain by the German company Deutsche Telekom; and the $6.4
billion acquisition of Excel Communications in the United States by Teleglobe of Canada.28 A similar
wave of cross-border acquisitions occurred in the global automobile industry, with Daimler acquiring
Chrysler, Ford acquiring Volvo (and then selling Volvo as well), and Renault acquiring Nissan.
ird, managers may believe acquisitions to be less risky than greenfield ventures. When a firm
makes an acquisition, it buys a set of assets that are producing a known revenue and profit stream. In
contrast, the revenue and profit stream that a greenfield venture might generate is uncertain because it
does not yet exist. When a firm makes an acquisition in a foreign market, it not only acquires a set of
tangible assets, such as factories, logistics systems, and customer service systems, but it also acquires
valuable intangible assets, including a local brand name and managers’ knowledge of the business
environment in that nation. Such knowledge can reduce the risk of mistakes caused by ignorance of
the national culture.
Despite the arguments for engaging in acquisitions, many acquisitions often produce disappointing
results.29 For example, a study by Mercer Management Consulting looked at 150 acquisitions worth
more than $500 million each.30 e Mercer study concluded that 50 percent of these acquisitions
eroded shareholder value, while another 33 percent created only marginal returns. Only 17 percent
were judged to be successful. Similarly, a study by KPMG, an accounting and management consulting
company, looked at 700 large acquisitions. e study found that while some 30 percent of these
actually created value for the acquiring company, 31 percent destroyed value, and the remainder had
little impact.31 A similar study by McKinsey & Company estimated that some 70 percent of mergers
and acquisitions failed to achieve expected revenue synergies.32 In a seminal study of the
postacquisition performance of acquired companies, David Ravenscraft and Mike Scherer
concluded that on average, the profits and market shares of acquired companies declined following
acquisition.33 ey also noted that a smaller but substantial subset of those companies experienced
traumatic difficulties, which ultimately led to their being sold by the acquiring company. Ravenscraft
and Scherer’s evidence suggests that many acquisitions destroy rather than create value. While most
research has looked at domestic acquisitions, the findings probably also apply to cross-border
acquisitions.34
Why Do Acquisitions Fail? Acquisitions fail for several reasons. First, the acquiring firms often overpay for the assets of the acquired firm. e price of the target firm can get bid up if more than one
firm is interested in its purchase, as is often the case. In addition, the management of the acquiring
firm is often too optimistic about the value that can be created via an acquisition and is thus willing to
pay a significant premium over a target firm’s market capitalization. is is called the “hubris
hypothesis” of why acquisitions fail. e hubris hypothesis postulates that top managers typically
overestimate their ability to create value from an acquisition, primarily because rising to the top of a
corporation has given them an exaggerated sense of their own capabilities.35 For example, Daimler
acquired Chrysler in 1998 for $40 billion, a premium of 40 percent over the market value of Chrysler
before the takeover bid. Daimler paid this much because it thought it could use Chrysler to help it
grow market share in the United States. At the time, Daimler’s management issued bold
announcements about the “synergies” that would be created from combining the operations of the two
companies. However, within a year of the acquisition, Daimler’s German management was faced with
a crisis at Chrysler, which was suddenly losing money due to weak sales in the United States. In
retrospect, Daimler’s management had been far too optimistic about the potential for future demand
in the U.S. auto market and about the opportunities for creating value from “synergies.” Daimler
acquired Chrysler at the end of a multiyear boom in U.S. auto sales and paid a large premium over
Chrysler’s market value just before demand slumped (and in 2007, in an admission of failure, Daimler
sold its Chrysler unit to a private equity firm, now owned by Fiat Chrysler Automobiles).36
Second, many acquisitions fail because there is a clash between the cultures of the acquiring and
acquired firms. After an acquisition, many acquired companies experience high management turnover,
possibly because their employees do not like the acquiring company’s way of doing things.37 is
happened at DaimlerChrysler; many senior managers left Chrysler in the first year after the merger.
Apparently, Chrysler executives disliked the dominance in decision making by Daimler’s German
managers, while the Germans resented that Chrysler’s American managers were paid two to three
times as much as their German counterparts. ese cultural differences created tensions, which
ultimately exhibited themselves in high management turnover at Chrysler.38 e loss of management
talent and expertise can materially harm the performance of the acquired unit.39 is may be
particularly problematic in an international business, where management of the acquired unit may
have valuable local knowledge that can be difficult to replace.
ird, many acquisitions fail because attempts to realize gains by integrating the operations of the
acquired and acquiring entities often run into roadblocks and take much longer than forecast.
Differences in management philosophy and company culture can slow the integration of operations.
Differences in national culture may exacerbate these problems. Bureaucratic haggling between
managers also complicates the process. Again, this reportedly occurred at DaimlerChrysler, where
grand plans to integrate the operations of the two companies were bogged down by endless committee
meetings and by simple logistical considerations such as the six-hour time difference between Detroit
and Germany. By the time an integration plan had been worked out, Chrysler was losing money, and
Daimler’s German managers suddenly had a crisis on their hands.
Finally, many acquisitions fail due to inadequate preacquisition screening.40 Many firms decide to
acquire other firms without thoroughly analyzing the potential benefits and costs. ey often move
with undue haste to execute the acquisition, perhaps because they fear another competitor may
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preempt them. After the acquisition, however, many acquiring firms discover that instead of buying a
well-run business, they have purchased a troubled organization. is may be a particular problem in
cross-border acquisitions because the acquiring firm may not fully understand the target firm’s national
culture and business system.
Reducing the Risks of Failure ese problems can all be overcome if the firm is careful about its acquisition strategy.41 Screening of the foreign enterprise to be acquired, including a detailed auditing
of operations, financial position, and management culture, can help to make sure the firm (1) does not
pay too much for the acquired unit, (2) does not uncover any nasty surprises after the acquisition, and
(3) acquires a firm whose organization culture is not antagonistic to that of the acquiring enterprise. It
is also important for the acquirer to allay any concerns that management in the acquired enterprise
might have. e objective should be to reduce unwanted management attrition after the acquisition.
Finally, managers must move rapidly after an acquisition to put an integration plan in place and to act
on that plan. Some people in both the acquiring and acquired units will try to slow or stop any
integration efforts, particularly when losses of employment or management power are involved, and
managers should have a plan for dealing with such impediments before they arise.
PROS AND CONS OF GREENFIELD VENTURES
e big advantage of establishing a greenfield venture in a foreign country is that it gives the firm a
much greater ability to build the kind of subsidiary company that it wants. For example, it is much
easier to build an organization culture from scratch than it is to change the culture of an acquired unit.
Similarly, it is much easier to establish a set of operating routines in a new subsidiary than it is to
convert the operating routines of an acquired unit. is is a very important advantage for many
international businesses, where transferring products, competencies, skills, and know-how from the
established operations of the firm to the new subsidiary are principal ways of creating value. For
example, when Lincoln Electric, the U.S. manufacturer of arc welding equipment, first ventured
overseas in the mid-1980s, it did so by acquisitions, purchasing arc welding equipment companies in
Europe. However, Lincoln’s competitive advantage in the United States was based on a strong
organizational culture and a unique set of incentives that encouraged its employees to do everything
possible to increase productivity. Lincoln found through bitter experience that it was almost
impossible to transfer its organizational culture and incentives to acquired firms, which had their own
distinct organizational cultures and incentives. As a result, the firm switched its entry strategy in the
mid-1990s and began to enter foreign countries by establishing greenfield ventures, building
operations from the ground up. While this strategy takes more time to execute, Lincoln has found that
it yields greater long-run returns than the acquisition strategy.
Set against this significant advantage are the disadvantages of establishing a greenfield venture.
Greenfield ventures are slower to establish. ey are also risky. As with any new venture, a degree of
uncertainty is associated with future revenue and profit prospects. However, if the firm has already
been successful in other foreign markets and understands what it takes to do business in other
countries, these risks may not be that great. For example, having already gained great knowledge about
operating internationally, the risk to McDonald’s of entering yet another country is probably not that
great. Also, greenfield ventures are less risky than acquisitions in the sense that there is less potential
for unpleasant surprises. A final disadvantage is the possibility of being preempted by more aggressive
global competitors who enter via acquisitions and build a big market presence that limits the market
potential for the greenfield venture.
Page 376
How Risky Would Indonesia Be for a New Greenfield Investment?
Business is all about risk, the right risks. Choosing which risks to accept and which to avoid is at the heart of
international business. ese risks increase and become more interesting with entry into foreign markets.
David Conklin discusses the idea of managing risk through planned uncertainty. By “planned uncertainty,” he
means an awareness of contingencies, with possible what-if scenarios developed in advance. e key idea here
is that through an ongoing monitoring of the various risk areas, decision makers can have much of the data
they may need to address a number of possible outcomes. Of course, we have to know what uncertainty to
plan for, and we don’t know what we don’t know. Planning for everything is impossible, but what Conklin
suggests is that planned uncertainty is a way of thinking. Given that we don’t know the future, this way of
thinking may be helpful in career development and other parts of our lives. Who ever said business wasn’t like
surfing? So, as just one country example, how big do you think the risk is by entering Indonesia with a new
greenfield investment?
WHICH CHOICE?
e choice between acquisitions and greenfield ventures is not an easy one. Both modes have their
advantages and disadvantages. In general, the choice will depend on the circumstances confronting the
firm. If the firm is seeking to enter a market where there are already well-established incumbent
enterprises and where global competitors are also interested in establishing a presence, it may pay the
firm to enter via an acquisition. In such circumstances, a greenfield venture may be too slow
to establish a sizable presence. However, if the firm is going to make an acquisition, its
management should be cognizant of the risks associated with acquisitions that were discussed earlier
and consider these when determining which firms to purchase. It may be better to enter by the slower
route of a greenfield venture than to make a bad acquisition.
If the firm is considering entering a country where there are no incumbent competitors to be
acquired, then a greenfield venture may be the only mode. Even when incumbents exist, if the
competitive advantage of the firm is based on the transfer of organizationally embedded competencies,
skills, routines, and culture, it may still be preferable to enter via a greenfield venture. ings such as
skills and organizational culture, which are based on significant knowledge that is difficult to articulate
and codify, are much easier to embed in a new venture than they are in an acquired entity, where the
firm may have to overcome the established routines and culture of the acquired firm. us, as our
earlier examples suggest, firms such as McDonald’s and Lincoln Electric prefer to enter foreign markets
by establishing greenfield ventures.
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Key Terms
timing of entry, p. 360
first-mover advantages, p. 360
first-mover disadvantages, p. 360
pioneering costs, p. 360
exporting, p. 364
turnkey project, p. 365
licensing agreement, p. 366
franchising, p. 367
joint venture, p. 368
wholly owned subsidiary, p. 369
Summary
is chapter reviewed basic entry decisions and entry modes (exporting, turnkey projects, licensing,
franchising, joint ventures, and wholly owned subsidiaries), and how to go about selecting an entry
mode. We reviewed entering foreign markets in developed countries (e.g., United Kingdom, Sweden,
United States, and similar countries) and emerging markets (e.g., Argentina, Brazil, China, India,
Indonesia, Mexico, Poland, South Africa, South Korea, Turkey). We touched on market entry into less
developed nations as well. e chapter made the following points:
1. Basic entry decisions include identifying which markets to enter, when to enter those markets,
and on what scale.
2. e most attractive foreign markets tend to be found in politically stable developed and
developing nations that have free market systems and where there is no dramatic upsurge in
either inflation rates or private-sector debt.
3. ere are several advantages associated with entering a national market early, before other
international businesses have established themselves. ese advantages must be balanced against
the pioneering costs that early entrants often have to bear, including the greater risk of business
failure.
4. Large-scale entry into a national market constitutes a major strategic commitment that is likely
to change the nature of competition in that market and limit the entrant’s future strategic
flexibility. Although making major strategic commitments can yield many benefits, there are also
risks associated with such a strategy.
5. ere are six modes of entering a foreign market: exporting, creating turnkey projects, licensing,
franchising, establishing joint ventures, and setting up a wholly owned subsidiary.
6. Exporting has the advantages of facilitating the realization of experience curve economies and of
avoiding the costs of setting up manufacturing operations in another country. Disadvantages
include high transport costs, trade barriers, and problems with local marketing agents.
7. Turnkey projects allow firms to export their process know-how to countries where foreign direct
investment (FDI) might be prohibited, thereby enabling the firm to earn a greater return from
this asset. e disadvantage is that the firm may inadvertently create efficient global competitors
in the process.
8. e main advantage of licensing is that the licensee bears the costs and risks of opening a foreign
market. Disadvantages include the risk of losing technological know-how to the licensee and a
lack of tight control over licensees.
Page 377
9. e main advantage of franchising is that the franchisee bears the costs and risks of opening a
foreign market. Disadvantages center on problems of quality control of distant franchisees.
10. Joint ventures have the advantages of sharing the costs and risks of opening a foreign market and
of gaining local knowledge and political influence. Disadvantages include the risk of
losing control over technology and a lack of tight control.
11. e advantages of wholly owned subsidiaries include tight control over technological know-how.
e main disadvantage is that the firm must bear all the costs and risks of opening a foreign
market.
12. e optimal choice of entry mode depends on the firm’s strategy. When technological know-
how constitutes a firm’s core competence, wholly owned subsidiaries are preferred, since they
best control technology. When management know-how constitutes a firm’s core competence,
foreign franchises controlled by joint ventures seem to be optimal. When the firm is pursuing a
global standardization or transnational strategy, the need for tight control over operations to
realize location and experience curve economies suggests wholly owned subsidiaries are the best
entry mode.
13. When establishing a wholly owned subsidiary in a country, a firm must decide whether to do so
by a greenfield venture strategy or by acquiring an established enterprise in the target market.
14. Acquisitions are quick to execute, may enable a firm to preempt its global competitors, and
involve buying a known revenue and profit stream. Acquisitions may fail when the acquiring
firm overpays for the target, when the cultures of the acquiring and acquired firms clash, when
there is a high level of management attrition after the acquisition, and when there is a failure to
integrate the operations of the acquiring and acquired firm.
15. e advantage of a greenfield venture in a foreign country is that it gives the firm a much greater
ability to build the kind of subsidiary company that it wants. For example, it is much easier to
build an organization culture from scratch than it is to change the culture of an acquired unit.
Critical inking and Discussion Questions
1. Review the Management Focus “Tesco’s International Growth Strategy,” and then answer the
following questions:
a. Why did Tesco’s initial international expansion strategy focus on developing nations?
b. How does Tesco create value in its international operations?
c. In Asia, Tesco has a history of entering into joint-venture agreements with local partners.
What are the benefits of doing this for Tesco? What are the risks? How are those risks
mitigated?
d. When Tesco decided to enter the United States, this represented a departure from its historic
strategy of focusing on developing nations. Why do you think Tesco made this decision?
How is the U.S. market different from other markets that Tesco has entered?
2. Licensing proprietary technology to foreign competitors is the best way to give up a firm’s
competitive advantage. Discuss.
3. Discuss how the need for control over foreign operations varies with firms’ strategies and core
competencies. What are the implications for the choice of entry mode?
Page 378
4. A small Canadian firm that has developed valuable new medical products using its unique
biotechnology know-how is trying to decide how best to serve the European Union market. Its
choices are given below. e cost of investment in manufacturing facilities will be a major one
for the Canadian firm, but it is not outside its reach. If these are the firm’s only options, which
one would you advise it to choose? Why?
a. Manufacture the products at home, and let foreign sales agents handle marketing.
b. Manufacture the products at home, and set up a wholly owned subsidiary in Europe to
handle marketing.
c. Enter into an alliance with a large European pharmaceutical firm. e products would be
manufactured in Europe by the 50–50 joint venture and marketed by the European firm.
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. Entrepreneur magazine annually publishes a ranking of the top global franchises. Provide a list of the top 25 companies that pursue franchising as their preferred mode of international
expansion. Study one of these companies in detail, and describe its business model, its
international expansion pattern, desirable qualifications in possible franchisees, and the support
and training the company typically provides.
2. e U.S. Commercial Service prepares reports known as the Country Commercial Guide for countries of interest to U.S. investors. Utilize the Country Commercial Guide for Russia to gather information on this country’s energy and mining industry. Considering that your company has
plans to enter Russia in the foreseeable future, select the most appropriate entry method. Be sure
to support your decision with the information collected.
C u t c o C o r p o r a t i o n — S h a r p e n i n g Yo u r M a r k e t E n t r y
c l o s i n g c a s e
e name Cutco comes from “Cooking UTensils COmpany,” a name once owned by Alcoa. Alcoa is a U.S.
company now concentrating on work with lightweight metals and advanced manufacturing techniques.
Together with W. R. Case & Sons Cutlery Company, Alcoa created the joint venture Alcas Corporation in
1949, which subsequently became Cutco Corporation in 2009.
Cutco Corporation includes the wholly owned subsidiaries Vector Marketing Corporation, which it
acquired in 1985, and Cutco Cutlery Corporation. Vector Marketing is the U.S.-based sales arm of Cutco
Corporation, which is headquartered in Olean, New York. More than 700 manufacturing and administrative
employees work at the Olean location.
Cutco is now the largest manufacturer of high-quality kitchen cutlery in the United States and Canada.
e product line includes kitchen knives and utensils, shears, flatware, cookware, and sporting knives. Look
around your house and your friends’ houses, and you are likely to see one of their well-known blocks of knives
in the kitchen! e price for one of the blocks with a dozen or so knives ranges from about $100 to upwards
of a couple of thousand dollars. Some 16 million people have bought Cutco knives.
Originally, Cutco was created as a product for Wear-Ever Aluminum (a company focused on cookware),
which at the time was a division of Alcoa. Cutco evolved from there, eventually adding its signature Wedge-
Lock handle and Double-D recessed edge on some of its knives. Two things that have never changed are
Cutco’s commitment to fine craftsmanship and the Forever Guarantee. e guarantee means what it implies
—that Cutco stands behind its knives’ performance and sharpness forever. ey also have a forever guarantee
of replacing their knives for any misuse or abuse at half the cost.
Cutco, as it operates today, was formed in 1982 following a management buyout that took the company
private. As with any employee or manager buyout, it was a leap of faith for the team that bought the
company. But based on the company’s story, it was also the moment that secured Cutco’s future for
generations to come. In this process, in 1985, Vector Marketing Corporation became the exclusive marketer
of Cutco products directly to consumers via sales representatives located throughout the United States and
Canada. Cutco International Inc. is responsible for international marketing.
Annual sales for Cutco now stand at about $200 million worldwide, but mainly in the United States and
Canada. e product line includes more than 100 choices under the Cutco name alone. e extended line
includes kitchen utensils, gadgets and flatware, sporting and pocket knives, and garden tools. For the Cutco
line, the products are marketed via what is called “direct selling” (marketing of products directly to the
consumer away from a fixed retail location). Internationally, outside North America, Cutco has independent
office arrangements in Australia, Costa Rica, Germany, South Korea, and the United Kingdom. Puerto Rico
also has independently run sales locations.
In the United States and Canada, Vector Marketing Corporation typically employs college students in the
18-to-24 age range part-time during the school year and full-time during the summers to be part of their
direct sales force. e sales pitch to students is good pay, flexible schedules, personal growth, no experience
needed, great training, and engagement with quality products. In fact, 85 percent of the sales force at Cutco is
college-aged individuals.
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©Don Heupel/AP Images
is sales force is a drastic change from the early days of the company. Early on, Cutco had hundreds of
small independent sellers of the company’s knives and other products. Vector Marketing became one of these
sellers in 1981 and stayed in this role until 1984. In 1985, Cutco bought out Vector Marketing, and Vector
became the sole channel for sales across the United States. As a core member of the Direct Selling Association,
Vector Marketing Corporation drives Cutco sales using college-aged students whom they pay $12 to $20 per
hour in a direct-to-customer business model. But internationally, Cutco products are still sold via a myriad of
independent sellers in Australia, Costa Rica, Germany, South Korea, and the United Kingdom.
Sources: Cutco website, www.cutco.com; Vector Marketing Corporation, http://vectormarketing.com; “Company Overview of
Cutco Corporation,” Bloomberg Business, March 24, 2016; J. Berghoff, Cutting Edge Sales: Confessions of Success, Influence & Self-
Fulfillment from the World’s Finest Knife Dealers (New York: Morgan James Publishing, 2009); and “Bringing Help to Haiti: Vector
Marketing Sales Record Holder Michael Arrieta,” PRweb, September 15, 2015.
CASE DISCUSSION QUESTIONS
1. e Cutco brand is affiliated with Cutco Corporation, Vector Marketing Corporation, and
Cutco Cutlery Corporation. It seems overly cumbersome for customers to understand that
Vector Marketing Corporation is selling Cutco knives! Meanwhile, Cutco is now the largest
manufacturer of high-quality kitchen cutlery in the United States and Canada. How would
you structure Cutco’s branding if you entered a new international market?
2. Two things that have never changed at Cutco are their commitment to fine craftsmanship
and the Forever Guarantee. e guarantee means what it implies—that Cutco stands behind
its knives’ performance and sharpness forever. ey also have a forever guarantee of replacing
their knives for any misuse or abuse at half the cost. Is this a viable international strategy
when considering entry into the vastly diverse markets that exist globally?
3. Vector Marketing Corporation is the exclusive marketer of Cutco products directly to
consumers via sales representatives located throughout the United States and Canada. Cutco
International Inc. is responsible for international marketing. Can the direct sales model work
as a market entry strategy internationally? Where can it work and where does it potentially
not work?
4. Cutco’s product line includes more than 100 choices under the Cutco name alone. e
extended line includes kitchen utensils, gadgets and flatware, sporting and pocket knives, and
garden tools. Is it realistic to think that Cutco can enter global markets with all of its
products for each market every time they consider a new market entry?
Endnotes
1. For interesting empirical studies that deal with the issues of timing and resource commitments,
see T. Isobe, S. Makino, and D. B. Montgomery, “Resource Commitment, Entry Timing, and
Market Performance of Foreign Direct Investments in Emerging Economies,” Academy of Management Journal 43, no. 3 (2000), pp. 468–84; and Y. Pan and P. S. K. Chi, “Financial Performance and Survival of Multinational Corporations in China,” Strategic Management Journal 20, no. 4 (1999), pp. 359–74. A complementary theoretical perspective on this issue can be found in V. Govindarjan and A. K. Gupta, e Quest for Global Dominance (San Francisco: Jossey-Bass, 2001). Also see F. Vermeulen and H. Barkeme, “Pace, Rhythm and Scope: Process
Page 380
Dependence in Building a Profitable Multinational Corporation,” Strategic Management Journal 23 (2002), pp. 637–54.
2. is can be reconceptualized as the resource base of the entrant, relative to indigenous
competitors. For work that focuses on this issue, see W. C. Bogner, H. omas, and J. McGee,
“A Longitudinal Study of the Competitive Positions and Entry Paths of European Firms in the
U.S. Pharmaceutical Market,” Strategic Management Journal 17 (1996), pp. 85–107; D. Collis, “A Resource-Based Analysis of Global Competition,” Strategic Management Journal 12 (1991), pp. 49–68; and S. Tallman, “Strategic Management Models and Resource-Based Strategies
among MNEs in a Host Market,” Strategic Management Journal 12 (1991), pp. 69–82.
3. For a discussion of first-mover advantages, see M. Lieberman and D. Montgomery, “First-Mover
Advantages,” Strategic Management Journal 9 (Summer Special Issue, 1988), pp. 41–58.
4. J. M. Shaver, W. Mitchell, and B. Yeung, “e Effect of Own Firm and Other Firm Experience
on Foreign Direct Investment Survival in the United States, 1987–92,” Strategic Management Journal 18 (1997), pp. 811–24.
5. S. Zaheer and E. Mosakowski, “e Dynamics of the Liability of Foreignness: A Global Study
of Survival in the Financial Services Industry,” Strategic Management Journal 18 (1997), pp. 439–64.
6. Shaver et al., “e Effect of Own Firm and Other Firm Experience.”
7. P. Ghemawat, Commitment: e Dynamics of Strategy (New York: Free Press, 1991).
8. R. Luecke, Scuttle Your Ships before Advancing (Oxford: Oxford University Press, 1994).
9. Isobe et al., “Resource Commitment, Entry Timing, and Market Performance”; Pan and Chi,
“Financial Performance and Survival of Multinational Corporations in China”; and Govindarjan
and Gupta, e Quest for Global Dominance.
10. Christopher Bartlett and Sumantra Ghoshal, “Going Global: Lessons from Late Movers,”
Harvard Business Review, March–April 2000, pp. 132–45.
11. is section draws on numerous studies, including C. W. L. Hill, P. Hwang, and W. C. Kim,
“An Eclectic eory of the Choice of International Entry Mode,” Strategic Management Journal 11 (1990), pp. 117–28; C. W. L. Hill and W. C. Kim, “Searching for a Dynamic eory of the
Multinational Enterprise: A Transaction Cost Model,” Strategic Management Journal 9 (Special Issue on Strategy Content, 1988), pp. 93–104; E. Anderson and H. Gatignon, “Modes of
Foreign Entry: A Transaction Cost Analysis and Propositions,” Journal of International Business Studies 17 (1986), pp. 1–26; F. R. Root, Entry Strategies for International Markets (Lexington, MA: D. C. Heath, 1980); A. Madhok, “Cost, Value and Foreign Market Entry: e Transaction
and the Firm,” Strategic Management Journal 18 (1997), pp. 39–61; K. D. Brouthers and L. B. Brouthers, “Acquisition or Greenfield Start-Up?” Strategic Management Journal 21, no. 1 (2000), pp. 89–97; X. Martin and R. Salmon, “Knowledge Transfer Capacity and Its Implications for
the eory of the Multinational Enterprise,” Journal of International Business Studies, July 2003, p. 356; and A. Verbeke, “e Evolutionary View of the MNE and the Future of Internalization
eory,” Journal of International Business Studies, November 2003, pp. 498–515.
12. For a general discussion of licensing, see F. J. Contractor, “e Role of Licensing in
International Strategy,” Columbia Journal of World Business, Winter 1982, pp. 73–83.
13. See E. Terazono and C. Lorenz, “An Angry Young Warrior,” Financial Times, September 19, 1994, p. 11; and K. McQuade and B. Gomes-Casseres, “Xerox and Fuji-Xerox,” Harvard
Business School Case No. 9-391-156.
14. O. E. Williamson, e Economic Institutions of Capitalism (New York: Free Press, 1985).
15. J. H. Dunning and M. McQueen, “e Eclectic eory of International Production: A Case
Study of the International Hotel Industry,” Managerial and Decision Economics 2 (1981), pp. 197–210.
16. Andrew E. Serwer, “McDonald’s Conquers the World,” Fortune, October 17, 1994, pp. 103–16.
17. For an excellent review of the basic theoretical literature of joint ventures, see B. Kogut, “Joint
Ventures: eoretical and Empirical Perspectives,” Strategic Management Journal 9 (1988), pp. 319–32. More recent studies include T. Chi, “Option to Acquire or Divest a Joint Venture,”
Strategic Management Journal 21, no. 6 (2000), pp. 665–88; H. Merchant and D. Schendel, “How Do International Joint Ventures Create Shareholder Value?” Strategic Management Journal 21, no. 7 (2000), pp. 723–37; H. K. Steensma and M. A. Lyles, “Explaining IJV Survival in a
Transitional Economy though Social Exchange and Knowledge Based Perspectives,” Strategic Management Journal 21, no. 8 (2000), pp. 831–51; and J. F. Hennart and M. Zeng, “Cross Cultural Differences and Joint Venture Longevity,” Journal of International Business Studies, December 2002, pp. 699–717.
18. D. G. Bradley, “Managing against Expropriation,” Harvard Business Review, July–August 1977, pp. 78–90.
19. J. A. Robins, S. Tallman, and K. Fladmoe-Lindquist, “Autonomy and Dependence of
International Cooperative Ventures,” Strategic Management Journal, October 2002, pp. 881– 902.
20. Speech given by Tony Kobayashi at the University of Washington Business School, October
1992.
21. A. C. Inkpen and P. W. Beamish, “Knowledge, Bargaining Power, and the Instability of
International Joint Ventures,” Academy of Management Review 22 (1997), pp. 177–202; and S. H. Park and G. R. Ungson, “e Effect of National Culture, Organizational
Complementarity, and Economic Motivation on Joint Venture Dissolution,” Academy of Management Journal 40 (1997), pp. 279–307.
22. Inkpen and Beamish, “Knowledge, Bargaining Power, and the Instability of International Joint
Ventures.”
23. See Brouthers and Brouthers, “Acquisition or Greenfield Start-Up?”; and J. F. Hennart and Y. R.
Park, “Greenfield versus Acquisition: e Strategy of Japanese Investors in the United States,”
Management Science, 1993, pp. 1054–70.
24. is section draws on Hill et al., “An Eclectic eory of the Choice of International Entry
Mode.”
25. C. W. L. Hill, “Strategies for Exploiting Technological Innovations: When and When Not to
License,” Organization Science 3 (1992), pp. 428–41.
26. See Brouthers and Brouthers, “Acquisition or Greenfield Start-Up?”; and J. Anand and A.
Delios, “Absolute and Relative Resources as Determinants of International Acquisitions,”
Strategic Management Journal, February 2002, pp. 119–34.
27. United Nations, World Investment Report, 2010 (New York and Geneva: United Nations, 2010).
28. United Nations, World Investment Report, 2010 (New York and Geneva: United Nations, 2010).
29. For evidence on acquisitions and performance, see R. E. Caves, “Mergers, Takeovers, and
Economic Efficiency,” International Journal of Industrial Organization 7 (1989), pp. 151–74; M. C. Jensen and R. S. Ruback, “e Market for Corporate Control: e Scientific Evidence,”
Journal of Financial Economics 11 (1983), pp. 5–50; R. Roll, “Empirical Evidence on Takeover Activity and Shareholder Wealth,” in Knights, Raiders and Targets, ed. J. C. Coffee, L. Lowenstein, and S. Rose (Oxford: Oxford University Press, 1989); A. Schleifer and R. W.
Vishny, “Takeovers in the 60s and 80s: Evidence and Implications,” Strategic Management Journal 12 (Winter 1991 Special Issue), pp. 51–60; T. H. Brush, “Predicted Changes in Operational Synergy and Post-acquisition Performance of Acquired Businesses,” Strategic Management Journal 17 (1996), pp. 1–24; and A. Seth, K. P. Song, and R. R. Pettit, “Value Creation and Destruction in Cross-Border Acquisitions,” Strategic Management Journal 23 (October 2002), pp. 921–40.
30. J. Warner, J. Templeman, and R. Horn, “e Case against Mergers,” BusinessWeek, October 30, 1995, pp. 122–34.
31. “Few Takeovers Pay Off for Big Buyers,” Investor’s Business Daily, May 25, 2001, p. 1.
32. S. A. Christofferson, R. S. McNish, and D. L. Sias, “Where Mergers Go Wrong,” e McKinsey Quarterly 2 (2004), pp. 92–110.
33. D. J. Ravenscraft and F. M. Scherer, Mergers, Selloffs, and Economic Efficiency (Washington, DC: Brookings Institution, 1987).
34. See P. Ghemawat and F. Ghadar, “e Dubious Logic of Global Mega-Mergers,” Harvard Business Review, July–August 2000, pp. 65–72.
35. R. Roll, “e Hubris Hypothesis of Corporate Takeovers,” Journal of Business 59 (1986), pp. 197–216.
36. “Marital Problems,” e Economist, October 14, 2000.
37. See J. P. Walsh, “Top Management Turnover Following Mergers and Acquisitions,” Strategic Management Journal 9 (1988), pp. 173–83.
38. B. Vlasic and B. A. Stertz, Taken for a Ride: How Daimler-Benz Drove Off with Chrysler (New York: HarperCollins, 2000).
39. See A. A. Cannella and D. C. Hambrick, “Executive Departure and Acquisition Performance,”
Strategic Management Journal 14 (1993), pp. 137–52.
40. P. Haspeslagh and D. Jemison, Managing Acquisitions (New York: Free Press, 1991).
41. P. Haspeslagh and D. Jemison, Managing Acquisitions (New York: Free Press, 1991).
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-
Hill Education
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14
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Part 6 International Business Functions
Exporting, Importing, and Countertrade
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO14-1 Explain the promises and risks associated with exporting.
LO14-2 Identify the steps managers can take to improve their firm’s export performance.
LO14-3 Recognize the basic steps involved in export financing.
LO14-4 Identify information sources and government programs that exist to help exporters.
LO14-5 Describe how countertrade can be used to facilitate exports.
Spotify and SoundCloud
opening case
Numerous online music platforms exist today, with Apple Music, Google Play Music, Pandora, Spotify, SoundCloud,
and YouTube as perhaps the most common ways people listen to music online around the world. What’s popular, of
course, can change rapidly. Numerous other music platforms exist or have existed (e.g., 8tracks, AccuRadio, Dash
Radio, Deezer, Grooveshark, iHeartRadio, Incus Tunes, Jango, last.fm, Mixloud, MusixHub, MySpace, RDIO,
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Slacker Radio, TuneIn Radio, e Sixty One, Xbox Music), and some of these will overtake the top platforms of
today, some will be gone soon, and some already have very few users remaining. In this fierce competitive technology
environment, Swedish entrepreneurs have made an incredible mark on the music industry.
It all begins, really, with the countless start-ups that Sweden has produced. e focus of this case is on Spotify and
SoundCloud. However, to better understand the creation of companies and brands such as these, it’s important to
know how a tiny country like Sweden with a population of 10 million people and high government spending can be
so innovative and entrepreneurial. Given its size, it should come as no surprise that companies from Sweden rely on
exports for much of their sales. And the start-ups have become a cultural phenomenon in Sweden that has helped the
economy grow in unimaginable ways from just a couple of decades ago.
Stockholm, the capital city of Sweden, produces the second-highest number of billion-dollar tech companies per
capita, after Silicon Valley. e change happened in the 1990s when Sweden needed a boost to its economy. e
country used to be heavily regulated and public monopolies dominated the market, but regulations have been eased
since that time. Interestingly, while Sweden was making it harder for monopolies to dominate the market, the
regulatory landscape in the U.S. was changed to favor big companies and established firms. Despite the global
fascination with start-ups, only 8 percent of all firms in the U.S. meet that definition today, a remarkable drop from a
few decades ago.
In Sweden, the trend has been reversed. e pace of new-business creation start-ups has been accelerating.
Countries like Brazil, India, Romania, Germany, and Singapore have also seen an increasing trend of start-ups in
recent years. ese start-ups are critical to a country’s economy. ey create jobs, spur innovation, and foster the
entrepreneurial spirit that drives economic growth. For example, in the United States, small- and medium-sized
enterprises account for 98 percent of the country’s exporters, and start-ups fall into this SME category (often as so-
called “born globals”—companies that start selling internationally early on after inception). Spotify and SoundCloud
fit all of these categories as start-ups—they were initially small, went international early on, and helped drive
exporting numbers.
Spotify is a Swedish entertainment company founded in 2008 by Daniel Ek and Martin Lorentzon that specializes
in music, podcast, and video streaming. Spotify Technology SA is headquartered in Stockholm and listed on the New
York Stock Exchange as SPOT. e company has more than 3,000 employees, 160 million users, and revenue of
about $5 billion. Spotify is available in most of Europe, the Americas, Oceania, and parts of Asia. Spotify gives users
access to more than 30 million songs and has some 140 million active monthly users, with more than 70 million
paying subscribers.
SoundCloud was founded in 2007 in Stockholm, Sweden, by Alexander Ljung and Eric Wahlforss, who almost
immediately developed a headquarters for the company in Berlin, Germany. In effect, Alexander Ljung and Eric
Wahlforss used the great infrastructure for start-ups in both Sweden and Germany to launch SoundCloud and build
it into what it has now become—a company with 300 employees, 40 million registered users, and 175 million
monthly listeners. With a different focus than Spotify, SoundCloud positioned itself as an online audio distribution
platform that enables users to upload, record, promote, and share their originally created sounds.
Both Spotify and SoundCloud are service businesses that have entered into the global marketplace with music
platforms that customers find valuable. Service exports are an important and increasing trend in global trade. Take,
for example, the developed countries in the world, most of whose economies—around 75 percent—are service-based.
If these economies, like Sweden and Germany, did not find an opportunity to export their services, they would likely
fall behind in the trade balance (imports versus exports). Interestingly, the US has a relatively large trade surplus in
services but a massive trade deficit in manufactured goods. If the US could reduce the deficit in products to have a
neutral import-export ratio, the country’s service economy would automatically create a trade surplus—which the
country has not seen for some 50 years. Given that a service export is really any service provided by a resident in one
country to people or organizations in another country, we know many countries can be successful, or at least have the
opportunity to export more services like what Sweden and Germany are doing with Spotify and SoundCloud. •
Sources: Stacy Fisher, “e Top 14 Places to Listen to Free Music Online,” e Balance Every Day, April 3, 2018; Namrata Ahuja, “Spotify
vs. Soundcloud: What Is the Best Platform for Music Lovers?” Odyssey, June 1, 2016; Alana Semuels, “Why Does Sweden Have So Many
Start-Ups?” e Atlantic, September 28, 2018; “Spotify Makes Its Stock Market Debut,” e Economist, April 4, 2018; “Having Rescued
Recorded Music, Spotify May Upend the Industry Again,” e Economist, January 11, 2018; and “SoundCloud Streaming Hones In On
Creator Uploaded Content: CEO,” BusinessWeek, April 23, 2018.
Introduction
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Chapter 13 reviewed exporting from a strategic perspective as a part of the chapter’s focus on entering foreign
markets. We considered exporting as just one of a range of strategic options for profiting from international
expansion. is chapter is more concerned with the nuts and bolts of exporting, along with tackling
importing and countertrade. In some way, we can say that importing is exporting in reverse since the
importing country and its companies buy from companies in other countries that are exporting.
Unfortunately, the rules and regulations for importing and exporting are not always the same and, in fact, are
often different in even the same country.
Did You Know?
Did you know you can call Sweden and France and chat with a random person from those countries?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the
authors.
Exporting is a tremendously important mode of foreign market entry, preferred by more than 90 percent of
all companies engaging in the global marketplace. e reason exporting is preferred by such a large portion
of companies engaging in the global marketplace is that most small- and medium-sized enterprises (SMEs)
prefer exporting as a relatively low commitment to getting their products or services out globally.
Importantly, these SMEs also make up more than 80 percent of companies going international from almost
every country in the world.
e volume of export activity in the world economy has increased as exporting has become easier from a
large number of countries. Even countries now export themselves, such as France with its award-winning
“Calling France” number. In a positive move for international trade, the gradual decline in trade barriers
under the umbrella of the World Trade Organization (see Chapter 7), along with regional economic
agreements such as the European Union (EU) and the North American Free Trade Agreement (NAFTA) (see
Chapter 9), has significantly increased export opportunities.
At the same time, modern communication and transportation technologies have alleviated the logistical
problems associated with exporting. Over the last two decades, firms have increasingly used e-commerce and
international air services to reduce the costs, distance, and cycle time associated with exporting. Still, more
than 90 percent of products and component parts still logistically get shipped via large ships around the
world. Consequently, it is not unusual to find thriving exporters among small companies. In fact, of U.S.
companies that trade internationally, some 85 percent of them are SMEs, and they generally do so via
exporting. Nevertheless, exporting remains a challenge for many firms. Take the United States as an example.
Fewer than 1 percent of all U.S. firms trade across their country borders to other countries, and those
companies that do engage in trade do so with typically only one other country (about 60 percent of all U.S.
companies that export trade only with one other country). is means that knowledge, data, and experience
often are lacking, and smaller enterprises, in particular, can find the exporting process intimidating.
For Which Product Is Autarky a Good Choice for Countries?
e word autarky refers to the quality and belief that a country should be self-sufficient and avoid trade and/or
external assistance with other nations. Many economists regard autarky as an idealistic, but impractical, goal of
countries. Basically, it sounds like a nice idea to be self-sufficient and practice autarky. In reality, throughout history
countries have tried to achieve autarky but soon discovered they could not produce the wide range of products and
services customers in their population wanted and needed. ese countries also found out that manufacturing
products at competitive prices over the long term became a daunting task. In fact, those countries found themselves
worse off economically than nations that engaged in international trade. So, a word to the wise; unless your country
can efficiently produce everything it needs, the country needs to engage in international trade. A more logical and
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achievable possibility is to focus on being self-sufficient in certain areas, for certain products or services. Which
product or service do you think a country should strive to be self-sufficient in?
Sources: “China Pursues Lithium Autarky,” Strategic Risk, March 27, 2018; J. Heathcote, Catherine Rampell, “e Dangerous New Age of
Global Autarky,” e Washington Post, June 6, 2016; and Mahdi Amirisefat, “Autarky and Trade Wars: What Does Economic eory Say?”
PressTV, March 10, 2018.
Companies wishing to export must identify foreign market opportunities, avoid a host of unanticipated
problems that are often associated with doing business in a foreign market, familiarize themselves with the
mechanics of export and import financing, learn where they can get financing and export credit insurance,
and learn how they should deal with foreign exchange risk. e process can be made more problematic by
currencies that are not freely convertible. Arranging payment for exports to countries with weak currencies
can be a problem. is is where countertrade comes in as a potential solution, and why we have made
countertrade a focus in this chapter. Countertrade allows payment for exports to be made through goods and
services rather than money. is chapter discusses all these issues, with the exception of foreign exchange risk,
which was covered in Chapter 10.
In Chapter 13, we dealt with the scale of market entry and strategic commitments in going international.
Essentially, our focus was on involvement and commitment when engaging in the international marketplace.
What we find is that the first international level for both involvement and commitment was the exporting
(outbound international activity) and importing (inbound international activity) options. e remaining
options for involvement and commitment, although they overlapped in some areas, were a bit different
(Chapter 13 discusses turnkey projects, licensing, franchising, joint ventures, and wholly owned subsidiaries
—the latter also a production facility focus in Chapter 15). at places a lot of emphasis on exporting and
importing as modes of operations for many companies, and we think that this area deserves more coverage;
thus, this chapter is devoted to digging deeper into the knowledge of operations (“nuts and bolts”) of
exporting and importing as well as the unique case of countertrade. is is, after all, the lowest level of
involvement and the lowest level of commitment a company can make when going international: selling to
foreign markets (exporting) or purchasing raw materials, component parts, or finished goods for operations
(importing).
e bottom line is that as the global marketplace becomes more viable for many companies over time,
companies must also adapt to this opportunity by strategically engaging in exporting (see Chapter 13) and
operationally go about seeking opportunities globally. is could mean using suppliers from developing
nations, importing products from new sources, or exporting products to new markets. Companies that have
traditionally operated within national or regional trading groups may feel ill equipped to extend their market
horizon. is may be as simple as feeling unable to select and manage a foreign supplier or not knowing how
to sell products in a new country. But keep in mind that, by some accounts, 90 percent of the products and
services that are needed locally are not produced locally; they are shipped in from somewhere else. And so,
market opportunities are globally available everywhere and exporting and importing fill these voids.1
e chapter opens in the next section by considering the promise and pitfalls of exporting. e
logic for both exporting and importing is very similar. Readiness to export and/or import is a large part of
the story, as illustrated in Figure 14.1.2
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Export Tutorials
14.1 FIGURE
Product readiness and company readiness to export or import.
Source: Adapted from T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Leveraging Processes, Measurements,
and Tools for Strategic Corporate Advantage (New York: McGraw-Hill, 2014).
e Promise and Pitfalls of Exporting
LO 14-1 Explain the promises and risks associated with exporting.
e great promise of exporting is that large revenue and profit opportunities are to be found in foreign
markets for most firms in most industries. is was true for both Spotify and SoundCloud in the opening
case to this chapter (as well as Tata Motors in the closing case). e international market is normally so much
larger than the firm’s domestic market that exporting is nearly always a way to increase the revenue and profit
base of a company. By expanding the size of the market, exporting can enable a firm to achieve economies of
scale, thereby lowering its unit costs. Firms that do not export often lose out on significant opportunities for
growth and cost reduction.3
Consider the case of Marlin Steel Wire Products, a Baltimore manufacturer of wire baskets and fabricated
metal items with revenues of about $5 million. Among its products are baskets to hold dedicated parts for
aircraft engines and automobiles. Its engineers design custom wire baskets for the assembly lines of
companies such as Boeing and Toyota. It has a reputation for producing high-quality products for
these niche markets. Like many small businesses, Marlin did not have a history of exporting. However,
Marlin decided to engage globally in the export market, shipping small numbers of products to Mexico and
Canada.
Exporting, importing, and
countertrade are the focus areas
of Chapter 14. e exporting entry mode choice, also discussed in Chapter 13, is the most often used way to conduct
cross-border trade for companies. e vast majority of small- and medium-sized enterprises, for example, use
exporting as their way to expand to international markets. But that begs the question of whether the company is
ready to export and whether the product the company plans to export is ready to be exported. e “Export Tutorials”
section of globalEDGE™ (globaledge.msu.edu/reference-desk/export-tutorials) includes CORE as a diagnostic tool to
assess “company readiness to export.” e “Export Tutorials” section also has a lengthy set of questions and answers
to the most common exporting-related questions in the categories of government regulations, financial
considerations, sales and marketing, and logistics. For example, one question deals with whether a company needs a
license to export. Assume you are based in the United States. How can you identify the relevant commodity
jurisdiction for a product?
Marlin’s president and CEO, Drew Greenblatt, soon realized that export sales could be the key to growth.
In 2008, when the global financial crisis hit and America slid into a serious recession, Marlin was exporting
only 5 percent of its orders to foreign markets. Greenblatt’s strategy for dealing with weak demand in the
United States was to aggressively expand international sales. Today, Marlin Steel has been exporting for eight
years, with sales going to more than 20 countries. One-fourth of the company’s 28 employees are employed
as a direct result of its export success. By 2019, exports accounted for some 20 percent of sales, and the
company set a goal of exporting half its output.
Despite examples such as Marlin Steel Wire Products, studies have shown that while many large firms
tend to be proactive about seeking opportunities for profitable exporting—systematically scanning foreign
markets to see where the opportunities lie for leveraging their technology, products, and marketing skills in
foreign countries—many medium-sized and small firms are very reactive.4 Typically, such reactive firms do
not even consider exporting until their domestic market is saturated and the emergence of excess productive
capacity at home forces them to look for growth opportunities in foreign markets.
Many small- and medium-sized firms tend to wait for the world to come to them, rather than going out
into the world to seek opportunities. Even when the world does come to them, they may not respond. An
example is MMO Music Group, which makes sing-along tapes for karaoke machines. Foreign sales
accounted for about 15 percent of MMO’s revenues of $8 million, but the firm’s CEO admits this figure
would probably have been much higher had he paid attention to building international sales. Unanswered e-
mails and phone messages from Asia and Europe often piled up while he was trying to manage the
burgeoning domestic side of the business. By the time MMO did turn its attention to foreign markets,
competitors had stepped into the breach, and MMO found it tough going to build export volume.5
MMO’s experience is common, and it suggests a need for firms to become more proactive about seeking
export opportunities. One reason more firms are not proactive is that they are unfamiliar with foreign market
opportunities; they simply do not know how big the opportunities actually are or where they might lie.
Simple ignorance of the potential opportunities is a huge barrier to exporting.6 Also, many would-be
exporters, particularly smaller firms, are often intimidated by the complexities and mechanics of exporting to
countries where business practices, language, culture, legal systems, and currency are very different from
those in the home market.7 is combination of unfamiliarity and intimidation probably explains why
exporters still account for only a tiny percentage of U.S. firms, less than 5 percent of firms with fewer than
500 employees, according to the Small Business Administration.8
To make matters worse, many neophyte exporters run into significant problems when first trying to do
business abroad, and this sours them on future exporting ventures. Common pitfalls include poor market
analysis, a poor understanding of competitive conditions in the foreign market, a failure to customize the
product offering to the needs of foreign customers, a lack of an effective distribution program, a poorly
executed promotional campaign, and problems securing financing.9 Novice exporters tend to underestimate
the time and expertise needed to cultivate business in foreign countries.10 Few realize the amount of
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management resources that have to be dedicated to this activity. Many foreign customers require face-to-face
negotiations on their home turf. An exporter may have to spend months learning about a country’s trade
regulations, business practices, and more before a deal can be closed. e accompanying Management Focus,
which documents the experience of Embraer, illustrates cultural barriers that sometimes can hinder both
exporting and importing.
Exporters often face voluminous paperwork, complex formalities, and many potential delays and errors.
Exporting to Brazil is a unique experience in and of itself that still to this day often requires more than just
following the rules and regulations stipulated by the country. According to a United Nations report on trade
and development, a typical international trade transaction may involve 30 parties, 60 original documents,
and 360 document copies—all of which have to be checked, transmitted, reentered into various information
systems, processed, and filed. e UN has calculated that the time involved in preparing documentation,
along with the costs of common errors in paperwork, often amounts to 10 percent of the final value of goods
exported.11
Improving Export Performance
LO 14-2 Identify the steps managers can take to improve their firm’s export performance.
Inexperienced exporters have a number of ways to gain information about foreign market opportunities and
avoid common pitfalls that tend to discourage and frustrate novice exporters.12 In this section, we look at
information sources for exporters to increase their knowledge of foreign market opportunities, we consider a
number of service providers, we review various exporting strategies that can increase the probability of
successful exporting, and we illustrate the globalEDGETM Diagnostic Tool called Company Readiness to
Export (CORE) that can help exporters. We begin, however, with a look at how several nations try to help
domestic firms export.
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m a n a g e m e n t F O C U S
Embraer and Brazilian Importing
Embraer is a Brazilian company that manufactures commercial, military, executive, and agricultural aircraft and
provides aeronautical services. It is headquartered in São José dos Campos, São Paulo State in Brazil. Importantly,
Embraer is the fourth largest airplane manufacturer in the world, and its imports of various raw material and
component parts to Brazil to make its airplanes constitute up slightly more than 1 percent of the Brazilian trade
balance with all other countries, which is a relatively large portion of the Brazilian economy for just one importer.
Embraer has consistently been one of the top importers in Brazil since its founding in 1969. Today, the company
has about 20,000 employees from 20 countries, revenue of more than R$20 billion (Brazilian Real, BRL) or about $6
billion, and more than $300 million in net income. e company consists of three primary divisions: Embraer
Defense and Security, Embraer Commercial Aviation, and Embraer Executive Jets. Across these divisions, the output
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is impressive. Embraer has served more than 90 airlines in more than 60 countries and delivered more than 5,000
aircraft to this clientele.
To be able to produce that many aircraft and achieve a top four position in its industry, Embraer has to import a
lot of raw materials and component parts to Brazil to build the aircraft at the company’s main locations at its
headquarters in São José dos Campos as well as its other core plants in Brazil in Botucatu, Eugênio de Melo, and
Gavião Peixoto. Some of these component parts are in reality finished products that are then inserted into the planes
in a certain position, such as the PurePower Geared Turbofan engines from Pratt & Whitney to power its E-Jets.
Embraer also collaborates with some of its competitors in the industry, such as Boeing, in building its stretch civilian
model of the KC-390 military transport/aerial refueler.
e list of suppliers to Embraer’s operations is lengthy, with partnerships with Honeywell, Saab, UTC Aerospace,
SNC, Flight Safety International, Goodrich, Eaton, ales, Sierra, and Air France Industries, to mention some of the
company’s top suppliers. But the complete list of suppliers needed for Embraer planes is incredibly lengthy—even
lengthier than most car manufacturers, which have a reputation for using a lot of suppliers (some 50,000 in the case
of General Motors, for example). ough the number of suppliers for Embraer—or any aircraft manufacturer is
somewhat fluid—we can certainly put the number of parts used at more than 300,000. is places incredible
pressure on operating an efficient and effective global supply chain system and, most importantly, a well-structured
importing operation into Brazil.
Importing into Brazil, some would say, is a difficult task for most companies and product categories. At the
consumer product level, it was almost impossible to find imported products in Brazil before 1990. e Brazilian
government used a number of protectionist measures and high taxes to discourage the importing of products. Bribing
of officials that can facilitate the importing process is normal. Adding to the importing difficulty, the World Bank
considers Brazil to be one of the most difficult places to start a business. Brazil’s tax system has also been ranked as
one of the most complex worldwide by analysts at PwC.
Sources: Jon Ostrower, “You Wait Ages for a New Airplane and en Two Come Along,” CNN Money, March 7,
2017; Dimitra DeFotis, “Embraer Flies Higher on Earnings,” Barron’s, March 9, 2017; Asif Suria, “Embraer: An
Impressive Brazilian Jet Producer,” Seeking Alpha, August 8, 2007; and Russ Mitchell, “e Little Aircraft Company
at Could,” Fortune, November 14, 2005.
INTERNATIONAL COMPARISONS
One big impediment to exporting is the simple lack of knowledge of the opportunities available. Often,
there are many markets for a firm’s product, but because they are in countries separated from the firm’s home
base by culture, language, distance, and time, the firm does not know of them. Identifying export
opportunities is made even more complex because almost 196 countries with widely differing cultures
compose the world of potential opportunities. Faced with such complexity and diversity, firms sometimes
hesitate to seek export opportunities.
e way to overcome ignorance is to collect information. In Germany—one of the world’s most
successful exporting nations—trade associations, government agencies, and commercial banks gather
information, helping small firms identify export opportunities. A similar function is provided by the Japanese
Ministry of International Trade and Industry (MITI), which is always on the lookout for export
opportunities. In addition, many Japanese firms are affiliated in some way with the sogo shosha,
Japan’s great trading houses. e sogo shosha have offices all over the world, and they proactively,
continuously seek export opportunities for their affiliated companies large and small.13
German and Japanese firms can draw on the large reservoirs of experience, skills, information, and other
resources of their respective export-oriented institutions. Unlike their German and Japanese competitors,
many U.S. firms are relatively blind when they seek export opportunities; they are information-
disadvantaged. In part, this reflects historical differences. Both Germany and Japan have long made their
living as trading nations, whereas until recently, the United States has been a relatively self-contained
continental economy in which international trade played a minor role. is is changing; both imports and
exports now play a greater role in the U.S. economy than they did 20 years ago. However, the United States
has not yet created an institutional structure for promoting exports similar to that of either Germany or
Japan.
INFORMATION SOURCES
Despite institutional disadvantages, U.S. firms can increase their awareness of export opportunities. e most
comprehensive source of information is the U.S. Department of Commerce and its district offices all over the
country (U.S. Export Assistance Centers, USEAC). Within that department are two organizations dedicated
to providing businesses with intelligence and assistance for attacking foreign markets: U.S. and Foreign
Commercial Service and International Trade Administration (ITA). ITA regularly publishes A Guide to
Exporting. is is the United States’ “Official Government Resource for Small and Medium-Sized Businesses”
in their exporting quest.
e U.S. and Foreign Commercial Service and International Trade Administration are governmental
agencies that provide the potential exporter with a “best prospects” list, which gives the names and addresses
of potential distributors in foreign markets along with businesses they are in, the products they handle, and
their contact person. In addition, the Department of Commerce has assembled a “comparison shopping
service” for countries that are major markets for U.S. exports. For a small fee, a firm can receive a customized
market research survey on a product of its choice. is survey provides information on marketability, the
competition, comparative prices, distribution channels, and names of potential sales representatives. Each
study is conducted on site by an officer of the Department of Commerce.
e Department of Commerce also organizes trade events that help potential exporters make foreign
contacts and explore export opportunities. e department organizes exhibitions at international trade fairs,
which are held regularly in major cities worldwide. e department also has a matchmaker program, in
which department representatives accompany groups of U.S. businesspeople abroad to meet with qualified
agents, distributors, and customers. Affiliated with the U.S. Department of Commerce and its USEAC
offices is a set of District Export Councils (DECs; connected also via the National District Export Council).
DECs are composed of some 1,500 volunteers appointed by the U.S. Secretary of Commerce to help U.S.
business be more competitive internationally.
Is Chinese Exporting the Next Edge for the Country?
With hundreds of television sets stacked high, Changhong Electronics’ warehouse in Shunde resembles many other
storage depots in southern China, but the TVs’ destinations reveal an important shift in global trade patterns. While
Changhong’s smaller sets are headed for Europe, its 50-inch plasma screens, which dominate the warehouse, will be
shipped to South Africa. Fast growth in developing countries and sluggish Western economies are prompting Chinese
companies to abandon their obsession with the United States and Europe and to try to capitalize on rapidly growing
markets in Asia, Africa, and Latin America. e so-called China price—a vastly lower price because of low labor costs
and the low cost of capital for large government-owned companies—now applies to industrial goods, not just
consumer goods. Experts believe that cheap Chinese exports could provide a boost to investment in the developing
world, just as they once did to consumption in the developed world. Can China boost investment in the developing
world and also boost its own economy?
Another governmental organization, the Small Business Administration (SBA), can help potential
exporters (see the accompanying Management Focus on exporting desserts for an example of the SBA’s
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work). e SBA employs 76 district international trade officers and 10 regional international trade officers
throughout the United States, as well as a 10-person international trade staff in Washington, DC. Among the
SBA’s no-fee services are Small Business Development Centers (SBDCs), the Service Corps of Retired
Executives (SCORE), and the Export Legal Assistance Network (ELAN). e SBDCs around the country
provide a full range of export assistance to business, particularly small companies new to exporting. rough
SCORE, the SBA oversees some 11,500 volunteers with international trade experience to provide
one-on-one counseling to active and new-to-export businesses. e SBA also coordinates ELAN, a
nationwide group of international trade attorneys who provide free initial consultations to small businesses
on export-related matters.
m a n a g e m e n t F O C U S
Exporting Desserts by a Hispanic Entrepreneur
Taking basic ingredients and creating a myriad of flavors has led to worldwide exporting success for Lulu’s Foods Inc.
(lulus-foods.com). Started in 1982 in a 700-square-foot storefront in Torrance, California, followed by exporting to
Mexico in 1992, the company is a gelatin dessert business with core customer target markets in the United States and
Mexico but with exporting to several countries worldwide. Lulu is the nickname of the founder, Maria de Lourdes
Sobrino.
Lulu thought of the idea of ready-to-eat flavored gelatin desserts when she was looking for the popular dessert in
local stores. At the time, she was living in the United States, but originally she came from Mexico. e ready-to-eat
flavored gelatin desserts were a staple in her native Mexico, but the concept was a novelty when she introduced it to
American grocers. Today, Lulu’s Foods Inc. can be found in a variety of well-known stores (e.g., Albertsons, Safeway,
Walmart).
Back in the early 1980s, Lulu identified and recognized a need for gelatin desserts, filled it with what has now
become 45 ready-to-eat products of different sizes and flavors, and transformed the food industry by creating the first
ready-to-eat gelatin category based largely on her mother’s recipes. e business concept has become quite a “spoon
spectacular” since Lulu first began, with a catch line for the company of “More fun for your spoon.©”
e party started out very small with just Lulu making her mother’s gelatin recipe desserts, with an initial
production of 300 cups of gelatin per day. Ultimately, the party grew so big that Lulu could not handle it by herself
and had to negotiate help from established markets and wholesale distributors. Lulu wanted everyone within reach to
enjoy her festival of flavors. In going international, Lulu spent some 10 years trying to gain international sales but
continued to run into all kinds of problems and issues. After the trial-and-error decade, she found assistance from the
U.S. Export-Import Bank services and now has deeper confidence in her abilities to export products worldwide.
Over the years, Lulu has kept making more and more varieties of her gelatin desserts. A carnival of colors of three-
layer gelatins, fruit parfaits, and festive containers of wild new colors and flavors have become identifying marks. is
exporting innovation led Bill Hopkins of USA Today to call Maria de Lourdes Sobrino “the queen of ready-to-eat
gelatins and a force in the surging number of Hispanic Entrepreneurs.” Hal Lancaster of e Wall Street Journal also
recognized her as an innovator and very successful entrepreneur in “getting out and selling customers your dream.”
Today, with its exporting worldwide, but especially to Mexico, and sales across the United States, Lulu’s Foods
Inc.’s core focus is on gelatin cups, with flavors that include such exotic descriptors as Fruit Fantasia, Orange Blast,
Creamy Vanilla with Cinnamon, and Sugar Free-De-Light.
Sources: D. Barry, “Maria de Lourdes Sobrino, Founder, LuLu’s Dessert,” Exporters: e Wit and Wisdom of Small
Businesspeople Who Sell Globally (Washington, DC: U.S. Commerce Department, 2013); J. Hopkins, “Bad Times
Spawn Great Start-Ups,” USA Today, December 18, 2001; and Lulu’s Foods Inc., www.lulus-foods.com.
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e United States has also established a set of 17 Centers for International Business Education and
Research (CIBERs), which assist with exporting needs. e CIBERs were created by the U.S. Congress
under the Omnibus Trade and Competitiveness Act of 1988 to increase and promote the nation’s capacity
for international understanding and competitiveness. Administered by the U.S. Department of Education,
the CIBER network links the human resource and technological needs of the U.S. business community with
the international education, language training, and research capacities of universities across the country. e
17 CIBERs, including the University of Washington and Michigan State University, where the authors of
this text are professors (www2.ed.gov/programs/iegpscibe), serve as regional and national resources to
businesspeople, students, and teachers at all levels. Many countries around the world are trying to replicate
the U.S. CIBER initiative (e.g., the European Union).
Additionally, the vast majority of U.S. states, regions, and many large cities maintain active trade
commissions whose purpose is to promote exports. Most of these provide business counseling, information
gathering, technical assistance, and financing. Unfortunately, many have fallen victim to budget cuts or to
turf battles for political and financial support with other export agencies.
A number of private organizations are also beginning to provide more assistance to would-be exporters.
Commercial banks and major accounting firms are more willing to assist small firms in starting export
operations than they were a decade ago. In addition, large multinationals that have been successful in the
global arena are typically willing to discuss opportunities overseas with the owners or managers of small
firms.14
SERVICE PROVIDERS
Most companies that engage in international trade enlist the help of export–import service providers, but
there are many choices. Let’s look at the main ones: freight forwarders, export management companies,
export trading companies, export packaging companies, customs brokers, confirming houses, export agents
and merchants, piggyback marketing, and economic processing zones.
Freight forwarders are mainly in business to orchestrate transportation for companies that are shipping
internationally. eir primary task is to combine smaller shipments into a single large shipment to minimize
the shipping cost. Freight forwarders also provide other services that are beneficial to the exporting firm, such
as documentation, payment, and carrier selection.
An export management company (EMC) offers services to companies that have not previously exported
products. EMCs offer a full menu of services to handle all aspects of exporting, similar to having an internal
exporting department within your own firm. For example, EMCs deal with export documents and operate as
the firm’s agent and distributor; this may include selling the products directly or operating a sales unit to
process sales orders.
Export trading companies export products for companies that contract with them. ey identify and
work with companies in foreign countries that will market and sell the products. ey provide
comprehensive exporting services, including export documentation, logistics, and transportation.
Export packaging companies, or export packers for short, provide services to companies that are
unfamiliar with exporting. For example, some countries require packages to meet certain specifications, and
the export packaging firm’s knowledge of these requirements is invaluable to new exporters in particular. e
export packer can also advise companies on appropriate design and materials for the packaging of their items.
Export packers can assist companies in minimizing packaging to maximize the number of items to be
shipped.
Customs brokers can help companies avoid the pitfalls involved in customs regulations. e customs
requirements of many countries can be difficult for new or infrequent exporters to understand, and the
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knowledge and experience of the customs broker can be very important. For example, many countries have
certain laws and documentation regulations concerning imported items that are not always obvious to the
exporter. Customs brokers can offer a firm a complete package of services that are essential when a firm is
exporting to a large number of countries.
Confirming houses, sometimes called buying agents, represent foreign companies that want to buy your
products. Typically, they try to get the products they want at the lowest prices and are paid a commission by
their foreign clients. A good place to find these potential exporting linkages is via government embassies.
Export agents, merchants, and remarketers buy products directly from the manufacturer and package and
label the products in accordance with their own wishes and specifications. ey then sell the products
internationally through their own contacts under their own names and assume all risks. e effort it takes for
you to market the product internationally is very small, but you also lose any control over the marketing,
promotion, and positioning of your product.
Piggyback marketing is an arrangement whereby one firm distributes another firm’s products. For
example, a firm may have a contract to provide an assortment of products to an overseas client, but it does
not have all the products requested. In such cases, another firm can piggyback its products to fill the
contract’s requirements. Successful piggybacking usually requires complementary products and the same
target market of customers.
ere are now more than 600 export processing zones (EPZs) in the world, and they exist in more than
100 countries. e EPZs include foreign trade zones (FTZs), special economic zones, bonded warehouses,
free ports, and customs zones. Many companies use EPZs to receive shipments of products that are then
reshipped in smaller lots to customers throughout the surrounding areas. Founded in 1978 by the United
Nations, the World Economic Processing Zones Association (wepza.org) is a private nonprofit organization
dedicated to the improvement of the efficiency of all EPZs.
EXPORT STRATEGY
In addition to using export service providers, a firm can reduce the risks associated with exporting if it is
careful about its choice of export strategy.15 A few guidelines can help firms improve their odds of success.
For example, one of the most successful exporting firms in the world, 3M (originally, Minnesota Mining &
Manufacturing Company), has built its export success on three main principles: enter on a small scale to
reduce risks, add additional product lines once the exporting operations start to become successful,
and hire locals to promote the firm’s products. Another company—Two Men and a Truck
(profiled in the accompanying Management Focus)—has had global success with a franchising approach.
m a n a g e m e n t F O C U S
Two Men and a Truck
By some accounts, moving is ranked as the third-most-stressful event a person can experience, after death of a relative
and divorce. Two Men and a Truck (https://twomenandatruck.com) started as an after-school business for two high
school boys in Lansing, Michigan. As a small business focused on local moving services, the company began in 1985
with $350, a hand-drawn logo, and an advertisement in a local community newspaper.
In 1989, Melanie Bergeron, the daughter of founder Mary Ellen Sheets, opened the first franchised office of Two
Men and a Truck in her hometown of Atlanta, Georgia. Melanie is now board chair, with Brig Sorber as the chief
executive officer and Jon Sorber as executive vice president. Randy Shacka, who joined the company as an intern in
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2001, was promoted in 2012 to president. is is the first president of the company who did not come from the
family.
Two Men and a Truck is no longer “two men and a truck.” e company has grown both domestically and
internationally to most of the United States and some 380 locations worldwide. Two Men and a Truck is the fastest-
growing franchised moving company in the United States (with more than 95 consecutive months of growth as of
May 2018), with more than $300 million in sales, 2,800 moving trucks, and some 6,000 workers. e average
franchise grosses about $1.5 million annually. Bergeron said that “we never imagined being in the moving business—
that is, until my mom and my brothers Brig and Jon scraped together some money to buy a truck to help raise extra
cash for college.”
Two Men and a Truck has remained branded as “Two Men and a Truck” in all parts of the world in which it
operates franchises (e.g., Canada, Ireland, the United Kingdom). Names such as “Two Blokes and a Lorry” do not
appeal to them! e company has decided to stick to the core American brand name because “that’s what master
franchisers and their investors want,” said Bergeron. “e customers are less interested in whether it’s a U.S. brand . .
. the appeal is the opposite . . . it’s a local [franchise] company that will be available when I need them. . . . ey want
the U.S. brand power and mystique.”
In going international to new markets, Two Men and a Truck’s primary factors to evaluate are the size of the
middle class in a country and the population’s mobility. ey use software tools to help pinpoint income levels by
neighborhood and whether the housing market is primarily based on single- or multifamily units. e market for
Two Men and a Truck is best where there is a good mix of both. In addition, Bergeron said that two other key areas
in determining locations in which to operate include obtaining accurate market research and identifying potential
master franchisees.
In the case of Two Men and a Truck going international, the industry itself also represented a challenge. ere are
plenty of moving businesses worldwide; why should franchisees represent Two Men and a Truck? e company’s
answer to this market differentiation problem is its exceptional focus on customer service and a sophisticated web-
based tracking system. Quality control, labor costs, and cycle time to complete a move are core performance metrics
in the system. In fact, the company has become known in its industry for faster and better analytics to run the
business. It has installed a private cloud system to make its business operations more efficient, using business analytics
to capture and identify growth opportunities worldwide.
Sources: D. Barry, “Melanie Bergeron, Chair of the Board of Two Men and a Truck,” Exporters: e Wit and Wisdom
of Small Businesspeople Who Sell Globally (Washington, DC: U.S. Commerce Department, 2013); C. Boulton,
“Moving Company Gets a Lift from Faster Analytics,” e Wall Street Journal, August 20, 2013; and A. Wittrock,
“Two Men and a Truck Wins State Grant, Plans $4 Million Expansion of Lansing-Area Headquarters,” MLive.com,
February 27, 2013.
e probability of exporting successfully can be increased dramatically by taking a handful of simple
strategic steps. First, particularly for the novice exporter, it helps to hire an EMC or at least an experienced
export consultant to identify opportunities and navigate the paperwork and regulations so often involved in
exporting. Second, it often makes sense to initially focus on one market or a handful of markets. Learn what
is required to succeed in those markets before moving to other markets. e firm that enters many markets at
once runs the risk of spreading its limited management resources too thin. e result of such a shotgun
approach to exporting may be a failure to become established in any one market.
ird, as with Two Men and a Truck, it often makes sense to enter a foreign market on a small scale to
reduce the costs of any subsequent failure. Most important, entering on a small scale provides the time and
opportunity to learn about the foreign country before making significant capital commitments to that
market. Fourth, the exporter needs to recognize the time and managerial commitment involved in building
export sales and should hire additional personnel to oversee this activity. Fifth, in many countries, it is
important to devote a lot of attention to building strong and enduring relationships with local distributors
and/or customers. Sixth, as 3M often does, it is important to hire local personnel to help the firm establish
itself in a foreign market. Local people are likely to have a much greater sense of how to do
business in a given country than a manager from an exporting firm who has previously never set
foot in that country. Seventh, several studies have suggested the firm needs to be proactive about seeking
export opportunities.16 Armchair exporting does not work! e world will not normally beat a pathway to
your door.
Finally, it is important for the exporter to retain the option of local production. Once exports reach a
sufficient volume to justify cost-efficient local production, the exporting firm should consider establishing
production facilities in the foreign market. Such localization helps foster good relations with the foreign
country and can lead to greater market acceptance. Exporting is often not an end in itself but merely a step
on the road toward establishment of foreign production (again, 3M provides an example of this philosophy).
THE GLOBALEDGE™ EXPORTING TOOL
In Chapter 1, we introduced the globalEDGETM website (globaledge.msu.edu), a product of the
International Business Center in the Eli Broad College of Business at Michigan State University.
globalEDGETM has been the top-ranked website in the world for “international business resources” on
Google since 2004. Some 10 million people now use globalEDGETM, with about 2 million active users. e
site is free, including the “Diagnostic Tools” section. In that section of the site, the Company Readiness to
Export (CORE) tool has become a frequently used option by a variety of small, medium, and large firms to
assess (1) a company’s readiness to export a product and (2) the product’s readiness to be exported.
CORE (Company Readiness to Export) assists firms in self-assessment of their exporting proficiency,
evaluates both the firm’s and the intended product’s readiness to be taken internationally, and systematically
identifies the firm’s strengths and weaknesses within the context of exporting (see Figure 14.2). e CORE
tool also serves as a tutorial in exporting and has been used by the U.S. Department of Commerce, U.S.
District Export Councils, and other exporting facilitators to help companies succeed with their exporting.
14.2 FIGURE
Company readiness to export.
Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill
Education, 2017).
Figure 14.3 shows the online interface of the CORE Results Report. e overall report includes a
prediction by respondents of where they think their company is in terms of readiness to export, as well as the
actual readiness (organizational and product) based on the 70-question CORE diagnostic tool assessment.
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e users also receive scores on all questions and various strengths and weaknesses associated with their
exporting capabilities and capacities.
14.3 FIGURE
A screenshot of select results from the globalEDGE CORE (Company Readiness to Export) diagnostic tool.
Source: Global Edge, Michigan State University.
test PREP
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Export and Import Financing
LO 14-3 Recognize the basic steps involved in export financing.
Mechanisms for financing exports and imports have evolved over the centuries in response to a problem that
can be particularly acute in international trade: the lack of trust that exists when one must put faith in a
stranger. In this section, we examine the financial devices that have evolved to cope with this problem in the
context of international trade: the letter of credit, the draft (or bill of exchange), and the bill of lading. en
we trace the 14 steps of a typical export–import transaction.17
LACK OF TRUST
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Firms engaged in international trade have to trust someone they may have never seen, who lives in a different
country, who speaks a different language, who abides by (or does not abide by) a different legal system, and
who could be very difficult to track down if he or she defaults on an obligation. Consider a U.S. firm
exporting to a distributor in France. e U.S. businessperson might be concerned that if he ships the
products to France before he receives payment from the French businessperson, she might take delivery of
the products and not pay him. Conversely, the French importer might worry that if she pays for the products
before they are shipped, the U.S. firm might keep the money and never ship the products or might ship
defective products. Neither party to the exchange completely trusts the other. is lack of trust is exacerbated
by the distance between the two parties—in space, language, and culture—and by the problems of using an
underdeveloped international legal system to enforce contractual obligations.
How Trusting Can You Be?
In Chapter 14, we discuss the fact that firms engaged in international trade have to trust someone they may have
never seen, who lives in a different country, who speaks a different language, who abides by (or does not abide by) a
different legal system, and who could be very difficult to track down if he or she defaults on an obligation. Basically,
there is a lot of potential for unknown issues to arise and for complications to happen, given the lack of established
trust between trading partners. With almost 200 countries in the world, lots of cultural values and beliefs, and many
potential avenues to run into complications, how much trust would you place on a relationship that involved (1) an
organization from a country like yours (e.g., Swedish people doing business with Danish people) or (2) an
organization from a country very different from yours (e.g., a Canadian doing business with someone from Turkey)?
Due to the (quite reasonable) lack of trust between the two parties, each has his or her own
preferences as to how the transaction should be configured. To make sure he is paid, the manager
of the U.S. firm would prefer the French distributor to pay for the products before he ships them (see Figure
14.4). Alternatively, to ensure she receives the products, the French distributor would prefer not to pay for
them until they arrive (see Figure 14.5). us, each party has a different set of preferences. Unless there is
some way of establishing trust between the parties, the transaction might never occur.
14.4 FIGURE
Preference of the U.S. exporter.
Source: C. W. L. Hill and G. T. M. Hult, International Business: Competing in the Global Marketplace (New York: McGraw-Hill
Education, 2017).
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14.5 FIGURE
Preference of the French importer.
Source: C. W. L. Hill and G. M. T. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
e problem is solved by using a third party trusted by both—normally a reputable bank—to act as an
intermediary. What happens can be summarized as follows (see Figure 14.6). First, the French importer
obtains the bank’s promise to pay on her behalf, knowing the U.S. exporter will trust the bank. is promise
is known as a letter of credit. Having seen the letter of credit, the U.S. exporter now ships the products to
France. Title to the products is given to the bank in the form of a document called a bill of lading. In return,
the U.S. exporter tells the bank to pay for the products, which the bank does. e document for requesting
this payment is referred to as a draft. e bank, having paid for the products, now passes the title on to the
French importer, whom the bank trusts. At that time or later, depending on their agreement, the importer
reimburses the bank. In the remainder of this section, we examine how this system works in more detail.
14.6 FIGURE
e use of a third party.
Source: C. W. L. Hill and G. M. T. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
LETTER OF CREDIT
A letter of credit, abbreviated as L/C, stands at the center of international commercial transactions. Issued by
a bank at the request of an importer, the letter of credit states that the bank will pay a specified sum of
money to a beneficiary, normally the exporter, on presentation of particular, specified documents.
Consider again the example of the U.S. exporter and the French importer. e French importer applies to
her local bank, say, the Bank of Paris, for the issuance of a letter of credit. e Bank of Paris then undertakes
a credit check of the importer. If the Bank of Paris is satisfied with her creditworthiness, it will issue a letter
of credit. However, the Bank of Paris might require a cash deposit or some other form of collateral from her
first. In addition, the Bank of Paris will charge the importer a fee for this service. Typically, this amounts to
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between 0.5 and 2 percent of the value of the letter of credit, depending on the importer’s creditworthiness
and the size of the transaction. (As a rule, the larger the transaction, the lower the percentage.)
Assume the Bank of Paris is satisfied with the French importer’s creditworthiness and agrees to issue a
letter of credit. e letter states that the Bank of Paris will pay the U.S. exporter for the merchandise as long
as it is shipped in accordance with specified instructions and conditions. At this point, the letter of credit
becomes a financial contract between the Bank of Paris and the U.S. exporter. e Bank of Paris then sends
the letter of credit to the U.S. exporter’s bank, say, the Bank of New York. e Bank of New York tells the
exporter that it has received a letter of credit and that he can ship the merchandise. After the exporter has
shipped the merchandise, he draws a draft against the Bank of Paris in accordance with the terms of the letter
of credit, attaches the required documents, and presents the draft to his own bank, the Bank of New York,
for payment. e Bank of New York then forwards the letter of credit and associated documents to the Bank
of Paris. If all the terms and conditions contained in the letter of credit have been complied with, the Bank
of Paris will honor the draft and will send payment to the Bank of New York. When the Bank of New York
receives the funds, it will pay the U.S. exporter.
As for the Bank of Paris, once it has transferred the funds to the Bank of New York, it will collect
payment from the French importer. Alternatively, the Bank of Paris may allow the importer some time to
resell the merchandise before requiring payment. is is not unusual, particularly when the importer is a
distributor and not the final consumer of the merchandise since it helps the importer’s cash flow. e Bank
of Paris will treat such an extension of the payment period as a loan to the importer and will charge an
appropriate rate of interest.
e great advantage of this system is that both the French importer and the U.S. exporter are likely to
trust reputable banks, even if they do not trust each other. Once the U.S. exporter has seen a letter of credit,
he knows that he is guaranteed payment and will ship the merchandise. Also, an exporter may find that
having a letter of credit will facilitate obtaining pre-export financing. For example, having seen the letter of
credit, the Bank of New York might be willing to lend the exporter funds to process and prepare the
merchandise for shipping to France. is loan may not have to be repaid until the exporter has received his
payment for the merchandise. As for the French importer, she does not have to pay for the merchandise until
the documents have arrived and unless all conditions stated in the letter of credit have been satisfied. e
drawback for the importer is the fee she must pay the Bank of Paris for the letter of credit. In addition,
because the letter of credit is a financial liability against her, it may reduce her ability to borrow funds for
other purposes.
DRAFT
A draft, sometimes referred to as a bill of exchange, is the instrument normally used in international
commerce to effect payment. A draft is simply an order written by an exporter instructing an importer, or an
importer’s agent, to pay a specified amount of money at a specified time. In the example of the U.S. exporter
and the French importer, the exporter writes a draft that instructs the Bank of Paris, the French importer’s
agent, to pay for the merchandise shipped to France. e person or business initiating the draft is known as
the maker (in this case, the U.S. exporter). e party to whom the draft is presented is known as the drawee
(in this case, the Bank of Paris).
International practice is to use drafts to settle trade transactions. is differs from domestic practice in
which a seller usually ships merchandise on an open account, followed by a commercial invoice that specifies
the amount due and the terms of payment. In domestic transactions, the buyer can often obtain possession
of the merchandise without signing a formal document acknowledging his or her obligation to pay. In
contrast, due to the lack of trust in international transactions, payment or a formal promise to pay is required
before the buyer can obtain the merchandise.
Drafts fall into two categories, sight drafts and time drafts. A sight draft is payable on presentation to the
drawee. A time draft allows for a delay in payment—normally 30, 60, 90, or 120 days. It is presented to the
drawee, who signifies acceptance of it by writing or stamping a notice of acceptance on its face. Once
accepted, the time draft becomes a promise to pay by the accepting party. When a time draft is drawn on and
accepted by a bank, it is called a banker’s acceptance. When it is drawn on and accepted by a business firm, it
is called a trade acceptance.
Time drafts are negotiable instruments; that is, once the draft is stamped with an acceptance, the maker
can sell the draft to an investor at a discount from its face value. Imagine that the agreement between the
U.S. exporter and the French importer calls for the exporter to present the Bank of Paris (through the Bank
of New York) with a time draft requiring payment 120 days after presentation. e Bank of Paris stamps the
time draft with an acceptance. Imagine further that the draft is for $100,000.
e exporter can either hold onto the accepted time draft and receive $100,000 in 120 days or sell it to
an investor, say, the Bank of New York, for a discount from the face value. If the prevailing discount rate is 7
percent, the exporter could receive $97,700 by selling it immediately (7 percent per year discount rate for
120 days for $100,000 equals $2,300, and $100,000 − $2,300 = $97,700). e Bank of New York would
then collect the full $100,000 from the Bank of Paris in 120 days. e exporter might sell the accepted time
draft immediately if he needed the funds to finance merchandise in transit and/or to cover cash flow
shortfalls.
BILL OF LADING
e third key document for financing international trade is the bill of lading. e bill of lading is issued to
the exporter by the common carrier transporting the merchandise. It serves three purposes: it is a receipt, a
contract, and a document of title. As a receipt, the bill of lading indicates that the carrier has received the
merchandise described on the face of the document. As a contract, it specifies that the carrier is obligated to
provide a transportation service in return for a certain charge. As a document of title, it can be used to obtain
payment or a written promise of payment before the merchandise is released to the importer. e bill of
lading can also function as collateral against which funds may be advanced to the exporter by its local bank
before or during shipment and before final payment by the importer.
A TYPICAL INTERNATIONAL TRADE TRANSACTION
Now that we have reviewed the elements of an international trade transaction, let us see how the process
works in a typical case, sticking with the example of the U.S. exporter and the French importer. e typical
transaction involves 14 steps (see Figure 14.7).
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14.7 FIGURE
A typical international trade transaction.
Source: C. W. L. Hill and G. M. T. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
1. e French importer places an order with the U.S. exporter and asks the American if he would be
willing to ship under a letter of credit.
2. e U.S. exporter agrees to ship under a letter of credit and specifies relevant information such as
prices and delivery terms.
3. e French importer applies to the Bank of Paris for a letter of credit to be issued in favor of the U.S.
exporter for the merchandise the importer wishes to buy.
4. e Bank of Paris issues a letter of credit in the French importer’s favor and sends it to the U.S.
exporter’s bank, the Bank of New York.
5. e Bank of New York advises the exporter of the opening of a letter of credit in his favor.
6. e U.S. exporter ships the goods to the French importer on a common carrier. An official of the
carrier gives the exporter a bill of lading.
7. e U.S. exporter presents a 90-day time draft drawn on the Bank of Paris in accordance with its letter
of credit and the bill of lading to the Bank of New York. e exporter endorses the bill of lading so
title to the goods is transferred to the Bank of New York.
8. e Bank of New York sends the draft and bill of lading to the Bank of Paris. e Bank of Paris accepts
the draft, taking possession of the documents and promising to pay the now-accepted draft in 90 days.
9. e Bank of Paris returns the accepted draft to the Bank of New York.
10. e Bank of New York tells the U.S. exporter that it has received the accepted bank draft, which is
payable in 90 days.
11. e exporter sells the draft to the Bank of New York at a discount from its face value and
receives the discounted cash value of the draft in return.
12. e Bank of Paris notifies the French importer of the arrival of the documents. She agrees to pay the
Bank of Paris in 90 days. e Bank of Paris releases the documents so the importer can take possession
of the shipment.
13. In 90 days, the Bank of Paris receives the importer’s payment, so it has funds to pay the maturing draft.
14. In 90 days, the holder of the matured acceptance (in this case, the Bank of New York) presents it to the
Bank of Paris for payment. e Bank of Paris pays.
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Export Assistance
LO 14-4 Identify information sources and government programs that exist to help exporters.
Prospective U.S. exporters can draw on two forms of government-backed assistance to help finance their
export programs. ey can get financing aid from the Export-Import Bank and export credit insurance from
the Foreign Credit Insurance Association (similar programs are available in most countries).
EXPORT-IMPORT BANK
Export-Import Bank (Ex-Im Bank) is a wholly owned U.S. government corporation that was established in
1934. Its mission is to assist in the financing of U.S. exports of products and services to support U.S.
employment and market competitiveness. Based on its charter and mandate from the U.S. Congress, the Ex-
Im Bank’s financing must have a “reasonable assurance of repayment” and should supplement, and not
compete with, private capital lending. e Ex-Im Bank also follows the international rules for government-
backed export credit activity under the Organisation for Economic Co-operation and Development
(OECD).
e Ex-Im Bank reported authorizing about $20.5 billion for 3,746 transactions of finance and insurance
to support some $27.5 billion in U.S. exports and 164,000 U.S. jobs the last year it was fully operational
(2014). e Ex-Im Bank’s overall exposure was $112 billion, below the $140 billion statutory cap for
its fiscal year. Interestingly, 2014 was the last year the Ex-Im Bank was fully operational due to a lack of
quorum on the board of directors. But the Ex-IM Bank’s financing of exports of U.S. goods and services still
supported more than 50,000 jobs in the last year completed (2018), even with a smaller operation.
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Export-Import Bank of the United States headquarters - Washington, DC USA
©B Christopher/Alamy Stock Photo
Overall, the Ex-Im Bank pursues its mission with various loan and loan-guarantee programs.
e agency guarantees repayment of medium- and long-term loans that U.S. commercial banks
make to foreign borrowers for purchasing U.S. exports. e Ex-Im Bank guarantee makes the commercial
banks more willing to lend cash to foreign enterprises. is facilitates cross-border trade by U.S. companies.
About 85 percent of the banks’ transactions support small businesses (under 500 employees).
Ex-Im Bank also has a direct lending operation under which it lends dollars to foreign borrowers for use
in purchasing U.S. exports. In some cases, it grants loans that commercial banks would not if it sees a
potential benefit to the United States in doing so. e foreign borrowers use the loans to pay U.S. suppliers
and repay the loan to the Ex-Im Bank with interest. Using the structure of the U.S. Ex-Im Bank, many
countries now have their own export-import banks to facilitate cross-border trade (e.g., China, India).
EXPORT CREDIT INSURANCE
For reasons outlined earlier, exporters clearly prefer to get letters of credit from importers. However,
sometimes an exporter who insists on a letter of credit will lose an order to one who does not require a letter
of credit. us, when the importer is in a strong bargaining position and able to play competing suppliers
against each other, an exporter may have to forgo a letter of credit.18 e lack of a letter of credit exposes the
exporter to the risk that the foreign importer will default on payment. e exporter can insure against this
possibility by buying export credit insurance. If the customer defaults, the insurance firm will cover a major
portion of the loss.
In the United States, export credit insurance is provided by the Foreign Credit Insurance Association
(FCIA), an association of private commercial institutions operating under the guidance of the Export-Import
Bank. e FCIA provides coverage against commercial risks and political risks. Losses due to commercial risk
result from the buyer’s insolvency or payment default. Political losses arise from actions of governments that
are beyond the control of either buyer or seller. Marlin, the small Baltimore manufacturer of wire baskets
discussed earlier, credits export credit insurance with giving the company the confidence to push ahead with
export sales. For a premium of roughly half a percentage of the price of a sale, Marlin has been able to insure
itself against the possibility of nonpayment by a foreign buyer.19
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Countertrade
LO 14-5 Describe how countertrade can be used to facilitate exports.
Countertrade is an alternative means of structuring an international sale when conventional means of
payment are difficult, costly, or nonexistent. We first encountered countertrade in Chapter 10’s discussion of
currency convertibility. A government may restrict the convertibility of its currency to preserve its foreign
exchange reserves so they can be used to service international debt commitments and purchase crucial
imports.20 is is problematic for exporters. Nonconvertibility implies that the exporter may not be paid in
his or her home currency, and few exporters would desire payment in a currency that is not convertible.
Countertrade is a common solution.21 Countertrade denotes a range of barterlike agreements; its principle
is to trade goods and services for other goods and services when they cannot be traded for money. Some
examples of countertrade are
An Italian company that manufactures power-generating equipment, ABB SAE Sadelmi SpA, was
awarded a 720 million baht ($17.7 million) contract by the Electricity Generating Authority of
ailand. e contract specified that the company had to accept 218 million baht ($5.4 million) of
ai farm products as part of the payment.
Saudi Arabia agreed to buy ten 747 jets from Boeing with payment in crude oil, discounted at 10
percent below posted world oil prices.
General Electric won a contract for a $150 million electric generator project in Romania by agreeing to
market $150 million of Romanian products in markets to which Romania did not have access.
e Venezuelan government negotiated a contract with Caterpillar under which Venezuela would trade
350,000 tons of iron ore for Caterpillar earthmoving equipment.
Albania offered such items as spring water, tomato juice, and chrome ore in exchange for a $60 million
fertilizer and methanol complex.
Philip Morris shipped cigarettes to Russia, for which it received chemicals that can be used to make
fertilizer. Philip Morris shipped the chemicals to China, and in return, China shipped glassware to
North America for retail sale by Philip Morris.22
THE POPULARITY OF COUNTERTRADE
Countertrade emerged in the 1960s as a way for the old Soviet Union and the then-communist states of
eastern Europe, whose currencies were generally nonconvertible, to purchase imports. e technique has
grown in popularity among many developing nations that lack the foreign exchange reserves required to
purchase necessary imports. Also, reflecting their own shortages of foreign exchange reserves, some successor
states to the former Soviet Union and the eastern European communist nations periodically engage in
countertrade to purchase their imports. Estimates of the percentage of world trade covered by some sort of
countertrade agreement grew from 2 to 10 percent about a decade ago to, by most estimates, some 20 to 25
percent today.23 e precise figure is unknown, but it is probably at the very low end of these estimates,
given the increasing liquidity of international financial markets and wider currency convertibility. However, a
short-term spike in the volume of countertrade can follow periodic financial crises (e.g., 1997, 2008). For
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example, countertrade activity increased notably after the Asian financial crisis of 1997. at crisis left many
Asian nations with little hard currency to finance international trade. In the tight monetary regime that
followed the crisis in 1997, many Asian firms found it very difficult to get access to export credit to finance
their own international trade. us, they turned to the only option available to them—countertrade.
Is Countertrade an Appropriate Way of Trading Today?
Countertrade can take many forms, and there are several examples of how it works internationally. For instance, the
Malaysian government recently bought 20 diesel electric locomotives from General Electric. Officials of the
government said that GE will be paid with palm oil supplied by a plantation company. e company will supply
about 200,000 metric tons of palm oil over a period of 30 months. No money changed hands, and no third parties
were involved. As another example, in order to save foreign exchange reserves, the Philippine government offered
some creditors tinned tuna to repay part of a state $4 billion debt. In other examples, General Motors Corporation
sold $12 million worth of locomotive and diesel engines to Yugoslavia and took cash and $4 million in Yugoslavian
cutting tools as payment. Plus, McDonnell Douglas agreed to a compensation deal with ailand for eight top-of-
the-line F/A–18 strike aircraft. ailand agreed to pay $578 million of the total cost in cash, and McDonnell
Douglas agreed to accept $93 million in a mixed bag of goods, including ai rubber, ceramics, furniture, frozen
chicken, and canned fruit. To some, these types of trading contracts are strange, and to some they are normal,
especially if we go back in time. But what about today? Should the global marketplace engage in these types of
nonmonetary trades?
Given that countertrade is a means of financing international trade, albeit a minor one,
prospective exporters may have to engage in this technique from time to time to gain access to
certain international markets. e governments of developing nations sometimes insist on a certain amount
of countertrade.24
TYPES OF COUNTERTRADE
With its roots in the simple trading of goods and services for other goods and services, countertrade has
evolved into a diverse set of activities that can be categorized as five distinct types of trading arrangements:
barter, counterpurchase, offset, switch trading, and compensation or buyback.25 Many countertrade deals
involve not just one arrangement but elements of two or more.
Barter Barter is the direct exchange of goods and/or services between two parties without a cash transaction. Although barter is the simplest arrangement, it is not common. Its problems are twofold. First, if
goods are not exchanged simultaneously, one party ends up financing the other for a period. Second, firms
engaged in barter run the risk of having to accept goods they do not want, cannot use, or have difficulty
reselling at a reasonable price. For these reasons, barter is viewed as the most restrictive countertrade
arrangement. It is primarily used for one-time-only deals in transactions with trading partners who are not
creditworthy or trustworthy.
Counterpurchase Counterpurchase is a reciprocal buying agreement. It occurs when a firm agrees to purchase a certain amount of materials back from a country to which a sale is made. Suppose a U.S. firm sells
some products to China. China pays the U.S. firm in dollars, but in exchange, the U.S. firm agrees to spend
some of its proceeds from the sale on textiles produced by China. us, although China must draw on its
foreign exchange reserves to pay the U.S. firm, it knows it will receive some of those dollars back because
of the counterpurchase agreement. In one counterpurchase agreement, Rolls-Royce sold jet parts to Finland.
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As part of the deal, Rolls-Royce agreed to use some of the proceeds from the sale to purchase Finnish-
manufactured TV sets that it would then sell in Great Britain.
Offset An offset is similar to a counterpurchase insofar as one party agrees to purchase goods and services with a specified percentage of the proceeds from the original sale. e difference is that this party can fulfill
the obligation with any firm in the country to which the sale is being made. From an exporter’s perspective,
this is more attractive than a straight counterpurchase agreement because it gives the exporter greater
flexibility to choose the goods that it wishes to purchase.
Switch Trading e term switch trading refers to the use of a specialized third-party trading house in a countertrade arrangement. When a firm enters a counterpurchase or offset agreement with a country, it often
ends up with what are called counterpurchase credits, which can be used to purchase goods from that
country. Switch trading occurs when a third-party trading house buys the firm’s counterpurchase credits and
sells them to another firm that can better use them. For example, a U.S. firm concludes a counterpurchase
agreement with Poland for which it receives some number of counterpurchase credits for purchasing Polish
goods. e U.S. firm cannot use and does not want any Polish goods, however, so it sells the credits to a
third-party trading house at a discount. e trading house finds a firm that can use the credits and sells them
at a profit.
In one example of switch trading, Poland and Greece had a counterpurchase agreement that called for
Poland to buy the same U.S.-dollar value of goods from Greece that it sold to Greece. However, Poland
could not find enough Greek goods that it required, so it ended up with a dollar-denominated
counterpurchase balance in Greece that it was unwilling to use. A switch trader bought the right to 250,000
counterpurchase dollars from Poland for $225,000 and sold them to a European sultana (grape) merchant
for $235,000, who used them to purchase sultanas from Greece.
Compensation or Buybacks A buyback occurs when a firm builds a plant in a country—or supplies technology, equipment, training, or other services to the country—and agrees to take a certain percentage of
the plant’s output as partial payment for the contract. For example, Occidental Petroleum negotiated a deal
with Russia under which Occidental would build several ammonia plants in Russia and as partial payment
receive ammonia over a 20-year period.
A subsea oil and gas tree is lowered into a testing pool at the General Electric Co. manufacturing
plant in Montrose, United Kingdom.
©Simon Dawson/Bloomberg/Getty Images
PROS AND CONS OF COUNTERTRADE
Countertrade’s main attraction is that it can give a firm a way to finance an export deal when other means are
not available. Given the problems that many developing nations have in raising the foreign exchange
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necessary to pay for imports, countertrade may be the only option available when doing business in these
countries. Even when countertrade is not the only option for structuring an export transaction, many
countries prefer countertrade to cash deals. us, if a firm is unwilling to enter a countertrade agreement, it
may lose an export opportunity to a competitor that is willing to make a countertrade agreement.
In addition, a countertrade agreement may be required by the government of a country to which a firm is
exporting goods or services. Boeing often has to accept counterpurchase agreements to capture orders for its
commercial jet aircraft. For example, in exchange for gaining an order from Air India, Boeing may be
required to purchase certain component parts, such as aircraft doors, from an Indian company. Taking this
one step further, Boeing can use its willingness to enter into a counterpurchase agreement as a way of
winning orders in the face of intense competition from its global rival, Airbus. us, countertrade can
become a strategic marketing weapon.
However, the drawbacks of countertrade agreements are substantial. Other things being equal, firms
would normally prefer to be paid in hard currency. Countertrade contracts may involve the exchange of
unusable or poor-quality goods that the firm cannot dispose of profitably. For example, a few years ago, one
U.S. firm got burned when 50 percent of the television sets it received in a countertrade agreement with
Hungary were defective and could not be sold. In addition, even if the goods it receives are of high quality,
the firm still needs to dispose of them profitably. To do this, countertrade requires the firm to invest in an in-
house trading department dedicated to arranging and managing countertrade deals. is can be expensive
and time-consuming.
Given these drawbacks, countertrade is most attractive to large, diverse multinational enterprises that can
use their worldwide network of contacts to dispose of goods acquired in countertrading. e masters of
countertrade are Japan’s giant trading firms, the sogo shosha, which use their vast networks of affiliated
companies to profitably dispose of goods acquired through countertrade agreements. e trading firm of
Mitsui & Company, for example, has about 120 affiliated companies in almost every sector of the
manufacturing and service industries. If one of Mitsui’s affiliates receives goods in a countertrade agreement
that it cannot consume, Mitsui & Company will normally be able to find another affiliate that can profitably
use them. Firms affiliated with one of Japan’s sogo shosha often have a competitive advantage in countries
where countertrade agreements are preferred.
Western firms that are large, diverse, and have a global reach (e.g., General Electric, Philip Morris, and
3M) have similar profit advantages from countertrade agreements. Indeed, 3M has established its own
trading company—3M Global Trading Inc.—to develop and manage the company’s international
countertrade programs. Unless there is no alternative, small and medium-sized exporters should probably try
to avoid countertrade deals because they lack the worldwide network of operations that may be required to
profitably utilize or dispose of goods acquired through them.26
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Key Terms
MITI, p. 388
sogo shosha, p. 389
export management company (EMC), p. 391
letter of credit, p. 396
bill of exchange, p. 396
draft, p. 396
sight draft, p. 397
time draft, p. 397
bill of lading, p. 397
Export-Import Bank (Ex-Im Bank), p. 398
countertrade, p. 400
barter, p. 401
counterpurchase, p. 401
offset, p. 401
switch trading, p. 401
buyback, p. 402
Summary
is chapter examined the steps that firms must take to establish themselves as exporters. e chapter made
the following points:
1. One big impediment to exporting is ignorance of foreign market opportunities.
2. Neophyte exporters often become discouraged or frustrated with the exporting process because they
encounter many problems, delays, and pitfalls.
3. e way to overcome ignorance is to gather information. In the United States, a number of
institutions, the most important of which is the U.S. Department of Commerce, can help firms gather
information in the matchmaking process. Export management companies can also help identify export
opportunities.
4. Many of the pitfalls associated with exporting can be avoided if a company hires an experienced export
service provider (e.g., export management company) and if it adopts the appropriate export strategy.
5. Firms engaged in international trade must do business with people they cannot trust and people who
may be difficult to track down if they default on an obligation. Due to the lack of trust, each party to
an international transaction has a different set of preferences regarding the configuration of the
transaction.
6. e problems arising from lack of trust between exporters and importers can be solved by using a third
party that is trusted by both, normally a reputable bank.
7. A letter of credit is issued by a bank at the request of an importer. It states that the bank promises to
pay a beneficiary, normally the exporter, on presentation of documents specified in the letter.
8. A draft is an instrument normally used in international commerce to effect payment. It is an order
written by an exporter instructing an importer or an importer’s agent to pay a specified amount of
money at a specified time.
9. Drafts are either sight drafts or time drafts. Time drafts are negotiable instruments.
10. A bill of lading is issued to the exporter by the common carrier transporting the merchandise. It serves
as a receipt, a contract, and a document of title.
11. U.S. exporters can draw on two types of government-backed assistance to help finance their exports:
loans from the Export-Import Bank and export credit insurance from the Foreign Credit Insurance
Association.
12. Countertrade includes a range of barter-like agreements. It is primarily used when a firm exports to a
country whose currency is not freely convertible and may lack the foreign exchange reserves required to
purchase the imports.
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13. e main attraction of countertrade is that it gives a firm a way to finance an export deal when other
means are not available. A firm that insists on being paid in hard currency may be at a competitive
disadvantage vis-à-vis one that is willing to engage in countertrade.
14. e main disadvantage of countertrade is that the firm may receive unusable or poor-quality goods
that cannot be disposed of profitably.
Critical inking and Discussion Questions
1. A firm based in California wants to export a shipload of finished lumber to the Philippines. e
would-be importer cannot get sufficient credit from domestic sources to pay for the shipment but
insists that the finished lumber can quickly be resold in the Philippines for a profit. Outline the steps
the exporter should take to effect this export to the Philippines.
2. You are the assistant to the CEO of a small technology firm that manufactures quality, premium-
priced, stylish clothing. e CEO has decided to see what the opportunities are for exporting and has
asked you for advice as to the steps the company should take. What advice would you give the CEO?
3. An alternative to using a letter of credit is export credit insurance. What are the advantages
and disadvantages of using export credit insurance rather than a letter of credit for exporting
(a) a luxury yacht from California to Canada and (b) machine tools from New York to Ukraine?
4. How do you explain the use of countertrade? Under what scenarios might its use increase further by
2020? Under what scenarios might its use decline?
5. How might a company make strategic use of countertrade schemes as a marketing weapon to generate
export revenues? What are the risks associated with pursuing such a strategy?
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. One way that exporters analyze conditions in emerging markets is through the use of macroeconomic
indicators. e Market Potential Index (MPI) is a yearly study conducted by Michigan State
University’s International Business Center to compare the market potential of country markets for U.S.
exporters. Provide a description of the dimensions used in the index. Which of the dimensions would
have greater importance for a company that markets wireless devices? What about a company that sells
clothing?
2. You work in the sales department of a company that manufactures and sells medical implants. A
Brazilian company contacted your department and expressed interest in purchasing a large quantity of
your products. e Brazilian company requested an FOB price quote. One of your colleagues
mentioned to you that FOB is part of a collection of international shipping terms called “Incoterms,”
but that was all he knew. Find the Export Tutorials on the globalEDGETM site, and find a more
detailed explanation of Incoterms. For an FOB quote, what line items will you need to include in your
price quote, in addition to the price your company will charge for the products?
Ta t a M o t o r s a n d E x p o r t i n g
c l o s i n g c a s e
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Tata Motors Limited (tatamotors.com) was formerly called TELCO, an abbreviation for Tata Engineering and
Locomotive Company. Today, Tata Motors is an Indian multinational automotive company headquartered in
Mumbai and a core member of the very successful Tata Group. e Tata Group was founded in 1868 and has annual
sales of more than 105 billion U.S. dollars, of which Tata Motors makes up about INR 262,796 crores or about 42
billion U.S. dollars. Tata Motors has more than 60,000 employees; was founded in 1945; and serves a worldwide
clientele with Tata Motors Cars, Jaguar Land Rover, Tata Daewoo, and Tata Hispano. e company entered the
passenger vehicle market in 1991 with the launch of the model Tata Sierra (a three-door sport utility vehicle).
Tata Motors thrives in exporting, strategically using exporting as a global vehicle to sell cars worldwide, as well as
to help offset cyclical tendencies in sales in the home market of India. Tata Motors exported about 55,000
commercial vehicles last year and plans to export 100,000 commercial units within two years. e target for the
increase in exporting is everywhere worldwide except Europe and North America. e global strategy for Tata Motors
specifically includes making deeper inroads into the Middle East, Africa, and Latin America.
As the fourth-largest bus manufacturer globally, Tata Motors provides innovatively designed and technologically
sophisticated buses for the smart cities of tomorrow. e buses personify safety and comfort, reliability and
profitability. Designed using the most advanced technology, Tata Motors’ bus chassis are a benchmark in terms of
performance and reliability in the bus industry. Fully finished, built buses from Tata Motors are often viewed as a
hallmark of excellence, and these buses have been designed with the utmost quality standards in mind.
TATA ARIA on display at e 30th ailand International Motor Expo 2013 in Bangkok, ailand.
©Tassaphon Vongkittipong/123RF
Tata Motors exports buses and trucks to nearly 47 countries, including 18 countries in Africa; four
markets in Latin America; Russia; and various countries in Europe, the Middle East, and Asia Pacific.
Some of the popular vehicles exported include the company’s globally benchmarked range of Prima and Ultra. ese
brands have been developed with modern design and global markets in mind. Tata Motors also exports a variety of
premium buses and coaches, from luxurious intercity travel vehicles to safe transportation choices for elementary
school children. e buses come in 12 seaters to 67 seaters. Additionally, in the pickup and small commercial vehicle
(SCV) segments, Xenon XT and Super Ace have been popular choices in many of the countries.
Future exporting activities for Tata Motors are mainly planned to target an increased presence in emerging
countries (e.g., Africa, Asia Pacific, Middle Eastern, and Latin America). e company will place its worldwide bets
on world-class products like the Xenon, Super Ace, Prima, and Ultra range of trucks. e overall exporting goal is to
continue to enter into new markets and keep expanding the global footprint of Tata Motors.
Sources: Shally Seth Mohile, “Tata Motors Plans to Double Export of Commercial Vehicles in Two Years,” Live Mint, September 16, 2016;
“Tata Motors Exports Up 12% in December at 5,119 Units,” Indian Information Online (IIFL), January 2, 2017; and “Tata Motors Expect
30% Growth in Exports,” Business Standard, October 23, 2015.
CASE DISCUSSION QUESTIONS
1. Tata Motors is an Indian multinational automotive company headquartered in Mumbai and a core
member of the very successful Tata Group. India is a potentially enormous market, and Tata
Motors is doing well in that market. How can Tata Motors use their core competencies in doing
well in India as a way to also do well in exporting?
2. Jaguar Land Rover Automotive PLC is the holding company of Jaguar Land Rover Limited, a
British automotive company which has its headquarters in the United Kingdom. It is also
subsidiary of Indian automotive company Tata Motors. How can Tata Motors leverage Jaguar Land
Rover in its exporting? How can Jaguar Land Rover leverage Tata Motors in its exporting?
3. e Volvo Group is a manufacturer of trucks, buses, and construction equipment, which is owned
by Swedish interests. Volvo Car Corporation or Volvo Cars, on the other hand, is owned by the
Zhejiang Geely Holding Group (and formerly owned by Ford Motor Company). Should Tata
Motors use this Volvo Group example and focus more or exclusively on buses and trucks in its
exporting (since they are already successful in the market in much of the world)?
4. Tata Motors is primarily targeting emerging countries (e.g., Africa, Asia Pacific, Middle Eastern,
and Latin America) for its future exporting growth. Is this a viable and logical exporting strategy?
Endnotes
1. T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Leveraging Processes, Measurements,
and Tools for Strategic Corporate Advantage (New York: McGraw-Hill, 2014).
2. T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Leveraging Processes, Measurements,
and Tools for Strategic Corporate Advantage (New York: McGraw-Hill, 2014).
3. R. A. Pope, “Why Small Firms Export: Another Look,” Journal of Small Business Management 40
(2002), pp. 17–26.
4. S. T. Cavusgil, “Global Dimensions of Marketing,” in Marketing, ed. P. E. Murphy and B. M. Enis
(Glenview, IL: Scott, Foresman, 1985), pp. 577–99.
5. S. M. Mehta, “Enterprise: Small Companies Look to Cultivate Foreign Business,” e Wall Street
Journal, July 7, 1994, p. B2.
6. P. A. Julien and C. Ramagelahy, “Competitive Strategy and Performance of Exporting SMEs,”
Entrepreneurship eory and Practice (2003), pp. 227–94.
7. W. J. Burpitt and D. A. Rondinelli, “Small Firms’ Motivations for Exporting: To Earn and Learn?”
Journal of Small Business Management 38 (2000), pp. 1–14; and J. D. Mittelstaedt, G. N. Harben, and
W. A. Ward, “How Small Is Too Small?” Journal of Small Business Management 41 (2003), pp. 68–85.
8. Small Business Administration, “e State of Small Business 1999–2000: Report to the President,”
2001; and D. Ransom, “Obama’s Math: More Exports Equals More Jobs,” e Wall Street Journal,
February 6, 2010.
9. A. O. Ogbuehi and T. A. Longfellow, “Perceptions of U.S. Manufacturing Companies Concerning
Exporting,” Journal of Small Business Management 32 (1994), pp. 37–59; and U.S. Department of
Commerce, “A Basic Guide to
Exporting,” https://2016.export.gov/missouri/build/groups/public/@eg_us_mo/documents/webconten
t/eg_us_mo_097311.pdf.
10. R. W. Haigh, “inking of Exporting?” Columbia Journal of World Business 29 (December 1994), pp.
66–86.
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11. F. Williams, “e Quest for More Efficient Commerce,” Financial Times, October 13, 1994, p. 7.
12. See Burpitt and Rondinelli, “Small Firms’ Motivations for Exporting”; and C. S. Katsikeas, L. C.
Leonidou, and N. A. Morgan, “Firm Level Export Performance Assessment,” Academy of Marketing
Science 28 (2000), pp. 493–511.
13. M. Y. Yoshino and T. B. Lifson, e Invisible Link (Cambridge, MA: MIT Press, 1986).
14. L. W. Tuller, Going Global (Homewood, IL: Business One–Irwin, 1991).
15. M. A. Raymond, J. Kim, and A. T. Shao. “Export Strategy and Performance,” Journal of Global
Marketing 15 (2001), pp. 5–29; P. S. Aulakh, M. Kotabe, and H. Teegen, “Export Strategies and
Performance of Firms from Emerging Economies,” Academy of Management Journal 43 (2000), pp.
342–61.
16. J. Francis and C. Collins-Dodd, “e Impact of Firms’ Export Orientation on the Export Performance
of High-Tech Small and Medium Sized Enterprises,” Journal of International Marketing 8 (2000), pp.
84–103.
17. J. Koch, “Integration of U.S. Small Businesses into the Export Trade Sector Using Available
Financial Tools and Resources,” Business Credit 109, no. 10 (2007), pp. 64–68.
18. For a review of the conditions under which a buyer has power over a supplier, see M. E. Porter,
Competitive Strategy (New York: Free Press, 1980).
19. M. C. White, “Marlin Steel Wire Products: How a Small Factory Survives and rives, anks to
Overseas Sales,” Slate, November 10, 2009.
20. Exchange Agreements and Exchange Restrictions (Washington, DC: International Monetary Fund,
1989).
21. It’s also sometimes argued that countertrade is a way of reducing the risks inherent in a traditional
money-for-goods transaction, particularly with entities from emerging economies. See C. J. Choi, S.
H. Lee, and J. B. Kim, “A Note of Countertrade: Contractual Uncertainty and Transactional
Governance in Emerging Economies,” Journal of International Business Studies 30, no. 1 (1999), pp.
189–202.
22. J. R. Carter and J. Gagne, “e Do’s and Don’ts of International Countertrade,” Sloan Management
Review, Spring 1988, pp. 31–37; and W. Maneerungsee, “Countertrade: Farm Goods Swapped for
Italian Electricity,” Bangkok Post, July 23, 1998.
23. Estimate from the Global Offset and Countertrade Association (G.O.C.A.) at www.globaloffset.org.
See also D. West, “Countertrade,” Business Credit 104, no. 4 (2001), pp. 64–67; and B. Meyer, “e
Original Meaning of Trade Meets the Future of Barter,” World Trade 13 (January 2000), pp. 46–50.
24. Carter and Gagne, “e Do’s and Don’ts of International Countertrade.”
25. For details, see Carter and Gagne, “e Do’s and Don’ts of International Countertrade”; J. F. Hennart,
“Some Empirical Dimensions of Countertrade,” Journal of International Business Studies, 21, no. 2
(1990), pp. 240–60; and West, “Countertrade.”
26. D. J. Lecraw, “e Management of Countertrade: Factors Influencing Success,” Journal of International
Business Studies, Spring 1989, pp. 41–59.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill
Education
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15
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Part 6 International Business Functions
Global Production and Supply Chain Management
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO15-1 Explain why global production and supply chain management decisions are of central importance to many
global companies.
LO15-2 Explain how country differences, production technology, and production factors all affect the choice of
where to locate production activities.
LO15-3 Recognize how the role of foreign subsidiaries in production can be enhanced over time as they accumulate
knowledge.
LO15-4 Identify the factors that influence a firm’s decision of whether to source supplies from within the company
or from foreign suppliers.
LO15-5 Understand the functions of logistics and purchasing (sourcing) within global supply chains.
LO15-6 Describe what is required to efficiently manage a global supply chain.
Procter & Gamble Remakes Its Global Supply Chains
Page 410
opening case
Procter & Gamble (P&G) is the world’s leading manufacturer of consumer products. P&G, founded in 1837 by
British American William Procter and Irish American James Gamble, is headquartered in Cincinnati in the United
States, and the company has now been built into a $65 billion conglomerate. Within its portfolio, P&G has 21
billion-dollar brands (e.g., Bounty, Crest, Tide), operates 130 plants staffed by 95,000 people, has some 70,000
suppliers around the world, and sells its products in more than 180 countries. By all accounts, P&G has been a
giant multinational corporation for more than a century and will continue to be highly influential in consumer
products for years to come.
At the same time, very few industries are as competitive as consumer packaged goods. Just think about the
options that you now have compared with five years ago. In most cases, we as customers have numerous more
options in every consumer packaged-goods category than we did then. e global marketplace has a lot to do with
this competitive environment. Fragmentation and specialization in consumer products from more companies have
resulted in more products and more places from which to buy. e infrastructure for developing products,
entering markets, and maintaining customer relationships is more robust than ever, resulting in small- and
medium-sized enterprises (SMEs) being competitive with companies like P&G (which they could not have
competed with just a few years ago).
is market competitiveness has led companies like P&G to constantly assess the efficiencies and effectiveness
of their production, operations, and global supply chains. For a long-standing industry titan like P&G, this
increasingly competitive global environment—see the figures in Chapter 1 that show the drastically increased
international trade in the last 20 years—has led to a newfound sense of urgency for P&G to get closer to both its
customers and suppliers to maximize diminishing margins while selling products at a competitive price. is is not
an easy task since margins in the consumer packaged goods market are already very tight. at led P&G to
evaluate and ultimately remake their global supply chains.
P&G’s goal is to replenish at least 80 percent of the retail orders the company receives in less than a day. To be
able to do this, P&G redesigned its distribution network. e company has improved transparency throughout
the end-to-end supply chain, developed even stronger partnerships with its suppliers, and focused on maximizing
synergy throughout the production cycle. Given this focus on synergy and supplier partnerships, P&G now
develops global strategic supply chain plans jointly with (at least) its core suppliers. is is not to say that all
70,000 suppliers working with P&G are involved but the so-called “strategic suppliers” are very much entrenched
in working together with P&G.
P&G’s 70,000 suppliers include chemical companies (e.g., Dow Chemicals, DuPont) that supply raw materials
for cleaning supplies; packaging companies (e.g., Diamond Packaging, Van Genechten Packaging) that
supply packaging materials for the company’s products; and indirect spend providers (e.g., Jones Lang
Lasalle) that deliver services such as warehouse maintenance and janitorial services. With the number and breadth
of suppliers, P&G continuously focuses on maintaining a strong supplier relations program. Guiding its supplier
relations program, P&G has a set of core principles: (1) Best Total Value, (2) Honest, Ethical, and Fair Dealings,
(3) Externally Linked Supply Solutions, (4) Competition and Collaboration, and (5) Supplier Incumbency.
P&G appears to be in the forefront of continually evaluating and, when needed, remaking its global supply
chains to maintain the titan position in the consumer packaged goods industry. Despite this success at being able
to remake itself so far, one can wonder if P&G, at some point, will run into difficulties competing with companies
like Alibaba and Amazon. Or, will Alibaba and Amazon simply continue to sell P&G’s products (instead of
starting to market their own). Alternatively, will companies like P&G be able to use their sophisticated global
supply chains to expand into new territories similar to what Alibaba and Amazon did not too long ago? •
Sources: “Technology Has Upended the World’s Advertising Giants,” e Economist, March 28, 2018; Demitrios Kalogeropoulo, “Will
2018 Be Procter & Gamble’s Best Year Yet?” e Motley Fool, November 12, 2017; and Matt Gunn, “How Supply Chain Transformation
Saved P&G $1.2 Billion,” GT Nexus Commerce Network, April 29, 2015.
Introduction
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As trade barriers fall and global markets develop, many firms increasingly confront a set of interrelated
issues. First, where in the world should production activities be located? Should they be concentrated in a
single country, or should they be dispersed around the globe, matching the type of activity with country
differences in factor costs, tariff barriers, political risks, and the like to minimize costs and maximize value
added? Single-country strategies may be efficient operationally but often become ineffective strategically.
For example, what if the company focused all of its attention on one country for production and that
country became politically or economically unstable? Some redundancy is usually the best approach in
both global production and supply chain management practices, and such redundancy often demands that
a company spreads its production and supply chains across countries.
Second, what should be the long-term strategic role of foreign production sites? Should the firm
abandon a foreign site if factor costs change, moving production to another more favorable location, or is
there value to maintaining an operation at a given location even if underlying economic conditions
change? Value can come from cost inefficiencies. Moving factory locations from one country to another
solely due to cost considerations is usually not a strategic move. Successful companies typically evaluate
cost considerations along with quality, flexibility, and time issues. At the same time, cost is one of the most
important considerations and serves as the starting point for discussion of making a strategic move from
one country to a more advantageous production home.
Which Career Would You Choose in Global Supply Chain Management?
With increased outsourcing and overseas production sites and customers, supply chain management is a growing
field. e Council of Supply Chain Management Professionals (CSCMP), a professional association with more
than 9,000 members worldwide, says the industry offers a promising outlook. What’s more, potential employers
are everywhere: manufacturers and distributors; government agencies; consulting firms; the transport industry;
universities and colleges; service firms such as banks, hospitals, and hotels; and third-party logistics providers. e
basic career options in global supply chains include its main functions of logistics, purchasing (sourcing),
production and operations management, and marketing channels. Which functional area would you choose if you
decided to get a job in supply chain management and why? For more information about the organization and
careers in this field, visit the CSCMP website at www.cscmp.org and its Career Center, http://careers.cscmp.org.
ird, should the firm own foreign production activities, or is it better to outsource those activities to
independent vendors? Outsourcing means less control, but it can be cost-efficient. Fourth, how should a
globally dispersed supply chain be managed, and what is the role of information technology in the
management of global logistics, purchasing (sourcing), and operations? Fifth, similar to issues of
production, should the company manage global supply chains itself, or should it outsource the
management to enterprises that specialize in this activity? ere are myriad options for supply
chain management by third parties. Few companies want to manage the full supply chain from raw
material to delivering the product to the end-customer. e question, though, is what portion of the
supply chain should be managed by third parties and what portion should be managed by the company
itself.
As illustrated by the examples of P&G (opening case) and Alibaba (closing case), as well as illustrations
in the Management Focus boxes in the chapter (describing global supply chain issues at IKEA and
Amazon), companies also need to be very careful when deciding on supply chain partners globally, and
they need to think about the total costs of their supply chains. A total cost focus of a global supply chain ensures that the goal is not to strive for the lowest cost possible at each stage of the supply chain (each
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node in the chain) but, instead, strive for the lowest total cost to the customer—and, by extension,
greatest value—at the end of the product supply chain. is means that all aspects of cost—including
integration and coordination of companies in the supply chain—have been incorporated in addition to
the cost of raw material, component parts, and assembly worldwide. And these cost issues, as they relate to
global logistics and global purchasing—both considered supply chains functions in a company—have
been strategically and tactically addressed.
Strategy, Production, and Supply Chain Management
LO 15-1 Explain why global production and supply chain management decisions are of central
importance to many global companies.
Chapter 12 introduced the concept of the value chain and discussed a number of value creation activities,
including production, marketing, logistics, R&D, human resources, and information systems. is
chapter focuses on two of these value creation activities—production and supply chain management—
and attempts to clarify how they might be performed internationally to (1) lower the costs of value
creation and (2) add value by better serving customer needs. Production is sometimes also referred to as
manufacturing or operations when discussed in relation to global supply chains. We also discuss the
contributions of information technology to these activities, which has become particularly important in a
globally integrated world. e remaining chapters in this text look at other value creation activities in the
international context (marketing, R&D, and human resource management).
Did You Know?
Did you know global supply chains are not just about transportation?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the
authors.
In Chapter 12, we stated that production is concerned with the creation of a good or service. We used
the term production to denote both service and manufacturing activities because either a service or a physical product can be produced. Although in this chapter we focus more on the production of physical
goods, we should not forget that the term can also be applied to services. is has become more evident in
recent years, with the continued pattern among U.S. firms to outsource the “production” of certain service
activities to developing nations where labor costs are lower (e.g., the trend among many U.S. companies
to outsource customer care services to places such as India, where English is widely spoken and labor costs
are much lower). Supply chain management is the integration and coordination of logistics,
purchasing, operations, and market channel activities from raw material to the end-customer.
Production and supply chain management are closely linked because a firm’s ability to perform its
production activities efficiently depends on a timely supply of high-quality material and information
inputs, for which purchasing and logistics are critical functions. Purchasing represents the part of the
supply chain that involves worldwide buying of raw material, component parts, and products used in
manufacturing of the company’s products and services. Logistics is the part of the supply chain that plans,
implements, and controls the effective flows and inventory of raw material, component parts, and
products used in manufacturing.
Outsourcingis chapter tackles a number of issues related to production,
make-or-buy decisions, sourcing, and logistics. Outsourcing is one of the most commonly discussed topics in news
media and on the Internet related to production and supply chains. In effect, the word outsourcing sometimes even creates an “us against them” mentality (i.e., should the company outsource production or other activities to
entities outside its country borders, or should it use only domestic operations?). Often, the answer is more of a
political issue than a strategic resource issue. To stay competitive, companies typically opt for the best value to
infuse into their supply chains. e “Outsourcing” section on globalEDGE™ ensures that you have an updated set
of data and knowledge on outsourcing (globaledge.msu.edu/global-resources/outsourcing). For example, did you
know that there is an International Association of Outsourcing Professionals? Do you know what it does, its goals,
and how many members it has worldwide?
e production and supply chain management functions (purchasing, logistics) of an international
firm have a number of important strategic objectives.1 One is to ensure that the total cost of moving from
raw materials to finished goods is as low as possible for the value provided to the end-customer. Dispersing
production activities to various locations around the globe where each activity can be performed most
efficiently can lower the total costs. Costs can also be cut by managing the global supply chain efficiently
to better match supply and demand. is involves both coordination and integration of the supply chain
functions inside a global company (e.g., purchasing, logistics, production and operations management) and across the independent organizations (e.g., suppliers) involved in the chain. For example, efficient
logistics practices reduce the amount of inventory in the system, increase inventory turnover, and facilitate
the appropriate transportation modes being used. Maximizing purchasing operations enhances the order
fulfillment and delivery, outsourcing initiatives, and supplier selections. Efficient operations ensure that
the right location of production is made, establishes which production priorities should be stressed, and
facilitates a high-quality outcome of the supply chain.
Another strategic objective shared by production and supply chain management is to increase product
(or service) quality by establishing process-based quality standards and eliminating defective raw material,
component parts, and products from the manufacturing process and the supply chain.2 In this context,
quality means reliability, implying that ultimately the finished product has no defects and performs well. ese quality assurances should be embedded in both the upstream and downstream portions of the
global supply chain. e upstream supply chain includes all of the organizations (e.g., suppliers) and
resources that are involved in the portion of the supply chain from raw materials to the production facility
(this is sometimes also called the inbound supply chain). e downstream supply chain includes all of the
organizations (e.g., wholesaler, retailer) that are involved in the portion of the supply chain from the
production facility to the end-customer (this is also sometimes called the outbound supply chain).
rough the upstream and downstream chains, the objectives of reducing costs and increasing quality are
not independent of each other. As illustrated in Figure 15.1, the firm that improves its quality control will
also reduce its costs of value creation. Improved quality control reduces costs by
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15.1 FIGURE
e relationship between quality and costs.
Source: David A. Garvin, “What Does Product Quality Really Mean?” MIT Sloan Management Review, Fall 1984, pp. 25–43.
Increasing productivity because time is not wasted producing poor-quality products that cannot be
sold, leading to a direct reduction in unit costs.
Lowering rework and scrap costs associated with defective products.
Reducing the warranty costs and time associated with fixing defective products.
e effect is to lower the total costs of value creation by reducing both production and after-sales
service costs. is creates an increased overall reliability in global production and supply chain
management.
e principal tool that most managers now use to increase the reliability of their product offering is the
Six Sigma quality improvement methodology. Six Sigma is a direct descendant of the total quality
management (TQM) philosophy that was widely adopted, first by Japanese companies and then
American companies, during the 1980s and early 1990s.3 e TQM philosophy was developed by a
number of American consultants such as W. Edwards Deming, Joseph Juran, and A. V. Feigenbaum.4
Deming identified a number of steps that should be part of any TQM program. He argued that
management should embrace the philosophy that mistakes, defects, and poor-quality materials are not
acceptable and should be eliminated. Deming suggested that the quality of supervision should be
improved by allowing more time for supervisors to work with employees and by providing them with the
tools they need to do the job. Deming also recommended that management should create an environment
in which employees will not fear reporting problems or recommending improvements. He
believed that work standards should not only be defined as numbers or quotas, but also include
some notion of quality to promote the production of defect-free output. Deming argued that
management has the responsibility to train employees in new skills to keep pace with changes in the
workplace. In addition, he believed that achieving better quality requires the commitment of everyone in
the company.
Six Sigma, the modern successor to TQM, is a statistically based philosophy that aims to reduce
defects, boost productivity, eliminate waste, and cut costs throughout a company. Six Sigma programs
have been adopted by several major corporations, such as Motorola, General Electric, and Honeywell.
Sigma comes from the Greek letter that statisticians use to represent a standard deviation from a mean; the
higher the number of “sigmas,” the smaller the number of errors. At six sigmas, a production process
would be 99.99966 percent accurate, creating just 3.4 defects per million units. While it is almost
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impossible for a company to achieve such perfection, Six Sigma quality is a goal to strive toward. e Six
Sigma program is particularly informative in structuring global processes that multinational corporations
can follow in quality and productivity initiatives. As such, increasingly companies are adopting Six Sigma
programs to try to boost their product quality and productivity.5
e growth of international standards has also focused greater attention on the importance of product
quality. In Europe, for example, the European Union requires that the quality of a firm’s manufacturing
processes and products be certified under a quality standard known as ISO 9000 before the firm is
allowed access to the EU marketplace. Although the ISO 9000 certification process has proved to be
somewhat bureaucratic and costly for many firms, it does focus management attention on the need to
improve the quality of products and processes.6
In addition to lowering costs and improving quality, two other objectives have particular importance in
international businesses. First, production and supply chain functions must be able to accommodate
demands for local responsiveness. As we saw in Chapter 12, demands for local responsiveness arise from
national differences in consumer tastes and preferences, infrastructure, distribution channels, and host-
government demands. Demands for local responsiveness create pressures to decentralize production
activities to the major national or regional markets in which the firm does business or to implement
flexible manufacturing processes that enable the firm to customize the product coming out of a factory
according to the market in which it is to be sold.
Second, production and supply chain management must be able to respond quickly to shifts in
customer demand. In recent years, time-based competition has grown more important.7 When consumer
demand is prone to large and unpredictable shifts, the firm that can adapt most quickly to these shifts will
gain an advantage.8 As we shall see, both production and supply chain management play critical roles
here.
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to
learnsmartadvantage.com for help.
Where to Produce
LO 15-2 Explain how country differences, production technology, and production factors all affect
the choice of where to locate production activities.
An essential decision facing an international firm is where to locate its production activities to best
minimize costs and improve product quality. For the firm contemplating international production, a
number of factors must be considered. ese factors can be grouped under three broad headings: country
factors, technological factors, and production factors.9
COUNTRY FACTORS
We reviewed country-specific factors in some detail earlier in the book. Political and economic systems,
culture, and relative factor costs differ from country to country. In Chapter 6, we saw that due to
differences in factor costs, some countries have a comparative advantage for producing certain products. In
Chapters 2, 3, and 4, we saw how differences in political and economic systems—and national culture—
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influence the benefits, costs, and risks of doing business in a country. Other things being equal, a firm
should locate its various manufacturing activities where the economic, political, and cultural conditions—
including relative factor costs—are conducive to the performance of those activities (for an example, see
the accompanying Management Focus, which looks at the IKEA production in China). In Chapter 12, we
referred to the benefits derived from such a strategy as location economies. We argued that one result of
the strategy is the creation of a global web of value creation activities.
Also important in some industries is the presence of global concentrations of activities at certain
locations. In Chapter 8, we discussed the role of location externalities in influencing foreign direct
investment decisions. Externalities include the presence of an appropriately skilled labor pool and
supporting industries.10 Such externalities can play an important role in deciding where to locate
production activities. For example, because of a cluster of semiconductor manufacturing plants in Taiwan,
a pool of labor with experience in the semiconductor business has developed. In addition, the plants have
attracted a number of supporting industries, such as the manufacturers of semiconductor capital
equipment and silicon, which have established facilities in Taiwan to be near their customers. is implies
that there are real benefits to locating in Taiwan, as opposed to another location that lacks such
externalities. Other things being equal, the externalities make Taiwan an attractive location for
semiconductor manufacturing facilities. e same process is now under way in two Indian
cities, Hyderabad and Bangalore, where both Western and Indian information technology companies have
established operations. For example, locals refer to a section of Hyderabad as “Cyberabad,” where
Microsoft, IBM, Infosys, and Qualcomm (among others) have major facilities.
m a n a g e m e n t F O C U S
IKEA Production in China
Founded in Sweden in 1943 by 17-year-old Ingvar Kamprad, IKEA is the largest furniture retailer in the world.
We covered some of the global strategy of IKEA in the opening case to Chapter 13. As we have mentioned, the
IKEA name comes from its founder, Ingvar Kamprad—an acronym of the founder’s initials from his first and last
names (Ingvar Kamprad) along with the first initials of the farm where he grew up (Elmtaryd) and his hometown
in Sweden (Agunnaryd).
Beyond its founding in Sweden and its current headquarters in Delft, e Netherlands, IKEA presents an
amazing global supply chain story and production apparatus. IKEA is a multinational corporation where most of
the company’s operations, management of the more than 350 stores in 46 countries, and design and
manufacturing of furniture are run by a trust, INGKA Holding. It is the trust that is headquartered in Delft,
Holland. Most of the furniture designs of IKEA products are still made in Sweden, but the manufacturing of that
furniture—or, really, the pieces that customers buy to put together into furniture—has been outsourced to China
and other Asian countries.
Considering that IKEA produces an assortment of some 12,000 furniture and related products, production
capabilities and capacities are at a premium for IKEA to sustain its market leadership in the world. To start, IKEA
has a clear vision for the products that it designs and produces. e company’s idea is to provide well-designed,
functional home furnishings at prices so low that as many people around the world as possible will be able to
afford them. Importantly, the critical functions to make this happen, such as global supply chains and global
inventory management, work in concert to support IKEA’s distinctive value proposition.
e Sweden-based home furnishing giant opened its first wholly owned manufacturing facility in China on
August 28, 2013. In a local move, the factory supports the rapid expansion in Asia and, especially, in China (the
facility is located in Nantong, Jiangsu province). As the largest sourcing country for IKEA, China accounts for
more than 20 percent of its global procurement, with about 300 local Chinese suppliers. e factory is also not far
from IKEA’s two biggest warehouses, which are located in Shanghai.
Sources: Lindsey Rupp, “Ikea, Dollar General CEOs Lobby Republicans in Tax Showdown,”
Bloomberg Businessweek, March 7, 2017; D. L. Yohn, “How IKEA Designs Its Brand Success,” Forbes, June 10, 2015; J. Kane, “e 21 Emotional Stages of Shopping at IKEA, From Optimism to Total Defeat,” e Huffington Post, May 6, 2015; J. Leland, “How the Disposable Sofa Conquered America,” e New York Times Magazine, October 5, 2005, p. 45; “e Secret of IKEA’s Success,” e Economist, February 24, 2011; B. Torekull, Leading by Design: e IKEA Story (New York: HarperCollins, 1998); and P. M. Miller, “IKEA with Chinese Characteristics,” Chinese Business Review, July–August 2004, pp. 36–69.
Of course, other things are not equal. Differences in relative factor costs, political economy, culture,
and location externalities are important, but other factors also loom large. Formal and informal trade
barriers obviously influence location decisions (see Chapter 7), as do transportation costs and rules and
regulations regarding foreign direct investment (see Chapter 8). For example, although relative factor costs
may make a country look attractive as a location for performing a manufacturing activity, regulations
prohibiting foreign direct investment may eliminate this option. Similarly, a consideration of factor costs
might suggest that a firm should source production of a certain component from a particular country, but
trade barriers could make this uneconomical.
Another important country factor is expected future movements in its exchange rate (see Chapters 10
and 11). Adverse changes in exchange rates can quickly alter a country’s attractiveness as a manufacturing
base. Currency appreciation can transform a low-cost location into a high-cost location. Many Japanese
corporations had to grapple with this problem during the 1990s and early 2000s. e relatively low value
of the yen on foreign exchange markets between 1950 and 1980 helped strengthen Japan’s position as a
low-cost location for manufacturing. More recently, however, the yen’s steady appreciation against the
dollar increased the dollar cost of products exported from Japan, making Japan less attractive as a
manufacturing location. In response, many Japanese firms moved their manufacturing offshore to lower-
cost locations in East Asia.
TECHNOLOGICAL FACTORS
e type of technology a firm uses to perform specific manufacturing activities can be pivotal in location
decisions. For example, because of technological constraints, in some cases it is necessary to perform
certain manufacturing activities in only one location and serve the world market from there. In other
cases, the technology may make it feasible to perform an activity in multiple locations. ree
characteristics of a manufacturing technology are of interest here: the level of fixed costs, the minimum
efficient scale, and the flexibility of the technology.
Fixed Costs As noted in Chapter 12, in some cases the fixed costs of setting up a production plant are so high that a firm must serve the world market from a single location or from very few locations. For
example, it now costs up to $5 billion to set up a state-of-the-art plant to manufacture semiconductor
chips. Given this, other things being equal, serving the world market from a single plant sited at a single
(optimal) location can make sense.
Conversely, a relatively low level of fixed costs can make it economical to perform a particular activity
in several locations at once. is allows the firm to better accommodate demands for local responsiveness.
Manufacturing in multiple locations may also help the firm avoid becoming too dependent on one
location. Being too dependent on one location is particularly risky in a world of floating exchange rates.
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Many firms disperse their manufacturing plants to different locations as a “real hedge” against potentially
adverse moves in currencies.
Minimum Efficient Scale e concept of economies of scale tells us that as plant output expands, unit costs decrease. e reasons include the greater utilization of capital equipment and the productivity
gains that come with specialization of employees within the plant.11 However, beyond a certain level of
output, few additional scale economies are available. us, the “unit cost curve” declines with output until
a certain output level is reached, at which point further increases in output realize little reduction in unit
costs. e level of output at which most plant-level scale economies are exhausted is referred to as the
minimum efficient scale of output. is is the scale of output a plant must operate to realize all major
plant-level scale economies (see Figure 15.2).
15.2 FIGURE
Typical unit cost curve.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
e implications of this concept are as follows: e larger the minimum efficient scale of a plant
relative to total global demand, the greater the argument for centralizing production in a single location or
a limited number of locations. Alternatively, when the minimum efficient scale of production is
low relative to global demand, it may be economical to manufacture a product at several
locations. For example, the minimum efficient scale for a plant to manufacture personal computers is
about 250,000 units a year, while the total global demand exceeds 35 million units a year. e low level of
minimum efficient scale in relation to total global demand makes it economically feasible for companies
such as Dell and Lenovo to assemble PCs in multiple locations.
As in the case of low fixed costs, the advantages of a low minimum efficient scale include allowing the
firm to accommodate demands for local responsiveness or to hedge against currency risk by
manufacturing the same product in several locations.
Flexible Manufacturing and Mass Customization Central to the concept of economies of scale is the idea that the best way to achieve high efficiency, and hence low unit costs, is through the mass
production of a standardized output. e trade-off implicit in this idea is between unit costs and product
variety. Producing greater product variety from a factory implies shorter production runs, which in turn
implies an inability to realize economies of scale. at is, wide product variety makes it difficult for a
company to increase its production efficiency and thus reduce its unit costs. According to this logic, the
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way to increase efficiency and drive down unit costs is to limit product variety and produce a standardized
product in large volumes.
is view of production efficiency has been challenged by the rise of flexible manufacturing
technologies. e term flexible manufacturing technology—or lean production, as it is often called—
covers a range of manufacturing technologies designed to (1) reduce setup times for complex equipment,
(2) increase the utilization of individual machines through better scheduling, and (3) improve quality
control at all stages of the manufacturing process.12 Flexible manufacturing technologies allow the
company to produce a wider variety of end products at a unit cost that at one time could be achieved only
through the mass production of a standardized output. Research suggests the adoption of flexible
manufacturing technologies may actually increase efficiency and lower unit costs relative to what can be
achieved by the mass production of a standardized output while enabling the company to customize its
product offering to a much greater extent than was once thought possible. e term mass customization
has been coined to describe the ability of companies to use flexible manufacturing technology to reconcile
two goals that were once thought to be incompatible: low cost and product customization.13 Flexible
manufacturing technologies vary in their sophistication and complexity.
One of the most famous examples of a flexible manufacturing technology, Toyota’s production system,
has been credited with making Toyota the most efficient auto company in the world. (Despite Toyota’s
recent problems with sudden uncontrolled acceleration, the company continues to be an efficient
producer of high-quality automobiles, according to J.D. Power, which produces an annual quality survey.
Toyota’s Lexus models continue to top J.D. Power’s quality rankings.14) Toyota’s flexible manufacturing
system was developed by one of the company’s engineers, Taiichi Ohno. After working at
Toyota for five years and visiting Ford’s U.S. plants, Ohno became convinced that the mass
production philosophy for making cars was flawed. He saw numerous problems with mass production.
First, long production runs created massive inventories that had to be stored in large warehouses. is
was expensive, both because of the cost of warehousing and because inventories tied up capital in
unproductive uses. Second, if the initial machine settings were wrong, long production runs resulted in
the production of a large number of defects (i.e., waste). ird, the mass production system was unable to
accommodate consumer preferences for product diversity.
In response, Ohno looked for ways to make shorter production runs economical. He developed a
number of techniques designed to reduce setup times for production equipment (a major source of fixed
costs). By using a system of levers and pulleys, he reduced the time required to change dies on stamping
equipment from a full day in 1950 to three minutes by 1971. is made small production runs
economical, which allowed Toyota to respond better to consumer demands for product diversity. Small
production runs also eliminated the need to hold large inventories, thereby reducing warehousing costs.
Plus, small product runs and the lack of inventory meant that defective parts were produced only in small
numbers and entered the assembly process immediately. is reduced waste and helped trace defects back
to their source to fix the problem. In sum, these innovations enabled Toyota to produce a more diverse
product range at a lower unit cost than was possible with conventional mass production.15
Flexible machine cells are another common flexible manufacturing technology. A flexible machine cell
is a grouping of various types of machinery, a common materials handler, and a centralized cell controller
(computer). Each cell normally contains four to six machines capable of performing a variety of
operations. e typical cell is dedicated to the production of a family of parts or products. e settings on
machines are computer controlled, which allows each cell to switch quickly between the production of
different parts or products.
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Improved capacity utilization and reductions in work in progress (i.e., stockpiles of partly finished
products) and in waste are major efficiency benefits of flexible machine cells. Improved capacity utilization
arises from the reduction in setup times and from the computer-controlled coordination of production
flow between machines, which eliminates bottlenecks. e tight coordination between machines also
reduces work-in-progress inventory. Reductions in waste are due to the ability of computer-controlled
machinery to identify ways to transform inputs into outputs while producing a minimum of unusable
waste material. While freestanding machines might be in use 50 percent of the time, the same machines
when grouped into a cell can be used more than 80 percent of the time and produce the same end product
with half the waste. is increases efficiency and results in lower costs.
e effects of installing flexible manufacturing technology on a company’s cost structure can be
dramatic. e Ford Motor Company has been introducing flexible manufacturing technologies into its
automotive plants around the world. ese new technologies should allow Ford to produce multiple
models from the same line and to switch production from one model to another much more quickly than
in the past, allowing Ford to take $2 billion out of its cost structure.16
Should Nestlé Continue to Invest Heavily in Turkey?
According to Nestlé Turkey’s CEO Hans Ulrich Mayer, Turkey has been a great place to invest. “Turkey has been
the recipient of several Nestlé investments many times greater than we invest in other markets,” reported Mayer.
Nestlé has invested about $500 million in Turkey over the last four years, and following its successful breakfast
cereal investment, the company intends to go on investing because of the strong Turkish economy compared to
other European economies. Nestlé products sold in Turkey, ranging from pet food to chocolates, are manufactured
in Turkey and also exported to North Africa and the Middle East. Given the political situation in Turkey, should
Nestlé continue to establish increased production (i.e., expand its production facility) in delivering to North Africa
and the Middle East, or should it establish production elsewhere?
Source: Invest in Turkey. www.spotblue.co.uk.
Besides improving efficiency and lowering costs, flexible manufacturing technologies enable companies
to customize products to the demands of small consumer groups—at a cost that at one time could be
achieved only by mass-producing a standardized output. us, the technologies help a company achieve
mass customization, which increases its customer responsiveness. Most important for international
business, flexible manufacturing technologies can help a firm customize products for different national
markets. e importance of this advantage cannot be overstated. When flexible manufacturing
technologies are available, a firm can manufacture products customized to various national markets at a
single factory sited at the optimal location. And it can do this without absorbing a significant
cost penalty. us, firms no longer need to establish manufacturing facilities in each major
national market to provide products that satisfy specific consumer tastes and preferences, part of the
rationale for a localization strategy (Chapter 12).
PRODUCTION FACTORS
Several production factors feature prominently into the reasons why production facilities are located and
used in a certain way worldwide. ey include (1) product features, (2) locating production facilities, and
(3) strategic roles for production facilities.
Product Features Two product features affect location decisions. e first is the product’s value-to- weight ratio because of its influence on transportation costs. Many electronic components and pharmaceuticals have high value-to-weight ratios; they are expensive, and they do not weigh very much.
us, even if they are shipped halfway around the world, their transportation costs account for a very
small percentage of total costs. Given this, other things being equal, there is great pressure to produce
these products in the optimal location and to serve the world market from there. e opposite holds for
products with low value-to-weight ratios. Refined sugar, certain bulk chemicals, paint, and petroleum
products all have low value-to-weight ratios; they are relatively inexpensive products that weigh a lot.
Accordingly, when they are shipped long distances, transportation costs account for a large percentage of
total costs. us, other things being equal, there is great pressure to make these products in multiple
locations close to major markets to reduce transportation costs.
e other product feature that can influence location decisions is whether the product serves universal
needs, needs that are the same all over the world. Examples include many industrial products (e.g.,
industrial electronics, steel, bulk chemicals) and modern consumer products (e.g., Apple’s iPhone or iPad,
Amazon’s Kindle, Lenovo’s inkPad, Sony’s Cyber-shot camera, Microsoft’s Xbox). Because there are few
national differences in consumer taste and preference for such products, the need for local responsiveness
is reduced. is increases the attractiveness of concentrating production at an optimal location.
LO 15-3 Recognize how the role of foreign subsidiaries in production can be enhanced over time as
they accumulate knowledge.
Locating Production Facilities ere are two basic strategies for locating production facilities: (1) concentrating them in a centralized location and serving the world market from there or (2) decentralizing
them in various regional or national locations that are close to major markets. e appropriate strategic
choice is determined by the various country-specific, technological, and product factors discussed in this
section and summarized in Table 15.1.
15.1 TABLE
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Location Strategy and Production
As can be seen, concentration of production makes most sense when
Differences among countries in factor costs, political economy, and culture have a substantial
impact on the costs of manufacturing in various countries.
Trade barriers are low.
Externalities arising from the concentration of like enterprises favor certain locations.
Important exchange rates are expected to remain relatively stable.
e production technology has high fixed costs and high minimum efficient scale relative to global
demand or flexible manufacturing technology exists.
e product’s value-to-weight ratio is high.
e product serves universal needs.
Alternatively, decentralization of production is appropriate when
Differences among countries in factor costs, political economy, and culture do not have a substantial
impact on the costs of manufacturing in various countries.
Trade barriers are high.
Location externalities are not important.
Volatility in important exchange rates is expected.
e production technology has low fixed costs and low minimum efficient scale, and flexible
manufacturing technology is not available.
e product’s value-to-weight ratio is low.
e product does not serve universal needs (i.e., significant differences in consumer tastes and
preferences exist among nations).
In practice, location decisions are seldom clear-cut. For example, it is not unusual for
differences in factor costs, technological factors, and product factors to point toward
concentrated production, while a combination of trade barriers and volatile exchange rates points toward
decentralized production. is seems to be the case in the world automobile industry. Although the
availability of flexible manufacturing and cars’ relatively high value-to-weight ratios suggest concentrated
manufacturing, the combination of formal and informal trade barriers and the uncertainties of the world’s
current floating exchange rate regime (see Chapter 10) have inhibited firms’ ability to pursue this strategy.
For these reasons, several automobile companies have established “top-to-bottom” manufacturing
operations in three major regional markets: Asia, North America, and Western Europe.
Strategic Roles for Production Facilities e growth of global production among multinational companies has been tremendous over the past two decades, outdoing the growth of home country
production by more than 10-fold.17 In essence, since the early 1990s, multinationals have opted to set up
production facilities outside their home country 10 times for every 1 time they have opted to create such
facilities at home. ere is a clear strategic rational for this; multinationals are trying to capture the gains
associated with a dispersed global production system. is trend is expected to continue going forward.
us, managers need to be ready to make the decision to open up a new production facility outside of
their home base and decide where to locate the facility.
When making these decisions, managers need to think about the strategic role assigned to a foreign
factory. A major consideration here is the importance of global learning—the idea that valuable
knowledge does not reside just in a firm’s domestic operations; it may also be found in its foreign
subsidiaries. Foreign factories that upgrade their capabilities over time are creating valuable knowledge
that might benefit the whole corporation. Foreign factories can have one of a number of strategic roles or
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designations, including (1) offshore factory, (2) source factory, (3) server factory, (4) contributor factory,
(5) outpost factory, and (6) lead factory.18
An offshore factory is one that is developed and set up mainly for producing component parts or
finished goods at a lower cost than producing them at home or in any other market. At an offshore
factory, investments in technology and managerial resources should ideally be kept to a minimum to
achieve greater cost-efficiencies. Basically, the best offshore factory should involve minimal
everything—from engineering to development to engaging with suppliers to negotiating prices
to any form of strategic decisions being made at that facility. In reality, we expect at least some strategic
decisions to include input from the offshore factory personnel.
e primary purpose of a source factory is also to drive down costs in the global supply chain. e
main difference between a source factory and an offshore factory is the strategic role of the factory, which
is more significant for a source factory than for an offshore factory. Managers of a source factory have
more of a say in certain decisions, such as purchasing raw materials and component parts used in the
production at the source factory. ey also have strategic input into production planning, process changes,
logistics issues, product customization, and implementation of newer designs when needed. Centrally, a
source factory is at the top of the standards in the global supply chain, and these factories are used and
treated just like any factory in the global firm’s home country. is also means that source factories should
be located where production costs are low, where infrastructure is well developed, and where it is relatively
easy to find a knowledgeable and skilled workforce to make the products.
A server factory is linked into the global supply chain for a global firm to supply specific country or
regional markets around the globe. is type of factory—often with the same standards as the top
factories in the global firm’s system—is set up to overcome intangible and tangible barriers in the global
marketplace. For example, a server factory may be intended to overcome tariff barriers, reduce taxes, and
reinvest money made in the region. Another obvious reason for a server factory is to reduce or eliminate
costly global supply chain operations that would be needed if the factory were located much farther away
from the end customers. Managers at a server factory typically have more authority to make minor
customizations to please their customers, but they still do not have much more input than managers in an
offshore factory relative to the home country factories of the same global firm.
A contributor factory also serves a specific country or world region. e main difference between a
contributor factory and a server factory is that a contributor factory has responsibilities for product and
process engineering and development. is type of factory also has much more of a choice in terms of
which suppliers to use for raw materials and component parts. In fact, a contributor factory often
competes with the global firm’s home factories for testing new ideas and products. A contributor factory
has its own infrastructure when it comes to development, engineering, and production. is means that a
contributor factory is very much stand-alone in terms of what it can do and how it contributes to the
global firm’s supply chain efforts.
An outpost factory can be viewed as an intelligence-gathering unit. is means that an outpost factory
is often placed near a competitor’s headquarters or main operations, near the most demanding customers,
or near key suppliers of unique and critically important parts. An outpost factory also has a function to fill
in production; it often operates as a server and/or offshore factory as well. e outpost factory can be very
much connected to the idea of selecting countries for operations based on the countries’ strategic
importance rather than on the production logic of a location. Maintaining and potentially even enhancing
the position of the global firm in strategic countries is sometimes viewed as a practical factor. For example,
the fact that Nokia has its headquarters in Finland may result in another mobile phone manufacturer
locating some operations in Finland, even though the country market is rather small (about 5.5 million
people).
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A lead factory is intended to create new processes, products, and technologies that can be used
throughout the global firm in all parts of the world. is is where cutting-edge production should take
place or at least be tested for implementation in other parts of the firm’s production network. Given the
lead factory’s prominent role in setting a high bar for how the global firm wants to provide products to
customers, we also expect that it will be located in an area where highly skilled employees can be found (or
where they want to locate). A lead factory scenario also implies that managers and employees at the site
have a direct connection to and say in which suppliers to use, what designs to implement, and other issues
that are of critical importance to the core competencies of the global firm.
THE HIDDEN COSTS OF FOREIGN LOCATIONS
ere may be some “hidden costs” to basing production in a foreign location. Numerous anecdotes
suggest that high employee turnover, shoddy workmanship, poor product quality, and low productivity are
significant issues in some outsourcing locations.19
Microsoft, for example, established a major facility in Hyderabad, India, for four very good reasons: (1)
e wage rate of software programmers in India is one-third of that in the United States; (2)
India has an excellent higher education system that graduates many computer science majors
every year; (3) there was already a high concentration of information technology companies and workers
in Hyderabad; and (4) many of Microsoft’s highly skilled Indian employees, after spending years in the
United States, wanted to return home, and Microsoft saw the Hyderabad facility as a way of holding on to
this valuable human capital.
However, the company found that the turnover rate among its Indian employees is higher than in the
United States. Demand for software programmers in India is high, and many employees are prone to
switch jobs to get better pay. Although Microsoft has tried to limit turnover by offering good benefits and
long-term incentive pay, such as stock grants to high performers who stay with the company, many of the
Indians who were hired locally apparently place little value on long-term incentives and prefer higher
current pay. High employee turnover, of course, has a negative impact on productivity. One Microsoft
manager in India noted that 40 percent of his core team had left within the past 12 months, making it
very difficult to stay on track with development projects.20
Microsoft is not alone in experiencing this problem. e manager of an electronics company that
outsourced the manufacture of wireless headsets to China noted that after four years of frustrations with
late deliveries and poor quality, his company decided to move production back to the United States. In his words: “On the face of it, labor costs seemed so much lower in China that the decision to move
production there was a very easy one. In retrospect, I wish we had looked much closer at productivity and
workmanship. We have actually lost market share because of this decision.”21 Another example of
efficiency and effectiveness issues is highlighted in the accompanying Management Focus, which looks at
Amazon and its world-leading global supply chains.
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to
learnsmartadvantage.com for help.
m a n a g e m e n t F O C U S
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Amazon’s Global Supply Chains
Amazon.com Inc.—typically referred to as just Amazon—has ranked among the top companies for years in the
“Gartner Global Supply Chain Top 25” ranking. Other regular entries among the companies with the best global
supply chains include Unilever, McDonald’s, and Intel. Amazon is passing through about $160 billion in sales via
its global supply chains and partnerships annually, a staggering amount given that the company seldom takes
possession in any true sense of the products that it channels to customers from various companies.
Amazon is based in Seattle, Washington. It has now become the largest online retailer in the United States,
surpassing Walmart as the most valuable retailer by market capitalization (but Walmart’s revenue is still gigantic at
about $500 billion annually). Amazon started in 1994 as an online bookstore but has diversified to a variety of
products, including music downloads, furniture, food, and almost all consumer electronics. ese days, customers
can seemingly buy anything they need via the Amazon platform. In the United States alone, roughly 150 million
customers per month visit Amazon.com. But this massive availability of products also puts a strain on Amazon’s
global supply chains.
As customers, we have come to expect that Amazon will deliver whatever we buy in the shortest cycle time
possible, often no more than two days, especially if a customer is signed up for Amazon Prime. e Amazon Prime
service includes free two-day shipping (on many products), video streaming, music, photos, and the Kindle
lending library for an annual fee (currently $99 per year or $12.99 per month). All these services are welcomed by
customers, but the free two-day shipping is really what drives the Amazon Prime service.
e free two-day shipping (and a myriad of other shipping alternatives for a fee) requires Amazon to leverage
its inventory management practices, global supply chains, and technology to cost effectively reach customers.
Delivery speed and efficiency require Amazon to have strategically located fulfillment centers worldwide that can
be used by select vendors on the Amazon platform. is includes strict requirements for packaging, labeling, and
shipment. Amazon stores these vendors’ products in bulk or in individual “pickable” locations.
So far, in addition to the United States, Amazon has retail websites for Australia, Brazil, Canada, China,
France, Germany, India, Italy, Japan, Mexico, the Netherlands, Spain, the United Kingdom, and Ireland. And, the
Amazon Prime service places great strain on Amazon’s supply chains where it is available in its worldwide locations
(e.g., Canada, France, Germany, Italy, Japan, and the United Kingdom).
In addition, Amazon’s customer service centers span some 15 countries worldwide. Plus, the company operates
retail websites for international brands such as Sears Canada, Bebe Stores, Marks & Spencer, Mothercare, and
Lacoste. is means that Amazon is benefiting from both its global supply chains for delivery of vendors’ products
and its service as a technology supply chain vendor to businesses.
Another interesting development—or, at least, idea at this stage—is the speculation that Amazon is thinking
about launching a global shipping and logistics operation that can compete with United Parcel Service (UPS) and
FedEx. Of course, Chief Financial Officer (CFO) Brian Olsavsky downplayed Amazon’s ambitions on this front.
He said that Amazon was just looking to supplement its delivery partners—not replace them—during the very
busy peak periods like the holiday seasons.
Sources: Todd Bishop, “Amazon Sales Rises 22% to $43.7B, Profit Beats Expectations But Stock Slips on Revenue
Miss,” GeekWire, February 2, 2017; Spencer Soper, “Amazon Building Global Delivery Business to Take On Alibaba,” Bloomberg Technology, February 9, 2016; V. Walt, “How Jeff Bezos Aims to Conquer the Next Trillion- dollar Market,” Fortune, January 1, 2016; B. Stone, “e Secrets of Bezos: How Amazon Became the Everything Store,” Bloomberg Business, October 10, 2013; and A. Cuthbertson, “Amazon Buries Zombie Apocalypse Clause in Terms of Service,” Newsweek, February 11, 2016.
Make-or-Buy Decisions
LO 15-4 Identify the factors that influence a firm’s decision of whether to source supplies from
within the company or from foreign suppliers.
e make-or-buy decision for a global firm is the strategic decision concerning whether to produce an
item in-house (“make”) or purchase it from an outside supplier (“buy”). Make-or-buy decisions are made
at both the strategic and operational levels, with the strategic level being focused on the long term and the
operational level being more focused on the short term. In some ways, the make-or-buy decision is also
the starting point for operations’ influence on global supply chains. at is, someone in the chain—within
one firm—has to take the lead in deciding whether the global firm should make the product in-house or
buy it from an external supplier. If the decision is to make it in-house, there are certain implications for
that firm’s global supply chains (e.g., where to purchase raw materials and component parts). If the
decision is to buy the product, that decision also has certain implications (e.g., quality control and
competitive priorities management).
A number of things are involved in determining which decision is the correct one for a particular
global firm in a particular situation. At a broad level, issues of product success, specialized knowledge, and
strategic fit can lead to the make (produce) decision. For example, if the item or part is critical to the
success of the product, including perceptions among primary stakeholders, such a scenario skews the
decision in favor of make. Another reason for a make decision is that the item or part requires specialized
design or production skills and/or equipment and reliable alternatives are very scarce. Strategic fit is also
important. If the item or part strategically fits within the firm’s current and/or planned core competencies,
then it should be a make decision for the global firm.
However, these are strategic decisions at a general level. In reality, the make-or-buy decision is often
based largely on two critical factors: cost and production capacity. Cost issues include such things as
acquiring raw materials, component parts, and any other inputs into the process, along with the costs of
finishing the product. e production capacity is really presented as an opportunity cost. at is, does the
firm have the capacity to produce the product at a cost that is at least no higher than the cost of buying it
from an external supplier? And if the product is made in-house, what opportunity cost would be incurred
as a result (e.g., what product or item was the firm unable to produce because of limited production
capacity)? Unfortunately, many, and perhaps most, global companies think that cost and production
capacity are the only factors playing into the make-or-buy decision. is is simply not true!
Do You Expect a Trend in Bringing Jobs Back from Overseas?
e United States may be on the verge of bringing back manufacturing jobs from China. Outsourcing
manufacturing to China is not as cheap as it used to be. Many companies, especially in the auto and furniture
industries, moved plants overseas once China opened its doors to free trade and foreign investment in the last few
decades. Labor was cheaper for American companies—less than $1 per hour by some estimates at the time. Today,
labor costs in China have risen dramatically, and shipping and fuel costs have skyrocketed. As China’s economy
has expanded and as China has built new factories all across the country, the demand for workers has risen. As a
result, wages are up as new companies compete to hire the best workers. Experts note that the fears that U.S.
manufacturing is in decline are overstated and that the United States is still a manufacturing giant. China and the
United States each account for about 20 percent of global manufacturing value added. e U.S. share of about 20
percent of global manufacturing value added “has declined only slightly over the past three decades,” according to
the Boston Consulting Group. With all this in mind, do you expect more and more outsourced jobs to be
“insourced” in the future?
Source: “Made in America Again,” Boston Consulting Group, 2012, www.bcg.com/documents/file84471.pdf
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Cost and production capacity are just the two main drivers behind make-or-buy choices made by
global companies when they engage in global supply chains. e decision of whether to buy or make a
product is a much more complex and research-intensive process than the typical global firm may expect.
For example, how many times have we heard, “Let’s move our production to China because we can get the
same quality for a dime-on-the-dollar cost, and that will free up production capacity that we can use to
focus on other products”? Of course, dime-on-the-dollar cost is not the sole relevant factor because we
have to take into account the costs of quality control measures that have to be instituted, raw materials
that have to be purchased far away from home, foreign entry requirements, multiple-party contracts,
management responsibilities for the outsourced production operations, and so on. Ultimately, we are
unlikely to end up with a dime-on-the-dollar cost. But where do we end up and how do we get there? In
other words, what are the core elements that we should be evaluating when we are determining whether
the correct decision is to make or to buy?
To facilitate your understanding of the make-or-buy decision, we have captured the dynamics of this
choice in two graphics that illustrate either operationally favoring a make decision or
operationally favoring a buy decision (see Figures 15.3 and 15.4). As shown in the figures, the
core elements in both cases are cost and production capacity. However, the other elements differ for each
of the decisions and influence the choice differently. is means that we need to evaluate each decision
separately, not jointly. In fact, through this process, we may end up thinking that both a make decision
and a buy decision would be acceptable and strategically logical for our firm. Keep in mind that this
simply means that we have a choice; if both choices seem positive for your firm, choose the best one—the
one that is the best strategic fit with the least opportunity cost.
15.3 FIGURE
Operationally favoring a make decision.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
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15.4 FIGURE
Operationally favoring a buy decision.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
e elements that favor a make decision—beyond the core elements of cost and production capacity—
include quality control, proprietary technology, having control, excess capacity, limited suppliers,
assurance of continual supply, and industry drivers (see Figure 15.3). So, the starting point is lower (or at
least no greater) cost than what we can expect when we outsource the production to an external party in
another country (or another external party in general). e limitation is that we must have excess
production capacity or capacity that is best used by our firm for making the product in-house.
After the cost and production capacity decisions have been explored and made (really, after the cost and
production hurdles have been overcome), the next set of decisions follows logically from the path in
Figure 15.3. For example, if quality control is important to the global firm, cannot be relied on fully if the
part is outsourced, and is at the center of the strategic core that customers expect from the firm, then the
quality control issue favors a make decision. If there is proprietary technology involved in making the
product that cannot or should not be shared with outsourcing parties, then the decision has to be to
make.
e idea that limited suppliers may influence the make-or-buy choice in the direction of the make
selection is important as well. Specifically, it could be that some suppliers do not want to work with
certain companies in certain parts of the world. It could also be that a supplier cannot, because of various
restrictions on production or location or because of international barriers, follow the production of your
firm’s products to wherever you see fit to locate your production lines.
Naturally, if the firm has excess capacity that otherwise would not be productively used, the decision
should favor a make choice to allow that excess capacity to be used for the benefit of the firm in the global
marketplace. Some companies also simply want to have control over certain elements of their production
processes. is affects the make-or-buy decision in favor of the make choice.
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A make decision is also favored if there is any chance that supply cannot be guaranteed if the firm
moves its production overseas. And, finally, the industry globalization drivers may dictate that a make
decision should be the choice for various trust and commitment reasons involving your industry and the
marketplace that you engage with in order to find success.
Now, some of these elements that favor make can probably influence a buy decision as well. Naturally,
if one of the make elements is not in favor of the make decision (e.g., if there is no excess capacity), this
would suggest that the global firm should think more seriously about a buy decision. However, again, the
buy decision also involves a number of other elements that are not necessarily factors in the make decision
(see Figure 15.4). As with the make decision, after the cost and production capacity decisions have been
considered and made, the next set of decisions for the buy choice follow logically from the path in Figure
15.4. For example, if the global firm has minimal restrictions on which firms or companies it can source
raw materials and component parts from, then a buy decision is more likely because outsourcing
production also increases the likelihood that other and/or more suppliers in those parts of the world will
be used.
Another good reason to choose a buy scenario is if the firm lacks the needed expertise to make a
product or component part and the supplier or outsourced production choice has that expertise. Supplier
competencies can affect the decision in favor of a buy choice as well, especially if those competencies
reside closer to the production facility that you buy from than the ones that will be available if you make
the product. Small volumes would also be a reason favoring a buy decision; cost-efficiencies can seldom be
achieved when only small volumes are produced.
Inventory planning is also of critical importance. Even if your firm can make the product equally well
in terms of quality and expectations set, perhaps a better choice is to buy simply in order to strategically
manage inventory (which is a cost center in the global supply chain). In certain cases, even brand
preference is a reason to go with a buy decision; for example, many computer users favor Intel microchips
in their computers, so many of the large computer manufacturers opt to buy chips from Intel instead of
making them in-house for that reason (this was truer in the 1990s and 2000s than it is now, but it is still a
factor). And, of course, if the item to be made is a so-called nonessential item that has little effect on the
firm’s core competencies and what the customers expect in terms of uniqueness, this is a factor in favor of
a buy decision.
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Global Supply Chain Functions
LO 15-5 Understand the functions of logistics and purchasing (sourcing) within global supply
chains.
To this point in the chapter, we have emphasized global production, a component of the operations
management of a supply chain. Issues such as where to produce, the strategic role of a foreign production
site, and the make-or-buy decisions are the core aspects of global production. In addition to global
production, three additional supply chain functions need to be developed in concert with global
production. ey are logistics, purchasing (sourcing), and the company’s distribution strategy (i.e.,
marketing channels). e latter—distribution strategy—is addressed in Chapter 16, where we discuss
marketing and R&D. Here we address logistics and purchasing. From earlier in this chapter, we know that
production and supply chain management are closely linked because a firm’s ability to perform its
production activities depends on information inputs and a timely supply of high-quality material (raw
material, component parts, and even finished products that are used in the manufacturing of new
products). Logistics and purchasing are critical functions in ensuring that materials are ordered and
delivered and that an appropriate level of inventory is managed.
GLOBAL LOGISTICS
From earlier in this chapter, we know that logistics is the part of the supply chain that plans, implements,
and controls the effective flows and inventory of raw material, component parts, and products used in
manufacturing. e core activities performed in logistics are (1) global distribution center management,
(2) inventory management, (3) packaging and materials handling, (4) transportation, and (5) reverse
logistics. Each of these core logistics is described in the next paragraphs.
A global distribution center (or warehouse) is a facility that positions and allows customization of
products for delivery to worldwide wholesalers or retailers or directly to consumers anywhere in the world.
Distribution centers (DCs) are used by manufacturers, importers, exporters, wholesalers, retailers,
transportation companies, and customs agencies to store products and provide a location where
customization can be facilitated. When warehousing shifted from passive storage of products to strategic
assortments and processing, the term distribution center became more widely used to capture this strategic and dynamic aspect of not only storing, but also of adding value to products that are being warehoused or
staged. A DC is at the center of the global supply chain; specifically, the order-processing part of the
order-fulfillment process. DCs are the foundation of a global supply network because they allow either a
single location or satellite warehouses to store quantities and assortments of products and allow for value-
added customization. ey should be located strategically in the global marketplace, considering the
aggregate total labor and transportation cost of moving products from plants or suppliers through the
distribution center and then delivering them to customers.
How Much Relationship Building Do You Want to Do?
Like manufacturers, professional service firms have also been learning how to better manage their delivery on a
global basis. For example, some global services firms are dealing with other global firms in a new way, using one
supplier for all their service-related needs around the world. e traditional approach involved the development of
market-specific relationships, so the same multinational client would have a number of individual service
relationships, one in each major market for each company division. Under a global account management
approach, one relationship has a global span—and one contract. Such supply chain practices allow for more
effective relationship management, a better sense of what the client needs, more product extension opportunities,
and better pricing and economies. But global account management also takes time, energy, and resources. How
many “global accounts” do you think would be ideal for a global company? What is the minimum and the
maximum number of global account relationships a large multinational corporation should have (e.g., Microsoft)?
Global inventory management can be viewed as the decision-making process regarding the raw
materials, work-in-process (component parts), and finished goods inventory for a multinational
corporation. e decisions include how much inventory to hold, in what form to hold it, and where to
locate it in the supply chain. Examining the largest 20,910 global companies with headquarters in 105
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countries, we find that these companies, on average across all industries, carry 14.41 percent of their total
assets in some form of inventory.22 ese companies have 32 percent of their inventory in raw materials,
18 percent of their inventory in work-in-process, and 50 percent of their inventory in finished goods.23 At
the company level, Toyota (www.toyota.com) from Japan, one of the largest automobile firms in the
world, has 8.71 percent of its total assets in inventory, with a mix of 26, 14, and 60 percent in raw
materials, work-in-process, and finished vehicles, respectively. Another example is Sinopec
(www.sinopec.com), a petroleum firm and the largest firm in China. Sinopec has 21 percent of
its total assets in inventory, with a mix of 37, 43, and 20 percent in raw materials and
component parts, work-in-process, and finished goods, respectively. Note that Sinopec maintains a much
higher percentage of its inventories in work-in-process and a much lower percentage in finished goods
than Toyota does. is suggests that petroleum firms want more flexibility in deciding exactly how to
formulate the finished product. e company’s global inventory strategy must effectively trade off the
service and economic benefits of making products in large quantities and positioning them near customers
against the risk of having too much stock or the wrong items.
Packaging comes in all shapes, sizes, forms, and uses. It can be divided into three different types:
primary, secondary, and transit. Primary packaging holds the product itself. ese are the packages brought home from the store, usually a retailer, by the end-consumer. Secondary packaging (sometimes called case- lot packaging) is designed to contain several primary packages. Bulk buying or warehouse store customers
may take secondary packages home (e.g., from Sam’s Club), but this is not the typical mode for retailers.
Retailers can also use secondary packaging as an aid when stocking shelves in the store. Transit packaging comes into use when a number of primary and secondary packages are assembled on a pallet or unit load
for transportation. Unit-load packaging—through palletizing, shrink-wrapping, or containerization—is
the outer packaging envelope that allows for easier handling or product transfer among international
suppliers, manufacturers, distribution centers, retailers, and any other intermediaries in the global supply
chain.
Regardless of where the product is in the global supply chain, packaging is intended to achieve a set of
multilayered functions. ese can be grouped into (1) perform, (2) protect, and (3) inform.24 Perform refers to (1) the ability of the product in the package to handle being transported between nodes in the
global supply chain, (2) the ability of the product to be stored for typical lengths of time for a particular
product category, and (3) the package providing the convenience expected by both the supply chain
partners and the end-customers. Protect refers to the package’s ability to (1) contain the products properly, (2) preserve the products to maintain their freshness or newness, and (3) provide the necessary security
and safety to ensure that the products reach their end destination in their intended shape. Inform refers to the package’s inclusion of (1) logical and sufficient instructions for the use of the products inside the
package, including specific requirements to satisfy local regulations; (2) a statement of a compelling
product guarantee; and (3) information about service for the product if and when it is needed.
Transportation refers to the movement of raw material, component parts, and finished goods
throughout the global supply chain. It typically represents the largest percentage of any logistics budget
and an even greater percentage for global companies because of the distances involved. Global supply
chains are directly or indirectly responsible for transporting raw materials from their suppliers to the
production facilities, work-in-process, and finished goods inventories between plants and distribution
centers, and finished goods from distribution centers to customers. e primary drivers of transportation
rates and the resulting aggregate cost are distance, transport mode (ocean, air, or land), size of the load,
load characteristics, and oil prices. As would be expected, longer distances require more fuel and more
time from vehicle operators, so transport rates increase with distance. Transport mode influences rates
because of the different technologies involved. Ocean is the least expensive because of the size of the
vehicles used and the low friction of water. Land is the next least expensive, with rail being less expensive
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than motor carriers. Air is the most expensive because there is a substantial charge for defying gravity.
Transportation rates are heavily influenced by economies of scale, so larger shipments are typically
relatively less expensive than smaller shipments. e characteristics of the shipment also influence
transportation rates through such factors as product density, value, perishability, the potential for damage,
and other such factors. Finally, oil prices have a major impact on transportation rates because anywhere
from 10 to 40 percent of most carrier costs, depending on the mode, are related to fuel.
Reverse logistics is the process of planning, implementing, and controlling the efficient, cost-effective
flow of raw materials, in-process inventory, finished goods, and related information from the point of
consumption to the point of origin for the purpose of recapturing value or proper disposal. e ultimate
goal is to optimize the after-market activity or make it more efficient, thus saving money and
environmental resources. Reverse logistics is critically important in global supply chains. For example,
product returns cost manufacturers and retailers more than $100 billion per year in the United
States, or an average of 3.8 percent in lost profits.25 Overall, manufacturers spend about 9 to 14
percent of their sales revenue on returns. Even more staggering, each year, consumers in America return
more than the GDP of two-thirds of the nations in the world. Just these sample numbers suggest that
reverse logistics is an incredibly important part of the global supply chain.
GLOBAL PURCHASING
As we defined it earlier in this chapter, purchasing represents the part of the supply chain that involves
worldwide buying of raw material, component parts, and products used in the manufacturing of the
company’s products and services. e core activities performed in purchasing include development of an
appropriate strategy for global purchasing and selecting the type of purchasing strategy best suited for the
company.
ere are five strategic levels—from domestic to international to global—that can be undertaken by a
global company.26 Level I is simply companies engaging in domestic purchasing activities only. Often,
these companies stay close to their home base in their domestic market when purchasing raw materials,
component parts, and the like for their operations (e.g., a Michigan firm purchasing raw materials, such as
cherries, from another Michigan firm). Levels II and III are both considered “international purchasing,”
but of various degrees and forms. Companies that are at level II engage in international purchasing
activities only as needed. is means that their approach to international purchasing is often reactive and
uncoordinated among the buying locations within the firm and/or across the various units that make up
the firm, such as strategic business units and functional units. Companies at level III engage in
international purchasing activities as part of the firm’s overall supply chain management strategy. At the
level III stage, companies begin to recognize that a well-formulated and well-executed worldwide
international purchasing strategy can be very effective in elevating the firm’s competitive edge in the
marketplace. Levels IV and V both involve “global purchasing” to various degrees. Level IV refers to global
purchasing activities that are integrated across worldwide locations. is involves integration and
coordination of purchasing strategies across the firm’s buying locations worldwide. With level IV, we are
now dealing with a sophisticated form of worldwide purchasing. Level V involves engaging in global
purchasing activities that are integrated across worldwide locations and functional groups. Broadly, this
means that the firm integrates and coordinates the purchasing of common items, purchasing processes,
and supplier selection efforts globally, for example.
Beyond the domestic, international, and global purchasing strategies in levels I through V, purchasing
includes a number of basic choices that companies make in deciding how to engage with markets.27 e
starting point is a choice of internal purchasing versus external purchasing—in other words, “how to
purchase.” We find that roughly 35 percent of the purchasing in global companies today is internal (i.e.,
from sources within their own company), with 65 percent being classified as external (i.e., from sources
outside their company). e next decision, in both internal and external purchasing, is to figure out
“where to purchase” (domestically or globally). is takes us ultimately to the “types of purchasing”
(where and how) and the four choices for purchasing strategy: domestic internal purchasing, global
internal purchasing, domestic external purchasing, and global external purchasing.
e types of purchasing activities and strategies just discussed come with a set of generic options for
the “international arena.” But we all know that outsourcing and offshoring, along with many by-products
and other similar yet quite different options, exist in the purchasing world today. At this stage of the text,
we feel it is important to go over the outsourcing-related terms and options that companies have,
especially the following terms that are often confusing to understand, develop strategy around, and
implement: outsourcing, insourcing, offshoring, offshore outsourcing, nearshoring, and co-sourcing (see
Table 15.2).
15.2 TABLE
Outsourcing Terms and Options
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Managing a Global Supply Chain
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LO 15-6 Describe what is required to efficiently manage a global supply chain.
e potential for reducing costs through more efficient supply chain management is enormous. For the
typical manufacturing enterprise, material costs account for between 50 and 70 percent of revenues,
depending on the industry. Even a small reduction in these costs can have a substantial impact on
profitability. According to one estimate, for a firm with revenues of $1 million, a return on
investment rate of 5 percent, and materials costs that are 50 percent of sales revenues, a $15,000
increase in total profits could be achieved either by increasing sales revenues 30 percent or by reducing
materials costs by 3 percent.28 In a saturated market, it would be much easier to reduce materials costs by
3 percent than to increase sales revenues by 30 percent. us, managing global supply chains is one of the
strategically most important areas for a global company. Four main areas are of concern in managing a
global supply chain, including the role of just-in-time inventory, the role of information technology,
coordination in global supply chains, and interorganizational relationships in global supply chains.
ROLE OF JUST-IN-TIME INVENTORY
Pioneered by Japanese firms during that country’s remarkable economic transformation during the 1960s
and 1970s, just-in-time inventory systems now play a major role in most manufacturing firms. e basic
philosophy behind just-in-time (JIT) inventory systems is to economize on inventory holding costs by
having materials arrive at a manufacturing plant just in time to enter the production process and not
before. e major cost savings comes from speeding up inventory turnover. is reduces inventory
holding costs, such as warehousing and storage costs. It means the company can reduce the amount of
working capital it needs to finance inventory, freeing capital for other uses and/or lowering the total
capital requirements of the enterprise. Other things being equal, this will boost the company’s profitability
as measured by return on capital invested. It also means the company is less likely to have excess unsold
inventory that it has to write off against earnings or price low to sell.
In addition to the cost benefits, JIT systems can also help firms improve product quality. Under a JIT
system, parts enter the manufacturing process immediately; they are not warehoused. is allows defective
inputs to be spotted right away. e problem can then be traced to the supply source and fixed before
more defective parts are produced. Under a more traditional system, warehousing parts for
weeks before they are used allows many defective parts to be produced before a problem is
recognized.
e drawback of a JIT system is that it leaves a firm without a buffer stock of inventory. Although
buffer stocks are expensive to store, they can help a firm respond quickly to increases in demand and tide a
firm over shortages brought about by disruption among suppliers. Such a disruption occurred after the
September 11, 2001, attacks on the World Trade Center and Pentagon, when the subsequent shutdown of
international air travel and shipping left many firms that relied on globally dispersed suppliers and tightly
managed “just-in-time” supply chains without a buffer stock of inventory. A less pronounced but similar
situation occurred again in April 2003, when the outbreak of the pneumonia-like severe acute respiratory
syndrom (SARS) virus in China resulted in the temporary shutdown of several plants operated by foreign
companies and disrupted their global supply chains. Similarly, in late 2004, record imports into the
United States left several major West Coast shipping ports clogged with too many ships from Asia that
could not be unloaded fast enough, which disrupted the finely tuned supply chains of several major U.S.
enterprises.29
ere are ways of reducing the risks associated with a global supply chain that operates on just-in-time
principles. To reduce the risks associated with depending on one supplier for an important input, some
firms source these inputs from several suppliers located in different countries. While this does not help in
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the case of an event with global ramifications, such as September 11, 2001, it does help manage country-
specific supply disruptions, which are more common. Strategically, all global companies need to build in
some degree of redundancy in supply chains by having multiple options for suppliers.
ROLE OF INFORMATION TECHNOLOGY
Web- and cloud-based information systems play a crucial role in modern materials management. By
tracking component parts as they make their way across the globe toward an assembly plant, information
systems enable a firm to optimize its production scheduling according to when components are expected
to arrive. By locating component parts in the supply chain precisely, good information systems allow the
firm to accelerate production when needed by pulling key components out of the regular supply chain and
having them flown to the manufacturing plant.
Firms now typically use some form of a supply chain information system to coordinate the flow of
materials into manufacturing, through manufacturing, and out to customers. ere are a variety of
options for global supply chains. Electronic data interchange (EDI) refers to the electronic interchange of
data between two or more companies. Enterprise resource planning (ERP) is a wide-ranging business
planning and control system that includes supply chain-related subsystems (e.g., materials requirements
planning, or MRP). Collaborative planning, forecasting, and replenishment (CPFR) was developed to fill
the inter-organizational connections that ERP cannot fill. Vendor management of inventory (VMI) allows
for a holistic overview of the supply chain with a single point of control for all inventory management. A
warehouse management system (WMS) often operates in concert with ERP systems; for example, an ERP
system defines material requirements, and these are transmitted to a distribution center for a WMS.
Before the emergence of the Internet as a major communication medium, firms and their suppliers
normally had to purchase expensive proprietary software solutions to implement EDI systems. e
ubiquity of the Internet and the availability of web- and cloud-based applications have made most of these
proprietary solutions obsolete. Less expensive systems that are much easier to install and manage now
dominate the market for global supply chain management software. ese systems have transformed the
management of globally dispersed supply chains, allowing even small firms to achieve a much better
balance between supply and demand, thereby reducing the inventory in their systems and reaping the
associated economic benefits. Importantly, with most firms now using these systems, those that do not will
find themselves at a competitive disadvantage. is has implications for small and medium-sized
companies that may not always have the resources to implement the most sophisticated supply chain
information systems.
COORDINATION IN GLOBAL SUPPLY CHAINS
Consider how to turn an aircraft, and think in terms of coordination and leverage points. at is, aircraft
are typically steered using an integrated system of ailerons on the wings and the rudder at the tail of the
aircraft. In comparison to the aircraft, the ailerons and the rudder seem very small. However,
leverage allows the coordinated effort of the ailerons and the rudder to turn the aircraft. In
other words, putting the right combination of a little leverage in the right places together with a
coordinated effort leads to incredible maneuvering ability for the plane. Global supply chains are the
same. Integration and coordination are critically important. Global supply chain coordination refers to
shared decision-making opportunities and operational collaboration of key global supply chain activities.
Shared decision making—such as joint consideration of replenishment, inventory holding costs,
collaborative planning, costs of different processes, the frequency of orders, batch size, and product
development—creates a more integrated, coherent, efficient, and effective global supply chain. is
includes shared decision making by supply chain members both inside an organization (e.g., logistics,
purchasing, operations, and marketing channels employees) and across organizations (e.g., raw materials
producers, transportation companies, manufacturers, wholesalers, retailers). Shared decision making is not joint decision making; it is decision making involving joint considerations. Shared decision making helps in resolving potential conflicts among global supply chain members and fosters a culture of coordination
and integration. In most supply chains, certain parties are more influential, and shared decision making, at
a minimum, should include the critically important chain members.
To achieve operational integration and collaboration within a global supply chain, six operational
objectives should be addressed: responsiveness, variance reduction, inventory reduction, shipment
consolidation, quality, and life-cycle support.30 Responsiveness refers to a global firm’s ability to satisfy customers’ requirements across global supply chain functions in a timely manner. Variance reduction refers to integrating a control system across global supply chain functions to eliminate global supply chain
disruptions. Inventory reduction refers to integrating an inventory system, controlling asset commitment, and turning velocity across global supply chain functions. Shipment consolidation refers to using various programs to combine small shipments and provide timely, consolidated movement. is includes
multiunit coordination across global supply chain functions. Quality refers to integrating a system so that it achieves zero defects throughout global supply chains. Finally, life-cycle support refers to integrating the activities of reverse logistics, recycling, after-market service, product recall, and product disposal across
global supply chain functions.
INTERORGANIZATIONAL RELATIONSHIPS
Interorganizational relationships have been studied and talked about in various contexts for decades. e
two keys are trust and commitment. If we always had 100 percent trust in relationships and 100 percent
commitment to them, most global supply chains would ultimately be efficient and effective. But we don’t!
However, by looking at the building blocks for global supply chains, we would also assume that not all
relationships are equally valuable and that they should not be treated as if they were. Two examples
centered on upstream/inbound and downstream/outbound supply chain activities can effectively be used
to illustrate this point. Figure 15.5 focuses on the upstream (or inbound) supply chain relationships, and
Figure 15.6 focuses on the downstream (or outbound) supply chain relationships.
15.5 FIGURE
Upstream/inbound relationships.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
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15.6 FIGURE
Downstream/outbound relationships.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
For the upstream/inbound portion of the global supply chain, the three logical scenarios of
interacting organizations are labeled as vendors, suppliers, and partners. Each scenario is based
on the degree of coordination, integration, and transactional versus relationship emphasis that the firm
should adopt in partnering with other entities in the global supply chain. For instance, a firm uses vendors
to obtain raw materials and component parts through a transactional relationship that can change easily. A
given firm may use suppliers to obtain raw materials and parts and maintain a relationship with those
suppliers based on experience and performance. Another firm may engage with partners to obtain raw
materials and parts, maintaining a relationship based on trust and commitment.
For the downstream/outbound portion of the global supply chain, the three logical scenarios of
interacting organizations are labeled as buyers, customers, and clients. As with the upstream/inbound
examples, each downstream/outbound scenario is based on the degree of coordination, integration, and
transactional versus relationship focus that the firm should adopt in partnering with other entities in the
global supply chain. One firm may sell products and parts to buyers through a transactional relationship
that can change easily. Another firm may sell products and parts to customers and maintain a relationship
that is based on experience and performance. Yet another firm may sell products and parts to clients and
maintain a relationship that is based on trust and commitment.
Having reviewed the three scenarios for the upstream/inbound and downstream/outbound portions of
the global supply chain, let’s look at the emphasis a global company should place on the relationships with
each entity: the benefits to be expected, favorable points of distinction, and resonating focus in the
relationship.31 First, however, some basics on value are appropriate. e value between nodes and actors in
global supply chains is a function of the cost (money and nonmoney resources) given up in return for the
quality (products, services, information, trust, and commitment) received. Basically, greater value is
achieved if the quality is greater while the cost remains the same or is reduced or when the cost is reduced
and the quality remains constant.
A global company should allocate 20 percent of its efforts to the vendor category, 30 percent to the
supplier category, and 50 percent to the partner category in the upstream/inbound portion of the global
supply chain. Likewise, a global company should allocate 20 percent of its efforts to the buyer category, 30
percent to the customer category, and 50 percent to the client category in the downstream/outbound
portion of the chain. In the vendor (upstream) and buyer (downstream) portions of the supply chain, the
benefits that can be expected include those typical of a transactional exchange (costs equal to quality for
the goods bought but not necessarily the best goods in the marketplace). In the supplier (upstream) and
customer (downstream) stages, the expectation is that the firm will receive all the favorable points that the
raw materials, component parts, and/or products have relative to the next best alternative in the global
marketplace. is takes into account the ideas that the costs are equal to quality for the goods bought and
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that the goods are among the best goods in the marketplace. Finally, in the partner (upstream) and client
(downstream) portions of the supply chain, the benefits that the firm can expect to receive include the one
or two points of difference for the raw materials, component parts, and/or products whose improvements
will deliver the greatest value to the customer for the foreseeable future (quality greater than cost).
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to
learnsmartadvantage.com for help.
Key Terms
production, p. 411
supply chain management, p. 411
purchasing, p. 412
logistics, p. 412
upstream supply chain, p. 412
downstream supply chain, p. 412
total quality management (TQM), p. 412
Six Sigma, p. 413
ISO 9000, p. 413
minimum efficient scale, p. 415
flexible manufacturing technology, p. 416
lean production, p. 416
mass customization, p. 416
flexible machine cells, p. 417
global learning, p. 419
offshore factory, p. 419
source factory, p. 420
server factory, p. 420
contributor factory, p. 420
outpost factory, p. 420
lead factory, p. 420
make-or-buy decision, p. 422
global distribution center, p. 425
global inventory management, p. 425
packaging, p. 426
transportation, p. 426
reverse logistics, p. 426
just in time (JIT), p. 428
global supply chain coordination, p. 430
Summary
is chapter explained how global production and supply chain management can improve the competitive
position of an international business by lowering the total costs of value creation and by performing value
creation activities in such ways that customer service is enhanced and value added is maximized. We
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looked closely at five issues central to global production and supply chain management: where to produce,
the strategic role of foreign production sites, what to make and what to buy, global supply chain
functions, and managing a global supply chain. e chapter made the following points:
1. e choice of an optimal production location must consider country factors, technological factors,
and production factors.
2. Country factors include the influence of factor costs, political economy, and national culture on
production costs, along with the presence of location externalities.
3. Technological factors include the fixed costs of setting up production facilities, the minimum
efficient scale of production, and the availability of flexible manufacturing technologies that allow
for mass customization.
4. Production factors include product features, locating production facilities, and strategic roles for
production facilities.
5. Location strategies either concentrate or decentralize manufacturing. e choice should be made in
light of country, technological, and production factors. All location decisions involve trade-offs.
6. Foreign factories can improve their capabilities over time, and this can be of immense strategic
benefit to the firm. Managers need to view foreign factories as potential centers of excellence and
encourage and foster attempts by local managers to upgrade factory capabilities.
7. An essential issue in many international businesses is determining which component parts should be
manufactured in-house and which should be outsourced to independent suppliers. Both making
and buying component parts are primarily based on cost considerations and production capacity
constraints, but each decision (make or buy) is also influenced by several different factors.
8. e core global supply chain functions are logistics, purchasing (sourcing), production (and
operations management), and marketing channels.
9. Logistics is the part of the supply chain that plans, implements, and controls the effective flows and
inventory of raw material, component parts, and products used in manufacturing. e core
activities performed in logistics are to manage global distribution centers, inventory management,
packaging and materials handling, transportation, and reverse logistics.
10. Purchasing represents the part of the supply chain that involves worldwide buying of raw material,
component parts, and products used in manufacturing of the company’s products and services. e
core activities performed in purchasing include development of an appropriate strategy for global
purchasing and selecting the type of purchasing strategy best suited for the company.
11. Managing a supply chain involves orchestrating effective just-in-time inventory systems, using
information technology, coordination among functions and entities in the chain, and developing
interorganizational relationships.
12. Just-in-time systems generate major cost savings by reducing warehousing and inventory holding
costs and by reducing the need to write off excess inventory. In addition, JIT systems help the firm
spot defective parts and remove them from the manufacturing process quickly, thereby improving
product quality.
13. Information technology, particularly Internet-based electronic data interchange, plays a
major role in materials management. EDI facilitates the tracking of inputs, allows the firm to
optimize its production schedule, lets the firm and its suppliers communicate in real time, and
eliminates the flow of paperwork between a firm and its suppliers.
14. Global supply chain coordination refers to shared decision-making opportunities and operational
collaboration of key global supply chain activities.
15. e depth and involvement in interorganizational relationships in global supply chains should be
based on the degree of coordination, integration, and transactional versus relationship emphasis that
the firm should adopt in partnering with other entities in the global supply chain.
Critical inking and Discussion Questions
1. An electronics firm is considering how best to supply the world market for microprocessors used in
consumer and industrial electronic products. A manufacturing plant costs about $500 million to
construct and requires a highly skilled workforce. e total value of the world market for this
product over the next 10 years is estimated to be between $10 billion and $15 billion. e tariffs
prevailing in this industry are currently low. What kind of location(s) should the firm favor for its
plant(s)?
2. A chemical firm is considering how best to supply the world market for sulfuric acid. A
manufacturing plant costs about $20 million to construct and requires a moderately skilled
workforce. e total value of the world market for this product over the next 10 years is estimated
to be between $20 billion and $30 billion. e tariffs prevailing in this industry are moderate. What
kind of location(s) should the firm seek for its plant(s)?
3. A firm must decide whether to make a component part in-house or to contract it out to an
independent supplier. Manufacturing the part requires a nonrecoverable investment in specialized
assets. e most efficient suppliers are located in countries with currencies that many foreign
exchange analysts expect to appreciate substantially over the next decade. What are the pros and
cons of (a) manufacturing the component in-house and (b) outsourcing manufacturing to an independent supplier? Which option would you recommend? Why?
4. Reread the Management Focus “IKEA Production in China,” and then answer the following
questions:
a. What are the benefits to IKEA of shifting so much of its global production to China?
b. What are the risks associated with a heavy concentration of manufacturing assets in China?
c. What strategies might IKEA adopt to maximize the benefits and mitigate the risks associated
with moving so much product?
5. Explain how the global supply chain functions of (a) logistics and (b) purchasing can be used to strategically leverage the global supply chains for a manufacturing company producing mobile
phones.
6. What type of interorganizational relationship should a global company consider in the (a) inbound portion of its supply chains if the goal is to buy commodity-oriented component parts for its own
production and (b) outbound portion of its supply chains if the goal is to establish a strong partnership in reaching end-customers?
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. e globalization of production makes many people aware of the differences in manufacturing costs
worldwide. e U.S. Department of Labor’s Bureau of International Labor Affairs publishes the
Chartbook of International Labor Comparisons. Locate the latest edition of this report, and identify
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the hourly compensation costs for manufacturing workers in China, Brazil, Mexico, Turkey,
Germany, and the United States.
2. e World Bank’s Logistics Performance Index (LPI) assesses the trade logistics environment and
performance of countries. Locate the most recent LPI ranking. What components for each country
are examined to construct the index? Identify the top 10 logistics performers. Prepare an executive
summary highlighting the key findings from the LPI. How are these findings helpful for companies
trying to build a competitive supply chain network?
A l i b a b a a n d G l o b a l S u p p l y C h a i n s
c l o s i n g c a s e
Alibaba Group Holding Limited (alibaba.com) was founded in 1999 by Jack Ma as an e-commerce company to
facilitate sales among companies that provide consumer-to-consumer, business-to-consumer, and business-to-
business products that are sold via the Internet. As the world’s largest e-commerce platform, Alibaba is on a path
to realizing its vision of facilitating $1 trillion in product sales annually as it also pursues a goal of reaching 2
billion consumers. e company is headquartered in Hangzhou, Zhejiang, China, has a revenue of more than 23
billion U.S. dollars (primarily via advertisements on its sites), and employs about 51,000 people.
Alibaba’s global supply chains are constrained tremendously on “Singles Day” or Guanggun Jie, a Chinese
holiday celebrated on November 11, the solitary ones of the date—11.11—suggesting “bare branches,” the
common slang for singles in China. On this day alone, more than $20 billion in sales, or more than 300 million
orders, takes place on Alibaba’s Internet platforms (e.g., Tmall, Taobao). When global retailers think of mega-sales
online, they generally think of Black Friday or Cyber Monday, but they ought to be watching 11.11 closely as
well, especially as 11.11 doubles the combined sales of those U.S. e-commerce holidays.
Each year, Alibaba handles more than 80 percent of China’s e-commerce business. e company now operates
in 190 countries. Moving forward, the vision for Alibaba is simple: Bring in non-Chinese brands to the Chinese
market and expand products to customers outside of China’s borders. So far, the impact is clear. Beyond its own
employees, Jack Ma claims that Alibaba has created more than 30 million jobs in China related to companies that
sell their products on the Alibaba e-commerce platforms. Ma has also committed to create 1 million new jobs in
the U.S. With such a large scope, the global supply chains that Alibaba facilitates have to be top-notch, innovative,
and always pushing the boundaries for what can be done in delivering products from manufacturers to consumers.
Alibaba does this by focusing on a differentiation strategy, partner connections, buyer protection, mobile
technology, and large-scale product selections. Alibaba’s differentiation strategy entails operating as an
intermediary, connecting buyers and sellers while largely avoiding the need for maintaining capital-intensive
warehouses and depots. Partnering with Alibaba enables small manufacturers and suppliers to reach thousands,
and likely tens of thousands, of new customers. Importantly, in these buyer–seller exchanges, Alibaba emphasizes
buyer protection. at is, if a customer is not satisfied for any reason, he or she can make a refund request. is
consumer focus also carries over to how customers interact with the company. Alibaba has seamlessly adapted its e-
commerce sites to mobile platforms, an important part of its strategy given that more than 80 percent is done via
mobile devices. e large-scale product selection that can be found on the Alibaba platforms has
resulted in some 15 billion products being sold annually and 15 million packages being shipped daily
(compared with 5 billion items on Amazon and 3 million packages per day).
©Drserg/Shutterstock
Sources: “How to Cut Supply Chain Costs: 6 Lessons From Alibaba,” UNA Purchasing Solutions, March 26, 2017; Frank Lavin,
“Alibaba‘s Singles’ Day: What We Know about the World‘s Biggest Shopping Event,” Forbes, November 6, 2016; Bob Bryan, “Alibaba
Just Proved It’s More an Just Some Chinese Company,” Business Insider, November 15, 2015; Catherine Cadell, “Alibaba Posts Record
Singles Day Sales, But Growth Slows,” Technology News, November 11, 2016; Jake Novak, “Here’s the Really Brilliant ing about
Trump’s Meeting with Alibaba’s Jack Ma,” CNBC, January 10, 2017; Brian Deagon, “Alibaba’s Audacious Goal to Reach $1 Trillion in
Merchandise Sales,” Investor’s Business Daily, May 6, 2016; Catherine Clifford, “By the Numbers: Amazon vs. Alibaba,” Entrepreneur, July
13, 2015; Nick Wells, “A Tale of Two Companies: Matching Up Alibaba vs. Amazon,” CNBC, May 5, 2016.
CASE DISCUSSION QUESTIONS
1. According to Alibaba’s promotional efforts and strategic initiatives, Alibaba is on a path to
realizing its vision of facilitating $1 trillion in product sales annually as it also pursues a goal of
reaching 2 billion consumers. It is already the world’s largest e-commerce platform. Can one
company really achieve $1 trillion in sales and reach 2 billion of the world’s 7 billion people?
2. Each year, Alibaba handles more than 80 percent of China’s e-commerce business. e company
now operates in 190 countries (only 196 countries and 61 territories exist in the world). Moving
forward, the vision for Alibaba sounds simple: Bring in non-Chinese brands to the Chinese
market and expand products to customers outside of China’s borders. Do you think this global
strategy is viable?
3. e large-scale product selection that can be found on the Alibaba platforms has resulted in
some 15 billion products being sold annually and 15 million packages being shipped daily
(compared with 5 billion items on Amazon and 3 million packages per day). is puts
tremendous pressure on global supply chains. Can the supply chains continuously facilitate the
increased demand that we as customers place on the global supply chain systems?
Endnotes
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1. T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill Professional, 2014).
2. D. A. Garvin, “What Does Product Quality Really Mean,” Sloan Management Review 26 (Fall 1984), pp. 25–44.
3. See the articles published in the special issue of the Academy of Management Review on Total Quality Management 19, no. 3 (1994). e following article provides a good overview of many of the issues involved from an academic perspective: J. W. Dean and D. E. Bowen, “Management eory and
Total Quality,” Academy of Management Review 19 (1994), pp. 392–418. Also see T. C. Powell, “Total Quality Management as Competitive Advantage,” Strategic Management Journal 16 (1995), pp. 15–37; and S. B. Han et al., “e Impact of ISO 9000 on TQM and Business Performance,”
Journal of Business and Economic Studies 13, no. 2 (2007), pp. 1–25.
4. For general background information, see “How to Build Quality,” e Economist, September 23, 1989, pp. 91–92; A. Gabor, e Man Who Discovered Quality (New York: Penguin, 1990); P. B. Crosby, Quality Is Free (New York: Mentor, 1980); and M. Elliot et al., “A Quality World, a Quality Life,” Industrial Engineer, January 2003, pp. 26–33.
5. G. T. Lucier and S. Seshadri, “GE Takes Six Sigma Beyond the Bottom Line,” Strategic Finance, May 2001, pp. 40–46; and U. D. Kumar et al., “On the Optimal Selection of Process Alternatives
in a Six Sigma Implementation,” International Journal of Production Economics 111, no. 2 (2008), pp. 456–70.
6. M. Saunders, “U.S. Firms Doing Business in Europe Have Options in Registering for ISO 9000
Quality Standards,” Business America, June 14, 1993, p. 7; Han et al., “e Impact of ISO 9000.”
7. G. Stalk and T. M. Hout, Competing against Time (New York: Free Press, 1990).
8. N. Tokatli, “Global Sourcing: Insights from the Global Clothing Industry—e Case of Zara, a
Fast Fashion Retailer,” Journal of Economic Geography 8, no. 1 (2008), pp. 21–39.
9. Diana Farrell, “Beyond Offshoring,” Harvard Business Review, December 2004, pp. 1–8; and M. A. Cohen and H. L. Lee, “Resource Deployment Analysis of Global Manufacturing and Distribution
Networks,” Journal of Manufacturing and Operations Management 2 (1989), pp. 81–104.
10. P. Krugman, “Increasing Returns and Economic Geography,” Journal of Political Economy 99, no. 3 (1991), pp. 483–99; J. M. Shaver and F. Flyer, “Agglomeration Economies, Firm Heterogeneity, and
Foreign Direct Investment in the United States,” Strategic Management Journal 21 (2000), pp. 1175–93; and R. E. Baldwin and T. Okubo, “Heterogeneous Firms, Agglomeration Economies, and
Economic Geography,” Journal of Economic Geography 6, no. 3 (2006), pp. 323–50.
11. For a review of the technical arguments, see D. A. Hay and D. J. Morris, Industrial Economics: eory and Evidence (Oxford, UK: Oxford University Press, 1979). See also C. W. L. Hill and G. R. Jones, Strategic Management: An Integrated Approach (Boston: Houghton Mifflin, 2004).
12. See P. Nemetz and L. Fry, “Flexible Manufacturing Organizations: Implications for Strategy
Formulation,” Academy of Management Review 13 (1988), pp. 627–38; N. Greenwood, Implementing Flexible Manufacturing Systems (New York: Halstead Press, 1986); J. P. Womack, D. T. Jones, and D. Roos, e Machine at Changed the World (New York: Rawson Associates, 1990); R. Parthasarthy and S. P. Seith, “e Impact of Flexible Automation on Business Strategy and
Organizational Structure,” Academy of Management Review 17 (1992), pp. 86–111.
13. B. J. Pine, Mass Customization: e New Frontier in Business Competition (Boston: Harvard Business School Press, 1993); S. Kotha, “Mass Customization: Implementing the Emerging
Paradigm for Competitive Advantage,” Strategic Management Journal 16 (1995), pp. 21–42; J. H. Gilmore and B. J. Pine II, “e Four Faces of Mass Customization,” Harvard Business Review, January–February 1997, pp. 91–101; M. Zerenler and D. Ozilhan, “Mass Customization
Manufacturing: e Drivers and Concepts,” Journal of American Academy of Business 12, no. 1 (2007), pp. 230–62.
14. “Toyota Motor Corporation Captures Ten Segment Awards,” J. D. Power press release, March 19,
2009.
15. M. A. Cusumano, e Japanese Automobile Industry (Cambridge, MA: Harvard University Press, 1989); and T. Ohno, Toyota Production System (Cambridge, MA: Productivity Press, 1990); Womack et al., e Machine at Changed the World.
16. P. Waurzyniak, “Ford’s Flexible Push,” Manufacturing Engineering, September 2003, pp. 47–50.
17. Hult et al., Global Supply Chain Management.
18. F. Kasra, “Making the Most of Foreign Factories,” in World View, ed. J. E. Garten (Boston: Harvard Business School Press, 2000).
19. “e Boomerang Effect,” e Economist, April 21, 2012; and Charles Fishman, “e Insourcing Boom,” e Atlantic, December 2012.
20. is anecdote was told to one of the authors by a Microsoft manager while the author was visiting
Microsoft facilities in Hyderabad, India.
21. Interview by one of the authors. e manager was a former executive MBA student of the author.
22. Hult et al., Global Supply Chain Management.
23. Hult et al., Global Supply Chain Management.
24. D. A. Beeton, Technology Roadmapping in the Packaging Sector (Cambridge, UK: Institute for Manufacturing, University of Cambridge, 2004).
25. J. A. Peterson and V. Kumar, “Can Product Returns Make You Money?” MIT Sloan Management Review 51, no. 3 (2013), pp. 85–89.
26. Hult et al., Global Supply Chain Management; and R. J. Trent and R. M. Monczka, “Achieving Excellence in Global Sourcing,” MIT Sloan Management Review 47, no. 1 (2005), pp. 24–32.
27. M. Kotabe and K. Helsen, Global Marketing Management (Hoboken, NJ: Wiley, 2010).
28. H. F. Busch, “Integrated Materials Management,” IJPD & MM 18 (1990), pp. 28–39.
29. T. Aeppel, “Manufacturers Cope with the Costs of Strained Global Supply Lines,” e Wall Street Journal, December 8, 2004, p. A1.
30. D. J. Bowersox, D. J. Closs, M. B. Cooper, and J. C. Bowersox, Supply Chain Logistics Management (New York: McGraw-Hill Companies, 2012).
31. J. C. Anderson, J. A. Narus, and W. van Rossum, “Customer Value Propositions in Business
Markets,” Harvard Business Review, March 2006, pp. 1–10.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill
Education
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16
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Part 6 International Business Functions
Global Marketing and Business Analytics
L e a r n i n g O b j e c t i v e s After reading this chapter, you will be able to:
LO16-1 Understand the importance of business analytics and international market research.
LO16-2 Explain why it might make sense to vary the attributes of a product from country to country.
LO16-3 Recognize why and how a firm’s distribution strategy might vary among countries.
LO16-4 Identify why and how advertising and promotional strategies might vary among countries.
LO16-5 Explain why and how a firm’s pricing strategy might vary among countries.
LO16-6 Understand how to configure the marketing mix globally.
LO16-7 Describe how globalization is affecting product development.
Fake News and Alternative Facts
Page 440
opening case Advertising is an important part of marketing, but mass advertising, which is generally despised by a lot of people around the world, is more and more becoming an ancient way of doing business. Today, with big data, business analytics, and much more sophisticated international marketing research, customization of advertisements in line with a company’s marketing mix is becoming a must for most multinational corporations. at is not to say that you will not get the customary call to your phone about supporting some cause that you are not interested in, or that an advertisement during a prime time TV show will be for a product you want. Some level of mass marketing will most likely always exist as a form of spreading the word and getting the buzz into the marketplace, engaging people who have not been identified (yet) as within the company’s prime target market, or simply trying to sell more (commodity) products by the old adage that advertising leads to sales.
But we as customers expect more. e least the companies can do, we now expect, is to understand our wants and needs and target advertisements to us appropriately. In such cases, it is also not really an advertisement—it is a form of messaging that informs us of opportunities that we had perhaps not considered. is is one of the strategic elements of Facebook, for example. Today, more than two billion people use Facebook on a monthly basis. Companies around the world can target just the right segment of those two billion Facebook users with advertisements in people’s newsfeeds based on interests and characteristics that are likely to be important and/or similar to existing or potential customers (e.g., demographics, interests, and behaviors). is is targeted global messaging with a much higher probability of customer action than traditional advertising.
While targeted, customized ads seem like they should be preferred over mass advertisements that often annoy people, these customized ads by Facebook and Google, as heavyweights in this space, also annoy customers! Interestingly, Mark Zuckerberg’s former pollster at Facebook, Tavis McGinn, concluded based on a survey that Facebook is having a negative impact on the global society. In effect, customers want companies marketing to them to know who they are and what they may potentially want and need, but they don’t want companies to be too intrusive into their personal life. is is a gigantic challenge that has put Facebook in a negative light. As the founder of Facebook, Zuckerberg clearly set out to collect “big data” on everyone interacting in some way with Facebook and even those who are nonusers.
Amazingly, Facebook with all its sophisticated technology and user tracking got caught off guard in the rollout of the fake news and alternative facts debacle that became pronounced in 2016 through 2018. Organizations, in particular political action organizations, used Facebook for fake news distribution about political competitors (e.g., Donald Trump vs. Hillary Clinton) and political referendum votes (e.g., United Kingdom leaving the European Union). Facebook’s solution apparently is to reduce the visual prominence of feed stories that are fact-checked as false by third-party fact-checkers instead of editorializing those stories by removing them from the Facebook newsfeeds. Clearly, the editorializing/removal would constitute a form of censoring, but if the information is deemed to be inaccurate, what obligation should Facebook have to mark such postings as false and/or remove them altogether?
at people and organizations are using alternative facts when they don’t like or agree with real news based on real data and information is surely problematic. Proponents of “alternative facts” say that it is a way to provide additional facts and information while opponents, of course, say that alternative facts are simply lies and inaccurate information. Most people would argue that information and data should be presented in an accurate, trustworthy, and correct manner, and there is really no middle ground. Interestingly, that is not the crux of the debate. e focus is instead on interpreting the truth of the data and information, the key word being “interpretation.” Apparently everything is open to interpretation. If there is even a tiny sliver of a chance that a piece of data or information is not trustworthy and accurate, a portion of the populace will interpret the data or information as inaccurate if they dislike it (97 percent of the world’s climate scientists agree that global warming is real, but the larger population still cannot totally agree that it is!).
e prevalence of “fake news” and “alternative facts,” whatever your opinion of them, creates a conundrum for global marketing professionals and companies marketing globally. For now, what is real news or not is in
Get Insights by Industry
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the eye of the beholder. What is promotional or trustworthy for one customer can be viewed as an opinionated viewpoint or a downright false claim by another in the overheated atmosphere where a general mistrust prevails. Clearly fake news is not new and did not start in 2016, even though it got popularized at that time. Companies can leverage big data, business analytics, and international marketing research today in sophisticated ways that potentially should be good for society and useful to the consumer. But the temptation to make fake news is a troublesome development abetted by technology—at least as long as (some) people
believe the storyline. •
Sources: Rani Molla and Kurt Wagner, “Many Believe Facebook Is Having a Negative Impact on Society around the World,” Recode, April 12, 2018; uy Ong, “Facebook Is Shrinking Fake News Posts in the News Feed,” e Verge, April 30, 2018; “Scientists Agree: Global Warming is Happening and Humans Are the Primary Cause,” Union of Concerned Scientists, January 9, 2018; “Demand for Lies and Misinformation Encourages Media Organizations to Provide em,” e Economist, April 5, 2018; and “Fake News: You Ain’t Seen Nothing Yet,” e Economist, July 1, 2017.
Introduction
Chapter 15 looked at the roles of global production and supply chain management in an international business. is chapter continues our focus on specific business functions by examining the roles of global marketing and research and development (R&D). We focus on how marketing and R&D can be performed so they will reduce the costs of value creation and add value by better serving customer needs in the global marketplace. is includes distribution strategy (sometimes also called marketing channels), which is part of global supply chains that we discussed in Chapter 15.
When conducting research and development (R&D) and creating international marketing campaigns, the vast majority of global companies focus on the customers’ needs in a particular industry. Industries worldwide are classified according to the Harmonized Commodity Description and Coding System, or simply HS Codes, which are maintained by the World Customs Organization. e HS Codes are divided into about 20 sections for its roughly 5,000 commodity groups. e “Get Insights by Industry” section on globalEDGE™ (globaledge.msu.edu/global-insights/by/industry) is a great source for international business–related resources, statistics, risk assessments, regulatory agencies, corporations, and events for these 20 industry sectors. An interesting aspect of each industry section on globalEDGE™ is the rating provided of the industry’s level of fragmentation. Highly concentrated industries are dominated by many large firms that are capable of shaping the industry’s direction and price levels. Highly fragmented industries have many companies involved, with none of them really large enough to be able to influence the industry’s direction or price levels. Which do you think is more fragmented: consumer products or technology? Check out the industry section on globalEDGE™ for an answer.
In Chapter 13, we spoke of the tension existing in most international businesses between the need to reduce costs and, at the same time, respond to local conditions, which tends to raise costs. is tension continues to be a persistent theme in this chapter. Basically, the world is becoming more globalized in some respects but remains different in others. A global marketing strategy that views the world’s consumers as similar in their tastes and preferences is consistent with the mass production of a standardized output. By mass-producing a standardized output—whether it
be soap, semiconductor chips, or high-end apparel—the firm can realize substantial unit cost reductions from experience curve effects and other economies of scale.
At the same time, ignoring country differences in consumer tastes and preferences can lead to
failure. Some industries are more ripe for globalization than others; check out the globalEDGETM
“Get Insights by Industry” section for comparisons. Strategically, the global marketing function of a company needs to determine when product standardization is appropriate, how standardized it can be, and when it is not in the business’s best interest to standardize a product too much. And, even if product standardization is appropriate, the way in which a product is positioned in a market and the promotions and messages used to sell that product may still have to be customized so that they resonate with local consumers.
ankfully, we are now in a time when homogenization of customers’ needs and wants, especially of younger populations across developed and emerging nations, help marketing professionals sell products and services globally. To some degree, the globalization of product and service needs is age- dependent. Younger people want more similar products worldwide and actually expect to be able to buy any products anywhere and get them immediately. Globalization is also industry-dependent in that some industries are more likely to be able to standardize their products and value proposition (e.g., electronics) than other industries (e.g., furniture), at least not to the same degree, based on customers’ desires. is chapter is exciting as a learning experience because globalization has increased the pressure on marketing to deliver on product quality and availability in a far-spanning way worldwide, with effective distribution strategies, appropriate communication strategies, and competitive pricing strategies.
We consider marketing and R&D within the same chapter because of their close relationship. A critical aspect of the marketing function is identifying gaps in the market so that the firm can develop new products to fill those gaps. Developing new products requires R&D—thus the linkage between marketing and R&D. A firm should develop new products with market needs in mind, and marketing is best suited to define those needs for R&D personnel, given, among many things, its closeness to the market via front-line customer service personnel. Also, marketing personnel are well suited to communicate to R&D personnel whether to produce globally standardized or locally customized products. e reason marketing is so well positioned to communicate with R&D about (1) customer needs and wants and (2) degree of product standardization or customization needed is that the marketing function is responsible for the international marketing research that is conducted by the global company. Overall, our thinking here is in line with long-standing research that maintains that a major contributor to the success of new-product introductions is a close relationship between
marketing and R&D.1
In this chapter, we begin by reviewing the debate on the globalization of markets. en we discuss the issue of market segmentation. Next, we look at four elements that constitute a firm’s marketing mix: product attributes, distribution strategy, communication strategy, and pricing strategy (these are sometimes called the 4 Ps for product, place, promotion, and price in many basic marketing texts). e marketing mix is the set of choices the firm offers to its targeted markets. Many firms vary their marketing mix from country to country, depending on differences in national culture, economic development, product standards, distribution channels, and so on. e best way to think about the marketing mix is that it represents the tactical activities and behaviors that are implemented by a global company based on its international marketing strategy to offer the best possible “mix” of product, distribution, communication, and price to a specific target market in a country or region.
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Given the importance of the marketing mix and having the right products, we include three sections on those topics in this chapter after we provide a detailed discussion of the marketing mix elements. First, we have a section on configuring an appropriate marketing mix for each unique international market segment. is includes a set of sample questions to ask for each of the marketing mix elements (product, distribution, communication, and price) to gauge how standardized or customized a marketing mix should be for a certain international market segment. Next, we discuss international market research as a way to better understand how to configure the marketing mix for international market segments. ird, we focus a discussion on product development issues, with a particular emphasis on new-product development. Here we integrate R&D, marketing, and production issues along with management issues such as cross-functional teams.
Globalization of Markets and Brands
In a now-classic Harvard Business Review article, eodore Levitt wrote lyrically about the globalization of world markets. Levitt’s arguments have become something of a lightning rod in the debate about the extent of globalization. According to Levitt,
A powerful force drives the world toward a converging commonality, and that force is technology. It has proletarianized communication, transport, and travel. e result is a new commercial reality —the emergence of global markets for standardized consumer products on a previously unimagined scale of magnitude.
Gone are accustomed differences in national or regional preferences. e globalization of markets is at hand. With that, the multinational commercial world nears its end, and so does the multinational corporation. e multinational corporation operates in a number of countries and adjusts its products and practices to each—at high relative costs. e global corporation operates with resolute consistency—at low relative cost—as if the entire world were a single entity; it sells the same thing in the same way everywhere.
Commercially, nothing confirms this as much as the success of McDonald’s from the Champs Élysées to the Ginza, of Coca-Cola in Bahrain and Pepsi-Cola in Moscow, and of rock music, Greek salad, Hollywood movies, Revlon cosmetics, Sony television, and Levi’s jeans everywhere.
Ancient differences in national tastes or modes of doing business disappear. e commonalty of preference leads inescapably to the standardization of products, manufacturing, and the
institutions of trade and commerce.2
is is eloquent and evocative writing, but is Levitt correct? e rise of the global media phenomenon from CNN to MTV and the ability of such media to help shape a global culture would seem to lend weight to Levitt’s argument. If Levitt is correct, his argument has major implications for the marketing strategies pursued by international businesses. However, many academics feel that Levitt
overstates his case.3 Although Levitt may have a point when it comes to many basic industrial products, such as steel, bulk chemicals, and semiconductor chips, globalization in the sense used by Levitt seems to be the exception rather than the rule in many consumer goods markets and industrial markets. Even a firm such as McDonald’s, which Levitt holds up as the archetypal example of a consumer products firm that sells a standardized product worldwide, modifies its menu from country to country in light of local consumer preferences. In select Arab countries and Pakistan, for example,
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McDonald’s sells the McArabia, a chicken sandwich on Arabian-style bread, and in France, the
Croque McDo, a hot ham and cheese sandwich.4
On the other hand, Levitt is probably correct to assert that modern transportation and communications technologies are facilitating a convergence of certain tastes and preferences among consumers in the more advanced countries of the world, and this has become even more prevalent since he wrote his article. By extension, in the long run, technological and other forces may lead to the evolution of a global culture. At present, however, the continuing persistence of some unique cultural and economic differences between nations acts as a brake on many trends toward the standardization of consumer tastes and preferences across nations. While we see more homogenization and standardization of needs and wants among younger people, typically 40 years and younger, there are still wide gaps in tastes among older people. What will be interesting to find out is if this increased homogenization among younger people will remain when they become older. Some indications exist that standardization of needs and wants stays with people when they become older, but, at least anecdotally, we also see people adopt more culturally specific needs as they grow older.
So, we may never see a world where globalization is fully spread across the almost 200 countries that exist (see globaledge.msu.edu for a comparison of information and data on the countries in the world). Some writers have argued that the rise of global culture does not mean that consumers share
the same tastes and preferences.5 Rather, people in different nations, often with conflicting viewpoints, are increasingly participating in a shared “global” conversation, drawing on shared symbols that include global brands from Nike and Dove to Coca-Cola and Sony but also Toyota and Volkswagen,
as the world’s largest automobile makers.6 But the way in which these brands are perceived, promoted, and used still varies from country to country, depending on local differences in tastes and preferences.
Will Toyota Stay Number 1?
Yundong, or Cloud Action, is Toyota China’s first-ever strategic plan for its business in China. China is the “most important” market in the world, but the Japanese carmaker has less than 10 percent of the auto market, far behind global rivals such as General Motors and Volkswagen. e auto giant aims to become a company “that is beyond consumers’ expectations and creates happiness and fortune for consumers and the regions where it operates,” emphasizing local responsiveness to Chinese customers but still maintaining a global strategy. e Yundong plan combines the company’s global strategy and local marketing operation, which will bring advanced technologies to the local market, improve the local management and marketing system, and build “exciting” products “that touch the hearts of Chinese consumers and are beyond their expectations” according to company officials. China is clearly an important market if Toyota is to maintain the overall worldwide leadership in auto sales. Do you think Toyota will capture a significant share of the Chinese auto market? And do you think Toyota can maintain its number one position in the worldwide auto market?
Sources: ChinaDaily.com; and J. Korceniewski, “Toyota Is World’s Top-Selling Automaker for Second Year in a Row,” Autoblog, January 26, 2014, www.autoblog.com/2014/01/26/toyota-worlds-largest-automaker-2014.
Another reason it appears that globalization is spreading is that certain products simply exist everywhere—but that does not mean consumers everywhere prefer those products over more local options if such product alternatives existed. Better technology, production processes, and innovation may lead to better local product alternatives in the future that can compete with global products. If so,
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international marketing is going to be even more critical than it already is for global and local
companies.7 Furthermore, trade barriers and differences in product and technical standards also constrain a firm’s ability to sell a standardized product to a global market using a standardized marketing strategy. We discuss the sources of these differences in subsequent sections when we look at how products must be altered from country to country. In short, Levitt’s fully standardized international marketplace is some way off in many industries.
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Market Segmentation
Market segmentation refers to identifying distinct groups of consumers whose needs, wants, and purchasing behavior differ from others in important ways. Markets can be segmented in numerous ways: by geography, demography (e.g., gender, age, income, race, education level), sociocultural factors (e.g., social class, values, religion, lifestyle choices), and psychological factors (e.g., personality). Because different segments exhibit different needs, wants, and patterns of purchasing behavior, firms often adjust their marketing mix from segment to segment. us, the precise design of a product, the pricing strategy, the distribution channels used, and the choice of communication strategy may all be varied from segment to segment. e goal is to optimize the fit between the purchasing behavior of consumers in a given segment and the marketing mix, thereby maximizing sales to that segment. Automobile companies, for example, use a different marketing mix to sell cars to different socioeconomic segments. us, Toyota uses its Lexus division to sell high-priced luxury cars to high- income consumers while selling its entry-level models, such as the Toyota Corolla, to lower-income consumers. Similarly, computer manufacturers will offer different computer models, embodying different combinations of product attributes and price points, to appeal to consumers from different market segments (e.g., business users and home users).
When managers in an international business consider market segmentation in foreign countries, they need to be cognizant of two main issues: the differences between countries in the structure of market segments and the existence of segments that transcend national borders. For example, some companies opt to target a country with a number of different product options based on the multiple unique market segments in a country. Other companies opt to target one unique market segment in a country that also has parallels in other countries. A segment that spans multiple countries, transcending national boarders, is often called an intermarket segment. Strategically, marketing managers have marketing mix options with these two choices. Targeting one country and its multiple potential market segments with multiple marketing mixes allows a company to focus on the cultural characteristics of one country (or the characteristics of a manageable set of countries). Targeting many countries and the intermarket segment that has characteristics that are largely the same across countries allows a company to focus on the cultural characteristics that are universal for certain customers across countries.
ese are important choices because the structure of the many potential market segments may differ significantly from country to country as well as within countries. In fact, an important market
segment in a foreign country may have no parallel in the firm’s home country, and vice versa. In such a case, the focus cannot be on an intermarket segment, at least not one involving the home-country market. e firm may have to develop a unique marketing mix to appeal to the needs, wants, and purchasing behavior of a certain segment in a given country. An example of such a market segment is given in the accompanying Management Focus, where Marvel Studios targets certain audiences with its various super hero movies—the most recent being the Black Panther, which has reached Marvel’s most diverse audience ever.
m a n a g e m e n t F O C U S
Global Branding, Marvel Studios, and Walt Disney Company
Marvel Studios is an American TV and motion picture studio that is part of Marvel Entertainment, a wholly owned subsidiary of the Walt Disney Company. As a part of the Walt Disney Empire, Marvel Studios operates jointly with Walt Disney Studios on distribution and marketing of Marvel’s films, such as the incredibly successful Iron Man and Avengers movies. Other high-profile projects of Marvel Studios have included the X- Men, Spider-Man, and Captain America franchises. Anything embedded in the global branding of the Walt Disney Company has tremendous potential, reach, and longevity.
Walter Elias “Walt” Disney was an American business mogul as well as animator, cartoonist, director, philanthropist, producer, screenwriter, and voice actor who lived from 1901 to 1966. An international icon, he started Disney Brothers Cartoon Studio with his brother, Roy O. Disney, in 1923. e current name of the Walt Disney Company has been around since 1986. Disney has one of the largest and most well-known studios in the world. It also operates numerous related businesses, such as the ABC broadcast TV network, cable TV networks (e.g., Disney Channel, ESPN), publishing, merchandising, theater divisions, theme parks (e.g., Disney World, Disneyland), and much more. Mickey Mouse is the primary symbol of the Walt Disney Company, and one of the most globally recognized brands ever!
Global branding is a staple at Walt Disney, and this branding prowess carries well to the Marvel Studios projects. In a global branding move, the post-credits to the original Iron Man movie had S.H.I.E.L.D. director Nick Fury visit Tony Stark’s home. Fury told Stark that Iron Man is not “the only superhero in the world,” and says that he wants to discuss the “Avenger’s Initiative.”
e Avengers and Iron Man movie franchises have made billions of dollars for Marvel Studios. ey have also contributed heavily to making Robert Downey, Jr. one of the highest paid actors in Hollywood. Robert Downey, Jr. was born in 1965 in the United States. He made his movie debut at the age of five when he appeared in his father’s movie titled Pound. e “up-and-down-and-up” career of Downey is also a fascinating global brand story. He is riding high with three incredible multi-sequel franchises—Iron Man, e Avengers, and Sherlock Holmes. He has also portrayed Tony Stark—his Iron Man and Avengers character—in several other related Marvel Studios projects (e.g., e Incredible Hulk, Captain America: Civil War, Spider-Man: Homecoming) and coming sequels.
Iron Man premiered April 30, 2008, in international markets and a few days later in the United States. Amazingly, the movie had been in development since 1990 at Universal Pictures, 20th Century Fox, and New Line Cinema. Marvel Studios reacquired the rights to the movie in 2006. e basic plot has playboy, philanthropist, and genius Tony Stark (played by Downey) as the “superhero.” Iron Man is a fictional character that first appeared in the Marvel Comics, Tales of Suspense, in 1963. e character itself was created by Stan Lee. Iron Man 2 was released in 2010, and Iron Man 3 was released in 2013.
e Avengers premiered on April 11, 2012, at the El Capitan eatre in Hollywood. e film’s development began in 2005, is based on the Marvel Comics superhero team with the same name, and was
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written and directed by Joss Whedon. e Avengers are a superhero team with familiar heroes such as Iron Man, Captain America, Hulk, or, Black Widow, Hawkeye, and so on. No one really plays the superhero, although Scarlett Johansson’s role as Black Widow was important to the movie franchise; it set the release date back from 2011 to 2012 to accommodate her inclusion. e second movie in the Avengers franchise came out on May 1, 2015, in the United States (e Avengers: Age of Ultron), and the third movie (Avengers: Infinity War) came out in 2018, with the next installment (Avengers 4) scheduled for release in May of 2019.
While the movie character Iron Man is heavily connected to Downey, he also plays an integral part of Tony Stark in e Avengers. In doing so, the actor has been part of Marvel Studios productions that have brought in more than $1.5 billion (e Avengers) and $1.2 billion (Iron Man 3). Iron Man 1 and Iron Man 2, respectively, made more than $600 million each as well. In total, Downey has starred in six films that have made more than $500 million each at the box office worldwide and numerous other successful movies as a part of the Marvel Studios lineup.
e connection between Tony Stark as Iron Man in the Iron Man franchise and in the Avengers franchise is perhaps not needed for the movie plot in e Avengers or its sequels. Marvel Comics has drawn from more than 100 characters for its Avengers superheroes since 1963, but Iron Man was one of the original ones (along with Ant-Man, the Wasp, or, and the Hulk). e global branding success of Tony Stark, as played by Robert Downey Jr., across these two brands is also very advantageous for Marvel Studios’ global branding.
Sources: Megan Peters, “e MCU Will Be Very Different After Avengers 4,” Comic Book, April 23, 2017; K. Buchanan and J. Wolk, “How Vulture Ranked Its 2013 Most Valuable Stars List,” Vulture, October 22, 2013; T. Culpan, “HTC Said to Hire Robert Downey Jr. for $12 Million Ad Campaign,” Bloomberg Businessweek, June 20, 2013; C. Isidore, “Avengers Set to Rescue Disney and Hollywood,” CNNMoney, May 7, 2012; and “Iron Man 3: Clank Clank Bang Bang,” e Wall Street Journal, May 2, 2013.
In another example, a segment of consumers in China in the 55-to-65 age range has few
parallels in other countries.8 is group came of age during China’s Cultural Revolution. e group’s values have been shaped by their members’ experiences during the Cultural Revolution. ey tend to be highly sensitive to price and respond negatively to new products and most forms of marketing. us, firms doing business in China may need to customize their marketing mix to address the unique values and purchasing behaviors of the group. e existence of such a segment constrains the ability of firms to standardize their global marketing strategy.
In contrast, the existence of market segments that transcend national borders clearly enhances the ability of an international business to view the global marketplace as a single entity and pursue a global strategy—selling a standardized product worldwide and using the same basic marketing mix to help position and sell that product in a variety of national markets. For a segment to transcend national borders, consumers in that segment must have some compelling similarities along important dimensions—such as age, values, lifestyle choices—and those similarities must translate into similar needs, wants, and purchasing behavior. If this is true, the company can globalize its marketing mix efforts by adopting the so-called intermarket segment to target customers’ needs, wants, and purchasing behavior. Although such segments clearly exist in certain industrial markets, they have historically been rarer in consumer markets.
e forecast, however, is that these intermarket segments will become more and more common with the increased globalization among younger consumers (40 years and younger) in the developed- and emerging-country markets. For example, one emerging global segment that is attracting the attention of international marketers of consumer goods is the global teenage segment. Global media are paving the way for a global youth segment. Evidence that such a segment exists comes from a study
of the cultural attitudes and purchasing behavior of more than 6,500 teenagers in 26 countries.9 e
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findings suggest that teens and young adults around the world are increasingly living parallel lives that share many common values. It follows that they are likely to purchase the same kind of consumer goods and for the same reasons.
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Business Analytics
LO 16-1 Understand the importance of business analytics and international market research.
In the context of companies focusing on the global marketplace as their current or potential market to target customers, business analytics can be defined as the knowledge, skills, and technology that allow for the exploration as well as deeper investigation of a company’s international business strategies and activities to gain insight and drive future strategy development and implementation. e extension of this definition is that business analytics has become the preferred terminology when we talk about understanding data and help companies develop and maintain a particular customer strategy.
Broadly, the process of using business analytics begins with a dataset that has been collected to address a specific international business issue. e knowledge and skills that the business analyst’s previous experiences and education have resulted in serve as the guide for the type of data collected. After the data have been collected or compiled, technologies such as computer clouds, data warehousing, or traditional office computers can store data. If the database includes smaller datasets (e.g., a few hundred cases and dozens of variables), then storage can be done on almost any technological device (e.g., secured office computer). If the data is larger—“big data”—where the data include a massive volume of both structured and unstructured data that are so large they may be difficult to process using traditional database and software techniques, then the data would often be stored on large-scale servers (e.g., computer clouds, data warehousing).
Business analytics can be focused on one of three core applications: descriptive, predictive, and prescriptive. Descriptive analytics refers to the use of relatively simple statistical techniques to describe what is contained in a dataset. For example, the descriptive statistics can be an age bar chart that is used to depict Starbucks customers in Uppsala, Sweden (a medium-sized university town in the middle of Sweden). is would give the Starbucks franchise owner a basic understanding of the clientele he or she has developed and, perhaps, a better understanding of the type of bakery items to offer in the store. e purpose of descriptive analytics is to get a rough picture of what the data look like in the most general sense.
Predictive analytics can be defined as the use of advanced statistical techniques (and software) to identify and build predictive models that can help to identify trends and relationships not readily observed in descriptive analyses. Oftentimes, we talk about the use of longitudinal data that can help show cause-and-effect relationships (i.e., an increase in social media exposure for Starbucks in Uppsala, Sweden leads to an increase in number of cups of coffee sold at the local Uppsala, Sweden Starbucks location within two weeks of the increased social media coverage).
Prescriptive analytics can be defined as the use of management science methodologies (i.e., applied mathematical techniques) to guide a company in its endeavors to best use allocable resources. For example, the Starbucks store in Uppsala, Sweden has a limited budget to allocate to advertising to target customers (which is often the case for franchise owners for their specific store). In such a case, management science tools (e.g., linear programming) can be used to optimally allocate advertising spending to various advertising opportunities (e.g., social media interactions driven by the local Starbucks store, advertising in the newspaper or on the local radio station, or messaging via Snapchat, Instagram, and similar vehicles). e goal then is to allocate the Starbucks store’s limited resources optimally and to include the best possible trends or future opportunities.
Whether we talk about “small data” or “big data,” business analytics can be used to better understand a company’s current products and services in the global marketplace and future business opportunities. To effectively configure the marketing mix and answer questions such as those in Table 16.1 (which we will discuss later in this chapter), global companies use the toolkit offered within business analytics and conduct international marketing research.
16.1 TABLE
Questions to Address to Configure the Marketing Mix
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INTERNATIONAL MARKETING RESEARCH
To effectively segment the global marketplace, companies conduct international marketing research. International market research is defined as the systematic collection, recording, analysis, and interpretation of data to provide knowledge that is useful for decision making in a global company. Compared with market research that is domestic only, international market research involves additional issues such as (1) translation of questionnaires and reports into appropriate foreign languages and (2) accounting for cultural and environmental differences in data collection. In this section, some of the more prominent international market research companies are highlighted; the basic steps and issues in conducting international market research are then discussed.
International market research is one of the most critical aspects of understanding the global marketplace. Given this importance, global companies often have their own in-house marketing
research department to continually assess customers’ needs, wants, and purchasing behavior.10 In addition, global companies also typically undertake ongoing data collection to assess customers’
satisfaction with products and services offered.11 J.D. Power (www.jdpower.com) and the American Customer Satisfaction Index (ACSI) (www.theacsi.org) are two of the most prominent companies that measure customer satisfaction of a cross-section of the industries globally. In addition, for large-scale projects such as better understanding a new country market, global companies often work with outside marketing research firms for input. A sample of prominent international market research firms includes Nielsen, Kantar, Ipsos, and the NPD Group.
Nielsen (www.nielsen.com) is an international market research company with headquarters in New York in the United States and Diemen in the Netherlands. e company was founded in 1923, is active in more than 100 countries, employs about 40,000 people, and has revenue of
about $6 billion annually.12 Nielsen says on its website that “Whether you’re eyeing markets in the next town or across continents, we understand the importance of knowing what consumers
watch and buy.”13
Kantar (www.kantar.com) is an international market research company based in London. e company was founded in 1993 as the market research, insight, and consultancy division of WPP (an advertising and public relations firm). It operates in more than 100 countries, employs some 28,000 people, and has revenues of about $4 billion annually. As a conglomerate of research companies, Kantar works with more than half of the Fortune 500 companies (a kantar is a measure for cotton that is still used in the ports of Egypt today). Ipsos (www.ipsos.com) is an international market research company based in Paris, France. e company was founded in 1975, has offices in some 90 countries, employs about 15,000 people, and has revenue of about $2 billion annually. Ipsos is now the only major international market research firm that is controlled and operated by market researchers; it focuses on a mantra of BQC (“better, quicker, cheaper”) as a way to be competitive in the global marketplace. NPD Group (www.npd.com) is an international market research firm based in Port
Washington, New York.14 e company was founded in 1967, has 25 worldwide offices, employs about 5,000 people, and is a privately held company (estimated to have revenues of about $500 million annually). NPD Group is known for its retail tracking services and market size and trends analysis. Today, it tracks businesses that represent more than $1 trillion in sales worldwide.
Nielsen, Kantar, Ipsos, and the NPD Group, along with many other market research firms, follow a similar process when conducting international market research. e basic data that companies want collected in international market research include (1) data on the country and potential market segments (geography, demography, sociocultural factors, and psychological factors), (2) data to forecast customer demands within specific country or world region (social, economic, consumer, and industry trends), and (3) data to make marketing mix decisions (product, distribution, communication, and price). e data collection needed to address these three areas always entails give-and-take in terms of time, cost, and available data collection techniques. e process, however, is somewhat universal across both domestic and international settings and includes (1) defining the research objectives, (2) determining the data sources, (3) assessing the costs and benefits of the research, (4) collecting the
data, (5) analyzing and interpreting the research, and (6) reporting the research findings.15 Each step is discussed in more detail in the following paragraphs (see Figure 16.1).
16.1 FIGURE
International market research steps.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
Defining the research objectives includes both (1) defining the research problem and (2) setting objectives for the international market research. At the outset of any international market research project, one of the problem areas is to have a baseline understanding of a country market or target segment that is sufficient enough to properly capture what should be done and what can be accomplished with the research. Oftentimes, the research starts with a relatively vague idea of the research problem and the objectives, subsequently refined when a better understanding of country
markets and potential customer segments has been reached and more data have been collected.16 One of the most critical aspects of the early stages of international market research is a willingness to refine the research problem and objectives throughout the process; not doing so may lead to unwanted conclusions. For example, not understanding the scope of the research problem (i.e., children turning to more electronic devices and video games) and accompanying objectives led Mattel Inc., the world’s largest toy maker by sales, to suffer dismal holiday season sales. While the NPD Group reported that U.S. toy sales dropped just 1 percent, Mattel’s CEO, Bryan G. Stockton, concluded that “our product
innovations and our marketing programs were not strong enough.”17
Determining the data sources that will address specific research problems and ultimately achieve the objectives is often not an easy task, especially if the international market research spans more than one country market. In market research, we talk about two forms of data that can be used: primary and
secondary data.18 Primary data refers to data collected by the global company and/or its recruited international market research agency for the purpose of addressing the research problem and objectives defined by the company. Given the costs of collecting international data, most companies try to avoid duplicating similar data that have been collected previously. However, for more than half of the world’s countries, so-called secondary data that can be helpful can be tough to come by, are often unreliable, and typically do not address what global companies require to better understand the needs, wants, and purchasing behaviors of targeted customers. Secondary data refers to data that have been collected
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previously by organizations, people, or agencies for purposes other than specifically addressing the research problem and objectives at hand. Overall, the data used in international market research should be evaluated based on (1) availability, (2) comparability across countries and potential market segments, (3) reliability (whether the research produces consistent results), and (4) validity (whether the research measures what it set out to measure). globalEDGE.msu.edu is a great starting point for secondary data on countries and industries, among many data categories, and the research firms mentioned earlier (i.e., Nielsen, Kantar, Ipsos, and the NPD Group) are great organizations used by many global companies for primary data collection worldwide.
Assessing the costs and benefits of the research often relates to the cost of collecting primary data that can address the research problem and objectives directly versus using available secondary data. If secondary data are available, such data are typically available as a less costly alternative to collecting primary data. e costs that drive up the spending in primary data collections broadly include survey development and sampling frame issues. For the survey, the questions have to be developed so that they clearly communicate the attitudes, attributes, or characteristics about a product or customer issue in such a way that the respondent recognizes the value. is also means overcoming any barriers or differences in language, answer choices, and cultural values and beliefs. For example, the most common way of converting a survey question into another language is to have the question translated into the foreign language (e.g., from English to Spanish) and then back-translated into English again by another person. e two English versions are then compared to ensure similarity in the back- translated version with the original. For the sampling frame, one of the core issues internationally is to make sure that comparable samples can be drawn in the countries in which international market research is conducted. is includes identifying reliable lists or groups of potential people to survey
and cultivating potential people to respond to the survey.19
Collecting the data simply refers to gathering data via primary or secondary methods that address the research problem and objectives that the global company has established. e two mechanisms to collect data are quantitative and qualitative data collection. Quantitative methods include experiments, clinical trials, observing and recording events, and administering surveys with closed-end questions. e goal of quantitative methods is to systematically gain an understanding of customers’ needs, wants, and purchase behavior via numerical data and computational techniques. A popular way of collecting quantitative data today is to use online surveys and consumer mail panels. Most large international market research firms have access to global customer mail panels and potential sampling frames that target both business-to-business customers and end-customers. Qualitative methods include in-depth interviews, observation methods, and document reviews. Here, the focus is broad- based questions aimed at gaining an in-depth understanding of customers’ needs, wants, and purchase behaviors.
Analyzing and interpreting the research begins when the data have been collected. Assuming the survey is reliable and valid, whether the data come from primary or secondary data collection methods, analyzing and interpreting the data is an important step in the international market research process. It takes a fairly high degree of knowledge—both statistically and culturally—to analyze and interpret international market research. First, statistically the goal should be to use the technique that best addresses the research problem—often stated in the form of research questions or hypothesis (a specified relationship between study variables). ere is a plethora of quantitative and qualitative methods of analyzing data, often taught in sophisticated marketing research programs around the
world.20 In these programs, software such as SAS, SPSS, LISREL, and Smart-PLS21 are used for quantitative analysis, and ATLAS.ti and MAXQDA are used for qualitative methods. Second, the
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researcher interpreting the findings must be in tune culturally with the values, beliefs, norms, and artifacts that affect a respondent’s answers in a certain world region, country, and/or subculture. If possible, it is always advisable to include at least one native of the country being researched to add to the understanding of the research findings, social customs, semantics, attitudes, and business customs. For example, some societies have a tendency to not provide extreme answers (e.g., strongly agree or strongly disagree) to questions but instead answer by using middle-of-the-scale choices (e.g., Japan), while other countries use more of the extreme answer choices (e.g., the United States).
Reporting the research findings is a way to communicate the overall results of the international market research project. Such reports often include information about customers, competitors, countries, the industry, and the environment that affect how the global company develops an appropriate marketing mix for the targeted international market segment. Ultimately, the focus will be on how best to reach customers by addressing their needs, wants, and purchasing behavior in a way that is competitive vis-à-vis existing competitors and potential new entrants into the market. Ideally, top executives who receive the report should have been part of the formulation of the research problem and objectives earlier on in the international market research process. Preferably, they should also take part in some of the fieldwork to collect the data to better understand the voices of customers. If critical employee levels of the global company—from front-line service employees to market researchers to top executives—are insiders of the culture in which the customers are targeted, a lot of misunderstanding and faulty market research can be prevented. e worst-case scenario would be if customers misunderstand the questions and managers misunderstand the answers! One such example was the case of the Toyota accelerator debacle. Toyota had issues with accelerator
pedals that could get stuck, causing vehicles to speed unintentionally.22 Toyota was slow to correct the problems with the accelerator due to a disconnect between identifying the problem (i.e., it did not know why the accelerator pedals got stuck), analyzing the damage, and reporting it to senior management for rectification. Culturally, Japan prides itself on quality products, which means that disclosing poor quality, assuming responsibility, communicating with senior management, and fixing the problem are very difficult tasks within a Japanese firm.
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Product Attributes
LO 16-2 Explain why it might make sense to vary the attributes of a product from country to country.
A product can be viewed as a bundle of attributes.23 For example, the attributes that make up a car include power, design, quality, performance, fuel consumption, and comfort; the attributes of a hamburger include taste, texture, and size; a hotel’s attributes include atmosphere, quality, comfort, and service. Products sell well when their attributes match consumer needs (and when their prices are appropriate). BMW cars sell well to people who have high needs for luxury, quality, and performance precisely because BMW builds those attributes into its cars. If consumer needs were the same the world over, a firm could simply sell the same product worldwide. However, consumer needs vary from
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country to country, depending on culture and the level of economic development. A firm’s ability to sell the same product worldwide is further constrained by countries’ differing product standards. is section reviews each of these issues and discusses how they influence product attributes.
CULTURAL DIFFERENCES
We discussed countries’ cultural differences in Chapter 4. Countries differ along a whole range of
dimensions, including social structure, language, religion, and education.24 ese differences have
important implications for marketing strategy.25 For example, “hamburgers” do not sell well in Islamic countries, where the consumption of ham is forbidden by Islamic law (thus, the sandwich’s name is changed). e most important aspect of cultural differences is probably the impact of tradition. Tradition is particularly important in foodstuffs and beverages. For example, reflecting differences in traditional eating habits, the Findus frozen food division of Nestlé, the Swiss food giant, markets fish cakes and fish fingers in Great Britain, but beef bourguignon and coq au vin in France and vitéllo con funghi and braviola in Italy. In addition to its normal range of products, Coca-Cola in Japan markets Georgia, a cold coffee in a can, and Aquarius, a tonic drink, both of which appeal to traditional Japanese tastes.
For historical and idiosyncratic reasons, a range of other cultural differences exist among countries. For example, scent preferences differ from one country to another. SC Johnson, a manufacturer of waxes and polishes, encountered resistance to its lemon-scented Pledge furniture polish among older consumers in Japan. Careful market research revealed the polish smelled similar to a latrine
disinfectant used widely in Japan. Sales rose sharply after the scent was adjusted.26
ere is some evidence of the trends Levitt talked about. Tastes and preferences are becoming more cosmopolitan. Coffee is gaining ground against tea in Japan and the United Kingdom, while American-style frozen dinners have become popular in Europe (with some fine-tuning to local tastes). Taking advantage of these trends, Nestlé has found that it can market its instant coffee, spaghetti bolognese, and Lean Cuisine frozen dinners in essentially the same manner in both North America and Western Europe. However, there is no market for Lean Cuisine dinners in most of the rest of the world, and there may not be for years or decades. Although some cultural convergence has occurred, particularly among the advanced industrial nations of North America and Western Europe, Levitt’s global culture characterized by standardized tastes and preferences is still a long way off.
Takayama vending machine coffee in Japan.
©Phillip Augustavo/Alamy Stock Photo
Can Spotify and Coca-Cola Leverage eir Partnership for Sales?
Swedish music-streaming service Spotify has gained access to Coca-Cola’s global marketing engine, and Coca- Cola can use Spotify tunes in its online marketing. Spotify is hoping that Coke will teach the world to click its play button. e Swedish digital music service has a broad-ranging marketing deal with Coca-Cola Co. that could help turbocharge the number of people who are exposed to, and ultimately sign up for, Spotify. For Spotify, getting access to Coca-Cola’s formidable global marketing engine will come in handy as it expands its international footprint. In return, Coca-Cola can now use Spotify’s service to instantly add music to its online marketing repertoire. For instance, the drink giant can add songs to its Facebook page via Spotify without having to negotiate licenses for each tune (Spotify already has financial agreements with major record labels to pay royalties for every song that is played on its digital service). ese co-branding deals sometimes motivate customers to buy more from each company—if you are a fan of Spotify, you may buy more from Coca-Cola, and vice versa. If your favorite company co-branded with a company you have never bought from, would you try that company’s products?
Sources: A. Pham, “Spotify and Coca-Cola Form Marketing Partnership,” Los Angeles Times, April 18, 2012, http://articles.latimes.com/2012/apr/18/business/la-fi-ct-spotify-coca-cola-20120419; and “Spotify and Coca-Cola Partner to Share Music with the World,” Spotify press release, http://press.spotify.com.
ECONOMIC DEVELOPMENT
Just as important as differences in culture are differences in the level of economic development. We discussed the extent of country differences in economic development in Chapter 3. Consumer behavior is influenced by the level of economic development of a country. Firms based in highly developed countries such as the United States tend to build a lot of extra performance attributes into their products. ese extra attributes are not usually demanded by consumers in less developed nations, where the preference is for more basic products. us, cars sold in less developed nations typically lack many of the features found in developed nations, such as air-conditioning, power steering, power windows, radios, and CD players. For most consumer durables, product reliability may be a more important attribute in less developed nations, where such a purchase may account for a major proportion of a consumer’s income, than it is in advanced nations.
Contrary to Levitt’s suggestions, consumers in the most developed countries are often not willing to sacrifice their preferred attributes for lower prices. Consumers in the most advanced countries often shun globally standardized products that have been developed with the lowest common denominator in mind. ey are willing to pay more for products that have additional features and attributes customized to their tastes and preferences. For example, demand for top-of-the-line four-wheel-drive sport-utility vehicles—such as Chrysler’s Jeep, Ford’s Explorer, and Toyota’s Land Cruiser—has been largely restricted to the United States. is is due to a combination of factors, including the high income level of U.S. consumers, the country’s vast distances, the relatively low cost of gasoline, and the culturally grounded “outdoor” theme of American life.
PRODUCT AND TECHNICAL STANDARDS
Even with the forces that are creating some convergence of consumer tastes and preferences among advanced, industrialized nations, Levitt’s vision of global markets may still be a long way off because of
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national differences in product and technological standards.27 However, if anything, the increased development and implementation of regional trade agreements, often taking into account technical standards setting, may influence certain regional markets to become more globalized, as Levitt suggested.
For now, differing government-mandated product standards can often result in companies ruling out mass production and marketing of a fully global and standardized product. Differences in technical standards also constrain the globalization of markets. Some of these differences result from idiosyncratic decisions made long ago, rather than from government actions, but their long-term effects are profound. For example, DVD equipment manufactured for sale in the United States will not play DVDs recorded on equipment manufactured for sale in Great Britain, Germany, and France (and vice versa). ankfully, most songs and movies are now streamed and, thus, can be played in a
compatible way almost anywhere in the world.28
Distribution Strategy
LO 16-3 Recognize why and how a firm’s distribution strategy might vary among countries.
A critical element of a firm’s marketing mix is its distribution strategy: the means it chooses for
delivering the product to the consumer.29 e way the product is delivered is determined by the firm’s entry strategy, discussed in Chapter 13. is section examines a typical distribution system, discusses how its structure varies between countries and looks at how appropriate distribution strategies vary from country to country.
Figure 16.2 illustrates a typical distribution system consisting of a channel that includes a wholesale distributor and a retailer. If the firm manufactures its product in the particular country, it can sell directly to the consumer, to the retailer, or to the wholesaler. e same options are available to a firm that manufactures outside the country. Plus, this firm may decide to sell to an import agent, which then deals with the wholesale distributor, the retailer, or the consumer. Later in the chapter, we consider the factors that determine the firm’s choice of channel.
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16.2 FIGURE
A typical distribution system.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
DIFFERENCES BETWEEN COUNTRIES
e four main differences between distribution systems worldwide are retail concentration, channel length, channel exclusivity, and channel quality.
Retail Concentration In some countries, the retail system is very concentrated, but it is fragmented in others. In a concentrated retail system, a few retailers supply most of the market. A fragmented retail system is one in which there are many retailers, none of which has a major share of the market. Many of the differences in concentration are rooted in history and tradition. In the United States, the importance of the automobile and the relative youth of many urban areas have resulted in a retail system centered on large stores or shopping malls to which people can drive. is has facilitated system concentration. Japan, with a much greater population density and a large number of urban centers that grew up before the automobile, has a more fragmented retail system, with many small stores serving local neighborhoods and to which people frequently walk. In addition, the Japanese legal system protects small retailers. Small retailers can try to block the establishment of a large retail outlet by petitioning their local government.
ere is a tendency for greater retail concentration in developed countries. ree factors that contribute to this are the increases in car ownership, the number of households with refrigerators and freezers, and the number of two-income households. All these factors have changed shopping habits and facilitated the growth of large retail establishments sited away from traditional shopping areas. e last decade has seen consolidation in the global retail industry, with companies such as Walmart and Carrefour attempting to become global retailers by acquiring retailers in different countries. is has increased retail concentration.
In contrast, retail systems are very fragmented in many developing countries, which can make for interesting distribution challenges. In rural China, large areas of the country can be reached only by traveling rutted dirt roads. In India, Unilever has to sell to retailers in 600,000 rural villages, many of which cannot be accessed via paved roads, which means products can reach their destination only by bullock, bicycle, or cart. In neighboring Nepal, the terrain is so rugged that even bicycles and carts are not practical, and businesses rely on yak trains and the human back to deliver products to thousands of small retailers.
Channel Length Channel length refers to the number of intermediaries between the producer (or manufacturer) and the consumer. If the producer sells directly to the consumer, the channel is very short. If the producer sells through an import agent, a wholesaler, and a retailer, a long channel exists. e choice of a short or long channel is, in part, a strategic decision for the producing firm. However, some countries have longer distribution channels than others. e most important determinant of channel length is the degree to which the retail system is fragmented. Fragmented retail systems tend to promote the growth of wholesalers to serve retailers, which lengthens channels.
e more fragmented the retail system, the more expensive it is for a firm to make contact with each individual retailer. Imagine a firm that sells toothpaste in a country where there are more than a
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million small retailers, as in rural India. To sell directly to the retailers, the firm would have to build a huge sales force. is would be very expensive, particularly because each sales call would yield a very small order. But suppose a few hundred wholesalers in the country supply retailers not only with toothpaste but also with all other personal care and household products. Because these wholesalers carry a wide range of products, they get bigger orders with each sales call, making it worthwhile for them to deal directly with the retailers. Accordingly, it makes economic sense for the firm to sell to the wholesalers and the wholesalers to deal with the retailers.
Because of such factors, countries with fragmented retail systems also tend to have long channels of distribution, sometimes with multiple layers. e classic example is Japan, where there are often two or three layers of wholesalers between the firm and retail outlets. In countries such as Great Britain, Germany, and the United States, where the retail systems are far more concentrated, channels are much shorter. When the retail sector is very concentrated, it makes sense for the firm to deal directly with retailers, cutting out wholesalers. A relatively small sales force is required to deal with a concentrated retail sector, and the orders generated from each sales call can be large. Such circumstances tend to prevail in the United States, where large food companies may sell directly to supermarkets rather than going through wholesale distributors.
Another factor that is shortening channel length in some countries is the entry of large discount superstores, such as Carrefour, Walmart, and Tesco. e business model of these retailers is, in part, based on the idea that in an attempt to lower prices, they cut out wholesalers and instead deal directly with manufacturers. us, when Walmart entered Mexico, its policy of dealing directly with manufacturers, instead of buying merchandise through wholesalers, helped shorten distribution channels in that nation. Similarly, Japan’s historically long distribution channels are now being shortened by the rise of large retailers, some of them foreign-owned, such as Walmart, and some of them indigenous enterprises that are imitating the American model, all of which are progressively cutting out wholesalers and dealing directly with manufacturers.
Channel Exclusivity An exclusive distribution channel is one that is difficult for outsiders to access. For example, it is often difficult for a new firm to get access to shelf space in supermarkets. is occurs because retailers tend to prefer to carry the products of established manufacturers of foodstuffs with national reputations rather than gamble on the products of unknown firms. e exclusivity of a distribution system varies among countries. Japan’s system is often held up as an example of a very exclusive system. In Japan, relationships among manufacturers, wholesalers, and retailers often go back decades. Many of these relationships are based on the understanding that distributors will not carry the products of competing firms. In return, the distributors are guaranteed an attractive markup by the manufacturer. As many U.S. and European manufacturers have learned, the close ties that result from this arrangement can make access to the Japanese market difficult. However, it is possible to break into the Japanese market with a new consumer product. Procter & Gamble did during the 1990s with its Joy brand of dish soap. P&G was able to overcome a tradition of exclusivity for two reasons. First, after two decades of lackluster economic performance, Japan is changing. In their search for profits, retailers are far more willing than they have been historically to violate the old norms of exclusivity. Second, P&G has been in Japan long enough and has a broad enough portfolio of consumer products to give it considerable leverage with distributors, enabling it to push new products out through the distribution channel.
Channel Quality Channel quality refers to the expertise, competencies, and skills of established retailers in a nation and their ability to sell and support the products of international businesses.
Although the quality of retailers is good in most developed nations, in emerging markets and less developed nations from Russia to Indonesia, channel quality is variable at best. e lack of a high- quality channel may impede market entry, particularly in the case of new or sophisticated products that require significant point-of-sale assistance and after-sales services and support. When channel quality is poor, an international business may have to devote considerable attention to upgrading the channel, for example, by providing extensive education and support to existing retailers and, in extreme cases, by establishing its own channel. us, after pioneering its Apple retail store concept in the United States, Apple opened retail stores in several nations—including the United Kingdom, France, Germany, Japan, and China—to provide point-of-sales education, service, and support for its popular iPhone, iPad, and MacBook products. Apple believes that this strategy will help it gain market share in these nations.
CHOOSING A DISTRIBUTION STRATEGY
A choice of distribution strategy determines which channel the firm will use to reach potential consumers. Should the firm try to sell directly to the consumer? Or should it go through retailers, go through a wholesaler, use an import agent, or invest in establishing its own channel? e optimal strategy is determined by the relative costs and benefits of each alternative, which vary from country to country, depending on the four factors we have just discussed: retail concentration, channel length, channel exclusivity, and channel quality.
Because each intermediary in a channel adds its own markup to the products, there is generally a critical link among channel length, the final selling price, and the firm’s profit margin. e longer a channel, the greater the aggregate markup, and the higher the price that consumers are charged for the final product. To ensure that prices do not get too high as a result of markups by multiple intermediaries, a firm might be forced to operate with lower profit margins. us, if price is an important competitive weapon, and if the firm does not want to see its profit margins squeezed, other things being equal, the firm would prefer to use a shorter channel.
However, the benefits of using a longer channel may outweigh these drawbacks. As we have seen, one benefit of a longer channel is that it cuts selling costs when the retail sector is very fragmented. us, it makes sense for an international business to use longer channels in countries where the retail sector is fragmented and shorter channels in countries where the retail sector is concentrated. Another benefit of using a longer channel is market access—the ability to enter an exclusive channel. Import agents may have long-term relationships with wholesalers, retailers, or important consumers and thus be better able to win orders and get access to a distribution system. Similarly, wholesalers may have long-standing relationships with retailers and be better able to persuade them to carry the firm’s product than the firm itself would.
Import agents are not limited to independent trading houses; any firm with a strong local reputation could serve as well. For example, to break down channel exclusivity and gain greater access to the Japanese market, when Apple Computer originally entered Japan, it signed distribution agreements with five large Japanese firms, including business equipment giant Brother Industries, stationery leader Kokuyo, Mitsubishi, Sharp, and Minolta. ese firms use their own long-established distribution relationships with consumers, retailers, and wholesalers to push Apple computers through the Japanese distribution system. Today, Apple has supplemented this strategy with its own stores in the country.
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If such an arrangement is not possible, the firm might want to consider other, less traditional alternatives to gaining market access. Frustrated by channel exclusivity in Japan, some foreign manufacturers of consumer goods have attempted to sell directly to Japanese consumers using direct mail and catalogs. Finally, if channel quality is poor, a firm should consider what steps it could take to upgrade the quality of the channel, including establishing its own distribution channel.
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Communication Strategy
LO 16-4 Identify why and how advertising and promotional strategies might vary among countries.
Another critical element in the marketing mix is communicating the attributes of the product to prospective customers. A number of communication channels are available to a firm, including social media (a technology that facilitates the sharing of information and the building of virtual global networks and communities), direct selling, sales promotion, and various forms of advertising. A firm’s communication strategy is partly defined by its choice of channel. Unfortunately, the number of channels available today has also resulted in companies having less control over the messaging that they try to do regarding their products and services.
Traditionally, some firms have relied on direct selling, others on point-of-sale promotions, and others on mass advertising; still others have used several channels simultaneously to communicate their message to prospective customers. Prior to social media, firms were able to “signal” what type of product or service they offered in the global marketplace. Today, that messaging is collectively done by customers and the companies. Consequently, multinational corporations need to have active, interactive social media platforms to go along with the more traditional direct selling, sales promotion, and various forms of advertising that they use.
is section on communications strategy looks first at the barriers to these types of international communications. Keep in mind that the approach to communicating with and among customers (e.g., social media, direct selling, sales promotion, and various forms of advertising) is one aspect of the global company’s communication strategy. e other is the potential barriers to communication and forms of advertising that can be used. Operating within these constraints and opportunities, the accompanying Management Focus illustrates nicely how an old-fashioned brand such as Burberry used social media marketing to resurrect and reinvent its high-profile luxurious brand.
m a n a g e m e n t F O C U S
Burberry’s Social Media Marketing
Burberry, the icon British luxury apparel retailer founded in 1856 by omas Burberry and famed for its trench coats and plaid-patterned accessories, has been on a roll in recent years. In the late 1990s, one critic described Burberry as “an outdated business with a fashion cache of almost zero.” But by 2019, Burberry has become widely recognized as one of the world’s premier luxury brands with a strong presence in many of the world’s richest cities, some 500 retail stores, about 10,800 employees, and revenues in excess of $3.6 billion. e reason is that Burberry used social media to become a digital marketing icon and one of the top social media brands.
Two successive American CEOs were behind Burberry’s transformation, and it started before the current revolution of the digital marketplace. e first, Rose Marie Bravo, joined the company in 1997 from Saks Fifth Avenue. Bravo saw immense hidden value in the Burberry brand. One of her first moves was to hire world-class designers to re-energize the brand. e company also shifted its orientation toward a younger, hipper demographic, perhaps best exemplified by the ads featuring supermodel Kate Moss that helped to reposition the brand. By the time Bravo retired in 2006, she had transformed Burberry into what one commentator called an “achingly hip,” high-end fashion brand whose raincoats, clothes, handbags, and other accessories were must-have items for younger, well-heeled, fashion-conscious consumers worldwide.
Bravo was succeeded by Angela Ahrendts, whose career had taken her from a small town in Indiana and a degree at Ball State University, through Warnaco and LizClaiborne, to become the CEO of Burberry at age 46. Ahrendts realized that for all of Bravo’s success, Burberry still faced significant problems. e company had long pursued a licensing strategy, allowing partners in other countries to design and sell their own offerings under the Burberry label. is lack of control over the offering was hurting its brand equity. e Spanish partner, for example, was selling casual wear that bore no relationship to what was being designed in London. So long as this state of affairs continued, Burberry would struggle to build a unified global brand.
Ahrendts’s solution was to start acquiring partners and/or buying back licensing rights in order to regain control over the brand. Hand in hand with this, she pushed for an aggressive expansion of the company’s retail store strategy. e company’s core demographics under Ahrendts remained the well-heeled, younger, fashion-conscious set. To reach this demographic, Burberry has focused on 25 of the world’s wealthier cities. Key markets include New York, London, and Beijing, which according to Burberry account for more than half the global luxury fashion trade. As a result of this strategy, the number of retail stores increased from 211 in 2007 to 556 in 2019.
An important aspect of Burberry’s strategy has been to embrace digital marketing tools to reach its tech- savvy customer base. Indeed, there are few luxury brand companies that have utilized digital technology as aggressively as Burberry. Burberry has simulcast its runway shows in 3-D in New York, Los Angeles, Dubai, Paris, and Tokyo. Viewers at home can stream the shows over the Internet and post comments in real time. Outerwear and bags are made available through “click and buy” technology with delivery several months before they reach the stores. Burberry had more than 17 million Facebook fans as of 2018. At “e Art of the Trench,” a company-run social media site, people can submit photos of themselves in the company’s iconic rainwear.
e global marketing strategy seems to be working. Between 2007 and 2018, revenues at Burberry increased from some $1.3 billion to $3.6 billion. In April 2014, Angela Ahrendts was replaced as CEO by Christopher Bailey (Ahrendts took a position as senior vice president of retail and online at Apple, Inc.). Bailey, with a heritage from Halifax, United Kingdom, first started with Burberry in May 2001 as a creative director. One of the branding decisions that happened on his creative director watch was to remove the Burberry brand’s iconic check pattern from virtually all Burberry products, leaving only 10 percent of the products with the famous check pattern. He also masterminded the design of Burberry’s largest store, 121 Regent Street in London, United Kingdom, which opened as a bricks-and-mortar incarnation of the brand’s website.
Sources: S. Davis, “Burberry’s Blurred Lines: e Integrated Customer Experience,” Forbes, March 27, 2014; A. Ahrendts, “Burberry’s CEO on Turning an Aging British Icon into a Global Luxury Brand,” Harvard Business Review, January-February 2013; Nancy Hass, “Earning Her Stripes,” e Wall Street Journal, September 9, 2010; “Burberry Shines as Aquascutum Fades,” e Wall Street Journal, April 17, 2010; Peter
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Evans, “Burberry Sales Ease from Blistering Pace,” e Wall Street Journal, April 17, 2010; and “Burberry Case Study,” Market Line, http://marketline.com.
BARRIERS TO INTERNATIONAL COMMUNICATION
International communication occurs whenever a firm uses a marketing message to sell its products in another country. e effectiveness of a firm’s international communication can be jeopardized by three potentially critical variables: cultural barriers, source effects, and noise levels.
Cultural Barriers Cultural barriers can make it difficult to communicate messages across cultures. We discussed some sources and consequences of cultural differences between nations in Chapter 4 and in the previous section of this chapter. Because of cultural differences, a message that means one thing in one country may mean something quite different in another. Benetton, the Italian clothing manufacturer and retailer, ran into cultural problems with its advertising. e company launched a worldwide advertising campaign with the theme “United Colors of Benetton” that had won awards in France. One of its ads featured a black woman breast-feeding a white baby, and another one showed a black man and a white man handcuffed together. Benetton was surprised when the ads were attacked by U.S. civil rights groups for promoting white racial domination. Benetton withdrew its ads and fired its advertising agency, Eldorado of France.
Is the Google Advertising Model Viable in the Long Term?
Google’s share of the Internet ads is at about 33 percent of the $304 billion market, making it the undisputed Goliath of online advertising. Google also continues to grow, thanks to acquisitions such as DoubleClick, YouTube, and even drone company Titan Aerospace. Facebook is solidly in the number two spot in Internet ads but is gaining market share. Google is also a heavyweight in mobile ads. Research experts predict that new ad dollars will come from emerging markets such as China, Russia, and Indonesia. Over the next three years, about half of all global ad growth will come from 10 developing markets—with Brazil, Russia, India, and China combined accounting for 33 percent. Currently, there are four markets in which Internet ads account for more than 30 percent of total spending: Canada, Norway, Sweden, and the United Kingdom. Basically, the world is shifting its ad spending to the Internet and similar options. With that in mind, where can global companies reach you via advertisements if they wanted to target you? And do you think the Google advertisement business model is viable as a way to reach customers for the long term?
e best way for a firm to overcome cultural barriers is to develop cross-cultural literacy (see Chapter 4). In addition, it should use local input, such as a local advertising agency, in developing its marketing message. If the firm uses direct selling rather than advertising to communicate its message, it should develop a local sales force whenever possible. Cultural differences limit a firm’s ability to use the same marketing message and selling approach worldwide. What works well in one country may be offensive in another.
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Source and Country of Origin Effects Source effects occur when the receiver of the message (the potential consumer in this case) evaluates the message on the basis of status or image of the sender. Source effects can be damaging for an international business when potential consumers in a target country have a bias against foreign firms. For example, a wave of “Japan bashing” swept the United States in the early 1990s. Worried that U.S. consumers might view its products negatively, Honda responded by creating ads that emphasized the U.S. content of its cars to show how “American” the company had become.
Many international businesses try to counter negative source effects by deemphasizing their foreign origins. When the French antiglobalization protester José Bové was hailed as a hero by some in France for razing a partly built McDonald’s, the French franchisees of McDonald’s responded with an ad depicting a fat, ignorant American who could not understand why McDonald’s France used locally produced food that wasn’t genetically modified. e edgy ad worked, and McDonald’s French
operations are now among the most robust in the company’s global network.30
A subset of source effects is referred to as country of origin effects, or the extent to which the place of manufacturing influences product evaluations. Research suggests that the consumer may use country of origin as a cue when evaluating a product, particularly if he or she lacks more detailed knowledge of the product. For example, one study found that Japanese consumers tended to rate Japanese products more favorably than U.S. products across multiple dimensions, even when
independent analysis showed that they were actually inferior.31 When a negative country of origin effect exists, an international business may have to work hard to counteract this effect by, for example, using promotional messages that stress the positive performance attributes of its product.
Source effects and country of origin effects are not always negative. French wine, Italian clothes, and German luxury cars benefit from nearly universal positive source effects. In such cases, it may pay a firm to emphasize its foreign origins.
Noise Levels Noise tends to reduce the probability of effective communication. Noise refers to the number of other messages competing for a potential consumer’s attention, and this too varies across countries. In highly developed countries such as the United States, noise is extremely high. Fewer firms vie for the attention of prospective customers in developing countries; thus, the noise level is lower.
PUSH VERSUS PULL STRATEGIES
e main decision with regard to communications strategy is the choice between a push strategy and a pull strategy. A push strategy emphasizes personal selling rather than mass media advertising in the promotional mix. Although effective as a promotional tool, personal selling requires intensive use of a sales force and is relatively costly. A pull strategy depends more on mass media advertising to communicate the marketing message to potential consumers.
Although some firms employ only a pull strategy and others only a push strategy, still other firms combine direct selling with mass advertising to maximize communication effectiveness. Factors that determine the relative attractiveness of push and pull strategies include product type relative to consumer sophistication, channel length, and media availability.
Product Type and Consumer Sophistication Firms in consumer goods industries that are trying to sell to a large segment of the market generally favor a pull strategy. Mass communication has cost advantages for such firms; thus, they rarely use direct selling. Exceptions can be found in poorer
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nations with low literacy levels, where direct selling may be the only way to reach consumers. Firms that sell industrial products or other complex products favor a push strategy. Direct selling allows the firm to educate potential consumers about the features of the product. is may not be necessary in advanced nations where a complex product has been in use for some time, where the product’s attributes are well understood, where consumers are sophisticated, and where high-quality channels exist that can provide point-of-sale assistance. However, customer education may be important when consumers have less sophistication toward the product, which can be the case in developing nations or in advanced nations when a new complex product is being introduced, or where high-quality channels are absent or scarce.
Channel Length e longer the distribution channel, the more intermediaries there are that must be persuaded to carry the product for it to reach the consumer. is can lead to inertia in the channel, which can make entry difficult. Using direct selling to push a product through many layers of a distribution channel can be expensive. In such circumstances, a firm may try to pull its product through the channels by using mass advertising to create consumer demand; once demand is created, intermediaries will feel obliged to carry the product.
In Japan, products often pass through two, three, or even four wholesalers before they reach the final retail outlet. is can make it difficult for foreign firms to break into the Japanese market. Not only must the foreign firm persuade a Japanese retailer to carry its product, but it may also have to persuade every intermediary in the chain to carry the product. Mass advertising may be one way to break down channel resistance in such circumstances. However, in countries such as India, which has a very long distribution channel to serve its massive rural population, mass advertising may not work because of low literacy levels, in which case the firm may need to fall back on direct selling or rely on the goodwill of distributors.
Media Availability A pull strategy relies on access to advertising media. Around the world, especially the relatively developed world that includes some 80 countries, a large number of media are available, including print media (newspapers and magazines), broadcasting media (television and radio), and various forms using the Internet (e.g., social media). ese media options have facilitated extremely focused advertising (e.g., MTV for teens and young adults, Lifetime for women, ESPN for sports enthusiasts, and Google targeted adverting). However, in some developing nations, the situation is more restrictive because mass media of all types are typically more limited. Consequently, a firm’s ability to use a pull strategy is limited in some countries by media availability. In such circumstances, a push strategy is more attractive. For example, Unilever uses a push strategy to sell consumer products in rural India, where few mass media are available.
Media availability is limited by law in some cases. Few countries allow advertisements for tobacco and alcohol products on television and radio, though they are usually permitted in print media. When the leading Japanese whiskey distiller, Suntory, entered the U.S. market, it had to do so without television, its preferred medium. e firm spends about $50 million annually on television advertising in Japan. Similarly, while advertising pharmaceutical products directly to consumers is allowed in the United States, it is prohibited in many other advanced nations. In such cases, pharmaceutical firms must rely heavily on advertising and direct-sales efforts focused explicitly at doctors to get their products prescribed.
e Push-Pull Mix e optimal mix between push and pull strategies depends on product type and consumer sophistication, channel length, and media sophistication. Push strategies tend to be
emphasized
For industrial products or complex new products. When distribution channels are short. When few print or social media are available.
Pull strategies tend to be emphasized
For consumer goods. When distribution channels are long. When sufficient print and social media are available to carry the marketing message.
GLOBAL ADVERTISING
In recent years, largely inspired by the work of visionaries such as eodore Levitt, there has been
much discussion about the pros and cons of standardizing advertising worldwide.32 One of the most successful standardized campaigns in history was Philip Morris’s promotion of Marlboro cigarettes. When the brand was repositioned, the idea was to ensure smokers that Marlboro cigarettes would maintain the customary flavor. e campaign theme of “Come to where the flavor is: Come to Marlboro country” was a worldwide success some time ago. Marlboro built on this when it introduced “the Marlboro man,” a rugged cowboy smoking his Marlboro while riding his horse through the great outdoors. is ad proved successful in almost every major market around the world, and it helped propel Marlboro to the top of the world market.
For Standardized Advertising e support for global advertising is threefold. First, it has significant economic advantages. Standardized advertising lowers the costs of value creation by spreading the fixed costs of developing the advertisements over many countries. For example, McCann Erickson, claims to have saved Coca-Cola more than $100 million over 20 years by using certain elements of its campaigns globally.
Second, there is the concern that creative talent is scarce, so one large effort to develop a campaign will produce better results than 40 or 50 smaller efforts. A third justification for a standardized approach is that many brand names are global. With the substantial amount of international travel today and the considerable overlap in media across national borders, many international firms want to project a single brand image to avoid confusion caused by local campaigns. is is particularly important in regions such as Western Europe, where travel across borders is almost as common as travel across state lines in the United States.
Against Standardized Advertising ere are two main arguments against globally standardized advertising. First, as we have seen repeatedly in this chapter and in Chapter 4, cultural differences among nations are such that a message that works in one nation can fail miserably in another. Cultural diversity makes it extremely difficult to develop a single advertising theme that is effective worldwide. Messages directed at the culture of a given country may be more effective than global messages.
Second, advertising regulations may block implementation of standardized advertising. For example, Kellogg could not use a television commercial it produced in Great Britain to promote its cornflakes in many other European countries. A reference to the iron and vitamin content of its cornflakes was not permissible in the Netherlands, where claims relating to health and medical benefits
Page 458are outlawed. A child wearing a Kellogg T-shirt had to be edited out of the commercial before it could be used in France because French law forbids the use of children in product endorsements. e key line “Kellogg’s makes their cornflakes the best they have ever been” was
disallowed in Germany because of a prohibition against competitive claims.33
Dealing with Country Differences Some firms are experimenting with capturing some benefits of global standardization while recognizing differences in countries’ cultural and legal environments. A firm may select some features to include in all its advertising campaigns and localize other features. By doing so, it may be able to save on some costs and build international brand recognition and yet customize its advertisements to different cultures.
Nokia tried to do this. Historically, Nokia had used a different advertising campaign in different markets. In 2004, however, when Nokia was still a Finnish company (and not part of Microsoft), the company launched a global advertising campaign that used the slogan “1001 reasons to have a Nokia imaging phone.” Nokia did this to reduce advertising costs, capture some economies of scale, and establish a consistent global brand image. At the same time, Nokia tweaked the advertisements for different cultures. e campaign used actors from the region where the ad ran to reflect the local population, though they said the same lines. Local settings were also modified when showcasing the phones by, for example, using a marketplace when advertising in Italy or a bazaar when advertising in
the Middle East.34
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Pricing Strategy
LO 16-5 Explain why and how a firm’s pricing strategy might vary among countries.
International pricing strategy is an important component of the overall international marketing mix.35
is section looks at three aspects of international pricing strategy. First, we examine the case for pursuing price discrimination, charging different prices for the same product in different countries. Second, we look at what might be called strategic pricing. ird, we review regulatory factors, such as government-mandated price controls and antidumping regulations that limit a firm’s ability to charge the prices it would prefer in a country.
PRICE DISCRIMINATION
Price discrimination exists whenever consumers in different countries are charged different prices for
the same product or for slightly different variations of the product.36 Price discrimination involves charging whatever the market will bear; in a competitive market, prices may have to be lower than in a market where the firm has a monopoly. Price discrimination can help a company maximize its profits. It makes economic sense to charge different prices in different countries.
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Two conditions are necessary for profitable price discrimination. First, the firm must be able to keep its national markets separate. If it cannot do this, individuals or businesses may undercut its attempt at price discrimination by engaging in arbitrage. Arbitrage occurs when an individual or business capitalizes on a price differential for a firm’s product between two countries by purchasing the product in the country where prices are lower and reselling it in the country where prices are higher. For example, many automobile firms have long practiced price discrimination in Europe. A Ford Escort once cost $2,000 more in Germany than it did in Belgium. is policy broke down when car dealers bought Escorts in Belgium and drove them to Germany, where they sold them at a profit for slightly less than Ford was selling Escorts in Germany. To protect the market share of its German auto dealers, Ford had to bring its German prices into line with those being charged in Belgium. Ford could not keep these markets separate, unlike in Britain where the need for right-hand-drive cars keeps the market separate from the rest of Europe.
Is iPhone the Next BlackBerry?
BlackBerry now accounts for less than half a percentage point of smartphone sales in the United States, down from its dominating position as the market leader just a few years ago. e rise of Apple and Samsung in the mobile phone market has made BlackBerry nearly irrelevant today. At the same time, Apple is in a fierce battle against Android and Windows-based phones. Apple’s smartphone market share has steadily declined in the global marketplace. Apple has also traditionally maintained higher prices for the iPhone by leveraging its brand value and gaining maximum profits during the process. Analysts believe that Apple could gain by showing some price flexibility on the iPhone, especially for weaker economies. Another initiative that Apple could take is to come up with a cheaper iPhone with lower specifications than the current iPhones. Where will Apple’s iPhone be by the year 2030? Will it still be a strong force in the mobile phone market, or will it be the next BlackBerry?
Sources: S. Rodriguez, “BlackBerry Accounts for Less an 0.5% of Smartphone Sales,” Los Angeles Times, January 31, 2014, http://articles.latimes.com/2014/jan/31/business/la-fi-tn-blackberry-smartphone-sales-fourth-quarter-20140131; J. Pepitone, “New BlackBerry CEO Optimistic Despite Loss,” CNNMoney, December 30, 2013; and L. Whitney, “iPhone Market Share Shrinks as Android, Windows Phone Grow,” CNET, January 6, 2014.
e second necessary condition for profitable price discrimination is different price elasticities of demand in different countries. e price elasticity of demand is a measure of the responsiveness of demand for a product to change in price. Demand is said to be elastic when a small change in price produces a large change in demand; it is said to be inelastic when a large change in price produces only a small change in demand. Figure 16.3 illustrates elastic and inelastic demand curves. Generally, a firm can charge a higher price in a country where demand is inelastic.
16.3 FIGURE
Elastic and inelastic demand curves.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
e elasticity of demand for a product in a given country is determined by a number of factors, of which income level and competitive conditions are the two most important. Price elasticity tends to be greater in countries with low income levels. Consumers with limited incomes tend to be very price conscious; they have less to spend, so they look much more closely at price. us, price elasticity for products such as personal computers is greater in countries such as India, where a PC is still a luxury item, than in the United States, where it is now considered a necessity. e same is true of the software that resides on those PCs; thus, to sell more software in India, Microsoft has had to introduce low- priced versions of its products into that market, such as Windows Starter Edition.
In general, the more competitors there are, the greater consumers’ bargaining power will be and the more likely consumers will be to buy from the firm that charges the lowest price. us, many competitors cause high elasticity of demand. In such circumstances, if a firm raises its prices above those of its competitors, consumers will switch to the competitors’ products. e opposite is true when a firm faces few competitors. When competitors are limited, consumers’ bargaining power is weaker, and price is less important as a competitive weapon. us, a firm may charge a higher price for its product in a country where competition is limited than in one where competition is intense.
STRATEGIC PRICING
e concept of strategic pricing has three aspects, which we refer to as predatory pricing, multipoint pricing, and experience curve pricing. Both predatory pricing and experience curve pricing may violate antidumping regulations. After we review predatory and experience curve pricing, we will look at antidumping rules and other regulatory policies.
Predatory Pricing Predatory pricing is the use of price as a competitive weapon to drive weaker competitors out of a national market. Once the competitors have left the market, the firm can raise prices and enjoy high profits. For such a pricing strategy to work, the firm must normally have a profitable position in another national market, which it can use to subsidize aggressive pricing in the market it is trying to monopolize. Historically, many Japanese firms were accused of pursuing such a
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policy. e argument ran like this: Because the Japanese market was protected from foreign competition by high informal trade barriers, Japanese firms could charge high prices and earn high profits at home. ey then used these profits to subsidize aggressive pricing overseas, with the goal of driving competitors out of those markets. Once this had occurred, so it is claimed, the Japanese firms then raised prices. Matsushita was accused of using this strategy to enter the U.S. TV market. As one of the major TV producers in Japan, Matsushita earned high profits at home. It then used these profits to subsidize the losses it made in the United States during its early years there, when it priced low to increase its market penetration. Ultimately, Matsushita became the world’s
largest manufacturer of TVs.37
Multipoint Pricing Strategy Multipoint pricing becomes an issue when two or more international businesses compete against each other in two or more national markets. Multipoint pricing refers to the fact that a firm’s pricing strategy in one market may have an impact on its rivals’ pricing strategy in another market. Aggressive pricing in one market may elicit a competitive response from a rival in another market. For example, Fuji launched an aggressive competitive attack against Kodak in the U.S. company’s home market, cutting prices by as much as 50 percent on some
products.38 is price cutting resulted in a 28 percent increase in shipments of Fuji products, while Kodak’s shipments dropped by 11 percent. is attack created a dilemma for Kodak: the company did not want to start price discounting in its largest and most profitable market. Kodak’s response was to aggressively cut prices in Fuji’s largest market, Japan. is strategic response recognized the interdependence between Kodak and Fuji and the fact that they compete against each other in many different nations. Fuji responded to Kodak’s counterattack by pulling back from its aggressive stance in the United States.
e Kodak story illustrates an important aspect of multipoint pricing: Aggressive pricing in one market may elicit a response from rivals in another market. e firm needs to consider how its global rivals will respond to changes in its pricing strategy before making those changes. A second aspect of multipoint pricing arises when two or more global companies focus on particular national markets and launch vigorous price wars in those markets in an attempt to gain market dominance. In Brazil’s market for disposable diapers, two U.S. companies, Kimberly-Clark and Procter & Gamble, entered a
price war as each struggled to establish dominance in the market.39 As a result, over three years, the cost of disposable diapers fell from $1 per diaper to 33 cents per diaper, while several other competitors, including indigenous Brazilian firms, were driven out of the market. Kimberly-Clark and Procter & Gamble are engaged in a global struggle for market share and dominance, and Brazil is one of their battlegrounds. Both companies can afford to engage in this behavior, even though it reduces their profits in Brazil, because they have profitable operations elsewhere in the world that can subsidize these losses.
Pricing decisions around the world need to be centrally monitored. It is tempting to delegate full responsibility for pricing decisions to the managers of various national subsidiaries, thereby reaping the benefits of decentralization. However, because pricing strategy in one part of the world can elicit a competitive response in another, central management needs to at least monitor and approve pricing decisions in a given national market, and local managers need to recognize that their actions can affect competitive conditions in other countries.
Experience Curve Pricing We first encountered the experience curve in Chapter 12. As a firm builds its accumulated production volume over time, unit costs fall due to experience effects. Learning effects and economies of scale underlie the experience curve. Price comes into the picture because
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aggressive pricing (along with aggressive promotion and advertising) can build accumulated sales volume rapidly and thus move production down the experience curve. Firms farther down the experience curve have a cost advantage vis-à-vis those farther up the curve.
Many firms pursuing an experience curve pricing strategy on an international scale will price low worldwide in attempting to build global sales volume as rapidly as possible, even if this means taking large losses initially. Such a firm believes that in several years, when it has moved down the experience curve, it will be making substantial profits and have a cost advantage over its less aggressive competitors.
REGULATORY INFLUENCES ON PRICES
e ability to engage in either price discrimination or strategic pricing may be limited by national or international regulations. Most important, a firm’s freedom to set its own prices is constrained by antidumping regulations and competition policy.
Antidumping Regulations Both predatory pricing and experience curve pricing can run afoul of antidumping regulations. Dumping occurs whenever a firm sells a product for a price that is less than the cost of producing it. Most regulations, however, define dumping more vaguely. For example, a country is allowed to bring antidumping actions against an importer under Article 6 of GATT as long as two criteria are met: sales at “less than fair value” and “material injury to a domestic industry.” e problem with this terminology is that it does not indicate what a fair value is. e ambiguity has led some to argue that selling abroad at prices below those in the country of origin, as opposed to below cost, is dumping.
Antidumping rules set a floor under export prices and limit firms’ ability to pursue strategic pricing. e rather vague terminology used in most antidumping actions suggests that a firm’s ability to engage in price discrimination also may be challenged under antidumping legislation.
Competition Policy Most developed nations have regulations designed to promote competition and to restrict monopoly practices. ese regulations can be used to limit the prices a firm can charge in a given country. For example, at one time the Swiss pharmaceutical manufacturer Hoffmann–La Roche had a monopoly on the supply of Valium and Librium tranquilizers. e company was investigated by the British Monopolies and Mergers Commission, which is responsible for promoting fair competition in Great Britain. e commission found that Hoffmann–La Roche was overcharging for its tranquilizers and ordered the company to reduce its prices 50 to 60 percent and repay excess profit of $30 million. Hoffmann–La Roche maintained unsuccessfully that it was merely engaging in price discrimination. Similar actions were later brought against Hoffmann–La Roche by the German
cartel office and by the Dutch and Danish governments.40
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Configuring the Marketing Mix
LO 16-6 Understand how to configure the marketing mix globally.
A firm might vary aspects of its marketing mix from country to country to take into account local differences in culture, economic conditions, competitive conditions, product and technical standards, distribution systems, government regulations, and the like. Such differences may require variation in product attributes, distribution strategy, communication strategy, and pricing strategy.
Did You Know?
Did you know “Pure Michigan” is a global brand?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
e cumulative effect of these factors made it rare that a firm would adopt the same marketing mix worldwide just a few years ago, and it holds true in many cases still. But we are also seeing a new generation of customers—younger customers—worldwide who appear more and more willing to engage in a “global” way in what they want, need, and use in their daily lives.
e movie industry and the financial services industry are often thought of as industries in which global standardization of the marketing mix is the norm. A financial services company such as American Express sells the same basic charge card service worldwide, utilizes the same basic fee structure for that product, and adopts the same basic global advertising message (“Don’t leave home without it”). at said, Amex also runs into differences in national regulations, which means that it still has to vary aspects of its communication strategy from country to country.
Similarly, while McDonald’s is often thought of as the quintessential example of a firm that sells the same basic standardized product worldwide, in reality, it varies one important aspect of its marketing mix—its menu—from country to country. McDonald’s also varies its distribution strategy. In Canada and the United States, most McDonald’s are located in areas that are easily accessible by car, whereas in more densely populated and less automobile-reliant societies of the world, such as Japan and Great Britain, location decisions are driven by the accessibility of a restaurant to pedestrian traffic. Because countries typically still differ along one or more of the dimensions discussed earlier, some customization of the marketing mix is normal.
Basically, there are significant opportunities for standardization along one or more elements of the
marketing mix.41 Firms may find that it is possible and desirable to standardize their global advertising message or core product attributes to realize substantial cost economies. ey may find it desirable to customize their distribution and pricing strategy to take advantage of local differences. In reality, the “customization versus standardization” debate is not an all-or-nothing issue; it frequently makes sense to standardize some aspects of the marketing mix and customize others, depending on conditions in various national marketplaces.
Table 16.1 illustrates issues that should be evaluated to assess how standardized or customized the marketing mix needs to be for various international market segments. Keep in mind that a truly “globalized” product—a product that is 100 percent standardized across worldwide markets—is generally an illusion, but companies can come close by leveraging certain marketing mix attributes and customizing others.
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Product Development and R&D
LO 16-7 Describe how globalization is affecting product development.
So far in this chapter, we have discussed several issues related to globalization of markets and brands, characteristics of the marketing mix (product attributes, distribution strategy, communication strategy, and pricing strategy), configuring the marketing mix, and international market research. ese issues represent the core of this chapter’s discussion of international marketing and R&D. However, firms that successfully develop and market new products can earn enormous returns, and this final section of the chapter addresses the interplay among international marketing, R&D, and manufacturing.
Examples of firms that have been very successful at mastering the interplay among international marketing, R&D, and manufacturing include DuPont, which has produced a steady stream of successful innovations such as cellophane, nylon, Freon, and Teflon (nonstick coating); Sony, whose successes include PlayStation and Blu-ray; Pfizer, the drug company that developed Viagra; 3M, which has applied its core competency in tapes and adhesives to developing a wide range of new products; Intel, which has consistently managed to lead in the development of innovative microprocessors to run personal computers; and Apple, with its string of hits, including the iPod, iPhone, and iPad. ese and other success stories warrant a specific focus. We draw on the material up to this point in the chapter and combine it with the global production material in Chapter 15 to illustrate this interplay of marketing, R&D, and manufacturing.
In today’s world, competition is as much about technological innovation as anything else. e pace of technological change has accelerated since the Industrial Revolution in the eighteenth century, and it continues to do so today. e result has been a dramatic shortening of product life cycles.
Technological innovation is both creative and destructive.42 An innovation can make established products obsolete overnight. But an innovation can also make a host of new products possible. Witness changes in the electronics industry. For 40 years before the early 1950s, vacuum tubes were a major component in radios and then in record players and early computers. e advent of transistors destroyed the market for vacuum tubes, but at the same time, it created new opportunities connected with transistors. Transistors took up far less space than vacuum tubes, creating a trend toward miniaturization that continues today. e transistor held its position as the major component in the electronics industry for just a decade. Microprocessors were developed in the 1970s, and the market for transistors declined rapidly. e microprocessor created yet another set of new-product opportunities: handheld calculators (which destroyed the market for slide rules), compact disc players (which destroyed the market for analog record players), personal computers (which destroyed the market for typewriters), and smartphones (which are making landline phones and some computer gadgets obsolete).
is “creative destruction” unleashed by technological change makes it critical that a firm stays on the leading edge of technology, lest it lose out to a competitor’s innovations. As explained next, this not only creates a need for the firm to invest in R&D, but also requires the firm to establish R&D activities at those locations where expertise is concentrated. As we shall see, leading-edge technology on its own is not enough to guarantee a firm’s survival. e firm must also apply that technology to
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developing products that satisfy consumer needs, and it must design the product so that it can be manufactured in a cost-effective manner. To do that, the firm needs to build close links among R&D, marketing, and manufacturing. is is difficult enough for the domestic firm, but it is even more problematic for the international business competing in an industry where consumer tastes and
preferences differ from country to country.43 With all of this in mind, we move on to examine locating R&D activities and building links among R&D, marketing, and manufacturing.
THE LOCATION OF R&D
Ideas for new products are stimulated by the interactions of scientific research, demand conditions, and competitive conditions. Other things being equal, the rate of new-product development seems to be greater in countries where
More money is spent on basic and applied research and development. Underlying demand is strong. Consumers are affluent.
Competition is intense.44
Basic and applied research and development discovers new technologies and then commercializes them. Strong demand and affluent consumers create a potential market for new products. Intense competition among firms stimulates innovation as the firms try to beat their competitors and reap potentially enormous first-mover advantages that result from successful innovation.
For most of the post–World War II period, the country that ranked highest on these criteria was the United States. e United States devoted a greater proportion of its gross domestic product to R&D than any other country did. Its scientific establishment was the largest and most active in the world. U.S. consumers were the most affluent, the market was large, and competition among U.S. firms was brisk. Due to these factors, the United States was the market where most new products were developed and introduced. Accordingly, it was the best location for R&D activities; it was where the action was.
Over the past 25 years, things have been changing quickly. e U.S. monopoly on new-product development has weakened considerably. Although U.S. firms are still at the leading edge of many new technologies, Asian and European firms are also strong players. Companies such as Sony, Sharp, Samsung, Ericsson, Nokia, and Philips have often driven product innovation in their respective industries. In addition, Japan, the European Union, and increasingly parts of China and other developing nations are large, affluent markets, and the wealth gap between them and the United States is closing.
As a result, it is often no longer appropriate to consider the United States as the lead market. In video games, for example, Japan is often the lead market, with companies such as Sony and Nintendo introducing their latest video-game players in Japan some six months before they introduce them in the United States. However, it often is questionable whether any developed nation can be considered the lead market. To succeed in today’s high-technology industries, it is often necessary to simultaneously introduce new products in all major industrialized markets. When Intel introduces a new microprocessor, for example, it does not first introduce it in the United States and then roll it out in Europe a year later. It introduces it simultaneously around the world. e same is true of Microsoft with new versions of its Windows operating system or Samsung with a new smartphone.
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Because leading-edge research is now carried out in many locations around the world, the argument for centralizing R&D activity in the United States is not as strong as it was three decades ago. (It used to be argued that centralized R&D eliminated duplication.) Much leading-edge research is now occurring in Asia and Europe. Dispersing R&D activities to those locations allows a firm to stay close to the center of leading-edge activity to gather scientific and competitive information and to
draw on local scientific resources.45 is may result in some duplication of R&D activities, but the cost disadvantages of duplication are outweighed by the advantages of dispersion.
For example, to expose themselves to the research and new-product development work being done in Japan, many U.S. firms have set up satellite R&D centers in Japan. U.S. firms that have established R&D facilities in Japan include Corning, Texas Instruments, IBM, Procter & Gamble, Pfizer,
DuPont, Monsanto, and Microsoft.46 e National Science Foundation (NSF) has documented a
sharp increase in the proportion of total R&D spending by U.S. firms that is now done abroad.47 For example, Bristol-Myers Squibb has 12 facilities in five countries. At the same time, to internationalize their own research and gain access to U.S. talent, many European and Asian firms are investing in U.S.-based research facilities, according to the NSF.
INTEGRATING R&D, MARKETING, AND PRODUCTION
Although a firm that is successful at developing new products may earn enormous returns, new- product development has a high failure rate. One study of product development in 16 companies in the chemical, drug, petroleum, and electronics industries suggested that only about 20 percent of
R&D projects result in commercially successful products or processes.48 Another in-depth case study of product development in three companies (one in chemicals and two in drugs) reported that about 60 percent of R&D projects reached technical completion, 30 percent were commercialized, and only
12 percent earned an economic profit that exceeded the company’s cost of capital.49 Along the same lines, another study concluded that one in nine major R&D projects, or about 11 percent, produced
commercially successful products.50 In sum, the evidence suggests that only 10 to 20 percent of major R&D projects give rise to commercially successful products.
e reasons for such high failure rates are various and include development of a technology for which demand is limited, failure to adequately commercialize promising technology, and inability to manufacture a new product cost effectively. Firms can reduce the probability of making such mistakes by insisting on tight cross-functional coordination and integration among three core functions
involved in the development of new products: R&D, marketing, and production.51 Tight cross- functional integration among R&D, production, and marketing can help a company ensure that
1. Product development projects are driven by customer needs.
2. New products are designed for ease of manufacture.
3. Development costs are kept in check.
4. Time to market is minimized.
Close integration between R&D and marketing is required to ensure that product development projects are driven by the needs of customers. A company’s customers can be a primary source of new- product ideas. Identification of customer needs, particularly unmet needs, can set the context within which successful product innovation occurs. As the point of contact with customers, the marketing function of a company can provide valuable information in this regard. Integration of R&D and
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marketing is crucial if a new product is to be properly commercialized. Without integration of R&D and marketing, a company runs the risk of developing products for which there is little or no demand.
Integration between R&D and production can help a company design products with manufacturing requirements in mind. Designing for manufacturing can lower costs and increase product quality. Integrating R&D and production can also help lower development costs and speed products to market. If a new product is not designed with manufacturing capabilities in mind, it may prove too difficult to build. en the product will have to be redesigned, and both overall development costs and the time it takes to bring the product to market may increase significantly. Making design changes during product planning could increase overall development costs by 50
percent and add 25 percent to the time it takes to bring the product to market.52 Many quantum product innovations require new processes to manufacture them, which makes it all the more important to achieve close integration between R&D and production. Minimizing time to market and
development costs may require the simultaneous development of new products and new processes.53
CROSS-FUNCTIONAL TEAMS
One way to achieve cross-functional integration is to establish cross-functional product development
teams composed of representatives from R&D, marketing, and production.54 Because these functions may be located in different countries, the team will sometimes have a multinational membership. e objective of a team should be to take a product development project from the initial concept development to market introduction. A number of attributes seem to be important for a product
development team to function effectively and meet all its development milestones.55
First, the team should be led by a “heavyweight” project manager who has high status within the organization and who has the power and authority required to get the financial and human resources the team needs to succeed. e leader should be dedicated primarily, if not entirely, to the project. He or she should be someone who believes in the project (a champion) and who is skilled at integrating the perspectives of different functions and at helping personnel from different functions and countries work together for a common goal. e leader should also be able to act as an advocate of the team to senior management.
Second, the team should be composed of at least one member from each key function. e team members should have a number of attributes, including an ability to contribute functional expertise, high standing within their function, a willingness to share responsibility for team results, and an ability to put functional and national advocacy aside. It is generally preferable if core team members are 100 percent dedicated to the project for its duration. is ensures their focus on the project, not on the ongoing work of their function.
ird, the team members should physically be in one location if possible to create a sense of camaraderie and to facilitate communication. is presents problems if the team members are drawn from facilities in different nations. One solution is to transfer key individuals to one location for the duration of a product development project. Fourth, the team should have a clear plan and clear goals, particularly with regard to critical development milestones and development budgets. e team should have incentives to attain those goals, such as receiving pay bonuses when major development milestones are hit. Fifth, each team needs to develop its own processes for communication and conflict resolution. For example, one product development team at Quantum Corporation, a California-based manufacturer of hard drives for personal computers, instituted a rule
that all major decisions would be made and conflicts resolved at meetings that were held every Monday afternoon. is simple rule helped the team meet its development goals. In this case, it was also common for team members to fly in from Japan, where the product was to be manufactured, to
the U.S. development center for the Monday morning meetings.56
BUILDING GLOBAL R&D CAPABILITIES
e need to integrate R&D and marketing to adequately commercialize new technologies poses special problems in the international business because commercialization may require different
versions of a new product to be produced for various countries.57 To do this, the firm must build close links between its R&D centers and its various country operations. A similar argument applies to the need to integrate R&D and production, particularly in those international businesses that have dispersed production activities to different locations around the globe in consideration of relative factor costs and the like.
Integrating R&D, marketing, and production in an international business may require R&D centers in North America, Asia, and Europe that are linked by formal and informal integrating mechanisms with marketing operations in each country in their regions and with the various manufacturing facilities. In addition, the international business may have to establish cross-functional teams whose members are dispersed around the globe. is complex endeavor requires the company to utilize formal and informal integrating mechanisms to knit its far-flung operations together so they can produce new products in an effective and timely manner.
While there is no one best model for allocating product development responsibilities to various centers, one solution adopted by many international businesses involves establishing a global network of R&D centers. Within this model, fundamental research is undertaken at basic research centers around the globe. ese centers are normally located in regions or cities where valuable scientific knowledge is being created and where there is a pool of skilled research talent (e.g., Silicon Valley in the United States, Cambridge in England, Kobe in Japan, Singapore). ese centers are the innovation engines of the firm. eir job is to develop the basic technologies that become new products.
ese technologies are picked up by R&D units attached to global product divisions and are used to generate new products to serve the global marketplace. At this level, commercialization of the technology and design for manufacturing are emphasized. If further customization is needed so the product appeals to the tastes and preferences of consumers in individual markets, such redesign work will be done by an R&D group based in a subsidiary in that country or at a regional center that customizes products for several countries in the region.
Hewlett-Packard has seven basic research centers located in Palo Alto, California; Bristol, England;
Haifa, Israel; Beijing, China; Singapore; Bangalore, India; and St. Petersburg, Russia.58 ese labs are the seedbed for technologies that ultimately become new products and businesses. ey are the company’s innovation engines. e Palo Alto center, for example, pioneered HP’s thermal ink-jet technology. e products are developed by R&D centers associated with HP’s global product divisions. us, HP’s Consumer Products Group, which has its worldwide headquarters in San Diego, California, designs, develops, and manufactures a range of imaging products using HP-pioneered thermal ink-jet technology. Subsidiaries might then customize the product so that it best matches the needs of important national markets. HP’s subsidiary in Singapore, for example, is responsible for the design and production of thermal ink-jet printers for Japan and other Asian markets. is subsidiary
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takes products originally developed in San Diego and redesigns them for the Asian market. In addition, the Singapore subsidiary has taken the lead from San Diego in the design and development of certain portable thermal ink-jet printers. HP delegated this responsibility to Singapore because this subsidiary has acquired important competencies in the design and production of thermal ink-jet products, so it has become the best place in the world to undertake this activity.
test PREP
Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
John Maltabes, research engineer at Hewlett-Packard, takes out a thin flexible electronic display that has etched resistors and uses self-aligned imprint lithography technology for testing at Hewlett-Packard Laboratories.
Tony Avelar/Christian Science Monitor/Getty Images
Key Terms
marketing mix, p. 441 market segmentation, p. 443 intermarket segment, p. 443 business analytics, p. 445 big data, p. 445 international market research, p. 446 concentrated retail system, p. 451
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fragmented retail system, p. 451 channel length, p. 452 exclusive distribution channel, p. 452 channel quality, p. 453 social media, p. 453 source effects, p. 455 country of origin effects, p. 455 noise, p. 456 push strategy, p. 456 pull strategy, p. 456 price elasticity of demand, p. 459 elastic, p. 459 inelastic, p. 459 strategic pricing, p. 459 predatory pricing, p. 459 multipoint pricing, p. 460 experience curve pricing, p. 460
Summary
is chapter discussed the marketing and R&D functions in international business. A persistent theme of the chapter is the tension that exists between the need to reduce costs and the need to be responsive to local conditions, which raises costs. e chapter made the following points:
1. eodore Levitt argued that due to the advent of modern communications and transport technologies, consumer tastes and preferences are becoming global, which is creating global markets for standardized consumer products. However, this position is regarded as extreme by many experts, who argue that substantial differences still exist between customers from different countries and cultures.
2. Market segmentation refers to the process of identifying distinct groups of consumers whose needs, wants, and purchasing behavior differs from each other in important ways. Managers in an international business need to be aware of two main issues relating to segmentation: the extent to which there are differences between countries in the structure of market segments and the existence of segments that transcend national borders (i.e., intermarket segments).
3. A product can be viewed as a bundle of attributes. Product attributes often need to be varied from country to country to satisfy different consumer tastes and preferences.
4. Country differences in consumer tastes and preferences are due to differences in culture and economic development. In addition, differences in product and technical standards may require the firm to customize product attributes from country to country.
5. A distribution strategy decision is an attempt to define the optimal channel for delivering a product to the consumer. In the global supply chain, the marketing channel is a part of the downstream (also called outbound) portion of the supply chain (refer to Chapter 15).
6. Significant country differences exist in distribution systems. In some countries, the retail system is concentrated; in others, it is fragmented. In some countries, channel length is short; in others, it is long. Access to distribution channels is difficult to achieve in some countries, and the quality of the channel may be poor, especially in less developed nations.
7. A critical element in the marketing mix is communication strategy, which defines the process the firm will use in communicating the attributes of its product to prospective customers.
8. Barriers to international communication include cultural differences, source effects, and noise levels.
9. A communication strategy is either a push strategy or a pull strategy. A push strategy emphasizes personal selling, and a pull strategy emphasizes mass media advertising. Whether a push strategy or a pull strategy is optimal depends on the type of product, consumer sophistication, channel length, and media availability.
10. A globally standardized advertising campaign, which uses the same marketing message all over the world, has economic advantages, but it fails to account for differences in culture and advertising regulations.
11. Price discrimination exists when consumers in different countries are charged different prices for the same product. Price discrimination can help a firm maximize its profits. For price discrimination to be effective, the national markets must be separate and their price elasticities of demand must differ.
12. Predatory pricing is the use of profit gained in one market to support aggressive pricing in another market to drive competitors out of that market.
13. Multipoint pricing refers to the fact that a firm’s pricing strategy in one market may affect rivals’ pricing strategies in another market. Aggressive pricing in one market may elicit a competitive response from a rival in another market that is important to the firm.
14. Experience curve pricing is the use of aggressive pricing to build accumulated volume as rapidly as possible to quickly move the firm down the experience curve.
15. International market research involves (a) defining the research objectives, (b) determining the data sources, (c) assessing the costs and benefits of the research, (d) collecting the data, (e) analyzing and interpreting the research, and (f) reporting the research findings.
16. New-product development is a high-risk, potentially high-return activity. To build a competency in new-product development, an international business must do two things: disperse R&D activities to those countries where new products are being pioneered and integrate R&D with marketing and manufacturing.
17. Achieving tight integration among R&D, marketing, and manufacturing requires the use of cross-functional teams.
Critical inking and Discussion Questions
1. Imagine that you are the marketing manager for a U.S. manufacturer of disposable diapers. Your firm is considering entering the Brazilian market. Your CEO believes the advertising message that has been effective in the United States will suffice in Brazil. Outline some possible objections to this. Your CEO also believes that the pricing decisions in Brazil can be delegated to local managers. Why might she be wrong?
2. Within 20 years, we will have seen the emergence of enormous global markets for standardized consumer products. Do you agree with this statement? Justify your answer.
3. You are the marketing manager of a food products company that is considering entering the Indian market. e retail system in India tends to be very fragmented. Also, retailers and
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wholesalers tend to have long-term ties with Indian food companies; these ties make access to distribution channels difficult. What distribution strategy would you advise the company to pursue? Why?
4. Price discrimination is indistinguishable from dumping. Discuss the accuracy of this statement.
5. You work for a company that designs and manufactures personal computers. Your company’s R&D center is in Michigan. e computers are manufactured under contract in Taiwan. Marketing strategy is delegated to the heads of three regional groups: a North American group (based in Chicago), a European group (based in Paris), and an Asian group (based in Singapore). Each regional group develops the marketing approach within its region. In order of importance, the largest markets for your products are North America, Germany, Great Britain, China, and Australia. Your company is experiencing problems in its product development and commercialization process. Products are late to market, the manufacturing quality is poor, costs are higher than projected, and market acceptance of new products is less than hoped for. What might be the source of these problems? How would you fix them?
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. e consumer purchase of specific brands is an indication of the relationship that develops over time between a company and its customers. Locate and retrieve the most current ranking of best global brands. Identify the criteria used. Which countries appear to dominate the top 100 global brands list? Why do you think this is the case? Now look at which sectors appear to dominate the list, and try to identify the reasons. Prepare a short report identifying the countries that possess global brands and the potential reasons for success.
2. Part of developing a long-term R&D strategy is to locate facilities in countries that are widely known to be competitive. Your company seeks to develop R&D facilities in Asia to counter recent competitor responses. A publication that evaluates economies based on their competitiveness is the Global Competitiveness Report. Locate this report, and develop a presentation for the top management team that presents the benefits and drawbacks for the top five Asian economies listed.
A C S I a n d S a t i s f y i n g G l o b a l C u s t o m e r s
c l o s i n g c a s e
e American Customer Satisfaction Index (ACSI, theacsi.org) is an economic-based index, or indicator, that measures the satisfaction of consumers across the U.S. economy. e ACSI is produced by the American Customer Satisfaction Index (ACSI LLC), which is headquartered in Ann Arbor, Michigan. With the leadership of its founder—Dr. Claes Fornell—the ACSI was created by a team of researchers at the University of Michigan’s Ross School of Business in 1994, in cooperation with the American Society for Quality and the
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CFI Group Inc. e U.S. satisfaction index was modeled after Fornell’s Swedish Customer Satisfaction Barometer, which originated in 1989.
ACSI scores in the United States are updated monthly on a rolling basis, factoring in annual data from almost 200,000 customers who represent more than 300 companies from 10 economic sectors and 43 industries. Each month, ACSI issues an update on one or more specific industries. Additionally, a quarterly reported national measure of ACSI serves as a macro indicator of the economic health of the national economy. is national ACSI score reflects an aggregate of customer satisfaction from the measured companies that, together, comprise the largest market share in any given industry, producing a gauge of economic utility and consumer demand in the country. Since its beginnings in 1994, the nationwide ACSI score has ranged from a low of 70.7 in Quarter 1 of 1997 to a high of 77.0 in Quarter 1 of 2017 (on a 100- point scale, where 100 is perfectly satisfied and 0 is not satisfied at all).
© American Customer Satisfaction Index. Used with permission. e American Customer Satisfaction Index uses customer interviews as input to a multi- equation econometric model developed at the University of Michigan’s Ross School of Business (see picture). e ACSI model is a cause-and-effect model with indices for drivers of satisfaction on the left side (customer expectations, perceived quality, and perceived value), satisfaction (ACSI) in the center, and outcomes of satisfaction on the right side (customer complaints and customer loyalty, including customer retention and price tolerance).
e Swedish and American customer satisfaction indices have also evolved into Global Customer
Satisfaction Indices (Global CSITM). Some of the countries where ACSI has global partners include Australia, Colombia, India, Kuwait, Saudi Arabia, Singapore, South Africa, and South Korea. e Global CSI enables organizations around the world to better understand customer satisfaction via ACSI’s scientific methodology, allowing for benchmarking of national economies and multinational corporations’ customers worldwide. Globally, customer satisfaction has become an indicator of the health of each country’s economy at large and, importantly, a driving force that impacts the financial outlook of individual companies.
For example, Amazon uses the ACSI to gauge that it continues to do well on customer satisfaction metrics worldwide. Jeffrey P. Bezos, founder and chief executive officer of Amazon.com, Inc., wrote in the first sentence of his 2017 Letter to Shareholders: “e American Customer Satisfaction Index recently announced the results of its annual survey, and for the 8th year in a row customers ranked Amazon #1.” For Amazon, which also announced that it has surpassed 100 million “Prime” members in 2018, constantly having the correct pulse on what customers think is critically important to its business success. (Amazon Prime is a paid subscription service offered by Amazon that gives users access to free two-day delivery, streaming video and music, and other benefits for a monthly or yearly fee.)
is “customer pulse” traces back to Bezos’s first Letter to Shareholders in 1997, where he focused a whole section on “obsess over customers.” e buzzwords and phrases then, as now, for Amazon are “offering our customers compelling value” and “saves customers money and precious time.” But the company
also wants to be part of the customer journey and “accelerate the very process of discovery.” Bezos says: “One thing I love about customers is that they are divinely discontent. eir expectations are never static—they go up. It’s human nature.” ese intricate nuances of customers’ needs, wants, and attributes make it clear that a core performance outcome for Amazon is customer satisfaction globally.
Beyond Amazon’s focus on customer satisfaction globally, some of the core takeaways from cross-cultural satisfaction analyses suggest, for example, that customers in traditional societies have higher levels of satisfaction than those in secular-rational societies. Also, customers in self-expressive nations have higher levels of satisfaction scores than those in nations with survival values. Several customer demographics and country infrastructure variables influence customer satisfaction as well: Literacy rate, trade freedom, and business freedom have positive influences on customer satisfaction. On the other hand, per capita gross domestic product (GDP) has a negative effect on satisfaction.
At the company level, the effects of customer satisfaction on a variety of important business performance indicators have been studied for more than two decades. Amazon certainly understands this. And more and more companies are getting on board with the idea that customer satisfaction is not just a “feel good” thing for companies; it has concrete connection to the bottom-line performance. More than ever, data highlight the importance of the need to satisfy global customers continuously. Previously, a debate about whether companies with superior customer satisfaction also earn better-than-average stock returns had persisted in business circles. Proponents of the customer satisfaction–stock market relationship make a simple, intuitive argument that is highly relevant to both customers and investors: Companies that do better by their customers also do better in the stock market. A 15-year study supports this notion. Cumulative satisfaction portfolio returns over that time period produced results of 518 percent growth compared to only a 31 percent increase in the Standard and Poor’s 500 benchmark (S&P 500). On an annual basis, the customer satisfaction portfolio also outperformed the S&P 500 in 14 out of the 15 years.
ese results take on added importance globally when accounting for the lack of understanding many companies’ managers have of their customers’ needs and wants. Research indicates that managers generally fail to understand their companies’ customers in two important ways: Managers overestimate customers’ satisfaction levels as well as the loyalty customers have to the companies’ products and services. Managers’ understanding of how to satisfy customers is also often disconnected from what the customers actually expect the companies to do. Creating a better connection between multinational corporations and their customers is the job of global marketing professionals. is takes research and development (R&D), global marketing strategy development, and implementation of tactical marketing activities.
Sources: Claes Fornell, Forrest Morgeson, and Tomas Hult, “Companies at Do Better by eir Customers Also Do Better in the Stock Market,” LSE Business Review, February 20, 2017; Forrest Morgeson, Sunil Mithas, Timothy Keiningham, and Lerzan Aksoy, “An Investigation of the Cross-National Determinants of Customer Satisfaction,” Journal of the Academy of Marketing Science 39, no. 2 (2011), pp. 198–215; Tomas Hult, Forrest Morgeson, Neil Morgan, Sunil Mithas, and Claes Fornell, “Do Firms Know What eir Customers ink and Why?” Journal of the Academy of Marketing Science 45, no. 1 (2017), pp. 37–54; Claes Fornell, Forrest Morgeson, and Tomas Hult, “Stock Returns on Customer Satisfaction Do Beat the Market: Gauging the Effect of a Marketing Intangible” Journal of Marketing 80, no. 5 (2016), pp. 92–107; and Claes Fornell, Forrest Morgeson, and Tomas Hult, “An Abnormally Abnormal Intangible: Stock Returns on Customer Satisfaction,” Journal of Marketing 80, no. 5 (2016), pp. 122–25.
CASE DISCUSSION QUESTIONS
1. Customer satisfaction is a “soft measure” of what customers think of a product or service. We already know that people from different cultures have a tendency to answer surveys and these “soft” questions differently based on their cultural background. In general, how would we expect someone from the United States, China, Japan, Canada, and the United Kingdom (the top five countries with the largest number of Starbucks stores worldwide) to answer how satisfied they were with a recent Starbucks visit?
2. Jeffrey P. Bezos, founder and chief executive officer of Amazon.com, Inc., says, “One thing I love about customers is that they are divinely discontent. eir expectations are never static —they go up. It’s human nature.” Do your expectations constantly go up? Is this fair to
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companies? Why or why not? And do you think it is true that customers expect more today than before?
3. Proponents of the customer satisfaction–stock market relationship make a simple, intuitive argument that is highly relevant to both customers and investors: Companies that do better by their customers also do better in the stock market. Describe a company you have bought from in the last couple of years, and discuss how satisfied, or not, you were with the experience, and how that affected the company’s stock price in the same time period.
Endnotes
1. See R. W. Ruekert and O. C. Walker, “Interactions between Marketing and R&D Departments in Implementing Different Business-Level Strategies,” Strategic Management Journal 8 (1987), pp. 233–48; and K. B. Clark and S. C. Wheelwright, Managing New Product and Process Development (New York: Free Press, 1993).
2. T. Levitt, “e Globalization of Markets,” Harvard Business Review, May–June 1983, pp. 92– 102.
3. For example, see S. P. Douglas and Y. Wind, “e Myth of Globalization,” Columbia Journal of World Business, Winter 1987, pp. 19–29; C. A. Bartlett and S. Ghoshal, Managing across Borders: e Transnational Solution (Boston: Harvard Business School Press, 1989); V. J. Govindarajan and A. K. Gupta, e Quest for Global Dominance (San Francisco: Jossey-Bass, 2001); J. Quelch, “e Return of the Global Brand,” Harvard Business Review, August 2003, pp. 1–3; and P. J. Ghemawat, Redefining Global Strategy (Boston: Harvard Business School Press, 2007).
4. J. Tagliabue, “U.S. Brands Are Feeling Global Tension,” e New York Times, March 15, 2003, p. C3.
5. D. B. Holt, J. A. Quelch, and E. L. Taylor, “How Global Brands Compete,” Harvard Business Review, September 2004.
6. Bertel Schmitt, “It’s Official: Volkswagen Is World’s Largest Automaker In 2016. Or Maybe Toyota,” Forbes, January 30, 2017.
7. Brian R. Chabowski, Samiee Saeed, and G. Tomas M. Hult “A Bibliometric Analysis of the Global Branding Literature and a Research Agenda,” Journal of International Business Studies 44, no. 6(2013), pp. 622–34.
8. J. T. Landry, “Emerging Markets: Are Chinese Consumers Coming of Age?” Harvard Business Review, May–June 1998, pp. 17–20.
9. C. Miller, “Teens Seen as the First Truly Global Consumers,” Marketing News, March 27, 1995, p. 9.
10. Michael Giebelhausen, Helen Chun HaeEun J. Joseph Cronin Jr., and G. Tomas M. Hult, “Adjusting the Warm Glow ermostat: How Incentivizing Participation in Voluntary Green Programs Moderates eir Impact on Service Satisfaction,” Journal of Marketing 80, no. 4 (2016), pp. 56–71.
11. Claes Fornell, Forrest V. Morgeson III, and G. Tomas M. Hult, “Stock Returns on Customer Satisfaction Do Beat the Market: Gauging the Effect of a Marketing Intangible” Journal of Marketing 80, no. 5 (2016), pp. 92–107.
12. Austen Hufford, “Nielsen Revenue Up, But Profit Slips,” e Wall Street Journal, February 9, 2017.
13. e Nielsen Company, www.nielsen.com.
14. For full disclosure, G. Tomas M. Hult, who is an author on this text, holds the John WillIam Byington Endowed Chair in Global Marketing. J. W. Byington was a former president of the NPD Group Worldwide Inc.
15. We summarized the basic steps in the international market research process. Detailed discussions of similar processes can be found in P. Cateora, M. Gilly, and J. Graham, International Marketing (New York: McGraw-Hill, 2013); V. Kumar, International Marketing Research (Upper Saddle River, NJ: Pearson Prentice Hall, 2000); and C. S. Craig and S. P. Douglas, International Marketing Research (West Sussex, UK: Wiley, 2005).
16. B. Pedersen, T. Pedersen, and M. Lyles, “Closing the Knowledge Gaps in Foreign Markets,” Journal of International Business Studies 39 (2008), pp. 1097–13.
17. Quoted in P. Ziobro, “Mattel Takes a Hit as Barbie Sales Slump,” e Wall Street Journal, January 31, 2014.
18. Kumar, International Marketing Research; and Craig and Douglas, International Marketing Research.
19. A-W. Harzing, “Response Rates in International Mail Surveys: Results of a 22-Country Study,” International Business Review 6 (1997), pp. 641–65.
20. Kumar, International Marketing Research; Craig and Douglas, International Marketing Research; J. Hair, W. Black, B. Babin, and R. Anderson, Multivariate Data Analysis (Upper Saddle River, NJ: Pearson Prentice Hall, 2010); andJ. Hair, T. Hult, C. Ringle, and M. Sarstedt, A Primer on Partial Least Squares Structural Equation Modeling (PLS-SEM) (Los Angeles, CA: Sage, 2014).
21. Joseph F. Hair Jr., G. Tomas M. Hult, Christian Ringle, and Marko Sarstedt, A Primer on Partial Least Squares Structural Equation Modeling (PLS-SEM), 2nd ed. (Newbury Park, CA: Sage, 2017).
22. N. Bunkley, “Toyota Issues a 2nd Recall,” e New York Times, January 21, 2010.
23. is approach was originally developed in K. Lancaster, “A New Approach to Demand eory,” Journal of Political Economy 74 (1965), pp. 132–57.
24. Vassiliki Bamiatzi, Konstantinos Bozos, S. Tamer Cavusgil, and G. Tomas M. Hult, “Revisiting the Firm, Industry and Country Effects on Profitability under Recessionary and Expansion Periods: A Multi-Level Analysis,” Strategic Management Journal 37, no. 7 (2016), pp. 1448–71.
25. Tatiana Kostova and G. Tomas M. Hult, “Meyer and Peng’s 2005 Article as a Foundation for an Expanded and Refined International Business Research Agenda: Context, Organizations, and eories,” Journal of International Business Studies 47, no. 1 (2016), pp. 23–32.
26. V. R. Alden, “Who Says You Can’t Crack Japanese Markets?” Harvard Business Review, January– February 1987, pp. 52–56.
27. G. Tomas M. Hult, Forrest V. Morgeson III, Neil A. Morgan, Sunil Mithas, and Claes Fornell, “Do Firms Know What eir Customers ink and Why?” Journal of the Academy of Marketing Science 45, no. 1 (2017), pp. 37–54.
28. Amelia Josephson, “e Economics of Video Streaming Services,” Smart Asset, January 8, 2016.
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29. Tomas Hult, David Closs, and David Frayer, Global Supply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill Professional, 2014).
30. C. Matlack and P. Gogoi, “What’s is? e French Love McDonald’s?” BusinessWeek, January 13, 2003, pp. 50–51.
31. Z. Gurhan-Cvanli and D. Maheswaran, “Cultural Variation in Country of Origin Effects,” Journal of Marketing Research, August 2000, pp. 309–17.
32. See M. Laroche, V. H. Kirpalani, F. Pons, and L. Zhou, “A Model of Advertising Standardization in Multinational Corporations,” Journal of International Business Studies 32 (2001), pp. 249–66; and D. A. Aaker and E. Joachimsthaler, “e Lure of Global Branding,” Harvard Business Review, November–December 1999, pp. 137–44.
33. “Advertising in a Single Market,” e Economist, March 24, 1990, p. 64.
34. R. G. Matthews and D. Pringle, “Nokia Bets One Global Message Will Ring True in Many Markets,” e Wall Street Journal, September 27, 2004, p. B6.
35. R. J. Dolan and H. Simon, Power Pricing (New York: Free Press, 1999).
36. B. Stottinger, “Strategic Export Pricing: A Long Winding Road,” Journal of International Marketing 9 (2001), pp. 40–63; S. Gil-Pareja, “Export Process Discrimination in Europe and Exchange Rates,” Review of International Economics, May 2002, pp. 299–312; and G. Corsetti and L. Dedola, “A Macro Economic Model of International Price Discrimination,” Journal of International Economics, September 2005, pp. 129–40.
37. ese allegations were made on a PBS Frontline documentary telecast in the United States in May 1992.
38. G. Smith and B. Wolverton, “A Dark Moment for Kodak,” BusinessWeek, August 4, 1997, pp. 30–31.
39. R. Narisette and J. Friedland, “Disposable Income: Diaper Wars of P&G and Kimberly-Clark Now Heat Up in Brazil,” e Wall Street Journal, June 4, 1997, p. A1.
40. J. F. Pickering, Industrial Structure and Market Conduct (London: Martin Robertson, 1974).
41. S. P. Douglas, C. Samuel Craig, and E. J. Nijissen, “Integrating Branding Strategy across Markets,” Journal of International Marketing 9, no. 2 (2001), pp. 97–114.
42. e phrase was first used by economist Joseph Schumpeter in Capitalism, Socialism, and Democracy (New York: Harper Brothers, 1942).
43. S. Kotabe, S. Srinivasan, and P. S. Aulakh. “Multinationality and Firm Performance: e Moderating Role of R&D and Marketing,” Journal of International Business Studies 33 (2002), pp. 79–97.
44. D. C. Mowery and N. Rosenberg, Technology and the Pursuit of Economic Growth (Cambridge, UK: Cambridge University Press, 1989); and M. E. Porter, e Competitive Advantage of Nations (New York: Free Press, 1990).
45. W. Kuemmerle, “Building Effective R&D Capabilities Abroad,” Harvard Business Review, March–April 1997, pp. 61–70; and C. Le Bas and C. Sierra, “Location versus Home Country Advantages in R&D Activities,” Research Policy 31 (2002), pp. 589–609.
46. “When the Corporate Lab Goes to Japan,” e New York Times, April 28, 1991, sec. 3, p. 1.
47. D. Shapley, “Globalization Prompts Exodus,” Financial Times, March 17, 1994, p. 10.
48. E. Mansfield, “How Economists See R&D,” Harvard Business Review, November–December 1981, pp. 98–106.
49. E. Mansfield, “How Economists See R&D,” Harvard Business Review, November–December 1981, pp. 98–106.
50. G. A. Stevens and J. Burley, “Piloting the Rocket of Radical Innovation,” Research Technology Management 46 (2003), pp. 16–26.
51. K. B. Clark and S. C. Wheelwright, Managing New Product and Process Development (New York: Free Press, 1993); and M. A. Shilling and C. W. L. Hill, “Managing the New Product Development Process,” Academy of Management Executive 12, no. 3 (1998), pp. 67–81.
52. O. Port, “Moving Past the Assembly Line,” BusinessWeek Special Issue: Reinventing America, 1992, pp. 177–80.
53. K. B. Clark and T. Fujimoto, “e Power of Product Integrity,” Harvard Business Review, November–December 1990, pp. 107–18; Clark and Wheelwright, Managing New Product and Process Development; S. L. Brown and K. M. Eisenhardt, “Product Development: Past Research, Present Findings, and Future Directions,” Academy of Management Review 20 (1995), pp. 348– 78; and G. Stalk and T. M. Hout, Competing against Time (New York: Free Press, 1990).
54. G. Tomas M. Hult, Boundary-Spanning Marketing Organization: A eory and Insights from 31 Organization eories (Springer, 2012).
55. Shilling and Hill, “Managing the New Product Development Process.”
56. C. Christensen, “Quantum Corporation—Business and Product Teams,” Harvard Business School case no. 9–692–023.
57. R. Nobel and J. Birkinshaw, “Innovation in Multinational Corporations: Control and Communication Patterns in International R&D Operations,” Strategic Management Journal 19 (1998), pp. 479–96.
58. Information comes from the company’s website; also see K. Ferdows, “Making the Most of Foreign Factories,” Harvard Business Review, March–April 1997, pp. 73–88.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw- Hill Education
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17
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Part 6 International Business Functions
Global Human Resource Management
L e a r n i n g O b j e c t i v e s
After reading this chapter, you will be able to:
LO17-1 Summarize the strategic role of human resource management in international business.
LO17-2 Identify the pros and cons of different approaches to staffing policy in international business.
LO17-3 Explain why managers may fail to thrive in foreign postings.
LO17-4 Recognize how management development and training programs can increase the value of human capital in the
international business firm.
LO17-5 Explain how and why performance appraisal systems might vary across nations.
LO17-6 Understand how and why compensation systems might vary across nations.
LO17-7 Understand how organized labor can influence strategic choices in international business firms.
Global Mobility at Shell
opening case
Royal Dutch Shell is a British-Dutch multinational oil and gas company that is headquartered in the Netherlands and
incorporated in the United Kingdom. e company is one of the world’s largest oil producers with revenues of over $300
billion and operations in more than 70 countries. e company has some 90,000 employees, of which 6,000–7,000 at
any one time are on expatriate assignments outside their home country. A crucial task for Shell is to manage this extensive
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population of expatriate workers in order to meet its commercial goals and transfer valuable technical and managerial
knowledge across operations located in different nations. It’s no easy task.
Shell’s long-term goal is to develop local talent wherever possible, thereby leveraging local employees’ networks, market
knowledge, and language skills, while also minimizing costs. However, there are many cases where deploying foreign
nationals makes the most commercial sense. First, there is often a shortage of skills in certain locations. Shell has found
this to be a vital issue in the Middle East and North Africa, where Shell often works with local joint venture partners or
third parties. Moving Shell employees from other countries to work with partners and transfer expertise is often a key part
of the company’s strategy. Second, Shell recognizes that the skills of staff and senior leadership are improved by significant
exposure to overseas markets. In other words, in a multinational like Shell, high-potential employees need to understand
what it is like to live and work in other countries—to get a sense for the conditions on the ground. ird, in many
instances, senior Shell employees need to be on the management boards of local subsidiaries in order to effectively
monitor and control those operations and keep the head office informed of developments.
As Shell has found, however, moving employees to other countries raises a number of important challenges. It’s not
always easy to recruit skilled personnel to work in different locations. A survey of expatriate personnel at Shell found that
five issues had the greatest impact on the willingness of an employee to accept an international assignment. In order of
importance, these were (1) separation from children during their secondary education, (2) harm done to a spouse’s career
and employment, (3) failure to recognize and involve a spouse in the relocation decision, (4) failure to provide adequate
information and assistance regarding relocation, and (5) health issues. e underlying message was that the family is the
basic unit of expatriation, not the individual, and Shell needed to do more to recognize this.
To deal with these issues, Shell implemented a number of programs designed to address some of these problems. To
help with the education of children, Shell built elementary schools for Shell employees where there was a heavy
concentration of expatriates. As for secondary school education, Shell worked with local schools, often providing grants,
to help them upgrade their educational offerings. It also offered an education supplement to help expatriates send their
children to private schools in the host country.
Helping spouses with their careers is a more vexing problem. According to the survey data, half the spouses
accompanying Shell staff on assignment were employed until the transfer. When expatriated, only 12 percent were able to
secure employment, while a further 33 percent wished to be employed. Shell set up a spouse employment center to
address the problem. e center provides career counseling and assistance in locating employment opportunities both
during and immediately after an international assignment. e company also agreed to reimburse up to 80 percent of the
costs of vocational training, further education, or reaccreditation.
Shell set up a global information and advice network known as “e Outpost” to provide support for families facing
the challenges of global mobility. e Outpost has its headquarters in e Hague with about 50 local offices around the
world. e center recommends schools and medical facilities and provides housing advice and up-to-date information on
employment, study, self-employment, and volunteer work.
Finally, there are also important issues with expatriate pay. An expatriate’s basic salary and bonus are linked to what
they would receive in their home country. Additional pay is given to expatriates moving to more expensive locations so
that they can maintain their standard of living. Shell also recognizes that employees often need additional financial
incentives to persuade them to leave family and friends and location “premiums” to persuade them to move to less popular
expatriate destinations, such as Kuwait and Iraq. Shell also uses tax equalization as part of its expatriate pay approach.
Specifically, home country taxes are deducted from an expatriate’s pay, while the host country taxes are paid by the
company. Of course, all of these added factors make expatriates an expensive resource that can cost up to three times as
much as a local employee. •
Sources: Binbraik, Aysha, “International Mobility at Shell,” Mercer Management Consulting, 2016; DeGraff, J., “Single System Expatriate
Compensation,” Cornell HR Review, April 7, 2010; Barbian, J., “Return to Sender,” Training, January 2002, 40–43; and Mainwaring, J., “Shell
Schools: Supporting Expat Families,” Rigzone, June 21, 2012.
Introduction
is chapter continues our focus on business functions within a company engaged in a global marketplace of
some 7 billion people by looking at global human resource management. Human resource management
(HRM) refers to the activities an organization carries out to use its human resources effectively.1 ese activities
include determining the firm’s human resource strategy, staffing, performance evaluation, management
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development, compensation, and labor relations. Taken together, these activities determine how an international
business builds and manages its global workforce.
Did You Know?
Did you know the world population is now 7 billion?
Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
None of these global HRM activities is performed in a vacuum; all are related to the global strategy of the
firm. As we will see in this chapter, HRM has an important strategic component.2 rough its influence on the
character, development, quality, and productivity of the firm’s human resources, the HRM function can help the
firm achieve its primary strategic goals of reducing the costs of value creation and adding value by better serving
customers. A good example of this is given in the opening case, which looks at how Shell uses its human
resources around the world. At any one time, some 7 percent of Shell’s employees are working outside of their
home country, many for extended periods. e benefits of this include transferring valuable managerial and
technical skills to local operations, developing leaders who know what it is like to do business in different
countries (a major issue in a multinational like Shell, which has operations in 70 nations), and ensuring
management oversight of local operations.
Irrespective of the desire of managers in multinational companies such as Shell to build a truly global
enterprise with a global workforce, the reality is that HRM practices still have to be modified to national
contexts. e strategic role of HRM is complex enough in a purely domestic firm, but it is more complex in an
international business, where staffing, management development, performance evaluation, and compensation
activities are complicated by profound differences between countries in labor markets, culture, legal
systems, economic systems, and the like (see Chapters 2, 3, and 4). For example,
Compensation practices may vary from country to country, depending on prevailing management customs.
Labor laws may prohibit union organization in one country and mandate it in another.
Equal employment legislation may be strongly pursued in one country and not in another.
Ethnic and cultural realities may require some modification of company policies.
If it is to build a cadre of managers capable of managing a multinational enterprise, the HRM function must
deal with a host of issues. It must decide how to staff key management posts in the company, how to develop
managers so that they are familiar with the nuances of doing business in different countries, how to compensate
people in different nations, and how to evaluate the performance of managers based in different countries. HRM
must also deal with a myriad of issues related to expatriate managers. (An expatriate manager is a citizen of one
country who is working abroad in one of the firm’s subsidiaries.) It must decide when to use expatriates,
determine whom to send on expatriate postings, be clear about the reasons why, compensate expatriates
appropriately, and make sure that they are adequately debriefed and reoriented once they return home.
is chapter looks closely at the role of HRM in an international business. It begins by briefly discussing the
strategic role of HRM. en we turn our attention to four major tasks of the HRM function: staffing policy,
management training and development, performance appraisal, and compensation policy. We point out the
strategic implications of each task. We then look at how firms can build a globally diverse workforce, and why
this can benefit the enterprise, resulting in higher financial performance. e chapter closes with a look at
international labor relations and the relationship between the firm’s management of labor relations and its overall
strategy.
Strategic Role of Global HRM: Managing a Global Workforce
LO 17-1 Summarize the strategic role of human resource management in international business.
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International Internship Directory
A large and expanding body of academic research suggests that a strong fit between human resource practices and
strategy is required for high profitability.3 You will recall from Chapter 12 that superior performance requires not
only the right strategy, but that the strategy be supported by the right organizational architecture. Strategy is
implemented through organization. As shown in Figure 17.1, people are the linchpin of a firm’s organizational
architecture. For a firm to outperform its rivals in the global marketplace, it must have the right people in the
right postings. ose people must be trained appropriately so that they have the skill sets required to
perform their jobs effectively and so that they behave in a manner that is congruent with the desired
culture of the firm. eir compensation packages must create incentives for them to take actions that are
consistent with the strategy of the firm, and the performance appraisal system the firm uses must measure the
behavior that the firm wants to encourage.
17.1 FIGURE
e role of human resources in shaping organizational architecture.
As indicated in Figure 17.1, the HRM function, through its staffing, training, compensation, and
performance appraisal policies, has a critical impact on the people, culture, incentive, and control system
elements of the firm’s organizational architecture (performance appraisal systems are part of the control systems in
an enterprise). us, HRM professionals have a critically important strategic role. It is incumbent on them to
shape these elements of a firm’s organizational architecture in a manner that is consistent with the strategy of the
enterprise so that the firm can effectively implement its strategy.
People are what make value
chains “valuable,” and global
human resource management, which is the focus of Chapter 17, is a critical part of operating worldwide. e obvious HR
issue to us as authors is YOU—the student and reader of this text! Our goal is to provide information and data and infuse
our knowledge to each student using the text. globalEDGE™ can help take this knowledge to another level with its
International Internship Directory (globaledge.msu.edu/international-internships). e directory is a reference guide for
students and others (e.g., faculty, staff, and administrators) to help match students with international internship
opportunities offered by universities, governmental agencies, nonprofit groups, private organizations, and corporations. To
search for an internship, you can select a type of organization, country, or subject of study (e.g., international business).
Check it out. What opportunities can you find based on your interests?
In short, superior human resource management can be a sustained source of high productivity and
competitive advantage in the global economy. At the same time, research suggests that many international
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businesses have room for improving the effectiveness of their HRM function. In one study of competitiveness
among 326 large multinationals, the authors found that human resource management was one of the weakest
capabilities in most firms, suggesting that improving the effectiveness of international HRM practices might have
substantial performance benefits.4
In Chapter 12, we examined four strategies pursued by international businesses: localization strategy, global
standardization strategy, transnational strategy, and international strategy. In this chapter, we will see that success
also requires HRM policies to be congruent with the firm’s strategy. For example, a transnational strategy imposes
different requirements for staffing, management development, and compensation practices from a localization
strategy. Firms pursuing a transnational strategy need to build a strong corporate culture and an informal
management network for transmitting information and knowledge within the organization. rough its
employee selection, management development, performance appraisal, and compensation policies, the HRM
function can help develop these things. us, as we have noted, HRM has a critical role to play in implementing
strategy. In each section that follows, we review the strategic role of HRM in some detail.
test PREP
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Staffing Policy
LO 17-2 Identify the pros and cons of different approaches to staffing policy in international business.
Staffing policy is concerned with the selection of employees for particular jobs. At one level, this involves
selecting individuals who have the skills required to do particular jobs. At another level, staffing policy can be a
tool for developing and promoting the desired corporate culture of the firm.5 By corporate culture, we mean the
organization’s norms and value systems. A strong corporate culture can help a firm implement its strategy.
General Electric, for example, is not just concerned with hiring people who have the skills required for
performing particular jobs; it wants to hire individuals whose behavioral styles, beliefs, and value systems are
consistent with those of GE. is is true whether an American is being hired, or an Australian, a German, or a
Swede, and whether the hiring is for a U.S. operation or a foreign operation. e belief is that if employees are
predisposed toward the organization’s norms and value systems by their personality type, the firm will be able to
attain higher performance.
TYPES OF STAFFING POLICIES
Research has identified three types of staffing policies in international businesses: the ethnocentric approach, the
polycentric approach, and the geocentric approach.6 We review each policy and link it to the strategy pursued by
the firm. e most attractive staffing policy is probably the geocentric approach, although there are several
impediments to adopting it.
e Ethnocentric Approach An ethnocentric staffing policy is one in which all key management positions are filled by parent-country nationals. is practice was widespread at one time. Firms such as Procter
& Gamble, Philips, and Matsushita (now called Panasonic) originally followed it. In the Dutch firm Philips, for
example, all important positions in most foreign subsidiaries were at one time held by Dutch nationals, who were
referred to by their non-Dutch colleagues as the Dutch Mafia. Historically, in many Japanese and South Korean
firms, such as Toyota, Matsushita, and Samsung, key positions in international operations have often been held
by home-country nationals. For example, according to the Japanese Overseas Enterprise Association, only 29
percent of foreign subsidiaries of Japanese companies had presidents who were not Japanese. In contrast, 66
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percent of the Japanese subsidiaries of foreign companies had Japanese presidents.7 Today, there is evidence that
as Chinese enterprises are expanding internationally, they too are using an ethnocentric staffing policy in their
foreign operations.8
Firms pursue an ethnocentric staffing policy for three reasons. First, the firm may believe the host country
lacks qualified individuals to fill senior management positions. is argument is heard most often when the firm
has operations in less developed countries. Second, the firm may see an ethnocentric staffing policy as the best
way to maintain a unified corporate culture. Many Japanese firms, for example, have traditionally preferred their
foreign operations to be headed by expatriate Japanese managers because these managers will have been socialized
into the firm’s culture while employed in Japan.9 Procter & Gamble until fairly recently preferred to staff
important management positions in its foreign subsidiaries with U.S. nationals who had been socialized into
P&G’s corporate culture by years of employment in its U.S. operations. Such reasoning tends to predominate
when a firm places a high value on its corporate culture.
ird, if the firm is trying to create value by transferring core competencies to a foreign operation, as firms
pursuing an international strategy are, it may believe that the best way to do this is to transfer parent-country
nationals who have knowledge of that competency to the foreign operation. Imagine what might occur if a firm
tried to transfer a core competency in marketing to a foreign subsidiary without a corresponding transfer of
home-country marketing management personnel. e transfer would probably fail to produce the anticipated
benefits because the knowledge underlying a core competency cannot easily be articulated and written down.
Such knowledge often has a significant tacit dimension; it is acquired through experience. Just like the great
tennis player who cannot instruct others how to become great tennis players simply by writing a handbook, the
firm that has a core competency in marketing, or anything else, cannot just write a handbook that tells a foreign
subsidiary how to build the firm’s core competency anew in a foreign setting. It must also transfer management
personnel to the foreign operation to show foreign managers how to become good marketers, for example. e
need to transfer managers overseas arises because the knowledge that underlies the firm’s core competency resides
in the heads of its domestic managers and was acquired through years of experience, not by reading a handbook.
us, if a firm is to transfer a core competency to a foreign subsidiary, it must also transfer the appropriate
managers.
Will We See an Influx of Chinese Workers Worldwide?
Asia is among the fastest-growing areas of the world for international students. For example, foreign enrollment of
students at universities in Indonesia and South Korea has more than doubled since 2005. In particular, China has become
the most popular destination in Asia, and the country ranks third among all countries in hosting international students.
Education in China is still a state-run system of public education, where the Ministry of Education is in charge. By some
estimates, China has been growing investment in education by some 20 percent annually for more than a decade, and the
quality of education has been improved along with this increased spending. is has resulted in Chinese people becoming
more knowledgeable about today’s global marketplace; adding to the pool of talent are the Chinese who are educated
abroad and decide to return home after their education. Collectively, these highly educated Chinese are more likely to
want to work for a foreign company than a Chinese company. Companies already recruit Chinese in China for their
foreign operations, but how significant do you think the potential influx of Chinese-educated people around the world
will become in the next five years?
Source: Sheehy, K., “Explore the World’s Top Universities,” U.S. News & World Report, October 8, 2013, http://www.usnews.com/education/best-global-universities/articles/2013/10/08/explore-the-worlds-top-universities.
Despite this rationale for pursuing an ethnocentric staffing policy, the policy is now on the wane in
most international businesses for two reasons. First, an ethnocentric staffing policy limits advancement
opportunities for host-country nationals. is can lead to resentment, lower productivity, and increased turnover
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among that group. Resentment can be greater still if, as often occurs, expatriate managers are paid significantly
more than home-country nationals.
Second, an ethnocentric policy can lead to cultural myopia—the firm’s failure to understand host-country
cultural differences that require different approaches to marketing and management. e adaptation of expatriate
managers can take a long time, during which they may make major mistakes. For example, expatriate managers
may fail to appreciate how product attributes, distribution strategy, communications strategy, and pricing strategy
should be adapted to host-country conditions. e result may be costly blunders. ey may also make decisions
that are ethically suspect simply because they do not understand the culture in which they are managing.10 In
one highly publicized case in the United States, Mitsubishi Motors was sued by the federal Equal Employment
Opportunity Commission for tolerating extensive and systematic sexual harassment in a plant in Illinois. e
plant’s top management, all Japanese expatriates, denied the charges. e Japanese managers may have failed to
realize that behavior that would be viewed as acceptable in Japan was not acceptable in the United States.11
e Polycentric Approach A polycentric staffing policy requires host-country nationals to be recruited to manage subsidiaries, while parent-country nationals occupy key positions at corporate headquarters. In many
respects, a polycentric approach is a response to the shortcomings of an ethnocentric approach. One advantage of
adopting a polycentric approach is that the firm is less likely to suffer from cultural myopia. Host-country
managers are unlikely to make the mistakes arising from cultural misunderstandings to which expatriate
managers are vulnerable. A second advantage is that a polycentric approach may be less expensive to implement,
reducing the costs of value creation. Expatriate managers can be expensive to maintain.
A polycentric approach has its drawbacks. Host-country nationals have limited opportunities to gain
experience outside their own country and thus cannot progress beyond senior positions in their own subsidiary.
As in the case of an ethnocentric policy, this may cause resentment. Perhaps the major drawback with a
polycentric approach, however, is the gap that can form between host-country managers and parent-country
managers. Language barriers, national loyalties, and a range of cultural differences may isolate the corporate
headquarters staff from the various foreign subsidiaries. e lack of management transfers from home to host
countries and vice versa can exacerbate this isolation and lead to a lack of integration between corporate
headquarters and foreign subsidiaries. e result can be a “federation” of largely independent national units with
only nominal links to the corporate headquarters. Within such a federation, the coordination required to transfer
core competencies or to pursue experience curve and location economies may be difficult to achieve. us,
although a polycentric approach may be effective for firms pursuing a localization strategy, it is inappropriate for
other strategies.
e federation that may result from a polycentric approach can also be a force for inertia within the firm.
After decades of pursuing a polycentric staffing policy, food and detergents giant Unilever found that shifting
from a strategic posture that emphasized localization to a transnational posture was very difficult. Unilever’s
foreign subsidiaries had evolved into quasi-autonomous operations, each with its own strong national identity.
ese “little kingdoms” objected strenuously to corporate headquarters’ attempts to limit their autonomy and to
rationalize global manufacturing.12
e Geocentric Approach A geocentric staffing policy seeks the best people for key jobs throughout the organization, regardless of nationality. is policy has a number of advantages. First, it enables the firm to make
the best use of its human resources. Second, and perhaps more important, a geocentric policy enables the firm to
build a cadre of international executives who feel at home working in a number of cultures. Creation of such a
cadre may be a critical first step toward building a strong unifying corporate culture and an informal
management network, both of which are required for global standardization and transnational
strategies.13 Firms pursuing a geocentric staffing policy may be better able to create value from the
pursuit of experience curve and location economies and from the multidirectional transfer of core competencies
than firms pursuing other staffing policies. In addition, the multinational composition of the management team
that results from geocentric staffing tends to reduce cultural myopia and to enhance local responsiveness.
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In sum, other things being equal, a geocentric staffing policy seems the most attractive. Indeed, in recent years
there has been a sharp shift toward adoption of a geocentric staffing policy by many multinationals. For example,
India’s Tata Group, now more than a $100 billion global conglomerate, runs several of its companies with
American and British executives. Japan’s Sony Corporation broke 60 years of tradition in 2005 when it installed
its first non-Japanese chair and CEO, Howard Stringer, a former CBS president and a U.S. citizen who was born
and raised in Wales. American companies increasingly draw their managerial talent from overseas. In 2014, for
example, Microsoft appointed Satya Nadella, a native of India, to its CEO position. One study found that by the
mid-2000s, 24 percent of the managers among the top 100 to 250 people in U.S. companies were from outside
the United States. For European companies, the average was 40 percent.14
However, a number of problems limit the firm’s ability to pursue a geocentric policy. Many countries want
foreign subsidiaries to employ their citizens. To achieve this goal, they use immigration laws to require the
employment of host-country nationals if they are available in adequate numbers and have the necessary skills.
Most countries, including the United States, require firms to provide extensive documentation if they wish to
hire a foreign national instead of a local national. is documentation can be time-consuming, expensive, and at
times futile. A geocentric staffing policy also can be expensive to implement. Training and relocation costs
increase when transferring managers from country to country. e company may also need a compensation
structure with a standardized international base pay level higher than national levels in many countries. In
addition, the higher pay enjoyed by managers placed on an international fast track may be a source of resentment
within a firm.
Types of Staffing Policies Summary e advantages and disadvantages of the three approaches to staffing policy are summarized in Table 17.1. Broadly speaking, an ethnocentric approach is compatible with an
international strategy, a polycentric approach is compatible with a localization strategy, and a geocentric approach
is compatible with both global standardization and transnational strategies. (See Chapter 12 for details of the
strategies.)
17.1 TABLE
Comparison of Staffing Approaches
While the staffing policies described here are well known and widely used among both practitioners
and scholars of international businesses, some critics have claimed that the typology is too simplistic
and that it obscures the internal differentiation of management practices within international businesses. e
critics claim that within some international businesses, staffing policies vary significantly from national subsidiary
to national subsidiary; while some are managed on an ethnocentric basis, others are managed in a polycentric or
geocentric manner.15 Other critics note that the staffing policy adopted by a firm is primarily driven by its
geographic scope, as opposed to its strategic orientation. Firms that have a broad geographic scope are the most
likely to have a geocentric mindset.16
EXPATRIATE MANAGERS
LO 17-3 Explain why managers may fail to thrive in foreign postings.
Two of the three staffing policies we have discussed—the ethnocentric and the geocentric—rely on extensive use
of expatriate managers. As defined earlier, expatriates are citizens of one country who are working in another
country. Sometimes the term inpatriates is used to identify a subset of expatriates who are citizens of a foreign
country working in the home country of their multinational employer.17 us, a citizen of Japan who moves to
the United States to work at Microsoft would be classified as an inpatriate (Microsoft has large numbers of
inpatriates working at its main U.S. location near Seattle). With an ethnocentric policy, the expatriates are all
home-country nationals who are transferred abroad. With a geocentric approach, the expatriates need not be
home-country nationals; the firm does not base transfer decisions on nationality. A prominent issue in the
international staffing literature is expatriate failure—the premature return of an expatriate manager to his or her
home country.18 Here, we briefly review the evidence on expatriate failure before discussing a number of ways to
minimize the failure rate.
Expatriate Failure Rates Expatriate failure represents a failure of the firm’s selection policies to identify individuals who will not thrive abroad.19 e consequences include premature return from a foreign posting and
high resignation rates, with expatriates leaving their company at about twice the rate of domestic managers.20
e costs of expatriate failure are high. One estimate is that the average cost per failure to the parent firm can be
as high as three times the expatriate’s annual domestic salary plus the cost of relocation (which is affected by
currency exchange rates and location of assignment). Estimates of the costs of each failure run between $40,000
and $1 million.21 In addition, approximately 30 to 50 percent of American expatriates, whose average annual
compensation package runs to $250,000, stay at their international assignments but are considered ineffective or
marginally effective by their firms.22 In a seminal study undertaken in the 1980s, Rosalie Tung surveyed a
number of U.S., European, and Japanese multinationals.23 Her results, summarized in Table 17.2, show that 76
percent of U.S. multinationals experienced expatriate failure rates of 10 percent or more, and 7 percent
experienced a failure rate of more than 20 percent. Tung’s work also suggests that U.S.-based multinationals
experience a much higher expatriate failure rate than either European or Japanese multinationals. However, more
recent work suggests that Tung’s widely quoted estimates may no longer hold. For example, a study of 136 large
multinationals from four different countries undertaken in the late 2000s found that the rate of premature return
of expatriate managers had dropped to 6.3 percent and that there was little difference between multinationals
from different nations. e authors of this study suggest that multinationals have gotten much better at the
selection and training of expatriates since Tung’s study.24
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17.2 TABLE
Expatriate Failure Rates
Source: R. L. Tung, “Selection and Training Procedures of U.S., European, and Japanese Multinationals,” California Management Review vol. 25, no. 1, 1982, 51–71.
Would You Send a Woman on an International Assignment?
Would you send a woman expatriate to Saudi Arabia, Japan, Korea, or Kuwait? How are Western women expatriates
doing in foreign cultures that have traditionally limited women’s public roles? In many cases, women sent to these
countries have met with substantial success. eir key challenge is often simply to get the assignments! Once in place,
women expatriates are usually successful. is is in part because once in the culture, women expatriates are seen first as
expatriates who fall outside the local role for women. In addition, “expat” women also have salience in their new
environment—they are noticed—and this can be a distinct business advantage. Locals often take pride in developing
business relationships with women expatriates because by doing so, they can suggest that the foreign stereotype of their
culture is superficial and incomplete. But cultural barriers still remain, with some cultures having restrictions on what
women are allowed to do and not do in business settings and social life. With these lingering potential problems in some
countries in the world, would you send a woman on an international assignment?
Tung asked her sample of multinational managers to indicate reasons for expatriate failure. For U.S.
multinationals, the reasons, in order of importance, were
1. Inability of spouse to adjust.
2. Manager’s inability to adjust.
3. Other family problems.
4. Manager’s personal or emotional maturity.
5. Inability to cope with larger overseas responsibilities.
Managers of European firms gave only one reason consistently to explain expatriate failure: the inability of the
manager’s spouse to adjust to a new environment. For the Japanese firms, the reasons for failure were
1. Inability to cope with larger overseas responsibilities.
2. Difficulties with new environment.
3. Personal or emotional problems.
4. Lack of technical competence.
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5. Inability of spouse to adjust.
Which Country Do You Want to Go to?
e HSBC Expat Explorer Survey is an interesting way to better understand the friendliness of a country. e Expat
Explorer Survey provides an overall ranking based on economics, experience, and raising children in the country (because
expatriates are often younger professionals establishing their family lives while abroad). Singapore, Norway, New Zealand,
Germany, Netherlands, Canada, and Australia are at the top today. Interestingly, of the 46 countries ranked, at the bottom
of the ranking are Brazil, Peru, Argentina, and Egypt. Many rankings are based on how countries see foreign visitors, and
visiting instead of staying to work in the country also has implications. According to the World Economic Forum’s
“friendliest countries” ranking, the attitude of the local population toward foreign visitors is the best in Iceland,
New Zealand, Morocco, Macedonia, and Austria. e bottom five countries, from the ranking of 140 countries are
Bolivia, Venezuela, Russia, Kuwait, and Latvia. Kuwait is at the bottom both for expats to work and visitors in general for
tourism. If you can pick one country in the world to work in and also to visit as a visitor—not at the same time, naturally
—which country would it be?
Sources: Davis, C., “e World’s Friendliest Countries to Foreigners, According to the World Economic Forum,” e Huffington Post, April 9,
2013; Blanke, J., and Chiesa, T., e Travel and Tourism Competitiveness Report 2013, World Economic Forum; and HSBC Expat Explorer
Survey, www.expatexplorer.hsbc.com.
e most striking difference between these lists is that “inability of spouse to adjust” was the top reason for
expatriate failure among U.S. and European multinationals but only the fifth reason among Japanese
multinationals. Tung comments that this difference was not surprising, given the role and status to which
Japanese society traditionally relegates the wife and the fact that most of the Japanese expatriate managers in the
study were men.
Since Tung’s study, a number of other studies have consistently confirmed that the inability of a spouse to
adjust, the inability of the manager to adjust, or other family problems remain major reasons for continuing high
levels of expatriate failure.25 One study by International Orientation Resources, an HRM consulting firm, found
that 60 percent of expatriate failures occur due to these three reasons.26 Another study found that the most
common reason for assignment failure is lack of partner (spouse) satisfaction, which was listed by 27 percent of
respondents.27 e inability of expatriate managers to adjust to foreign postings seems to be caused by
a lack of cultural skills on the part of the manager being transferred. According to one HRM
consulting firm, this is because the expatriate selection process at many firms is fundamentally flawed: “Expatriate
assignments rarely fail because the person cannot accommodate to the technical demands of the job. Typically,
the expatriate selections are made by line managers based on technical competence. ey fail because of family
and personal issues and lack of cultural skills that haven’t been part of the selection process.”28
e failure of spouses to adjust to a foreign posting seems to be related to a number of factors. Often, spouses
find themselves in a foreign country without the familiar network of family and friends. Language differences
make it difficult for them to make new friends. While this may not be a problem for the manager, who can make
friends at work, it can be difficult for the spouse, who might feel trapped at home. e problem is often
exacerbated by immigration regulations prohibiting the spouse from taking employment. With the recent rise of
two-career families in many developed nations, this issue has become much more important. One survey found
that 69 percent of expatriates are married, with spouses accompanying them 77 percent of the time. Of those
spouses, half were employed before an assignment and only 12 percent were employed during an assignment.29
Research suggests that the main reason managers now turn down international assignments is concern over the
impact such an assignment might have on their spouse’s career.30
Expatriate Selection One way to reduce expatriate failure rates is by improving selection procedures to screen out inappropriate candidates. In a review of the research on this issue, Mendenhall and Oddou state that a
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major problem in many firms is that HRM managers tend to equate domestic performance with overseas
performance potential.31 Domestic performance and overseas performance potential are not the same thing. An
executive who performs well in a domestic setting may not be able to adapt to managing in a different cultural
setting. From their review of the research, Mendenhall and Oddou identified four dimensions that seem to
predict success in a foreign posting: self-orientation, others-orientation, perceptual ability, and cultural toughness.
1. Self-orientation. e attributes of this dimension strengthen the expatriate’s self-esteem, self-confidence, and
mental well-being. Expatriates with high self-esteem, self-confidence, and mental well-being were more
likely to succeed in foreign postings. Mendenhall and Oddou concluded that such individuals were able to
adapt their interests in food, sport, and music; had interests outside of work that could be pursued (e.g.,
hobbies); and were technically competent.
2. Others-orientation. e attributes of this dimension enhance the expatriate’s ability to interact effectively
with host-country nationals. e more effectively the expatriate interacts with host-country nationals, the
more likely he or she is to succeed. Two factors seem to be particularly important here: relationship
development and willingness to communicate. Relationship development refers to the ability to develop
long-lasting friendships with host-country nationals. Willingness to communicate refers to the expatriate’s
willingness to use the host-country language. Although language fluency helps, an expatriate need not be
fluent to show willingness to communicate. Making the effort to use the language is what is important.
Such gestures tend to be rewarded with greater cooperation by host-country nationals.
3. Perceptual ability. is is the ability to understand why people of other countries behave the way they do—
that is, the ability to empathize. is dimension seems critical for managing host-country nationals.
Expatriate managers who lack this ability tend to treat foreign nationals as if they were home-country
nationals. As a result, they may experience significant management problems and considerable frustration.
As one expatriate executive from Hewlett-Packard observed, as reported by in the Mendenhall and Oddou
study: “It took me six months to accept the fact that my staff meetings would start 30 minutes late, and
that it would bother no one but me.” According to Mendenhall and Oddou, well-adjusted expatriates tend
to be nonjudgmental and nonevaluative in interpreting the behavior of host-country nationals and willing
to be flexible in their management style, adjusting it as cultural conditions warrant.
4. Cultural toughness. is dimension refers to the relationship between the country of assignment
and how well an expatriate adjusts to a particular posting. Some countries are much tougher postings than
others because their cultures are more unfamiliar and uncomfortable. For example, many Americans regard
Great Britain as a relatively easy foreign posting and for good reason—the two cultures have much in
common. But many Americans find postings in non-Western cultures, such as India, Southeast Asia, and
the Middle East, to be much tougher.32 e reasons are many, including poor health care and housing
standards, inhospitable climate, lack of Western entertainment, and language difficulties. Also, many
cultures are extremely male-dominated and may be particularly difficult postings for female Western
managers.
GLOBAL MINDSET
Some researchers suggest that a global mindset, one characterized by cognitive complexity and a cosmopolitan
outlook, is the fundamental attribute of a global manager. Such managers can deal with high levels of complexity
and ambiguity, and are open to the world. In a study of 615 people in the United States in March 2015 for this
textbook, people’s global mindset was assessed as it is today and what they hope or predict it would be in the next
20 years (margin of error = 3.89 percent). Figure 17.2 illustrates the findings, indicating that people act and
behave like global citizens in less than half of what they undertake today but that the expectation is that people’s
global mindset will improve significantly in the next 20 years.
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17.2 FIGURE
Global mindset of Americans.
Given that people are expected to become more globally minded over time, how do you develop these
attributes (high levels of complexity, ambiguity, and openness to the world)? Often they are gained in early life
from a family that is bicultural, lives in foreign countries, or learns foreign languages as a regular part of family
life. Mendenhall and Oddou note that standard psychological tests can be used to assess the first three of these
dimensions, whereas a comparison of cultures can give managers a feeling for the fourth dimension.
Mendenhall and Oddou contend that these four dimensions, in addition to domestic performance, should be
considered when selecting a manager for foreign posting. However, practice does not often conform to
the authors’ recommendations. Tung’s research, for example, showed that only 5 percent of the firms
in her sample used formal procedures and psychological tests to assess the personality traits and relational abilities
of potential expatriates.33 Research by International Orientation Resources suggests that when selecting
employees for foreign assignments, only 10 percent of the 50 Fortune 500 firms surveyed tested for important
psychological traits such as cultural sensitivity, interpersonal skills, adaptability, and flexibility. Instead, 90 percent
of the time employees were selected on the basis of their technical expertise, not their cross-cultural fluency.34
Mendenhall and Oddou do not address the problem of expatriate failure due to a spouse’s inability to adjust.
According to a number of other researchers, a review of the family situation should be part of the expatriate
selection process (see the opening case on Royal Dutch Shell for an example).35 A survey by Windam
International, another international HRM consulting firm, found that spouses were included in preselection
interviews for foreign postings only 21 percent of the time and that only half of them received any cross-cultural
training. e rise of dual-career families has added an additional and difficult dimension to this long-standing
problem.36 Increasingly, spouses wonder why they should have to sacrifice their own career to further that of
their partner.37
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Page 487
Training and Management Development
LO 17-4 Recognize how management development and training programs can increase the value of human
capital in the international business firm.
Selection is just the first step in matching a manager with a job. e next step is training the manager to do the
specific job. For example, an intensive training program might be used to give expatriate managers the skills
required for success in a foreign posting. However, management development is a much broader concept. It is
intended to develop the manager’s skills over his or her career with the firm. us, as part of a management
development program, a manager might be sent on several foreign postings over a number of years to build his or
her cross-cultural sensitivity and experience. At the same time, along with other managers in the firm, the person
might attend management education programs at regular intervals. e thinking behind job transfers is that
broad international experience will enhance the management and leadership skills of executives. Research
suggests this may be the case.38
Historically, most international businesses have been more concerned with training than with management
development. Plus, they tended to focus their training efforts on preparing home-country nationals for foreign
postings. Recently, however, the shift toward greater global competition and the rise of transnational firms have
changed this. It is increasingly common for firms to provide general management development programs in
addition to training for particular posts. In many international businesses, the explicit purpose of these
management development programs is strategic. Management development is seen as a tool to help the firm
achieve its strategic goals, not only by giving managers the required skill set but also by helping reinforce the
desired culture of the firm and by facilitating the creation of an informal network for sharing knowledge within
the multinational enterprise.
With this distinction between training and management development in mind, we first examine the types of
training managers receive for foreign postings. en we discuss the connection between management
development and strategy in the international business.
TRAINING FOR EXPATRIATE MANAGERS
Earlier in the chapter, we saw that the two most common reasons for expatriate failure were the inability of a
manager’s spouse to adjust to a foreign environment and the manager’s own inability to adjust to a foreign
environment. Training can help the manager and spouse cope with both these problems. Cultural training,
language training, and practical training all seem to reduce expatriate failure. We discuss each of these kinds of
training here.39 Despite the usefulness of the training, evidence suggests that many managers receive no training
before they are sent on foreign postings. One study found that only about 30 percent of managers sent on one-
to five-year expatriate assignments received training before their departure.40
Cultural Training Cultural training seeks to foster an appreciation for the host country’s culture. e belief is that understanding a host country’s culture will help the manager empathize with the culture, which
will enhance his or her effectiveness in dealing with host-country nationals. It has been suggested that
expatriates should receive training in the host country’s culture, history, politics, economy, religion, and social
and business practices.41 If possible, it is also advisable to arrange for a familiarization trip to the host country
before the formal transfer, because this seems to ease culture shock. Given the problems related to spouse
adaptation, it is important that the spouse, and perhaps the whole family, be included in cultural training
programs.
Language Training English is the language of world business; it is quite possible to conduct business all over the world using only English. Notwithstanding the prevalence of English, however, an exclusive reliance on
English diminishes an expatriate manager’s ability to interact with host-country nationals. As noted earlier, a
willingness to communicate in the language of the host country, even if the expatriate is far from fluent, can help
build rapport with local employees and improve the manager’s effectiveness. Despite this, one study of 74
executives of U.S. multinationals found that only 23 believed knowledge of foreign languages was necessary for
conducting business abroad.42 ose firms that did offer foreign language training for expatriates believed it
improved their employees’ effectiveness and enabled them to relate more easily to a foreign culture, which
fostered a better image of the firm in the host country.
Chairman of China’s Lenovo Group Ltd., Yang Yuanqing (left), shakes hands with CEO Steve Ward
(right), as the nonexecutive director, Li Chuanzhi (center), smiles after a press conference in Hong
Kong.
©Vincent Yu/AP Images
Practical Training Practical training is aimed at helping the expatriate manager and family ease themselves into day-to-day life in the host country. e sooner a routine is established, the better are the prospects that the
expatriate and his or her family will adapt successfully. One critical need is for a support network of friends for
the expatriate. Where an expatriate community exists, firms often devote considerable effort to ensuring the new
expatriate family is quickly integrated into that group. e expatriate community can be a useful source of
support and information and can be invaluable in helping the family adapt to a foreign culture.
REPATRIATION OF EXPATRIATES
A largely overlooked but critically important issue in the training and development of expatriate managers is to
prepare them for reentry into their home-country organization.43 Repatriation should be seen as the final link in
an integrated, circular process that connects good selection and cross-cultural training of expatriate managers
with completion of their term abroad and reintegration into their national organization. However, instead of
coming home to share their knowledge and encourage other high-performing managers to take the same
international career track, expatriates too often face a different scenario.44
Often when they return home after a stint abroad—where they have typically been autonomous, well
compensated, and celebrated as a big fish in a little pond—they face an organization that doesn’t know what they
have done for the past few years, doesn’t know how to use their new knowledge, and doesn’t particularly care. In
the worst cases, reentering employees have to scrounge for jobs, or firms will create standby positions that don’t
use the expatriate’s skills and capabilities and fail to make the most of the business investment the firm has made
in that individual.
Research illustrates the extent of this problem. According to one study of repatriated employees, 60 to 70
percent didn’t know what their position would be when they returned home. Also, 60 percent said their
organizations were vague about repatriation, about their new roles, and about their future career progression
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within the company; 77 percent of those surveyed took jobs at a lower level in their home organization than in
their international assignments.45 Not surprisingly, 15 percent of returning expatriates leave their firms within a
year of arriving home, and 40 percent leave within three years.46
m a n a g e m e n t F O C U S
Monsanto’s Repatriation Program
Monsanto is a global provider of agricultural products with some 22,000 employees and about $15 billion in sales. At any
one time, the company will have 100 mid- and higher-level managers on extended postings abroad. Two-thirds of these
are Americans posted overseas; the remainder are foreign nationals employed in the United States. At Monsanto,
managing expatriates and their repatriation begins with a rigorous selection process and intensive cross-cultural training,
both for the managers and for their families. As is the case at many other global companies, the idea is to build an
internationally minded cadre of highly capable managers who will lead the organization in the future.
One of the strongest features of this program is that employees and their sending and receiving managers, or sponsors,
develop an agreement about how this assignment will fit into the firm’s business objectives. e focus is on why employees
are going abroad to do the job and what their contribution to Monsanto will be when they return. Sponsoring managers
are expected to be explicit about the kind of job opportunities the expatriates will have once they return home.
Once they arrive back in their home country, expatriate managers meet with cross-cultural trainers during debriefing
sessions. ey are also given the opportunity to showcase their experiences to their peers, subordinates, and superiors in
special information exchanges.
However, Monsanto’s repatriation program focuses on more than just business; it also attends to the family’s reentry.
Monsanto has found that difficulties with repatriation often have more to do with personal and family-related issues than
with work-related issues. But the personal matters obviously affect an employee’s on-the-job performance, so it is
important for the company to pay attention to such issues.
is is why Monsanto offers returning employees an opportunity to work through personal difficulties. About three
months after they return home, expatriates meet for three hours at work with several colleagues of their choice. e
debriefing session is a conversation aided by a trained facilitator who has an outline to help the expatriate cover all the
important aspects of the repatriation. e debriefing allows the employee to share important experiences and to enlighten
managers, colleagues, and friends about his or her expertise so others within the organization can use some of the global
knowledge. According to one participant, “It sounds silly, but it’s such a hectic time in the family’s life, you don’t have
time to sit down and take stock of what’s happening. You’re going through the move, transitioning to a new job, a new
house, and the children may be going to a new school. is is a kind of oasis; a time to talk and put your feelings on the
table.” Apparently it works; since the program was introduced, the attrition rate among returning expatriates has dropped
sharply.
Sources: A. Walton, “Who Says Monsanto Roundup Ingredient Is Probably Carcinogenic. Are ey Right,” Forbes, March 21, 2015; C. M. Solomon, “Repatriation: Up, Down, or Out?” Personnel Journal, January 1995, pp. 28–34; and J. Schaefer, E. Hannibal, and J. O’Neill, “How Strategy, Culture and Improved Service Delivery Reshape Monsanto’s
International Assignment Program,” Journal of Organizational Excellence 22, no. 3 (2003), pp. 35–40.
e key to solving this problem is good human resource planning. Just as the HRM function needs to develop
good selection and training programs for its expatriates, it also needs to develop good programs for reintegrating
expatriates back into work life within their home-country organization, for preparing them for changes in their
physical and professional landscape, and for utilizing the knowledge they acquired while abroad. For an example
of the kind of program that might be used, see the accompanying Management Focus that looks at the
repatriation program developed by Monsanto.
MANAGEMENT DEVELOPMENT AND STRATEGY
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Management development programs are designed to increase the overall skill levels of managers through a mix of
ongoing management education and rotations of managers through a number of jobs within the firm to give
them varied experiences. ey are attempts to improve the overall productivity and quality of the firm’s
management resources.
International businesses are increasingly using management development as a strategic tool. is is particularly
true in firms pursuing a transnational strategy, as increasing numbers are. Such firms need a strong unifying
corporate culture and informal management networks to assist in coordination and control. In addition,
transnational firm managers need to be able to detect pressures for local responsiveness—and that requires them
to understand the culture of a host country.
Management development programs help build a unifying corporate culture by socializing new managers into
the norms and value systems of the firm. In-house company training programs and intense interaction during
offsite training can foster esprit de corps—shared experiences, informal networks, perhaps a company language or
jargon—as well as develop technical competencies. ese training events often include songs, picnics, and
sporting events that promote feelings of togetherness. ese rites of integration may include “initiation
rites” wherein personal culture is stripped, company uniforms are donned (e.g., T-shirts bearing the
company logo), and humiliation is inflicted (e.g., a pie in the face). All these activities aim to strengthen a
manager’s identification with the company.47
Bringing managers together in one location for extended periods and rotating them through different jobs in
several countries help the firm build an informal management network. Such a network can then be used as a
conduit for exchanging valuable performance-enhancing knowledge within the organization.48 Consider the
Swedish telecommunications company Ericsson. Interunit cooperation is extremely important at Ericsson,
particularly for transferring know-how and core competencies from the parent to foreign subsidiaries, from
foreign subsidiaries to the parent, and between foreign subsidiaries. To facilitate cooperation, Ericsson transfers
large numbers of people back and forth between headquarters and subsidiaries. Ericsson sends a team of 50 to
100 engineers and managers from one unit to another for a year or two. is establishes a network of
interpersonal contacts. is policy is effective for both solidifying a common culture in the company and
coordinating the company’s globally dispersed operations.49
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Performance Appraisal
LO 17-5 Explain how and why performance appraisal systems might vary across nations.
Performance appraisal systems are used to evaluate the performance of managers against some criteria that the
firm judges to be important for the implementation of strategy and the attainment of a competitive advantage. A
firm’s performance appraisal systems are an important element of its control systems, and control systems are a
central component of organizational architecture. A particularly thorny issue in many international businesses is
how best to evaluate the performance of expatriate managers.50 is section looks at this issue and considers
guidelines for appraising expatriate performance.
PERFORMANCE APPRAISAL PROBLEMS
Unintentional bias makes it difficult to evaluate the performance of expatriate managers objectively. In many
cases, two groups evaluate the performance of expatriate managers—host-nation managers and home-office
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managers—and both are subject to bias. e host-nation managers may be biased by their own cultural frame of
reference and expectations. For example, Oddou and Mendenhall report the case of a U.S. manager who
introduced participative decision making while working in an Indian subsidiary.51 e manager subsequently
received a negative evaluation from host-country managers because in India, the strong social stratification means
managers are seen as experts who should not have to ask subordinates for help. e local employees apparently
viewed the U.S. manager’s attempt at participatory management as an indication that he was incompetent and
did not know his job.
Home-country managers’ appraisals may be biased by distance and by their own lack of experience working
abroad. Home-office managers are often not aware of what is going on in a foreign operation. Accordingly, they
tend to rely on hard data in evaluating an expatriate’s performance, such as the subunit’s productivity,
profitability, or market share. Such criteria may reflect factors outside the expatriate manager’s control (e.g.,
adverse changes in exchange rates, economic downturns). Also, hard data do not take into account many less
visible soft variables that are also important, such as an expatriate’s ability to develop cross-cultural awareness and
to work productively with local managers. Due to such biases, many expatriate managers believe that
headquarters management evaluates them unfairly and does not fully appreciate the value of their skills and
experience. is could be one reason many expatriates believe a foreign posting does not benefit their careers. In
one study of personnel managers in U.S. multinationals, 56 percent of the managers surveyed stated that a
foreign assignment is either detrimental or immaterial to one’s career.52
GUIDELINES FOR PERFORMANCE APPRAISAL
Several things can reduce bias in the performance appraisal process.53 First, most expatriates appear to believe
more weight should be given to an onsite manager’s appraisal than to an offsite manager’s appraisal. Due to
proximity, an onsite manager is more likely to evaluate the soft variables that are important aspects of
an expatriate’s performance. e evaluation may be especially valid when the onsite manager is of the
same nationality as the expatriate because cultural bias should be alleviated. In practice, home-office managers
often write performance evaluations after receiving input from onsite managers. When this is the case, most
experts recommend that a former expatriate who served in the same location should be involved in the appraisal
to help reduce bias. Finally, when the policy is for foreign onsite managers to write performance evaluations,
home-office managers should be consulted before an onsite manager completes a formal termination evaluation.
is gives the home-office manager the opportunity to balance what could be a very hostile evaluation based on a
cultural misunderstanding.
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Compensation
LO 17-6 Understand how and why compensation systems might vary across nations.
Two issues are raised in every discussion of compensation practices in an international business. One is how
compensation should be adjusted to reflect national differences in economic circumstances and compensation
practices (see Shell in the opening case). e other issue is how expatriate managers should be paid. From a
strategic perspective, the important point is that whatever compensation system is used, it should reward
managers for taking actions that are consistent with the strategy of the enterprise.
NATIONAL DIFFERENCES IN COMPENSATION
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Differences exist in the compensation of executives at the same level in various countries. e results of a survey
undertaken by Towers Watson, for example, suggest that U.S. CEOs earn, on average, roughly double the pay of
non-U.S. CEOs.54
National differences in compensation raise a perplexing question for an international business: Should the
firm pay executives in different countries according to the prevailing standards in each country, or should it
equalize pay on a global basis? e problem does not arise in firms pursuing ethnocentric or polycentric staffing
policies. In ethnocentric firms, the issue can be reduced to that of how much home-country expatriates should be
paid (which we consider later). As for polycentric firms, the lack of managers’ mobility among national
operations implies that pay can and should be kept country-specific. ere would seem to be no point in paying
executives in Great Britain the same as U.S. executives if they never work side by side.
However, this problem is very real in firms with geocentric staffing policies. A geocentric staffing policy is
consistent with a transnational strategy. One aspect of this policy is the need for a cadre of international managers
that may include many different nationalities. Should all members of such a cadre be paid the same salary and
the same incentive pay? For a U.S.-based firm, this would mean raising the compensation of foreign nationals to
U.S. levels, which could be expensive. If the firm does not equalize pay, it could cause considerable resentment
among foreign nationals who are members of the international cadre and work with U.S. nationals. If a firm is
serious about building an international cadre, it may have to pay its international executives the same basic salary
irrespective of their country of origin or assignment. Currently, however, this practice is not widespread.
Over the past decade many firms have moved toward a compensation structure that is based on consistent
global standards, with employees being evaluated by the same grading system and having access to the same
bonus pay and benefits structure irrespective of where they work. Some 85 percent of the companies in a survey
by Mercer Management Consulting stated they now have a global compensation strategy in place.55 McDonald’s,
which is featured in the accompanying Management Focus, is one such enterprise. Another survey found that
two-thirds of multinationals now exercise central control over the benefit plans offered in different nations.56
However, except for a relative small cadre of internationally mobile executives, base pay in most firms is set with
regard to local market conditions.
EXPATRIATE PAY
e most common approach to expatriate pay is the balance sheet approach. According to Organizational
Resources Counselors, some 80 percent of the 781 companies it surveyed used this approach.57 is approach
equalizes purchasing power across countries so employees can enjoy the same living standard in their foreign
posting that they enjoyed at home. In addition, the approach provides financial incentives to offset qualitative
differences between assignment locations.58 Figure 17.3 shows a typical balance sheet. Note that
home-country outlays for the employee are designated as income taxes, housing expenses, expenditures
for goods and services (food, clothing, entertainment, etc.), and reserves (savings, pension contributions, etc.).
e balance sheet approach attempts to provide expatriates with the same standard of living in their host
countries as they enjoy at home plus a financial inducement (i.e., premium, incentive) for accepting an overseas
assignment.
17.3 FIGURE
e balance sheet approach to expatriate pay.
m a n a g e m e n t F O C U S
McDonald’s Global Compensation Practices
With more than 400,000 managers and senior staff employees in 118 countries around the world, by the early 2000s
McDonald’s realized it had to develop a consistent global compensation and performance appraisal strategy. As with many
companies that have expanded to many corners of the world, McDonald’s found itself with a decentralized and
inconsistent compensation program. Many reasons existed for this new global HR compensation strategy. Foremost
among them was that McDonald’s executive of worldwide human resources, Rich Floersch, pointed to a need to have a
consistent global HR strategy to attract and retain better people. After months of consultation with global managers to
ensure that any new system was formed via a collaborative approach, McDonald’s began to roll out its new global
compensation program.
One important element of this program calls for the corporate head office to provide local-country managers with a
menu of business principles to focus on in the coming year. ese principles include areas such as customer service,
marketing, and restaurant re-imaging. Each country manager then picks three to five areas to focus on for success in the
local market. For example, if France is introducing a new menu item, it might create business targets around that for the
year. Human resource managers then submit their business cases and targets to senior executives at headquarters for
approval. At the end of the year, the country’s annual incentive pool is based on how the region met its targets, as well as
on the business unit’s operating income. A portion of an individual employee’s annual bonus is based on that mix.
e other portion of an employee’s annual incentive is based on individual performance. McDonald’s has always had a
performance rating system, but within its new HR management strategy, the company has now introduced global
guidelines that suggest 20 percent of employees receive the highest rating, 70 percent the middle, and 10 percent the
bottom. By giving guidelines rather than forced ranking, McDonald’s hopes to encourage differentiation of performance
while allowing for some local flexibility. Also, by providing principles and guidance, and yet allowing local-country
managers to customize their compensation programs to meet local market demands, McDonald’s also claims it has seen a
reduction in turnover. e company’s own internal surveys suggest more employees now believe that their compensation is
fair and reflects local market conditions. Overall, “McDonald’s benefits and compensation program is designed to attract,
retain and engage talented people who will deliver strong performance and help McDonald’s achieve our business goals
and objectives.”
Sources: Marquez, J., “McDonald’s Rewards Program Leaves Room for Some Local Flavor,” Workforce Management, April 10, 2006, 26; Zillman, C., “McDonald’s Loses Big on Labor Ruling,” Forbes, July 29, 2014; “McDonald’s Corporate
Page 492
Careers,” http://careers.mcdonalds.com/corporate/benefits.jsp, accessed May 9, 2018; and Black, V., “How I Got Here:
Rich Floersch of McDonald’s,” Bloomberg Business, August 14, 2012.
e components of the typical expatriate compensation package are a base salary, a foreign service
premium, allowances of various types, tax differentials, and benefits. We briefly review each of these
components.59 An expatriate’s total compensation package may amount to three times what he or she would cost
the firm in a home-country posting. Because of the high cost of expatriates, many firms have reduced their use of
them in recent years. However, a firm’s ability to reduce its use of expatriates may be limited, particularly if it is
pursuing an ethnocentric or geocentric staffing policy.
Where Would You Go to Find Expat Resources?
Not so many years ago, business professionals whose companies sent them overseas to work had few outside resources to
help them become acclimated to their new status as expatriates. Today, however, a wealth of information is available. For
example, a simple keyword search online for “expatriate” yields an almost endless supply of links: newspapers and
magazines published exclusively for expats; websites catering to expatriates in specific regions or countries; general
information sites offering insiders’ guides to different countries and their finance, culture, and health care systems; not to
mention blogs and chat rooms, forums and groups. e expatriate boom has even fueled an industry offering a broad
array of services for expats, from mail forwarding to tax preparation to health and life insurance. One example is
globalEDGETM’s section on “Travel/Living Abroad” (https://globaledge.msu.edu/global-resources/travel-living-abroad).
While often good, the examples in this short write-up are all online, removed from the country itself. How much would
you trust online information and data as the only source for “getting to know” the new country you have just signed on to
spend three years in as an expat?
Base Salary An expatriate’s base salary should normally be in the same range as the base salary for a similar position in the home country. At the same time, while an expatriate may have a base salary that he or she would
have in their home country, foreign nationals in these expatriate locations do not necessarily get the same salary
levels. Oftentimes, developed nations (e.g., Germany, the United States) offer higher base salaries than
comparable jobs and positions in the company in other, developing or less developed, countries. e base salary
is normally paid in either the home-country currency or in the local currency.
Foreign Service Premium A foreign service premium is extra pay the expatriate receives for working outside his or her country of origin. It is offered as an inducement to accept foreign postings. It compensates the
expatriate for having to live in an unfamiliar country isolated from family and friends, having to deal with a new
culture and language, and having to adapt to new work habits and practices. Many firms pay foreign service
premiums as a percentage of base salary, ranging from 10 to 30 percent after tax, with 16 percent being the
average premium.60
Allowances Four types of allowances are often included in an expatriate’s compensation package: hardship, housing, cost of living, and education. A hardship allowance is paid when the expatriate is being sent to a
difficult location, usually defined as one where such basic amenities as health care, schools, and retail stores are
grossly deficient by the standards of the expatriate’s home country. A housing allowance is normally given to
ensure that the expatriate can afford the same quality of housing in the foreign country as at home. In locations
where housing is expensive (e.g., London, Tokyo), this allowance can be substantial—as much as 10 to 30
percent of the expatriate’s total compensation package. A cost-of-living allowance ensures that the expatriate will
enjoy the same standard of living in the foreign posting as at home. An education allowance ensures that an
expatriate’s children receive adequate schooling (by home-country standards). Host-country public schools are
sometimes not suitable for an expatriate’s children, in which case they must attend a private school.
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Taxation Unless a host country has a reciprocal tax treaty with the expatriate’s home country, the expatriate may have to pay income tax to both the home- and host-country governments. When a reciprocal tax treaty is
not in force, the firm typically pays the expatriate’s income tax in the host country. In addition, firms normally
make up the difference when a higher income tax rate in a host country reduces an expatriate’s take-home pay.
Benefits Many firms also ensure that their expatriates receive the same level of medical and pension benefits abroad that they received at home. is can be costly for the firm, because many benefits that are tax-deductible
for the firm in the home country (e.g., medical and pension benefits) may not be deductible out of the country.
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Building a Diverse Global Workforce
A diverse global workforce can be a source of competitive advantage. A diverse workforce is one that has a
significant mix of both genders and in which cultural and ethnic minorities are well represented. Workforce
diversity has been linked to superior financial performance. One study by McKinsey and Company found that
companies in the top quartile of gender and ethnic diversity were 35 percent more likely to have financial returns
above their national industry median. Another study concluded that companies with the strongest record of
promoting women to the executive suite outperformed their industry norms, with return on assets 18 percent
higher.61
ere are a number of reasons for thinking that a diverse workforce will improve performance.62 First, diverse
talents bring insights into the needs of a diverse customer base that (for example) a homogenous management
group composed exclusively of white males cannot. Due to their different perspective and life experiences,
women and minorities may see things that white males don’t. People with different lifestyles and different
backgrounds challenge each other more, which can lead to creative insights. is can result in improved problem
solving, better product design and delivery, more effective marketing, and better sales promotions. Second, an
enterprise with a homogenous employee base is underutilizing the talent to be found among women and
minorities. Its human capital will not be a strong as it could be, and performance will suffer as a result. ird,
when the customer set is diverse (as is often the case for many global businesses), those customers may appreciate
interacting with an enterprise whose employees look like them, and therefore, have a better understanding of
their needs, tastes, and preference. Fourth, a diverse workforce may improve the brand image of an enterprise,
setting up a virtuous circle where it does better among its customer set and is more able to attract top talent from
among women and minorities. Finally, there is evidence that diversity increases employee satisfaction, which
results in higher productivity, so long as the workforce is diverse enough.63 For minority workers, the boost in
satisfaction kicks in when representation exceeds 15 percent of the workforce. In contrast, when diversity
recruitment is a token effort, psychological outcomes are poorer.
e available evidence suggests that many companies still have a long way to go when it comes to promoting
diversity. For example, the consulting company Mercer looked at gender diversity among 164 companies from 28
different countries.64 It found that women continue to be underrepresented at all levels in the labor force
worldwide. Fewer women participate in the global labor force, and women make up a small percentage of senior
management positions in most organizations. For example, the study found that in 2014, only 24 percent of
senior executives in North America were women, 18 percent in Europe, and just 12 percent in Latin America.
e imbalance between men and women also tends to get larger the higher up in an organization one goes. For
the average global organization, Mercer found that while 36 percent of lower-level managers were women, only
26 percent of senior managers and 19 percent of company executives were women.
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Building a diverse workforce is not easy—particularly for an international business—since the definition of
what constitutes a cultural and ethnic minority may vary across nations, as may the acceptance of women in the
workplace. If the numbers are any guide, acceptance of women as senior managers is lower in Latin America than
in North America, probably for cultural reasons. Similarly, relative to North America, it is unlikely that there will
be many women in senior management positions in Japan or the Middle East, where traditional values are
emphasized.
is being said, there are a number of steps that international businesses can take to promote workforce
diversity.65 It is important to understand that diversity efforts represent a type of organizational change. As with
all change efforts, it must be driven from the top but also incorporate all levels of the organization. Top managers
must create a clear value proposition that identifies the benefits of building a diverse and inclusive culture. ey
must also set clear goals (not quotas) for what they would like to achieve, identify the gap between the current
situation and the desired state, and measure performance improvements over time. It is also important to hold
managers accountable for attaining global diversity goals and reward those who hit or exceed goals. Senior
management must also lead by example, hiring and promoting people from diverse backgrounds.
Diversity workshops can be used to educate employees at all levels about the value of building a more
inclusive and diverse workforce. A key task here is to overcome the subconscious biases and stereotyping of the
majority that may lead to discrimination against minority employees. Techniques include (1) role playing, where
members of the majority get to experience bias personally; (2) reminding people about biases at key moments,
such as just before performance reviews; and (3) helping people to focus on differences to reduce stereotyping. In
one experiment, French students discriminated against potential employees who were Arabs but stopped doing so
if asked to describe the differences between photos. e act of articulating differences made the students aware of
their own subconscious biases.
Outreach to women and minorities can help to increase recruitment from these demographics. Adjusting
work policies can help to foster a more diverse workforce (e.g., having child care facilities on site can make a
company more attractive to women). Several companies have also found that it helps to create employee reference
groups where minorities can help each other through networking, advice, and mutual support.
International Labor Relations
LO 17-7 Understand how organized labor can influence strategic choices in international business firms.
e HRM function of an international business is typically responsible for international labor relations. From a
strategic perspective, the key issue in international labor relations is the degree to which organized labor can limit
the choices of an international business. A firm’s ability to integrate and consolidate its global operations to
realize experience curve and location economies can be limited by organized labor, constraining the pursuit of a
transnational or global standardization strategy. Prahalad and Doz cite the example of General Motors, which
gained peace with labor unions in Germany by agreeing not to integrate and consolidate operations in the most
efficient manner.66 General Motors made substantial investments in Germany—matching its new investments in
Austria and Spain—at the demand of the German metalworkers’ unions.
One task of the HRM function is to foster harmony and minimize conflict between the firm and organized
labor. With this in mind, this section is divided into three parts. First, we review organized labor’s concerns about
multinational enterprises. Second, we look at how organized labor has tried to deal with these concerns. And
third, we look at how international businesses manage their labor relations to minimize labor disputes.
THE CONCERNS OF ORGANIZED LABOR
Labor unions generally try to get better pay, greater job security, and better working conditions for their members
through collective bargaining with management. Unions’ bargaining power is derived largely from their ability to
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threaten to disrupt production, either by a strike or some other form of work protest (e.g., refusing to work
overtime). is threat is credible, however, only insofar as management has no alternative but to employ union
labor.
A principal concern of domestic unions about multinational firms is that the company can counter its
bargaining power with the power to move production to another country. Ford, for example, clearly threatened
British unions with a plan to move manufacturing to continental Europe unless British workers abandoned work
rules that limited productivity, showed restraint in negotiating for wage increases, and curtailed strikes and other
work disruptions.67
Another concern of organized labor is that an international business will keep highly skilled tasks in its home
country and farm out only low-skilled tasks to foreign plants. Such a practice makes it relatively easy for an
international business to switch production from one location to another as economic conditions warrant.
Consequently, the bargaining power of organized labor is once more reduced.
Employees work on the chassis of an Adam Opel AG car at a GM factory in Eisenach, Germany.
©Martin Leissl/Bloomberg/Getty Images
A final union concern arises when an international business attempts to import employment practices and
contractual agreements from its home country. When these practices are alien to the host country, organized
labor fears the change will reduce its influence and power. is concern has surfaced in response to
Japanese multinationals that have been trying to export their style of labor relations to other countries.
For example, much to the annoyance of the United Auto Workers, many Japanese auto plants in the United
States are not unionized. As a result, union influence in the auto industry is declining.
THE STRATEGY OF ORGANIZED LABOR
Organized labor has responded to the increased bargaining power of multinational corporations by taking three
actions: (1) trying to establish international labor organizations, (2) lobbying for national legislation to restrict
multinationals, and (3) trying to achieve international regulations on multinationals through such organizations
as the United Nations. ese efforts have not been very successful.
In the 1960s, organized labor began to establish international trade secretariats (ITSs) to provide worldwide
links for national unions in particular industries. e long-term goal was to be able to bargain transnationally
with multinational firms. Organized labor believed that by coordinating union action across countries through an
ITS, it could counter the power of a multinational corporation by threatening to disrupt production on an
international scale. For example, Ford’s threat to move production from Great Britain to other European
locations would not have been credible if the unions in various European countries had united to oppose it.
However, the ITSs have had virtually no real success. Although national unions may want to cooperate, they
also compete with each other to attract investment from international businesses and hence jobs for their
members. For example, in attempting to gain new jobs for their members, national unions in the auto industry
often court auto firms that are seeking locations for new plants. One reason Nissan chose to build its European
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production facilities in Great Britain rather than Spain was that the British unions agreed to greater concessions
than the Spanish unions did. As a result of such competition between national unions, cooperation is difficult to
establish.
A further impediment to cooperation has been the wide variation in union structure. Trade unions developed
independently in each country. As a result, the structure and ideology of unions tend to vary significantly from
country to country, as does the nature of collective bargaining. For example, in Great Britain, France, and Italy,
many unions are controlled by left-wing socialists, who view collective bargaining through the lens of “class
conflict.” In contrast, most union leaders in Germany, the Netherlands, Scandinavia, and Switzerland are far
more moderate politically. e ideological gap between union leaders in different countries has made cooperation
difficult. Divergent ideologies are reflected in radically different views about the role of a union in society and the
stance unions should take toward multinationals.
Organized labor has also met with only limited success in its efforts to get national and international bodies to
regulate multinationals. Such international organizations as the International Labour Organization and the
Organisation for Economic Co-operation and Development have adopted codes of conduct for multinational
firms to follow in labor relations. However, these guidelines are not as far-reaching as many unions would like.
ey also do not provide any enforcement mechanisms. Many researchers report that such guidelines are of only
limited effectiveness.68
APPROACHES TO LABOR RELATIONS
International businesses differ markedly in their approaches to international labor relations. e main difference
is the degree to which labor relations activities are centralized or decentralized. Historically, most international
businesses have decentralized international labor relations activities to their foreign subsidiaries because labor
laws, union power, and the nature of collective bargaining varied so much from country to country. It made sense
to decentralize the labor relations function to local managers. e belief was that there was no way central
management could effectively handle the complexity of simultaneously managing labor relations in a number of
different environments.
Although this logic still holds, the trend is toward greater centralized control. is trend reflects international
firms’ attempts to rationalize their global operations. e general rise in competitive pressure in industry after
industry has made it more important for firms to control their costs. Because labor costs account for such a large
percentage of total costs, some firms are now using the threat to move production to another country in their
negotiations with unions to change work rules and limit wage increases (as Ford did in Europe).
Because such a move would involve major new investments and plant closures, this bargaining tactic
requires the input of headquarters management. us, the level of centralized input into labor relations is
increasing.
In addition, the realization is growing that the way work is organized within a plant can be a major source of
competitive advantage. Much of the competitive advantage of Japanese automakers, for example, has been
attributed to the use of self-managing teams, job rotation, cross-training, and the like in their Japanese
plants.69 To replicate their domestic performance in foreign plants, the Japanese firms have tried to replicate their
work practices there. is often brings them into direct conflict with traditional work practices in those
countries, as sanctioned by the local labor unions, so the Japanese firms have often made their foreign
investments contingent on the local union accepting a radical change in work practices. To achieve this, the
headquarters of many Japanese firms bargains directly with local unions to get union agreement to changes in
work rules before committing to an investment. For example, before Nissan decided to invest in northern
England, it got a commitment from British unions to agree to a change in traditional work practices. By its very
nature, pursuing such a strategy requires centralized control over the labor relations function.
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Key Terms
human resource management (HRM), p. 476
expatriate manager, p. 477
staffing policy, p. 478
corporate culture, p. 478
ethnocentric staffing policy, p. 479
polycentric staffing policy, p. 480
geocentric staffing policy, p. 480
expatriate failure, p. 482
Summary
is chapter focused on human resource management in international businesses. HRM activities include human
resource strategy, staffing, performance evaluation, management development, compensation, and labor relations.
None of these activities is performed in a vacuum; all must be appropriate to the firm’s strategy. e chapter
made the following points:
1. Firm success requires HRM policies to be congruent with the firm’s strategy and with its formal and
informal structure and controls.
2. Staffing policy is concerned with selecting employees who have the skills required to perform particular
jobs. Staffing policy can be a tool for developing and promoting a corporate culture.
3. An ethnocentric approach to staffing policy fills all key management positions in an international business
with parent-country nationals. e policy is congruent with an international strategy. A drawback is that
ethnocentric staffing can result in cultural myopia.
4. A polycentric staffing policy uses host-country nationals to manage foreign subsidiaries and parent-country
nationals for the key positions at corporate headquarters. is approach can minimize the dangers of
cultural myopia, but it can create a gap between home- and host-country operations. e policy is best
suited to a localization strategy.
5. A geocentric staffing policy seeks the best people for key jobs throughout the organization, regardless of
their nationality. is approach is consistent with building a strong, unifying culture and informal
management network and is well suited to both global standardization and transnational strategies.
Immigration policies of national governments may limit a firm’s ability to pursue this policy.
6. A prominent issue in the international staffing literature is expatriate failure, defined as the premature
return of an expatriate manager to his or her home country. e costs of expatriate failure can be
substantial.
7. Expatriate failure can be reduced by selection procedures that screen out inappropriate candidates. e
most successful expatriates seem to be those who have high self-esteem and self-confidence, can get along
well with others, are willing to attempt to communicate in a foreign language, and can empathize with
people of other cultures.
8. Training can lower the probability of expatriate failure. It should include cultural training, language
training, and practical training, and it should be provided to both the expatriate manager and the spouse.
9. Management development programs attempt to increase the overall skill levels of managers
through a mix of ongoing management education and rotation of managers through different
jobs within the firm to give them varied experiences. Management development is often used as a strategic
tool to build a strong unifying culture and informal management network, both of which support
transnational and global standardization strategies.
10. It can be difficult to evaluate the performance of expatriate managers objectively because of unintentional
bias. A firm can take a number of steps to reduce this bias.
11. Country differences in compensation practices raise a difficult question for an international business:
Should the firm pay executives in different countries according to the standards in each country or equalize
pay on a global basis?
12. e most common approach to expatriate pay is the balance sheet approach. is approach aims to
equalize purchasing power so employees can enjoy the same living standard in their foreign posting that
they had at home.
13. Building a globally diverse workforce can help a company to improve its financial performance.
14. A key issue in international labor relations is the degree to which organized labor can limit the choices
available to an international business. A firm’s ability to pursue a transnational or global standardization
strategy can be significantly constrained by the actions of labor unions.
15. A principal concern of organized labor is that the multinational can counter union bargaining power with
threats to move production to another country.
16. Organized labor has tried to counter the bargaining power of multinationals by forming international labor
organizations. In general, these efforts have not been effective.
Critical inking and Discussion Questions
1. What are the main advantages and disadvantages of the ethnocentric, polycentric, and geocentric
approaches to staffing policy? When is each approach appropriate?
2. Research suggests that many expatriate employees encounter problems that limit both their effectiveness in
a foreign posting and their contribution to the company when they return home. What are the main causes
and consequences of these problems, and how might a firm reduce the occurrence of such problems?
3. What is the link between an international business’s strategy and its human resource management policies,
particularly with regard to the use of expatriate employees and their pay scale?
4. In what ways can organized labor constrain the strategic choices of an international business? How can an
international business limit these constraints?
5. Reread the Management Focus “McDonald’s Global Compensation Practices.” How does McDonald’s
approach help the company take into account local differences when reviewing the performance of
different country managers and awarding bonus pay?
6. Why is diversity good for an international business? What actions can a company take to foster greater
diversity?
Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. e impact of strikes and lockouts on business activities can be substantial. Because your manufacturing
company is planning to expand its operations in the Asian markets, you have to identify the countries
where strikes and lockouts could introduce interruptions to your operations. Using labor statistics from the
International Labour Organization to develop your report, identify the three Asian countries with the
highest number of strikes and lockouts, as well as the total number of lost worker days. What types of
precautions can your company take to prevent interruptions from occurring in these markets?
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2. You work in the human resource department at the headquarters of a multinational corporation. Your
company is about to send a number of managers overseas as expatriates to France and New Zealand. You
need to create an executive summary evaluating, comparing, and contrasting the possible issues expats may
encounter in these two countries. Your manager tells you that a tool called Expat Explorer created by HSBC
can assist you in your task.
S o d e x o : B u i l d i n g a D i v e r s e G l o b a l Wo r k f o r c e
c l o s i n g c a s e
Founded in 1966 by Pierre Bellon in France, Sodexo (sodexo.com) is the worldwide leader in providing a range of “quality
of life” services, including workplace design, onsite food provision, facilities management, cleaning, health care, prisoner
rehabilitation, employee benefits and rewards, and personal and home services. e company has 425,000 employees in
80 countries, serves 75 million customers every day, and generates more than €20 billion in revenues annually.
Headquartered in France, 43 percent of its revenues are generated in North America; 11 percent in the United Kingdom;
30 percent in continental Europe, including France; and 16 percent in the rest of the world.
Sodexo is well known for its commitment to building a globally diverse workforce and was ranked number 6 in the
world in DiversityInc’s 2017 list of the top 50 companies for workforce diversity. Sodexo’s commitment to workforce diversity derives from a deeply held belief that there is a relationship between workforce diversity and company
performance. is belief has been confirmed in a recent study by McKinsey and Company that found that companies in
the top quartile of gender and ethnic diversity were 35 percent more likely to have financial returns above their national
industry median. Sodexo sees diversity as a marketplace differentiator that is important for many of its clients, who are
themselves diverse. Diversity initiatives can also be used to attract top talent. Moreover, bringing a diverse perspective to
bear on problems can improve decision making and result in innovative solutions for clients and customers.
Sodexo focuses on five key areas of diversity: generations, sexual orientation, disabilities, culture and origins, and
gender. Globally, Sodexo’s board of directors is 50 percent female, and 31 percent of its global executive team are women,
as are 30 percent of its top 1,400 senior leaders. CEO Michel Landel would like 40 percent of all senior leaders to be
women by 2025. Some 60 percent of managers at Sodexo are also people of color.
Sodexo translates its commitment to building a diverse workforce and management team into practice through a
number of mechanisms. It starts at the top with CEO Michel Landel, who also chairs the company’s Diversity Leadership
Council, which sets companywide diversity priorities and oversees corporate staffing and diversity training programs. e
company then decentralizes authority to develop and fine-tune programs and implement them to managers in each
country. Each country reports to a regional Diversity Leadership Council (North America, Europe, South America, etc.)
that is chaired by the CEO for that region. e company allows each country to establish its own local diversity initiatives
while also requiring them to participate in some corporate initiatives, such as diversity training.
is decentralized approach can result in varying progress throughout the company, reflecting different national
conditions. As the company’s chief diversity office in the United States explained, “Even though we’re more advanced in
the U.S. around diversity efforts, we’re really not able to necessarily use the successes to engage the rest of the organization,
because everything happens from the ground up. For each of the 25 countries [in Europe], we have . . . to start
from the ground and build the diversity efforts so they have more ownership of it. Each country feels that . . . if
it’s not made here [locally] it’s rejected.” At the same time Sodexo has put a Cross Market Diversity Council in place to
make sure that good ideas can be shared across the company.
©Michel Euler/AP Images
To drive home the importance of diversity, Sodexo measures the performance of individual managers against a diversity
scorecard that includes quantitative and qualitative metrics and can be varied by country to account for different cultural
contexts. Twenty-five percent of the annual bonus of executive team members, and 10 to 15 percent of the bonuses for
senior and mid-level managers are connected to how they perform on the diversity scorecard metrics.
Sources: Diversity Inc, “e 2017 DiversityInc Top 50 Companies for Diversity,” www.diversityinc.com/sodexo-2017; Aperian Global, “Leaders in
Diversity and Inclusion,” www.aperianglobal.com/leaders-diversity-inclusion-5-lessons-top-global-companies; “Driving Global Diversity: Selected
Examples of Global Diversity Efforts,” Diversity Best Practice, May 2013; Hunt, V., Layton, D., and Prince, S., “Diversity Matters,” McKinsey &
Co, February 2, 2015; and Silva, Betsy, “Diversity and Inclusion: A Strategic Imperative—e Sodexo Story,” Commission on Economic
Inclusion, Greater Cleveland Partnership Change Management Conference, July 17, 2011.
CASE DISCUSSION QUESTIONS
1. How might building a more diverse global workforce help Sodexo to achieve high performance?
2. What barriers do companies like Sodexo face when trying to increase workforce diversity in their global
operations?
3. How does Sodexo implement its policy of increasing the diversity of its global workforce?
4. Evaluate Sodexo’s diversity policy. Is the company doing the right thing? Are the right policies in place?
Are there other things the company might do?
5. Sodexo’s strategy is to decentralize authority to develop and fine-tune programs and implement them to
managers in each country. What are the benefits of this approach? What are the potential drawbacks?
Endnotes
1. P. J. Dowling and R. S. Schuler, International Dimensions of Human Resource Management (Boston: PSW-
Kent, 1990).
2. J. Millman, M. A. von Glinow, and M. Nathan, “Organizational Life Cycles and Strategic International
Human Resource Management in Multinational Companies,” Academy of Management Review 16 (1991),
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pp. 318–39; A. Bird and S. Beechler, “Links between Business Strategy and Human Resource
Management,” Journal of International Business Studies 26 (1995), pp. 23–47; B. A. Colbert, “e Complex
Resource-Based View: Implications for eory and Practice of Strategic Human Resource Management,”
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Human Resource Practices, Top Management Team Social Networks, and Firm Performance,” Academy of
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3. See Peter Bamberger and Ilan Meshoulam, Human Resource Strategy: Formulation, Implementation, and
Impact (ousand Oaks, CA: Sage, 2000); P. M. Wright and S. Snell, “Towards a Unifying Framework for
Exploring Fit and Flexibility in Human Resource Management,” Academy of Management Review 23
(October 1998), pp. 756–72; Colbert, “e Complex Resource-Based View”; R. S. Schuler and S. E.
Jackson, “A Quarter Century Review of Human Resource Management in the US: e Growth in
Importance of the International Perspective,” Management Review 16 (2005), pp. 1–25.
4. R. Colman, “HR Management Lags behind at World Class Firms,” CMA Management, July–August 2002,
p. 9.
5. E. H. Schein, Organizational Culture and Leadership (San Francisco: Jossey-Bass, 1985).
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Business 4 (1969), pp. 9–18; D. A. Heenan and H. V. Perlmutter, Multinational Organizational
Development (Reading, MA: Addison-Wesley, 1979); D. A. Ondrack, “International Human Resources
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People to Run eir Overseas Operations,” e Wall Street Journal, September 26, 1996, p. 17.
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A1.
9. S. Beechler and J. Z. Yang, “e Transfer of Japanese-Style Management to American Subsidiaries,” Journal
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10. M. Banai and L. M. Sama, “Ethical Dilemma in MNCs’ International Staffing Policies,” Journal of Business
Ethics, June 2000, pp. 221–35.
11. Reitman and Schuman, “Men’s Club.”
12. C. A. Bartlett and S. Ghoshal, Managing across Borders: e Transnational Solution (Boston: Harvard
Business School Press, 1989).
13. S. J. Kobrin, “Geocentric Mindset and Multinational Strategy,” Journal of International Business Studies 25
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14. F. Hansen, “International Business Machine,” Workforce Management, July 2005, pp. 36–44.
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Corporations,” Journal of International Business Studies 25 (1994), pp. 229–51.
16. Kobrin, “Geocentric Mindset and Multinational Strategy.”
17. M. Harvey and H. Fung, “Inpatriate Managers: e Need for Realistic Relocation Reviews,” International
Journal of Management 17 (2000), pp. 151–59.
18. S. Black, M. Mendenhall, and G. Oddou, “Toward a Comprehensive Model of International Adjustment,”
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Altman, “Expatriation and Repatriation in MNCs—A Taxonomy,” Human Resource Management 41
(2002), pp. 239–59.
19. M. G. Harvey, “e Multinational Corporation’s Expatriate Problem: An Application of Murphy’s Law,”
Business Horizons 26 (1983), pp. 71–78.
20. J. Barbian, “Return to Sender,” Training, January 2002, pp. 40–43.
21. Barbian, “Return to Sender”; K. Yeaton and N. Hall, “Expatriates: Reducing Failure Rates,” Journal of
Corporate Accounting and Finance, March–April 2008, pp. 75–78.
22. Black et al., “Toward a Comprehensive Model of International Adjustment.”
23. R. L. Tung, “Selection and Training Procedures of U.S., European, and Japanese Multinationals,”
California Management Review 25 (1982), pp. 57–71.
24. T. Zsuzzanna and M. Pieperl, “Expatriate Practices in German, Japanese, U.K., and U.S. Multinational
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25. H. W. Lee, “Factors at Influence Expatriate Failure,” International Journal of Management 24 (2007), pp.
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26. C. M. Solomon, “Success Abroad Depends upon More an Job Skills,” Personnel Journal, April 1994, pp.
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27. C. M. Solomon, “Unhappy Trails,” Workforce, August 2000, pp. 36–41.
28. Solomon, “Success Abroad Depends upon More an Job Skills.”
29. Solomon, “Unhappy Trails.”
30. M. Harvey, “Addressing the Dual-Career Expatriation Dilemma,” Human Resource Planning 19, no. 4
(1996), pp. 18–32.
31. M. Mendenhall and G. Oddou, “e Dimensions of Expatriate Acculturation: A Review,” Academy of
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32. I. Torbiorin, Living Abroad: Personal Adjustment and Personnel Policy in the Overseas Setting (New York:
Wiley, 1982).
33. R. L. Tung, “Selection and Training of Personnel for Overseas Assignments,” Columbia Journal of World
Business 16 (1981), pp. 68–78.
34. Solomon, “Success Abroad.”
35. S. Ronen, “Training and International Assignee,” in Training and Career Development, ed. I. Goldstein (San
Francisco: Jossey-Bass, 1985); and Tung, “Selection and Training of Personnel for Overseas Assignments.”
36. Solomon, “Success Abroad.”
37. Harvey, “Addressing the Dual-Career Expatriation Dilemma”; and J. W. Hunt, “e Perils of Foreign
Postings for Two,” Financial Times, May 6, 1998, p. 22.
38. C. M. Daily, S. T. Certo, and D. R. Dalton, “International Experience in the Executive Suite: A Path to
Prosperity?” Strategic Management Journal 21 (2000), pp. 515–23.
39. Dowling and Schuler, International Dimensions.
40. Dowling and Schuler, International Dimensions.
41. G. Baliga and J. C. Baker, “Multinational Corporate Policies for Expatriate Managers: Selection, Training,
and Evaluation,” Advanced Management Journal, Autumn 1985, pp. 31–38.
42. J. C. Baker, “Foreign Language and Departure Training in U.S. Multinational Firms,” Personnel
Administrator, July 1984, pp. 68–70.
43. A 1997 study by the Conference Board looked at this in depth. For a summary, see L. Grant, “at
Overseas Job Could Derail Your Career,” Fortune, April 14, 1997, p. 166. Also see J. S. Black and H.
Gregersen, “e Right Way to Manage Expatriates,” Harvard Business Review, March–April 1999, pp. 52–
63.
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44. J. S. Black and M. E. Mendenhall, Global Assignments: Successfully Expatriating and Repatriating
International Managers (San Francisco: Jossey-Bass, 1992); and K. Vermond, “Expatriates Come Home,”
CMA Management, October 2001, pp. 30–33.
45. Black and Mendenhall, Global Assignments; and Vermond, “Expatriates Come Home.”
46. Figures from the Conference Board study. For a summary, see Grant, “at Overseas Job Could Derail
Your Career.”
47. S. C. Schneider, “National vs. Corporate Culture: Implications for Human Resource Management,”
Human Resource Management 27 (Summer 1988), pp. 231–46.
48. I. M. Manve and W. B. Stevenson, “Nationality, Cultural Distance and Expatriate Status,” Journal of
International Business Studies 32 (2001), pp. 285–303; and D. Minbaeva et al., “MNC Knowledge
Transfer, Subsidiary Absorptive Capacity, and HRM,” Journal of International Business Studies 34, no. 6
(2003), pp. 586–604.
49. Bartlett and Ghoshal, Managing across Borders.
50. See G. Oddou and M. Mendenhall, “Expatriate Performance Appraisal: Problems and Solutions,” in
International Human Resource Management, ed. M. Mendenhall and G. Oddou (Boston: PWS-Kent,
1991); Dowling and Schuler, International Dimensions; R. S. Schuler and G.W. Florkowski, “International
Human Resource Management,” in Handbook for International Management Research, ed. B. J. Punnett and
O. Shenkar (Oxford: Blackwell, 1996); and K. Roth and S. O’Donnell, “Foreign Subsidiary Compensation
Strategy: An Agency eory Perspective,” Academy of Management Journal 39, no. 3 (1996), pp. 678–703.
51. Oddou and Mendenhall, “Expatriate Performance Appraisal.”
52. “Expatriates Often See Little Benefit to Careers in Foreign Stints, Indifference at Home,” e Wall Street
Journal, December 11, 1989, p. B1.
53. Oddou and Mendenhall, “Expatriate Performance Appraisal”; and Schuler and Florkowski, “International
Human Resource Management.”
54. Towers Perrin, Towers Perrin Worldwide Total Remuneration Study, 2005–2006, www.towerswatson.com.
Not all researchers agree with this conclusion; see, for example, N. Fernandes et al., “Are US CEOs Paid
More? New International Evidence,” e Review of Financial Studies 26, no. 2 (2013), pp. 323–67.
55. J. Cummings and L. Brannen, “e New World of Compensation,” Business Finance, June 2005,
p. 8.
56. “Multinationals Tighten Control of Benefit Plans,” Workforce Management, May 2005, p. 5.
57. Organizational Resource Counselors, 2002 Survey of International Assignment Policies and Practices, March
2003.
58. C. Reynolds, “Compensation of Overseas Personnel,” in Handbook of Human Resource Administration, ed.
J. J. Famularo (New York: McGraw-Hill, 1986).
59. M. Helms, “International Executive Compensation Practices,” in International Human Resource
Management, ed. M. Mendenhall and G. Oddou (Boston: PWS-Kent, 1991).
60. G. W. Latta, “Expatriate Incentives,” HR Focus 75, no. 3 (March 1998), p. S3.
61. Vivian Hunt, Dennis Layton, and Sara Prince, Diversity Matters, McKinsey & Co, February 2, 2015; Roy
D. Adler, “Profit y Name Is Woman,” Pacific Standard, February 27, 2009.
62. Hunt et al., Diversity Matters; Boris Groysberg and Katherine Connolly, “Great Leaders Who Make the
Mix Work,” Harvard Business Review, September 2013, pp. 68–76.
63. Groysberg and Connolly, “Great Leaders Who Make the Mix Work.”
64. Mercer Consulting, When Women rive, Businesses rive, Mercer LLC, 2014.
65. Hunt et al., Diversity Matters.
66. C. K. Prahalad and Y. L. Doz, e Multinational Mission (New York: Free Press, 1987).
67. C. K. Prahalad and Y. L. Doz, e Multinational Mission (New York: Free Press, 1987).
68. Schuler and Florkowski, “International Human Resource Management.”
69. See J. P. Womack, D. T. Jones, and D. Roos, e Machine at Changed the World (New York: Rawson
Associates, 1990).
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education
Page 503glossary
A
absolute advantage A country has an absolute advantage in the production of a product when it is
more efficient than any other country at producing it.
ad valorem tariff A tariff levied as a proportion of the value of an imported good.
administrative trade policies Administrative policies, typically adopted by government
bureaucracies, that can be used to restrict imports or boost exports.
Andean Community A 1969 agreement among Bolivia, Chile, Ecuador, Colombia, and Peru to
establish a customs union.
antidumping policies Designed to punish foreign firms that engage in dumping and thus protect
domestic producers from unfair foreign competition.
arbitrage e purchase of securities in one market for immediate resale in another to profit from a
price discrepancy.
Association of Southeast Asian Nations (ASEAN) Formed in 1967, an attempt to establish a free
trade area among Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore,
Vietnam, and ailand.
B
balance-of-payments accounts National accounts that track both payments to and receipts from
foreigners.
balance-of-trade equilibrium Reached when the income a nation’s residents earn from exports
equals money paid for imports.
bandwagon effect Movement of traders like a herd, all in the same direction and at the same time, in
response to each other’s perceived actions.
banking crisis A loss of confidence in the banking system that leads to a run on banks, as individuals
and companies withdraw their deposits.
barter e direct exchange of goods or services between two parties without a cash transaction.
big data A massive volume of structured and/or unstructured data that are so large they may be
difficult to process using traditional database and software techniques.
bill of exchange An order written by an exporter instructing an importer, or an importer’s agent, to
pay a specified amount of money at a specified time.
bill of lading A document issued to an exporter by a common carrier transporting merchandise. It
serves as a receipt, a contract, and a document of title.
business analytics e knowledge, skills, and technology that allow for the exploration as well as
deeper investigation of a company’s international business strategies and activities to gain insight and
drive future strategy development and implementation.
business ethics e accepted principles of right and wrong governing the conduct of businesspeople.
buyback Agreement to accept a percentage of a plant’s output as payment for contract to build a
plant.
C
capital account In the balance of payments, records transactions involving one-time changes in the
stock of assets.
capital flight Converting domestic currency into a foreign currency.
Caribbean Single Market and Economy (CSME) e six CARICOM members that agreed to
lower trade barriers and harmonize macroeconomic and monetary policies.
CARICOM An association of English-speaking Caribbean states that are attempting to establish a
customs union.
carry trade A kind of speculation that involves borrowing in one currency where interest rates are
low and then using the proceeds to invest in another currency where interest rates are high.
caste system A system of social stratification in which social position is determined by the family
into which a person is born, and change in that position is usually not possible during an individual’s
lifetime.
Central America Free Trade Agreement (CAFTA) e agreement of the member states of the
Central American Common Market joined by the Dominican Republic to trade freely with the
United States.
Central American Common Market A trade pact among Costa Rica, El Salvador, Guatemala,
Honduras, and Nicaragua, which began in the early 1960s but collapsed in 1969 due to war.
channel length e number of intermediaries that a product has to go through before it reaches the
final consumer.
channel quality e expertise, competencies, and skills of established retailers in a nation and their
ability to sell and support the products of international businesses.
civil law system A system of law based on a very detailed set of written laws and codes.
class consciousness A tendency for individuals to perceive themselves in terms of their class
background.
class system A system of social stratification in which social status is determined by the family into
which a person is born and by subsequent socioeconomic achievements; mobility between classes
is possible.
code of ethics A business’s formal statement of ethical priorities.
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collectivism A political system that emphasizes collective goals as opposed to individual goals.
command economy An economic system where the allocation of resources, including determination
of what goods and services should be produced, and in what quantity, is planned by the government.
common law A system of law based on tradition, precedent, and custom; when law courts
interpret common law, they do so with regard to these characteristics.
common market A group of countries committed to (1) removing all barriers to the free flow of
goods, services, and factors of production between each other and (2) the pursuit of a common
external trade policy.
communist totalitarianism A version of collectivism advocating that socialism can be achieved only
through a totalitarian dictatorship.
communists ose who believe socialism can be achieved only through revolution and totalitarian
dictatorship.
concentrated retail system A retail system in which a few retailers supply most of the market.
constant returns to specialization e units of resources required to produce a good are assumed to
remain constant no matter where one is on a country’s production possibility frontier.
contract A document that specifies the conditions under which an exchange is to occur and details
the rights and obligations of the parties involved.
contract law e body of law that governs contract enforcement.
contributor factory A factory that serves a specific country or world region.
controls e metrics used to measure the performance of subunits and make judgments about how
well managers are running those subunits.
Convention on Combating Bribery of Foreign Public Officials in International Business
Transactions An OECD convention that establishes legally binding standards to criminalize bribery
of foreign public officials in international business transactions and provides for a host of related
measures that make this effective.
copyrights e exclusive legal rights of authors, composers, playwrights, artists, and publishers to
publish and disperse their work as they see fit.
core competence Firm skills that competitors cannot easily match or imitate.
corporate culture e organization’s norms and value systems.
corporate social responsibility (CSR) Refers to the idea that businesspeople should consider the
social consequences of economic actions when making business decisions and that there should be a
presumption in favor of decisions that have both good economic and social consequences.
counterpurchase A reciprocal buying agreement.
countertrade e trade of goods and services for other goods and services.
countervailing duties Antidumping duties.
country of origin effects A subset of source effects, the extent to which the place of manufacturing
influences product evaluations.
Court of Justice Supreme appeals court for EU law.
cross-cultural literacy Understanding how the culture of a country affects the way business is
practiced.
cultural relativism e belief that ethics are culturally determined and that firms should adopt the
ethics of the cultures in which they operate.
culture A system of values and norms that are shared among a group of people and that when taken
together constitute a design for living.
currency board Means of controlling a country’s currency.
currency crisis Occurs when a speculative attack on the exchange value of a currency results in a
sharp depreciation in the value of the currency or forces authorities to expend large volumes of
international currency reserves and sharply increase interest rates to defend the prevailing exchange
rate.
currency speculation Involves short-term movement of funds from one currency to another in
hopes of profiting from shifts in exchange rates.
currency swap Simultaneous purchase and sale of a given amount of foreign exchange for two
different value dates.
current account In the balance of payments, records transactions involving the export or import of
goods and services.
current account deficit e current account of the balance of payments is in deficit when a country
imports more goods, services, and income than it exports.
current account surplus e current account of the balance of payments is in surplus when a
country exports more goods, services, and income than it imports.
customs union A group of countries committed to (1) removing all barriers to the free flow of goods
and services between each other and (2) the pursuit of a common external trade policy.
D
democracy Political system in which government is by the people, exercised either directly or
through elected representatives.
deregulation Removal of government restrictions concerning the conduct of a business.
dirty-float system A system under which a country’s currency is nominally allowed to float freely
against other currencies but in which the government will intervene, buying and selling currency, if it
believes that the currency has deviated too far from its fair value.
dollarization e process of aligning a country’s currency with the U.S. dollar.
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downstream supply chain e portion of the supply chain from the production facility to the end-
customer.
draft An order written by an exporter telling an importer what and when to pay.
dumping Selling goods in a foreign market for less than their cost of production or below their “fair”
market value.
E
eclectic paradigm Argument that combining location-specific assets or resource endowments and the
firm’s own unique assets often requires FDI; it requires the firm to establish production facilities where
those foreign assets or resource endowments are located.
economic exposure e extent to which a firm’s future international earning power is affected by
changes in exchange rates.
economic risk e likelihood that events, including economic mismanagement, will cause drastic
changes in a country’s business environment that adversely affect the profit and other goals of a
particular business enterprise.
economic union A group of countries committed to (1) removing all barriers to the free flow of
goods, services, and factors of production between each other; (2) the adoption of a common
currency; (3) the harmonization of tax rates; and (4) the pursuit of a common external trade policy.
economies of scale Cost advantages associated with large-scale production.
efficient market A market where prices reflect all available information.
elastic A small change in price produces a large change in demand.
entrepreneurs ose who first commercialize innovations.
ethical dilemma A situation in which there is no ethically acceptable solution.
ethical strategy A course of action that does not violate a company’s business ethics.
ethical system A set of moral principles, or values, that is used to guide and shape behavior.
ethnocentric staffing policy A staffing approach within the multinational enterprise in which all key
management positions are filled by parent-country nationals.
ethnocentrism Behavior that is based on the belief in the superiority of one’s own ethnic group or
culture; often shows disregard or contempt for the culture of other countries.
European Commission Responsible for proposing EU legislation, implementing it, and monitoring
compliance.
European Council e heads of state of EU members and the president of the European
Commission.
European Free Trade Association (EFTA) A free trade association including Norway, Iceland,
Liechtenstein, and Switzerland.
European Monetary System (EMS) EU system designed to create a zone of monetary stability in
Europe, control inflation, and coordinate exchange rate policies of EU countries.
European Parliament Elected EU body that provides consultation on issues proposed by the
European Commission.
European Union (EU) An economic and political union of 28 countries (2017) that are located in
Europe.
exchange rate e rate at which one currency is converted into another.
exclusive distribution channel A distribution channel that outsiders find difficult to access.
expatriate failure e premature return of an expatriate manager to the home country.
expatriate manager A national of one country appointed to a management position in another
country.
experience curve Systematic production cost reductions that occur over the life of a product.
experience curve pricing Aggressive pricing designed to increase volume and help the firm realize
experience curve economies.
export ban A policy that partially or entirely restricts the export of a good.
export management company (EMC) Export specialist that acts as an export marketing department
for client firms.
export tariff A tax placed on the export of a good.
Export-Import Bank (Ex-Im Bank) Agency of the U.S. government whose mission is to provide aid
in financing and facilitate exports and imports.
exporting Sale of products produced in one country to residents of another country.
external stakeholders Individuals or groups that have some claim on a firm such as customers,
suppliers, and unions.
externalities Knowledge spillovers.
externally convertible currency Limitations on the ability of residents to convert domestic currency,
though nonresidents can convert their holdings of domestic currency into foreign currency.
F
factor endowments A country’s endowment with resources such as land, labor, and capital.
factors of production Inputs into the productive process of a firm, including labor, management,
land, capital, and technological know-how.
financial account In the balance of payments, transactions that involve the purchase or sale of assets.
first-mover advantages Advantages accruing to the first to enter a market.
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first-mover disadvantages Disadvantages associated with entering a foreign market before other
international businesses.
Fisher effect Nominal interest rates (i) in each country equal the required real rate of interest (r) and
the expected rate of inflation over the period of time for which the funds are to be lent (l). at is, i =
r + I.
fixed exchange rate A system under which the exchange rate for converting one currency into
another is fixed.
flexible machine cells Flexible manufacturing technology in which a grouping of various machine
types, a common materials handler, and a centralized cell controller produce a family of products.
flexible manufacturing technology Manufacturing technology designed to improve job scheduling,
reduce setup time, and improve quality control.
floating exchange rate A system under which the exchange rate for converting one currency into
another is continuously adjusted depending on the laws of supply and demand.
flow of FDI e amount of foreign direct investment undertaken over a given time period (normally
one year).
folkways Routine conventions of everyday life.
Foreign Corrupt Practices Act (FCPA) U.S. law regulating behavior regarding the conduct of
international business in the taking of bribes and other unethical actions.
foreign debt crisis Situation in which a country cannot service its foreign debt obligations, whether
private-sector or government debt.
foreign direct investment (FDI) Direct investment in business operations in a foreign country.
foreign exchange market A market for converting the currency of one country into that of another
country.
foreign exchange risk e risk that changes in exchange rates will hurt the profitability of a business
deal.
forward exchange When two parties agree to exchange currency and execute a deal at some specific
date in the future.
forward exchange rate e exchange rate governing a forward exchange transaction.
fragmented retail system A retail system in which there are many retailers, none of which has a
major share of the market.
franchising A specialized form of licensing in which the franchiser sells intangible property to the
franchisee and insists on rules to conduct the business.
free trade e absence of barriers to the free flow of goods and services between countries.
free trade area A group of countries committed to removing all barriers to the free flow of goods and
services between each other but pursuing independent external trade policies.
freely convertible currency A country’s currency is freely convertible when the government of that
country allows both residents and nonresidents to purchase unlimited amounts of foreign currency
with the domestic currency.
G
General Agreement on Tariffs and Trade (GATT) International treaty that committed signatories
to lowering barriers to the free flow of goods across national borders and led to the WTO.
geocentric staffing policy A staffing policy where the best people are sought for key jobs throughout
a multinational enterprise, regardless of nationality.
global distribution center A facility that positions and allows customization of products for delivery
to worldwide wholesalers or retailers or directly to consumers anywhere in the world; also called a
global distribution warehouse.
global inventory management e decision-making process regarding the raw materials, work-in-
process (component parts), and finished goods inventory for a multinational corporation.
global learning e flow of skills and product offerings from foreign subsidiary to home country
and from foreign subsidiary to foreign subsidiary.
global standardization strategy A firm focuses on increasing profitability and profit growth by
reaping the cost reductions that come from economies of scale, learning effects, and location
economies.
global supply chain coordination e shared decision-making opportunities and operational
collaboration of key global supply chain activities.
global web When different stages of value chain are dispersed to those locations around the globe
where value added is maximized or where costs of value creation are minimized.
globalization Trend away from distinct national economic units and toward one huge global market.
globalization of markets Moving away from an economic system in which national markets are
distinct entities, isolated by trade barriers and barriers of distance, time, and culture, and toward a
system in which national markets are merging into one global market.
globalization of production Trend by individual firms to disperse parts of their productive processes
to different locations around the globe to take advantage of differences in cost and quality of factors of
production.
gold par value e amount of currency needed to purchase one ounce of gold.
gold standard e practice of pegging currencies to gold and guaranteeing convertibility.
greenfield investment Establishing a new operation in a foreign country.
gross national income (GNI) Measures the total annual income received by residents of a nation.
group An association of two or more individuals who have a shared sense of identity and who
interact with each other in structured ways on the basis of a common set of expectations about each
other’s behavior.
Group of Twenty (G20) Established in 1999, the G20 comprises the finance ministers and central
bank governors of the 19 largest economies in the world, plus representatives from the European
Union and the European Central Bank.
H
Human Development Index (HDI) An attempt by the United Nations to assess the impact of a
number of factors on the quality of human life in a country.
human resource management (HRM) Activities an organization conducts to use its human
resources effectively.
I
import quota A direct restriction on the quantity of a good that can be imported into a country.
incentives e devices used to reward appropriate managerial behavior.
individualism An emphasis on the importance of guaranteeing individual freedom and self-
expression.
individualism versus collectivism eory focusing on the relationship between the individual and
his or her fellows; in individualistic societies, the ties between individuals are loose and individual
achievement is highly valued; in societies where collectivism is emphasized, ties between individuals
are tight, people are born into collectives, such as extended families, and everyone is supposed to look
after the interests of his or her collective.
inefficient market One in which prices do not reflect all available information.
inelastic When a large change in price produces only a small change in demand.
infant industry argument New industries in developing countries must be temporarily protected
from international competition to help them reach a position where they can compete on world
markets with the firms of developed nations.
inflows of FDI Flow of foreign direct investment into a country.
innovation Development of new products, processes, organizations, management practices, and
strategies.
intellectual property Products of the mind, ideas (e.g., books, music, computer software, designs,
technological know-how); intellectual property can be protected by patents, copyrights, and
trademarks.
intermarket segment A segment of customers that spans multiple countries, transcending national
borders.
internal stakeholders People who work for or own the business such as employees, directors, and
stockholders.
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internalization theory Marketing imperfection approach to foreign direct investment.
international business Any firm that engages in international trade or investment.
International Fisher Effect (IFE) For any two countries, the spot exchange rate should change in an
equal amount but in the opposite direction to the difference in nominal interest rates between
countries.
international market research e systematic collection, recording, analysis, and interpretation of
data to provide knowledge that is useful for decision making in a global company.
International Monetary Fund (IMF) International institution set up to maintain order in the
international monetary system.
international monetary system Institutional arrangements countries adopt to govern exchange rates.
international strategy Trying to create value by transferring core competencies to foreign markets
where indigenous competitors lack those competencies.
international trade Occurs when a firm exports goods or services to consumers in another country.
ISO 9000 Certification process that requires certain quality standards that must be met.
J
joint venture A cooperative undertaking between two or more firms.
just distribution A distribution of goods and services that is considered fair and equitable.
just in time (JIT) Inventory logistics system designed to deliver parts to a production process as they
are needed, not before.
K
Kantian ethics e belief that people should be treated as ends and never as means to the ends of
others.
L
lag strategy Delaying the collection of foreign currency receivables if that currency is expected to
appreciate and delaying payables if that currency is expected to depreciate.
late-mover disadvantages Handicaps experienced by being a late entrant in a market.
law of one price In competitive markets free of transportation costs and barriers to trade, identical
products sold in different countries must sell for the same price when their price is expressed in the
same currency.
lead factory A factory that is intended to create new processes, products, and technologies that can
be used throughout the global firm in all parts of the world.
lead strategy Collecting foreign currency receivables early when a foreign currency is expected to
depreciate and paying foreign currency payables before they are due when a currency is expected to
appreciate.
lean production See flexible manufacturing technology.
learning effects Cost savings from learning by doing.
legal risk e likelihood that a trading partner will opportunistically break a contract or expropriate
intellectual property rights.
legal system System of rules that regulate behavior and the processes by which the laws of a country
are enforced and through which redress of grievances is obtained.
letter of credit Issued by a bank, indicating that the bank will make payments under specific
circumstances.
licensing Occurs when a firm (the licensor) licenses the right to produce its product, use its
production processes, or use its brand name or trademark to another firm (the licensee). In return for
giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells.
licensing agreement Arrangement in which a licensor grants the rights to intangible property to a
licensee for a specified period and receives a royalty fee in return.
local content requirement (LCR) A requirement that some specific fraction of a good be produced
domestically.
localization strategy Increasing profitability by customizing the firm’s goods and services so that they
provide a good match to tastes and preferences in different national markets.
location economies Cost advantages from performing a value creation activity at the optimal
location for that activity.
location-specific advantages Advantages that arise from using resource endowments or assets that
are tied to a particular foreign location and that a firm finds valuable to combine with its own unique
assets (such as the firm’s technological, marketing, or management know-how).
logistics e part of the supply chain that plans, implements, and controls the effective flows and
inventory of raw material, component parts, and products used in manufacturing.
long-term versus short-term orientation e theory of the extent to which a culture programs its
citizens to accept delayed gratification of their material, social, and emotional needs. It captures
attitudes toward time, persistence, ordering by status, protection of face, respect for tradition, and
reciprocation of gifts and favors.
M
Maastricht Treaty Treaty agreed to in 1992, but not ratified until January 1, 1994, that committed
the 12 member states of the European Community to a closer economic and political union.
make-or-buy decision e strategic decision concerning whether to produce an item in-house
(“make”) or purchase it from an outside supplier (“buy”).
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managed-float system System under which some currencies are allowed to float freely, but the
majority are either managed by government intervention or pegged to another currency.
market economy An economic system in which the interaction of supply and demand determines
the quantity in which goods and services are produced.
market imperfections Imperfections in the operation of the market mechanism.
market segmentation Identifying groups of consumers whose purchasing behavior differs from
others in important ways.
marketing mix Choices about product attributes, distribution strategy, communication strategy, and
pricing strategy that a firm offers its targeted markets.
masculinity versus femininity eory of the relationship between gender and work roles. In
masculine cultures, sex roles are sharply differentiated and traditional “masculine values” such as
achievement and the effective exercise of power determine cultural ideals; in feminine cultures, sex
roles are less sharply distinguished, and little differentiation is made between men and women in the
same job.
mass customization e production of a variety of end products at a unit cost that could once be
achieved only through mass production of a standardized output.
mercantilism An economic philosophy advocating that countries should simultaneously encourage
exports and discourage imports.
Mercosur Pact among Argentina, Brazil, Paraguay, and Uruguay to establish a free trade area.
minimum efficient scale e level of output at which most plant-level scale economies are
exhausted.
MITI Japan’s Ministry of International Trade and Industry.
Moore’s law e power of microprocessor technology doubles and its costs of production fall in half
every 18 months.
moral hazard Arises when people behave recklessly because they know they will be saved if things go
wrong.
mores Norms seen as central to the functioning of a society and to its social life.
multilateral or bilateral trade agreements Reciprocal trade agreements between two or more
partners.
multinational enterprise (MNE) A firm that owns business operations in more than one country.
multipoint competition Arises when two or more enterprises encounter each other in different
regional markets, national markets, or industries.
multipoint pricing Occurs when a pricing strategy in one market may have an impact on a rival’s
pricing strategy in another market.
N
naive immoralist One who asserts that if a manager of a multinational sees that firms from other
nations are not following ethical norms in a host nation, that manager should not either.
new trade theory e observed pattern of trade in the world economy may be due in part to the
ability of firms in a given market to capture first-mover advantages.
noise e number of other messages competing for a potential consumer’s attention.
nonconvertible currency A currency is not convertible when both residents and nonresidents are
prohibited from converting their holdings of that currency into another currency.
norms Social rules and guidelines that prescribe appropriate behavior in particular situations.
North American Free Trade Agreement (NAFTA) Free trade area among Canada, Mexico, and the
United States.
O
offset Agreement to purchase goods and services with a specified percentage of proceeds from an
original sale in that country from any firm in the country.
offshore factory A factory that is developed and set up mainly for producing component parts or
finished goods at a lower cost than producing them at home or in any other market.
offshore production FDI undertaken to serve the home market.
oligopoly An industry composed of a limited number of large firms.
operations e various value creation activities a firm undertakes.
optimal currency area Region in which similarities in economic activity make a single currency and
exchange rate feasible instruments of macroeconomic policy.
organization architecture e totality of a firm’s organization, including formal organizational
structure, control systems and incentives, organizational culture, processes, and people.
organizational culture e values and norms shared among an organization’s employees.
organizational structure e three-part structure of an organization, including its formal division
into subunits such as product divisions, its location of decision-making responsibilities within that
structure, and the establishment of integrating mechanisms to coordinate the activities of all subunits.
outflows of FDI Flow of foreign direct investment out of a country.
outpost factory A factory that can be viewed as an intelligence-gathering unit.
P
packaging e container that holds the product itself. It can be divided into primary, secondary, and
transit packaging.
Paris Convention for the Protection of Industrial Property International agreement to protect
intellectual property.
patent Grants the inventor of a new product or process exclusive rights to the manufacture, use, or
sale of that invention.
pegged exchange rate Currency value is fixed relative to a reference currency.
people e employees of the organization, the strategy used to recruit, compensate, and retain those
individuals, and the type of people that they are in terms of their skills, values, and orientation.
pioneering costs Costs an early entrant bears that later entrants avoid, such as the time and effort in
learning the rules, failure due to ignorance, and the liability of being a foreigner.
political economy e political, economic, and legal systems of a country.
political risk e likelihood that political forces will cause drastic changes in a country’s business
environment that will adversely affect the profit and other goals of a particular business enterprise.
political system System of government in a nation.
political union A central political apparatus coordinates economic, social, and foreign policy.
polycentric staffing policy A staffing policy in a multinational enterprise in which host-country
nationals are recruited to manage subsidiaries in their own country, while parent-country nationals
occupy key positions at corporate headquarters.
power distance eory of how a society deals with the fact that people are unequal in physical and
intellectual capabilities. High power distance cultures are found in countries that let inequalities grow
over time into inequalities of power and wealth; low power distance cultures are found in societies that
try to play down such inequalities as much as possible.
predatory pricing Reducing prices below fair market value as a competitive weapon to drive weaker
competitors out of the market (“fair” being cost plus some reasonable profit margin).
price elasticity of demand A measure of how responsive demand for a product is to changes in
price.
private action Violation of property rights through theft, piracy, blackmail, and the like by private
individuals or groups.
privatization e sale of state-owned enterprises to private investors.
processes e manner in which decisions are made and work is performed within any organization.
product liability Involves holding a firm and its officers responsible when a product causes injury,
death, or damage.
product safety laws Set certain safety standards to which a product must adhere.
production Activities involved in creating a product.
profit growth e percentage increase in net profits over time.
Page 509profitability A ratio or rate of return concept.
property rights Bundle of legal rights over the use to which a resource is put and over the use made
of any income that may be derived from that resource.
public action e extortion of income or resources of property holders by public officials, such as
politicians and government bureaucrats.
pull strategy A marketing strategy emphasizing mass media advertising as opposed to personal
selling.
purchasing e part of the supply chain that includes the worldwide buying of raw material,
component parts, and products used in manufacturing of the company’s products and services.
purchasing power parity (PPP) An adjustment in gross domestic product per capita to reflect
differences in the cost of living.
push strategy A marketing strategy emphasizing personal selling rather than mass media advertising.
Q
quota rent Extra profit producers make when supply is artificially limited by an import quota.
R
regional economic integration Agreements among countries in a geographic region to reduce and
ultimately remove tariff and nontariff barriers to the free flow of goods, services, and factors of
production between each other.
religion A system of shared beliefs and rituals concerned with the realm of the sacred.
representative democracy A political system in which citizens periodically elect individuals to
represent them in government.
reverse logistics e process of moving inventory from the point of consumption to the point of
origin in supply chains for the purpose of recapturing value or proper disposal.
right-wing totalitarianism A political system in which political power is monopolized by a party,
group, or individual that generally permits individual economic freedom but restricts individual
political freedom, including free speech, often on the grounds that it would lead to the rise of
communism.
righteous moralist One who claims that a multinational’s home-country standards of ethics are the
appropriate ones for companies to follow in foreign countries.
rights theories Twentieth-century theories that recognize that human beings have fundamental
rights and privileges that transcend national boundaries and cultures.
S
server factory A factory linked into the global supply chain for a global firm to supply specific
country or regional markets around the globe.
sight draft A draft payable on presentation to the drawee.
Six Sigma Statistically based methodology for improving product quality.
Smoot–Hawley Act Enacted in 1930 by the U.S. Congress, this act erected a wall of tariff barriers
against imports into the United States.
social democrats ose committed to achieving socialism by democratic means.
social media A technology that facilitates the sharing of information and the building of virtual
global networks and communities.
social mobility e extent to which individuals can move out of the social strata into which they are
born.
social strata Hierarchical social categories often based on family background, occupation, and
income.
social structure e basic social organization of a society.
socialists ose who believe in public ownership of the means of production for the common good
of society.
society Group of people who share a common set of values and norms.
sogo shosha Japanese trading companies; a key part of the keiretsu, the large Japanese industrial
groups.
source effects Effects that occur when the receiver of the message (i.e., a potential consumer)
evaluates the message on the basis of status or image of the sender.
source factory A factory whose primary purpose is also to drive down costs in the global supply
chain.
specific tariff Tariff levied as a fixed charge for each unit of good imported.
spot exchange rate e exchange rate at which a foreign exchange dealer will convert one currency
into another that particular day.
staffing policy Strategy concerned with selecting employees for particular jobs.
stakeholders e individuals or groups that have an interest, stake, or claim in the actions and
overall performance of a company.
stock of FDI e total accumulated value of foreign-owned assets at a given time.
strategic alliances Cooperative agreements between potential or actual competitors.
strategic pricing e concept containing the three aspects: predatory pricing, multipoint pricing,
and experience curve pricing.
Page 510
strategic trade policy Government policy aimed at improving the competitive position of a domestic
industry and/or domestic firm in the world market.
strategy Actions managers take to attain the firm’s goals.
subsidy Government financial assistance to a domestic producer.
supply chain management e integration and coordination of logistics, purchasing, operations,
and market channel activities from raw material to the end-customer.
sustainable strategies Strategies that not only help the multinational firm make good profits but that
do so without harming the environment, while simultaneously ensuring that the corporation acts in a
socially responsible manner with regard to its multiple stakeholders.
switch trading Use of a specialized third-party trading house in a countertrade arrangement.
T
tariff A tax levied on imports.
tariff rate quota Lower tariff rates applied to imports within the quota than those over the quota.
theocratic law system A system of law based on religious teachings.
theocratic totalitarianism A political system in which political power is monopolized by a party,
group, or individual that governs according to religious principles.
time draft A promise to pay by the accepting party at some future date.
timing of entry Entry is early when a firm enters a foreign market before other foreign firms and late
when a firm enters after other international businesses have established themselves.
total quality management (TQM) Management philosophy that takes as its central focus the need
to improve the quality of a company’s products and services.
totalitarianism Form of government in which one person or political party exercises absolute control
over all spheres of human life and opposing political parties are prohibited.
trade creation Trade created due to regional economic integration; occurs when high-cost domestic
producers are replaced by low-cost foreign producers within a free trade area.
trade diversion Trade diverted due to regional economic integration; occurs when low-cost foreign
suppliers outside a free trade area are replaced by higher-cost suppliers within a free trade area.
trademarks e designs and names, often officially registered, by which merchants or manufacturers
designate and differentiate their products.
transaction exposure e extent to which income from individual transactions is affected by
fluctuations in foreign exchange values.
translation exposure e extent to which the reported consolidated results and balance sheets of a
corporation are affected by fluctuations in foreign exchange values.
transnational strategy Attempt to simultaneously achieve low costs through location economies,
economies of scale, and learning effects while also differentiating product offerings across geographic
markets to account for local differences and fostering multidirectional flows of skills between different
subsidiaries in the firm’s global network of operations.
transportation e movement of inventory through the supply chain.
Treaty of Lisbon A European Union–sanctioned treaty that will allow the European Parliament to
become the co-equal legislator for almost all European laws.
Treaty of Rome e 1957 treaty that established the European Community.
tribal totalitarianism A political system in which a party, group, or individual that represents the
interests of a particular tribe (ethnic group) monopolizes political power.
turnkey project A project in which a firm agrees to set up an operating plant for a foreign client and
hand over the “key” when the plant is fully operational.
U
uncertainty avoidance Extent to which cultures socialize members to accept ambiguous situations
and to tolerate uncertainty.
United Nations (UN) An international organization made up of 193 countries headquartered in
New York City, formed in 1945 to promote peace, security, and cooperation.
United Nations Convention on Contracts for the International Sale of Goods (CISG) A set of
rules governing certain aspects of the making and performance of commercial contracts between sellers
and buyers who have their places of businesses in different nations.
Universal Declaration of Human Rights A United Nations document that lays down the basic
principles of human rights that should be adhered to.
universal needs Needs that are the same all over the world, such as steel, bulk chemicals, and
industrial electronics.
upstream supply chain e portion of the supply chain from raw materials to the production
facility.
utilitarian approaches to ethics ese hold that the moral worth of actions or practices is
determined by their consequences.
V
value creation Performing activities that increase the value of goods or services to consumers.
values Abstract ideas about what a society believes to be good, right, and desirable.
voluntary export restraint (VER) A quota on trade imposed from the exporting country’s side,
instead of the importer’s; usually imposed at the request of the importing country’s government.
W
wholly owned subsidiary A subsidiary in which the firm owns 100 percent of the stock.
World Bank International institution set up to promote general economic development in the
world’s poorer nations.
World Intellectual Property Organization An international organization whose members sign
treaties to agree to protect intellectual property.
World Trade Organization (WTO) e organization that succeeded the General Agreement on
Tariffs and Trade (GATT) as a result of the successful completion of the Uruguay Round of GATT
negotiations.
Z
zero-sum game A situation in which an economic gain by one country results in an economic loss by
another.
Page 511
name index
A
Ahrendts, Angela, 219, 454
al-Sissi, Abdel Fatah, 318
Aristotle, 40
Arslan, Saffet, 103
Autor, David, 164
B
Bailey, Christopher, 219, 454
Barra, Mary T., 113, 372
Barrow, Robert, 99–100
Bartlett, Christopher, 344, 363
Bartlett, D. L., 25
Bentham, Jeremy, 137
Bergeron, Melanie, 392
bin Abd al-Aziz Al Saud, Salman, 37
bin Salman, Muhammad, 37
Bond, Michael Harris, 110
Bono, 29
Bové, José, 24
Bravo, Rose Marie, 454
Brito, Carlos, 326
Buchanan, James, 41
Buddha, 105
Burberry, omas, 454
Bush, George W., 193
C
Castro, Fidel, 80
Chandler, Alfred, 170
Chávez, Hugo, 43, 70, 80, 224, 295
Cohen, Jack, 361
Conklin, David, 375
Cortés, Hernán, 363
Cruz, Eduardo, 345
D
Dalai Lama, 29
Delors, Jacques, 250
Deming, W. Edward, 412–413
Deng Xiaoping, 87
Diaz, Manuel, 24
Disney, Roy O., 444
Disney, Walter Elias “Walt,” 444
Downey, Robert, Jr., 444
Doz, Yves, 350, 494
Dunning, John, 222–223, 232
F
Feigenbaum, A. V., 412
Floersch, Rich, 491
Fornell, Claes, 469–470
Frankel, Jeffrey, 165
Friedman, Milton, 41, 135–136
Friedman, Nancy, 105
Friedman, omas, 6, 14
Fukuyama, Francis, 72
Fury, Nick, 444
G
Gamble, James, 384
Gandhi, Mahatma, 104
Gautama, Siddhartha, 105
Ghoshal, Sumantra, 344, 363
Glassman, David, 332–333
Goudet, Olivier, 326
Greenblatt, Drew, 387
Grossman, G.M., 27
H
Hall, Edward T., 114–115
Hamel, Gary, 350
Hamilton, Alexander, 195
Hardin, Garrett, 129
Hayek, Friedrich von, 41
Hayek, Nayla, 118
Hayek, Nicolas, 118
Heckscher, Eli, 153, 158, 165–167, 186
Hendrick, Rick, 4
Hewlett, Bill, 134
Hofstede, Geert, 90, 110–112, 134
Hopkins, Bill, 390
Hume, David, 40, 137, 155–156
Huntington, Samuel, 72, 92
J
Johansson, Scarlett, 444
Johnson, Lyndon, 301
Jong-un, Kim, 45
Juran, Joseph, 412
K
K’ung-Fu-tzu, 105
Kant, Immanuel, 137–138
Kearney, A.T., 219
Kissinger, Henry, 83
Kluckhohn, Florence, 90
Knickerbocker, F. T., 221–222, 234
Kobayashi, Yotaro, 369
Kotchian, Carl, 130
Krueger, A. B., 27
Krugman, Paul, 155, 197
L
Lancaster, Hal, 390
Landel, Michel, 498
Leontief, Wassily, 166–167
Levitt, eodore, 442–443, 457
Lieberman, Marvin, 362
Ljung, Alexander, 384
Luca, Allysson, 63
Lündstrum, Marie, 358
M
Ma, Jack, 434
Maduro, Nicolas, 224, 295
Mao, 107
Marcos, Ferdinand, 49
Marx, Karl, 39, 40, 223
Mateschitz, Dietrich, 321
Mayer, Hans Ulrich, 417
McCleary, Rachel, 99–100
Mello, Fernando Collor de, 50
Mendenhall, M., 484–486, 489
Mill, John Stuart, 40, 137
Minkov, Michael, 110–111
Mintz, Dan, 107
Mittal, Lakshmi, 225
Mnangagwa, Emmerson, 56–57
Mondavi, Robert, 24
Montgomery, David, 362
Morales, Evo, 224
Morsi, Mohamed, 71
Moss, Kate, 454
Mugabe, Robert, 56–57
Mun, omas, 155
N
Nadella, Satya, 481
Nader, Ralph, 28
Nakane, C., 95
Namenwirth, Zvi, 90
Nixon, Richard, 301
North, Douglass, 67
Nyerere, Julius, 56
O
Page 512
O’Neill, Jim, 87
Obama, Barack, 178, 188, 264
Oddou, G., 484–486, 489
Ohlin, Bertil, 153, 158, 165–167, 186
Ohno, Taiichi, 416–417
Olsvasky, Brian, 421
P
Packard, David, 134
Paphitis, Dennis, 124
Parker, David, 178
Perot, Ross, 258
Pinochet, Augusto, 43
Plato, 39, 40
Porter, Michael, 109, 155, 171–174, 326
Powell, Colin, 73
Prahalad, C. K., 350, 494
Procter, William, 409, 384
Putin, Vladimir, 42–44, 54
R
Ravenscraft, David, 374
Rawls, John, 139–140, 141–142
Reich, Robert, 8, 229
Ricardo, David, 153–155, 156–165, 186, 198–200, 224
Roddick, Anita, 123
Roddick, Gordon, 123
Rokeach, Milton, 90
Romer, David, 165
Rometty, Virginia, 113
Romney, Mitt, 188
Rousseff, Dilma, 50, 59, 60
S
Sachs, Jeffrey, 29, 68–69, 165
Samuelson, Paul, 161, 163–165
Scherer, Mike, 374
Schwartz, Shalom, 90
Scott, Lee, Jr., 51
Scott, Myron, 3–4
Scott, Robert, 193
Sen, Amartya, 64, 68, 69
Shacka, Randy, 392
Sheets, Mary Ellen, 392
Shufu, Li, 213
Silva, Lula da, 261
Smith, Adam, 18, 40, 41, 68, 153–158, 224
Sobrino, Maria de Lourdes, 390
Son, Masayoshi, 115
Sorber, Brig, 392
Sorber, Jon, 392
Soros, George, 284
Soto, Hernando de, 67
Spielberg, Steven, 107
Stalin, Joseph, 246
Steele, J. B., 25
Stockton, Bryan G., 447
Stringer, Howard, 481
Strodtbeck, Fred, 90
Suharto, Haji Mohamed, 49
Sullivan, Leon, 128
Sumner, William Graham, 91
T
Terner, Michel, 59–60
atcher, Margaret, 76
Trump, Donald, 08, 23, 26, 72, 114, 151–153, 156, 177, 185–186, 200, 205–206, 241–242, 260,
265, 292
Tung, Rosalie, 482–483
Tylor, Edward, 90
V
Vernon, Raymond, 154, 167–168
W
Wacziarg, R., 165
Wahlforss, Eric, 384
Warner, Andrew, 165
Weber, Max, 100, 104, 106, 116
Weber, Robert, 90
Welch, Jack, 141
Welch, K.H., 165
Whedon, Joss, 444
Wu, Bing, 107
X
Xiao, Peter, 10
Y
Yafi, Wissam, 68
Yeats, Alexander, 261
Yew, Lee Kuan, 68
Yoovidhya, Chaleo, 321
Z
Zuckerberg, Mark, 439–440
Zyuganove, Gennadiy, 42
Page 513
subject index
A
AACSB International (Association to Advance Collegiate Schools of Business), 71
AB InBev, 326
ABB SAE Sadelmi SpA, 400
Absolute advantage, theory of, 157f, 158t
Academy of International Business, 111
A-CAPPP (Anti-Counterfeiting and Product Protection Program), 193
Accounts, balance-of-payments. See Balance-of-payments
Acer, 249
Acquisitions. See Mergers and acquisitions
ACSI (American Customer Satisfaction Index), 446, 469–470
Ad valorem tariffs, 187
Administrative trade policies, 191
Advertising and advertisements. See Marketing and sales
Aesop, 123–124
Afghanistan, 29, 102
Africa. See also specific countries
FDI in, 216
free trade in, 267–268
political systems in, 40, 43
regional economic integration in, 262–264
AFTA (ASEAN Free Trade Area), 265
AIG, 46
Air China Ltd., 271
Airbus
currency hedging by, 314–315
first-mover advantages for, 170
illegal subsidies and, 209–210
subsidization of, 197
AirTouch Communications, 373
Al Jazeera news network, 16
Albania, 400
Alcoa, 192, 378
Alcohol use, values and norms of, 92
Alenia Aeronautica, 9
Algeria, 101, 102, 144
Alibaba Group Holding Limited, 434–435
Alliances, strategic, 323, 347–351
al-Qaeda, 72–73
Amazon
global supply chains, 421
website, 66
AMC Entertainment Holdings, 21
AMD, 249
American cultures and societies, 92–93. See also United States
American Customer Satisfaction Index (ACSI), 446, 469–470
Amgen, 25
Andean Community, 244, 260
Android phones, 348
Angola, 40, 73
Anheuser & Co. brewery, 326
Anheuser-Busch InBev, 326
Anti-Counterfeiting and Product Protection Program (A-CAPPP), 193
Antidumping duties and policies
explanation of, 191
ITC ruling on, 192
pricing regulations, 460–461
as trade barrier, 206–207
WTO ruling on, 202–203
Antiglobalization protests, 23–24
Apartheid and apartheid laws, 127–128
Apple and Apple products
cultural change and, 113
customer tastes/preferences and, 338
economic development and, 66
global markets for, 16
location-specific advantage for, 222
marketing and sales practices of, 453, 458
outsourcing by, 8
product development, 463
trade theory and, 175
Appraisals (performance), 489–490
Arab Spring, 68
Arbitrage, 277–278, 282–283
Arcelor, 225
Argentina
IMF loans for, 10
political system in, 43
regional economic integration and, 243, 244, 260–261
Articles of Agreement (IMF), 299
ASEAN Free Trade Area (AFTA), 263m, 265
Asian currency crisis of 1997, 284, 311–312, 400–401
Association of Southeast Asian Nations, 262
Association to Advance Collegiate Schools of Business (AACSB International), 71
Atag Holdings NV, 265
AT&T, 366
Audi, 107
Australia
economic development of, 74
expatriates in, 483
G20 member, 11
political system of, 40
trade policies of, 204, 205
Trans Pacific Partnership and, 264
Austria, 244, 247, 483
autarky (self-sufficient country), 385
Authoritarianism. See Totalitarianism
e Avengers (film), 444
e Avengers: Age of Ultron (film), 444
B
Balance-of-payments accounts
analysis of, 285–286
benefits and costs of, 229–230
competition and growth effects, 227
fixed exchange rate system and, 301–302
International trade and, 179–182, 179t
overview, 19t
Balance-of-trade equilibrium, 298
Page 514
Bandwagon effects, 284
Bangalore (India), 16, 18
Bangladesh, 83–84, 223
Bank of America, 164
Banking
for exporting, 394–399, 395f, 398f
Islamic law and, 47, 102–103
R&D for, 327
theocratic law and, 47
Banking crises
explanation of, 310
Iceland crisis of 2008, 310
Barriers to trade
decline of, 11–15
tarries (See Tariffs)
trade theory on, 150–183 (See also Trade theory)
Barter, countertrades as, 287, 401
Bavarian Motor Works (BMW), 33–34
Bayerische Flugzeugwerke, 33
Bayerische Motoren Werke, 33
BBC news network, 16
Beck’s, 326
Beef exports, 194
Belgium, 108, 247, 458
Bell Laboratories, 366
Benefit-cost-risk trade-offs
cost reduction pressures, 337–338, 337f, 372–373
of cross-cultural literacy, 89
of distribution strategies, 453
of economies of scale, 168–170 (See also Economies of scale)
ethics of, 137
of expatriate staffing, 482–485
Benefit-cost-risk trade-offs (continued)
of exporting, 399
of foreign direct investments, 218, 225–230, 232–234
foreign exchange risks, 275–277, 287–290
of make-or-buy decisions, 422–424, 423f
market attractiveness analysis, 78–81, 81f
of market choice, timing, and scale of entry, 359–363
of market entry modes, 364–370, 371t
of NAFTA, 246
of product life-cycle theory application, 167–168
Benefits, 78–79, 81f
Benetton, 455
“Big data,” 445
Big Mac Index, 279–280
Bilateral trade agreements, 205
Bill of exchange, 396–397, 398f
Bill of lading, 397
Black economy, 63
Blackberry, 458
Blendax, 321
BMW (Bavarian Motor Works), 33–34
Bodyshop, 123–124
Boeing
as Airbus competitor, 314–315
countertrading by, 400
first-mover advantages for, 170, 196–197
as global symbol, 9
illegal subsidies and, 209–210
joint venture possibilities, 369
new trade theory and, 155
outsourcing by, 8
strategic alliances of, 348
trade wars and, 151
Trans Pacific Partnership and, 151
Bolivia
as Andean Community member, 244, 260
culture of, 483
FDI opposition by, 225
hyperinflation in, 280–281, 281t
political system in, 41, 43
Bombardier, 340
Bosnia, 80
Bound tariff rates, 204
BP (British Petroleum), 131, 137, 144
Brahma (beer brand), 326
Brahmin (elite caste), 97
Brand loyalty, 218
Brand positioning, 328
Brazil
corruption in, 49, 50
culture of, 108
currency crisis of 2002, 22
currency values in, 276
economic system in, 45
economy in, 59–60
foreign direct investment and, 216, 231
importing, 388
marketing and sales practices in, 455
as Mercosur member, 244, 260–261
Mexico-Brazil trade relations, 189–190
patterns of trade for, 154
political system in, 40, 43
regional economic integration for, 243
strategies for, 340
Bretton Woods system, 10, 299–301, 306
Brexit, 256
Bribery. See Corruption
BRIC economies, 87
Bristol-Myers Squibb, 464
British Monopolies and Mergers Commission, 461
British Petroleum (BP), 131, 137, 144
British Telecom (BT), 76
Brunei, 262
B&S Aircraft Alloys, 7
BT (British Telecom), 76
Bud Light, 326
Buddhism, 99, 105
Budweiser, 107, 326
Bulgaria, 247, 254
Bund (Shanghai road), 107
Burberry, 219, 454
Burma. See Myanmar
Burundi, 52, 264
Business analytics, 445–449
Business ethics. See Corporate social responsibility
Business Software Alliance report on intellectual property rights, 52
Buy America Act, 190
Buybacks (compensations), 402
Buy-or-make decisions, 422–424, 423f
C
Cabotage, 250
CAFTA (Central American Free Trade Agreement), 261, 264
Call centers, 8
Calvinism (Islamic), 103
Cambodia, 40, 262
Canada
economic development of, 74
exports of, 193
G20 member, 11
languages of, 108
marketing and sales practices of, 455
NAFTA and (See North American Free Trade Agreement (NAFTA))
trade policies of, 203
work-related values of, 111, 111t
CAP (Common Agricultural Policy), 193, 197
Capital accounts, 179t
Capital flight, 287
Capitalism
Marx on, 223–224
religion and, 100, 102
Carbon emissions, 27–28, 27f, 130
Caribbean Community, 262
Caribbean Single Market and Economy (CSME), 262
CARICOM, 262
Carrefour, 227–228, 346, 361, 451
Carry trade, 274
Caste system, 96, 104–105
Caterpillar
countertrading by, 287, 400
customer service of, 328
risk management by, 288
trade wars and, 151
transnational strategy of, 344
Catholic Church, 100
CDMA, 340
Cemex, 218–219
Centers for International Business Education and Research (CIBERs), 390
Central American Common Market, 261
Central American Free Trade Agreement (CAFTA), 261, 264
CFTA (Continentail Free Trade Area), 268
chaebol (Korean large enterprises), 312
Channel quality, 453
Chile
as Andean Community member, 260
economic development in, 22, 71
political system of, 43
Trans Pacific Partnership and, 264
U.S.-Chile trade relations, 205
China
antidumping actions of, 202
business strategies on, 332–334
carbon emissions agreement (2015), 27–28
class system in, 98
Confucianism in, 105–106
countertrading by, 400
culture in, 87–88
currency value in, 272, 296–297
economic development in, 21–22, 60–64, 68, 72–74, 76–77
education in, 479
exporting and, 193, 389
foreign direct investments and, 19, 19f, 216–217, 225
foreign exchange risk and, 271–272
foreign expansion and, 372
human rights in, 128–129
IKEA production in, 414
as industrial power, 17, 17t
labor in, 26
Page 515
language differences in, 108
market attractiveness of, 54, 360, 361
natural resources of, 154
outsourcing and, 24–26, 422
political system in, 40, 43
production and distribution in, 414
property rights in, 48, 52, 53, 67, 77
strategic alliances of, 347
trade policies of, 163–165, 190, 194, 205
Trans Pacific Partnership member, 151
as WTO member, 200
China Eastern Airlines Corp., 271
China Film Group Corporation, 107
China Mobile, 107
China National Offshore Oil Company, 225
China Resources Enterprise (CRE), 361
China Southern Airlines Co., 271
Chinese Value Survey (CVS) on ethics in business, 110
Christian Democratic Party (Germany), 40
Christianity, 100
Chrysler Corporation, 315, 373
CIBERs (Centers for International Business Education and Research), 390
Cinemas, 21
Cisco Systems, 25
Citigroup Inc.
international strategy of, 345
Islamic financial services offered by, 103
outsourcing by, 25
state-ownership in, 46
Civil law system, 46–47, 53
Class consciousness, 98
Class divisions, 96–98
Class systems, 96–98
Clear Vision, 332–334
Climate change, 130
CNN television network, 16
Co-branding, 450
e Coca-Cola Company (TCCC)
competition of, 79
customer tastes/preferences and, 338
legal risks for, 80–81
licensing agreements of, 366
localization strategy of, 342
marketing and sales practices of, 79, 449
Code of ethics, 140–141
Cognizant Technology Solutions, 97
Cold War, 41, 72, 77
Colgate-Palmolive, 346
Collectivism
cultural change from, 113–114
as political system, 39–41
as work-related value, 110, 111t
Colombia, 244, 260
Colonialism, 229
Command economies, 45, 74–75
Commerce Department (U.S.), 191
Commercial jet travel, 15
Common Agricultural Policy (CAP), 193, 197
Common law system, 46, 47–48
Common market, 244, 261
Communication and information technologies
for business management, 383–384
cultural change and, 113
economic development with, 76
exporting of, 25
FDI and, 227, 232
Internet, 8, 15, 20–21, 71
mergers and acquisitions of, 373–374
political systems and, 71
supply chains and, 429
Communication strategies for marketing, 453–458
Communism
collapse of, 42, 43
command economies and, 45, 74–75
culture and, 93
foreign direct investment and, 223–224
market economies and, 66, 73–74
property rights and, 48, 67
right-wing totalitarianism and, 43
in Russia, 48
social mobility and, 98
socialism and, 39–40
Communist totalitarianism, 43
Comparative advantage theory
extensions of, 161–165
Heckscher-Ohlin theory comparison to, 165–166
overview, 159, 159f, 165–166
qualifications and assumptions of, 160–161
trade gains, 159–160, 160t
on trade patterns and benefits, 154–155
trade policies and, 195–196
Compensation (pay), 490–492, 491f
Compensations (buybacks), 402
Competition and competitive advantages
core competencies as, 331–332, 370–371
cost reduction pressures, 337–338, 337f, 372–373
cross-cultural literacy and, 114–116
education as, 109
FDI’s effect on, 227
human resource management as, 478
licensing as, 219
location-specific advantages for, 222–223
policy implications for, 207
pricing policies and, 461
privatization and, 76
regional economic integration and, 249, 265
trade theory on, 155–159, 164
value creation for, 324–325, 327–331, 329f
Comprehensive and Progressive Trans Pacific Partnership (CPTPP), 178
Concentrated retail system, 451
Confederation of Indian Industry, 97
Confirming houses, 391
Confucianism, 98–99, 105–106, 110
Conservative Party (Great Britain), 40
Constant returns to specialization, 162
Consumer protection
product safety, 53
trade policies for, 194
Containerization, 15
Continental Free Trade Area (CFTA), 268
Contract law, 47–48
Contributor factory, 420
Controls, 330
Convention on Combating Bribery of Foreign Public Officials in International Business Transactions
(1997), 50–51, 130
Convention on Contracts for the International Sale of Goods (CISG), 48
Convergence hypothesis of values and norms, 113
Con-way, 131
Copenhagen Summit (2009), 27
Copyrights, 11, 52
Core competence, 331–332, 370–371
Corn Laws, 198
Corning, 464
Corona, 326
Corporate culture, 478. See also Organizational culture
Corporate responsibility strategy, 147–148
Corporate social responsibility (CSR), 122–149
corruption and, 130–131
cultural relativism, 135–136
decision-making processes, 132f, 133, 141–142
dilemmas in, 131–132
in employment practices, 126, 140
explanation of, 143–145
human rights, 127–129
justice theories, 139–140
Kantian, 137–138
leadership, 134, 140–141
naive immoralist, 136–137
philosophical ethical approaches to, 134–140
on pollution, 129–130
righteous moralist, 136
rights theories, 138–139
societal culture and, 134
straw men approaches, 135–137
unethical behavior roots, 132–134, 132f
unrealistic performance goals, 134
utilitarian approaches to, 137–138
Corruption
corporate social responsibility as opposition to, 130–131, 141
economic development in, 67
as market risk, 54
property rights and, 42, 48–51, 49f
Costa Rica, 261
Costco, 227–228
Costs, 79, 81f, 413f. See also Benefit-cost-risk trade-offs
Council of Ministers (EU), 245
Council of Supply Chain Management Professionals (CSCMP), 410
Counterpurchases, 401
Countertrades, 287, 400–402
Countervailing duties, 191. See also Antidumping duties and policies
Country of origin effects, 455
Court of Justice (EU), 250
CPTPP (Comprehensive and Progressive Trans Pacific Partnership), 178
CRE (China Resources Enterprise), 361
Crimea region, 42
Criminal liability laws, 53
Croatia, 80, 247, 254
Cross-cultural literacy and awareness
competitive advantage of, 107, 114–116
for expatriate staffing, 486–489
explanation of, 89
in marketing and sales, 455
work-related values and, 109–112, 111t
Cross-functional teams, 465–466
Cross-licensing agreements, 367
CSCMP (Council of Supply Chain Management Professionals), 410
CSME (Caribbean Single Market and Economy), 262
CSR (Corporate social responsibility). See Corporate social responsibility
Cuba
economic development in, 29, 74, 80
Page 516
FDI and, 231
political system of, 40, 43
U.S.-Cuba trade relations, 194
Cultural myopia, 480
Cultural relativism, 135–136
Cultural uniqueness, 118
Culture (organizational). See Organizational culture
Culture (societal), 86–121
Buddhism, 105
businesses and, 109–112
change in, 113–114
Christianity, 100
Confucianism, 105–106
cross-cultural literacy as competitive advantage, 114–116
determinants of, 93–94, 93f
education, 109
ethical systems of, 98–100, 132f, 134
expatriate workers, pressures of, 482–485
explanation of, 90–93
globalization impact on, 16
groups in, 95–96
Hinduism, 104–105, 115, 116
individualism, 94–95
Islam, 101–104
language, 107–109
marketing practices addressing, 455
mindset and, 485–486, 485f
of nation-state, 92–93
overview, 90–91
regional economic integration and, 244, 264
religious systems in, 98–106
social stratification in, 96–98
social structure and organization of, 93–98
staffing policies and, 481t
values and norms, 91–92
Currency. See also Foreign exchange market; International Monetary System
convertibility, 286–287
devaluation of, 296–297
dollar index, 303f
of European Union, 246, 251–254
gold and silver as, 156, 297–299, 302
hedging of, 275–277
in Japan, 292
in Mexico, 292
Currency boards, 309
Currency crises, 22, 261, 310
Currency speculation, 274
Currency swaps, 277, 288
Current accounts
balance-of-trade equilibrium, 298
deficit, 285–286
fixed exchange rate system collapse, 301–302
host-country costs, 228–229
overview, 179t
pegged exchange rates, 307–308
Customer service, 328–329
Customer tastes/preferences, 338
Customs brokers, 391
Customs union, 244, 260
Cutco Corporation, 378–379
Cyprus, 108, 247, 254
Czech Republic, 71, 76, 254
Czechoslovakia, 40
D
Daimler, 134, 374
Daimler-Benz, 314–315, 373
DaimlerChrysler, 374
Dalian Wanda Group, 20, 21
dalit (scheduled caste), 97
De Havilland, 171
Debate on globalization, 23–30
jobs and income increases, 24–26
labor and environmental policies, 26–28
national sovereignty, 28
overview, 23
poor nations and, 28–30
protests, 23–24
Decision-making processes
ethics of, 132f, 133, 141–142
for supply chains, 430
Dell, 16
Dell Computer, 16, 25, 66, 249, 328–329
Delors Commission, 250
Demand conditions of trade theory, 172, 172f
Democracy
economic development and, 68, 69–74
explanation of, 41
FDI and, 215
national differences in, 41–44
values and norms of, 90
Demographics and population
world order, 21–22
world output and trade, 17–18
Den Hoorn brewery, 326
Denmark
as EU member, 252, 256
as European Community member, 247
European Free Trade Association member, 244
work-related values of, 111, 111t
Department of Commerce (DOC) (U.S.), 389
Department of Justice (U.S.), 131
Deregulation, 74–75
Deutsche Telekom, 373
Devaluation of currency, 296–297
Developing nations and economies
economic development in, 69–74
environmental and labor regulations in, 26
FDI and, 215–216, 215f, 217
dharma (moral force), 104
Dictatorships. See Totalitarianism
Diehl Luftahrt Elektronik, 9
Difference principle, 139
Differentiation strategy, 325
Diminishing returns, 162, 162f, 325–326, 325f
Direct selling, 456
Dirty-float system, 296
Disney, 113
Disney Brothers Cartoon Studio, 444
Distribution centers, 425
Distribution channels, 340, 451f, 452
Distribution strategies, 450–453
Diversity, 493–494, 498–499
DMG, 107
DOC (Department of Commerce) (U.S.), 389
Doha Round, 200, 205, 242
Dollarization, 297
Dollars (U.S.)
currency board extensions of, 309
currency conversion for, 274–275
currency swaps of, 276
exchange rate history, 273, 302–305, 303f
fixed exchange rate of (Bretton Woods system), 301–302
floating exchange rate of, 302–305, 303f
forward exchange rates for, 275–276
gold standard and, 297–299, 302
hedging of, 275–277
pegged exchange rate to, 296–297
spot exchange rates and, 275
value index of, 303f
Dollops, 228
Dominican Republic, 261
DoubleClick, 455
Dow Corning, 131
Downstream supply chain, 412
Downstream supply relationships, 431, 431f
Drafts as financing mechanisms, 396–397
Dumping, 191
Dun & Bradstreet (USA), 97
Dunning’s theory of eclectic paradigm, 222–223
Dupont, 463, 464
Dutch Mafia, 479
Page 517
Dynamic effects and gains, 162–163
E
EAC (East African Community), 263–264
Early entrants. See First-mover advantages
Earth Summit (Rio de Janeiro,1992), 27
East African Community (EAC), 263–264
Eclectic paradigm, 218, 222–223
e-commerce, 15
Economic development, 58–85
in Bangladesh, 83–84
benefit-cost-risk trade-offs, 78–81, 81f
democracy and, 68, 69–72
deregulation and, 74–75
FDI’s effect on, 226, 227
free trade’s effect on, 162–163, 165, 203
geography and, 68–69
Human Development Index for, 64
innovation and entrepreneurship, 65–67
legal systems and, 76–77
market attractiveness for, 360
market economies and, 66
market-based systems, spread of, 73–74
market-based systems, transformation to, 74–77
marketing and, 450
overview, 60
political economy and, 65–69, 77
political systems for, 68
privatization and, 76
property rights and, 66–67
states in transition, 69–74
terrorism and, 72–73
trade policy support for, 195–197, 199
world order and, 72–73
Economic exposure, 288
Economic freedom, 43, 73–74, 100
Economic integration, 257m
Economic risks, 80. See also Benefit-cost-risk trade-offs
Economic systems
command economy, 45
corruption of, 4–5
as culture determinant, 93, 93f
market economy, 44
mixed economy, 45–46
of Russia, 42
systems of, 54
types of, 44–46
Economic union, 244–245
Economics
balance-of-payments accounts, 179t, 227, 285–286, 301–302
demographics of, 16–23
development of, 58–85 (See also Economic development)
foreign direct investment and, 212–239 (See also Foreign direct investment (FDI))
future implications for, 22–23
industrial power shifts, 17t
political systems influence on, 42
recovery, 306–307
of regional integration, 240–269 (See also Regional economic integration)
religion and (See Religion)
religion’s impact on, 98–106
risks (See Benefit-cost-risk trade-offs)
systems of (See Economic systems)
trade theory and, 162–163, 165
wage gaps of, 28–30
world output and trade, 17–18
Economies of scale
as business strategy, 335, 342
for foreign exchange risk management, 289
minimum efficient scale, 415–416, 416f
new trade theory and, 168–171
strategic trade policy, 196–197
subsidies and, 188–189
e Economist
on corruption, 136
on purchasing power parity exchange rate, 279–280
Ecuador, 244, 260
EDS, 18
Education
in China, 479
as competitive advantage, 173
culture and, 109
as culture determinant, 93, 93f
social mobility and, 97, 98
value chain and, 329
Efficiency frontier, 325–326, 325f
Efficient markets, 279, 285
EFTA (European Free Trade Association), 244, 247
Egypt, 71, 101, 102, 318–319
El Salvador, 261
ELAN (Export Legal Assistance Network), 389–390
Elastic demand, 459, 459f
Eldorado (ad agency), 455
Electricity Generating Authority (ailand), 400
E-Mart, 227–228
Embraer, 276, 388
EMC (Export management companies), 391
EMI, 249
emissions, 127
Empire of the Sun (film), 107
Employment. See Labor
EMS (European Monetary System), 297
England. See also Great Britain
individualism in, 40–41
mercantilism in, 156
Enso-Gutzeit Oy, 144
Entrepreneurship. See Innovation and entrepreneurship
Entry into markets. See Foreign expansion
Environment and environmental protection
corporate social responsibility for, 129–130, 138–139, 144
globalization’s effect on, 26–28
income-to-pollution ratio, 27f
NAFTA on, 258
pollution and income, 27f
sustainable strategies for, 145
EPZs (Export processing zones), 391
Equal Employment Opportunity Commission (U.S.), 480
Equal rights, justice theories on, 139–140
Ericsson, 464, 489
Estonia, 74
Ethical dilemmas, 131–132
Ethical strategies, 125
Ethics
of corporate social responsibility, 122–149 (See also Corporate social responsibility)
decision-making processes, 132f, 133, 141–142
dilemmas in, 131–132
of FDI, 229
of Islamic banking, 47
justice theories, 139–140
Kantian, 137–138
personal, 133
philosophical approaches to, 134–140
religion and, 98–106 (See also Religion)
rights theories, 138–139
straw men approaches to, 135–137
systems of, 98–100
utilitarian approaches to, 137–138
values and norms as, 93f (See also Values and norms)
Ethics officers, 142–143
Ethiopia, 73
Ethnocentric staffing policies, 479–480, 481t, 490
Ethnocentrism, 114, 168
Eton College, 97–98
Euro and euro zone
foreign exchange markets and, 273
regional economic integration and, 246, 251–254
European Central Bank (ECB), 10–11, 252–253
European Coal and Steel Community, 247
European Commission, 248–249, 265
European Community (EC), 245–246, 250
European Council, 249
European Free Trade Association (EFTA), 244, 247
European Monetary System (EMS), 297
European Parliament, 245, 249–250
European Stability Initiative on Turkey’s economy, 103
European Stability Mechanism, 254–255
European Union (EU)
business strategies of, 340–341
economic integration and, 244–245, 264–265
emergence of, 242, 247
euro as currency for, 251–254 (See also Euro and euro zone)
expansion of, 254–256
FDI and, 215, 224–225
foreign exchange market and, 273
G20 membership, 11
Great Britain-EU relations, 256
marketing and sales practices of, 464
member states of, 248m
membership in, 254–256
national sovereignty and, 28
political structure of, 245, 248–250
production by, 413
Single European Act, 250–251
trade policies of, 193, 197, 201–205
Transatlantic Trade and Investment Partnership and, 264
Turkey-EU trade relations, 103
U.S.-EU trade relations, 194
Excel Communications, 373
Exchange rates
bandwagon effects on, 283–284
China system for, 296–297
determination of, 278–285
explanation of, 272
Fisher effect on, 283–284
fixed, 301–302
floating, 305–306
forecasting approaches for, 285–286
gold standard, 156, 297–299, 302
hedging, 275–277
inflation and money supply, 280–282, 281t, 301–302
interest rates and, 283–284
Page 518
law of one price, 279
management of, 270–293 (See also International monetary system)
pegged, 307–308
purchasing power parity, 279–280, 282–283
risks, 275–277, 287–290
theories on, 278–285
Exclusive distribution channel, 452
Expansion. See Foreign expansion
Expat Explorer Survey on country rankings, 483
Expatriate failures, 482–484, 483t
Expatriates
compensation packages for, 490–492, 491f
foreign market expansion for, 364
as managers, 133, 361, 480, 482–485
performance appraisals of, 489
repatriation, 487–488
Experience curve pricing, 460
Experience curves and effects, 334–336, 334f
Export Legal Assistance Network (ELAN), 389–390
Export management companies (EMC), 391
Export packaging companies, 391
Export processing zones (EPZs), 391
Export-Import (Ex-Im) Bank, 398–399
Exporting, 382–406. See also Current accounts
assistance for, 398–399
countertrade, 400–402
explanation of, 218, 366
export credit insurance, 399
Export-Import (Ex-Im) Bank, 398–399
financing for, 394–398, 395f
foreign expansion, 364–365
foreign expansion through, 364–365
globalEDGETM DIAGNOSTIC TOOLS, 393
information sources on, 389–390
international comparisons of, 388–389
overview, 384–386
promise and pitfalls of, 386–387
readiness for, 386f, 393f
service providers, 391
strategies for, 391–393, 453
Tata Motors and, 404–405
trade policies on, 184–211 (See also Trade policies)
trade theory on, 150–183 (See also Trade theory)
transaction example, 397–398, 398f
External stakeholders, 141–142
Externalities, 223
Externally convertible currency, 286
ExxonMobil, 20
F
Facebook, 66, 71, 439–440
Facilitation payments, 130–131
Facism, 43
Factor endowments, 166, 172, 172f, 173
Factors of production
for economic integration, 244–245, 247
trade theory on, 154–155
Fahrzeugfabrik Eisenach, 33
Fair market value, 191
“Fake news,” 440
FCIA (Foreign Credit Insurance Association), 399
FCPA (Foreign Corrupt Practices Act of 1977), 50–51, 130–131, 136
FDI (foreign direct investment). See foreign direct investment (FDI)
Federal Reserve (U.S.), 282, 309
Federal Shariat Court, 47
Femininity as work-related value, 110, 111t
Financial accounts, 179t
Financial crises
Asian currency crisis of 1997, 284, 311–312, 400–401
Brazil currency crisis of 2002, 22, 261
foreign debt crisis (2010), 254–256, 310
future implications for, 22–23
global financial crisis (2008-2009) (See Global financial crisis (2008-2009))
Iceland banking crisis of 2008, 310
responses to, 309–314
in Russia, 42
Financing mechanisms for importing and exporting, 394–398
bill of lading, 397
draft for, 396–397
lack of trust issues, 394–395
letter of credit (L/C), 396
transaction example, 397–398, 398f
Finland
countertrading by, 401
FDI policies in, 231
global competitiveness of, 187
regional economic integration and, 244, 247
social responsibility practices in, 144
First-mover advantages
benefit-cost-risk trade-offs for, 79
foreign expansion entries and, 360, 362, 363
new trade theory on, 169–170, 174
strategic trade policy for, 196–197
subsidies and, 188–189
First-mover disadvantages, 360, 362
Fisher effect, 283–284
Fixed costs, 335, 415
Fixed exchange rates
Bretton Woods system as, 299–301
case for, 306–307
in China, 296–297
collapse of, 301–302
explanation of, 297
gold standard and, 297–299, 302
Flexible machine cells, 417
Flexible manufacturing technology, 416–418
Floating exchange rates
in China, 296–297
explanation of, 296
IMF’s establishment of, 302–305
Flour Corporation, 164
Flow of FDI, 214–215, 231
Fokker, 171
Folkways, 91–92
Forbes (magazine) on female CEOs, 113
Forbidden City (Beijing), 107
Ford Motor Company, 213
acquisitions of, 373
customer tastes/preferences and, 338
marketing and sales practices of, 108, 328, 458
as MNE, 20
production system of, 417
strategic alliances of, 350
value creation by, 328
Foreign Corrupt Practices Act of 1977 (FCPA), 50–51, 130–131, 136
Foreign Credit Insurance Association (FCIA), 399
Foreign debt crisis (2010), 254–256, 310
Foreign direct investment (FDI), 19f, 212–239
acquisitions as, 217–218
advantages of, 221
benefits-cost-risks trade-offs of, 225–230
direction of, 215–216
explanation of, 11
exporting limitations, 218–220
form of, 217–218
free market view, 224
as globalization driver, 11
greenfield investments as, 217–218
home-country costs and benefits, 229–230
home-country policies, 230–231
host-country costs and benefits, 225–228
host-country policies, 231–232
human rights violations and, 127–129
in Indian retail sector, 236–237
licensing limitations, 220–221
NAFTA on, 258
overview, 214
patterns of, 221–222
policy instruments, 230–232
political ideology and, 223–225
pragmatic nationalism view, 224–225
radical view of, 223–224
Page 519
regional economic integration and, 245
stock of, 19, 19f, 216–218
theories of, 218–223, 232–234, 233f
trends in, 216–218
in turnkey projects, 365
World Trade Organization on, 232
Foreign exchange markets, 270–293
bandwagon effects on, 284
benefits-cost-risks trade-offs of, 275–277, 287–290
currency conversion, 273–275, 286–287
exchange rate determination, 278–285
exchange rate forecasting, 285–286
explanation of, 272
as floating exchange system, 301–302
functions of, 273–277
insurance for, 275–277
interest rates and, 283–284
management of, 294–319 (See also International monetary system)
nature of, 277–278
overview, 272–273
prices and, 279–283
Foreign exchange risks, 275–277, 287–290
Foreign expansion, 356–380
core competencies and, 370–371
cost reduction pressures, 372–373
entry modes, 364–370, 371t
entry selection, 370–373
entry timing, 360–362
exporting, 364–365
franchising, 367–368
greenfield ventures, 373–376
joint ventures, 368–369
licensing, 366–367
market attractiveness, 359–360
overview, 358–359
scale of entry and strategic commitments, 362–363
turnkey projects, 365–366
wholly owned subsidiaries, 369–370
Foreign service premiums, 492
Foreign trade zones (FTZs), 391
Formal education. See Education
48 Hours (television program), 126
Forward exchange rates, 275–277, 285
Founding of a Republic (film), 107
Four Seasons, 325–326, 325f, 368
Fragmented retail system, 451
France
cultural differences in, 336
economic development in, 74
economic system of, 45
FDI and, 215, 217f
as G20 member, 11
as industrial power, 17, 17t
marketing and sales practices in, 453, 457–458
MNEs in, 20f
organized labor in, 495
political system of, 40
protests in, 23, 24
regional economic integration and, 247, 252, 256, 273
strategic trade policy of, 197
trade theory on, 156
Franchising. See also Licensing and licensing agreements
explanation of, 234, 367
for foreign expansion, 367–368
Free trade. See also European Union; General Agreement on Tariffs and Trade; North American Free
Trade Agreement (NAFTA)
in Africa, 267–268
arguments for, 197
economics of, 28–30
emergence of, 198–199
explanation of, 153, 154, 186
policies affected by, 26–28
regional economic integration and, 240–269 (See also Regional economic integration)
revised case for, 197
theory of, 150–183 (See also Trade theory)
trade policies as limiting (See Trade policies)
as trade policy, development of, 198–206
Trans Pacific Partnership of 2016 (TPP), 264
Transatlantic Trade and Investment Partnership (TTIP), 264
Free trade areas
in Africa, 262–264
Andean Community as, 260
ASEAN as, 262
CAFTA and, 261
CARICOM, 262
Central American Common Market as, 261
CSME as, 261
EFTA as, 244
EU as (See European Union (EU))
explanation of, 244
Mercosur as, 260–261
North America as, 257–260 (See also North American Free Trade Agreement (NAFTA))
Freedom, 70m, 74m
Freedom House reports on political freedom, 42, 69–70, 74
Freely convertible currency, 286–287
French (language), 108
Friedman doctrine, 135
FTZs (Foreign trade zones), 391
Fuji, 349
Fuji Photo Film Co., 366–367, 369
Fujifilm, 460
Fuji-Xerox, 366–367, 368, 369
Fundamental analysis, 285–286
Fundamental rights, 142
G
gaijin (Westerner), 113
Galápagos Declaration, 260
Gap Inc., 16, 113, 338
GATS (General Agreement on Trade in Services), 200
GATT. See General Agreement on Tariffs and Trade (GATT)
Gazprom, 42
GDP (Gross domestic product). See Gross domestic product (GDP)
General Agreement on Tariffs and Trade (GATT)
on antidumping, 461
on economic integration, 242
establishment of, 9, 186, 198
history of, 199–201
on trade barriers, 11–12, 11t
on trade diversions, 247
WTO creation by, 28
General Agreement on Trade in Services (GATS), 200
General Electric
countertrading by, 287, 400
management of, 141
organizational culture of, 478
production for, 413
strategic alliances of, 349
General Motors (GM), 3–4
countertrading by, 400
customer tastes/preferences and, 338
foreign expansion of, 368, 372
global markets for, 79
human rights policies of, 128
marketing and sales practices of, 108
as MNE, 20
organizational culture of, 113
state-ownership in, 46
strategic alliances of, 350
subsidies for, 188
Geneva Round (1947), 199
Geocentric staffing policies, 480–481, 481t, 490
German Bundesbank, 252
Germany
competitive advantages in, 173
culture of, 91–92, 108, 114
currency of, 273
domestic policies of, 197
economic development in, 74
expatriates in, 483
exporting and, 389
FDIs and, 215, 217f
Page 520
as industrial power, 17, 17t
marketing and sales practices of, 452, 453, 458
MNEs in, 20f
organized labor in, 495
political systems of, 40, 43
regional economic integration, 251–253, 256
strategic trade policy of, 197
Ghana, 154, 157–158, 157f, 158t, 159–165, 160t, 162f
Global (grocery store chain), 361
Global branding, 444
Global communications. See Communication and information technologies
Global distribution centers, 425
Global financial crisis (2008-2009)
euro value during, 254–256
exchange rates and, 302
Iceland and, 310
Global inventory management, 425–426
Global Leadership and Organizational Behavior Effectiveness (GLOBE) instrument, 112
Global learning, 419
Global mindset, 485–486, 485f
Global Reporting Initiative on sustainability indicators, 145
Global standardization strategy, 342, 346f
Global supply chains
Alibaba Group Holding Limited and, 434–435
Amazon, 421
coordination of, 429–430
Global warming, 130
Global web, 333–334
Globalization, 2–35
barriers to, 11–15 (See also Tariffs)
culture and, 86–121 (See also Culture (societal))
debate on, 23–30
drivers of, 11–16
of economy, 16–23, 58–85 (See also Economic development; Economics)
environmental regulations and, 26–28
exporting and, 382–406 (See also Exporting)
foreign direct investment and, 212–239 (See also Foreign direct investment)
foreign exchange market, 270–293 (See also Foreign exchange market)
foreign expansion and, 356–380 (See also Foreign expansion)
free trade and, 150–183 (See also Trade theory)
global economy of 21st century, 22–23
human resource management and, 474–501 (See also Human resource management)
international business explanation of, 30
international monetary system, 294–319 (See also International monetary system)
jobs and income effects by, 24–26
labor policies and, 26–28
management of international businesses overview, 30–31 (See also Management of international
businesses)
of marketing and sales, 438–472 (See also Marketing and sales)
of markets, 6–7, 16 (See also Markets)
national differences and (See Economic systems; Legal systems; Political systems)
Globalization (continued)
national sovereignty and, 28
overview, 4–9
poor nations and, 28–30
of production, 8–9, 16, 408–436 (See also Production)
protests against, 23–24
regional economic integration, 240–269 (See also Regional economic integration)
regulation of, overview (See Regulations)
strategies for, 320–355 (See also Strategies for international businesses)
technology’s role in, 15–16
trade policies, 184–211 (See also Trade policies)
world order and, 21–22
world trade picture of, 17–18
GM (General Motors Corporation). See General Motors (GM)
GNI per capita, 61m
Gold standard, 156, 297–299, 302
Goldman Sachs, 84
cultural change and, 113
innovation and entrepreneurship of, 66
location-specific advantage of, 222
market share for, 348
marketing and sales practices of, 455
Governments and government policies
corruption of (See Corruption)
national sovereignty and, 28
political systems of (See Political systems)
trade policies, 184–211 (See also Trade policies)
Grease payments, 51, 130–131
Great Britain. See also United Kingdom
culture in, 89
economic development in, 76
economic system of, 45
FDI and, 215, 231
foreign exchange market of, 273
legal system in, 46
marketing and sales practices in, 452, 457, 461
political system of, 40–41
regional economic integration and, 244, 246, 247, 252, 256
social mobility in, 97–98
trade policy of, 197, 198–199
trade theory of, 168
traditional practices and, 340
tragedy of the commons, 129
work-related values of, 111, 111t
Great Depression, 11, 191, 199
Great Recession (2008-2009). See Global financial crisis (2008-2009)
Greece
countertrading by, 401
culture of, 108
foreign debt crisis in, 254–256
regional economic integration and, 247, 251–253
Greenfield investments and ventures, 217–218, 373–376
Gross domestic product (GDP)
average annual growrth rate, 63m
as economic growth rate, 63–64
growth rate of, 63–64
of India, 75
of Russia, 42
trade volume’s relationship to, 17–18
world order changes and, 21–22
Gross national income (GNI), 60–64
Group of Twenty (G20), 10–11
Groups in society. See Collectivism
GSM, 340
G20 (Group of Twenty), 10–11
Guangdong Goworld, 271–272
guanxi (reciprocal obligations) and guanxiwang (relationship network), 106, 107
Guatemala, 261
A Guide to Exporting (Barry, ed.), 389
Gulf War (1991), 194
G.W. Barth (manufacturing company), 20–21
H
Haiti, 29
Harbin, 326
Harley-Davidson, 366
Harwood Industries, 25
Hawker Siddeley, 171
HBO television network, 16
Heckscher-Ohlin theory, 154–155, 158, 165–166, 169–170. See also Comparative advantage theory
Hedging of currency, 275–277
Heritage Foundation on market-based economic systems, 73–74
Hewlett-Packard (HP), 134, 222, 249, 466, 484
Highly indebted poorer countries (HIPCs), 29
Hindi, 104–105
Hinduism, 47, 99, 104–105, 115, 116
Hindustan Lever Ltd., 228
HIPCs (Highly indebted poorer countries), 29
Hitachi, 344
Hoegaarden, 326
Hoffmann-La Roche, 461
Holland, 215, 256
Hollywood movie industry, 16
Homeplus, 361
Honda, 222
Honduras, 25, 261
Honesty, as Confucian concept, 106, 115
Honeywell, 413
Hong Kong
business strategies of, 332–334
culture in, 87–88
economic development in, 68, 74
exchange rate system in, 39
FDI and, 217
Hoyts Group, 21
HP (Hewlett-Packard), 134, 222, 249, 466, 484
HRM (Human resource management). See Human resource management (HRM)
HSBC, 103, 483
Human Development Index, 65m
Human Development Index (HDI), 64
Human resource management (HRM), 474–501
as business strategy, 477–478, 477f
compensation, 490–492, 491f
development and strategies for, 488–489
expatriate managers, 133, 361, 477, 482–485, 490–492
explanation of, 476
global mindset, 485–486, 485f
labor relations, 490–492
overview, 476–477
performance appraisals, 489–490
staffing policies, 478–486
staffing policy, types of, 481t
training and management development, 486–489
Human rights
ethics and, 127–129, 138–139
fundamental, 142
trade policy for protecting, 195
Universal Declaration of Human Rights of 1948, 141
Hungary, 40, 254, 402
Hyderabad (India), 18, 415, 420–421
Hyperinflation, 280–281
I
IBM
cultural change and, 111–112, 113
employee attitude study by, 110, 111t
FDI and, 80–81, 225
Lenovo’s takeover, 21
Page 521
outsourcing by, 18, 25
production by, 415
R&D by, 464
tariffs and, 175
IBRD (International Bank for Reconstruction and Development), 300–301. See also World Bank
Iceland
banking crisis of 2008, 310
culture of, 483
regional economic integration, 244
IDA (International Development Association), 301
IFE (International Fisher effect), 283–284
IKEA
business strategies of, 332, 357–359
culture and, 108
glocal strategy of, 339
production in China, 414
IMF (International Monetary Fund). See International Monetary Fund (IMF)
Imitative behavior, 221–222
Immigration and immigration laws, 256, 259
Immobile resources, 161
Import licenses, 201
Import quotas, 189–190
Importing. See also Current accounts
Brazil, 388
distribution strategy for, 453
tariffs on, 219–220
Inbound supply relationships, 430f, 431
Incentives, 330
Income
cultural change and, 113
environmental pollution and, 27f
expatriate compensation, 490–492, 491f
pollution levels related to per capita, 27f
social mobility and, 95
wage gaps, 24–26, 28–30
IND (Indulgence versus restraint) dimension as work-related value, 110–111
India
corruption in, 49
culture of, 97, 104–105
economic development in, 75
economic system in, 45
expatriates and, 485
FDI and, 223, 228, 232
IKEA in, 357–359
as industrial power, 18
innovation and entrepreneurship in, 116
legal system in, 48, 80–81
market attractiveness of, 360
marketing and sales practices in, 452, 455
outsourcing to, 16, 24–26, 164
production and, 415, 420–421
retail sector in, 236–237
trade policies of, 202, 205
trade theory on, 164
Indigenisation and Economic Empowerment Act (2008), 56
Individualism
culture of, 94–95, 104, 113–114
ethics of, 134–140
explanation of, 40
in political systems, 40–41
as work-related values of, 110, 111, 111t
Indonesia
Asian currency crisis of 1997, 302
corruption in, 49
currency value in, 284
economic development in, 69
foreign expansion and, 375
IMF loan to, 10
political system of, 71
regional economic integration and, 262
Indo-Pakistani War of 1971, 223
Indulgence versus restraint (IND) dimension as work-related value, 110–111
Industrial goods and materials
antidumping actions in, 202–203
production factors of, 418
Inefficient markets, 285
Inelastic demand, 459, 459f
Infant industry argument, 195–196
Inflation rates
Asian currency crisis of 1997, 311–312
balance-of-trade equilibrium and, 298
exchange rates and, 280–282, 281t, 301–302
Inflows of foreign direct investment, 214–215, 215f, 231–232. See also Foreign direct investment
Information systems activities, 328–329
Information technology. See Communication and information technologies
Infosys Technologies, Ltd., 97, 164, 415
Infrastructure and logistics for businesses, 328–329, 339–340, 426–427
ING Group, 362, 369
Innovation and entrepreneurship
culture and, 94, 96, 100, 104, 115, 116
for economic development, 65–67
free trade and, 203
international monetary system, 301
in market economies, 44
product development as, 466
trade theory on, 168–169
Institute for International Development (Harvard) on economic development, 69
Institutions for regulating global marketplace. See also European Union; General Agreement on Tariffs
and Trade; International Monetary Fund; United Nations; World Bank; World Trade Organization
(WTO)
FDI liberalization and, 232
national sovereignty and, 28
Insurance and insurance industry
export credit insurance, 399
for foreign exchange market, 275–277
Intel
business strategies of, 342
experience curve of, 335–336
exporting by, 25
location-specific advantage of, 222
product development by, 463
regional economic integration and, 249
Intellectual property
market attractiveness and rights of, 81
protection of, 51–53
regional economic integration and, 258
trade policies on, 194, 200, 203
Interest and interest rates
Fisher effect on, 283–284
Islam on, 47, 102–103
Interest on loans (riba), 47, 102–103
Intermarket segments, 443–444
Internal stakeholders, 141–142
Internalization theory, 221, 222
International Bank for Reconstruction and Development (IBRD), 300–301. See also World Bank
International brands, 326
International businesses
explanation of, 30
management of (See Management of international businesses)
strategies of, 320–355 (See also Strategies for international businesses)
International communication barriers, 107–109
International Court of Justice, 10
International Development Association (IDA), 301
International Fisher effect (IFE), 283–284
International market research, 446–449, 447f
International Monetary Fund (IMF)
crisis management by, 254, 309–314
Egypt and, 318–319
floating exchange system of, 302–305
loans by, 29
on pegged exchange rates, 307–308
policies of, 312–314, 316
on protectionism, 203
role of, 299
on wage gaps, 25
International monetary system, 294–319
Bretton Woods system, 299–301
business strategies and, 314–316
corporate-government relations, 316
currency boards, 309
currency management, 296–297, 314
financial crises, 302
fixed exchange rates, 301–302
Page 522
floating exchange rates, 305–306
for foreign exchange market, 270–293 (See also Foreign exchange market)
gold standard, 156, 297–299, 302
IMF’s policies, evaluation of, 312–314
IMF’s role, 299, 309–314
pegged exchange rates, 307–308
regional integration and, 246
shocks to, 302–305, 303f
World Bank role, 300–301
International Orientation Resources studies
on expatriate failures, 483–484
on global mindset, 485–486
International Property Rights Index of 2013 (IPRI), 52
International shipping industry. See Transportation and transportation technology
International strategy, 345
International trade
Balance of Payments and, 179–182, 179t
changing picture of, 17–18
explanation of, 11
growth rate of, 12f, 13f
regulation of (See Regulations)
theories on, 150–183 (See also Trade theory)
world trading system for, 28, 198–207 (See also World trading system)
International Trade Administration (ITA), 389
International Trade Commission (ITC), 191, 192, 206–207
International trade secretariats (ITSs), 494–495
Internet
as globalization driver, 15, 16
mini-multinational rise and, 20–21
outsourcing of service activities using, 8
political systems and, 71
Interorganizational relationships, 430–431, 430f, 431f
Inuit language, 107
Inventory. See Suppliers and supply chains
Investments. See Foreign direct investment (FDI)
iPads, iPhones, and iPods. See Apple and Apple products
IPRI (International Property Rights Index of 2013), 52
Ipsos, 446–447
Iran
FDI policies in, 231
Islam and, 47
legal system of, 47
political system of, 43
trade sanctions against, 194
Iraq, 29, 72–73, 194
Ireland
economic development in, 74
foreign debt crisis in, 254–256, 310
Great Recession (2008-2009) effects on, 254–256
regional economic integration and, 247
Iron Man (film), 444
Iron Man 2 (film), 444
Iron Man 3 (film), 444
Islam
as ethical system, 101–104
fundamentalism, 72, 101–102
as legal system, 47, 102
as political system, 43
resurgence of, 72
Islamic banking, 47, 102–103
Islamic Calvinism, 103
Islamic fundamentalism, 72, 101–102
Islamic law, 47, 102–103
Islamic State (ISIS), 72–73
ISO 9000, 413
Israel, 20
ITA (International Trade Administration), 389
Italy
economic system of, 45
financial crisis in, 254
organized labor in, 495
political system of, 43
regional economic integration, 247
ITC (International Trade Commission), 191, 192, 206–207
ITSs (International trade secretariats), 494–495
J
J. D. Power and Associates reports
on international market research, 446
on Toyota’s production system, 416–417
Jamaica Agreement, 302
Jamco, 9
Japan
corruption in, 48, 130
culture in, 89
culture of, 92, 95–96, 98, 105–106, 109, 113, 115
currency in, 292
currency values in, 274–275
exporting and, 388–389
FDI and, 19f, 217f, 219
first-mover advantages in, 196
foreign expansion and, 369
GNI of, 60
as industrial power, 17t, 18–19
licensing in, 219, 366–367
marketing and sales practices of, 451–452, 457, 459–460, 461, 464
MNEs in, 20, 20f
outsourcing to, 9
production in, 415
R&D in, 464, 466
strategic alliances in, 348–351
trade policies of, 187, 191, 199, 206–207
trade theory on, 167, 168, 173
Trans Pacific Partnership and, 264
U.S.-Japan trade relations, 175, 194, 205
work-related values in, 111, 111t
Japanese Overseas Enterprise Association on Japanese employment, 479
JFC (Jollibee Foods Corporation), 364
Job mobility, 94
Jobs. See Labor
Joint ventures
foreign direct investment for, 234
for foreign expansion, 368–369, 372
Jollibee Foods Corporation (JFC), 364
JP Morgan, 345
Judaism, 99
Jupiler, 326
Just distribution, 139
Just-in-time inventory, 428–429
K
KAA, 9
Kantar Group, 446–447
Kantian ethics, 137–138, 141
karma, 104–105
Kashmir Conflict, 72–73, 223
Kawasaki, 9
Kayseri (Turkey), 102, 103
Kellogg, 457–458
Kentucky Fried Chicken (KFC), 362
Kenya, 43, 263
Kickbacks. See Corruption
Kikuyu tribe, 43
Kimberly-Clark, 346, 460
Knickerbocker theory on foreign direct investment, 221–222, 234
Knowledge spillovers, 223
Kodak, 460
Komatsu, 344
Koran, 47, 102
Korea, 8, 105–106
KPMG on acquisitions, 373
Krating Daeng, 321
Kuwait, 483
Kwality, 228
Kyoto Summit (1997), 27
L
Labor
economies of scale and, 168
ethical approaches to, 133, 136
FDI and, 226–227
free trade’s effect on, 162
human resource management, 474–501 (See also Human resource management (HRM))
management of, 140, 141
NAFTA’s effect on, 246, 257–260
outsourcing of, 163–165
policies on, 26–28
as production consideration, 422, 428t
social structure and (See Social structure)
trade policies on, 193, 199, 200
wage gaps, 24–26, 28–30
work-related values, 109–112, 111t
Labor Party (Great Britain), 40
Labor unions, 494–495
Lag strategies, 288
Language differences
as culture determinant, 93, 93f
lack of trust and, 394
spoken and unspoken, 107–109
training to address, 480, 487
Laos, 40, 43, 262
Large-scale market entries, 362–363
Late-mover disadvantages, 79
Latin America. See also specific countries
Andean Community in, 244, 260
business strategies in, 341
economic development in, 22
FDI and, 216
language differences, 108
political systems in, 40, 43–44
values and norms in, 91–92
work-related values in, 111, 111t
Latvia, 483
Law of one price, 279
LCR (Local content requirements), 190–191
Lead factory, 420
Lead strategies, 288
Lean production, 220–221, 416–418
Learning effects, 334–335
Leffe, 326
Legal risks, 80–81
Page 523
Legal systems, 46–53
contract law, 47–48
culture and, 107
economic development and, 74–77, 80–81
of EU, 248–249
explanation of, 46
market attractiveness of, 54
property rights, 48–51 (See also Property rights)
theocratic law, 47, 102
Lenovo, 21, 249, 333–334
Leontief paradox, 166–167
Letter of credit (L/C), 396
Libya, 29, 71
Licensing and licensing agreements
explanation of, 218
FDIs with home-country businesses, 220–221, 233–234, 233f
for foreign expansion, 366–367
franchises, 234, 367–368
Liechtenstein, 244
Lincoln Electric, 375–376
Lincoln Navigator, 328
Lixi Inc., 20
Local content requirements (LCR), 190–191
Local responsiveness pressures
as foreign expansion consideration, 372
strategies for, 337, 337f, 338–341
Localization strategy, 343, 346f
Location economies, 332–334
Location-specific advantages
for foreign direct investments, 222
for production, 414–421, 419t
for research and development (R&D), 463–464
Lockheed, 130
Logistics of businesses, 328–329, 426–427
Logistics of supply chains, 412
London, 277–278
London Borough of Islington, social stratification in, 97–98
Long-term orientation as work-related value, 110, 111, 111t
Los Angeles, MNE investment in, 21
Low cost strategy, 324–325, 325f
Loyalty and commitment, 106, 115
Lubricating Systems Inc., 20
Ludwigsburg (Germany), mini-multinational company in, 20–21
Lulu’s Foods Inc., 390
Luxembourg, 247
M
M&A (Mergers and acquisitions). See Mergers and acquisitions
Maastricht Treaty (1992), 247, 251, 252
Macau, 87–88
Macedonia, 483
Mafia, 42, 48
Make-or-buy decisions, 422–424, 423f
Malaysia
Asian currency crisis of 1997, 284, 302, 308
countertrading by, 400
economic development in, 29, 69
FDI and, 232
legal system of, 47
regional economic expansion and, 262–264
U.S.-Malaysia trade relations, 205
Malta, 247, 254
Managed-float system, 296, 302–305. See also Floating exchange rates
Management of international businesses
for competitive advantages, 174–175
corporate social responsibility in, 122–149 (See also Corporate social responsibility)
culture considerations, 94–95, 114–116
economic development and, 78–81
of FDIs, 232–234
foreign exchange rate risk and, 287–290
for foreign expansion, 356–380 (See also Foreign expansion)
human resource management (HRM), 474–501 (See also Human resource management (HRM))
legal systems and, 47–48
of multinational enterprises, 20
national differences as consideration in, 53, 54
overview, 30–31
production, 408–436 (See also Production)
R&D cross-functional teams, 465–466
regional economic integration and, 264–265
skill acquisition for, 226
strategies for, 314–316, 320–355 (See also Strategies for international businesses)
of suppliers and supply chains, 411–413, 427–431
trade policy strategies, 206–207
work-related values and, 109–112, 111t
Mandarin, 107, 108
Manufacturing
infant industry argument for, 195–196
outsourcing for, 26–28
production globalization and, 16
trade barriers on, 11–12, 11t
trade theory application to, 157–158, 166, 167, 173
Market attractiveness
for foreign expansion, 359–360
of market economies, 54
overview, 78–81, 81f
Market economies
economic development in, 166
innovation and entrepreneurship in, 66
legal systems of, 76–77
market attractiveness of, 54
overview, 44
political systems of, 68–69
trade theories on, 167–168
Market entry, 378–379
Market imperfections approach, 221
Market segmentation, 443–445
Marketing and sales, 438–472
advertising, 457–458
brands and markets, 442–443
communication strategies, 453–458
cultural considerations in, 108
distribution strategies, 450–453
as exporting limitation, 365
joint ventures and, 368
market attractiveness, 54, 78–81, 81f, 359–360
market research, 446–449
market segmentation, 443–445
marketing mix and, 441, 462t
marketing mix configurations, 461–462
overview, 440–442
piggyback marketing for exporting, 391
pricing strategies, 458–461
product attributes, 449–450
product development, 463–467
as value chain activity, 327–328
Markets
attractiveness of, 54, 78–81, 81f, 359–360
-based systems, spread of, 73–74
deregulation of, 74–75
entry modes for, 358–359, 364–370
entry selection, 370–373
entry timing, 360–362
expansion strategies of firms, 331–332
globalization of, 16
international business management and, 30–31
legal systems and, 76–77
for nonagricultural goods and services, 203–204
privatization and, 76
Single European Act and, 250–251
Marlboro cigarettes, 457
Marlin Steel Wire Products, 386–387
Marriott International, 325–326, 325f
Marshall Plan, 300
Marvel Comics, 444
Marvel Studios, 444
Marxist theory, 40, 67, 223–225
Masculinity as work-related value, 110, 111, 111t
Mass advertising, 439
Mass communication, 456
Mass customization, 416
Matrix of Peace (Peace rough Commerce), 71
Matsushita, 115, 221, 367, 459–460, 479
Mazda, 350
McDonald’s
benefit-cost-risk trade-offs, 79
business strategies of, 332, 336
customer tastes/preferences and, 338
FDI by, 234
foreign expansion of, 16, 113, 362, 364, 375
franchising of, 367–368
marketing and sales practices of, 455
protests against, 23, 24
staffing practices, 491
McDonnell Douglas, 400
McKinsey & Company studies, 373–374
Media availability, 456–457
Media Markt (company), 249
Media Saturn Holdings, 249
mensalao (monthly payoff scandal), 50
Mercantilism, 156
Mercedes-Benz, 314–315
Mercer Management Consulting surveys
on acquisitions, 373
on compensation, 490
Mercosur, 243, 244, 260–261
Mergers and acquisitions (M&A), 217–218, 228
Messier-Dowty, 9
Mexico
corruption in, 51
currency in, 292
economy of, 10
marketing and sales practices in, 452
NAFTA and (See North American Free Trade Agreement (NAFTA))
political system in, 70
trade relations of, 189–190
Mexico City, corruption in, 51
Microsoft
business strategies of, 345, 348
cultural differences and, 113
customer tastes/preferences and, 338
Page 524
economies of scale for, 168
innovation and entrepreneurship of, 66
intellectual property rights of, 53, 194
market expansion of, 25, 331
outsourcing by, 8
production for, 415, 420–421
R&D by, 464
regional economic integration and, 249
Middle East. See also specific countries
business strategies of, 341, 364
cultural differences of, 115
economic development in, 71
expatriates and, 485
Migration, 256, 259
Military dictatorship. See Totalitarianism
Milkfood, 228
Mindset (global), 485–486, 485f
MINI, 33–34
Miniature Earth project, 63
Mini-multinationals, growth of, 20–21
Minimum efficient scale, 415–416, 416f
Ministry of Education (China), 479
Ministry of International Trade and Industry of Japan (MITI), 388
Minnesota Mining & Manufacturing Company (3M), 391–392, 463
Minute Maid Pulpy, 342
Mitsubishi Heavy Industries, 9, 369
Mitsubishi Motors, 480
Mitsui & Company, 402
Mittal Steel, 225
Mixed economies
market-based systems transformation from, 73
overview, 45–46
MMO Music Group, 387
MNE (Multinational enterprises). See Multinational enterprises (MNE)
Modelo Especial, 326
Monetary discipline, 299
Money supply and inflation. See Inflation rates
Monopolies, 44, 461
Monsanto, 464, 488
Moore’s law, 15
Moral compass, 138, 139, 141–142
Moral courage, 143
Moral force (dharma), 104
Moral hazard, 312–313
Moral imagination, 142
Morality. See Ethics; Values and norms
Mores, 92
Morocco, 231, 483
Motorola, 342, 413
Mozambique, 40, 73
MTV Networks, 113
mudarabah (banking method), 103–104
Multi-culturalism. See Cross-cultural literacy and awareness
Multilateral trade agreements, 205
Multinational enterprises (MNE)
explanation of, 20
free market view of, 224
non-U.S., 20f
opposition to, 223–224
pragmatic nationalism on, 224–225
resource-transfer effects for, 226
rise of mini-MNEs, 20–21
in U.S., 20, 20f
Multinational workers. See Expatriates
Multipoint competition, 222
Multipoint pricing, 460
murabaha (banking method), 103–104
Muslim Brotherhood, 71
Muslims. See Islam
Myanmar
ethical responsibilities of, 129, 195
political system in, 70–71
regional economic integration and, 262
N
Nabisco, 107
NAFTA. See North American Free Trade Agreement (NAFTA)
Naive immoralist, 136–137
National competitive advantage. See Competition and competitive advantages
National differences
corruption and, 130–131
culture, 86–121 (See also Culture (societal))
economic development, 58–85 (See also Economic development)
economic systems, 44–46 (See also Economic systems)
employment practices, 126, 136, 481t, 490
environmental regulations, 129–130
ethical issues, 126–131
exporting considerations of, 388–389
legal systems, 46–53 (See also Legal systems)
market attractiveness and, 54
Miniature Earth project, 63
political systems, 39–46 (See also Political systems)
production considerations, 418–420, 419t
National identity, 112
National interests, 197
National markets
business strategies for, 336, 345, 360, 362–363
price discrimination in, 458–459
regional economic integration for, 240–269
regional integration for (See Regional economic integration)
National Science Foundation (NSF) on R&D spending, 464
National security, 193
National sovereignty, 28, 229, 246, 252
Nationalism, 223
Nation-states, explanation of by culture and society, 92–93
Natura, 123–124
Natural resources, 154–155
NEC, 249
Neo-mercantilism, 156
Nepal, 452
Nestlé, 449–450
Nestlé Turkey, 417
Netherlands
FDI and, 217f
marketing and sales practices in, 457
organized labor in, 495
political system of, 40
regional economic integration and, 247
values and norms of, 91–92
New Line Cinema, 444
New trade theory, 155, 162, 168–171, 196–197
New York City, 277–278
New York Times
on business ethics, 135
on free trade gains and losses, 163
on Walmart corruption case, 51
New Zealand
culture of, 483
economic development in, 74
regional economic integration and, 264
U.S.-New Zealand trade relations, 205
NewPage Corporation, 144
Nicaragua, 40, 261
Nielsen, 446–447
Nigeria, 29, 70–71
Nike, 126, 133, 141
Nintendo, 464
Nippon Air, 130
nirvana (state of spiritual perfection), 104
Nissan, 222, 229, 373, 495
Nobel Peace Prize, 135
Noble Eightfold Path, 105
Noblesse oblige, 143–144
Noise levels in marketing, 456
Nokia, 348, 458, 464
Nonconvertible currency, 286–287
Nonverbal communication, 108–109
Norms and values
of organizations (See Organizational culture)
work-related values, 109–112, 111t
North American Free Trade Agreement (NAFTA), 241–242
benefit-cost-risk trade-offs of, 246
Page 525
business implications of, 341
environmental protection by, 2
opposition to, 26
for regional economic integration, 242–243, 257–260, 264–265
Trump on, 151
North Korea, 29, 43, 74
Northern Ireland, 72–73, 257–260
Norway, 40, 90, 244
NPD Group, 446–447
O
Obligations for human rights, 138
Occidental Petroleum, 402
OECD (Organisation for Economic Co-operation and Development). See Organisation for Economic
Co-operation and Development
Offset (countertrade), 401
Offshore factory, 419–420
Offshore production, 230
Oligopolies and oligopolistic industries, 221–222, 233
Omnibus Trade and Competitiveness Act (1988), 90
One 2 One, 373
OPEC (Organization of the Petroleum Exporting Countries), 302
Optimal currency area, 253
Oracle, 66, 222
Organisation for Economic Co-operation and Development (OECD)
on corruption, 50–51, 130
on FDI, 226
on organized labor, 495
on protectionism in agriculture, 202–203
on wage gaps, 26, 28–29
Organization architecture and structure, 329–330, 329f
Organization of the Petroleum Exporting Countries (OPEC), 302
Organizational culture
business strategies based on, 373–376
as competitive advantage, 220–221
ethical implications of, 132f, 133–134, 140–141
staffing policies reflecting, 482–485
value creation and, 329–330
Organizational Resources Counselors survey on compensation, 490
Organized crime, 42, 48
Organized labor, 494–495
Orthodox Church, 100
Outbound supply relationships, 431, 431f
Outflows of foreign direct investment, 214–215, 214f, 217f, 231
Outpost factory, 420
Outsourcing
education and, 109
of jobs, 24–26, 422, 428t
of production and supplies, 8–9, 26–28, 428t
Overall attractiveness, 81, 81f. See also Market attractiveness
P
Packaging of products, 426
Pakistan
culture in, 102
economic development in, 69
FDI and, 223
legal system in, 47
Pakistani, 83
Palestinian conflict, 72–73
Pan-Asian Automotive Center, 372
Panasonic, 479
Paraguay, 41, 243, 244, 260–261
Paris Convention for the Protection of Industrial Property, 52
Paris terrorist attacks (2015), 72
Patents, 11, 51–52
Peace, 71, 72–73
Pegged exchange rates, 296, 297–299, 307–308
People, 330
People’s Republic of China. See China
PepsiCo, 108
Performance appraisals, 489–490
Personal ethics, 132f, 133, 140, 141–142
Peru, 43, 244, 260
Petrobras, 50
Pew Hispanic Center on illegal immigration, 259
Pfizer, 328, 463, 464
P&G. See Procter & Gamble
Philadelphia Inquirer on globalization’s effect on wages, 25
Philip Morris, 400, 457
Philippines
corruption in, 49, 131
countertrading by, 400
economic development in, 71
foreign expansion and, 364
outsourcing to, 164
regional economic integration and, 262
Philips, 464, 479
Piggyback marketing, 391
Pioneering costs, 360–361
Pizza Hut, 367
Pokemon Go, 292
Poland
communism in, 40
countertrading by, 401
economic development in, 71
outsourcing to, 164
regional economic integration and, 254
Political economy
economic development and, 65–69, 77
economic systems, 44–46
explanation of, 38
legal systems (See Legal systems)
political systems (See Political systems)
Political freedom, 43, 69–70
Political risks, 80
Political systems
collectivism, 39–41
in command economies, 45
as culture determinant, 93, 93f
democracy, 41–43
for economic development, 69–72
explanation of, 39
FDI and, 215, 223–225
individualism, 40–41
in market economies, 44, 54
in mixed economies, 45–46
overview, 39
pseudo-democracies, 44
totalitarianism, 41, 43–44
Political union, 245
Pollution
economic development and, 27f
ethical considerations for, 129–130, 136, 138–139
Polycentric staffing policies, 480, 481t, 490
Porter’s diamond, 171–174
Portugal, 247, 252, 254–256
Positive-sum game, 160
Power distance as work-related value, 110, 111t
PPF (Production possibility frontier), 157, 157f, 158t, 162
PPP (Purchasing power parity). See Purchasing power parity
Pragmatic nationalism, 224–225
PRC (People’s Republic of China). See China
Predatory pricing, 459–460
Price discrimination, 458–459
Price elasticity of demand, 459, 459f
Prices and exchange rates, 279–283
inflation and money supply, 280–282, 281t, 301–302
law of one price, 279
purchasing power parity, 279–280, 282–283
Pricing strategies
experience curve pricing, 460
multipoint pricing, 460
overview, 458
predatory pricing, 459–460
price discrimination, 458–459
Primary packaging, 426
Principles of Political Economy (Ricardo), 159
Private action, 48
Private ownership, 44
Private property, 102
Private sector, 74–75
Privatization
corruption and, 42
economic development and, 66, 76
explanation of, 40, 76
in mixed economies, 45–46
Processes, 330
Procter & Gamble, 321
business strategies of, 331–332, 345, 346
marketing and sales practices of, 452, 460
as MNE, 20
R&D by, 464
staffing policies of, 479
supply chains of, 409–410
Product attributes, 449–450
Product development. See Research and development (R&D)
Product liability, 53
Product life-cycle theory, 167–168, 234
Product safety, 53
Product standards, 450
Production, 408–436
absolute advantage theory application to, 157–158, 157f, 158t
business strategies for, 325, 327
comparative advantage theory application to, 159–165, 160t, 162f
economic development’s impact on, 12f, 13f
economic systems for, 44
economies of scale and, 168
facilities, types of, 419–420
factor endowments for, 166, 172, 172f, 173
globalization of, 8–9, 16
Heckscher-Ohlin theory application, 165–166
hidden costs of, 420–421
location choices, 414–421
make-or-buy decisions, 422–424, 423f
organizational culture and, 220–221
political systems and, 39, 40
product life-cycle theory and, 167–168
production factors, 418–420, 419t
supply chain functions, 425–427
Page 526
supply chain management, 411–413, 427–431
technological factors, 415–418
trade patterns and, 154–155
Production factors, 154–155, 418–420, 419t
Production possibility frontier (PPF), 157, 157f, 158t, 162, 163f
Profitability, 323
Profitability and profit growth, 323–324, 331, 336–337
Property rights, 48–53
economic development and, 66–67
explanation of, 48
Foreign Corrupt Practices Act (FCPA), 50–51
intellectual property protection, 51–53 (See also Intellectual property)
Islam on, 102
legal risks and, 80–81
private action, 48
product safety and liability, 53
public action and corruption, 48–50
Protectionism, 195–196, 199, 207
Protestantism, 100
Protests
antiglobalization, 23–24
in Russia, 42
against sweatshop labor, 126
Pseudo-democracies, 44
Public action, 48–50
Public Opinion Survey on Sustainability on performance goals, 145
Puerto Rico, 108
Pull versus push strategies, 456–457
Purchasing, 412, 427
Purchasing of supplies for production, 412
Purchasing power parity (PPP)
economic development indicator, 61–64, 62m, 62t
empirical tests for, 282–283
exchange rates and, 278–285, 283–284
inflation and, 280–282
Push versus pull strategies, 456–457
Pussy Riot (rock band), 42
Q
Qualcomm, 415
Quality, relationship between costs and, 413f
Quality control, of franchises, 368
Quantitative easing, 282
Quilmes, 326
Quota rent, 190
Quotas
for IMF, 302
import, 189–190
R
Rapp Motorenwerke, 33
Rawls’ theory of justice, 139–140, 141–142
RCA Corporation, 221, 367
Real estate companies, 21
Red Bull, 321–324
Regional economic integration, 240–269
in Africa, 262–264
in Americas, 257–262
Andean Community, 260
Association of Southeast Asian Nations, 262
business opportunities and threats to, 264–265
Caribbean Community, 262
case against, 246–247
Central American Common Market, 261
economic case for, 245
EU evolution, 247
EU political structure, 248–250
euro establishment, 251–254
in Europe, 247–256
explanation of, 242
impediments to, 246
levels of, 243–245, 243f
Mercosur, 260–261
NAFTA, 257–260
overview, 242–243
political case for, 245–246
Single European Act of 1992, 250–251
Trans Pacific Partnership, 264
Transatlantic Trade and Investment Partnership, 264
Regionalism, 340–341
Regulations. See also Management of international businesses
Confucianism on, 107
on currency convertibility, 286–287
economic development and, 74–75
environmental, 26–28, 129–130
of FDI, 230–232
of free trade, 150–183 (See also Trade theory)
institutions for management of globalization (See European Union; General Agreement on Tariffs
and Trade; International Monetary Fund; United Nations; World Bank; World Trade Organization)
labor, 26–28
against monopolies, 44
of prices, 460–461
for regional economic integration, 245
tariffs (See Tariffs)
trade policies as, 184–211 (See also Trade policies)
Relational capital, 350
Religion
Buddhism, 105
Christianity, 100
Confucianism, 107
as culture determinant, 93, 93f
explanation of, 98
Hinduism, 104–105, 115, 116
Islam, 101–104, 115
overview, 98–100, 99m
theocratic totalitarianism and, 43
Renault SA, 373
Repatriation, 487–488
Representative democracy, 41, 43
Republic of China. See Taiwan
Research and development (R&D), 463–467
cross-functional teams, 465–466
location for, 463–464
marketing and production integration with, 464–465
overview, 463
product life-cycle theory and, 167–168
strategic trade policy on, 196–197
as value chain activity, 327–331
Resource-transfer effects, 226, 229
Retail concentration, 451–452
Retaliatory actions, 194, 197, 207
Reverse logistics, 426–427
riba (interest on loans), 47, 102–103
Ricardian model extensions on trade theory, 161–165
Righteous moralist, 136
Rights theories, 138–139
Right-wing totalitarianism, 43–44
Risks, 80–81, 81f. See also Benefit-cost-risk trade-offs
Rituals, folkways as, 92
Rivalries between businesses
for competitive advantages, 173
in oligopolistic industries, 221–222
ROC (Republic of China), 88. See also Taiwan
Rolls-Royce, 9, 33–34, 401
Roman Catholic Church, 100
Romania, 247, 287, 400
Rosneft, 42
Royal Dutch Shell, 475–476, 486
Russia
corruption in, 49, 49f
countertrading by, 402
culture of, 483
currency value in, 287
economic development in, 10, 21, 22, 77, 79, 80
economic system of, 45–46
as former Soviet Union (See Soviet Union)
legal system of, 48
marketing and sales practices of, 455
political freedom of, 70, 71
political system of, 41–44
trade policies of, 192, 200
Rwanda, 92, 145, 263–264
S
Saab Aerostructures, 9
SAIC (Shanghai Automotive Industry Corp.), 368
Salah (Algeria), infrastructure for, 144
Sales. See Marketing and sales
Samsung, 464
Samuelson critique on trade theory, 163–165
Sanyo Shokai, 219
SAR (Special Administrative Region), 87
Saudi Arabia
countertrading by, 400
culture of, 102
economic development of, 80
natural resources of, 154
political system of, 43
transformation in, 37–38
values and norms of, 91–92
SBA (Small Business Administration of U.S.), 389
SC Johnson, 449
Scale economies. See Economies of scale
Scale of entry, 362–363
Scandinavia, 91–92, 495
Scheduled caste (dalit), 97
SCORE (Service Corps of Retired Executives), 389–390
Secondary packaging, 426
Self-sufficient country (autarky), 385
Senegal, 70
September 11th terrorist attacks, 72, 101, 429
Serbia, 80
Server factory, 420
Service Corps of Retired Executives (SCORE), 389–390
7-Eleven, 367
Severe acute respiratory syndrome (SARS) virus outbreak, 429
Shadow economy, 63
Shanghai Automotive Industry Corp. (SAIC), 368, 372
Shared decision making, 430
Sharp, 464
Shell, 486
Sherlock Holmes (film), 444
Page 527
Shia factions, 73
Shintoism, 99
Shipping industry. See Transportation and transportation technology
Short selling, 284
Short-term exchange rate movements, 284–285
Short-term orientation as work-related value, 110, 111, 111t
Siemens, 131
Sight draft, 397
Silicon Valley, location-specific advantage of, 222–223
Singapore
economic development in, 68, 69, 74
expatriates in, 483
R&D in, 466
regional economic integration and, 262
Single European Act of 1992, 250–251
Sinopec, 425–426
Six Sigma, 413
Skol, 326
Small Business Administration of U.S. (SBA), 389
Small-scale market entry, 363
Smoot-Hawley Act, 198–199
Snecma, 349
Social culture. See Culture (societal)
Social democracies, 40
Social media, 453–454
Social mobility, 95, 96–98
Social responsibilities. See Corporate social responsibility (CSR)
Social structure, 93–98
Confucianism on, 107
as culture determinant, 93–94, 93f
culture of, 90
explanation of, 93
groups in, 95–96
individualism in, 94–95
socialism on, 39
stratification of, 96–98
Social unrest, political risks of, 80
Socialism, 39–41
Society
culture of, 86–121 (See also Culture (societal))
explanation of, 90, 92–93
structure of, 90, 93–98 (See also Social structure)
Sodexo, 498–499
sogo shosha (trading house of Japan), 388–389, 402
Somalia, 49, 49f
Sony
innovation and entrepreneurship by, 115
licensing of, 221, 367
marketing and sales practices of, 107
as MNE, 20
product development by, 463
staffing policies of, 481
Sony Corporation, 352–353
SoundCloud, 383–384
Source effects, 455
Source factory, 420
South Africa, 70–71, 127–128, 195
South Korea
absolute advantage theory on, 157–158, 157f, 158t
antidumping actions of, 202
Asian currency crisis of 1997, 302, 311–312
comparative advantage theory on, 159–165, 160t, 162f
competitive advantage of, 115
currency value in, 284
economic development in, 10, 29, 68, 69, 71
ethical considerations for, 106
FDI and, 227–228
market attractiveness of, 78
market expansion of, 22
product life-cycle theory on, 168
regional economic integration and, 264
trade deal with United States, 185–186
trade policies of, 196, 204
trade relations of, 194, 205
Sovereign debt crisis (2010-2011), 254–256, 302
Soviet Union. See also Russia
currency value in, 287
FDI and, 215f
political system of, 21
regional economic integration and, 245–246
Spain
culture of, 108
financial crisis in, 254
organized labor in, 495
political system of, 40
regional economic integration and, 247
trade policy of, 197
Spanish, 108
Special Administrative Region (SAR), 87
Specialization, 162, 162f
Specific tariffs, 187
Speculation
bandwagon effect, 284
hedging, 275–277
Speed money, 51, 130–131
Spoken language. See Language
Spot exchange rates, 275, 283–285
Spotify, 383–384, 450
Staffing policies, 478–486
expatriate compensation packages, 490–492, 491f
expatriate managers, 133, 361, 477, 482–485
explanation of, 478
types of, 479–482, 481t
Stakeholders, 141–142
Standardization
in marketing and sales, 457–458, 461–462
for quality certification, 413
Stanley Black & Decker, 289
Starbucks Corporation
business strategies of, 332
ethical considerations for, 145
intellectual property of, 53
market expansion for, 24
Starwood Hotels & Resorts, 325–326, 325f
State-ownership
economic systems with, 45–46
political systems with, 40, 42
Steel industry and production
antidumping actions in, 202, 206–207
FDI in, 225
trade policies on, 188
Stella Artois, 326
Stock of foreign direct investment (FDI), 19, 19f, 214–215
Stora Enso, 144
Strategic alliances, 323, 347–351
Strategic behavior, 221–222
Strategic commitments, 362–363
Strategic fit, 331f
Strategic pricing, 459–460
Strategic trade policies, 188–189, 196–197
Strategies for international businesses, 320–355
choosing, 341–347, 342f
for competitive advantages, 173
competitive pressures, 337–341, 337f
core competencies and, 331–332
cost reduction pressures, 337–338, 337f, 372–373
currency hedging as, 275–277
distribution strategies for sales, 450–453
evolution of, 345–347, 346f
experience effects, 334–336
explanation of, 323
on exporting, 391–393
for foreign exchange risk management, 287–290
global standardization strategy, 342, 346f
human resource management as, 477–478, 477f
international strategy, 345
labor relation approaches, 495–496
leveraging subsidiary skills, 336
local responsiveness pressures, 337, 337f, 338–341, 364, 372
localization strategy, 343
location economies, 332–334
make-or-buy decisions, 422–424, 423f
market expansion, 331–337
for marketing, 453–458
overview, 322–323
pressures of, 337–341
pricing strategies for sales, 458–461
principles of, 323–331
for production location decisions, 418–420, 419t
profitability and profit growth, 336–337
for R&D, 466
strategic alliances, 347–351
strategic positioning, 325–326
transnational strategy, 344
value chain operations as, 327–331, 329f
value creation, 324–325f
Straw men approaches to business ethics, 135–137
Subsidiaries, 228, 336, 369–370
Subsidies, 209–210
for agriculture sector, 202–203
for FDI attraction, 224–225
trade policies on, 188–189, 195–197
Subway (company), 367
Sudan, 29, 102
Sullivan principles, 128
Sunbeam Corporation, 108
Sunnah (holy document), 47
Sunni factions, 73
Suppliers and supply chains
coordination of, 429–430
functions of, 425–427
information technology and, 429
interorganizational relationships and, 430–431, 430f, 431f
just-in-time inventory, 428–429
logistics of, 425–427
make-or-buy decisions, 422–424, 423f
management of, 427–431
purchasing for, 427
Supranational organizations, 28. See also European Union; General Agreement on Tariffs and Trade;
International Monetary Fund; United Nations; World Bank; World Trade Organization
Page 528
Sustainability, 145
Sustainable Development Goals (SDG), 128
Swatch Group, 118
e Swatch Group, 89
Sweatshop labor. See Labor
Sweden
competitive advantage in, 173
corruption in, 49, 49f, 136
cultural considerations in, 90
currency of, 252
economic development of, 60
economic system of, 45
FDI and, 226
marketing and sales practice of, 455
outsourcing to, 9
political system of, 40
regional economic integration, 244, 247
trade policies of, 187
work-related values of, 111, 111t
Switch trading, 401
Switzerland
competitive advantage in, 173
economic development in, 60, 73, 74
organized labor in, 495
regional economic integration and, 244
Symbolic behavior, folkways as, 92
Syria, 29, 72–73
T
Taiwan
antidumping actions of, 202
competitive advantage of, 115
Confucianism in, 106
culture in, 87–88
economic development in, 22, 68, 71, 73
as manufacturing location, 414–415
trade policies of, 196
Tale of Suspense (comic), 444
Tanzania, 43, 263
Tariff rate quota, 189f
Tariff rate quotas, 189–190
Tariffs. See also General Agreement on Tariffs and Trade (GATT)
agricultural, 29–30
decline of, 11–12, 11t
explanation of, 187
as exporting limitation, 365
on exports, 190
free trade and, 150–183 (See also Trade theory)
on imports, 187–188, 189–190
as trade policy instrument, 187–188
in Venezuela, 80
Tata Consultancy Services, 97
Tata Group, 481
Tata Motors, 404–405
Tata Oil Mills, 228
Taxation
of expatriates, 492
FDI and, 224–225
TCCC (e Coca-Cola Company). See e Coca-Cola Company
Tea Party, 73
Technical analysis, 286
Technology
economic development with, 15–16
FDI for, 226, 233
for production, 415–418
trade theory on, 167
Telebrás Brazil, 76
Telecommunications. See Communication and information technologies
Telefónica, 373
Teleglobe, 373
Teotihuacan (Mexico), 51
Terrorism, 72–73, 101, 429
Tesco, 227–228, 346, 361, 452
Texas Instruments (TI), 164, 225, 342, 369, 464
TFTA (Tripartite Free Trade Area), 264, 267–268
ailand
countertrading by, 400
cultural considerations for, 108
currency value in, 284
economic development and, 10, 29
exchange rate system in, 308
financial crisis in, 22, 302
intellectual property rights in, 52, 53
regional economic integration and, 262
work-related values of, 111
eocratic law system, 47
eocratic totalitarianism, 43
3M, 391–392, 463
3M Global Trading Inc., 402
Tiananmen Square massacre (1989), 21–22
Time, culture of, 91, 115
Time draft, 397
Time (magazine) on women in the workforce, 113
Time Warner, 249
Timing of entry, 360–362
3M, 391–392, 463
3M Global Trading Inc., 402
Tokyo, 277–278
Tokyo Round (1973-1979), 199
Toray Industries, 9
Toshiba, 348
Total quality management (TQM), 412–413
Totalitarianism
economic development and, 71
explanation of, 41
as political system, 43–44
Towers Watson survey on compensation, 490
Toyota
currency value and, 288
customer tastes/preferences and, 338
FDI and, 18–19, 222, 229, 231
licensing, 220–221
market expansion of, 331–332
marketing and sales strategies of, 443
production system, 416–417
strategic alliances of, 350
supply chain of, 425
Toys “R” Us, 231, 452
TPP (Trans Pacific Partnership), 191, 264
TQM (Total quality management), 412–413
Trade
barriers (See Tariffs)
international (See International trade)
policies on, 184–211 (See also Trade policies)
theories on, 150–183 (See also Trade theory)
Trade agreements and treaties. See European Union; General Agreement on Tariffs and Trade; North
American Free Trade Agreement (NAFTA); World Trade Organization
Trade benefits, 153–154
Trade creation, 246
Trade deficits, 303f
Trade diversion, 246
Trade fortresses, 265
Trade policies, 184–211
administrative, 191
antidumping, 191
economic arguments for, 195–197
export tariffs and bans, 190
FDI regulation, 230–232
firm strategies for, 206–207
free trade arguments against, 197
free trade development, 198–206
future implications for, 201–205, 207
GATT as, 199
history of, 198–199
import quotas and voluntary export restraints as, 189–190
international monetary system as, 294–319 (See also International monetary system)
local content requirements, 190–191
political arguments for, 192–195
protectionist trends for, 199
subsidies, 188–189
tariffs, 187–188
WTO and, 199–201
Page 529
Trade theory, 150–183
absolute advantage, 157–158
balance of payments and, 179t
benefits of trade, 153–154
comparative advantage extensions, 161–165, 162f
comparative advantage gains, 160, 160t
comparative advantage overview, 159, 162f
comparative advantage qualifications and assumptions, 160–161
demand conditions, 172
factor endowments, 172
on FDI, 227, 232–234
firm strategy, structure, and rivalry, 173
first-mover advantages, 169–170, 175
gains, 159–160
government policy and, 155–159
Heckscher-Ohlin theory and Leontief paradox, 165–166
mercantilism, 155–156
new trade theory, 168–171
overview, 153–155
patterns of trade, 154–155
product life-cycle theory, 167–168
on regional economic integration, 245
trade benefits, 153–154
Trade wars, 197
Trademarks, 11, 52
Trade-Related Aspects of Intellectual Property Rights (TRIPS), 52–53, 200, 203
Tragedy of the commons, 129
Trans Pacific Partnership (TPP), 151, 177–178, 191, 264
Transaction exposure, 287
Transatlantic Trade and Investment Partnership (TTIP), 264
Transit packaging, 426
Translation exposure, 287–288
Transnational strategy, 344
Transparency International reports on corruption, 42, 49, 49f
Transportation and transportation technology
cost as exporting limitation, 218–219, 233, 365
market expansion for, 15–16
as production consideration, 426
Treaty of Lisbon (2007), 250, 256
Treaty of Rome (1957), 247
Tribal totalitarianism, 43
Tripartite Free Trade Area (TFTA), 264, 267–268
TRIPS (Trade-Related Aspects of Intellectual Property Rights), 52–53, 200, 203
TRW Inc., 349
TTIP (Transatlantic Trade and Investment Partnership), 264
Turkey, 10, 102, 103, 108, 256, 417
Turnkey projects, 365–366
20th Century Fox, 444
Twitter, 71
Two Men and a Truck, 368, 392
U
Uber, 66
Uganda, 43
Ukraine, 42, 71
Uncertainty avoidance as work-related value, 110, 111, 111t
Unilever
competition for, 346
cultural considerations for, 107
global organization of, 343
market expansion for, 79
marketing strategies of, 451–452
as MNE, 20
staffing policies of, 480
subsidiaries of, 228
Union labor, 494–495
Unit cost curve, 416f
United Arab Emirates (UAE), 20, 92
United Kingdom
economic development and, 17–18, 17t, 74
FDI and, 19, 19f, 217f, 229
market expansion by, 361
marketing and sales practices of, 453, 455
MNEs in, 20, 20f
United Nations (UN)
Convention on Contracts for the International Sale of Goods (CISG), 47–48
establishment of, 10
International Court of Justice, 10
on national sovereignty, 28
on pollution, 28
United States. See also Dollars (U.S.)
antidumping actions and, 202, 206–207, 460–461
balance-of-payments accounts, 179t, 229
on CAFTA, 261
China-U.S. trade relations, 163–165, 194
competitive advantages for, 173
corporate-U.S. relations, 316
culture of, 16, 98, 113, 115
currency values in, 252–253, 282, 284–285, 287–288, 297–299
economic development and, 17–18, 205
economic freedom in, 73
economic system of, 46, 54
EU-U.S. trade relations, 205, 245–246
exporting considerations, 389–390, 398–399
FDI and, 19, 19f, 217f
financial crisis in, 282
first-mover advantages in, 196
foreign exchange market and, 273
on free trade, 205
HIPCs debt-relief legislation (2000), 29
Iraq-U.S. trade relations, 194
Japan-U.S. trade relations, 175, 206
legal system of, 46, 48, 51–53, 130–131
local responsiveness pressures in, 364
mad cow disease in, 194
marketing and sales practices in, 452, 453
Marshall Plan and, 300
mini-multinationals in, 20–21
MNEs in, 20, 20f
NAFTA and (See North American Free Trade Agreement (NAFTA))
outsourcing and, 8–9, 164
Pacific Rim countries-U.S. trade relations, 205
political system of, 245
protests in, 24
R&D in, 466
South Korea-U.S. relations, 205
strategic alliances of, 348
subsidies in, 188
terrorism in, 72, 101
trade deal with South Korea, 185–186
trade deficits in, 199, 227
trade policies of, 188, 191, 201, 204
trade theory on, 166–167, 169–170
Trans Pacific Partnership (TPP) and, 264
Transatlantic Trade and Investment Partnership and, 264
values and norms of, 91
work-related values of, 111, 111t
United Technologies, 143
Universal Declaration of Human Rights of 1948 (UDHR), 138, 141
World Bank (See World Bank)
World Economic Processing Zones Association, 391
Universal needs, 338
Universal Pictures, 444
Unocal, 225
Unspoken language, 108–109
Upstream supply chain, 412
Uruguay, 243, 244, 260–261
Uruguay Round (1986-1993), 11, 199–200
U.S. and Foreign Commercial Service, 389
U.S. Magnesium, 192
Utilitarianism, 137–138
V
Value chain, 327f
Value creation
market expansion, 331–337, 336
organization architecture and, 329f, 330
overview, 324–325, 324–325f
strategic fit, 329f, 330
value chain, primary activities of, 327–331, 327f
value chain, support activities of, 327f, 328–329
Values and norms
cultural change and, 113–114
as culture determinant, 93, 93f
education of, 109
groups and, 95–96
individualism as, 94–95
of organizational culture, 132f, 133–134, 140–141
overview, 91–92
Value-to-weight ratio, 418
Variety (magazine) on DMG’s success in China, 107
Veil of ignorance, 139, 142
Venezuela
corruption in, 49, 49f
countertrading by, 287, 400
culture of, 483
economic development in, 74, 80
economic system of, 45–46
FDI opposition by, 225
monetary system and, 295–296
political system of, 41, 43, 70, 71
regional economic integration and, 244, 260–261
VERs (Voluntary export restraints), 189–190, 199, 206
Vietnam
economic development in, 73, 77
employment practices in, 126
political system in, 40, 43
regional economic integration and, 262
Vodafone, 373
Volkswagen, 127
Volkswagen AG, 79, 107, 331
Voluntary export restraints (VERs), 189–190, 199, 206
Volvo, 213, 373
Vought Aircraft, 9
W
Wages. See Income
Walmart, 227–228, 236–237, 346, 451
Walmart de Mexico, 51
Walt Disney Company, 444
Page 530
Wanda Group, 20, 21
Warner Brothers, 347
e Wealth of Nations (Smith), 41, 157
WEF (World Economic Forum), 187
Wells Fargo, 345
West Germany, 247
Wholly owned subsidiaries, 366, 369–370
Windam International survey on expatriate failures, 486
Wipro Ltd., 97, 164
Wolverine World Wide, 366
Women and women’s issues
cultural, 113
in employment, 482
Woolworth, 147–148
Work conditions. See Labor
World Bank
establishment of, 10
on HIPCs debt relief, 29
World Bank (continued)
on nontariff trade barriers, 199
on regional economic integration, 261
role of, 300–301
on state ownership, 76
World Economic Forum (WEF), 187
World Economic Processing Zones Association, 391
World Intellectual Property Organization, 52
World order, 72–73
World trade. See International trade
World Trade Organization (WTO)
on agriculture subsidies, 29–30
on antidumping actions, 202
on economic development, 12
establishment of, 9–10, 198, 199–200
on FDI, 228, 232
future of, 201–205
history of, 199–201
on intellectual property protection, 52–53, 203
national governments and, 28
protests against, 23
on regional economic integration, 242, 245, 247
on South Korea’s trade liberalization, 311–312
support for, 207
on trade policies, 187, 188, 201–205
Trump on, 151
World trading system, 198–207
development of, 198–206
emergence of, 198–199
firm strategies for, 206–207
future implications for, 201–205
monitoring of, 199–201
national sovereignty and, 28
World Values Survey
on global norms and values, 112, 113
on labor dynamics, 110–111
World War I, 298
World War II, 245–246, 299
WPP, 46
WTO (World Trade Organization). See World Trade Organization
X
Xerox, 128, 168, 345, 348, 350, 365–369
Xing Ba Ke Coffee Shop, 53
Y
YouTube, 455
Yuan, 271–272
Yugoslavia, 21, 80, 400
Yundong strategy by Toyota, 443
Z
ZANU-PF Party, 56
Zen, 105
Zero-sum game, 156
Zhejiang Geely Holding Group Co., Ltd, 213
Zhejiang NHU Co., 272
Zimbabwe, 29, 43, 56–57, 74
Zoho Corporation, 164
Page 531 ACRONYM PROPER NAME
ADB Asian Development Bank
AfDB African Development Bank
AFIC Asian Finance and Investment Corporation
AFTA ASEAN Free Trade Area
ASEAN Association of Southeast Asian Nations
ATPA Andean Trade Preference Act
BIS Bank for International Settlements
BOP Balance of Payments
CIM Computer-Integrated Manufacturing
CIS Commonwealth of Independent States
CISG UN Convention on Contracts for the International Sale of Goods
CEMA Council for Mutual Economic Assistance
CRA Country Risk Assessment
DB Development Bank
DC Developed Country
DFIs Development Finance Institutions
DISC Domestic International Sales Corporation
EBRD European Bank for Reconstruction and Development
ECOWAS Economic Community of West African States
EMU Economic and Monetary Union
EEA European Economic Area
EFTA European Free Trade Association
EMs Export Management Companies
EMCF European Monetary Cooperation Fund
EMS European Monetary System
EPO European Patent Organization
ETC Export Trading Company
ETUC European Trade Union Confederation
EU European Union
FCPA Foreign Corrupt Practices Act
FDI Foreign Direct Investment
FSC Foreign Sales Corporation
FTAA Free Trade Area of the Americas
FTZ Foreign Trade Zone
Fx Foreign Exchange
G7 Group of Seven
GATT General Agreement on Tariffs and Trade
GC Global Company
GDP Gross Domestic Product
GNP Gross National Product
GSP Generalized System of Preferences
IAC International Anti-counterfeiting Coalition
ACRONYM PROPER NAME
IC International Company
IDA International Development Association
IDB Inter-American Development Bank
IEC International Electrotechnical Commission
IFC International Finance Corporation
IMF International Monetary Fund
IPLC International Product Life Cycle
IRC International Revenue Code
ISA International Seabed Authority
ISO International Organization for Standardization
ITA International Trade Administration
JIT Just-in-Time
JV Joint Venture
LAIA Latin American Integration Association (formerly LAFTA)
LDC Less Developed Country
LIBOR London Interbank Offer Rate
LOST Law of the Sea Treaty
Mercosur Free Trade Agreement between Argentina, Brazil, Paraguay, and Uruguay
MNC Multinational Company
MNE Multinational Enterprise
NAFTA North American Free Trade Agreement
NATO North Atlantic Treaty Organization
NIC Newly Industrializing Country
NTBs Nontariff Barriers
OECD Organization for Economic Cooperation & Development
OPEC Organizational of Petroleum Exporting Countries
PPP Purchasing Power Parity
PRC People’s Republic of China
PTA Preferential Trade Area for Eastern and Southern Africa
SACC Southern African Development Coordination Conference
SBA Small Business Administration
SBC Strategic Business Center
SBU Small Business Unit
SDR Special Drawing Rights
SEZ Special Economic Zone
TQM Total Quality Management
UN United Nations
UNCTAD UN Conference on Trade and Development
VAT Value Added Tax
VER Voluntary Export Restraint
VRAs Voluntary Restraints Agreements
WEC World Energy Council
WIPO World Intellectual Property Organization
ACRONYM PROPER NAME
WTO World Trade Organization
Page 532 COUNTRY CAPITAL
Afghanistan Kabul
Albania Tirana
Algeria Algiers
Andorra Andorra La Vella
Angola Luanda
Antigua and Barbuda St. John’s
Argentina Buenos Aires
Armenia Yerevan
Aruba Oranjestad
Australia Canberra
Austria Vienna
Azerbaijan Baku
Bahamas Nassau
Bahrain Manama
Bangladesh Dhaka
Barbados Bridgetown
Belarus Minsk
Belgium Brussels
Belize Belmopan
Benin Porto-Novo
Bermuda Hamilton
Bhutan imphu
Bolivia La Paz
Bosnia and Herzegovina Sarajevo
Botswana Gaborone
Brazil Brasilia
Brunei Bandar Seri Begawan
Bulgaria Sofia
Burkina Faso Ouagadougou
Burma Rangoon
Burundi Bujumbura
Cambodia Phnom Penh
Cameroon Yaounde
Canada Ottawa
Cape Verde Praia
Cayman Islands George Town
Central African Republic Bangui
Chad N’Djamena
Chile Santiago
China Beijing
Colombia Bogota
Comoros Moroni
COUNTRY CAPITAL
Democratic Republic of the Congo Kinshasa
Republic of Congo Brazzaville
Costa Rica San Jose
Cote d’Ivoire Yamoussoukro
Croatia Zagreb
Cuba Havana
Cyprus Nicosia
Czech Republic Prague
Denmark Copenhagen
Djibouti Djibouti
Dominica Roseau
Dominican Republic Santo Domingo
Ecuador Quito
Egypt Cairo
El Salvador San Salvador
Equatorial Guinea Malabo
Eritrea Asmara
Estonia Tallinn
Ethiopia Addis Ababa
Fiji Suva
Finland Helsinki
France Paris
Gabon Libreville
e Gambia Banjul
Georgia T’bilisi
Germany Berlin
Ghana Accra
Greece Athens
Grenada Saint George’s
Guatemala Guatemala City
Guinea Conakry
Guinea-Bissau Bissau
Guyana Georgetown
Haiti Port-au-Prince
Holy See Vatican City
Honduras Tegucigalpa
Hungary Budapest
Iceland Reykjavik
India New Delhi
Indonesia Jakarta
Iran Tehran
Iraq Baghdad
Ireland Dublin
COUNTRY CAPITAL
Israel Jerusalem
Italy Rome
Jamaica Kingston
Japan Tokyo
Jordan Amman
Kazakhstan Astana
Kenya Nairobi
Kiribati Tarawa
North Korea Pyongyang
South Korea Seoul
Kosovo Pristina
Kuwait Kuwait City
Kyrgyzstan Bishkek
Laos Vientiane
Latvia Riga
Lebanon Beirut
Lesotho Maseru
Liberia Monrovia
Libya Tripoli
Liechtenstein Vaduz
Lithuania Vilnius
Luxembourg Luxembourg
Macedonia Skopje
Madagascar Antananarivo
Malawi Lilongwe
Malaysia Kuala Lumpur
Maldives Male
Mali Bamako
Malta Valletta
Marshall Islands Majuro
Mauritania Nouakchott
Mauritius Port Louis
Mexico Mexico City
Federated States of Micronesia Palikir
Moldova Chisinau
Monaco Monaco
Mongolia Ulaanbaatar
Montenegro Podgorica
Morocco Rabat
Mozambique Maputo
Namibia Windhoek
Nauru No Official Capital
Nepal Kathmandu
COUNTRY CAPITAL
Netherlands Amsterdam
New Zealand Wellington
Nicaragua Managua
Niger Niamey
Nigeria Abuja
Norway Oslo
Oman Muscat
Pakistan Islamabad
Palau Melekeok
Panama Panama City
Papua New Guinea Port Moresby
Paraguay Asuncion
Peru Lima
Philippines Manila
Poland Warsaw
Portugal Lisbon
Qatar Doha
Romania Bucharest
Russia Moscow
Rwanda Kigali
Saint Kitts and Nevis Basseterre
Saint Lucia Castries
Saint Vincent and the Grenadines Kingstown
Samoa Apia
San Marino San Marino
Sao Tome and Principe Sao Tome
Saudi Arabia Riyadh
Senegal Dakar
Serbia Belgrade
Seychelles Victoria
Sierra Leone Freetown
Singapore Singapore
Slovakia Bratislava
Slovenia Ljubljana
Solomon Islands Honiara
Somalia Mogadishu
South Africa Pretoria
South Sudan Juba
Spain Madrid
Sri Lanka Colombo
Sudan Khartoum
Suriname Paramaribo
Swaziland Mbabane
COUNTRY CAPITAL
Sweden Stockholm
Switzerland Bern
Syria Damascus
Taiwan Taipei
Tajikistan Dushanbe
Tanzania Dar es Salaam
ailand Bangkok
Timor-Leste Dili
Togo Lome
Tonga Nuku’alofa
Trinidad and Tobago Port of Spain
Tunisia Tunis
Turkey Ankara
Turkmenistan Ashgabat
Tuvalu Funafuti
Uganda Kampala
Ukraine Kyiv
United Arab Emirates Abu Dhabi
United Kingdom London
United States Washington, DC
Uruguay Montevideo
Uzbekistan Tashkent
Vanuatu Port-Vila
Venezuela Caracas
Vietnam Hanoi
Yemen Sanaa
Zambia Lusaka
Zimbabwe Harare
Note: e list of the 199 “Countries and Capitals” on this page are from
http://globaledge.msu.edu/global-insights/by/country. More information about each country can be
found on globalEDGE (including statistics, economy, history, government, culture, risk factors,
corporations, trade indices, resources, and country memos).
- Title Page
- Copyright Page
- Dedication
- About the Author
- Contents in Brief
- The Proven Choice for International Business
- Acknowledgments
- Connect
- Contents
- Part One Introduction and Overview
- Chapter One Globalization
- Introduction
- What Is Globalization?
- The Emergence of Global Institutions
- Drivers of Globalization
- The Changing Demographics of the Global Economy
- The Globalization Debate
- Managing in the Global Marketplace
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Part Two National Differences
- Chapter Two National Differences in Political, Economic, and Legal Systems
- Introduction
- Political Systems
- Economic Systems
- Legal Systems
- Focus on Managerial Implications:The Macro Environment Influences Market Attractiveness
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Three National Differences in Economic Development
- Introduction
- Differences in Economic Development
- Political Economy and Economic Progress
- States in Transition
- The Nature of Economic Transformation
- Implications of Changing Political Economy
- Focus on Managerial Implications: Benefits, Costs, Risks, and Overall Attractiveness of Doing Business Internationally
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Four Differences in Culture
- Introduction
- What Is Culture?
- Social Structure
- Religious and Ethical Systems
- Language
- Education
- Culture and Business
- Cultural Change
- Focus on Managerial Implications:Cultural Literacy and Competitive Advantage
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Five Ethics, Corporate Social Responsibility, and Sustainability
- Introduction
- Ethics and International Business
- Ethical Dilemmas
- Roots of Unethical Behavior
- Philosophical Approaches to Ethics
- Focus on Managerial Implications: Making Ethical Decisions Internationally
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Part Three The Global Trade and Investment Environment
- Chapter Six International Trade Theory
- Introduction
- An Overview of Trade Theory
- Mercantilism
- Absolute Advantage
- Comparative Advantage
- Heckscher–Ohlin Theory
- The Product Life-Cycle Theory
- New Trade Theory
- National Competitive Advantage: Porter’s Diamond
- Focus on Managerial Implications: Location, First-Mover Advantages, and Government Policy
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Appendix: International Trade and the Balance of Payments
- Endnotes
- Chapter Seven Government Policy and International Trade
- Introduction
- Instruments of Trade Policy
- The Case for Government Intervention
- The Revised Case for Free Trade
- Development of the World Trading System
- Focus on Managerial Implications: Trade Barriers, Firm Strategy, and Policy implications
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Eight Foreign Direct Investment
- Introduction
- Foreign Direct Investment in the World Economy
- Theories of Foreign Direct Investment
- Political Ideology and Foreign Direct Investment
- Benefits and Costs of FDI
- Government Policy Instruments and FDI
- Focus on Managerial Implications: FDI and Government Policy
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Nine Regional Economic Integration
- Introduction
- Levels of Economic Integration
- The Case for Regional Integration
- The Case against Regional Integration
- Regional Economic Integration in Europe
- Regional Economic Integration in the Americas
- Regional Economic Integration Elsewhere
- Focus on Managerial Implications: Regional Economic Integration Threats
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Part Four The Global Monetary System
- Chapter Ten The Foreign Exchange Market
- Introduction
- The Functions of the Foreign Exchange Market
- The Nature of the Foreign Exchange Market
- Economic Theories of Exchange Rate Determination
- Exchange Rate Forecasting
- Currency Convertibility
- Focus on Managerial Implications: Foreign Exchange Rate Risk
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Eleven The International Monetary System
- Introduction
- The Gold Standard
- The Bretton Woods System
- The Collapse of the Fixed Exchange Rate System
- The Floating Exchange Rate Regime
- Fixed versus Floating Exchange Rates
- Exchange Rate Regimes in Practice
- Crisis Management by the IMF
- Focus on Managerial Implications: Currency Management, Business Strategy, and Government Relations
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Part Five The Strategy of International Business
- Chapter Twelve The Strategy of International Business
- Introduction
- Strategy and the Firm
- Global Expansion, Profitability, and Profit Growth
- Cost Pressures and Pressures for Local Responsiveness
- Choosing a Strategy
- Strategic Alliances
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Thirteen Entering Developed and Emerging Markets
- Introduction
- Basic Entry Decisions
- Entry Modes
- Selecting an Entry Mode
- Greenfield Venture or Acquisition?
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Part SIX International Business Functions
- Chapter Fourteen Exporting, Importing, and Countertrade
- Introduction
- The Promise and Pitfalls of Exporting
- Improving Export Performance
- Export and Import Financing
- Export Assistance
- Countertrade
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Fifteen Global Production and Supply Chain Management
- Introduction
- Strategy, Production, and Supply Chain Management
- Where to Produce
- Make-or-Buy Decisions
- Global Supply Chain Functions
- Managing a Global Supply Chain
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Sixteen Global Marketing and Business Analytics
- Introduction
- Globalization of Markets and Brands
- Market Segmentation
- Business Analytics
- Product Attributes
- Distribution Strategy
- Communication Strategy
- Pricing Strategy
- Configuring the Marketing Mix
- Product Development and R&D
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Chapter Seventeen Global Human Resource Management
- Introduction
- Strategic Role of Global HRM: Managing a Global Workforce
- Staffing Policy
- Training and Management Development
- Performance Appraisal
- Compensation
- Building a Diverse Global Workforce
- International Labor Relations
- Summary
- Critical Thinking and Discussion Questions
- Research Task
- Endnotes
- Glossary
- Name Index
- Subject Index
- Acronyms
- Countries and Their Capitals