D2: Social Trends

Strategic Management: Theory and Practice

The External Environment: Political-Legal and Economic Forces

Contributors: By: John A. Parnell

Book Title: Strategic Management: Theory and Practice

Chapter Title: "The External Environment: Political-Legal and Economic Forces"

Pub. Date: 2014

Access Date: July 2, 2018

Publishing Company: SAGE Publications, Ltd

City: 55 City Road

Print ISBN: 9781452234984

Online ISBN: 9781506374598

DOI: http://dx.doi.org/10.4135/9781506374598.n3

Print pages: 52-77

©2014 SAGE Publications, Ltd. All Rights Reserved.

This PDF has been generated from SAGE Knowledge. Please note that the pagination of

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The External Environment: Political-Legal and Economic Forces

Chapter Outline

Analysis of the External Environment

Political-Legal Forces Global Considerations

Economic Forces Gross Domestic Product

Inflation Rates

Interest Rates

Exchange Rates

Ecological Influences

Summary

Key Terms

Review Questions and Exercises

Practice Quiz

Student Study Site

Notes

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After the industry has been clearly defined and its potential profitability assessed, forces outside the industry should be considered. Constant changes in these external forces can present numerous challenges to strategic managers. It is important to understand how these forces collectively influence the industry in which a firm competes before strategic plans are developed. Although a number of individual companies are discussed, this chapter continues with an industrial organization (IO) perspective by emphasizing effects on entire industries, not just firms.

Analysis of the External Environment

Organizations and industries exist within a complex network of external forces. Together, these elements comprise the external environment, or macroenvironment There are four categories of macroenvironmental forces: (1) political-legal, (2) economic, (3) social, and (4) technological (see Figure 3.1). The analysis of external factors may be referenced as PEST— political-legal, economic, social, and technological—an acronym derived from the first letter of each of the four categories of forces. The effects of external environmental forces on a firm's industry should be well understood before strategic options are evaluated. Political-legal and economic forces are addressed in this chapter. Social and technological forces are addressed in the next chapter.

Firms operating in multiple, distinct geographical markets may be affected in different manners by external forces in each market. For example, wide roads and relatively modest fuel taxes (i.e., political/legal factors) and a high standard of living (i.e., an economic factor) suggest higher demand for moderate to (relatively) large vehicles in the United States. In contrast, increased environmental concerns (i.e., a social force) and advances in electric vehicle production (i.e., a technological force) suggest higher demand for small, more fuel- efficient vehicles. The environment is different in Latin America, where narrow roads, higher fuel taxes, and less disposable income suggest higher demand for smaller cars. Interpreting the complexities of the external environment is both important and challenging.

Figure 3.1 Macroenvironmental Forces

Although large organizations and trade associations often attempt to influence change in the macroenvironment, these forces are usually not under the direct control of business organizations. On occasion, a dominant firm like Wal-Mart may be able to exert some degree

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of influence over one or more aspects of the macroenvironment. However, this level of influence is not common to most organizations because strategic managers typically seek to enable a firm to operate effectively within largely uncontrollable environmental constraints while capitalizing on the opportunities provided by its environment.

Consider examples from rival retailers. Wal-Mart's political action committee usually contributes heavily to candidates of both major parties in the United States every election

year.1. Wal-Mart mobilized its store managers through the United States in 2008, warning that a win by the Democrats would likely make it easier for workers to unionize. In 2010, Target contributed $150,000 to Minnesota Forward, a political group in its home state that backs pro- business candidates. One such candidate also opposed same-sex marriage, sparking demonstrations of gay-rights supporters outside of Target stores across the United States and a petition signed by 240,000 consumers promising to boycott the retailer. The protest effort was organized by MoveOn.org and demonstrates the risks firms can face when they seek to

influence the political landscape.2.

As previously mentioned, strategic managers must first identify and analyze these national and global forces and understand how each force affects the industries in which they operate before addressing firm-specific strategy concerns. Hence, understanding a force's broad effects should precede understanding its specific effects. Applications of these forces that are unique or specific to the firm are considered as opportunities and threats later in the strategic management process.

Political-Legal Forces

Political-legal forces include such factors as the outcomes of elections, legislation, and judicial court decisions, as well as the decisions rendered by various commissions and agencies at every level of government. Some regulations affect many or all organizations. When the Massachusetts state legislature passed a bill in 2006 to require that businesses

provide health insurance for its workers, all firms operating in the state were affected.3. When the U.S. Supreme Court ruled in 2007 that the Clean Air Act applies to car and truck carbon dioxide emissions, carmakers knew immediately that higher federal fuel economy standards

were likely forthcoming.4. When President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, financial institutions were faced with heightened federal regulation.

Government regulations—regardless of intent or justification—can be costly to some business enterprises. For example, guidelines revised in April 2010 by the U.S. Environmental Protection Agency (EPA) required businesses that repair or renovate older buildings to adhere to strict lead-safe work practices. The new regulations most directly affect homes, schools, day care centers, and other buildings built before lead-based paint was banned in 1978. Renovators now must invest in equipment and supplies such as lead-testing kits, plastic sheeting, respirators, and protective clothing. At least one worker involved in the project must have EPA certification. Michael Davis, CEO of Guardian Preservation Services, a Chicago mold-removal company, estimates compliance costs to his company to be between $160,000

and $300,000 annually. These costs must be passed along to customers.5.

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Regulations can be much more stringent in certain nations, such as in Venezuela where President Hugo Chavez has nationalized firms in the oil, telecommunications, and electricity industries following ascendency to power in 1998. The Venezuelan government typically compensates firms it nationalizes, but the extent to which they receive market value for their

assets is widely questioned.6.

Argentina's president Cristina Kirchner has also heavily regulated a number of industries, especially in areas controlled by global interests. In 2009, her administration crafted restrictive import-licensing requirements and imposed what is known as el impuestazo (“the big tax”), a doubling of the value-added tax (VAT) on imported electronics. At the same time, her

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administration cut taxes paid by electronics firms in Tierra del Fuego—the frigid and isolated southernmost part of the nation—in a protectionist attempt to create jobs. Kirchner's move in 2012 to nationalize the country's largest oil-and-gas producer, YPF SA, received sharp criticism from both majority owner Repsol YPF of Spain and the Spanish government. Kirchner declared the petroleum industry to be of “national public interest” and confiscated 51% ownership of the firm from Repsol YPF's 57% stake. The Argentine government did not pay the market price for the shares but instead appointed a federal tribunal to calculate a

“fairer” (lower) payment.7.

The automobile industry in the United States has been affected by a number of regulations in recent years. The U.S. National Highway Traffic Safety Administration constantly tests cars a n d t r u c k s s o l d i n t h e U n i t e d S t a t e s a n d p r e s s u r e s c a r m a k e r s t o i m p r o v e s a f e t y

performance.8. Corporate average fuel economy (CAFE) standards can require that producers develop new vehicles or modify existing ones so that average fuel economy targets a r e m e t . T h i s c a n b e a c o s t l y v e n t u r e . W h e n P r e s i d e n t B u s h s i g n e d t h e E n e r g y Independence and Security Act of 2007, requiring automakers to increase average gas mileage to 35 miles per gallon by 2020, analysts estimated that the industry would spend

more than $6 billion to comply, adding $275 to the price tag of a large truck by 2011.9. When President Obama announced an additional increase in CAFE standards to 55 miles per gallon by 2025, some analysts estimated that production costs will rise by as much as $3,000 per vehicle. Proponents of the higher standards argue that fuel savings would more than

compensate for the additional costs if the target can be achieved.10.

The effects of regulations can be complex, especially when enforcement is lax or inconsistent. Chipotle Mexican Grill discovered this in 2011 when U.S. Immigration and Customs E n f o r c e m e n t ( I C E ) i n s p e c t e d c o m p a n y r e c o r d s a n d i d e n t i f i e d a l a r g e n u m b e r o f undocumented workers. Chipotle had to let go a large number of workers—more than half of its 900 employees in Minnesota alone. The fast-growing restaurant operated about 1,000 restaurants with 30,000 employees—about one-half Hispanic—in 2012 with plans to hire an additional 100,000 workers by 2015. Chipotle operates in a high turnover industry where illegal immigrants are frequently hired and enforcement is sporadic and unpredictable. The ICE raid prompted CEO Monty Moran to meet with several U.S. senators in an effort to reform

U.S. immigration policy.11.

Military conflicts can also influence how a number of industries operate—especially those with tight global ties. For example, during the 2003 war in Iraq, many firms modified their promotional strategies, fearing that their television advertisements might be considered insensitive if aired alongside breaking coverage of the war. At the same time, others began to plan for meeting the anticipated future needs in Iraq for such products as cell phones, refrigerators, and automobiles. After the previous regime was ousted in mid-2003, American

firms began to compete vigorously for lucrative reconstruction contracts.12.

Interestingly, some firms—particularly large ones—favor specific regulations because they erect barriers to newcomers in the industry. In some instances, firms welcome direct financial assistance from government entities. Following the sharp declines in air travel in the United States after the 9/11 tragedy, airlines on the verge of bankruptcy campaigned for and received

$15 billion in government support in 2002 and an additional $2.9 billion in 2003.13. In 2004, for example, Ford chief Bill Ford said he would support higher fuel taxes in exchange for

government incentives to produce more energy-efficient vehicles.14. In 2008, the Troubled

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Asset Relief Program (TARP) provided direct financial assistance to General Motors and a number of financial institutions in the United States. Most recipients welcomed the assistance although it was accompanied by increased oversight and scrutiny.

Some government intervention is specifically designed to benefit certain industries—at least in the short term. For example, in 2009, the Car Allowance Rebate System (CARS)—better known as “Cash for Clunkers”—was deployed in the United States. CARS sought to provide government rebates up to $4,500 to consumers who traded in their less fuel-efficient vehicles for more efficient new ones. The $3 billion program was designed to improve overall emissions by requiring that “clunkers” be destroyed, and to provide a boost for an automobile industry suffering in a recession. Although CARS resulted in a late summer increase in short-term

sales for carmakers as predicted.15.

The unintended consequences or side effects of such intervention should also be

considered.16. CARS likely prompted many consumers to purchase vehicles earlier than they otherwise would have, reducing demand the following year. Money spent on vehicles cannot be spent in other sectors of the economy, which may explain while retail sales in July 2009— the month CARS funds were made available—were the lowest since January. Sales at used car dealers also declined during this period and used car values rose because of the fewer number available for resale. Automobile parts retailers such as AutoZone and Pep Boys also

suffer when older vehicles are removed from the roads.17. Hence, as with any government action, the unintended consequences of market intervention designed to aid specific firms or industries must be considered.

In more cases than not, however, regulation can prove costly for firms in an industry. When mad-cow disease—a rare ailment of the brain transmitted through tainted meat—began to show up in the United Kingdom in early 2001, most of Europe responded by banning the

import of British beef. Financial losses for the industry were staggering.18. Since 2005, U.S. packaged food manufacturers have been required to disclose the amount of trans fats in the

products they distribute through grocery stores.19. Health advocates have also lobbied for governmental regulation of salt content in packaged foods, warning of the link between salt and high blood pressure. Deeply ingrained in the food production process, however, salt is all but impossible to eliminate because of its many benefits. Salt is inexpensive, enhances the

taste of myriad foods, and often extends the shelf life.20.

Additional examples of costly regulations abound. In 2006, the U.S. Food and Drug Administration (FDA) issued guidelines concerning when food companies can reference their products as “whole grain.” Food companies can use the label if their products are made of rye, oats, popcorn, and wild rice but not soybeans, chickpeas, and pearled barley. The use of terms such as good source and excellent source to describe the amount of whole grains

included in a product are also subject to debate and FDA rulings.21.

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In 2010, Chesapeake Bay Candle decided to build its first production facility in the United States. The candlemaker had three plants in Asia but wanted to be closer to its primary customer base in the United States. Its founders projected a cost of $2.5 million over 9 months to build the facility but ended up spending more than $3.5 million and waiting an additional several months due to regulatory delays. Expensive upgrades required to meet local building codes, special oil containment rooms and drainage requirements, new sprinkler and air-handling systems, and handicapped-accessible bathrooms slowed progress and

raised costs dramatically.22.

All societies have laws and regulations that affect business operations, although the extent of government intervention varies across nations. A major shift in U.S. policy occurred in the late 1970s and the 1980s in favor of “deregulation,” eliminating a number of legal constraints in such industries as airlines, trucking, and banking; however, not all industries were deregulated. By 1990, a reversal of trade protectionism and strong governmental influence in

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business operations began to take place. New economic policies reduced governmental influence in business operations by deregulating certain industries, lowering corporate taxes, and relaxing rules against mergers and acquisitions. This trend continued into the twenty-first century but crested in the early 2000s. President Barack Obama's election in 2008—coupled with Democrat Party majorities in both houses of Congress—solidified a shift in the opposite

direction toward a greater federal government role in business affairs.23. The political winds can change frequently, however, as Republicans regained a majority in the House of Representatives in 2010, a balance of power that continued with Obama's reelection in 2012. Interestingly, share prices of U.S. coal firms rose before Election Day in anticipation of a possible win by challenger Mitt Romney. Prices declined sharply the day after the election as investors expected a continuation of anti-coal policies initiated in President Obama's first term.

Table 3.1 Selected Examples of Government Regulation of Business in the United States

Legislation Purpose

Sherman Antitrust Act (1890)

Prohibits monopoly or conspiracy in restraint of trade

Clayton Act (1914) Forbids contracts that tie the sale of one product to the sale of another

Federal Trade Commission Act (1914)

Stops unfair methods of competition, including deceptive advertising, selling practices, and pricing

Webb-Pomerene Export Trade Act (1918)

Permits selected American firms to form monopolies in order to compete with foreign firms

Fair Labor Standards Act (1938)

Sets minimum-wage rates, regulations for overtime pay, and child labor laws

Antimerger Act (1950) Makes the buying of competitors illegal when it lessens competition

Equal Pay (1963) Prohibits discrimination in wages on the basis of sex when males and females are performing jobs requiring equal skill, effort, and responsibility under similar working conditions

Clean Air Act (1970) Directs the Environmental Protection Agency (EPA) to create emission standards for potential pollutants

Occupational Safety and Health Act (1970)

Requires employers to provide a hazard-free working environment

Consumer Product Safety Act (1972)

Sets standards on selected products, requires warning labels, and orders product recalls

Equal Employment Opportunity Act (1972)

Forbids discrimination in all areas of employer–employee relations

Foreign Corrupt Practices Act (1978)

Outlaws direct payoffs and bribes of foreign governments or business officials

Americans with Disabilities Act (1992)

Protects the physically and mentally disabled from job discrimination

Family and Medical Leave Act (1993)

Offers workers up to 12 weeks of unpaid leave after childbirth or adoption or to care for a seriously ill child, spouse, or parent

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Food Quality Protection Act (1996)

Reduces the amount of carcinogenic pesticides allowed in foods

Pension Security Act (2002)

Gives workers more freedom to diversify their investments and greater access to quality investment advice concerning their 401(k) plans

Sarbanes-Oxley Act (2002)

Created more detailed reporting requirements for boards and executives in public U.S. companies and accounting firms

CAN SPAM Act (2003) Prescribes rules and penalties for e-mail spammers, although enforcement is difficult

Car Allowance Rebate System (2009)

Provided government rebates for consumers who traded in cars with low gas mileage for new, more efficient models; also called CARS or “Cash for Clunkers”

Patient Protection and Affordable Care Act (2010)

Increases regulation of health care providers and insurance companies in an effort to lower costs and expand coverage

Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

Outlines comprehensive regulation of U.S. financial markets and credit rating agencies

A plethora of government regulations abounds; Table 3.1 presents examples of some of the major ones in the United States.

Many regulations, such as those listed in Table 3.1, affect multiple industries. Others, however, are designed specifically for a single industry, category of firms, or even a particular company. For example, a 1992 U.S. Supreme Court ruling requires retailers to collect state sales taxes only if they have a physical presence—typically a store—in the state where the customer initiates the purchase. Large and small retailers alike have since argued that the ruling enables online merchants like Amazon.com to effectively discount their goods at the expense of government coffers. Amid severe state budget crises in the early 2010s, big-box stores like Wal-Mart, Target, Best Buy, Home Depot, and others backed the efforts of a coalition called the Alliance for Main Street Fairness to change state laws to require online merchants to collect taxes across state lines. Online sales accounted for 4.4% of retail activity

in 2010, a figure projected to increase to 14.6% by 2020.24.

In 2005, 18 U.S. states implemented the Streamlined Sales Tax Project in an effort to remove obstacles preventing retailers from collecting sales taxes with online sales. Estimated uncollected taxes associated with Internet sales was between $10 billion and $11 billion in the United States in 2011. A Credit Suisse 2011 study estimated that if Internet retailers were required to collect state sales tax, Amazon alone would lose $653 million in sales in 2011,

approximately 1.4% of an estimated $46 billion in revenue.25.

Consider a second example. In 2006, a U.S. federal court ruled that cigarette manufacturers cannot use the adjectives light or low tar to describe their products. This ruling not only requires firms to rename some of their products but it requires them to reposition them and hope that smokers do not assume that other aspects of the cigarettes have been changed as well. Hence, familiar brands like Altria's Marlboro Lights and Reynolds American's Camel

Lights must be changed to accommodate the ruling.26.

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Industry- and firm-specific regulations often follow a safety crisis. After Kam Air Flight 904 crashed and killed all 104 people on board in 2005, the European Union placed Phoenix Aviation—the company that leased the plane to the small, private Afghan carrier—on its backlist of carriers considered too dangerous to fly within the European Union. The U.S. FDA instituted stricter food safety regulations for an entire industry in 2008 following a salmonella

outbreak linked to lettuce, peanut butter, and even pet food.27.

Other regulations represent a response to public demand. Debates over public bans on smoking, for example, have pitted smokers and defenders of their rights against those concerned about the effects of smoking on the health of nonsmokers. A prominent study in Scotland found that hospital admissions for heart attacks and coronary problems fell 14% for smokers and 20% for nonsmokers in the year after Scotland banned smoking in public. Such findings have fueled calls for greater limits, resulting in varying degrees of government regulation in various locales in the United States. Not only have such bans affected the cigarette industry but smoking bans also affect other establishments, including restaurants,

hotels, and retailers.28.

In late 2010, the San Francisco board of supervisors voted to disallow restaurants from including toys as part of a meal unless the accompanying food complied with prescribed limits of calories, sugar, sodium, and fat content. Ostensibly aimed at curbing childhood obesity, the measure targeted McDonald's Happy Meals. The new rule was scheduled to take effect in December 2011. Shortly after the San Francisco vote, the advocacy group Center for Science in the Public Interest—on behalf of a 41-year-old mother of two—filed a lawsuit against McDonald's accusing the chain of employing deceptive advertising practices to attract children to their restaurants. The center alleges that Happy Meals contain amounts of fat, sodium, and calories much higher than government recommended levels. Responding to the attacks, CEO Jim Skinner attacked the “food police,” charging the legislation “takes personal choice away from families who are more than capable of making their own decisions … We've seen many years of someone trying to dictate behavior through legislation. … We sell choices on the

menu that make our customers feel better about their lifestyle.”29.

Industry regulation can arise when consumers express confusion about a specific category of products or services. For example, in 2011, the U.S. FDA issued labeling requirements for sunscreens. Many consumers did not understand the different types of protection offered and simply relied on the ultraviolet B (UVB) sun protection factor (SPF) provided on the label. While UVB rays primarily cause sunburn, ultraviolet A (UVA) rays can also contribute to wrinkles and skin cancer. The new rules required sunscreens labeled broad spectrum t o protect against both UVA and UVB rays. Only those with an SPF rating of 15 or higher will be allowed to state that they reduce the risks of premature aging and cancer; those with SPF ratings below 15 were required to carry a warning. Moreover, manufacturers were prohibited from using the terms waterproof or sweat-proof, and only those that pass a test can claim to

be water-resistant.30.

Sometimes political-legal forces target specific firms, especially when they are dominant in

their industries.31. Environmental suits ostensibly funded by grassroots organizations slowed or prevented Wal-Mart's expansion into a number of communities in the 2000s. In 2010, the Wall Street Journal reported that competitors Safeway, Supervalu, and Ahold were secretly funding hundreds of lawsuits against the industry leader. In late 2010, Wal-Mart began fighting back against what it saw as an ongoing corporate-sabotage campaign sponsored by its rivals. Wal-Mart petitioned judges to require its opponents to disclose individuals and

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organizations funding the suits.32.

The threat of government regulation can have a significant affect on an industry as well. For example, a number of states passed laws prohibiting the use of talking and/or texting on cell phones while driving in the early 2010s. With other states and the National Highway Traffic Safety Administration considering additional regulations, many automobile and cell phone manufacturers joined in an effort called the Car Connectivity Consortium to develop and promote functionality standards for smartphones. The idea is to develop phones and apps that utilize hands-free technology and create fewer distractions for drivers. Surveys also suggest that most consumers consider texting while driving to be a major safety threat and favor government bans. Hence, social pressure—a topic discussed in the next chapter—is

also prompting industry change.33.

Government action can also emanate from litigation. In 2008, for example, the U.S. Justice Department reached a settlement with the National Association of Realtors in an antitrust case involving the trade group's control of home listings displayed on the Internet. Association rules had previously allowed brokers to block their listings of homes for sale from being displayed on the websites of other brokers. The settlement disallowed such activity aimed as restricting equal access of “online brokers” to the same database accessible by traditional, full-

commission brokers.34.

Sometimes the threat of government action can result in negotiated solutions that affect how business is transacted. For years, retailers in the United States were prohibited from charging fees to their customers who used credit cards. Some wanted to pass the so-called swipe fees — typically around 3% of a sale—to customers who chose to pay with a card. In 2012, a settlement of a lawsuit against Visa, MasterCard, and bank credit-card issuers was reached allowing retailers to charge additional fees at their discretion. The decision to charge a swipe fee is not an easy one, however, as some consumers might resist paying it, especially on big

ticket items.35.

Global Considerations

It is interesting to consider broad global trends toward regulation in recent decades. The period from World War II to the late 1980s was marked by increased trade protection. Many countries protected their industries by imposing tariffs, import duties, and other restrictions. Import duties in many Latin American countries ranged from less than 40% to more than

100%.36. However, this trend was not limited to developing nations. Countries in Europe and Asia—and even the United States—imposed import fees on a variety of products, including food, steel, and cars. In the 1980s, the United States also convinced Japanese manufacturers to voluntarily restrict exports of cars to the United States in lieu of a tariff. Interestingly, this particular tariff may be largely responsible for Japanese automobile manufacturers establishing a large number of production facilities in the United States, thereby blurring the concept of the “foreign car.”

During this time, however, leaders from many nations recognized that all countries would likely benefit if trade barriers could be reduced across the board. After the end of World War II, 23 countries entered into the cooperative General Agreement on Tariffs and Trade (GATT), working to relax quota and import license requirements, introduce fairer customs evaluation methods, and establish a common mechanism to resolve trade disputes. The World Trade

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Organization (WTO) and the International Monetary Fund (IMF) were also established. By 1994, GATT membership had expanded to more than 110 nations when it was replaced by a new WTO. Today, the WTO contains 153 members and continues to negotiate global trade agreements. Of course, member nations must ratify the agreements before they become effective.

The move toward free marketing has also been seen in Europe, where a number of nations banded together to develop a trade-free European Community. Today, the European Union represents a market of about 500 million consumers. The European Economic Area, as it is called, is the largest trading bloc on Earth, accounting for more than 40% of the world's gross

domestic product (GDP).37. The shift toward a united and ostensibly stronger Europe—with a common currency—has not been easy, as debt crises in the early 2010s in Spain, Portugal, Greece, Italy, and other member nations illustrate.

Meanwhile, the United States, Canada, and Mexico established the North American Free Trade Agreement (NAFTA) to create its own strategic trading bloc. Many analysts believe that world business will eventually be divided into several such blocs, each providing preferred trading status to other nations within the bloc.

The global trend toward less regulation extended to the former communist countries as well. Nations of the former Soviet bloc in Eastern Europe overturned their governments in the

1990s and began to open markets and to invite foreign investment.38. Markets have become freer in much of Africa as well but not in all nations. Nestle's milk business has been under constant threat in Zimbabwe, where regulations require that 51% of foreign companies

operating there be owned by local, black-owned entities.39.

China is an interesting case to consider. Although China is officially ruled by the Communist party, its economic development policies have shifted toward a free market approach since the late 1990s. McDonald's awarded its first franchise in China in 2004. The number of franchises awarded in China by McDonald's, Yum Brands (which includes KFC and Pizza Hut), and others began to increase dramatically in early 2005 after Chinese officials introduced new guidelines concerning such issues as recruitment of entrepreneurs and property rights, a move required before China's entry into the WTO. Previously, Western companies feared a

loss of trade secrets and brands by offering franchises in China.40. Regulation—or the lack thereof—always seems to be a key political and business issue, as has also been seen recently in copyrighted products distributed electronically such as software, music, and

movies.41.

In 2004, U.S. chemical maker SI Group opened a tire production factory in China. After SI plant manager Xu Jie left the firm and joined Chinese competitor Sino Legend Chemical, the Chinese rival developed a rubber-bonding resin remarkably similar to the signature resin used by SI. Sino Legend executives claimed the product was developed independently, but SI officials are not convinced. By 2011 SI had spent over $1 million pursuing legal action against Sino Legend, but CEO Steven J. Large alleged that Chinese authorities have thwarted his efforts. This case is but one of many intellectual property disputes in China. Almost 43,000

such cases were filed in China in 2010.42.

The case of China highlights the fact that political considerations and regulations are often inconsistent across borders and can require coordination. For example, China has lagged behind other nations in vehicle emissions regulations. In 2007, China's State Environmental

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Protection Agency postponed new standards originally slated for implementation that year

because oil refineries would have been unable to meet the demand for cleaner fuel.43.

Following a rash of toy recalls across the globe, Chinese and U.S. officials worked together in

2007 to ban lead paint in toys produced in China and exported to the United States.44. The new nations have also worked together to facilitate the export of Chinese pharmaceuticals to

the United States.45.

It is difficult to overstate the complex influence of political-legal forces on industries, especially when firms operate across borders. For example, Internet search firms Yahoo and Google must negotiate Chinese regulations in order to operate in China. The Chinese government believes that the Internet must be controlled to maintain social stability and thereby imposes strict censorship and security laws. This control represents a distinct challenge for the search engines, whose purpose is to enable users to access the full spectrum of information

available, not just what governments prefer users to see.46.

Pollution is also becoming more of a challenge every day in China's capital, Beijing, where nearly 1,000 new cars are added to the congestion every day. This is expected to change markedly, however, with some analysts predicting an increase to more than 130 million by

2020.47. Hence, automakers should anticipate increased regulations in the coming years to combat this growing problem.

The notion that globalization tends to benefit skilled more than unskilled workers, coupled with greater awareness of the social costs it engenders, has led many to conclude that some

forms of protectionism may be appropriate.48. In 2008, the U.S. housing and financial crises resulted in a cacophony of calls for greater government intervention into business affairs as

some Americans attributed the primary cause to lax regulation.49. The recession of the late 2000s also raised the specter of protectionist policies as governments sought measures that promoted their own firms without regard to global trade. The economic stimulus package passed by the Obama administration in 2009 included consumer incentives that favored troubled U.S. automakers. Of course, protectionist battles are waged outside of the United States as well.

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In 2009, the Chinese government disallowed Coca-Cola's proposed $2.4 billion acquisition of Huiyuan Juice, expressing concern that Coke might not buy its fruit from Chinese farmers and that the Huiyuan brand name might be changed. Hence, policy makers often shift their economic focus to immediate concerns in challenging economic times. The benefits free trade

creates are more apparent over the long term.50.

The notion of “free trade” is relative, as trade across borders is never completely unabated. Some trade restrictions across borders will always exist, especially in politically sensitive areas. For example, the United States and other Western countries have banned the export of advanced technology in certain circumstances. The United States prohibits the export of certain electronic, nuclear, and defense-related products to many countries, particularly those believed to be involved in international terrorism. Many of these restrictions were revised and

strengthened following the 9/11 terrorist attacks51. (see Case Analysis 3.1).

Step 5: What Political-Legal Forces Affect the Industry?

The answer to this question depends on the industry but should include the effects

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1.

2.

3.

4.

5.

6.

7.

8.

9.

that political and legal events will likely have on the industry in which the organization operates. Some key issues include (but are not limited to) the following:

Legislation at all levels

Court judgments, as well as decisions rendered by various federal, state, and local agencies

Environmental regulations and enforcement of antitrust regulations

Tax laws

Consumer lending regulations

Outcomes of elections

International trade regulations and tariffs

Laws on hiring, firing, promotion, and pay

Political stability

The focus at this point should be on the industry, not a specific firm. The application of the firm in question is discussed in the strengths, weaknesses, opportunities, and threats (SWOT) analysis in Chapter 9.

As with economic, social, and technological forces, some political-legal forces affect different firms in the same industry in different manners. However, one should identify the key external factors affecting the industry and explain how they affect the overall industry. For example, stating that a particular industry will be affected by changes in tax laws is not sufficient. One should elaborate by discussing specific changes, such as an increase in the investment tax credit, and elaborate on how this change affects the industry as a whole. Although referencing individual firms in this section is acceptable, emphasis should be placed on the effects of political-legal and other environmental forces on the entire industry. Specifics concerning how these factors affect a particular organization should be elaborated in the section on opportunities and threats, which is later in the analysis.

Researching political-legal forces, as well as other environmental forces, requires some digging and intuition and a lot of reading. Rarely will one find a website that provides a comprehensive “macroenvironmental report” for a given firm or industry. When one is conducting research, it is often helpful to create four charts—one for each element in the macroenvironment—and add to it throughout the research process. One may locate direct and indirect references at the company home page and in various articles, but trade journals are often the best single source of information for reports on relevant issues in the external environment. As many as two dozen (or more) different sources may be required to complete the analysis of the four macroenvironmental forces. It is rare that complete and thorough information can be found in only one or two sources.

If a company competes in multiple industries (with multiple business units), one needs to analyze the major business units and industries. What constitutes “major” depends on the firm. For example, Ford Motor Company receives the majority of its revenues

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from automobile sales, but it also has a business unit that provides customer financing. With Ford, it would make the most sense to analyze its automobile business unit and not spend considerable time on the financial business unit. With other companies, however, determining which business unit or units are “major” may be more difficult. The key is to consider the relative contribution of each business unit to corporate revenues and profits. If questions remain, it is a good idea to present the professor with a list of the company's business units and each one's proportion of company revenues and profits, along with a proposal on how to proceed, and ask for guidance.

Economic Forces

Economic forces significantly influence business operations, including growth or decline in GDP and increases or decreases in economic indicators such as inflation, interest rates, and exchange rates. Other factors such as hikes in energy prices and health care costs and access to labor can also play a role.

Although the focus here is on the effects of economic changes on an industry, some competitors may be hurt more than others. Increases in fuel prices in mid-2005, for example, did not have the same effect on all airlines, although specific effects are difficult to determine because of other simultaneous environmental and competitive changes in the industry. Initially, weak players like Delta Air Lines seem to have been hit the hardest, while budget carriers like Southwest Airlines and Ryanair may have been able to experience some mild gains. As prices continued to rise, however, it became apparent that low-cost airlines were not going to suffer less than their traditional counterparts because fuel represents a higher percentage of running costs on short-haul flights such as those championed by budget carriers. While low-cost airlines hoped to spread these increased costs over more customers with higher occupancy rates, this became more difficult because traditional airlines began to

lower fares in 2006 in an effort to increase their own occupancy rates.52.

Many airlines recovered in the late 2000s, but problems resurfaced in 2010 and 2011 when fuel prices rose again, winter storms in the United States were particularly treacherous, and the ripple effect from the Japanese earthquake and tsunami reduced travel. For example, the average cost of airline fuel rose by 45% between March 2010 and March 2011. As a result, the percentage of airline costs attributed to fuel increased from 24% to 35% during the same period. While some of the additional cost was passed along to consumers in the form of higher fares, increased travel costs and a sluggish economy kept many prospective travelers

at home.53.

The tragic events in Japan set off ripple effects in other markets as well. Consider that production in the automobile industry had been scaled back in 2009 and 2010. When Japan was hit with a major earthquake and a tsunami in early 2011, shortages hit the supply chain in Japan even further, leading to further cutbacks at Toyota, Nissan, and Honda. This confluence of events resulted in a shortage of new vehicles and higher prices as well. The price spikes were also evident with used cars, prompting some prospective buyers to defer

purchases and maintain their present vehicles, a boon for automobile repair shops.54.

When wholesale beef prices rose sharply in late 2009 and 2010, McDonald's, Burger King, and other fast-food restaurants shifted promotional efforts to chicken, turkey, and even pork ribs. Most of these hamburger alternatives were already on the menus or in development, but

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the hike in beef prices prompted the move.55.

Economic forces can also have interesting cross-border effects. Toymakers in the West suffered during the 2006 Christmas season when power and labor shortages in China limited

production of many of the projected top sellers.56. Hence, analyzing the political environment should not necessarily be limited to a firm's host country.

Several classes of economic forces tend to have broad effects on industries. Four of them are discussed next.

Gross Domestic Product

GDP refers to the value of a nation's annual total production of goods and services. GDP is a key area of concern for all firms but can become quite complex for those heavily involved in global markets. Although there are clear relationships among the world's economies, they do not always rise and fall together. For example, while GDP levels in the West were stagnant during the late 1990s and early 2000s, China's GDP grew at a staggering pace and provided expansion opportunities for a number of Western firms. China continued to grow during the

global recession in the late 2000s and early 2010s as well.57.

Consistent GDP growth generally produces a healthy economy fueled by increases in consumer spending. In contrast, however, a GDP decline signals lower consumer spending and decreased demand for goods and services. When GDP declines for two consecutive quarters, a nation's economy is generally considered to be in a recession, during which time competitive pressures can lower profits and increase business failure rates. Consumers respond to a recession by spending less. When a recession hit in the 2000s, revenues declined at restaurants such as Olive Garden, Red Lobster, Chili's, and Applebee's, while

fast-food chains like McDonald's and Burger King fared well.58. In Europe, consumers began

to eat out less and became more price-conscious in their visits to grocery stores.59.

Firms typically respond to economic downturns by cutting costs. Although Gordon Trucking typically replaces 20% of its 1,500 big rigs with new trucks each year, the company decided in

2008 to forgo purchases in 2009.60. Facing fewer passengers and rising fuel prices, airlines

began washing their engines more frequently to save fuel.61. Many, such as JetBlue and

Delta Air Lines, canceled and deferred orders for new planes.62. Because cost-cutting at one firm translates into lost revenues for another, a ripple effect is felt across the entire

economy.63.

After expanding stores in the early 2000s, many mall retailers suffered losses during the 2008 to 2010 recession. Sales per square foot in the United States peaked at $454 in 2007 and had declined to $401 by 2009. To cope, Gap, the largest retailer in the United States, responded by reducing the size of many of its stores from about 18,000 square feet to the 8,000 to 12,000 range. Long-term leases complicated the move, and Gap executives acknowledged that the shopping experience often declines in a smaller store. Nonetheless, economy reality

triggered the move.64.

Not all firms responded to the recession by pulling back, however. Volkswagen's Audi unit invested heavily in the United States in 2009, a down year for the automobile industry,

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increasing marketing expenditures by 20%. Audi's U.S. sales tracked industry trends and

declined that year, but its share of the American luxury car market grew from 6.9% to 8.3%.65.

Recessions do not threaten all industries equally. College and university enrollments often increase as undergraduate and graduate students seek to gain an advantage in a tight job

market.66. Likewise, dollar stores—those that price all products at $1—typically perform

especially well during times of economic downturn.67. The converse is also true, however. After an extended growth surge, sales at dollar stores in the U.S. leveled off in the mid-2000s after the economy rebounded from a recession. Some analysts at the time suggested that the industry had matured and retailers like Family Dollar, Dollar Tree, Dollar General, and Fred's

could no longer anticipate increased earnings from sales growth.68.

With dim prospects for rapid growth in the United States, some dollar stores began to move abroad in the mid-2000s. California-based My Dollar Store operates only about 50 stores in the United States and holds only a minuscule share of the market. It has expanded aggressively outside of the United States, however, and operates about 200 stores in Central America, Eastern Europe, and Southeast Asia where it faces less competition. My Dollar Store beat Wal-Mart to India, where it sells products for 99 Indian rupees—about $2—and targets

middle-class consumers.69. Some of these discounters have not performed as well as expected in India, however, as the expected retail boom never materialized, and activity was

thwarted by a global recession in the late 2000s.70. However, the recession bode well for dollar stores and other discount retailers back in the United States as consumers began to

trade down to less expensive merchandise.71. While most mall-based retailers reported profit declines and losses, many discounters like Dollar Tree, Big Lots, and Wal-Mart performed relatively well.

A recession can have long-term effects for an industry. The economic downturn that started in 2008 took a heavy toll on U.S. wineries that sold wine for $20 or more per bottle. Consumers traded down in this industry as well, a shift that benefited producers of wine in the $9 to $12 category. Sales in the $20 category improved as the recession began to abate in 2010 and 2011, but the lower-priced category grew faster as many consumers decided to stay with

cheaper wines.72.

The effect of an economic downturn on an industry can be complex, however. In the early months of the recession, chain pawnshops such as Cash America and EZCorp performed well. Share prices of First Cash Financial Services even doubled in one 7-week period in 2008. But these pawnshops do more than make collateral-based loans. All three make short- term, high-fee cash advances called payday loans. Fees from these loans accounted for a high percentage of revenues—more than half in the case of Cash America in 2007. A recession typically increases the default rate on such loans, creating greater risk for the

firms.73. In this instance, the recession created both opportunities and threats in the same

industry.74.

Unfortunately, it is difficult to forecast a recession in advance, and many are identified as such only after they have “bottomed out.”

Inflation Rates

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High inflation rates have a negative effect on most but not all businesses. High rates raise many of the costs of doing business, and continued inflation constricts the expansion plans of businesses and triggers governmental action designed to slow economic growth. The U.S. Federal Reserve often raises its discount rate during inflationary periods to slow economic growth and cuts it during recessions to spur activity. Its counterparts in other developed nations typically follow suit and in some cases precede Fed action.

Inflation concentrated in certain sectors can create significant challenges for specific firms and industries, as seen in the soft drink and snack food industries in the early 2010s. Although price increases across the board were modest at that time, costs associated with industry production—aluminum for cans, corn for snacks, corn syrup for drinks, and crude oil for plants and delivery trucks—had risen at a much faster pace. Unfortunately for companies like PepsiCo and Coca-Cola, the sluggish economy during this time made it very difficult to pass

these higher costs along to consumers in the form of higher prices.75.

Like high interest rates, periods of inflation can present opportunities for some firms. For instance, oil companies may benefit during inflationary times if the prices of oil and gas rise faster than the costs of exploration, refinement, and transportation. Companies that mine or sell precious metals may also benefit during periods of inflation because such metals serve as

inflation hedges for consumers.76.

Interest Rates

Short- and long-term interest rates affect the demand for many products and services, especially “big ticket” items whose costs are financed over an extended period of time, such as automobiles, appliances, and even major home renovations or repairs. At the consumer level, low short-term interest rates, for instance, are particularly beneficial for retailers such as Wal-Mart and J.C. Penney because they also tend to lower rates on credit cards, thereby encouraging consumer spending. At the corporate level, interest rates also influence strategic decisions related to financing. High rates, for instance, tend to dampen business plans to raise funds to expand or to replace aging facilities. Lower rates, however, are more likely to spawn capital expenditures on expansion and development.

An economic slowdown can have mixed effects on a particular industry through its effect on interest rates. During a recession, for example, new car retailers tend to have a difficult time attracting prospective customers to their showrooms. However, slowdowns are often accompanied by central bank interest rate cuts, which in turn reduce both interest rates for consumers and bank costs dealers must incur to finance their inventories. Hence, one needs to consider the composite impact that an economic factor may have on an industry, not only the single effect that may be most intuitive.

Interest rates are typically linked to inflation rates. The cost of borrowing can be high in developing countries with annual interest rates sometimes exceeding 100%. These high interest rates are often accompanied and influenced by excessive rates of inflation, as was the case in parts of Latin America in the 1990s. In small nations such as Bolivia, annual inflation has been as high as 26,000%. Even in the industrialized nation of Brazil, annual inflation

averaged 446% between 1980 and 2010.77. Routine decisions such as pricing and setting costs become almost impossible to make when rates are extraordinarily high. In addition, high inflation rates cause the prices of goods and services to rise and become less competitive in international trade.

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Exchange Rates

Currency exchange rates can be influenced by international agreements, the coordinated economic policies of governments, and international economic conditions. When such conditions raise the value of the dollar, for example, U.S. firms find themselves at a competitive disadvantage internationally—at least in the intermediate term—as the prices of American-made goods rise in foreign markets. At the same time, American consumers may be inclined to purchase products that were produced abroad, which are less expensive than goods produced domestically.

When the dollar is strong, American manufacturers tend to locate more of their plants abroad and make purchases from foreign sources. However, when the dollar weakens as it did during much of the 2000s and early 2010s, the financial incentive for American companies to purchase from foreign sources becomes more limited, and they tend to focus their activities more on the domestic markets. When the dollar weakened relative to the euro in early 2008, some Europeans even traveled to the United States to purchase a European car and ship it

back home.78. One U.S. dollar was worth over 120 Japanese yen in 2007 but less than 80 yen in 2012, a drop that negatively affected profits at Toyota and other Japan-based

carmakers.79. This precipitous decline in the dollar relative to the yen undermined the price competitiveness of Japanese autos, resulting in corresponding declines in U.S. market share

for both Honda and Toyota from 2008 to 2011.80.

When the U.S. dollar declined in value to the yen, the euro, and other world currencies in 2011, production costs for U.S. production firms operating in India, Mexico, and elsewhere became more expensive, and many contemplated a return to the United States. When rising wage rates abroad and tax incentives back home were also considered, firms like Caterpillar and General Electric began to announce plans to shift some existing production abroad back

home as well.81.

The exchange rate between the U.S. dollar and the Chinese yuan has been a key concern. China's central bank fixes the exchange value of its currency in part to the dollar, a policy that has facilitated a relatively strong dollar and cheap Chinese goods for U.S. consumers. A number of economists have encouraged China to allow its currency to float freely, a policy

that would strengthen the yuan and reduce China's trade surplus with the United States.82.

Currency exchange rates present challenges because of their dramatic and often unpredictable changes over time. For instance, the Mexican peso has been historically devalued relative to the world's major currencies once or twice every decade, reducing the profits of U.S. firms operating there. In 2010, when Hugo Chavez devalued the Venezuelan bolivar, it had a similar effect. These rampant fluctuations began to subside in the late 1990s and early 2000s, but the future remains uncertain.

Ecological Influences

The term ecology r e f e r s t o r e l a t i o n s h i p s b e t w e e n h u m a n s a n d t h e i r s u r r o u n d i n g environment, including other living creatures, plants, air, and water. Ecological influences include shifts in the natural environment that can influence business activity. Because organizations use natural resources in their production activities, the interdependence between firms and the environment is substantial. This is especially true in industries such as

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automobile production, where ecological ramifications include the production of steel and car batteries, the consumption of oil, and even the disposal of cars that are no longer operational.

Major ecological shifts—particularly natural disasters—can have substantial positive and negative economic effects, particularly in certain industries. In 2010, for example, farmers in the United States benefited from food shortages created by droughts in Russia and Eastern

Europe.83.

A prominent ecological concern for many industries—particularly those involved in heavy manufacturing—is the ongoing debate over anthropogenic (man-induced) climate change. Proponents contend that carbon dioxide produced by human activity is the impetus for substantial changes in global climate patterns. If unchecked, these changes will influence life on earth in dramatic ways. Because firms emit a significant amount of carbon dioxide into the atmosphere, they must voluntarily reduce their carbon footprint by modifying their production processes or governments should require them to do so (involuntarily).

Critics of the anthropogenic climate change hypothesis question the causal link between carbon dioxide in the atmosphere and global temperatures. While the two appear to be positively correlated—to the extent that average global temperatures can be measured and computed accurately—shifts in temperature appear to precede changes in carbon dioxide levels, not the other way around. They also note the inconsistency of recent scientific declarations. In the June 24, 1974, issue of Time magazine, a number of scientists warned of a coming ice age and speculated that a period of global cooling since 1945 could be attributed to increased manufacturing activity since World War II. When temperatures began to rise, however, many scientists in the 1990s and 2000s warned of impending global warming, also linking it to human activity and carbon emissions. Global temperatures appear to have been cooling in the late 2000s and early 2010s, however, prompting a change in

nomenclature to the more all-inclusive term climate change.84. Hence, critics emphasize that additional research is required before man's activity can be inexorably linked to significantly and adverse climate change.

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1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

Although this debate is complex and beyond the scope of this text, the economic considerations can be quite substantial. Moreover, ecological forces like climate change are often intertwined with political-legal forces as well because governments frequently attempt to manage economic development or address ecological concerns with various policies. For example, a number of plans have been proposed to tax carbon emissions, require firms to buy and sell carbon permits in order to engage in production, or restrict certain manufacturing activity altogether. While the ecological impact of such measures is open to debate, the economic ramifications of such measures would be significant, especially in manufacturing industries (see Case Analysis 3.2).

Step 6: What Economic Forces Affect the Industry?

Some key issues include (but are not limited to) the following:

GDP

Disposable personal income

Short-and long-term interest rates

Inflation

Exchange rates

Unemployment rate

Energy costs

Stage of the economic cycle

Monetary policy

Environmental disasters

As with other macroenvironmental forces, it is important to arify specifically how various economic forces influence the industry.

Summary

Four forces in the external environment affect every industry: political-legal, economic, social, and technological (PEST). Political-legal forces include various forms of legislation and judicial rulings, such as the decisions of various commissions and agencies at all levels of government. Economic forces include the effects of elements such as GDP, inflation, interest rates, and exchange rates. Regulatory changes have had dramatic effects on a number of industries. The recession of the late 2000s and early 2010s had also created a number of challenges, although some industries have benefited from the downturn. The other two components of PEST—social and technological forces—are discussed in the next chapter.

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Key Terms

Anthropogenic Climate Change: T h e n o t i o n t h a t h u m a n a c t i v i t y ( e . g . , h e a v y manufacturing) has a substantial effect on global weather patterns.

1.

2. 3.

4.

A. B.

manufacturing) has a substantial effect on global weather patterns. Ecology: Relationships between humans and their surrounding environment, including other living creatures, plants, air, and water. Gross Domestic Product (GDP): The value of a nation's annual total production of goods and services. Macroenvironment: The general environment that affects all business firms in an industry, which includes political-legal, economic, social, and technological forces. PEST: An acronym referring to the analysis of the four macroenvironmental forces: (1) political-legal, (2) economic, (3) social, and (4) technological. Recession: A decline in a nation's GDP for two or more consecutive quarters.

Review Questions and Exercises

Explain how changes in interest rates affect the automobile, home construction, and auto repair industries. How has government regulation affected the agriculture and banking industries? Using your college or university as an example, explain how political-legal and economic forces have affected its operations over the past decade. Select an industry with which you are at least somewhat familiar. Utilize the search e n g i n e s a t www.findarticles.com a n d i d e n t i f y s o m e o f t h e i m p o r t a n t macroenvironmental influences faced by competitors in the industry.

Practice Quiz

True or False?

1. It is unusual for a single firm to influence a macroenvironmental force. 2. Government regulations in the United States have declined consistently since the mid- 2000s. 3. Some firms favor specific regulations because they erect barriers to newcomers in the industry. 4. The Collective Trade Assessment (CTA) has worked toward greater freedom in trade across nations. 5. A decline in GDP negatively affects all industries. 6. When the dollar is weak, American manufacturers often open new production facilities abroad and increase purchases from foreign sources.

Multiple Choice

7.

The acronym referring to the analysis of forces in the external environment is__________.

WASP PEST

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C. D.

A. B. C. D.

A. B. C. D.

A. B. C. D.

A. B. C.

D.

A. B. C. D.

STOP SERCH

8.

In this stage of analysis, macroenvironmental forces should be applied to__________.

the firm the industry all industries multiple firms

9.

Increased government regulation__________.

is universally opposed by firms is necessary to promote free trade is all of the above is none of the above

10.

At the global level, the period from World War II to the late 1980s was marked by__________.

an increase in trade protection a decrease in trade protection an absence of U.S. imports none of the above

11.

When the value of the U.S. dollar increases, U.S. firms__________.

compete at an advantage in foreign markets compete at a disadvantage in foreign markets tend to decrease exports to nations whose currencies are directly tied to the

dollar none of the above

12.

A decline in a nation's GDP for two or more consecutive quarters is known as__________.

a depression a recession economic stagnation none of the above

Student Study Site

Visit the student study site at www.sagepub.com/parnell4e to access these additional materials:

Answers to Chapter 3 practice quiz questions Web quizzes

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SAGE journal articles Web resources eFlashcards

Notes

1. J. Cummings, “Wal-Mart Opens for Business in a Tough Market,” Wall Street Journal, March 24, 2004, A1, A15.

2. B. Mullins and A. Zimmerman, “Target Discovers Downside to Political Contributions,” Wall Street Journal, August 7–8, 2010, A2.

3. J. Hechinger and D. Armstrong, “Massachusetts Seeks to Mandate Health Coverage,” Wall Street Journal, April 5, 2006, A1, A15.

4. J. Bravin, “Court Rulings Could Hit Utilities, Auto Makers,” Wall Street Journal, April 3, 2007, A1, A9.

5. D. E. Needleman, “New Lead-Paint Law Heavy on Budgets,” Wall Street Journal, May 18, 2010, B5.

6. J. Millman and D. Crowe, “Chavez Takeover Pledge Buffets Cement Makers,” Wall Street Journal, April 5, 2008, A1.

7. M. Moffett, “Taxes Put Chill on Electronics,” Wall Street Journal, February 27, 2012, B1, B9; M. Moffett and T. Turner, “Argentina to Seize Control of Oil Firm,” Wall Street Journal, April 17, 2012, B1.

8. S. Power, “New Rollover Test Could Lead to Safer SUVs,” Wall Street Journal, October 8, 2003, D1, D7.

9. L. Meckler and K. Lundegaard, “New Fuel-Economy Rules Help the Biggest Truck Makers,” Wall Street Journal, August 24, 2005, B1, B2.

10. M. Tennant, “Obama's Automobile Standards Could Drive Industry Over a Cliff,” New American, September 23, 2011, http://thenewamerican.com/economy/sectors-mainmenu- 46/9100-obamas-automobile-standards-could-drive-industry-over-a-cliff (accessed November 21, 2011).

11. M. Jordan, “A CEO's Demand: Fix Immigration,” Wall Street Journal, December 19, 2011, B1, B8.

12. C. Cummins, “Business Mobilizes for Iraq,” Wall Street Journal, March 24, 2003, B1, B3; J. A. Trachtenberg and B. Steinberg, “Plan B for Marketers,” Wall Street Journal, March 20, 2003, B1, B3; N. King Jr., “The Race to Rebuild Iraq,” Wall Street Journal, April 11, 2003, B1, B3.

13. D. Sevastopulo, “US Airlines ‘Are On Life Support’,” Financial Times, October 2, 2003, 15.

14. D. Roberts and J. Mackintosh, “Ford Chief Backs Higher Fuel Tax,” Financial Times, April 8, 2004, 1, 24.

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15. A. P. Kellogg and J. Mitchell, “Clunker Rebates Stir Car Buyers,” Wall Street Journal, July 28, 2009, B2.

16. A detailed discussion of the unintended consequences of business regulations is presented in Henry Hazlitt's classic, Economics in One Lesson, originally published in 1946 and reprinted with more recent statistics by Laissez Faire Books (Baltimore) in 2008.

17. J. Pereira, “Retailers Brace for Weak School Shopping,” Wall Street Journal, August 7, 2009, B1.

18. A. Higgins, “It's a Mad, Mad, Mad-Cow World,” Wall Street Journal, March 12, 2001, A13– A14.

19. S. Gray, “Pressure Mounts on Fast-Food Chains to Remove Trans Fats,” Wall Street Journal, December 14, 2004, D1, D6.

20. S. Ellison, “Despite Big Health Concerns, Food Industry Can't Shake Salt,” Wall Street Journal, February 25, 2005, A1.

21. J. Zhang and S. Gray, “The Whole Truth About ‘Whole Grain’,” Wall Street Journal, February 16, 2006, D1, D8.

22. T. Aeppel, “Candle Maker Feels Burned,” Wall Street Journal, May 5, 2011, B1–B2.

23. E. Williamson, “Political Pendulum Swings Toward Stricter Regulation,” Wall Street Journal, March 24, 2008, A1.

24. M. Bustillo and S. Woo, “Retailers Push Amazon on Taxes,” Wall Street Journal, March 17, 2011, B11.

25. S. Woo, “Amazon Battles States Over Sales Tax,” Wall Street Journal, August 3, 2011, A1, A10.

26. W. O'Connell, “From the Ashes of Defeat,” Wall Street Journal, August 21, 2006, B1, B4.

27. J. Zhang, “Food-Safety Measures Faulted,” Wall Street Journal, June 12, 2008, A4.

28. J. Singer-Vine, “Study Supports Health Benefits of Smoking Ban,” Wall Street Journal, July 31, 2008, D1.

29. G. Farrell and H. Weitzman, “McDonald's Chief Attacks Children's Meal ‘Food Police,’” Financial Times, December 14, 2010, 18, 20; G. Farrell, “McDonald's Sued Over Toys With Meals,” Financial Times, December 16, 2010, 20.

30. J. C. Dooren, “FDA Issues Tougher Rules for Sunscreen Labeling,” Wall Street Journal, June 15, 2011, D1–D2.

31. A. Zimmerman and K. Maher, “Wal-Mart Warns of Democratic Win,” Wall Street Journal, August 1, 2008, A1.

32. A. Zimmerman and T. W. Martin, “Wal-Mart Tried to Unmask Foes,” Wall Street Journal, September 23, 2010, B1, B2.

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33. J. O'Donnell, “Do We Need to Regulate Drivers' Distractions?” USA Today, April 30, 2012, B1, B2.

34. J. R. Hagerty and J. R. Wilke, “Realtors Agree to Open Listings to Online Discounters,” Wall Street Journal, May 28, 2008, B1.

35. E. Maltby, “The ‘Swipe Fee’ Conundrum,” Wall Street Journal, July 19, 2012, B1, B8.

36. International Monetary Fund, International Financial Statistics Yearbook (Washington, DC: Author, 1989).

37. C. Rapoport, “Europe Looks Ahead to Hard Choices,” Fortune, December 14, 1992, 145.

38. F. M. E. Raiszadeh, M. M. Helms, and M. C. Varner, “How Can Eastern Europe Help American Manufacturers?” The International Executive 35 (1993): 357–365.

39. D. Maylie, “By Foot, by Bike, by Taxi, Nestle Expands in Africa,” Wall Street Journal, December 1, 2011, B1, B16.

40. S. Gray and G. A. Fowler, “China's New Entrepreneurs,” Wall Street Journal, January 25, 2005, B1, B4.

41. K. J. Delaney and C. Goldsmith, “Music Industry Targets Piracy By Europeans,” Wall Street Journal, January 20, 2004, B1, B2.

42. J. T. Areddy, “In China, Fight Over Tire Secrets,” Wall Street Journal, May 4, 2011, B1–B2.

43. S. Oster and G. Fairclough, “China May Delay on Emissions,” Wall Street Journal, June 21, 2007, A10.

44. C. Conkey and N. Zamiska, “China to Ban Lead Paint in Toys,” Wall Street Journal, September 12, 2007, B5.

45. N. Zamiska, “U.S. Opens the Door to Chinese Pills,” Wall Street Journal, October 9, 2007, B1.

46. P. Whoriskey, “GM Sales in China Surge 67 Percent in 2009,” Washington Post, January 5, 2010, www.washingtonpost.com/wp-dyn/content/article/2010/01/04/AR2010010403160.html (accessed November 21, 2011); J. Dean and K. J. Delaney, “As Google Pushes Into China, It Faces Clashes With Censors,” Wall Street Journal, December 16, 2005, A1, A12.

47. G. Farclough and S. Oster, “As China's Auto Market Booms, Leaders Clash Over Heavy Toll,” Wall Street Journal, June 13, 2006, A1, A14.

48. B. Davis, J. Lyons, and A. Batson, “Globalization Gains Come With a Price,” Wall Street Journal, May 24, 2007, A1.

49. B. Davis, D. Paletta, and R. Smith, “Amid Turmoil, U.S. Turns Away From Decades of Deregulation,” Wall Street Journal, July 25, 2008, A1.

50. D. Pilling, “Will China's Coke Moment Spark Retaliation? Financial Times, March 26, 2009, 11

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51. D. Henninger, “Whatever Happened to 9/11? Wall Street Journal, September 8, 2011, http://online.wsj.com/article/SB10001424053111904836104576556670982083348.html (accessed August 20, 2012).

52. D. Michaels and M. Trottman, “Fuel May Propel Airline Shakeout,” Wall Street Journal, September 7, 2005, C1, C5; A. Johnson, “Low-Cost Airlines Raise Fares,” Wall Street Journal, April 25, 2006, D1, D3.

53. T. W. Martin, “Airline Net Hits a Downdraft,” Wall Street Journal, April 20, 2011, B4; S. Carey, “Airline Profits Slip as Fuel Costs Rise,” Wall Street Journal, July 22, 2011, B3.

54. J. Bennett and M. Ramsey, “Shrinking Supplies Mean Bye-Bye Used-Car Bargain,” Wall Street Journal, May 9, 2011, B1.

55. P. Ziabro, “Fast-Food Joints Push Chicken as Beef Prices Hit New Highs,” Wall Street Journal, May 20, 2010, B1.

56. C. Binkley and N. Wingfield, “Trouble in Toyland,” Wall Street Journal, November 20, 2006, B1, B2.

57. M. Wolf, “Why Europe Was the Past, the US is the Present and a China-Dominated Asia the Future of the Global Economy,” Financial Times, September 22, 2003, 13.

58. J. Adamy, “Olive Garden's Parent Warns on Profit,” Wall Street Journal, August 27, 2008, B1.

59. C. Passariello, A. O. Patrick, and M. Colchester, “Europe Eats on the Cheap,” Wall Street Journal, September 30, 2008, B1.

60. C. Dade and A. Roth, “Freight Haulers Slam on the Brakes,” Wall Street Journal, December 11, 2008, A1.

61. J. L. Lunsford, “Airlines Dip Into Hot Water to Save Fuel,” Wall Street Journal, June 11, 2008, http://online.wsj.com/article/SB121313631087762243.html (accessed August 20, 2012).

62. J. L. Lunsford and S. Carey, “Oil Surge May Cost Jet Makers Orders,” Wall Street Journal, June 25, 2008, B1.

63. G. Fairclough, “Wal-Mart Sneezes, China Catches Cold,” Wall Street Journal, May 29, 2007, http://online.wsj.com/article/SB118040251770416752-search.html (accessed August 20, 2012); J. Jargon and C. Rohwedder, “Grocers Find Food Prices Hard to Swallow,” Wall Street Journal, October 20, 2008, B1.

64. E. Holmes, “Sizing Up Property, Mall Stores Try to Shrink,” Wall Street Journal, March 19, 2010, B1– B2.

65. V. Fuhrmans, “Volkswagen's Audi Redoubles Effort to Boost U.S. Market Share,” Wall Street Journal, November 25, 2009, B1, B2.

66. J. E. Hilsenrath, “America's Pricing Paradox,” Wall Street Journal, May 16, 2003, B1, B4.

67. C. Terhune, “In Modest Times, ‘Dollar’ Stores Remain Upbeat,” Wall Street Journal,

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December 22, 2000, B1.

68. K. Hudson, “Can the Dollar Stores Rebound?” Wall Street Journal, September 21, 2005, C1, C4.

69. E. Bellman, “A Dollar Store's Rich Allure in India,” Wall Street Journal, January 23, 2007, B1, B14.

70. E. Bellman, “Retailers Take a Slower Road in India,” Wall Street Journal, August 26, 2008, B1.

71. A. Cheng, “Results for Retailers Remain a Tale of Contrasts,” Wall Street Journal, August 27, 2008, B4; G. McWilliams, “U.S. Consumers Trade Down as Economic Angst Grows,” Wall Street Journal, July 11, 2008, A1.

72. D. Kesmodel, “Snooty? Not Today's Wine Drinkers,” Wall Street Journal, January 20, 2011, B1.

73. L. Eaton, “Suddenly, Pawn Shops Slip,” Wall Street Journal, May 12, 2008, C10.

74. N. Harris, “Unemployed Dot-Commers Face Tough Job Market,” Wall Street Journal, January 30, 2001, B1.

75. V. Bauerlein and P. Ziobro, “Pepsi Defends Strategy,” Wall Street Journal, February 11, 2011, B1.

76. P. Wright, M. Kroll, and J. A. Parnell, Strategic Management: Concepts (Upper Saddle River, NJ: Prentice Hall, 1998).

77. TradingEconomics.com, “Brazil Inflation Rate,” www.tradingeconomics.com/brazil/inflation- cpi (accessed November 11, 2011); C. S. Manegold and M. Kepp, “Elegant Armed Robbery,” Newsweek, April 2, 1990, 30.

78. E. Taylor, “Europeans Go to U.S. Dealers to Buy Cars From Home,” Wall Street Journal, June 21, 2008, B1.

79. J. Soble, “Toyota Fears Dollar Decline Will Hit Figures,” Financial Times, August 5, 2010, 14

80. M. Ramsey and Y. Takahashi, “Car Wreck: Honda and Toyota,” Wall Street Journal, November 1, 2011, B1, B7.

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84. C. C. Horner, The Politically Incorrect Guide to Global Warming and Environmentalism (Washington, DC: Regnery, 2007).

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Strategy + Business Reading: Competing for the Global Middle Class

Three types of companies are jockeying for position in emerging economies, seeking to capture the loyalty of billions of new consumers.

by Edward Tse, Bill Russo, and Ronald Haddock

In the 1920s, when Alfred P. Sloan Jr. reorganized General Motors Company, he promised shareholders “a car for every purse and purpose.” Sloan tapped into a teeming middle-class market of Americans who couldn't afford luxury cars, but nonetheless wanted product options far beyond the “any color so long as it's black” Model T Ford. This immense U.S. middle-class cohort propelled GM past Ford into a leadership position among carmakers that lasted for the rest of the century.

Today, leaders of multinational corporations have a similarly lucrative opportunity on a much bigger playing field: a global middle-class market. This worldwide economic phenomenon encompasses a huge customer base. In 2011, it includes about 400 million people in the mature middle classes of the U.S., Europe, and Japan, and another 300 to 500 million people, depending on how the middle class is defined, in emerging economies. (The World Bank defines middle class as people who are above the median poverty line of their own countries. This might make them poor by the standards of Europe or the U.S., but gives them enough purchasing power to become consumers of manufactured goods and services.) This new global middle class is particularly evident in Brazil, China, India, Indonesia, Mexico, Nigeria, Turkey, Vietnam, and other countries with relatively large working populations and rapid economic growth rates.

The middle class in each of these emerging economies has its own unique profile of demand. However, they all have one thing in common: They are recovering from the global recession with an increasingly urbanized lifestyle, and their numbers are expanding at very high rates, especially compared with the rest of the world. The value chain of companies that provide this population with goods, services, and infrastructure is becoming known as the “global middle market.” Companies that secure leading positions within that market could well become the 21st-century equivalents of Alfred Sloan's General Motors.

One such company may be China's Haier Group. In 1985, Haier was a bankrupt domestic refrigerator manufacturer. Product quality was so bad that general manager Zhang Ruimin (now chairman and CEO) built his case for change by lining up 76 defective units and ordering workers to destroy them with sledgehammers. Today, one of the sledgehammers is on display in corporate headquarters, and Haier is one of the world's largest appliance makers—a multinational corporation with a reputation for world-class quality and 2010 revenues approaching US$20 billion.

Zhang put in place three successive strategic initiatives, aimed, respectively, at improving product quality, expanding globally, and diversifying the company's product line: for example, offering washers at a range of price points for consumers in different income segments, just as GM did with its cars early in the 20th century. Then, in December 2005, Zhang announced a new thrust. Haier would stop shipping products

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1.

2.

3.

from China to the rest of the world; instead, it would design and manufacture products elsewhere, customizing them for specific national and regional markets. Today, Haier produces extra-large-capacity washers that can accommodate the robes of Middle East consumers; electronically sophisticated washers that can cope with the frequent power fluctuations in India; whisper-quiet, timer-equipped washers for Italians who want to take advantage of the lower power rates available late at night; and other locally targeted variants.

Haier is not the only company that has transformed itself to seek a share of the global middle-class market. In a variety of industries—including consumer packaged goods, electronics, automobiles, medical products, and agricultural equipment—corporate leaders are discovering that they must rethink their product and service lines, go-to- market strategies, and operating models to build a presence in emerging economies.

Momentum in the Middle

The first step toward becoming a leading company for the global middle market is recognizing the pace of development in the countries where you hope to do business. All industrializing countries follow an “arc of growth”: an evolutionary path of economic change. They start as nascent economies (emerging from subsistence, with large numbers of young people). They gradually evolve into mature economies, with relatively flat growth and large numbers of aging people. In between, there is a critical stage of urbanization and economic momentum. During this “momentum phase,” many countries have large, relatively young populations and high economic growth rates. These countries are the seedbed of the emerging middle-class markets. Three types of corporate players are jockeying for position in these markets:

Local upstarts are companies that have traditionally provided low-priced goods for bottom-of-the-pyramid customers in their home markets. They are migrating upward into their domestic middle markets as their customers become more prosperous. These companies now provide products and services with more features, better quality, and increased brand status. Global aspirants are local companies that have already developed products for their domestic middle markets. Now, they seek to expand their geographic reach and power, parlaying their existing capabilities and knowledge into serving the global middle class. Multinational incumbents are mature global companies, often from Japan, Europe, and the United States. They are intent on adapting their existing product lines to capture the attractive growth opportunities in emerging middle markets.

You can see all three types of competitors in most sectors in countries that are in the momentum phase. For example, in China's automobile sector, local upstarts are represented by players that have traditionally made low-cost cars, such as Chery Automobile Company, Great Wall Motor Company, and Geely Automobile Holdings. They are moving up the product pyramid. In 2010, Geely purchased the Swedish carmaker Volvo from Ford at the bargain- basement price of $1.8 billion and immediately raised production plans to 300,000 Volvos annually, almost double the previous worldwide production.

Global aspirants in China's middle market include South Korea's Hyundai Motor Company. Hyundai entered China in 2002 and has since achieved remarkable success in the middle market with a major redesign of its Elantra model.

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Among the multinational incumbents are long-established automakers aggressively seeking to carve out significant shares of China's middle market. These include GM, with its Chevrolet Spark and Buick Excelle, and Volkswagen, with its Polo and Golf models. All of these multinationals pursue this market through joint ventures with Chinese partners. For example, the Guangzhou Automobile Group makes Honda-branded cars for the middle-class market. The Shanghai Automotive Industry Corporation launched the Lavida with Volkswagen and is working with GM on a new-generation small car called the Baojun (Chinese for “treasured horse”).

Incumbent automakers such as Honda, Volkswagen, and GM aren't simply exporting cars from their home countries to China. Since 2005, they have been modifying and restyling their vehicles to better align them with the needs and tastes of Chinese consumers. For example, Volkswagen installs smaller engines in some vehicles, such as the Polo GTI and the Golf 6. Such changes enable incumbents to offer two types of vehicles. They make low-priced cars for entry-level Chinese consumers who prioritize cost and value, and cars with added features for more affluent mid-market consumers who can pay for the quality and brand status associated with foreign cars. One sign of the value of the Chinese auto market to incumbents is GM's sales there, which exceeded its U.S. sales in 2010—the first time sales in another national market eclipsed U.S. sales in the company's 102-year history.

The same three types of competitors—local upstarts, global aspirants, and multinational incumbents—are active in China's construction equipment market, probably the most vibrant construction equipment market in the world right now. Local upstarts such as Zoomlion and Longking have been moving into the domestic middle-class market in China. Some, like the LiuGong Machinery Corporation and Sany Heavy Industry, have become global aspirants. In 2008, LiuGong opened a factory in India. In 2009, Sany announced it would invest € 100 million ($144 million) in an R&D and manufacturing center in Germany; it also has major plants under construction in the U.S. and Brazil.

Incumbent construction equipment makers, such as South Korea's Doosan Infracore, Japan's Komatsu, and U.S.-based Caterpillar, are aggressively targeting the Chinese middle market as well. Caterpillar's stated goal is to become the top brand in its sector in China by 2015. In the 1990s, the company was focused on developing government relationships to facilitate sales of its existing product lines. But as the middle market heated up, Caterpillar found its market share squeezed by Japanese and Korean competitors and rising local players. In the late 2000s, Caterpillar's leaders recognized that the company's traditional product line and business model were not adequate for China. It lowered its cost base through the establishment of local R&D centers and through the acquisition of Shandong Engineering Machinery, a leading Chinese wheel loader manufacturer.

Just as countries evolve over time, so do companies. Many of today's local upstarts will be global aspirants tomorrow; today's global aspirants often become multinational incumbents. The differences among them appear primarily in the way they choose to compete, and in the level of resources that they use to enter a market. The more intelligent they are about their approach, the more likely they are to move to the next level. Unfortunately for the incumbents, local companies are increasingly intelligent about the way they make the transition, using joint ventures or regional expansion to gain the experience they need to compete on a larger scale.

A More Complex Market

The world is far from homogeneous. The buying power, needs, and desires of the middle

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classes vary by nation and region. In developing nations, for example, middle-market customers are seeking products that have some of the premium features and quality that customers in developed nations are used to, but at lower price points. Furthermore, customers in each geographic market are drawn to buy products that fulfill local needs and desires. As Pankaj Ghemawat, professor of global strategy at IESE Business School, notes in World 3.0: Global Prosperity and How to Achieve It (Harvard Business Press, 2011), there are

numerous casual examples of cultural difference [in consumer products]. … The Czechs drink way more beer than people in Saudi Arabia, and even more than the Irish, who come in second. Pakistanis google sex more often than any other national population, just slightly more than the Vietnamese and far more than the Irish and Czechs. Eritreans google god the most as well as figuring in the top five nationalities searching for sex. India and China are so close geographically that they still haven't resolved their territorial disputes, but couldn't display more distinct food cultures, particularly around which animals and parts of animals should or shouldn't be eaten. Argentines see psychotherapists more than other nationalities, and Brazilians spend a higher proportion of their income on beauty products than the citizens of any other major economy.

To successfully serve middle-market customers, companies must identify which product attributes the customers in a specific market value and don't value. Then, they must either add those attributes to or cull them from their existing products. Ghemawat uses the e x a m p l e s o f M c D o n a l d ' s , K F C , a n d C o c a - C o l a , a l l o f w h i c h v a r y t h e i r p r o d u c t s geographically: Coke, for instance, uses cane sugar as sweetener in some countries and corn syrup in others. This type of variation adds complexity across product and marketing mixes, and in all the operations and functions related to them. It can require much extra expense and attention from companies, especially those with heavily centralized, scale-driven business models.

But companies that seek leadership positions in their industries may have little choice but to p u r s u e t h e g l o b a l m i d d l e m a r k e t . T h e d e v e l o p e d m i d d l e m a r k e t s a r e a h u g e a n d indispensable source of sales volume, and market share can decline precipitously as local upstarts or global aspirants redouble their efforts. In most of these markets, competition is already intense: Companies track their market share gains and losses in tiny increments—a point or even a fraction of a point at a time. In addition, most developed middle markets are driven more by the rise and fall of macroeconomic cycles than by underlying fundamentals, such as an unusually fast-growing customer base. This means that during the stable parts of the cycle, the gains that new players make will come out of the pockets of incumbents.

The global middle market is also spawning game-changing new products that can migrate to and eventually threaten the status quo in developed markets. Tuck School of Business at Dartmouth College professors Vijay Govindarajan and Chris Trimble have coined the phrase reverse innovation to describe the process by which products designed for developing economies become hits in developed economies because they fill undiscovered needs and desires of customers in those nations. (See “How to Be a Truly Global Company,” by C. K. Prahalad and Hrishi Bhattacharyya, s+b, Autumn 2011.)

Myths and Realities

Because the case for pursuing the global middle market is compelling, and the complexities are daunting, it is understandable that many senior executives at major consumer and

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industrial product companies are ambivalent about—or even resistant to—the idea. Their resistance, however, should be reconsidered. It is usually based on one or more of the myths below.

Myth: It's too early to enter the middle markets in emerging economies.

Reality: It may already be too late. The competitive collisions between local upstarts, global aspirants, and multinational incumbents are occurring at different speeds in different industries, and some industries are already becoming saturated with competitive rivals. In major appliances, for example, most countries now have offerings from Haier (which not long ago was an upstart); South Korea's LG and Samsung (which were recently considered global aspirants, but now operate as full-fledged global incumbents); and GE, Whirlpool, and Electrolux (multinational incumbents trying to win share in emerging middle markets and defend their shares in the mature middle markets of developed nations).

The fortunes of companies will be made or lost depending on the timeliness of their entry into the emerging middle markets. If the current pattern holds true, those that fail will likely become the acquisition targets of global aspirants. This has already happened to some carmakers, such as Volvo and Saab. Midsized domestic companies in developed markets will also become targets as new competition enters their home markets and their home markets become an ever-smaller percentage of the global middle market.

Myth: We can't make money in the middle markets of emerging economies.

Reality: Yes, products aimed at the middle classes of developing nations are usually priced 20 to 40 percent lower than their counterparts in developed nations. But in emerging economies, lower prices do not necessarily mean lower profits, because the sales volume is potentially two to three times greater than the volume in more mature markets. Multinational incumbents need to develop the capability to profitably address consumers in these price segments, because that is often where emerging competitors gain their initial foothold.

Moreover, the cost of making products tends to be lower in emerging economies than in mature markets. These products usually have fewer premium features and often, as with the smaller engines in Volkswagen's Polo and Golf, have less-expensive parts. The producers of these goods tend to rely on a simpler value chain, with more of it located in low-cost countries, which also reduces costs and boosts margins. Finally, companies earn additional dividends in shareholder value as they expand into new, higher-growth markets.

Myth: We don't need to alter our products—we just need to educate our customers.

Reality: In the near term, many newly minted middle-class consumers cannot afford developed-market products no matter how much they might value them. As the middle classes mature and their purchasing power grows, this will change. Nonetheless, customers in countries such as India, Brazil, and Turkey will continue to want distinctive features and options. Many of their needs, wants, and tastes stem from unique cultural or environmental conditions, and are unlikely to change soon.

Too often, companies try to create middle-market variants of higher-priced products by subtracting a few features and pushing them through the existing business model and value chain. This results in compromised products at overly high prices. The better alternative is to rethink the value chain entirely. For example, the papermaking machinery industry in China is a rapid-growth, low-margin sector with many local upstart competitors. Multinational

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incumbents that want to enter this market must provide integrated manufacturing packages, including fiber systems, environmental solutions, automation, and rolls and fabrics. To accomplish this, they often build their capabilities through acquisitions and partnerships.

Myth: Entering the global middle market will be too disruptive to our operations.

Reality: Companies need a business model suited to the task. The R&D function, for example, should avoid innovation races and the creeping elegance associated with sophisticated and expensive products. Instead, take a more local approach to innovation, designing products for specific markets. The products can then flow elsewhere, finding support and additional markets wherever they strike a chord. Investing in local R&D that can rapidly turn middle- market customer insights into products and services is another key to success.

The manufacturing footprint will likely expand in many companies as the number of products designed for specific middle markets begins to grow. In lower-income markets, manufacturing processes may need to emphasize volume and efficiency over customization. Farther back in the value chain, suppliers will be rewarded for minimizing complexity and meeting the value and cost expectations of middle-market customers.

Marketing will need to identify distinct middle-class markets and gain an intimate understanding of the customer segments within each one. It will have to craft and effectively communicate tailored value propositions that don't undermine more expensive offerings, especially when they bear the same brand names. Sales and service will need to be rightsized for each market—often, this will entail more of a self-serve approach that keeps costs low.

For executives of multinational corporations, it may take a change in the conventional business mind-set to tap into global middle markets effectively. The most successful companies are establishing new business units; rethinking their decision rights and other practices; and giving their leaders the freedom, authority, financial resources, and talent needed to develop and run these businesses. The opportunities in the global middle market are worth the effort

Reprint No. 11309

Author Profiles:

Edward Tse is a senior partner with Booz & Company and the firm's chairman for Greater China, based in Hong Kong and Shanghai. He is the author of The China Strategy: Harnessing the Power of the World's Fastest-Growing Economy (Basic Books, 2010). Bill Russo is a senior advisor with Booz & Company. Based in Beijing, he has more than 20 years of experience in the automotive industry, most recently serving as vice president of Chrysler's business in Northeast Asia. Ronald Haddock is a former partner at Booz & Company, where he helped companies build businesses in China, India, Korea, Russia, and other emerging markets.

http://dx.doi.org/10.4135/9781506374598.n3

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