United state vs. Cambodia

From your course text, Global Business Today,9th read the following:

· Ethics, Corporate Social Responsibility, and Sustainability

· International Trade Theory

· The Political Economy of International Trade

· Foreign Direct Investment

https://digitalbookshelf.argosy.edu/books/1259669432/epubcfi/6/28[;vnd.vst.idref=body014]!/4/4/18/4@0:82.2

Ethics, Corporate Social Responsibility, and Sustainability (CHAPTER 5)

Making Toys Globally

opening case

Toys for children are made in numerous countries and then exported to buyers throughout the world. In some countries, such as the United States, certain protection exists to make sure that toys are safe for children. The U.S. Consumer Product Safety Commission (CPSC) regularly issues recalls of toys that have the potential to expose children to danger such as lead or other heavy metals. For example, lead may be found in the paint used on toys and in the plastic used to make the toys. If ingested (e.g., children chewing on toys), lead is poisonous and can damage the nervous system and cause brain disorders. Lead is also a neurotoxin that can accumulate in both soft tissue and bones in the body.

For these reasons, lead was banned in house paint, on toys marketed to children, and in dishes or cookware in the United States in 1978. In addition, in an agreement between China’s General Administration of Quality Supervision, Inspection and Quarantine (AQSIQ) and CPSC, the Chinese agreed to take immediate action in 2007 to eliminate the use of lead paint on Chinese manufactured toys that are exported to the United States. With China’s prominence as a toy manufacturing country, this agreement was a step toward making safe products for children.

Still, lead continues to be a hazard in a quarter of all U.S. homes with children under age 6. In fact, a wide range of toys and children’s products, including many market-leading and reputable brands, often contain either lead or other heavy metals (e.g., arsenic, cadmium, mercury, antimony, or chromium). Estimates exist that suggest that one-third of Chinese toys contain heavy metals. This is a major problem given that China manufactures 80 percent of the toys sold in the United States. Researchers from Greenpeace and IPEN conducted a study by buying 500 toys and children’s products in five Chinese cities. They tested the products with handheld X-ray scanners and found that 163 of the toys were tainted with heavy metals above the norm (32.6 percent). “These contaminated toys not only poison children when chewed or touched, but can enter the body through the air they breathe,” said Ada Kong Cheuk-san at Greenpeace.

While lead in the paint on toys has not been eliminated, the focus on cleaning up lead in the paint has been given front-page coverage ever since the agreement to eliminate it in 2007. It is certainly not gone, Page 128but at least more and more people are paying attention. Several organizations—both governmental and private—are examining lead-based paint in toys on a continual basis. For example, The New York Times and Consumer Reports recently found that dangerous products for children are still widely available. The Ecology Center has created a website called HealthyStuff.org that contains a database of toys and other products that have been tested for dangerous chemicals.

While lead in paint seems to be in focus, the use of lead in plastics has not been banned! Lead is used to soften the plastic and make it more flexible to allow it to go back to its original shape after children play with the toys. Plus, lead may also be used in plastic toys to stabilize molecules from heat. Unfortunately, when the plastic is exposed to sunlight, air, and detergents, for example, the chemical bond between the lead and plastics breaks down and forms dust that can enter the human body. Another unfortunate part about lead is that it is invisible to the naked eye and has no detectable smell. This means that children may be exposed to lead from toys (and other consumer products) through normal playing activity (e.g., hand-to-mouth activity). As everyone with children knows, children often put toys, fingers, and other objects in their mouth, exposing themselves to lead paint or dust.

Children are also more vulnerable to lead than adults; there is no safe level of lead for children. The worldwide toy industry has published a voluntary standard of 90 ppm for lead in toys, which, of course, is greater than a ban on lead in paint used for toys and in the materials used to make the toys (such as plastics). But since 2007, the world has at least seen stricter standards—either voluntary or regulated standards—that make it safer for children to play with newly purchased toys. The CPSC in the United States, the European Union, and China’s AQSIQ are actively monitoring and seemingly enforcing stricter standards. But, according to Scott Wolfson of the CPSC, many toy manufacturers have been violating safety regulations for almost 30 years. So, are toys safer now than they were before 2007, and are they really safe to play with throughout the world? And, what do we do with old, antique toys? images

Sources: M. Moore, “One Third of Chinese Toys Contain Heavy Metals,” The Telegraph, December 8, 2011; P. Kavilanz, “China to Eliminate Lead Paint in Toy Exports,” CNN Money, September 11, 2007; U.S. Centers for Disease Control and Prevention, www.cdc.gov/nceh/lead/tips/toys.htm, accessed March 8, 2014; and “U.S. Prosecutes Importers of Toys Containing Lead, Phthalates,” AmeriScan, February 26, 2014.

Introduction

The opening case describes the thriving toy manufacturing business and ethical concerns that exist in toy production. Total sales of toys worldwide are estimated to be about $85 billion annually according to the Toy Industry Association’s data, with the U.S. domestic toy market being around $21 billion. It is a large industry, especially in North America, Europe, and Asia; each of these regions has between $23 billion and $24 billion in toy sales annually.1

As noted in the opening case, there is some evidence that some companies and countries are less ethical in their toy manufacturing. While the worldwide toy industry has published a voluntary standard of 90 ppm for lead in toys, it is, after all, a voluntary standard and not a regulation that can be enforced worldwide. And while the U.S. Consumer Product Safety Commission and China’s General Administration of Quality Supervision, Inspection and Quarantine agreed that toys exported from China to the United States will no longer contain lead in paints, no such agreement exists for other materials such as plastics used in toy production, nor does the regulation appear to be working as effectively as it might.

Page 129images Module on International Ethics

globalEDGE provides more than 60 interactive educational modules for businesspeople, policy officials, and students. These modules focus on issues pertinent to international business and include a case study or anecdotes, a glossary of terms, quiz questions, and a list of references when applicable. The combination of the text and the free globalEDGE online course modules serves as an excellent resource to prepare for NASBITE’s Certified Global Business Professional Credential (with topics focus on management, marketing, supply chain management, and finance). Achieving the industry-leading NASBITE CGBP credential assures that employees are able to practice global business at the professional level required in today’s competitive environment. As related to Chapter 5, check out globalEDGE’s online module on international ethics at globaledge.msu.edu/reference-desk/online-course-modules. View the questions in the module as a quick-test on your understanding of the main issues in international ethics and your readiness to achieve the CGBP credential.

Perhaps some toy manufacturers have been violating safety regulations for almost 30 years and many will continue to do so in the future; time will tell, assuming we can track the ingredients in the materials being used to make toys. But, what we do know is that about a third of the toys that are exported out of China are tainted with heavy metals above the norm. Unfortunately, it is not illegal to use lead, for example, in plastics at this time; it is an ethical issue—and usually a voluntary one—that some companies tackle ethically and others choose to side-step given the large size of market opportunities in the toy industry. A basic question then is: Can it be considered unethical to manufacture toys that include heavy metals that are bad for children to ingest and come in contact with when using the toys in their proper way?

Ethical issues like the ones in the toys example arise frequently in international business, often because business practices and regulations differ from nation to nation. With regard to lead pollution, for example, what is allowed in Mexico is outlawed in the United States. These differences can create ethical dilemmas for businesses. Understanding the nature of an ethical dilemma, and deciding the course of action to pursue when confronted with one, is a central theme in this chapter. Ethics serves as the foundation for what people do or not, and ultimately what companies engage in globally. As such, companies’ involvement in corporate social responsibility practices and sustainability initiatives can be traced to the ethical foundation of its employees and other stakeholders such as customers, shareholders, suppliers, regulators, and communities.2

The term ethics refers to accepted principles of right or wrong that govern the conduct of a person, the members of a profession, or the actions of an organization. Business ethics are the accepted principles of right or wrong governing the conduct of businesspeople, and an ethical strategy is a strategy, or course of action, that does not violate these accepted principles. This chapter looks at how ethical issues should be incorporated into decision making in an international business. The chapter also reviews the reasons for poor ethical decision making and discusses different philosophical approaches to business ethics. Then, using the ethical decision-making process as platform, we include a series of illustrations via Management Focus boxes throughout the chapter, including issues related to Apple Computers, Myanmar, Daimler, and corporate social responsibility. The chapter closes by reviewing the different processes that managers can adopt to make sure that ethical considerations are incorporated into decision making in international business.

Business Ethics

Accepted principles of right or wrong governing the conduct of businesspeople.

Ethical Strategy

A course of action that does not violate a company’s business ethics.

Ethical Issues in International Business

images LO 5-1

Understand the ethical issues faced by international businesses.

Many of the ethical issues in international business are rooted in the fact that political systems, law, economic development, and culture vary significantly from nation to nation. What is considered normal practice in one nation may be considered unethical in another. Because they work for an institution that transcends national borders and cultures, Page 130managers in a multinational firm need to be particularly sensitive to these differences. In the international business setting, the most common ethical issues involve employment practices, human rights, environmental regulations, corruption, and the moral obligation of multinational corporations.

EMPLOYMENT PRACTICES When work conditions in a host nation are clearly inferior to those in a multinational’s home nation, which standards should be applied? Those of the home nation, those of the host nation, or something in between? While few would suggest that pay and work conditions should be the same across nations, how much divergence is acceptable? For example, while 12-hour workdays, extremely low pay, and a failure to protect workers against toxic chemicals may be common in some less developed nations, does this mean that it is okay for a multinational to tolerate such working conditions in its subsidiaries there or to condone it by using local subcontractors?

In the 1990s, Nike found itself in the center of a storm of protests when news reports revealed that working conditions at many of its subcontractors were very poor. Typical of the allegations were those detailed in a 48 Hours program that aired in 1996. The report painted a picture of young women who worked with toxic materials six days a week in poor conditions for only 20 cents an hour at a Vietnamese subcontractor. The report also stated that a living wage in Vietnam was at least $3 a day, an income that could not be achieved at the subcontractor without working substantial overtime. Nike and its subcontractors were not breaking any laws, but this report, and others like it, raised questions about the ethics of using sweatshop labor to make what were essentially fashion accessories. It may have been legal, but was it ethical to use subcontractors who, by Western standards, clearly exploited their workforce? Nike’s critics thought not, and the company found itself the focus of a wave of demonstrations and consumer boycotts. These exposés surrounding Nike’s use of subcon-tractors forced the company to reexamine its policies. Realizing that even though it was breaking no law, its subcontracting policies were perceived as unethical, Nike’s management established a code of conduct for Nike subcontractors and instituted annual monitoring by independent auditors of all subcontractors.3

As the Nike case demonstrates, a strong argument can be made that it is not okay for a multinational firm to tolerate poor working conditions in its foreign operations or those of subcontractors. However, this still leaves unanswered the question of which standards should be applied. We shall return to and consider this issue in more detail later in the chapter. For now, note that establishing minimal acceptable standards that safeguard the basic rights and dignity of employees, auditing foreign subsidiaries and subcontractors on a regular basis to make sure those standards are met, and taking corrective action if they are not up to standards are a good way to guard against ethical abuses. For another example of problems with working practices among suppliers, read the accompanying Management Focus, which looks at working conditions in a factory that supplied Apple with iPods.

HUMAN RIGHTS Questions of human rights can arise in international business. Basic human rights still are not respected in many nations. Rights taken for granted in developed nations, such as freedom of association, freedom of speech, freedom of assembly, freedom of movement, freedom from political repression, and so on, are by no means universally accepted (see Chapter 2 for details). One of the most obvious historic examples was South Africa during the days of white rule and apartheid, which did not end until 1994. The apartheid system denied basic political rights to the majority nonwhite population of South Africa, mandated segregation between whites and nonwhites, reserved certain occupations exclusively for whites, and prohibited blacks from being placed in positions where they would manage whites. Despite the odious nature of this system, Western businesses operated in South Africa. By the 1980s, however, many questioned the ethics of doing so. They argued that inward investment by foreign multinationals, by boosting the South African economy, supported the repressive apartheid regime.

Several Western businesses started to change their policies in the late 1970s and early 1980s.4 General Motors, which had significant activities in South Africa, was at the forefront of this trend. GM adopted what came to be called the Sullivan principles, named after Leon Sullivan, a black Baptist minister and a member of GM’s board of directors. Sullivan argued that it was ethically justified for GM to operate in South Africa so long as two conditions were fulfilled. First, the company should not obey the apartheid laws in its own South African operations (a form of passive resistance). Second, the company should do everything within its power to promote the abolition of apartheid laws. Sullivan’s principles were widely adopted by U.S. firms operating in South Africa. Their violation of the apartheid laws was ignored by the South African government, which clearly did not want to antagonize important foreign investors.

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Making Apple’s iPod

In mid-2006, news reports surfaced suggesting there were systematic labor abuses at a factory in China that makes the iPhone and iPod for Apple Computer. According to the reports, workers at Hongfujin Precision Industry were paid as little as $50 a month to work 15-hour shifts making the iPod. There were also reports of forced overtime and poor living conditions for the workers, many of them young women who had migrated from the countryside to work at the plant and lived in company-owned dormitories. The articles were the work of two Chinese journalists, Wang You and Weng Bao, employed by China Business News, a state-run newspaper. The target of the reports, Hongfujin Precision Industry, was reportedly China’s largest export manufacturer with overseas sales totaling $14.5 billion. Hongfujin is owned by Foxconn, a large Taiwanese conglomerate, whose customers (in addition to Apple) include Intel, Dell, and Sony Corporation. The Hongfujin factory is a small city in its own right, with clinics, recreational facilities, buses, and 13 restaurants that serve the 200,000 employees.

Upon hearing the news, Apple management responded quickly, pledging to audit the operations to make sure Hongfujin was complying with Apple’s code on labor standards for subcontractors. Managers at Hongfujin took a somewhat different tack; they filed a defamation suit against the two journalists, suing them for $3.8 million in a local court, which promptly froze the journalists’ personal assets pending a trial. Clearly, the management of Hongfujin was trying to send a message to the journalist community—criticism would be costly. The suit sent a chill through the Chinese journalist community because Chinese courts have shown a tendency to favor powerful, locally based companies in legal proceedings.

Within six weeks, Apple had completed its audit. The company’s report suggested that although workers had not been forced to work overtime and were earning at least the local minimum wage, many had worked more than the 60 hours a week allowed for by Apple, and their housing was substandard. Under pressure from Apple, management at Hongfujin agreed to bring practices in line with Apple’s code, committing to building new housing for employees and limiting work to 60 hours a week. However, Hongfujin did not immediately withdraw the defamation suit. In an unusually bold move in a country where censorship is still common, China Business News gave its unconditional backing to Wang and Weng. The Shanghai-based news organization issued a statement arguing that what the two journalists did “was not a violation of any rules, laws, or journalistic ethics.” The Paris-based Reporters Without Borders also took up the case of Wang and Weng, writing a letter to Apple’s then CEO, the late Steve Jobs, stating, “We believe that all Wang and Weng did was to report the facts and we condemn Foxconn’s reaction. We therefore ask you to intercede on behalf of these two journalists so that their assets are unfrozen and the lawsuit is dropped.”

Once again, Apple moved quickly, pressuring Foxconn behind the scenes to drop the suit. Foxconn agreed to do so and issued a “face-saving” statement saying the two sides had agreed to end the dispute after apologizing to each other “for the disturbances brought to both of them by the lawsuit.” The experience shed a harsh light on labor conditions in China. At the same time, the response of the Chinese media, and China Business News in particular, point toward the emergence of some journalistic freedoms in a nation that has historically seen news organizations as a mouthpiece for the state.

Sources: E. Kurtenbach, “The Foreign Factory Factor,” Seattle Times, August 31, 2006, pp. C1, C3; Elaine Kurtenbach, “Apple Says It’s Trying to Resolve Dispute over Labor Conditions at Chinese iPod Factory,” Associated Press Financial Wire, August 30, 2006; and “Chinese iPod Supplier Pulls Suit,” Associated Press Financial Wire, September 3, 2006.

After 10 years, Leon Sullivan concluded that simply following the principles was not sufficient to break down the apartheid regime and that any American company, even those adhering to his principles, could not ethically justify their continued presence in South Africa. Over the next few years, numerous companies divested their South African operations, including Exxon, General Motors, Kodak, IBM, and Xerox. At the same time, many state pension funds signaled they would no longer hold stock in companies that did business in South Africa, which helped persuade several companies to divest their South African operations. These divestments, coupled with the imposition of economic sanctions from the United States and other governments, contributed to the abandonment of white minority rule and apartheid in South Africa and the introduction of democratic elections in 1994. Thus, adopting an ethical stance was argued to have helped improve human rights in South Africa.5

Page 132Although change has come in South Africa, many repressive regimes still exist in the world. Is it ethical for multinationals to do business in them? It is often argued that inward investment by a multinational can be a force for economic, political, and social progress that ultimately improves the rights of people in repressive regimes. This position was first discussed in Chapter 2, when we noted that economic progress in a nation could create pressure for democratization. In general, this belief suggests it is ethical for a multinational to do business in nations that lack the democratic structures and human rights records of developed nations. Investment in China, for example, is frequently justified on the grounds that although China’s human rights record is often questioned by human rights groups, and although the country is not a democracy, continuing inward investment will help boost economic growth and raise living standards. These developments will ultimately create pressures from the Chinese people for more participative government, political pluralism, and freedom of expression and speech.

There is a limit to this argument. As in the case of South Africa, some regimes are so repressive that investment cannot be justified on ethical grounds. Another example would be Myanmar (formerly known as Burma). Ruled by a military dictatorship for more than 45 years, Myanmar has one of the worst human rights records in the world. Beginning in the mid-1990s, many Western companies exited Myanmar, judging the human rights violations to be so extreme that doing business there cannot be justified on ethical grounds. (In contrast, the accompanying Management Focus looks at the controversy surrounding one company, Unocal, which chose to stay in Myanmar.) However, a cynic might note that Myanmar has a small economy and that divestment carries no great economic penalty for Western firms, unlike, for example, divestment from China. Interestingly, after decades of pressure from the international community, in 2012 the military government of Myanmar finally acquiesced and allowed limited democratic elections to be held.

ENVIRONMENTAL POLLUTION Ethical issues arise when environmental regulations in host nations are inferior to those in the home nation. Many developed nations have substantial regulations governing the emission of pollutants, the dumping of toxic chemicals, the use of toxic materials in the workplace, and so on. Those regulations are often lacking in developing nations, and according to critics, the result can be higher levels of pollution from the operations of multinationals than would be allowed at home.

Early morning smog hangs over office towers in Shanghai, China. Companies are faced with ethical decisions in moving to host nations where environmental regulations are less stringent.

Page 133management FOCUS

Unocal in Myanmar

A number of years ago, in 1995, Unocal, an oil and gas enterprise based in California, took a 29 percent stake in a partnership with the French oil company Total and state-owned companies from both Myanmar and Thailand to build a gas pipeline from Myanmar to Thailand. At the time, the $1 billion project was expected to bring Myanmar about $200 million in annual export earnings, a quarter of the country’s total. The gas used domestically would increase Myanmar’s generating capacity by 30 percent. This investment was made when a number of other American companies were exiting Myanmar. Myanmar’s government, a military dictatorship, had a reputation for brutally suppressing internal dissent. Citing the political climate, the apparel companies Levi Strauss and Eddie Bauer had both withdrawn from the country. However, as far as Unocal’s management was concerned, the giant infrastructure project would generate healthy returns for the company and, by boosting economic growth, a better life for Myanmar’s now 53 million people. Moreover, while Levi Strauss and Eddie Bauer could easily shift production of clothes to another low-cost location, Unocal argued it had to go where the oil and gas were located.

However, Unocal’s investment quickly became highly controversial. Under the terms of the contract, the government of Myanmar was contractually obliged to clear a corridor for the pipeline through Myanmar’s tropical forests and to protect the pipeline from attacks by the government’s enemies. According to human rights groups, the Myanmar army forcibly moved villages and ordered hundreds of local peasants to work on the pipeline in conditions that were no better than slave labor. Those who refused suffered retaliation. News reports cited the case of one woman who was thrown into a fire, along with her baby, after her husband tried to escape from troops forcing him to work on the project. The baby died and she suffered burns. Other villagers reported being beaten, tortured, raped, and otherwise mistreated when the alleged slave labor conditions were occurring.

In 1996, human rights activists brought a lawsuit against Unocal in the United States on behalf of 15 Myanmar villagers who had fled to refugee camps in Thailand. The suit claimed that Unocal was aware of what was going on, even if it did not participate or condone it, and that awareness was enough to make Unocal in part responsible for the alleged crimes. The presiding judge dismissed the case, arguing that Unocal could not be held liable for the actions of a foreign government against its own people—although the judge did note that Unocal was indeed aware of what was going on in Myanmar. The plaintiffs appealed, and in late 2003 the case wound up at a superior court. In 2005, the case was settled out of court for an undisclosed amount. Unocal itself was acquired by Chevron in 2005.

Sources: Jim Carlton, “Unocal Trial for Slave Labor Claims Is Set to Start Today,” The Wall Street Journal, December 9, 2003, p. A19; Seth Stern, “Big Business Targeted for Rights Abuse,” Christian Science Monitor, September 4, 2003, p. 2; “Trouble in the Pipeline,” The Economist, January 18, 1997, p. 39; Irtani Evelyn, “Feeling the Heat: Unocal Defends Myanmar Gas Pipeline Deal,” Los Angeles Times, February 20, 1995, p. D1; and “Unocal Settles Myanmar Human Rights Cases,” Business and Environment, February 16, 2005, pp. 14–16.

Should a multinational feel free to pollute in a developing nation? To do so hardly seems ethical. Is there a danger that amoral management might move production to a developing nation precisely because costly pollution controls are not required and the company is, therefore, free to despoil the environment and perhaps endanger local people in its quest to lower production costs and gain a competitive advantage? What is the right and moral thing to do in such circumstances: pollute to gain an economic advantage, or make sure that foreign subsidiaries adhere to common standards regarding pollution controls?

These questions take on added importance because some parts of the environment are a public good that no one owns but anyone can despoil. No one owns the atmosphere or the oceans, but polluting both, no matter where the pollution originates, harms all.6 The atmosphere and oceans can be viewed as a global commons from which everyone benefits but for which no one is specifically responsible. In such cases, a phenomenon known as the tragedy of the commons becomes applicable. The tragedy of the commons occurs when a resource held in common by all, but owned by no one, is overused by individuals, resulting in its degradation. The phenomenon was first named by Garrett Hardin when describing a particular problem in sixteenth-century England. Large open areas, called commons, were free for all to use as pasture. The poor put out livestock on these commons and supplemented their meager incomes. It was advantageous for each to put out more and more livestock, but the social consequence was far more livestock than the commons could handle. The result was overgrazing, degradation of the commons, and the loss of this much-needed supplement.7

Page 134Should the United States Have Jurisdiction over Foreign Firms?

The Foreign Corrupt Practices Act (FCPA) is not just imposed on U.S. companies with operations globally. It also has jurisdiction over foreigners operating in the country. Settling a FCPA investigation, Siemens—Europe’s largest engineering company and the largest electronics company in the world—was fined $800 million by the U.S. Department of Justice and the U.S. Securities and Exchange Commission. Together with various penalties imposed in Germany, Siemens’ home country, the penalties total $1.6 billion. The settlement involved at least 4,200 allegedly corrupt payments totaling some $1.4 billion over six years to foreign officials in numerous countries. Meetings, negotiations, and bank account transfer were taking place in the United States between Siemens and officials from other countries. Is it appropriate that the U.S. government can use the FCPA to investigate and fine foreign companies doing business in other countries?

Sources: U.S. Department of Justice, www.justice.gov/opa/pr/2008/December/ 08-crm-1105.html, accessed March 9, 2014; “Siemens: A Giant Awakens,” The Economist, September 10, 2010; and J. Ewing, “Siemens Settlement: Relief, But Is It Over?” BusinessWeek, December 15, 2008.

Corporations can contribute to the global tragedy of the commons by moving production to locations where they are free to pump pollutants into the atmosphere or dump them in oceans or rivers, thereby harming these valuable global commons. While such action may be legal, is it ethical? Again, such actions seem to violate basic societal notions of ethics and corporate social responsibility. This issue is taking on greater importance as concerns about human-induced global warming move to center stage. Most climate scientists argue that human industrial and commercial activity is increasing the amount of carbon dioxide in the atmosphere; carbon dioxide is a greenhouse gas, which reflects heat back to the earth’s surface, warming the globe; and as a result, the average temperature of the earth is increasing. The accumulated scientific evidence from numerous databases supports this argument.8 Consequently, societies around the world are starting to restrict the amount of carbon dioxide that can be emitted into the atmosphere as a by-product of industrial and commercial activity. However, regulations differ from nation to nation. Given this, is it ethical for a company to try to escape tight emission limits by moving production to a country with lax regulations, given that doing so will contribute to global warming? Again, many would argue that doing so violates basic ethical principles.

CORRUPTION As noted in Chapter 2, corruption has been a problem in almost every society in history, and it continues to be one today.9 There always have been and always will be corrupt government officials. International businesses can and have gained economic advantages by making payments to those officials. A historical and classic example concerns a well-publicized incident in the 1970s. Carl Kotchian, the president of Lockheed, made a $12.6 million payment to Japanese agents and government officials to secure a large order for Lockheed’s TriStar jet from Nippon Air. When the payments were discovered, U.S. officials charged Lockheed with falsification of its records and tax violations. Although such payments were supposed to be an accepted business practice in Japan (they might be viewed as an exceptionally lavish form of gift-giving), the revelations created a scandal there too. The government ministers in question were criminally charged, one committed suicide, the government fell in disgrace, and the Japanese people were outraged. Apparently, such a payment was not an accepted way of doing business in Japan! The payment was nothing more than a bribe, paid to corrupt officials, to secure a large order that might otherwise have gone to another manufacturer, such as Boeing. Kotchian clearly engaged in unethical behavior—and to argue that the payment was an “acceptable form of doing business in Japan” was self-serving and incorrect.

The Lockheed case was the impetus for the 1977 passage of the Foreign Corrupt Practices Act in the United States, discussed in Chapter 2. The act outlawed the paying of bribes to foreign government officials to gain business. Some U.S. businesses immediately objected that the act would put U.S. firms at a competitive disadvantage (there is no evidence that has occurred).10 The act was subsequently amended to allow for “facilitating payments.” Sometimes known as speed money or grease payments, facilitating payments are not payments to secure contracts that would not otherwise be secured, nor are they payments to obtain exclusive preferential treatment. Rather they are payments to ensure receiving the standard treatment that a business ought to receive from a foreign government, but might not due to the obstruction of a foreign official. The accompanying Management Focus looks at what happened when the German company Daimler ran afoul of the Foreign Corrupt Practices Act (FCPA).

Foreign Corrupt Practices Act

U.S. law regulating behavior regarding the conduct of international business in the taking of bribes and other unethical actions.

management FOCUS

Corruption at Daimler

In 1998, Daimler, one of the world’s largest manufacturers of automobiles, purchased the Chrysler Corporation for what was a reported $38 billion. Soon afterward, a former Chrysler auditor identified suspicious payments being made by subsidiaries. For example, in 2002 Daimler’s Chinese subsidiary paid $25,000 to a Texas company listed at a residential apartment complex in Houston. The auditor suspected that such payments were bribes and reported the issue to the U.S. Securities and Exchange Commission (SEC), which then teamed up with the U.S. Department of Justice (DOJ) and began an investigation.

The investigation took eight years. During that time, investigators uncovered a pattern of corruption so widespread that an SEC official described it as “standard operating practice at Daimler.” In the case of the $25,000 payment, the Texas company was a shell organization established to launder the money, and the payment was to be passed on to the wife of a Chinese government official who was involved in contract negotiations for about $1.3 million in commercial vehicles. In another case, bribes were given to secure the sale of passenger and commercial vehicles to government entities in Russia. Daimler overcharged for the cars on invoices and passed the overpayments to bank accounts in Latvia controlled by the Russian officials responsible for the purchase decision. In certain cases, Daimler made bribes from “cash desks,” allowing employees to take out large amounts of currency to make payments to foreign officials.

In total, the investigation uncovered hundreds of such payments in at least 22 countries that were linked to the sale of vehicles valued at $1.9 billion. The SEC stated, “The bribery was so pervasive in Daimler’s decentralized corporate structure that it extended outside of the sales organization to internal audit, legal, and finance departments. These departments should have caught and stopped the illegal sales practices, but instead they permitted or were directly involved in the company’s bribery practices.”

Threatened with court proceedings in the United States, in 2010 Daimler entered into a consent decree with the SEC under which it agreed to pay $185 million in criminal and civil fines. While subsidiaries of Daimler in Germany and Russia pleaded guilty to corruption charges, the corporate parent and the Chinese subsidiary will avoid indictment so long as they live up to an agreement to halt such practices.

Some 10 years after Daimler bought Chrysler (some say it was a merger of equals) and became a target of the SEC because of a Chrysler employee’s whistleblower actions, Daimler sold off Chrysler in 2007 to Cerberus Capital Management for $6 billion, and the name was changed to simply “Daimler AG.” Since Chrysler’s bankruptcy filing in the United States in 2009, the company has been controlled by Italian automaker Fiat.

Sources: A. R. Sorkin, “Daimler to Pay $185 Million to Settle Corruption Charges,” The New York Times, March 24, 2010; and “Corruption: Daimler Settles with DoJ; SEC Wades in: Germany Next,” Chiefofficers.net, March 25, 2010.

In 1997, the trade and finance ministers from the member states of the Organization for Economic Cooperation and Development (OECD) followed the U.S. lead and adopted the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions.11 The convention, which went into force in 1999, obliges member-states and other signatories to make the bribery of foreign public officials a criminal offense. The convention excludes facilitating payments made to expedite routine government action from the convention.

Convention on Combating Bribery of Foreign Public Officials in International Business Transactions

An OECD convention that establishes legally binding standards to criminalize bribery of foreign public officials in international business transactions and provides for a host of related measures that make this effective.

While facilitating payments, or speed money, are excluded from both the Foreign Corrupt Practices Act and the OECD convention on bribery, the ethical implications of making such payments are unclear. From a pragmatic standpoint, giving bribes, although a little evil, might be the price that must be paid to do a greater good (assuming the investment creates jobs where none existed and assuming the practice is not illegal). Several economists advocate this reasoning, suggesting that in the context of pervasive and cumbersome regulations in developing countries, corruption may improve efficiency and help growth! These economists theorize that in a country where preexisting political structures distort or limit the workings of the market mechanism, corruption in the form of black-marketeering, smuggling, and side payments to government bureaucrats to “speed up” approval for business investments may enhance welfare.12 Arguments such as this persuaded the U.S. Congress to exempt facilitating payments from the Foreign Corrupt Practices Act.

Page 136In contrast, other economists have argued that corruption reduces the returns on business investment and leads to low economic growth.13 In a country where corruption is common, unproductive bureaucrats who demand side payments for granting the enterprise permission to operate may siphon off the profits from a business activity. This reduces businesses’ incentive to invest and may retard a country’s economic growth rate. One study of the connection between corruption and economic growth in 70 countries found that corruption had a significant negative impact on a country’s growth rate.14 Another study found that firms that paid more in bribes are likely to spend more, not less, management time with bureaucrats negotiating regulations, and that this tended to raise the costs of the firm.15

Given the debate and the complexity of this issue, we again might conclude that generalization is difficult and the demand for speed money creates a genuine ethical dilemma. Yes, corruption is bad, and yes, it may harm a country’s economic development, but yes, there are also cases where side payments to government officials can remove the bureaucratic barriers to investments that create jobs. However, this pragmatic stance ignores the fact that corruption tends to corrupt both the bribe giver and the bribe taker. Corruption feeds on itself, and once an individual starts down the road of corruption, pulling back may be difficult if not impossible. This argument strengthens the ethical case for never engaging in corruption, no matter how compelling the benefits might seem.

Many multinationals have accepted this argument. The large oil multinational BP, for example, has a zero-tolerance approach toward facilitating payments. Other corporations have a more nuanced approach. For example, Dow Corning used to formally state a few years ago in its Code of Conduct that “in countries where local business practice dictates such [facilitating] payments and there is no alternative, facilitating payments are to be for the minimum amount necessary and must be accurately documented and recorded.”16 This statement recognized that business practices and customs differ from country to country. At the same time, Dow Corning allowed for facilitating payments when “there is no alternative,” although they were also stated to be strongly discouraged. More recently, the latest version of Dow Corning’s Code of Conduct has removed the section on “international business guidelines” altogether, so our assumption has to be that the company is taking a stronger zero-tolerance approach at this time.

Dow Corning may have simply realized that the nuances between a bribe and a facilitating payment are very unclear in interpretation. Many U.S. companies have sustained FCPA violations due to facilitating payments that were made but did not fall within the general rules allowing such payments. For example, in 2008, the global freight forwarder Con-way paid a $300,000 penalty for making hundreds of what could be considered small payments to various Customs Officials in the Philippines. In total, Con-way distributed some $244,000 to these officials who were induced to violate customs regulations, settle disputes, and not enforce fines for administrative violations.17

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Ethical Dilemmas

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Recognize an ethical dilemma.

The ethical obligations of a multinational corporation toward employment conditions, human rights, corruption, and environmental pollution are not always clear-cut. There may be no agreement about accepted ethical principles. From an international business perspective, some argue that what is ethical depends on one’s cultural perspective.18 In the United States, it is considered acceptable to execute murderers, but in many cultures this is not acceptable—execution is viewed as an affront to human dignity, and the death penalty is outlawed. Many Americans find this attitude very strange, but many Europeans find the American approach barbaric. For a more business-oriented example, consider the practice of “gift-giving” between the parties to a business negotiation. While this is considered right and proper behavior in many Asian cultures, some Westerners view the practice as a form of bribery, and therefore unethical, particularly if the gifts are substantial.

Page 137Managers often confront very real ethical dilemmas where the appropriate course of action is not clear. For example, imagine that a visiting American executive finds that a foreign subsidiary in a poor nation has hired a 12-year-old girl to work on a factory floor. Appalled to find that the subsidiary is using child labor in direct violation of the company’s own ethical code, the American instructs the local manager to replace the child with an adult. The local manager dutifully complies. The girl, an orphan, who is the only breadwinner for herself and her 6-year-old brother, is unable to find another job, so in desperation she turns to prostitution. Two years later she dies of AIDS.

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Child labor is still common in many poor nations.

Had the visiting American understood the gravity of the girl’s situation, would he still have requested her replacement? Perhaps not! Would it have been better, therefore, to stick with the status quo and allow the girl to continue working? Probably not, because that would have violated the reasonable prohibition against child labor found in the company’s own ethical code. What then would have been the right thing to do? What was the obligation of the executive given this ethical dilemma?

There are no easy answers to these questions. That is the nature of ethical dilemmas—they are situations in which none of the available alternatives seems ethically acceptable.19 In this case, employing child labor was not acceptable, but given that she was employed, neither was denying the child her only source of income. What this American executive needs, what all managers need, is a moral compass, or perhaps an ethical algorithm, to guide them through such an ethical dilemma to find an acceptable solution. Later, we will outline what such a moral compass, or ethical algorithm, might look like. For now, it is enough to note that ethical dilemmas exist because many real-world decisions are complex, difficult to frame, and involve first-, second-, and third-order consequences that are hard to quantify. Doing the right thing, or even knowing what the right thing might be, is often far from easy.20

Ethical Dilemma

A situation in which there is no ethically acceptable solution.

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The Roots of Unethical Behavior

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Identify the causes of unethical behavior by managers.

Examples abound of managers behaving in a manner that might be judged unethical in an international business setting. Why do managers behave in an unethical manner? There is no simple answer to this question because the causes are complex, but some generalizations can be made (see Figure 5.1).21

PERSONAL ETHICS Societal business ethics are not divorced from personal ethics, which are the generally accepted principles of right and wrong governing the conduct of individuals. As individuals, we are typically taught that it is wrong to lie and cheat—it is unethical—and that it is right to behave with integrity and honor and to stand up for what we believe to be right and true. This is generally true across societies. The personal ethical code that guides our behavior comes from a number of sources, including our parents, our schools, our religion, and the media. Our personal ethical code exerts a profound influence on the way we behave as businesspeople. An individual with a strong sense of personal ethics is less likely to behave in an unethical manner in a business setting. It follows that the first step to establishing a strong sense of business ethics is for a society to emphasize strong personal ethics.

Home-country managers working abroad in multinational firms (expatriate managers) may experience more than the usual degree of pressure to violate their personal ethics. They are away from their ordinary social context and supporting culture, and they are psychologically and geographically distant from the parent company. They may be based in a culture that does not place the same value on ethical norms important in the manager’s home country, and they may be surrounded by local employees who have less rigorous ethical standards. The parent company may pressure expatriate managers to meet unrealistic goals that can only be fulfilled by cutting corners or acting unethically. For example, to meet centrally mandated performance goals, expatriate managers might give bribes to win contracts or might implement working conditions and environmental controls that are below minimal acceptable standards. Local managers might encourage the expatriate to adopt such behavior. Due to its geographic distance, the parent company may be unable to see how expatriate managers are meeting goals or may choose not to see how they are doing so, allowing such behavior to flourish and persist.

Page 1385.1 FIGURE

Determinants of Ethical Behavior

DECISION-MAKING PROCESSES Several studies of unethical behavior in a business setting have concluded that businesspeople sometimes do not realize they are behaving unethically, primarily because they simply fail to ask, “Is this decision or action ethical?”22 Instead, they apply a straightforward business calculus to what they perceive to be a business decision, forgetting that the decision may also have an important ethical dimension. The fault lies in processes that do not incorporate ethical considerations into business decision making. This may have been the case at Nike when managers originally made subcontracting decisions (see the earlier discussion). Those decisions were probably made based on good economic logic. Subcontractors were probably chosen based on business variables such as cost, delivery, and product quality, but the key managers simply failed to ask, “How does this subcontractor treat its workforce?” If they thought about the question at all, they probably reasoned that it was the subcon-tractor’s concern, not theirs.

To improve ethical decision making in a multinational firm, the best starting point is to better understand how individuals make decisions that can be considered ethical or unethical in an organizational environment.23 Two misnomers must be taken into account. First, too often it is assumed that individuals in the workplace make ethical decisions in the same way as they would if they were home. Second, too often it is assumed that people from different cultures make ethical decisions following a similar process (see Chapter 4 for more on cultural differences). Both of these assumptions are problematic. First, within an organization there are very few individuals who have the freedom (e.g., power) to decide ethical issues independent of pressures that may exist in an organizational setting (e.g., should we make a facilitating payment or resort to bribery?). Second, while the process for making an ethical decision may largely be the same in many countries, the relative emphasis on certain issues are unlikely to be the same. Some cultures may stress organizational factors (e.g., Japan) while others stress Page 139individual personal factors (e.g., the United States), yet some may base it purely on opportunity (e.g., Myanmar) and others base it on the importance to their superiors, for example (e.g., India).

ORGANIZATION CULTURE The climate in some businesses does not encourage people to think through the ethical consequences of business decisions. This brings us to the third cause of unethical behavior in businesses—an organizational culture that deemphasizes business ethics, reducing all decisions to the purely economic. The term organizational culture refers to the values and norms that are shared among employees of an organization. You will recall from Chapter 4 that values are abstract ideas about what a group believes to be good, right, and desirable, while norms are the social rules and guidelines that prescribe appropriate behavior in particular situations. Just as societies have cultures, so do business organizations. Together, values and norms shape the culture of a business organization, and that culture has an important influence on the ethics of business decision making.

Organizational Culture

The values and norms shared among an organization’s employees.

The Management Focus on corruption at Daimler, for example, strongly suggests that paying bribes to secure business contracts was long viewed as an acceptable way of doing business within that company. It was, in the words of an investigator, “standard business practice” that permeated much of the organization, including departments such as auditing and finance that were meant to detect and halt such behavior. It can be argued that such a widespread practice could have persisted only if the values and norms of the organization implicitly approved of paying bribes to secure business.

UNREALISTIC PERFORMANCE GOALS A fourth cause of unethical behavior has already been hinted at—pressure from the parent company to meet unrealistic performance goals that can be attained only by cutting corners or acting in an unethical manner. In the Daimler case, for example, bribery may have been viewed as a way to hit challenging performance goals. The combination of an organizational culture that legitimizes unethical behavior, or at least turns a blind eye to such behavior, and unrealistic performance goals may be particularly toxic. In such circumstances, there is a greater than average probability that managers will violate their own personal ethics and engage in unethical behavior. Conversely, an organization culture can do just the opposite and reinforce the need for ethical behavior. At Hewlett-Packard, for example, Bill Hewlett and David Packard, the company’s founders, propagated a set of values known as The HP Way. These values, which shape the way business is conducted both within and by the corporation, have an important ethical component. Among other things, they stress the need for confidence in and respect for people, open communication, and concern for the individual employee.

LEADERSHIP The Hewlett-Packard example suggests a fifth root cause of unethical behavior—leadership. Leaders help to establish the culture of an organization, and they set the example that others follow. Other employees in a business often take their cue from business leaders, and if those leaders do not behave in an ethical manner, they might not either. It is not just what leaders say that matters, but what they do or do not do. What message, then, did the leaders at Daimler sent about corrupt practices? Presumably, they did very little to discourage it and may have encouraged such behavior.

SOCIETAL CULTURE Societal culture may well have an impact on the propensity of people, and organizations, to behave in an unethical manner. One study of 2,700 firms in 24 countries found that there were significant differences among the ethical policies of firms headquartered in different countries.24 Using Hofstede’s dimensions of social culture (see Chapter 4), the study found that enterprises headquartered in cultures where individualism and uncertainty avoidance are strong were more likely to emphasize the importance of behaving ethically than firms headquartered in cultures where masculinity and power distance are important cultural attributes. Such analysis suggests that enterprises headquartered in a country such as Russia, which scores high on masculinity and power distance measures, and where corruption is endemic, are more likely to engage in unethical behavior than enterprises headquartered in Scandinavia.

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Page 140Philosophical Approaches to Ethics

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Describe the different philosophical approaches to ethics.

In this section on philosophical approaches to ethics in the global marketplace, we look at several different approaches to business ethics. Basically, all individuals adopt a process for making ethical (or unethical) decisions. This process is based on their personal philosophical approach to ethics—that is, the underlying moral fabric of the individual.

We begin with what can best be described as straw men, which either deny the value of business ethics or apply the concept in a very unsatisfactory way. Having discussed, and dismissed the straw men, we then move on to consider approaches that are favored by most moral philosophers and form the basis for current models of ethical behavior in international businesses.

STRAW MEN Straw men approaches to business ethics are raised by business ethics scholars primarily to demonstrate that they offer inappropriate guidelines for ethical decision making in a multinational enterprise. Four such approaches to business ethics are commonly discussed in the literature. These approaches can be characterized as the Friedman doctrine, cultural relativism, the righteous moralist, and the naive immoralist. All these approaches have some inherent value, but all are unsatisfactory in important ways. Nevertheless, sometimes companies adopt these approaches.

The Friedman Doctrine The Nobel Prize–winning economist Milton Friedman wrote an article in The New York Times in 1970 that has since become a classic straw man example that business ethics scholars outline only to then tear down.25 Friedman’s basic position is that “the social responsibility of business is to increase profits,” so long as the company stays within the rules of law. He explicitly rejects the idea that businesses should undertake social expenditures beyond those mandated by the law and required for the efficient running of a business. For example, his arguments suggest that improving working conditions beyond the level required by the law and necessary to maximize employee productivity will reduce profits and are therefore not appropriate. His belief is that a firm should maximize its profits because that is the way to maximize the returns that accrue to the owners of the firm, its shareholders. If the shareholders then wish to use the proceeds to make social investments, that is their right, according to Friedman, but managers of the firm should not make that decision for them. He states:

In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom. The key point is that, in his capacity as a corporate executive, the manager is the agent of the individuals who own the corporation or establish the eleemosynary institution, and his primary responsibility is to them.26

“When in Rome, Behave Like a Swede,” Really?

You would think that as one of the authors of this book is from Sweden, it seemed convenient to revise the ancient proverb “when in Rome, do as the Romans” to “when in Rome, behave like a Swede.” But, instead this slightly reworded saying was coined in an article in The Economist. As just one example, IKEA, the Swedish furniture giant, as mentioned in the article, has gone to great lengths to fight corruption worldwide. In that spirit, the argument is for the case that doing the right thing is smart business. But we all know—even the Swedish author of this book (!)—that the global marketplace can be a jungle: It’s eat or be eaten. Now if we go back to the ancient proverb, the meaning of it basically suggests that we should behave as those around us and conform to the culture in the foreign society in which we are doing business. So, what is your preference: Do you prefer “when in Rome, do as the Romans” or “when in Rome, behave like a Swede”?

Sources: “The Corruption Eruption,” The Economist, April 29, 2010; “Ethical Business Ethics,” May 6, 2010, http://ethicalbusinessethics.blogspot.com/2010/05/ when-in-rome-should-you-do-as-romans-do.html, accessed March 9, 2014.

Although Friedman is talking about social responsibility and “ethical custom,” rather than business ethics per se, many business ethics scholars equate social responsibility with ethical behavior and thus believe Friedman is also arguing against business ethics. However, the assumption that Friedman is arguing against ethics is not quite true given his viewpoints associated with “ethical custom” and his statements about engaging in open and free competition without deception or fraud:

There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say that it engages in open and free competition without deception or fraud.27

Are Human Rights a Moral Compass?

The Universal Declaration of Human Rights (UDHR) was adopted by the United Nations General Assembly on December 10, 1948, in Paris, France. The Preamble of UDHR starts by stating that “Whereas recognition of the inherent dignity and of the equal and inalienable rights of all members of the human family is the foundation of freedom, justice and peace in the world . . . .” The day on which UDHR was adopted, December 10, is known as “International Human Rights Day,” and this day is also used to award the Nobel Peace Prize annually. One human right that we discuss in the text is the right to free speech and, by the same token, we have an obligation to respect free speech. But, are there issues, situations, or reasons where free speech should not be granted?

Sources: “The Universal Declaration of Human Rights,” United Nations, www. un.org/en/documents/udhr, accessed March 9, 2014; “The Official Site of the Nobel Prize,” www.nobelprize.org/nobel_prizes/peace, accessed March 9, 2014.

In other words, Friedman states that businesses should behave in a socially responsible manner, according to ethical custom, and without deception and fraud.

Critics charge that Friedman’s arguments do break down under examination. This is particularly true in international business, where the “rules of the game” are not well established and differ from country to county. Consider again the case of sweatshop labor. Child labor may not be against the law in a developing nation, and maximizing productivity may not require that a multinational firm stop using child labor in that country, but it is still immoral to use child labor because the practice conflicts with widely held views about what is the right and proper thing to do. Similarly, there may be no rules against pollution in a less developed nation and spending money on pollution control may reduce the profit rate of the firm, but generalized notions of morality would hold that it is still unethical to dump toxic pollutants into rivers or foul the air with gas releases. In addition to the local consequences of such pollution, which may have serious health effects for the surrounding population, there is also a global consequence as pollutants degrade those two global commons so important to us all—the atmosphere and the oceans.

Cultural Relativism Another straw man often raised by business ethics scholars is cultural relativism, which is the belief that ethics are nothing more than the reflection of a culture—all ethics are culturally determined—and that accordingly, a firm should adopt the ethics of the culture in which it is operating.28 This approach is often summarized by the maxim when in Rome, do as the Romans. As with Friedman’s approach, cultural relativism does not stand up to a closer look. At its extreme, cultural relativism suggests that if a culture supports slavery, it is okay to use slave labor in a country. Clearly, it is not! Cultural relativism implicitly rejects the idea that universal notions of morality transcend different cultures, but, as we argue later in the chapter, some universal notions of morality are found across cultures.

Cultural Relativism

The belief that ethics are culturally determined and that firms should adopt the ethics of the cultures in which they operate.

While dismissing cultural relativism in its most sweeping form, some ethicists argue there is residual value in this approach.29 We agree. As we noted in Chapter 3, societal values and norms do vary from culture to culture, and customs do differ, so it might follow that certain business practices are ethical in one country but not another. Indeed, the facilitating payments allowed in the Foreign Corrupt Practices Act can be seen as an acknowledgment that in some countries, the payment of speed money to government officials is necessary to get business done, and if not ethically desirable, it is at least ethically acceptable.

The Righteous Moralist A righteous moralist claims that a multinational’s home-country standards of ethics are the appropriate ones for companies to follow in foreign countries. This approach is typically associated with managers from developed nations. While this seems reasonable at first blush, the approach can create problems. Consider the following example: An American bank manager was sent to Italy and was appalled to learn that the local branch’s accounting department recommended grossly underreporting the bank’s profits for income tax purposes.30 The manager insisted that the bank report its earnings accurately, American style. When he was called by the Italian tax department to the firm’s tax hearing, he was told the firm owed three times as much tax as it had paid, reflecting the department’s standard assumption that each firm underreports its earnings by two-thirds. Despite his protests, the new assessment stood. In this case, the righteous moralist has run into a problem caused by the prevailing cultural norms in the country where he was doing business. How should he respond? The righteous moralist would argue for maintaining the position, while a more pragmatic view might be that in this case, the right thing to do is to follow the prevailing cultural norms because there is a big penalty for not doing so.

Righteous Moralist

One who claims that a multinational’s home-country standards of ethics are the appropriate ones for companies to follow in foreign countries.

Page 142The main criticism of the righteous moralist approach is that its proponents go too far. While there are some universal moral principles that should not be violated, it does not always follow that the appropriate thing to do is adopt home-country standards. For example, U.S. laws set down strict guidelines with regard to minimum wage and working conditions. Does this mean it is ethical to apply the same guidelines in a foreign country, paying people the same as they are paid in the United States, providing the same benefits and working conditions? Probably not, because doing so might nullify the reason for investing in that country and therefore deny locals the benefits of inward investment by the multinational. Clearly, a more nuanced approach is needed.

The Naive Immoralist A naive immoralist asserts that if a manager of a multinational sees that firms from other nations are not following ethical norms in a host nation, that manager should not either. The classic example to illustrate the approach is known as the drug lord problem. In one variant of this problem, an American manager in Colombia routinely pays off the local drug lord to guarantee that her plant will not be bombed and that none of her employees will be kidnapped. The manager argues that such payments are ethically defensible because everyone is doing it.

Naive Immoralist

One who asserts that if a manager of a multinational sees that firms from other nations are not following ethical norms in a host nation, that manager should not either.

The objection is twofold. First, to say that an action is ethically justified if everyone is doing it is not sufficient. If firms in a country routinely employ 12-year-olds and make them work 10-hour days, is it therefore ethically defensible to do the same? Obviously not, and the company does have a clear choice. It does not have to abide by local practices, and it can decide not to invest in a country where the practices are particularly odious. Second, the multinational must recognize that it does have the ability to change the prevailing practice in a country. It can use its power for a positive moral purpose. This is what BP is doing by adopting a zero-tolerance policy with regard to facilitating payments. BP is stating that the prevailing practice of making facilitating payments is ethically wrong, and it is incumbent upon the company to use its power to try to change the standard. While some might argue that such an approach smells of moral imperialism and a lack of cultural sensitivity, if it is consistent with widely accepted moral standards in the global community, it may be ethically justified.

UTILITARIAN AND KANTIAN ETHICS In contrast to the straw men just discussed, most moral philosophers see value in utilitarian and Kantian approaches to business ethics. These approaches were developed in the eighteenth and nineteenth centuries, and although they have been largely superseded by more modern approaches, they form part of the tradition upon which newer approaches have been constructed.

Utilitarian Approaches to Ethics

These hold that the moral worth of actions or practices is determined by their consequences.

The utilitarian approach to business ethics dates to philosophers such as David Hume (1711–1776), Jeremy Bentham (1748–1832), and John Stuart Mill (1806–1873). Utilitarian approaches to ethics hold that the moral worth of actions or practices is determined by their consequences.31 An action is judged desirable if it leads to the best possible balance of good consequences over bad consequences. Utilitarianism is committed to the maximization of good and the minimization of harm. Utilitarianism recognizes that actions have multiple consequences, some of which are good in a social sense and some of which are harmful. As a philosophy for business ethics, it focuses attention on the need to weigh carefully all the social benefits and costs of a business action and to pursue only those actions where the benefits outweigh the costs. The best decisions, from a utilitarian perspective, are those that produce the greatest good for the greatest number of people.

Page 143Many businesses have adopted specific tools such as cost–benefit analysis and risk assessment that are firmly rooted in a utilitarian philosophy. Managers often weigh the benefits and costs of an action before deciding whether to pursue it. An oil company considering drilling in the Alaskan wildlife preserve must weigh the economic benefits of increased oil production and the creation of jobs against the costs of environmental degradation in a fragile ecosystem. An agricultural biotechnology company such as Monsanto must decide whether the benefits of genetically modified crops that produce natural pesticides outweigh the risks. The benefits include increased crop yields and reduced need for chemical fertilizers. The risks include the possibility that Monsanto’s insect-resistant crops might make matters worse over time if insects evolve a resistance to the natural pesticides engineered into Monsanto’s plants, rendering the plants vulnerable to a new generation of superbugs.

The utilitarian philosophy does have some serious drawbacks as an approach to business ethics. One problem is measuring the benefits, costs, and risks of a course of action. In the case of an oil company considering drilling in Alaska, how does one measure the potential harm done to the region’s ecosystem? The second problem with utilitarianism is that the philosophy omits the consideration of justice. The action that produces the greatest good for the greatest number of people may result in the unjustified treatment of a minority. Such action cannot be ethical, precisely because it is unjust. For example, suppose that in the interests of keeping down health insurance costs, the government decides to screen people for the HIV virus and deny insurance coverage to those who are HIV positive. By reducing health costs, such action might produce significant benefits for a large number of people, but the action is unjust because it discriminates unfairly against a minority.

Kantian ethics is based on the philosophy of Immanuel Kant (1724–1804). Kantian ethics holds that people should be treated as ends and never purely as means to the ends of others. People are not instruments, like a machine. People have dignity and need to be respected as such. Employing people in sweatshops, making them work long hours for low pay in poor work conditions, is a violation of ethics, according to Kantian philosophy, because it treats people as mere cogs in a machine and not as conscious moral beings that have dignity. Although contemporary moral philosophers tend to view Kant’s ethical philosophy as incomplete—for example, his system has no place for moral emotions or sentiments such as sympathy or caring—the notion that people should be respected and treated with dignity resonates in the modern world.

Kantian Ethics

The belief that people should be treated as ends and never as means to the ends of others.

RIGHTS THEORIES Developed in the twentieth century, rights theories recognize that human beings have fundamental rights and privileges that transcend national boundaries and cultures. Rights establish a minimum level of morally acceptable behavior. One well-known definition of a fundamental right construes it as something that takes precedence over or “trumps” a collective good. Thus, we might say that the right to free speech is a fundamental right that takes precedence over all but the most compelling collective goals and overrides, for example, the interest of the state in civil harmony or moral consensus.32 Moral theorists argue that fundamental human rights form the basis for the moral compass that managers should navigate by when making decisions that have an ethical component. More precisely, they should not pursue actions that violate these rights.

Rights Theories

A twentieth-century theory that recognizes that human beings have fundamental rights and privileges that transcend national boundaries and cultures.

The notion that there are fundamental rights that transcend national borders and cultures was the underlying motivation for the United Nations Universal Declaration of Human Rights, adopted in 1948, which has been ratified by almost every country on the planet and lays down basic principles that should always be adhered to irrespective of the culture in which one is doing business.33 Echoing Kantian ethics, Article 1 of this declaration states:

All human beings are born free and equal in dignity and rights. They are endowed with reason and conscience and should act towards one another in a spirit of brotherhood.

Article 23 of this declaration, which relates directly to employment, states:

1. Everyone has the right to work, to free choice of employment, to just and favorable conditions of work, and to protection against unemployment.

2. Everyone, without any discrimination, has the right to equal pay for equal work.

3. Everyone who works has the right to just and favorable remuneration ensuring for himself and his family an existence worthy of human dignity, and supplemented, if necessary, by other means of social protection.

4. Everyone has the right to form and to join trade unions for the protection of his interests.

Clearly, the rights to “just and favorable conditions of work,” “equal pay for equal work,” and remuneration that ensures an “existence worthy of human dignity” embodied in Article 23 imply that it is unethical to employ child labor in sweatshop settings and pay less than subsistence wages, even if that happens to be common practice in some countries. These are fundamental human rights that transcend national borders.

It is important to note that along with rights come obligations. Because we have the right to free speech, we are also obligated to make sure that we respect the free speech of others. The notion that people have obligations is stated in Article 29 of the Universal Declaration of Human Rights:

1. Everyone has duties to the community in which alone the free and full development of his personality is possible.

Within the framework of a theory of rights, certain people or institutions are obligated to provide benefits or services that secure the rights of others. Such obligations also fall on more than one class of moral agent (a moral agent is any person or institution that is capable of moral action such as a government or corporation).

For example, to escape the high costs of toxic waste disposal in the West, in the late 1980s several firms shipped their waste in bulk to African nations, where it was disposed of at a much lower cost. In 1987, five European ships unloaded toxic waste containing dangerous poisons in Nigeria. Workers wearing sandals and shorts unloaded the barrels for $2.50 a day and placed them in a dirt lot in a residential area. They were not told about the contents of the barrels.34 Who bears the obligation for protecting the rights of workers and residents to safety in a case like this? According to rights theorists, the obligation rests not on the shoulders of one moral agent, but on the shoulders of all moral agents whose actions might harm or contribute to the harm of the workers and residents. Thus, it was the obligation not just of the Nigerian government but also of the multinational firms that shipped the toxic waste to make sure it did no harm to residents and workers. In this case, both the government and the multinationals apparently failed to recognize their basic obligation to protect the fundamental human rights of others.

JUSTICE THEORIES Justice theories focus on the attainment of a just distribution of economic goods and services. A just distribution is one that is considered fair and equitable. There is no one theory of justice, and several theories of justice conflict with each other in important ways.35 Here, we focus on one particular theory of justice that is both very influential and has important ethical implications. The theory is attributed to philosopher John Rawls.36 Rawls argues that all economic goods and services should be distributed equally except when an unequal distribution would work to everyone’s advantage.

Just Distribution

A distribution of goods and services that is considered fair and equitable.

According to Rawls, valid principles of justice are those with which all persons would agree if they could freely and impartially consider the situation. Impartiality is guaranteed by a conceptual device that Rawls calls the veil of ignorance. Under the veil of ignorance, everyone is imagined to be ignorant of all of his or her particular characteristics, for example, race, sex, intelligence, nationality, family background, and special talents. Rawls then asks what system people would design under a veil of ignorance. Under these conditions, people would unanimously agree on two fundamental principles of justice.

The first principle is that each person be permitted the maximum amount of basic liberty compatible with a similar liberty for others. Rawls takes these to be political liberty (e.g., the right to vote), freedom of speech and assembly, liberty of conscience and freedom of thought, the freedom and right to hold personal property, and freedom from arbitrary arrest and seizure.

Page 145The second principle is that once equal basic liberty is ensured, inequality in basic social goods—such as income and wealth distribution, and opportunities—is to be allowed only if such inequalities benefit everyone. Rawls accepts that inequalities can be just if the system that produces inequalities is to the advantage of everyone. More precisely, he formulates what he calls the difference principle, which is that inequalities are justified if they benefit the position of the least-advantaged person. So, for example, wide variations in income and wealth can be considered just if the market-based system that produces this unequal distribution also benefits the least-advantaged members of society. One can argue that a well-regulated, market-based economy and free trade, by promoting economic growth, benefit the least-advantaged members of society. In principle at least, the inequalities inherent in such systems are therefore just (in other words, the rising tide of wealth created by a market-based economy and free trade lifts all boats, even those of the most disadvantaged).

In the context of international business ethics, Rawls’s theory creates an interesting perspective. Managers could ask themselves whether the policies they adopt in foreign operations would be considered just under Rawls’s veil of ignorance. Is it just, for example, to pay foreign workers less than workers in the firm’s home country? Rawls’s theory would suggest it is, so long as the inequality benefits the least-advantaged members of the global society (which is what economic theory suggests). Alternatively, it is difficult to imagine that managers operating under a veil of ignorance would design a system where foreign employees were paid subsistence wages to work long hours in sweatshop conditions and where they were exposed to toxic materials. Such working conditions are clearly unjust in Rawls’s framework, and therefore, it is unethical to adopt them. Similarly, operating under a veil of ignorance, most people would probably design a system that imparts some protection from environmental degradation to important global commons, such as the oceans, atmosphere, and tropical rain forests. To the extent that this is the case, it follows that it is unjust, and by extension unethical, for companies to pursue actions that contribute toward extensive degradation of these commons. Thus, Rawls’s veil of ignorance is a conceptual tool that contributes to the moral compass that managers can use to help them navigate through difficult ethical dilemmas.

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FOCUS ON MANAGERIAL IMPLICATIONS

MAKING ETHICAL DECISIONS INTERNATIONALLY

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Explain how managers can incorporate ethical considerations into their decision making.

What, then, is the best way for managers in a multinational firm to make sure that ethical considerations figure into international business decisions? How do managers decide on an ethical course of action when confronted with decisions pertaining to working conditions, human rights, corruption, and environmental pollution? From an ethical perspective, how do managers determine the moral obligations that flow from the power of a multinational? In many cases, there are no easy answers to these questions—many of the most vexing ethical problems arise because there are very real dilemmas inherent in them and no obvious correct action. Nevertheless, managers can and should do many things to make sure that basic ethical principles are adhered to and that ethical issues are routinely inserted into international business decisions.

Here, we focus on seven actions that an international business and its managers can take to make sure ethical issues are considered in business decisions: (1) favor hiring and promoting people with a well-grounded sense of personal ethics; (2) build an organizational culture and exemplify leadership behaviors that place a high value on ethical behavior; (3) put decision-making processes in place that require people to consider the ethical dimension of business decisions; (4) institute ethical officers in the organization, (5) develop moral courage; (6) make corporate social responsibility a cornerstone of enterprise policy; and (7) pursue strategies that are sustainable.

Page 146Hiring and Promotion

It seems obvious that businesses should strive to hire people who have a strong sense of personal ethics and would not engage in unethical or illegal behavior. Similarly, you would not expect a business to promote people, and perhaps to fire people, whose behavior does not match generally accepted ethical standards. However, actually doing so is very difficult. How do you know that someone has a poor sense of personal ethics? In our society, we have an incentive to hide a lack of personal ethics from public view. Once people realize that you are unethical, they will no longer trust you.

Is there anything that businesses can do to make sure they do not hire people who subsequently turn out to have poor personal ethics, particularly given that people have an incentive to hide this from public view (indeed, the unethical person may lie about his or her nature)? Businesses can give potential employees psychological tests to try to discern their ethical predispositions, and they can check with prior employees regarding someone’s reputation (e.g., by asking for letters of reference and talking to people who have worked with the prospective employee). The latter is common and does influence the hiring process. Promoting people who have displayed poor ethics should not occur in a company where the organization culture values the need for ethical behavior and where leaders act accordingly.

Not only should businesses strive to identify and hire people with a strong sense of personal ethics, but it also is in the interests of prospective employees to find out as much as they can about the ethical climate in an organization. Who wants to work at a multinational such as Enron, which ultimately entered bankruptcy because unethical executives had established risky partnerships that were hidden from public view and that existed in part to enrich those same executives?

Organization Culture and Leadership

To foster ethical behavior, businesses need to build an organization culture that values ethical behavior. Three things are particularly important in building an organization culture that emphasizes ethical behavior. First, the businesses must explicitly articulate values that emphasize ethical behavior. Many companies now do this by drafting a code of ethics, which is a formal statement of the ethical priorities a business adheres to. Often, the code of ethics draws heavily upon documents such as the UN Universal Declaration of Human Rights, which itself is grounded in Kantian and rights-based theories of moral philosophy. Others have incorporated ethical statements into documents that articulate the values or mission of the business. For example, the food and consumer products multinational Unilever has a code of ethics that includes the following points:37

Code of Ethics

A business’s formal statement of ethical priorities.

Employees: Unilever is committed to diversity in a working environment where there is mutual trust and respect and where everyone feels responsible for the performance and reputation of our company. We will recruit, employ, and promote employees on the sole basis of the qualifications and abilities needed for the work to be performed. We are committed to safe and healthy working conditions for all employees. We will not use any form of forced, compulsory, or child labor. We are committed to working with employees to develop and enhance each individual’s skills and capabilities. We respect the dignity of the individual and the right of employees to freedom of association. We will maintain good communications with employees through company-based information and consultation procedures.

Business Integrity: Unilever does not give or receive, whether directly or indirectly, bribes or other improper advantages for business or financial gain. No employee may offer, give, or receive any gift or payment which is, or may be construed as being, a bribe. Any demand for, or offer of, a bribe must be rejected immediately and reported to management. Unilever accounting records and supporting documents must accurately describe and reflect the nature of the underlying transactions. No undisclosed or unrecorded account, fund, or asset will be established or maintained.

It is clear from these principles that among other things, Unilever will not tolerate substandard working conditions, use child labor, or give bribes under any circumstances. Note alsoPage 147the reference to respecting the dignity of employees, a statement that is grounded in Kantian ethics. Unilever’s principles send a very clear message about appropriate ethics to managers and employees.

Having articulated values in a code of ethics or some other document, leaders in the business must give life and meaning to those words by repeatedly emphasizing their importance and then acting on them. This means using every relevant opportunity to stress the importance of business ethics and making sure that key business decisions not only make good economic sense but also are ethical. Many companies have gone a step further, hiring independent auditors to make sure they are behaving in a manner consistent with their ethical codes. Nike, for example, has hired independent auditors to make sure that subcontractors used by the company are living up to Nike’s code of conduct.

Finally, building an organization culture that places a high value on ethical behavior requires incentive and reward systems, including promotions that reward people who engage in ethical behavior and sanction those who do not. At General Electric, for example, the former CEO Jack Welch has described how he reviewed the performance of managers, dividing them into several different groups. These included over-performers who displayed the right values and were singled out for advancement and bonuses and over-performers who displayed the wrong values and were let go. Welch was not willing to tolerate leaders within the company who did not act in accordance with the central values of the company, even if they were in all other respects skilled managers.38

Decision-Making Processes

In addition to establishing the right kind of ethical culture in an organization, businesspeople must be able to think through the ethical implications of decisions in a systematic way. To do this, they need a moral compass, and both rights theories and Rawls’s theory of justice help provide such a compass. Beyond these theories, some experts on ethics have proposed a straightforward practical guide—or ethical algorithm—to determine whether a decision is ethical.39 According to these experts, a decision is acceptable on ethical grounds if a businessperson can answer yes to each of these questions:

• Does my decision fall within the accepted values or standards that typically apply in the organizational environment (as articulated in a code of ethics or some other corporate statement)?

• Am I willing to see the decision communicated to all stakeholders affected by it—for example, by having it reported in newspapers, television, or social media?

• Would the people with whom I have a significant personal relationship, such as family members, friends, or even managers in other businesses, approve of the decision?

Others have recommended a five-step process to think through ethical problems (this is another example of an ethical algorithm).40 In step 1, businesspeople should identify which stakeholders a decision would affect and in what ways. A firm’s stakeholders are individuals or groups that have an interest, claim, or stake in the company, in what it does, and in how well it performs.41 They can be divided into internal stakeholders and external stakeholders. Internal stakeholders are individuals or groups who work for or own the business. They include primary stakeholder such as employees, the board of directors, and shareholders. External stakeholders are all the other individuals and groups that have some direct or indirect claim on the firm. Typically, this group comprises primary stakeholders such as customers, suppliers, governments, and local communities as well as secondary stake-holders such as special interest groups, competitors, trade associations, mass media, and social media.42

Stakeholders

The individuals or groups that have an interest, stake, or claim in the actions and overall performance of a company.

Internal Stakeholders

People who work for or own the business such as employees, directors, and stockholders.

External Stakeholders

Individuals or groups that have some claim on a firm such as customers, suppliers, and unions.

All stakeholders are in an exchange relationship with the company.43 Each stakeholder group supplies the organization with important resources (or contributions), and in exchange each expects its interests to be satisfied (by inducements).44 For example, employees provide labor, skills, knowledge, and time and in exchange expect commensurate income, job satisfaction, job security, and good working conditions. Customers provide a company with its revenues and in exchange want quality products that represent value for money. Communities provide businesses with local infrastructure and in exchange want businesses Page 148that are responsible citizens and seek some assurance that the quality of life will be improved as a result of the business firm’s existence.

Stakeholder analysis involves a certain amount of what has been called moral imagination.45 This means standing in the shoes of a stakeholder and asking how a proposed decision might impact that stakeholder. For example, when considering outsourcing to subcontractors, managers might need to ask themselves how it might feel to be working under substandard health conditions for long hours.

Step 2 involves judging the ethics of the proposed strategic decision, given the information gained in step 1. Managers need to determine whether a proposed decision would violate the fundamental rights of any stakeholders. For example, we might argue that the right to information about health risks in the workplace is a fundamental entitlement of employees. Similarly, the right to know about potentially dangerous features of a product is a fundamental entitlement of customers (something tobacco companies violated when they did not reveal to their customers what they knew about the health risks of smoking). Managers might also want to ask themselves whether they would allow the proposed strategic decision if they were designing a system under Rawls’s veil of ignorance. For example, if the issue under consideration was whether to outsource work to a subcontractor with low pay and poor working conditions, managers might want to ask themselves whether they would allow such action if they were considering it under a veil of ignorance, where they themselves might ultimately be the ones to work for the subcontractor.

The judgment at this stage should be guided by various moral principles that should not be violated. The principles might be those articulated in a corporate code of ethics or other company documents. In addition, certain moral principles that we have adopted as members of society—for instance, the prohibition on stealing—should not be violated. The judgment at this stage will also be guided by the decision rule that is chosen to assess the proposed strategic decision. Although maximizing long-run profitability is the decision rule that most businesses stress, it should be applied subject to the constraint that no moral principles are violated—that the business behaves in an ethical manner.

Step 3 requires managers to establish moral intent. This means the business must resolve to place moral concerns ahead of other concerns in cases where either the fundamental rights of stakeholders or key moral principles have been violated. At this stage, input from top management might be particularly valuable. Without the proactive encouragement of top managers, middle-level managers might tend to place the narrow economic interests of the company before the interests of stakeholders. They might do so in the (usually erroneous) belief that top managers favor such an approach.

Step 4 requires the company to engage in ethical behavior. Step 5 requires the business to audit its decisions, reviewing them to make sure they were consistent with ethical principles, such as those stated in the company’s code of ethics. This final step is critical and often overlooked. Without auditing past decisions, businesspeople may not know if their decision process is working and if changes should be made to ensure greater compliance with a code of ethics.

Ethics Officers

To make sure that a business behaves in an ethical manner, firms now must have oversight by a high-ranking person or people known to respect legal and ethical standards. These individuals—often referred to as ethics officers—are responsible for managing their organizations ethics and legal compliance programs. They are typically responsible for (1) assessing the needs and risks that an ethics program must address; (2) developing and distributing a code of ethics; (3) conducting training programs for employees; (4) establishing and maintaining a confidential service to address employees’ questions about issues that may be ethical or unethical; (5) making sure that the organization is in compliance with government laws and regulations; (6) monitoring and auditing ethical conduct; (7) taking action, as appropriate, on possible violations; and (8) reviewing and updating the code of ethics periodically.46 Because of these broad topics covered by the ethics officer, in many businesses ethics officers act as an internal ombudsperson with responsibility for handling confidential inquiries from employees, investigating complaints from employees or others, reporting findings, and making recommendations for change.

For example, United Technologies, a multinational aerospace company with worldwide revenues of more than $30 billion, has had a formal code of ethics since 1990.47 United Technologies has some 450 business practices officers (the company’s name for ethics officers). They are responsible for making sure the code is followed. United Technologies also established an ombudsperson program in 1986 that lets employees inquire anonymously about ethics issues. The program has received some 60,000 inquiries since 1986, and more than 10,000 cases have been handled by an ombudsperson.

Moral Courage

It is important to recognize that employees in an international business may need significant moral courage. Moral courage enables managers to walk away from a decision that is profitable but unethical. Moral courage gives an employee the strength to say no to a superior who instructs her to pursue actions that are unethical. Moral courage gives employees the integrity to go public to the media and blow the whistle on persistent unethical behavior in a company. Moral courage does not come easily; there are well-known cases where individuals have lost their jobs because they blew the whistle on corporate behaviors they thought unethical, telling the media about what was occurring.48

However, companies can strengthen the moral courage of employees by committing themselves to not retaliate against employees who exercise moral courage, say no to superiors, or otherwise complain about unethical actions. For example, consider the following excerpt from Unilever.com “Our Principles”:

Any breaches of the Code must be reported in accordance with the procedures specified by the Chief Legal Officer. The Board of Unilever will not criticize management for any loss of business resulting from adherence to these principles and other mandatory policies and instructions. The Board of Unilever expects employees to bring to their attention, or to that of senior management, any breach or suspected breach of these principles. Provision has been made for employees to be able to report in confidence and no employee will suffer as a consequence of doing so.49

This statement gives permission to employees to exercise moral courage. Companies can also set up ethics hotlines, which allow employees to anonymously register a complaint with a corporate ethics officer.

Corporate Social Responsibility

Multinational corporations have power that comes from their control over resources and their ability to move production from country to country. Although that power is constrained not only by laws and regulations but also by the discipline of the market and the competitive process, it is substantial. Some moral philosophers argue that with power comes the social responsibility for multinationals to give something back to the societies that enable them to prosper and grow. The concept of corporate social responsibility (CSR) refers to the idea that businesspeople should consider the social consequences of economic actions when making business decisions and that there should be a presumption in favor of decisions that have both good economic and social consequences.50 In its purest form, corporate social responsibility can be supported for its own sake simply because it is the right way for a business to behave. Advocates of this approach argue that businesses, particularly large successful businesses, need to recognize their noblesse oblige and give something back to the societies that have made their success possible. Noblesse oblige is a French term that refers to honorable and benevolent behavior considered the responsibility of people of high (noble) birth. In a business setting, it is taken to mean benevolent behavior that is the responsibility of successful enterprises. This has long been recognized by many businesspeople, resulting in a substantial and venerable history of corporate giving to society, with businesses making social investments designed to enhance the welfare of the communities in which they operate.

Corporate Social Responsibility (CSR)

Refers to the idea that businesspeople should consider the social consequences of economic actions when making business decisions and that there should be a presumption in favor of decisions that have both good economic and social consequences.

Page 150Power itself is morally neutral; how power is used is what matters. It can be used in a positive way to increase social welfare, which is ethical, or it can be used in a manner that is ethically and morally suspect. Managers at some multinationals have acknowledged a moral obligation to use their power to enhance social welfare in the communities where they do business. BP, one of the world’s largest oil companies, has made it part of the company policy to undertake “social investments” in the countries where it does business.51 In Algeria, BP has been investing in a major project to develop gas fields near the desert town of Salah. When the company noticed the lack of clean water in Salah, it built two desalination plants to provide drinking water for the local community and distributed containers to residents so they could take water from the plants to their homes. There was no economic reason for BP to make this social investment, but the company believes it is morally obligated to use its power in constructive ways. The action, while a small thing for BP, is a very important thing for the local community. For another example of corporate social responsibility in practice, see the Management Focus feature on the Finnish company, Stora Enso.

Sustainability

As managers in international businesses strive to translate ideas about corporate social responsibility into strategic actions, many are gravitating toward strategies that are viewed as sustainable. By sustainable strategies, we mean strategies that not only help the multinational firm make good profits, but that also do so without harming the environment while simultaneously ensuring that the corporation acts in a socially responsible manner with regard to its stake-holders.52 The core idea of sustainability is that the organization—through its actions—does not exert a negative impact upon the ability of future generations to meet their own economic needs and that its actions impart long-run economic and social benefits on stakeholders.53 A company pursuing a sustainable strategy would not adopt business practices that deplete the environment for short-term economic gain because doing so would impose a cost on future generations. In other words, international businesses that pursue sustainable strategies try to ensure that they do not precipitate or participate in a situation that results in a tragedy of the commons Thus, for example, a company pursuing a sustainable strategy would try to reduce its carbon footprint (CO2 emissions) so that it does not contribute to global warming.

Sustainable Strategies

Strategies that not only help the multinational firm make good profits, but that do so without harming the environment, while simultaneously ensuring that the corporation acts in a socially responsible manner with regard to its multiple stakeholders.

Nor would a company pursuing a sustainable strategy adopt policies that negatively affect the well-being of key stakeholders such as employees and suppliers because managers would recognize that in the long run, this would harm the company. The company that pays its employees so little that it forces them into poverty, for example, may find it hard to recruit employees in the future and may have to deal with high employee turnover, which imposes its own costs on an enterprise. Similarly, a company that drives down the prices it pays to its suppliers so far that the suppliers cannot make enough money to invest in upgrading their operations may find that in the long run, its business suffers poor-quality inputs and a lack of innovation among its supplier base. Is Sustainability Bad for Profits?

Most customers prefer that the companies they buy products and services from engage in business-focused sustainability practices. Eighty-three percent of the respondents in the Public Opinion Survey on Sustainability said that they think companies should try to accomplish their performance goals while also trying to improve society and the environment. At the same time, multinational firms are overwhelmed about the varied stake-holder needs they face. And, the Global Reporting Initiative, with its some 80 equally important sustainability indicators, is not giving companies a clear set of sustainability proprieties. Meanwhile, sustainability executives in companies have not exactly been elevated to the importance levels of other top managers. If you had to pay more for a product, like gasoline for your automobile, how much more would you be willing to pay to buy from a highly rated sustainability-oriented company —5 percent, 10 percent, 25 percent, 40 percent?

Sources: J. Epstein-Reeves, “The Pain of Sustainability,” Forbes, January 18, 2012; “Consumers Expect Action from Companies on Sustainability,” Second Annual Public Opinion Survey on Sustainability, http://dowelldogood.net/?p=940, accessed March 9, 2014; and “Global Reporting Initiative,” www.globalreporting. org, accessed March 9, 2014.

Stora Enso, profiled in the Management Focus feature, is in essence pursuing sustainable strategies because, through its actions, it is trying to make sure that forest resources are well managed and available for future generations and that the communities with which it interacts benefit from its presence and will, therefore, support the company going forward. For another example, consider Starbucks. Starbucks has a goal of ensuring that 100 percent of its coffee is ethically sourced. By this, it means that the farmers who grow the coffee beans it purchases use sustainable farming methods that do not harm the environment and that they treat their employees well and pay them fairly. Starbucks agronomists work directly with farmers in places like Costa Rica and Rwanda to make sure that they use environmentally responsible farming methods. The company also provides loans to farmers to help them upgrade their production methods. As a result of these policies, by 2012, some 93 percent of Starbucks coffee beans were ethically sourced.

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Corporate Social Responsibility at Stora Enso

Stora Enso is a Finnish pulp and paper manufacturer that was formed by the merger of Swedish mining and forestry products company Stora and Finnish forestry products company Enso-Gutzeit Oy in 1998. The company is headquartered in Helsinki, the capital of Finland, and it has approximately 29,000 employees. In 2000, the company bought Consolidated Papers in North America. Stora Enso also expanded into South America, Asia, and Russia. By 2005, Stora Enso had become the world’s largest pulp and paper manufacturer as measured by production capacity. However, the North American operations were sold in 2007 to NewPage Corporation.

Stora Enso has a long-standing tradition of corporate social responsibility on a global scale. As part of the company’s section on “Global Responsibility in Stora Enso,” the company states that, “for Stora Enso, Global Responsibility means realizing concrete actions that will help us fulfil our Purpose, which is to do good for the people and the planet.” Stora Enso continues to state that:

Our purpose “do good for the people and the planet” is the ultimate reason why we run our business. It is the overriding rule that guides us in all that we do: producing and selling our renewable products, buying trees from a local forest-owner in Finland, selling electricity generated at Stora Enso Skoghall Mill, or managing our logistics on a global scale.

Interestingly, Stora Enso also asserts that it realizes that this statement is rather bold and perhaps not even fully believable. But, the company suggests that it makes the company accountable for its actions; that is, setting its purpose boldly in writing. At the same time, Stora Enso positions the company as though it has always been attending to the “socially responsible” needs of doing good for the people and the planet. It illustrates this by maintaining that it has created and enhanced communities around its mills, developed innovative systems to reduce the use of scarce resources, and maintained good relationships with key stakeholders such as forest-owners, their own employees, governments, and local communities near its mills.

Tracing to its past and reflecting on its future, Stora Enso has adopted three lead areas for its Global Responsibility Strategy: People and Ethics, Forests and Land Use, and Environment and Efficiency. For people and ethics, the company focuses on conducting business in a socially responsible manner throughout its global value chain. For forests and land use, it focuses on an innovative and responsible approach on forestry and land use to make it a preferred partner and a good local community citizen. For the environment and efficiency, the focus is on resource-efficient operations that help the company achieve superior environmental performance related to its products.

While a number of companies have corporate social responsibility statements incorporated as part of their websites, annual reports, and talking points, Stora Enso also presents clear targets and performance goals that are assessed by established metrics. Its overall operations are guided by corporate-level targets for environmental and social performance, aptly named Stora Enso’s Global Responsibility Key Performance Indicators (KPI). Targets are publicly listed in a document titled “Targets and Performance” and include two to five basic categories of measures for each of the three lead areas. For People and Ethics, the dimensions cover health and safety, human rights, ethics and compliance, sustainable leadership, and responsible sourcing. For Forests and Land Use, the dimensions cover efficiency of land use and sustainable forestry. For Environment and Efficiency, the dimensions cover climate and energy, material efficiency, and process water discharges. The “Targets and Performance” document also lists performance in the prior year, targets in the current year, and strategic objectives related to each dimension.

Sources: “Global Responsibility in Stora Enso,” www.storaenso.com/Rethink-Site/ Responsibility-Site, accessed March 9, 2014; K. Vita, “Stora Enso Falls as UBS Plays Down Merger Talk: Helsinki Mover,” Bloomberg Businessweek, September 30, 2013; and M. Huuhtanen, “Paper Maker Stora Enso Selling North American Mills,” USA Today, September 21, 2007.

An important aspect of the sustainable strategies pursued by both Stora Enso and Star-bucks is that they have helped both companies to gain a competitive advantage and, therefore, make more money for their shareholders. In the case of Starbucks, for example, its ethical sourcing policies send a powerful signal to its customers about the kind of company Starbucks wants to be. This resonates well with the company’s customer base and strengthens the Starbucks brand, resulting in more store traffic and higher sales and profits. So even though it may cost Starbucks some money up front to shift to an ethical sourcing policy, the benefits in terms of a more powerful brand outweigh the costs. For another example of a multinational that is pursuing a sustainable strategy, see the Management Focus feature about sustainability at Umicore, a Belgian company.

The basic point here is that well-crafted sustainable strategies can be good for shareholders, the environment, suppliers, local communities, employees, and customers. Business need not be a zero-sum game, where increasing the returns to one stakeholder group (e.g., shareholders), requires the imposition of costs on other stakeholder groups (e.g., the environment, suppliers, employees). As the examples we have given illustrate, it is possible to pursue sustainable strategies that result in a positive-sum game where all stakeholders benefit. To be sure, pursuing such strategies may impose some short-term costs on the multinational as it increases investments in better environmental practices, better employee working conditions, and safer products, and as it requires suppliers to adopt similar policies, but, in the long run, there is good evidence that all stakeholders can benefit from such an approach and, indeed, that such an approach may help the company to compete more effectively in the global market place. Good ethical practices are good for business!

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Sustainability at Umicore

In introducing Umicore as the most sustainable multinational firm in the world for 2013 on its “Global 100 Index,” Doug Morrow, vice president of research at Corporate Knights, a Toronto-based media company, said that sustainability is “recognizing that a corporation’s long-term interests are intellectually and financially consistent with resource efficiency, proactive health and safety practices, and responsible leadership.” “Sustainability is when what is good for a company is also good for the planet, and vice-versa,” added the editor-in-chief of Corporate Knights, Toby Heaps.

Umicore N.V., formerly Union Minière until 2001, is a multinational materials technology company headquartered in Brussels, Belgium. The company was founded in 1989 as a merger of four companies in the mining and smelting industries. Subsequent to the merger, Umicore reshaped itself to focus on technology-related businesses such as refining and recycling of precious metals along with the manufacturing of specialized products from precious metals. As a solid and respected company, Umicore has been included as a component of Belgium’s benchmark “BEL20” index since its inception in 1991 (BEL 20 is the benchmark stock market index of Euronext Brussels, the Brussels Stock Exchange).

Umicore’s core business areas are Catalysis, Energy Materials, Performance Materials, and Recycling. Catalysis is involved with abatement of global automotive emissions and production of compounds for use in chemicals, life science, and pharmaceutical industries. The materials produced by Energy Materials can be found in a number of applications used in the production and storage of clean energy. Performance Materials applies its technology and know-how to the unique properties of precious and other metals (to achieve safer products). Recycling treats complex waste streams containing precious and other nonferrous metals.

Across these four business areas, Umicore clearly defines its sustainability objectives and goals, which address market orientation, multiple stakeholders, and corporate social responsibility. The company’s financial objective is to achieve double-digit revenue growth, with the goal of generating an average return on capital employed of more than 15 percent annually. Such a goal is market-oriented with a clear, bottom-line financial expectation for performance. For corporate social responsibility, the focus is on two issues. Environmentally, Umicore focuses on reducing its carbon footprint by 20 percent, reducing the impact of metal emissions on water and air by 20 percent, and investing in tools to better understand and measure life cycles of its products. Socially, Umicore focuses on achieving zero lost-time accidents, reducing body concentrations of metals to which employees have exposure, and individual employee development. Umicore also takes a strong stand in its stakeholder management, stating that all of its sites are expected to identify key stakeholders and engaging with the local community.

Sources: J. Smith, “The World’s Most Sustainable Companies,” Forbes¸ January 23, 2013; Umicore’s Sustainability, www.umicore.com/sustainability, accessed March 9, 2014; and J. Martens, “Umicore Gains After Maintaining Profit Forecast: Brussels Mover,” Bloomberg Businessweek, July 30, 2013.

Key Terms

business ethics

ethical strategy

Foreign Corrupt Practices Act

Convention on Combating Bribery of Foreign Public Officials in International Business Transactions

ethical dilemma

organizational culture

cultural relativism

righteous moralist

naive immoralist

utilitarian approach to ethics

Kantian ethics

rights theories

Universal Declaration of Human Rights

just distribution

code of ethics

stakeholders

internal stakeholders

external stakeholders

corporate social responsibility

sustainable strategies

Summary

This chapter discussed the source and nature of ethical issues in international businesses, the different philosophical approaches to business ethics, and the steps managers can take to ensure that ethical issues are respected in international business decisions. The chapter made the following points:

1. The term ethics refers to accepted principles of right or wrong that govern the conduct of a person, the members of a profession, or the actions of an organization. Business ethics are the accepted principles of right or wrong governing the conduct of businesspeople, and an ethical strategy is one that does not violate these accepted principles.

2. Ethical issues and dilemmas in international business are rooted in the variations among political systems, law, economic development, and culture from nation to nation.

3. The most common ethical issues in international business involve employment practices, human rights, environmental regulations, corruption, and social responsibility of multinational corporations.

4. Ethical dilemmas are situations in which none of the available alternatives seems ethically acceptable.

5. Unethical behavior is rooted in poor personal ethics, societal culture, the psychological and geographic distances of a foreign subsidiary from the home office, a failure to incorporate ethical issues into strategic and operational decision making, a dysfunctional culture, and failure of leaders to act in an ethical manner.

6. Moral philosophers contend that approaches to business ethics such as the Friedman doctrine, cultural relativism, the righteous moralist, and the naive immoralist are unsatisfactory in important ways.

7. The Friedman doctrine states that the only social responsibility of business is to increase profits, as long as the company stays within the rules of law. Cultural relativism contends that one should adopt the ethics of the culture in which one is doing business. The righteous moralist monolithically applies home-country ethics to a foreign situation, while the naive immoralist believes that if a manager of a multinational sees that firms from other nations are not following ethical norms in a host nation, that manager should not either.

8. Utilitarian approaches to ethics hold that the moral worth of actions or practices is determined by their consequences, and the best decisions are those that produce the greatest good for the greatest number of people.

9. Kantian ethics state that people should be treated as ends and never purely as means to the ends of others. People are not instruments, like a machine. People have dignity and need to be respected as such.

10. Rights theories recognize that human beings have fundamental rights and privileges that transcend national boundaries and cultures. These rights establish a minimum level of morally acceptable behavior.

11. The concept of justice developed by John Rawls suggests that a decision is just and ethical if people would allow it when designing a social system under a veil of ignorance.

12. To make sure that ethical issues are considered in international business decisions, managers should (a) favor hiring and promoting people with a well-grounded sense of personal ethics; (b) build an organization culture and exemplify leadership behaviors that place a high value on ethical behavior; (c) put decision-making processes in place that require people to consider the ethical dimension of business decisions; (d) establish ethics officers in the organization with responsibility for ethical decision-making; (e) be morally courageous and encourage others to do the same; (f) make corporate social responsibility a cornerstone of enterprise policy; and (g) pursue strategies that are sustainable.

13. Multinational corporations that are practicing business-focused sustainability integrate a focus on market orientation, addressing the needs of multiple stakeholders, and adhering to corporate social responsibility principles.

Critical Thinking and Discussion Questions

1. A visiting American executive finds that a foreign subsidiary in a less developed country has hired a 12-year-old girl to work on a factory floor, in violation of the company’s prohibition on child labor. He tells the local manager to replace the child and tell her to go back to school. The local manager tells the American executive that the child is an orphan with no other means of support, and she will probably become a street child if she is denied work. What should the American executive do?

2. Drawing upon John Rawls’s concept of the veil of ignorance, develop an ethical code that will (a) guide Page 154the decisions of a large oil multinational toward environmental protection and (b) influence the policies of a clothing company in their potential decision of outsourcing its manufacturing operations.

3. Under what conditions is it ethically defensible to outsource production to the developing world where labor costs are lower when such actions also involve laying off long-term employees in the firm’s home country?

4. Do you think facilitating payments (speed payments) should be ethical?

5. A manager from a developing country is overseeing a multinational’s operations in a country where drug trafficking and lawlessness are rife. One day, a representative of a local “big man” approaches the manager and asks for a “donation” to help the big man provide housing for the poor. The representative tells the manager that in return for the donation, the big man will make sure that the manager has a productive stay in his country. No threats are made, but the manager is well aware that the big man heads a criminal organization that is engaged in drug trafficking. He also knows that that the big man does indeed help the poor in the rundown neighborhood of the city where he was born. What should the manager do?

6. Milton Friedman stated in his famous article in The New York Times in 1970 that “the social responsibility of business is to increase profits.” Do you agree? If not, do you prefer that multinational corporations adopt a focus on corporate social responsibility or sustainability practices?

7. Reread the Management Focus on Unocal, and answer the following questions:

a. Was it ethical for Unocal to enter into a partnership with a brutal military dictatorship for financial gain?

b. What actions could Unocal have taken, short of not investing at all, to safeguard the human rights of people affected by the gas pipeline project?

images Research Task http://globalEDGE.msu.edu

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. Promoting respect for universal human rights is a central dimension of many countries’ foreign policy. As history has shown, human rights abuses are an important concern worldwide. Some countries are more ready to work with other governments and civil society organizations to prevent abuses of power. Begun in 1977, the annual Country Reports on Human Rights Practices are designed to assess the state of democracy and human rights around the world, call attention to violations, and—where needed—prompt needed changes in U.S. policies toward particular countries. Find the latest annual Country Reports on Human Right Practices for the BRIC countries (Brazil, China, India, and Russia), and create a table to compare the findings under the “Worker Rights” sections. What commonalities do you see? What differences are there?

2. The use of bribery in the business setting is an important ethical dilemma many companies face both domestically and abroad. The Bribe Payers Index is a study published every three years to assess the likelihood of firms from 28 leading economies to win business overseas by offering bribes. It also ranks industry sectors based on the prevalence of bribery. Compare the five industries thought to have the largest problems with bribery with those five that have the least problems. What patterns do you see? What factors make some industries more conducive to bribery than others?

images Bitcoin as an Ethical Dilemma closing case

Bitcoin is an open-source, peer-to-peer digital currency introduced to the world on January 3, 2009, by developer Satoshi Nakamoto. The crypto-currency is based on a protocol and software that allows instant peer-to-peer transactions and worldwide payments with minimal costs. In its few years of existence, bitcoin has seen unprecedented media coverage, a rollercoaster ride of epic spikes and epic plunges, and adopters from major retailers to lemon stands (e.g., Amazon, Target, Victoria’s Secret, and Whole Foods). Bitcoin has also been covered by numerous major news organizations (e.g., ABC, CNBC, Forbes, Fox News, Reuters) as the most popular form of virtual currency.

At the same time, ethical concerns exist with this new digital currency. The coupling of no regulations, virtually free movement of value, and a Ponzi scheme–like system have led renowned economist Paul Krugman to suggest that “bitcoin is evil.” At the basic level, Krugman says that “to be successful, money must be both a medium of exchange and a reasonably stable store of value.” He continues to say that “it remains completely Page 155unclear why bitcoin should be a stable store of value.” Joining in the discussion, Charlie Stross, the British writer of science fiction, says that “bitcoin looks like it was designed as a weapon intended to damage central banking and money issuing banks, with a Libertarian political agenda in mind—to damage states’ ability to collect tax and monitor their citizens’ financial transactions.”

What is the difference between bitcoin and normal currency, such as the U.S. dollar? Bitcoin is an unregulated peer-to-peer digital currency that is not backed by any other commodity such as gold or silver. Bitcoins exist almost entirely in the digital, online world, although some bitcoins have actually been privately minted. The U.S. dollar, like many other stable currencies, are paper or coin currency issued by a national reserve–type bank (in the United States, it is the Federal Reserve Bank). This means that dollars are really Federal Reserve Notes that are printed or minted at the U.S. Bureau of Engraving and Printing. The dollar is so-called fiat money, which means that dollars derive their value from the U.S. government regulation or law. Interestingly, the United States decided in 2014 that bitcoins will be taxed as property, not currency, for International Revenue Services (IRS) purposes. The IRS defined bitcoin as a “convertible currency that can be used as a medium of exchange, a unit of account, and/or a store of value.”

Technically, Bitcoin with a capitalized “B” refers to the technology and network associated with the currency, while bitcoin with a lower case “b” refers to the actual currency. The philosophy underlying the bitcoin is complete mistrust in authority or control—basically a perfectly stateless, market-based approach, with no country or region-level bank intervention. It is also very technical. Bitcoins are generated through a process called “mining.” The mining process involves adding transaction records to bitcoin’s public ledger of past transactions, which is called the block chain (i.e., a chain of blocks). Bitcoin nodes use the block chain to identify legitimate bitcoin transactions. Even in today’s high-tech world, the mining process is intentionally designed to be resource-intensive and difficult. This means that the number of blocks found daily by miners remains relatively steady. So, basically, in order to “mine” a bitcoin, a person has to solve a complex mathematical problem using substantial computational power. There’s a twofold reason for this: It controls the supply of bitcoins and incentivizes people to maintain the underlying infrastructure that keeps bitcoins in place.

A unique feature of the bitcoin is that the number of new bitcoins that are created is intentionally halved every four years until the year 2140, when it will wind down to zero. So, starting in 2140, no more bitcoins will be added into virtual circulation and they will have reached their maximum of 21 million. Perhaps most people will not worry about the year 2140 just yet, but it does mean that there is, technically, a finite supply of bitcoins. Such a finite number has the potential to adversely affect the value of bit-coins. Economist John Quiggin argues that this has resulted in “the finest example of a pure bubble.”

Perhaps more remarkably, bitcoins do not have any real value per se (cf. gold, silver), which means that the coin’s value depends on classical demand-and-supply economics, leading many financial experts to liken bitcoins to a Ponzi scheme, similar to Krugman’s viewpoint. A Ponzi scheme is a fraudulent investment operation that returns payment to its investors from capital paid by new investors rather than from profit earned (Charles Ponzi was born in Italy but became known in the early 1920s as a swindler in North America for his unusual money-making scheme).

Bitcoins have also been the subject of scrutiny by various governments because of concerns that they can be used for illegal activities. Some say the cryptocurrency is unethical because it is allegedly used to buy illegal drugs and guns and to pay for other illegal activities. Additionally, given its unique code, once stolen, bitcoins cannot be returned, and there is no central bank or agency that can help catch thieves. But, bitcoins have also attacked the cost of moving money around and have successfully created a simple measure of value that can be very efficiently moved around at virtually no cost.

Sources: P. Krugman, “Bitcoin Is Evil,” The New York Times, December 28, 2013; U. Goyal, “Bitcoin and the Future of Money,” Informilo, June 5, 2013; and D. Leger, “IRS: Bitcoin Is Not a Currency,” USA Today, March 25, 2014.

CASE DISCUSSION QUESTIONS

1. Do you think bitcoins are approaching being unethical monetary instruments without technically carrying a value similar to “real” money?

2. If bitcoins are used to buy drugs, firearms, or other products that are considered illegal in the country in which the bitcoins are being used, does that make bitcoins unethical?

3. Do you think the bitcoin system is “evil” as Paul Krugman suggests? Is it similar to a Ponzi scheme?

4. Do you think that bitcoins were created as a weapon intended to damage central banking and money-issuing banks?

Endnotes

1. Toy Industry Association Inc. and the NPD Group, 2012. www.toyassociation.org, accessed March 8, 2014.

2. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!” Journal of the Academy of Marketing Science, 39, pp. 1–6, 2011; and T. Hult, J. Mena, O. C. Ferrell, and L. Ferrell, “Stakeholder Marketing: A Definition and Conceptual Framework,” AMS Review, 1 (2011), pp. 44–65.

3. S. Greenhouse, “Nike Shoe Plant in Vietnam Is Called Unsafe for Workers,” The New York Times, November 8, 1997; and V. Dobnik, “Chinese Workers Abused Making Nikes, Reeboks,” Seattle Times, September 21, 1997, p. A4.

4. R. K. Massie, Loosing the Bonds: The United States and South Africa in the Apartheid Years (New York: Doubleday, 1997).

5. Not everyone agrees that the divestment trend had much influence on the South African economy. For a counterview see S. H. Teoh, I. Welch, and C. P. Wazzan, “The Effect of Socially Activist Investing on the Financial Markets: Evidence from South Africa,” The Journal of Business 72, no. 1 (January 1999), pp. 35–60.

6. Peter Singer, One World: The Ethics of Globalization (New Haven, CT: Yale University Press, 2002).

7. Garrett Hardin, “The Tragedy of the Commons,” Science 162, no. 1 (1968), pp. 243–48.

8. For a summary of the evidence, see S. Solomon, D. Qin, M. Manning, Z. Chen, M. Marquis, K. B. Averyt, M. Tignor, and H. L. Miller, Eds., Contribution of Working Group I to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change (Cambridge, UK: Cambridge University Press, 2007).

9. J. Everett, D. Neu, and A. S. Rahaman, “The Global Fight against Corruption,” Journal of Business Ethics 65 (2006), pp. 1–18.

10. R. T. De George, Competing with Integrity in International Business (Oxford, UK: Oxford University Press, 1993).

11. Details can be found at www.oecd.org/corruption/ oecdantibriberyconvention.

12. B. Pranab, “Corruption and Development,” Journal of Economic Literature 36 (September 1997), pp. 1320–46.

13. A. Shleifer and R. W. Vishny, “Corruption,” Quarterly Journal of Economics, no. 108 (1993), pp. 599–617; and I. Ehrlich and F. Lui, “Bureaucratic Corruption and Endogenous Economic Growth,” Journal of Political Economy 107 (December 1999), pp. 270–92.

14. P. Mauro, “Corruption and Growth,” Quarterly Journal of Economics, no. 110 (1995), pp. 681–712.

15. D. Kaufman and S. J. Wei, “Does Grease Money Speed up the Wheels of Commerce?” World Bank policy research working paper, January 11, 2000.

16. Detailed at http://ethics.iit.edu/ecodes/node/3436, accessed March 8, 2014.

17. B. Vitou, R. Kovalevsky, and T. Fox, “Time to Call a Spade a Spade. Facilitation Payments and Why Neither Bans Nor Exemption Work,” http://thebriberyact.com/2011/02/03/time-to-call-a-spade-a-spade-facilitation-payments-why-neither-bans-nor-exemptions-work, accessed March 8, 2014.

18. This is known as the “when in Rome perspective.” T. Donaldson, “Values in Tension: Ethics Away from Home,” Harvard Business Review, September–October 1996.

19. De George, Competing with Integrity in International Business.

20. For a discussion of the ethics of using child labor, see J. Isern, “Bittersweet Chocolate: The Legacy of Child Labor in Cocoa Production in Cote d’Ivoire,” Journal of Applied Management and Entrepreneurship 11 (2006), pp. 115–32.

21. S. W. Gellerman, “Why Good Managers Make Bad Ethical Choices,” in Ethics in Practice: Managing the Moral Corporation, K. R. Andrews, Ed. (Cambridge, MA: Harvard Business School Press, 1989).

22. D. Messick and M. H. Bazerman, “Ethical Leadership and the Psychology of Decision Making,” Sloan Management Review 37 (Winter 1996), pp. 9–20.

23. O. C. Ferrell, J. Fraedrich, and L. Ferrell, Business Ethics, 9th ed. (Mason, OH: Cengage, 2013).

24. B. Scholtens and L. Dam, “Cultural Values and International Differences in Business Ethics,” Journal of Business Ethics, 2007.

25. M. Friedman, “The Social Responsibility of Business Is to Increase Profits,” The New York Times Magazine, September 13, 1970. Reprinted in T. L. Beauchamp and N. E. Bowie, Ethical Theory and Business, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).

26. Ibid., p. 55.

27. Ibid., p. 55.

28. For example, see Donaldson, “Values in Tension: Ethics Away from Home.” See also N. Bowie, “Relativism and the Moral Obligations of Multination Corporations,” in T. L. Beauchamp and N. E. Bowie, Ethical Theory and Business, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).

29. For example, see De George, Competing with Integrity in International Business.

30. This example is often repeated in the literature on international business ethics. It was first outlined by A. Kelly in “Case Study—Italian Style Mores,” in T. Donaldson and P. Werhane, Ethical Issues in Business (Englewood Cliffs, NJ: Prentice Hall, 1979).

31. See Beauchamp and Bowie, Ethical Theory and Business.

32. T. Donaldson, The Ethics of International Business (Oxford:Oxford University Press, 1989).

33. Found at www.un.org/Overview/rights.html.

34. T. Donaldson, The Ethics of International Business.

35. See Chapter 10 in Beauchamp and Bowie, Ethical Theory and Business.

36. J. Rawls, A Theory of Justice, rev. ed. (Cambridge, MA: Belknap Press, 1999).

37. Found on Unilever’s website at www.unilever.com/aboutus/ purposeandprinciples/ourprinciples/default.aspx.

38. J. Bower and J. Dial, “Jack Welch: General Electrics Revolutionary,” Harvard Business School Case 9-394-065, April 1994.

39. For example, see R. E. Freeman and D. Gilbert, Corporate Strategy and the Search for Ethics (Englewood Cliffs, NJ: Prentice Hall, 1988); T. Jones, “Ethical Decision Making by Individuals in Organizations,” Academy of Management Review 16 (1991), pp. 366–95; and J. R. Rest, Moral Development: Advances in Research and Theory (New York: Praeger, 1986).

40. Ibid.

41. See E. Freeman, Strategic Management: A Stakeholder Approach (Boston: Pitman Press, 1984); C. W. L. Hill and T. M. Jones, “Stakeholder-Agency Theory,” Journal of Management Studies 29 (1992), pp. 131–54; and J. G. March and H. A. Simon, Organizations (New York: John Wiley & Sons, 1958).

42. Hult, Mena, Ferrell, and Ferrell, “Stakeholder Marketing.”

43. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!” Journal of the Academy of Marketing Science, 39, pp. 1–6, 2011; and Hult, Mena, Ferrell, and Ferrell, “Stakeholder Marketing.”

44. Hill and Jones, “Stakeholder-Agency Theory”; and March and Simon, Organizations.

45. De George, Competing with Integrity in International Business.

Page 15746. OFerrell, Fraedrich, and Ferrell, Business Ethics.

47. The code can be accessed at United Technologies website, www.utc.com/profile/ethics/index.htm.

48. C. Grant, “Whistle Blowers: Saints of Secular Culture,” Journal of Business Ethics, September 2002, pp. 391–400.

49. “Our Principles,” Unilever’s website, www.unilever.com/ aboutus/purposeandprinciples/ourprinciples/default.aspx, accessed March 9, 2014.

50. S. A. Waddock and S. B. Graves, “The Corporate Social Performance–Financial Performance Link,” Strategic Management Journal 8 (1997), pp. 303–19; and I. Maignan, O. C. Ferrell, and T. Hult, “Corporate Citizenship: Cultural Antecedents and Business Benefits,” Journal of the Academy of Marketing Science, 27 (1999), pp. 455–69.

51. Details can be found at BP’s website, www.bp.com.

52. T. Hult, “Market-Focused Sustainability: Market Orientation Plus! Journal of the Academy of Marketing Science, 39 (2011), pp. 1–61.

53. M. Clarkson, “A Stakeholder Framework for Analyzing and Evaluating Corporate Social Performance,” Academy of Management Review, 20 (1995), pp. 92–117; R. Freeman, Strategic Management: A Stakeholder Approach (Marshfield: Pitman Publishing, 1984); T. Hult, J. Mena, O. Ferrell, and L. Ferrell, “Stakeholder Marketing: A Definition and Conceptual Framework,” AMS Review, 1, pp. 44–65, 2011.

International Trade Theory

Creating the World’s Biggest Free Trade Zone ( CHAPTER 6 )

opening case

In his February 12, 2013, State of the Union address, President Barack Obama committed the United States to negotiating a free trade deal with the European Union (EU). The United States and the 28 countries that are members of the EU already make up the world’s largest and richest trading partnership, accounting for about half of global GDP and one-third of all international trade. Nevertheless, the announcement was greeted with approval on both sides of the Atlantic and, unusually for this president, from both sides of the political divide in the United States.

The reason for the enthusiasm can be traced to widespread acceptance of the key axiom of international trade theory—trade is a good thing for all countries involved in a free trade agreement. Free trade is a positive sum game; it is equivalent to the rising tide that lifts all boats. Since 2008, both the United States and the EU have been struggling with low economic growth, persistently high unemployment, and large government deficits. A new free trade deal could help economies on both sides of the Atlantic grow faster, thereby reducing unemployment, without costing another dime in government spending. A trade deal is in effect a cost-free stimulus package.

How big the economic impact will be remains to be seen. For both the United States and the EU average tariffs (taxes) on imported goods are already low, close to 3 percent by most measures. Further reduction could nonetheless stimulate additional trade, and there are some areas where tariffs are much higher, notably on agricultural goods. Beyond tariff reductions, there are many nontariff barriers to international trade that could be reduced or eliminated as the result of a deal. One example is found in the automobile industry, where the EU and United States both employ equally strict but different safety standards. This means that to sell in both the EU and United States, automobile manufacturers must adhere to two different sets of regulations. Similarly, pharmaceutical firms currently have to submit new drugs to two sets of safety tests, one in the United States and one in the EU. Such regulatory requirements are functionally equivalent to an import tariff insofar as they raise the costs of business and international trade. By some calculations, nontariff barriers such as these are equivalent to a traditional import tariff of 10–20 percent. Initial Page 160estimates suggest that a comprehensive and ambitious agreement that covers both tariff and nontariff barriers to trade will boost annual GDP growth by about 0.5 percent per annum on both sides of the Atlantic, producing an additional $200 billion a year in economic activity. Talks on the proposed trade deal began in July 2013. The goal is to finalize the agreement by the end of 2014. images

Sources: “Transatlantic Trading,” The Economist, February 2, 2013; Andrew Walker, “EU and US Free Trade Talks Launched,” BBC News, February 13, 2013; and Paul Ames, “Parmesan Cheese: Thorn in US-EU Free Trade Deal?” GlobalPost.com, February 25, 2013; and Henry Chu, “U.S., EU Resume Negotiations on Free Trade Agreement,” Los Angeles Times, November 11, 2013.

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Introduction

The proposed free trade deal between the United States and the European Union is an example of the benefits of free trade. If an agreement can be reached, a reduction in tariff and nontariff barriers to the free flow of goods and services between the United States and the EU could boost economic growth rates and help bring down persistently high unemployment rates, without costing anything in additional government spending.

Economists have long argued that free trade stimulates economic growth and raises living standards across the board. As the opening case illustrates, the economic arguments concerning the benefits of free trade in goods and services are not abstract academic ones. International trade theories have shaped the economic policy of many nations for the past 60 years. They have been the driver behind the formation of the World Trade Organization and regional trade blocs such as the European Union and the North American Free Trade Agreement (NAFTA), and they underlie the current push for a free trade deal between the United States and EU. It is important to understand, therefore, what these theories are and why they have been so successful in shaping the economic policy of so many nations and the competitive environment in which international businesses compete.

This chapter has two goals that go to the heart of the debate over the benefits—and the costs—of free trade. The first is to review a number of theories that explain why it is beneficial for a country to engage in international trade. The second goal is to explain the pattern of international trade that we observe in the world economy. With regard to the pattern of trade, we will be primarily concerned with explaining the pattern of exports and imports of goods and services between countries. The pattern of foreign direct investment between countries is discussed in Chapter 8.

An Overview of Trade Theory

We open this chapter with a discussion of mercantilism. Propagated in the sixteenth and seventeenth centuries, mercantilism advocated that countries should simultaneously encourage exports and discourage imports. Although mercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the trade policies of many countries. Next, we will look at Adam Smith’s theory of absolute advantage. Proposed in 1776, Smith’s theory was the first to explain why unrestricted free trade is beneficial to a country. Free trade refers to a situation in which a government does not attempt to influence through quotas or duties what its citizens can buy from another country, or what they can produce and sell to another country. Smith argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exports. His arguments imply that such a laissez-faire stance toward trade was in the best interests of a country. Building on Smith’s work are two additional theories that we review. One is the theory of comparative advantage, advanced by the nineteenth-century English economist David Ricardo. This theory is the intellectual basis of the modern argument for unrestricted free trade. In the twentieth century, Ricardo’s work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher-Ohlin theory.

Free Trade

The absence of barriers to the free flow of goods and services between countries.

Page 161THE BENEFITS OF TRADE The great strength of the theories of Smith, Ricardo, and Heckscher-Ohlin is that they identify with precision the specific benefits of international trade. Common sense suggests that some international trade is beneficial. For example, nobody would suggest that Iceland should grow its own oranges. Iceland can benefit from trade by exchanging some of the products that it can produce at a low cost (fish) for some products that it cannot produce at all (oranges). Thus, by engaging in international trade, Icelanders are able to add oranges to their diet of fish.

The theories of Smith, Ricardo, and Heckscher-Ohlin go beyond this commonsense notion, however, to show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. This is a difficult concept for people to grasp. For example, many people in the United States believe that American consumers should buy products made in the United States by American companies whenever possible to help save American jobs from foreign competition. The same kind of nationalistic sentiments can be observed in many other countries.

However, the theories of Smith, Ricardo, and Heckscher-Ohlin tell us that a country’s economy may gain if its citizens buy certain products from other nations that could be produced at home. The gains arise because international trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, while importing products that can be produced more efficiently in other countries. Thus, it may make sense for the United States to specialize in the production and export of commercial jet aircraft, because the efficient production of commercial jet aircraft requires resources that are abundant in the United States, such as a highly skilled labor force and cutting-edge technological know-how. On the other hand, it may make sense for the United States to import textiles from Bangladesh because the efficient production of textiles requires a relatively cheap labor force—and cheap labor is not abundant in the United States.

Of course, this economic argument is often difficult for segments of a country’s population to accept. With their future threatened by imports, U.S. textile companies and their employees have tried hard to persuade the government to limit the importation of textiles by demanding quotas and tariffs. Although such import controls may benefit particular groups, such as textile businesses and their employees, the theories of Smith, Ricardo, and Heckscher-Ohlin suggest that the economy as a whole is hurt by such action. One of the key insights of international trade theory is that limits on imports are often in the interests of domestic producers, but not domestic consumers.

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Understand why nations trade with each other.

images Trade Tutorials

In Chapter 6, we discuss benefits and costs associated with free trade, discuss the benefits of international trade, and explain the pattern of international trade in today’s world economy. The general idea is that international trade theories explain why it can be beneficial for a country to engage in trade across country borders even though countries are at different stages of development, have different product needs, and produce different types of products. International trade theory assumes that countries—through their governments, laws, and regulations—engage in more or less trade across borders. In reality, the vast majority of trade happens across borders by companies from different countries. As related to Chapter 6, check out globalEDGE’s “trade tutorials” section where lots of information, data, and tools are compiled related to trading internationally (globaledge.msu.edu/global-resources/trade-tutorials). The potpourri of trade resources include export tutorials, online course modules, glossary, free trade agreement tariff tool, and much more. The glossary includes lots of terms related to trade. For example, “trade surplus” is defined as a situation in which a country’s exports exceeds its imports (i.e., it represents a net inflow of domestic currency from foreign markets). The opposite is called trade deficit and is considered a net outflow, but how is it really defined—the global EDGE glossary can help.

THE PATTERN OF INTERNATIONAL TRADE The theories of Smith, Ricardo, and Heckscher-Ohlin help explain the pattern of international trade that we observe in the world economy. Some aspects of the pattern are easy to understand. Climate and natural resource endowments explain why Ghana exports cocoa, Brazil exports coffee, Saudi Arabia exports oil, and China exports crawfish. However, much of the observed pattern of international trade is more difficult to explain. For example, why does Japan export automobiles, consumer electronics, and machine tools? Why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Bangladesh export garments? David Ricardo’s theory of comparative advantage offers an explanation in terms of international differences in labor productivity. The more sophisticated Heckscher-Ohlin theory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, and capital) are available in different countries and the proportions in which they are needed for producing particular goods. This explanation rests on the assumption that countries have varying endowments of the various factors of production. Tests of this theory, however, suggest that it is a less powerful explanation of real-world trade patterns than once thought.

One early response to the failure of the Heckscher-Ohlin theory to explain the observed pattern of international trade was the product life-cycle theory. Proposed by Raymond Vernon, this theory suggests that early in their life cycle, most new products are produced in and exported from the country in which they were developed. As a new product becomes widely accepted internationally, however, production starts in other countries. As a result, the theory suggests, the product may ultimately be exported back to the country of its original innovation.

In a similar vein, during the 1980s economists such as Paul Krugman developed what has come to be known as the new trade theory. New trade theory (for which Krugman won the Nobel Prize in 2008) stresses that in some cases countries specialize in the production and export of particular products not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of firms. (This is argued to be the case for the commercial aircraft industry.) In such industries, firms that enter the market first are able to build a competitive advantage that is subsequently difficult to challenge. Thus, the observed pattern of trade between nations may be due in part to the ability of firms within a given nation to capture first-mover advantages. The United States is a major exporter of commercial jet aircraft because American firms such as Boeing were first movers in the world market. Boeing built a competitive advantage that has subsequently been difficult for firms from countries with equally favorable factor endowments to challenge (although Europe’s Airbus has succeeded in doing that). In a work related to the new trade theory, Michael Porter developed a theory referred to as the theory of national competitive advantage. This attempts to explain why particular nations achieve international success in particular industries. In addition to factor endowments, Porter points out the importance of country factors such as domestic demand and domestic rivalry in explaining a nation’s dominance in the production and export of particular products.

TRADE THEORY AND GOVERNMENT POLICY

Although all these theories agree that international trade is beneficial to a country, they lack agreement in their recommendations for government policy. Mercantilism makes a crude case for government involvement in promoting exports and limiting imports. The theories of Smith, Ricardo, and Heckscher-Ohlin form part of the case for unrestricted free trade. The argument for unrestricted free trade is that both import controls and export incentives (such as subsidies) are self-defeating and result in wasted resources. Both the new trade theory and Porter’s theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain export-oriented industries. We discuss the pros and cons of this argument, known as strategic trade policy, as well as the pros and cons of the argument for unrestricted free trade, in Chapter 7.

New Trade Theory

The observed pattern of trade in the world economy may be due in part to the ability of firms in a given market to capture first-mover advantages.

Switzerland has long had a national competitive advantage in the manufacture of watches.

images test PREP

Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go to learnsmartadvantage.com for help.

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Summarize the different theories explaining trade flows between nations.

Mercantilism

An economic philosophy advocating that countries should simultaneously encourage exports and discourage imports.

Mercantilism

Page 163The first theory of international trade, mercantilism, emerged in England in the mid-sixteenth century. The principle assertion of mercantilism was that gold and silver were the mainstays of national wealth and essential to vigorous commerce. At that time, gold and silver were the currency of trade between countries; a country could earn gold and silver by exporting goods. Conversely, importing goods from other countries would result in an out-flow of gold and silver to those countries. The main tenet of mercantilism was that it was in a country’s best interests to maintain a trade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige, and power. As the English mercantilist writer Thomas Mun put it in 1630:

The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value.1

Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. The mercantilists saw no virtue in a large volume of trade. Rather, they recommended policies to maximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, while exports were subsidized.

The classical economist David Hume pointed out an inherent inconsistency in the mercantilist doctrine in 1752. According to Hume, if England had a balance-of-trade surplus with France (it exported more than it imported), the resulting inflow of gold and silver would swell the domestic money supply and generate inflation in England. In France, however, the outflow of gold and silver would have the opposite effect. France’s money supply would contract, and its prices would fall. This change in relative prices between France and England would encourage the French to buy fewer English goods (because they were becoming more expensive) and the English to buy more French goods (because they were becoming cheaper). The result would be a deterioration in the English balance of trade and an improvement in France’s trade balance, until the English surplus was eliminated. Hence, according to Hume, in the long run no country could sustain a surplus on the balance of trade and so accumulate gold and silver as the mercantilists had envisaged.

The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in which a gain by one country results in a loss by another.) It was left to Adam Smith and David Ricardo to show the shortsightedness of this approach and to demonstrate that trade is a positive-sum game, or a situation in which all countries can benefit. Unfortunately, the mercantilist doctrine is by no means dead. Neo-mercantilists equate political power with economic power and economic power with a balance-of-trade surplus. Critics argue that many nations have adopted a neo-mercantilist strategy that is designed to simultaneously boost exports and limit imports.2 For example, critics charge that China long pursued a neo-mercantilist policy, deliberately keeping its currency value low against the U.S. dollar in order to sell more goods to the United States and other developed nations, and thus amass a trade surplus and foreign exchange reserves (see the accompanying Country Focus).

Zero-Sum Game

A situation in which an economic gain by one country results in an economic loss by another.

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Absolute Advantage

In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently. In his time, the English, by virtue of their superior manufacturing processes, were the world’s most efficient textile manufacturers. Due to the combination of favorable climate, good soils, and accumulated expertise, the French had the world’s most efficient wine industry. The English had an absolute advantage in the production of textiles, while the French had an absolute advantage in the production of wine. Thus, a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it.

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Summarize the different theories explaining trade flows between nations.

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Page 164Is China a Neo-mercantilist Nation?

China’s rapid rise in economic power (it is now the world’s second-largest economy) has been built on export-led growth. The country takes raw material imports and, using its cheap labor, converts them into products that it sells to developed nations. For years, the country’s exports have been growing faster than its imports, leading some critics to claim that China is pursuing a neo-mercantilist policy, trying to amass record trade surpluses and foreign currency that will give it economic power over developed nations. By late 2013 its foreign exchange reserves exceeded $3.7 trillion, some 60 percent of which were held in U.S. denominated assets. Observers worry that if China ever decides to sell its holdings of U.S. currency, this could depress the value of the dollar against other currencies and increase the price of imports into America.

Throughout most of the 2000s China’s exports have grown faster than its imports, leading some to argue that China has been limiting imports by pursuing an import substitution policy, encouraging domestic investment in the production of products such as steel, aluminum, and paper, which it had historically imported from other nations. The trade deficit with America has been a particular cause for concern. In 2012, this reached a record $315 billion and it looked set to exceed $340 billion in 2013. At the same time, China long resisted attempts to let its currency float freely against the U.S. dollar. Many claim that China’s currency is too cheap, and that this keeps the prices of China’s goods artificially low, which fuels the country’s exports.

So is China a neo-mercantilist nation that is deliberately discouraging imports and encouraging exports in order to increase its trade surplus and accumulate foreign exchange reserves, which might give it economic power? The jury is out on this issue. Skeptics suggest that going forward, the country will have no choice but to increase its imports of commodities that it lacks, such as oil. They also note that China did start allowing the value of the yuan (China’s currency) to appreciate against the dollar in July 2005, albeit at a slow pace. In July 2005 one U.S. dollar purchased 8.11 yuan. By January 2014, one U.S. dollar purchased 6.05 yuan, a decline of 25 percent. Despite this, China’s trade surplus with the rest of the world remains persistently high and exceeded $240 billion in 2013.

Sources: A. Browne, “China’s Wild Swings Can Roil the Global Economy,” The Wall Street Journal, October 24, 2005, p. A2; S. H. Hanke, “Stop the Mercantilists,” Forbes, June 20, 2005, p. 164; G. Dyer and A. Balls, “Dollar Threat as China Signals Shift,” Financial Times, January 6, 2006, p. 1; Tim Annett, “Righting the Balance,” The Wall Street Journal, January 10, 2007, p. 15; “China’s Trade Surplus Peaks,” Financial Times, January 12, 2008, p. 1; W. Chong, “China’s Trade Surplus to U.S. to Narrow,” China Daily, December 7, 2009; A. Wang and K. Yao, “China’s Trade Surplus Dips, Taking Heat off Yuan,” Reuters, January 9, 2011; Aaron Back, “China’s Trade Surplus Shrank in ‘11,” The Wall Street Journal, January 11, 2012; and Richard Silk, “China’s Foreign Exchange Reserves Jump Again,” The Wall Street Journal, October 15, 2013.

According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for those produced by other countries. In Smith’s time, this suggested the English should specialize in the production of textiles, while the French should specialize in the production of wine. England could get all the wine it needed by selling its textiles to France and buying wine in exchange. Similarly, France could get all the textiles it needed by selling wine to England and buying textiles in exchange. Smith’s basic argument, therefore, is that a country should never produce goods at home that it can buy at a lower cost from other countries. Smith demonstrates that, by specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade.

Consider the effects of trade between two countries, Ghana and South Korea. The production of any good (output) requires resources (inputs) such as land, labor, and capital. Assume that Ghana and South Korea both have the same amount of resources and that these resources can be used to produce either rice or cocoa. Assume further that 200 units of resources are available in each country. Imagine that in Ghana it takes 10 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between these two extremes. The different combinations that Ghana could produce are represented by the line GG′ in Figure 6.1. This is referred to as Ghana’s production possibility frontier (PPF). Similarly, imagine that in South Korea it takes 40 resources to produce 1 ton of cocoa and 10 resources to produce 1 ton of rice. Thus, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination between these two extremes. The different combinations available to South Korea are represented by the line KK′ in Figure 6.1, which is South Korea’s PPF. Clearly, Ghana has an absolute advantage in the production of cocoa. (More resources are needed to produce a ton of cocoa in South Korea than in Ghana.) By the same token, South Korea has an absolute advantage in the production of rice.

Absolute Advantage

A country has an absolute advantage in the production of a product when it is more efficient than any other country at producing it.

6.1 FIGURE

The Theory of Absolute Advantage

Now consider a situation in which neither country trades with any other. Each country devotes half its resources to the production of rice and half to the production of cocoa. Each country must also consume what it produces. Ghana would be able to produce 10 tons of cocoa and 5 tons of rice (point A in Figure 6.1), while South Korea would be able to produce 10 tons of rice and 2.5 tons of cocoa (point B in Figure 6.1). Without trade, the combined production of both countries would be 12.5 tons of cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons in Ghana and 10 tons in South Korea). If each country were to specialize in producing the good for which it had an absolute advantage and then trade with the other for the good it lacks, Ghana could produce 20 tons of cocoa, and South Korea could produce 20 tons of rice. Thus, by specializing, the production of both goods could be increased. Production of cocoa would increase from 12.5 tons to 20 tons, while production of rice would increase from 15 tons to 20 tons. The increase in production that would result from specialization is therefore 7.5 tons of cocoa and 5 tons of rice. Table 6.1 summarizes these figures.

By engaging in trade and swapping 1 ton of cocoa for 1 ton of rice, producers in both countries could consume more of both cocoa and rice. Imagine that Ghana and South Korea swap cocoa and rice on a one-to-one basis; that is, the price of 1 ton of cocoa is equal to the price of 1 ton of rice. If Ghana decided to export 6 tons of cocoa to South Korea and import 6 tons of rice in return, its final consumption after trade would be 14 tons of cocoa and 6 tons of rice. This is 4 tons more cocoa than it could have consumed before specialization and trade and 1 ton more rice. Similarly, South Korea’s final consumption after trade would be 6 tons of cocoa and 14 tons of rice. This is 3.5 tons more cocoa than it could have consumed before specialization and trade and 4 tons more rice. Thus, as a result of specialization and trade, output of both cocoa and rice would be increased, and consumers in both nations would be able to consume more. Thus, we can see that trade is a positive-sum game; it produces net gains for all involved.

Which Products Should Always Be Produced at Home?

One of the key insights of international trade theory is that limits on imports are often in the interests of domestic producers, but not domestic consumers. This is especially true if Adam Smith’s theory of absolute advantage is in play, where one country is better at producing a product than another country. The reason is that consumers typically want the best products they can get for the amount of money they are willing to pay. But what about the comparative advantage theory that was originally conceptualized by David Ricardo and then refined by Eli Heckscher and Bertil Ohlin? Comparative advantage theory argues that a country should consider not producing products that it can actually produce reasonably well if the country can produce something else even more efficiently. In reality, not a single country has stopped all production of products they produce less efficiently than some other country. The reason is that countries always engage in a strategic balancing act! They prefer to be as efficient as possible (engage in international trade when advantageous) while also being as self-sufficient as possible (produce inside their country). So, what types of products should always be produced in the home country, and which products should always be considered for importing if other countries can produce them more efficiently?

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Summarize the different theories explaining trade flows between nations.

Comparative Advantage

Page 166David Ricardo took Adam Smith’s theory one step further by exploring what might happen when one country has an absolute advantage in the production of all goods.3 Smith’s theory of absolute advantage suggests that such a country might derive no benefits from international trade. In his 1817 book Principles of Political Economy, Ricardo showed that this was not the case. According to Ricardo’s theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.4 While this may seem counterintuitive, the logic can be explained with a simple example.

Assume that Ghana is more efficient in the production of both cocoa and rice; that is, Ghana has an absolute advantage in the production of both products. In Ghana it takes 10 resources to produce 1 ton of cocoa and 13½ resources to produce 1 ton of rice. Thus, given its 200 units of resources, Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or any combination in between on its PPF (the line GG′ in Figure 6.2). In South Korea it takes 40 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, South Korea can produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or any combination on its PPF (the line KK′ in Figure 6.2). Again assume that without trade, each country uses half its resources to produce rice and half to produce cocoa. Thus, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice (point A in Figure 6.2), while South Korea will produce 2.5 tons of cocoa and 5 tons of rice (point B in Figure 6.2).

In light of Ghana’s absolute advantage in the production of both goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it has a comparative advantage only in the production of cocoa: Ghana can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice.

6.2 FIGURE

The Theory of Comparative Advantage

Without trade the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade each country must consume what it produces. By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods.

THE GAINS FROM TRADE Imagine that Ghana exploits its comparative advantage in the production of cocoa to increase its output from 10 tons to 15 tons. This uses up 150 units of resources, leaving the remaining 50 units of resources to use in producing 3.75 tons of rice (point C in Figure 6.2). Meanwhile, South Korea specializes in the production of rice, producing 10 tons. The combined output of both cocoa and rice has now increased. Before specialization, the combined output was 12.5 tons of cocoa and 12.5 tons of rice. Now it is 15 tons of cocoa and 13.75 tons of rice (3.75 tons in Ghana and 10 tons in South Korea). The source of the increase in production is summarized in Table 6.2.

Not only is output higher, but both countries also can now benefit from trade. If Ghana and South Korea swap cocoa and rice on a one-to-one basis, with both countries choosing to exchange 4 tons of their export for 4 tons of the import, both countries are able to consume more cocoa and rice than they could before specialization and trade (see Table 6.2). Thus, if Ghana exchanges 4 tons of cocoa with South Korea for 4 tons of rice, it is still left with 11 tons of cocoa, which is 1 ton more than it had before trade. The 4 tons of rice it gets from South Korea in exchange for its 4 tons of cocoa, when added to the 3.75 tons it now produces domestically, leave it with a total of 7.75 tons of rice, which is 0.25 of a ton more than it had before specialization. Similarly, after swapping 4 tons of rice with Ghana, South Korea still ends up with 6 tons of rice, which is more than it had before specialization. In addition, the 4 tons of cocoa it receives in exchange is 1.5 tons more than it produced before trade. Thus, consumption of cocoa and rice can increase in both countries as a result of specialization and trade.

The basic message of the theory of comparative advantage is that potential world production is greater with unrestricted free trade than it is with restricted trade. Ricardo’s theory suggests that consumers in all nations can consume more if there are no restrictions on trade. This occurs even in countries that lack an absolute advantage in the production of any good. In other words, to an even greater degree than the theory of absolute advantage, the theory of comparative advantage suggests that trade is a positive-sum game in which all countries that participate realize economic gains. As such, this theory provides a strong rationale for encouraging free trade. So powerful is Ricardo’s theory that it remains a major intellectual weapon for those who argue for free trade.

QUALIFICATIONS AND ASSUMPTIONS The conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple model. Our simple model includes many unrealistic assumptions:

1. We have assumed a simple world in which there are only two countries and two goods. In the real world, there are many countries and many goods.

2. We have assumed away transportation costs between countries.

3. We have assumed away differences in the prices of resources in different countries. We have said nothing about exchange rates, simply assuming that cocoa and rice could be swapped on a one-to-one basis.

4. We have assumed that resources can move freely from the production of one good to another within a country. In reality, this is not always the case.

5. We have assumed constant returns to scale; that is, that specialization by Ghana or South Korea has no effect on the amount of resources required to produce one ton of cocoa or rice. In reality, both diminishing and increasing returns to specialization exist. The amount of resources required to produce a good might decrease or increase as a nation specializes in production of that good.

6. We have assumed that each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resources. This static assumption makes no allowances for the dynamic changes in a country’s stock of resources and in the efficiency with which the country uses its resources that might result from free trade.

7. We have assumed away the effects of trade on income distribution within a country.

Given these assumptions, can the conclusion that free trade is mutually beneficial be extended to the real world of many countries, many goods, positive transportation costs, volatile exchange rates, immobile domestic resources, nonconstant returns to specialization, and dynamic changes? Although a detailed extension of the theory of comparative advantage is beyond the scope of this book, economists have shown that the basic result derived from our simple model can be generalized to a world composed of many countries producing many different goods.5 Despite the shortcomings of the Ricardian model, research suggests that the basic proposition that countries will export the goods that they are most efficient at producing is borne out by the data.6

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Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

Page 169However, once all the assumptions are dropped, the case for unrestricted free trade, while still positive, has been argued by some economists associated with the “new trade theory” to lose some of its strength.7 We return to this issue later in this chapter and in the next when we discuss the new trade theory. In a recent and widely discussed analysis, the Nobel Prize– winning economist Paul Samuelson argued that contrary to the standard interpretation, in certain circumstances the theory of comparative advantage predicts that a rich country might actually be worse off by switching to a free trade regime with a poor nation.8 We consider Samuelson’s critique in the next section.

EXTENSIONS OF THE RICARDIAN MODEL Let us explore the effect of relaxing three of the assumptions identified earlier in the simple comparative advantage model. Next, we relax the assumptions that resources move freely from the production of one good to another within a country, that there are constant returns to scale, and that trade does not change a country’s stock of resources or the efficiency with which those resources are utilized.

Immobile Resources In our simple comparative model of Ghana and South Korea, we assumed that producers (farmers) could easily convert land from the production of cocoa to rice and vice versa. While this assumption may hold for some agricultural products, resources do not always shift quite so easily from producing one good to another. A certain amount of friction is involved. For example, embracing a free trade regime for an advanced economy such as the United States often implies that the country will produce less of some labor-intensive goods, such as textiles, and more of some knowledge-intensive goods, such as computer software or biotechnology products. Although the country as a whole will gain from such a shift, textile producers will lose. A textile worker in South Carolina is probably not qualified to write software for Microsoft. Thus, the shift to free trade may mean that she becomes unemployed or has to accept another less attractive job, such as working at a fast-food restaurant.

Resources do not always move easily from one economic activity to another. The process creates friction and human suffering too. While the theory predicts that the benefits of free trade outweigh the costs by a significant margin, this is of cold comfort to those who bear the costs. Accordingly, political opposition to the adoption of a free trade regime typically comes from those whose jobs are most at risk. In the United States, for example, textile workers and their unions have long opposed the move toward free trade precisely because this group has much to lose from free trade. Governments often ease the transition toward free trade by helping retrain those who lose their jobs as a result. The pain caused by the movement toward a free trade regime is a short-term phenomenon, while the gains from trade once the transition has been made are both significant and enduring.

Diminishing Returns The simple comparative advantage model developed above assumes constant returns to specialization. By constant returns to specialization we mean the units of resources required to produce a good (cocoa or rice) are assumed to remain constant no matter where one is on a country’s production possibility frontier (PPF). Thus, we assumed that it always took Ghana 10 units of resources to produce 1 ton of cocoa. However, it is more realistic to assume diminishing returns to specialization. Diminishing returns to specialization occur when more units of resources are required to produce each additional unit. While 10 units of resources may be sufficient to increase Ghana’s output of cocoa from 12 tons to 13 tons, 11 units of resources may be needed to increase output from 13 to 14 tons, 12 units of resources to increase output from 14 tons to 15 tons, and so on. Diminishing returns imply a convex PPF for Ghana (see Figure 6.3), rather than the straight line depicted in Figure 6.2.

Constant Returns to Specialization

The units of resources required to produce a good are assumed to remain constant no matter where one is on a country’s production possibility frontier.

6.3 FIGURE

Ghana’s PPF under Diminishing Returns

It is more realistic to assume diminishing returns for two reasons. First, not all resources are of the same quality. As a country tries to increase its output of a certain good, it is increasingly likely to draw on more marginal resources whose productivity is not as great as those initially employed. The result is that it requires ever more resources to produce an equal increase in output. For example, some land is more productive than other land. As Ghana tries to expand its output of cocoa, it might have to utilize increasingly marginal land that is less fertile than the land it originally used. As yields per acre decline, Ghana must use more land to produce 1 ton of cocoa.

A second reason for diminishing returns is that different goods use resources in different proportions. For example, imagine that growing cocoa uses more land and less labor than growing rice and that Ghana tries to transfer resources from rice production to cocoa production. The rice industry will release proportionately too much labor and too little land for efficient cocoa production. To absorb the additional resources of labor and land, the cocoa industry will have to shift toward more labor-intensive methods of production. The effect is that the efficiency with which the cocoa industry uses labor will decline, and returns will diminish.

Diminishing returns show that it is not feasible for a country to specialize to the degree suggested by the simple Ricardian model outlined earlier. Diminishing returns to specialization suggest that the gains from specialization are likely to be exhausted before specialization is complete. In reality, most countries do not specialize, but instead produce a range of goods. However, the theory predicts that it is worthwhile to specialize until that point where the resulting gains from trade are outweighed by diminishing returns. Thus, the basic conclusion that unrestricted free trade is beneficial still holds, although because of diminishing returns, the gains may not be as great as suggested in the constant returns case.

Dynamic Effects and Economic Growth The simple comparative advantage model assumed that trade does not change a country’s stock of resources or the efficiency with which it utilizes those resources. This static assumption makes no allowances for the dynamic changes that might result from trade. If we relax this assumption, it becomes apparent that opening an economy to trade is likely to generate dynamic gains of two sorts.9 First, free trade might increase a country’s stock of resources as increased supplies of labor and capital from abroad become available for use within the country. For example, this has been occurring in eastern Europe since the early 1990s, with many Western businesses investing significant capital in the former communist countries.

Second, free trade might also increase the efficiency with which a country uses its resources. Gains in the efficiency of resource utilization could arise from a number of factors. For example, economies of large-scale production might become available as trade expands the size of the total market available to domestic firms. Trade might make better technology from abroad available to domestic firms; better technology can increase labor productivity or the productivity of land. (The so-called green revolution had this effect on agricultural outputs in developing countries.) Also, opening an economy to foreign competition might stimulate domestic producers to look for ways to increase their efficiency. Again, this phenomenon has arguably been occurring in the once-protected markets of eastern Europe, where many former state monopolies have had to increase the efficiency of their operations to survive in the competitive world market.

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Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

6.4 FIGURE

The Influence of Free Trade on the PPF

Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized will cause a country’s PPF to shift outward. This is illustrated in Figure 6.4, where the shift from PPF1 to PPF2 results from the dynamic gains that arise from free trade. As a consequence of this outward shift, the country in Figure 6.4 can produce more of both goods than it did before introduction of free trade. The theory suggests that opening an economy to free trade not only results in static gains of the type discussed earlier but also results in dynamic gains that stimulate economic growth. If this is so, then one might think that the case for free trade becomes stronger still, and in general it does. However, as noted above, one of the leading economic theorists of the twentieth century, Paul Samuelson, argued that in some circumstances, dynamic gains can lead to an outcome that is not so beneficial.

The Samuelson Critique Paul Samuelson’s critique looks at what happens when a rich country—the United States—enters into a free trade agreement with a poor country—China—that rapidly improves its productivity after the introduction of a free trade regime (i.e., there is a dynamic gain in the efficiency with which resources are used in the poor country). Samuelson’s model suggests that in such cases, the lower prices that U.S. consumers pay for goods imported from China following the introduction of a free trade regime may not be enough to produce a net gain for the U.S. economy if the dynamic effect of free trade is to lower real wage rates in the United States. As he stated in a New York Times interview, “Being able to purchase groceries 20 percent cheaper at Wal-Mart (due to international trade) does not necessarily make up for the wage losses (in America).”10

Samuelson goes on to note that he is particularly concerned about the ability to offshore service jobs that traditionally were not internationally mobile, such as software debugging, call-center jobs, accounting jobs, and even medical diagnosis of MRI scans (see the accompanying Country Focus for details). Recent advances in communications technology have made this possible, effectively expanding the labor market for these jobs to include educated people in places such as India, the Philippines, and China. When coupled with rapid advances in the productivity of foreign labor due to better education, the effect on middle-class wages in the United States, according to Samuelson, may be similar to mass inward migration into the country: It will lower the market clearing wage rate, perhaps by enough to outweigh the positive benefits of international trade.

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Page 172Moving U.S. White-Collar Jobs Offshore

Economists have long argued that free trade produces gains for all countries that participate in a free trading system. As the next wave of globalization sweeps through the U.S. economy, many people are wondering if this is true. During the 1980s and 1990s, free trade was associated with the movement of low-skill, blue-collar manufacturing jobs out of rich countries such as the United States and toward low-wage countries—textiles to Costa Rica, athletic shoes to the Philippines, steel to Brazil, electronic products to Thailand, and so on. While many observers bemoaned the “hollowing out” of U.S. manufacturing, economists stated that high-skill and high-wage white-collar jobs associated with the knowledge-based economy would stay in the United States. Computers might be assembled in Thailand, so the argument went, but they would continue to be designed in Silicon Valley by highly skilled U.S. engineers, and software applications would be written in the United States by programmers at Apple, Microsoft, Adobe, Oracle, and the like.

Developments over the past several decades have people questioning this assumption. Many American companies have been moving white-collar, “knowledge-based” jobs to developing nations where they can be performed for a fraction of the cost. During the long economic boom of the 1990s, Bank of America had to compete with other organizations for the scarce talents of information technology specialists, driving annual salaries to more than $100,000. However, with business under pressure during the 2000s, the bank cut nearly 5,000 jobs from its 25,000-strong, U.S.-based information technology workforce. Some of these jobs were transferred to India, where work that costs $100 an hour in the United States could be done for $20 an hour.

One beneficiary of Bank of America’s downsizing is Infosys Technologies Ltd., a Bangalore, India, information technology firm where 250 engineers now develop information technology applications for the bank. Other Infosys employees are busy processing home loan applications for U.S. mortgage companies. Nearby in the offices of another Indian firm, Wipro Ltd., radiologists interpret 30 CT scans a day for Massachusetts General Hospital that are sent over the Internet. At yet another Bangalore business, engineers earn $10,000 a year designing leading-edge semiconductor chips for Texas Instruments. Nor is India the only beneficiary of these changes.

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Companies like Infosys in India provide many jobs through servicing U.S.-based companies.

Some architectural work also is being outsourced to lower-cost locations. Flour Corp., a California-based construction company, employs some 1,200 engineers and draftsmen in the Philippines, Poland, and India to turn layouts of industrial facilities into detailed specifications. For a Saudi Arabian chemical plant Flour is designing, 200 young engineers based in the Philippines earning less than $3,000 a year collaborate in real time over the Internet with elite U.S. and British engineers who make up to $90,000 a year. Why does Flour do this? According to the company, the answer is simple. Doing so reduces the prices of a project by 15 percent, giving the company a cost-based competitive advantage in the global market for construction design. Most disturbing of all for future job growth in the United States, some high-tech start-ups are outsourcing significant work right from inception. For example, Zoho Corporation, a California-based start-up offering online web applications for small businesses, has about 20 employees in the United States and more than 1,000 in India!

Sources: P. Engardio, A. Bernstein, and M. Kripalani, “Is Your Job Next?” BusinessWeek, February 3, 2003, pp. 50–60; “America’s Pain, India’s Gain,” The Economist, January 11, 2003, p. 57; M. Schroeder and T. Aeppel, “Skilled Workers Mount Opposition to Free Trade, Swaying Politicians,” The Wall Street Journal, October 10, 2003, pp. A1, A11; D. Clark, “New U.S. Fees on Visas Irk Outsources,” The Wall Street Journal, August 16, 2010, p. 6; and J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” The Wall Street Journal, January 18, 2012, p. B1.

Having said this, it should be noted that Samuelson concedes that free trade has historically benefited rich counties (as data discussed later seem to confirm). Moreover, he notes that introducing protectionist measures (e.g., trade barriers) to guard against the theoretical possibility that free trade may harm the United States in the future may produce a situation that is worse than the disease they are trying to prevent. To quote Samuelson: “Free trade Page 173may turn out pragmatically to be still best for each region in comparison to lobbyist- induced tariffs and quotas which involve both a perversion of democracy and non-subtle deadweight distortion losses.”11

One recent study found evidence in support of Samuelson’s thesis. The study looked at every county in the United States for its manufacturers’ exposure to competition from China.12 The researchers found that regions most exposed to China tended not only to lose more manufacturing jobs but also to see overall employment decline. Areas with higher exposure to China also had larger increases in workers receiving unemployment insurance, food stamps, and disability payments. The costs to the economy from the increased government payments amounted to two-thirds of the gains from trade with China. In other words, many of the ways trade with China has helped the United States—such as providing inexpensive goods to U.S. consumers—have been wiped out. Even so, the authors of this study argued that in the long run, free trade is a good thing. They note, however, that the rapid rise of China has resulted in some large adjustment costs that, in the short run, significantly reduce the gains from trade.

Other economists have dismissed Samuelson’s fears.13 While not questioning his analysis, they note that as a practical matter, developing nations are unlikely to be able to upgrade the skill level of their workforce rapidly enough to give rise to the situation in Samuelson’s model. In other words, they will quickly run into diminishing returns. However, such rebuttals are at odds with recent data suggesting that Asian countries are rapidly upgrading their educational systems. For example, about 56 percent of the world’s engineering degrees awarded in 2008 were in Asia, compared with 4 percent in the United States!14

Evidence for the Link Between Trade and Growth Many economic studies have looked at the relationship between trade and economic growth.15 In general, these studies suggest that as predicted by the standard theory of comparative advantage, countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade. Jeffrey Sachs and Andrew Warner created a measure of how “open” to international trade an economy was and then looked at the relationship between “openness” and economic growth for a sample of more than 100 countries from 1970 to 1990.16 Among other findings, they reported:

We find a strong association between openness and growth, both within the group of developing and the group of developed countries. Within the group of developing countries, the open economies grew at 4.49 percent per year, and the closed economies grew at 0.69 percent per year. Within the group of developed economies, the open economies grew at 2.29 percent per year, and the closed economies grew at 0.74 percent per year.17

A study by Wacziarg and Welch updated the Sachs and Warner data through the late 1990s. They found that over the period 1950–1998, countries that liberalized their trade regimes experienced, on average, increases in their annual growth rates of 1.5 percent compared to pre-liberalization times.18 An exhaustive survey of 61 studies published between 1967 and 2009 concluded: “The macroeconomic evidence provides dominant support for the positive and significant effects of trade on output and growth.”19

The message seems clear: Adopt an open economy and embrace free trade, and your nation will be rewarded with higher economic growth rates. Higher growth will raise income levels and living standards. This last point has been confirmed by a study that looked at the relationship between trade and growth in incomes. The study, undertaken by Jeffrey Frankel and David Romer, found that on average, a 1 percentage point increase in the ratio of a country’s trade to its gross domestic product increases income per person by at least 0.5 percent.20 For every 10 percent increase in the importance of international trade in an economy, average income levels will rise by at least 5 percent. Despite the short-term adjustment costs associated with adopting a free trade regime, trade would seem to produce greater economic growth and higher living standards in the long run, just as the theory of Ricardo would lead us to expect.21

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Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

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Summarize the different theories explaining trade flows between nations.

Factor Endowments

A country’s endowment with resources such as land, labor, and capital.

Heckscher-Ohlin Theory

Page 174Ricardo’s theory stresses that comparative advantage arises from differences in productivity. Thus, whether Ghana is more efficient than South Korea in the production of cocoa depends on how productively it uses its resources. Ricardo stressed labor productivity and argued that differences in labor productivity between nations underlie the notion of comparative advantage. Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of comparative advantage. They argued that comparative advantage arises from differences in national factor endowments.22 By factor endowments they meant the extent to which a country is endowed with such resources as land, labor, and capital. Nations have varying factor endowments, and different factor endowments explain differences in factor costs; specifically, the more abundant a factor, the lower its cost. The Heckscher-Ohlin theory predicts that countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. Thus, the Heckscher-Ohlin theory attempts to explain the pattern of international trade that we observe in the world economy. Like Ricardo’s theory, the Heckscher-Ohlin theory argues that free trade is beneficial. Unlike Ricardo’s theory, however, the Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments, rather than differences in productivity.

The Heckscher-Ohlin theory has commonsense appeal. For example, the United States has long been a substantial exporter of agricultural goods, reflecting in part its unusual abundance of arable land. In contrast, China has excelled in the export of goods produced in labor-intensive manufacturing industries. This reflects China’s relative abundance of low-cost labor. The United States, which lacks abundant low-cost labor, has been a primary importer of these goods. Note that it is relative, not absolute, endowments that are important; a country may have larger absolute amounts of land and labor than another country, but be relatively abundant in one of them.

THE LEONTIEF PARADOX The Heckscher-Ohlin theory has been one of the most influential theoretical ideas in international economics. Most economists prefer the Heckscher-Ohlin theory to Ricardo’s theory because it makes fewer simplifying assumptions. Because of its influence, the theory has been subjected to many empirical tests. Beginning with a famous study published in 1953 by Wassily Leontief (winner of the Nobel Prize in economics in 1973), many of these tests have raised questions about the validity of the Heckscher-Ohlin theory.23 Using the Heckscher-Ohlin theory, Leontief postulated that because the United States was relatively abundant in capital compared to other nations, the United States would be an exporter of capital-intensive goods and an importer of labor- intensive goods. To his surprise, however, he found that U.S. exports were less capital- intensive than U.S. imports. Because this result was at variance with the predictions of the theory, it has become known as the Leontief paradox.

No one is quite sure why we observe the Leontief paradox. One possible explanation is that the United States has a special advantage in producing new products or goods made with innovative technologies. Such products may be less capital-intensive than products whose technology has had time to mature and become suitable for mass production. Thus, the United States may be exporting goods that heavily use skilled labor and innovative entrepreneurship, such as computer software, while importing heavy manufacturing products that use large amounts of capital. Some empirical studies tend to confirm this.24 Still, tests of the Heck-scher-Ohlin theory using data for a large number of countries tend to confirm the existence of the Leontief paradox.25

Should Factor Endowments or Productivity Drive Trade?

Ricardo’s theory of trade suggests that it makes sense for a country to specialize in production of those products that it produces most efficiently and to buy the products that it produces less efficiently from other countries, even if this means that the country is buying products that in reality it could produce more efficiently itself. This means that Ricardo showed that a country can derive advantages by trade even though it has an absolute advantage in producing all products. The Heckscher-Ohlin theory of trade suggests that comparative advantage for a country arises from differences in national factor endowments (i.e., the extent to which a country is endowed with such resources as land, labor, and capital). Ricardo’s argument focused on relative productivity, while Heckscher-Ohlin’s argument focused on having important resources. If you can only have one of the two— better relative productivity or lots of resources such as land, labor, and capital—which would you prefer, any why?

This leaves economists with a difficult dilemma. They prefer the Heckscher-Ohlin theory on theoretical grounds, but it is a relatively poor predictor of real-world international trade patterns. On the other hand, the theory they regard as being too limited, Ricardo’s theory of comparative advantage, actually predicts trade patterns with greater accuracy. The best solution to this dilemma may be to return to the Ricardian idea that trade patterns are largely driven by international differences in productivity. Thus, one might argue that the United States exports commercial aircraft and imports textiles not because its factor endowments are especially suited to aircraft manufacture and not suited to textile manufacture, but because the United States is relatively more efficient at producing aircraft than textiles. A key assumption in the Heckscher-Ohlin theory is that technologies are the same across countries. This may not be the case. Differences in technology may lead to differences in productivity, which in turn, drives international trade patterns.26 Thus, Japan’s success in exporting automobiles from the 1970s onward has been based not only on the relative abundance of capital but also on its development of innovative manufacturing technology that enabled it to achieve higher productivity levels in automobile production than other countries that also had abundant capital. More recent empirical work suggests that this theoretical explanation may be correct.27 The new research shows that once differences in technology across countries are controlled for, countries do indeed export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. In other words, once the impact of differences of technology on productivity is controlled for, the Heckscher-Ohlin theory seems to gain predictive power.

The Product Life-Cycle Theory

Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s.28 Vernon’s theory was based on the observation that for most of the twentieth century a very large proportion of the world’s new products had been developed by U.S. firms and sold first in the U.S. market (e.g., mass-produced automobiles, televisions, instant cameras, photocopiers, personal computers, and semiconductor chips). To explain this, Vernon argued that the wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new consumer products. In addition, the high cost of U.S. labor gave U.S. firms an incentive to develop cost-saving process innovations.

Just because a new product is developed by a U.S. firm and first sold in the U.S. market, it does not follow that the product must be produced in the United States. It could be produced abroad at some low-cost location and then exported back into the United States. However, Vernon argued that most new products were initially produced in America. Apparently, the pioneering firms believed it was better to keep production facilities close to the market and to the firm’s center of decision making, given the uncertainty and risks inherent in introducing new products. Also, the demand for most new products tends to be based on nonprice factors. Consequently, firms can charge relatively high prices for new products, which obviates the need to look for low-cost production sites in other countries.

Vernon went on to argue that early in the life cycle of a typical new product, while demand is starting to grow rapidly in the United States, demand in other advanced countries is limited to high-income groups. The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the United States to those countries.

Over time, demand for the new product starts to grow in other advanced countries (e.g., Great Britain, France, Germany, and Japan). As it does, it becomes worthwhile for foreign producers to begin producing for their home markets. In addition, U.S. firms might set up production facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States.

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Summarize the different theories explaining trade flows between nations.

Page 176As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon. As this occurs, cost considerations start to play a greater role in the competitive process. Producers based in advanced countries where labor costs are lower than in the United States (e.g., Italy and Spain) might now be able to export to the United States. If cost pressures become intense, the process might not stop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated once more, as developing countries (e.g., Thailand) begin to acquire a production advantage over advanced countries. Thus, the locus of global production initially switches from the United States to other advanced nations and then from those nations to developing countries.

The consequence of these trends for the pattern of world trade is that over time the United States switches from being an exporter of the product to an importer of the product as production becomes concentrated in lower-cost foreign locations. Figure 6.5 shows the growth of production and consumption over time in the United States, other advanced countries, and developing countries.

PRODUCT LIFE-CYCLE THEORY IN THE TWENTY-FIRST CENTURY Historically, the product life-cycle theory seems to be an accurate explanation of international trade patterns. Consider photocopiers; the product was first developed in the early 1960s by Xerox in the United States and sold initially to U.S. users. Originally, Xerox exported photocopiers from the United States, primarily to Japan and the advanced countries of western Europe. As demand began to grow in those countries, Xerox entered into joint ventures to set up production in Japan (Fuji-Xerox) and Great Britain (Rank-Xerox). In addition, once Xerox’s patents on the photocopier process expired, other foreign competitors began to enter the market (e.g., Canon in Japan and Olivetti in Italy). As a consequence, exports from the United States declined, and U.S. users began to buy some photocopiers from lower-cost foreign sources, particularly Japan. More recently, Japanese companies found that manufacturing costs are too high in their own country, so they have begun to switch production to developing countries such as Thailand. Thus, initially the United States and now other advanced countries (e.g., Japan and Great Britain) have switched from being exporters of photocopiers to importers. This evolution in the pattern of international trade in photocopiers is consistent with the predictions of the product life-cycle theory that mature industries tend to go out of the United States and into low-cost assembly locations.

However, the product life-cycle theory is not without weaknesses. Viewed from an Asian or European perspective, Vernon’s argument that most new products are developed and introduced in the United States seems ethnocentric and increasingly dated. Although it may be true that during U.S. dominance of the global economy (from 1945 to 1975), most new products were introduced in the United States, there have always been important exceptions. These exceptions appear to have become more common in recent years. Many new products are now first introduced in Japan (e.g., video-game consoles) or South Korea (e.g., Samsung smartphones). Moreover, with the increased globalization and integration of the world economy discussed in Chapter 1, an increasing number of new products (e.g., tablet computers, smartphones, and digital cameras) are now introduced simultaneously in the United States and many European and Asian nations. This may be accompanied by globally dispersed production, with particular components of a new product being produced in those locations around the globe where the mix of factor costs and skills is most favorable (as predicted by the theory of comparative advantage). In sum, although Vernon’s theory may be useful for explaining the pattern of international trade during the period of American global dominance, its relevance in the modern world seems more limited.

New Trade Theory

The new trade theory began to emerge in the 1970s when a number of economists pointed out that the ability of firms to attain economies of scale might have important implications for international trade.29 Economies of scale are unit cost reductions associated with a large scale of output. Economies of scale have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipment. Economies of scale are a major source of cost reductions in many industries, from computer software to automobiles and from pharmaceuticals to aerospace. For example, Microsoft realizes economies of scale by spreading the fixed costs of developing new versions of its Windows operating system, which runs to about $10 billion, over the 2 billion or so personal computers upon which each new system is ultimately installed. Similarly, automobile companies realize economies of scale by producing a high volume of automobiles from an assembly line where each employee has a specialized task.

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Summarize the different theories explaining trade flows between nations.

Economies of Scale

Cost advantages associated with large-scale production.

Page 1776.5 FIGURE

The Product Life-Cycle Theory

Source: Adapted from Ramond Vernon and Louis T. Wells, The Economic Environment of International Business, 5th edition. ©1991. Reproduced by permission of Pearson Education, Inc., Upper Saddle River, New Jersey.

New trade theory makes two important points: First, through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods. Second, in those industries when the output required to attain economies of scale represents a significant proportion of total world demand, the global market may be able to support only a small number of enterprises. Thus, world trade in certain products may be dominated by countries whose firms were first movers in their production.

INCREASING PRODUCT VARIETY AND REDUCING COSTS Imagine first a world without trade. In industries where economies of scale are important, both the variety of goods that a country can produce and the scale of production are limited by the size of the market. If a national market is small, there may not be enough demand to enable producers to realize economies of scale for certain products. Accordingly, those products may not be produced, thereby limiting the variety of products available to consumers. Alternatively, they may be produced, but at such low volumes that unit costs and prices are considerably higher than they might be if economies of scale could be realized.

Now consider what happens when nations trade with each other. Individual national markets are combined into a larger world market. As the size of the market expands due to trade, individual firms may be able to better attain economies of scale. The implication, according to new trade theory, is that each nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods—thus trade offers an opportunity for mutual gain even when countries do not differ in their resource endowments or technology.

Suppose there are two countries, each with an annual market for 1 million automobiles. By trading with each other, these countries can create a combined market for 2 million cars. In this combined market, due to the ability to better realize economies of scale, more varieties (models) of cars can be produced, and cars can be produced at a lower average cost, than in either market alone. For example, demand for a sports car may be limited to 55,000 units in each national market, while a total output of at least 100,000 per year may be required to realize significant scale economies. Similarly, demand for a mini-van may be 80,000 units in each national market, and again a total output of at least 100,000 per year may be required to realize significant scale economies. Faced with limited domestic market demand, firms in each nation may decide not to produce a sports car, because the costs of doing so at such low volume are too great. Although they may produce minivans, the cost of doing so will be higher, as will prices, than if significant economies of scale had been attained. Once the two countries decide to trade, however, a firm in one nation may specialize in producing sports cars, while a firm in the other nation may produce minivans. The combined demand for 110,000 sports cars and 160,000 minivans allows each firm to realize scale economies. Consumers in this case benefit from having access to a product (sports cars) that was not available before international trade and from the lower price for a product (minivans) that could not be produced at the most efficient scale before international trade. Trade is thus mutually beneficial because it allows the specialization of production, the realization of scale economies, the production of a greater variety of products, and lower prices.

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Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

Can We Continue to Rely on Economies of Scale?

Economies of scale are unit cost reductions associated with a large scale of output. As we discuss in the text, economies of scale have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipment. Economies of scale have been a major source of cost reductions in many industries—from computer software to automobiles and from pharmaceuticals to aerospace. But some of these economies of scale advantages were realized when production platforms for computers, automobiles, and so on were used for years and spread across large numbers of customers. With more and more innovations coming on the market faster and faster every year, and more and more customers wanting customized products (even if the customization is small), how can companies continue to rely on economies of scale as a strategic advantage? Will large, mass market–type companies that are selling large quantities of specific products always have economies of scale advantages vis-à-vis small and medium-sized companies?

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Page 179ECONOMIES OF SCALE, FIRST-MOVER ADVANTAGES, AND THE PATTERN OF TRADE A second theme in new trade theory is that the pattern of trade we observe in the world economy may be the result of economies of scale and first-mover advantages. First-mover advantages are the economic and strategic advantages that accrue to early entrants into an industry.30 The ability to capture scale economies ahead of later entrants, and thus benefit from a lower cost structure, is an important first-mover advantage. New trade theory argues that for those products where economies of scale are significant and represent a substantial proportion of world demand, the first movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match. Thus, the pattern of trade that we observe for such products may reflect first-mover advantages. Countries may dominate in the export of certain goods because economies of scale are important in their production, and because firms located in those countries were the first to capture scale economies, giving them a first-mover advantage.

For example, consider the commercial aerospace industry. In aerospace there are substantial scale economies that come from the ability to spread the fixed costs of developing a new jet aircraft over a large number of sales. It has cost Airbus some $15 billion to develop its new superjumbo jet, the 550-seat A380. To recoup those costs and break even, Airbus will have to sell at least 250 A380 planes. If Airbus can sell more than 350 A380 planes, it will apparently be a profitable venture. Total demand over the next 20 years for this class of aircraft is estimated to be between 400 and 600 units. Thus, the global market can probably profitably support only one producer of jet aircraft in the superjumbo category. It follows that the European Union might come to dominate in the export of very large jet aircraft, primarily because a European-based firm, Airbus, was the first to produce a superjumbo jet aircraft and realize scale economies. Other potential producers, such as Boeing, might be shut out of the market because they will lack the scale economies that Airbus will enjoy. By pioneering this market category, Airbus may have captured a first-mover advantage based on scale economies that will be difficult for rivals to match, and that will result in the European Union becoming the leading exporter of very large jet aircraft.

IMPLICATIONS OF NEW TRADE THEORY New trade theory has important implications. The theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology. Trade allows a nation to specialize in the production of certain products, attaining scale economies and lowering the costs of producing those products, while buying products that it does not produce from other nations that specialize in the production of other products. By this mechanism, the variety of products available to consumers in each nation is increased, while the average costs of those products should fall, as should their price, freeing resources to produce other goods and services.

The theory also suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good. Because they are able to gain economies of scale, the first movers in an industry may get a lock on the world market that discourages subsequent entry. First movers’ ability to benefit from increasing returns creates a barrier to entry. In the commercial aircraft industry, the fact that Boeing and Airbus are already in the industry and have the benefits of economies of scale discourages new entry and reinforces the dominance of America and Europe in the trade of midsize and large jet aircraft. This dominance is further reinforced because global demand may not be sufficient to profitably support another producer of midsize and large jet aircraft in the industry. So although Japanese firms might be able to compete in the market, they have decided not to enter the industry but to ally themselves as major subcontractors with primary producers (e.g., Mitsubishi Heavy Industries is a major subcontractor for Boeing on the 777 and 787 programs).

First-Mover Advantages

Advantages accruing to the first to enter a market.

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Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

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Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

Page 180New trade theory is at variance with the Heckscher-Ohlin theory, which suggests a country will predominate in the export of a product when it is particularly well endowed with those factors used intensively in its manufacture. New trade theorists argue that the United States is a major exporter of commercial jet aircraft not because it is better endowed with the factors of production required to manufacture aircraft, but because one of the first movers in the industry, Boeing, was a U.S. firm. The new trade theory is not at variance with the theory of comparative advantage. Economies of scale increase productivity. Thus, the new trade theory identifies an important source of comparative advantage.

This theory is quite useful in explaining trade patterns. Empirical studies seem to support the predictions of the theory that trade increases the specialization of production within an industry, increases the variety of products available to consumers, and results in lower average prices.31 With regard to first-mover advantages and international trade, a study by Harvard business historian Alfred Chandler suggests the existence of first-mover advantages is an important factor in explaining the dominance of firms from certain nations in specific industries.32 The number of firms is very limited in many global industries, including the chemical industry, the heavy construction-equipment industry, the heavy truck industry, the tire industry, the consumer electronics industry, the jet engine industry, and the computer software industry.

Perhaps the most contentious implication of the new trade theory is the argument that it generates for government intervention and strategic trade policy.33 New trade theorists stress the role of luck, entrepreneurship, and innovation in giving a firm first-mover advantages. According to this argument, the reason Boeing was the first mover in commercial jet aircraft manufacture—rather than firms such as Great Britain’s De Havilland and Hawker Siddeley, or Holland’s Fokker, all of which could have been—was that Boeing was both lucky and innovative. One way Boeing was lucky is that De Havilland shot itself in the foot when its Comet jet airliner, introduced two years earlier than Boeing’s first jet airliner, the 707, was found to be full of serious technological flaws. Had De Havilland not made some serious technological mistakes, Great Britain might have become the world’s leading exporter of commercial jet aircraft. Boeing’s innovativeness was demonstrated by its independent development of the technological know-how required to build a commercial jet airliner. Several new trade theorists have pointed out, however, that Boeing’s R&D was largely paid for by the U.S. government; the 707 was a spin-off from a government-funded military program (the entry of Airbus into the industry was also supported by significant government subsidies). Herein is a rationale for government intervention; by the sophisticated and judicious use of subsidies, could a government increase the chances of its domestic firms becoming first movers in newly emerging industries, as the U.S. government apparently did with Boeing (and the European Union did with Airbus)? If this is possible, and the new trade theory suggests it might be, we have an economic rationale for a proactive trade policy that is at variance with the free trade prescriptions of the trade theories we have reviewed so far. We consider the policy implications of this issue in Chapter 7.

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Summarize the different theories explaining trade flows between nations.

National Competitive Advantage: Porter’s Diamond

Michael Porter, the famous Harvard strategy professor, has also written extensively on international trade.34 Porter and his team looked at 100 industries in 10 nations. Like the work of the new trade theorists, Porter’s work was driven by a belief that existing theories of international trade told only part of the story. For Porter, the essential task was to explain why a nation achieves international success in a particular industry. Why does Japan do so well in the automobile industry? Why does Switzerland excel in the production and export of precision instruments and pharmaceuticals? Why do Germany and the United States do so well in the chemical industry? These questions cannot be answered easily by the Heckscher-Ohlin theory, and the theory of comparative advantage offers only a partial explanation. The theory of comparative advantage would say that Switzerland excels in the production and export of precision instruments because it uses its resources very productively in these industries. Although this may be correct, this does not explain why Switzerland is more productive in this industry than Great Britain, Germany, or Spain. Porter tries to solve this puzzle.

6.6 FIGURE

Determinants of National Competitive Advantage: Porter’s Diamond

Source: From “The Competitive Advantage of Nations” by Michael E. Porter, Harvard Business Review, p.77, March-April, 1990. Copyright ©1990 by the Harvard Business School Publishing Corporation. All rights reserved. Reprinted by permission.

Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage (see Figure 6.6). These attributes are:

• Factor endowments—a nation’s position in factors of production, such as skilled labor or the infrastructure necessary to compete in a given industry.

• Demand conditions—the nature of home demand for the industry’s product or service.

• Related and supporting industries—the presence or absence of supplier industries and related industries that are internationally competitive.

• Firm strategy, structure, and rivalry—the conditions governing how companies are created, organized, and managed and the nature of domestic rivalry.

Porter speaks of these four attributes as constituting the diamond. He argues that firms are most likely to succeed in industries or industry segments where the diamond is most favorable. He also argues that the diamond is a mutually reinforcing system. The effect of one attribute is contingent on the state of others. For example, Porter argues favorable demand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firms to respond to them.

Porter maintains that two additional variables can influence the national diamond in important ways: chance and government. Chance events, such as major innovations, can re-shape industry structure and provide the opportunity for one nation’s firms to supplant another’s. Government, by its choice of policies, can detract from or improve national advantage. For example, regulation can alter home demand conditions, antitrust policies can influence the intensity of rivalry within an industry, and government investments in education can change factor endowments.

FACTOR ENDOWMENTS Factor endowments lie at the center of the Heckscher-Ohlin theory. While Porter does not propose anything radically new, he does analyze the characteristics of factors of production. He recognizes hierarchies among factors, distinguishing between basic factors (e.g., natural resources, climate, location, and demographics) and advanced factors (e.g., communication infrastructure, sophisticated and skilled labor, research facilities, and technological know-how). He argues that advanced factors are the most significant for competitive advantage. Unlike the naturally endowed basic factors, advanced factors are a product of investment by individuals, companies, and governments. Thus, government investments in basic and higher education, by improving the general skill and knowledge level of the population Page 182and by stimulating advanced research at higher education institutions, can upgrade a nation’s advanced factors.

The relationship between advanced and basic factors is complex. Basic factors can provide an initial advantage that is subsequently reinforced and extended by investment in advanced factors. Conversely, disadvantages in basic factors can create pressures to invest in advanced factors. An obvious example of this phenomenon is Japan, a country that lacks arable land and mineral deposits and yet through investment has built a substantial endowment of advanced factors. Porter notes that Japan’s large pool of engineers (reflecting a much higher number of engineering graduates per capita than almost any other nation) has been vital to Japan’s success in many manufacturing industries.

DEMAND CONDITIONS Porter emphasizes the role home demand plays in upgrading competitive advantage. Firms are typically most sensitive to the needs of their closest customers. Thus, the characteristics of home demand are particularly important in shaping the attributes of domestically made products and in creating pressures for innovation and quality. Porter argues that a nation’s firms gain competitive advantage if their domestic consumers are sophisticated and demanding. Such consumers pressure local firms to meet high standards of product quality and to produce innovative products. For example, Porter notes that Japan’s sophisticated and knowledgeable buyers of cameras helped stimulate the Japanese camera industry to improve product quality and to introduce innovative models.

RELATED AND SUPPORTING INDUSTRIES The third broad attribute of national advantage in an industry is the presence of suppliers or related industries that are internationally competitive. The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally. Swedish strength in fabricated steel products (e.g., ball bearings and cutting tools) has drawn on strengths in Sweden’s specialty steel industry. Technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in personal computers and several other technically advanced electronic products. Similarly, Switzerland’s success in pharmaceuticals is closely related to its previous international success in the technologically related dye industry.

One consequence of this process is that successful industries within a country tend to be grouped into clusters of related industries. This was one of the most pervasive findings of Porter’s study. One such cluster Porter identified was in the German textile and apparel sector, which included high-quality cotton, wool, synthetic fibers, sewing machine needles, and a wide range of textile machinery. Such clusters are important because valuable knowledge can flow between the firms within a geographic cluster, benefiting all within that cluster. Knowledge flows occur when employees move between firms within a region and when national industry associations bring employees from different companies together for regular conferences or workshops.35

FIRM STRATEGY, STRUCTURE, AND RIVALRY The fourth broad attribute of national competitive advantage in Porter’s model is the strategy, structure, and rivalry of firms within a nation. Porter makes two important points here. First, different nations are characterized by different management ideologies, which either help them or do not help them build national competitive advantage. For example, Porter noted the predominance of engineers in top management at German and Japanese firms. He attributed this to these firms’ emphasis on improving manufacturing processes and product design. In contrast, Porter noted a predominance of people with finance backgrounds leading many U.S. firms. He linked this to U.S. firms’ lack of attention to improving manufacturing processes and product design. He argued that the dominance of finance led to an overemphasis on maximizing short-term financial returns. According to Porter, one consequence of these different management ideologies was a relative loss of U.S. competitiveness in those engineering-based industries where manufacturing processes and product design issues are all-important (e.g., the automobile industry).

Page 183Porter’s second point is that there is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competitors. Domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced factors. All this helps create world-class competitors. Porter cites the case of Japan:

Nowhere is the role of domestic rivalry more evident than in Japan, where it is all-out warfare in which many companies fail to achieve profitability. With goals that stress market share, Japanese companies engage in a continuing struggle to outdo each other. Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings measure which companies are most popular with university graduates. The rate of new product and process development is breathtaking.36

How Important Is Education?

Both the Heckscher-Ohlin and Michael Porter theories of trade focus to a large degree on “factor endowments.” The Heck-scher-Ohlin theory specifies endowments such as resources as land, labor, and capital as being critical, while the Porter theory recognizes hierarchies among these factor endowments. Education-related endowments such as skilled labor, research facilities, and technological know-how are what Porter calls “advanced factors.” A long-standing argument across multiple governmental organizations, research studies, and prominent individuals is that education drives economic, social, and environmental well-being of countries (i.e., countries adopt sustainability principles the more educated the people in the country are relative to people in the global marketplace—see Chapter 5). The extension of this argument is that education helps people become better citizens of a country. But, what do you think education does to a customer’s product needs and wants—do they want more foreign products if they have more years of education (e.g., graduate degree) compared with fewer years of education (e.g., high school)? Or, does education not influence the type of products bought by customers (i.e., foreign-made or home-country made)?

Sources: T. Healy and S. Cote, “The Well-being of Nations: The Role of Human and Social Capital,” Organisation for Economic Cooperation and Development (OECD), 2001; S. Samuel, “Importance of Education in a Country’s Progress,” HowToLearn. com, March 13, 2013; and K. Matsui, “The Economic Benefits of Educating Women,” Bloomberg Businessweek, March 7, 2013.

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EVALUATING PORTER’S THEORY Porter contends that the degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry. He argues that the presence of all four components is usually required for this diamond to boost competitive performance (although there are exceptions). Porter also contends that government can influence each of the four components of the diamond—either positively or negatively. Factor endowments can be affected by subsidies, policies toward capital markets, policies toward education, and so on. Government can shape domestic demand through local product standards or with regulations that mandate or influence buyer needs. Government policy can influence supporting and related industries through regulation and influence firm rivalry through such devices as capital market regulation, tax policy, and antitrust laws.

If Porter is correct, we would expect his model to predict the pattern of international trade that we observe in the real world. Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable. Is he correct? We simply do not know. Porter’s theory has not been subjected to detailed empirical testing. Much about the theory rings true, but the same can be said for the new trade theory, the theory of comparative advantage, and the Heckscher-Ohlin theory. It may be that each of these theories, which complement each other, explains something about the pattern of international trade.

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Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

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Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go to learnsmartadvantage.com for help.

FOCUS ON MANAGERIAL IMPLICATIONS

LOCATION, FIRST-MOVER ADVANTAGES, AND GOVERNMENT POLICY

Why does all this matter for business? There are at least three main implications for international businesses of the material discussed in this chapter: location implications, first-mover implications, and government policy implications.

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Understand the important implications that international trade theory holds for business practice.

Page 184Location

Underlying most of the theories we have discussed is the notion that different countries have particular advantages in different productive activities. Thus, from a profit perspective, it makes sense for a firm to disperse its productive activities to those countries where, according to the theory of international trade, they can be performed most efficiently. If design can be performed most efficiently in France, that is where design facilities should be located; if the manufacture of basic components can be performed most efficiently in Singapore, that is where they should be manufactured; and if final assembly can be performed most efficiently in China, that is where final assembly should be performed. The result is a global web of productive activities, with different activities being performed in different locations around the globe depending on considerations of comparative advantage, factor endowments, and the like. If the firm does not do this, it may find itself at a competitive disadvantage relative to firms that do.

First-Mover Advantages

According to the new trade theory, firms that establish a first-mover advantage with regard to the production of a particular new product may subsequently dominate global trade in that product. This is particularly true in industries where the global market can profitably support only a limited number of firms, such as the aerospace market, but early commitments may also seem to be important in less concentrated industries. For the individual firm, the clear message is that it pays to invest substantial financial resources in trying to build a first-mover, or early-mover, advantage, even if that means several years of losses before a new venture becomes profitable. The idea is to preempt the available demand, gain cost advantages related to volume, build an enduring brand ahead of later competitors, and, consequently, establish a long-term sustainable competitive advantage. Although the details of how to achieve this are beyond the scope of this book, many publications offer strategies for exploiting first-mover advantages and for avoiding the traps associated with pioneering a market (first-mover disadvantages).37

Government Policy

The theories of international trade also matter to international businesses because firms are major players on the international trade scene. Business firms produce exports, and business firms import the products of other countries. Because of their pivotal role in international trade, businesses can exert a strong influence on government trade policy, lobbying to promote free trade or trade restrictions. The theories of international trade claim that promoting free trade is generally in the best interests of a country, although it may not always be in the best interest of an individual firm. Many firms recognize this and lobby for open markets.

For example, when the U.S. government announced its intention to place a tariff on Japanese imports of liquid crystal display (LCD) screens in the 1990s, IBM and Apple Computer protested strongly. Both IBM and Apple pointed out that (1) Japan was the lowest-cost source of LCD screens; (2) they used these screens in their own laptop computers; and (3) the proposed tariff, by increasing the cost of LCD screens, would increase the cost of laptop computers produced by IBM and Apple, thus making them less competitive in the world market. In other words, the tariff, designed to protect U.S. firms, would be self-defeating. In response to these pressures, the U.S. government reversed its posture.

Unlike IBM and Apple, however, businesses do not always lobby for free trade. In the United States, for example, restrictions on imports of steel have periodically been put into place in response to direct pressure by U.S. firms on the government. In some cases, the government has responded to pressure by getting foreign companies to agree to “voluntary” restrictions on their imports, using the implicit threat of more comprehensive formal trade barriers to get them to adhere to these agreements (historically, this has occurred in the automobile industry). In other cases, the government used what are called “antidumping” actions to justify tariffs on imports from other nations (these mechanisms will be discussed in detail in the next chapter).

Page 185As predicted by international trade theory, many of these agreements have been self-defeating, such as the voluntary restriction on machine tool imports agreed to in 1985. Shielded from international competition by import barriers, the U.S. machine tool industry had no incentive to increase its efficiency. Consequently, it lost many of its export markets to more efficient foreign competitors. Because of this misguided action, the U.S. machine tool industry shrunk during the period when the agreement was in force. For anyone schooled in international trade theory, this was not surprising.38

Finally, Porter’s theory of national competitive advantage also contains policy implications. Porter’s theory suggests that it is in the best interest of business for a firm to invest in upgrading advanced factors of production, for example, to invest in better training for its employees and to increase its commitment to research and development. It is also in the best interests of business to lobby the government to adopt policies that have a favorable impact on each component of the national diamond. Thus, according to Porter, businesses should urge government to increase investment in education, infrastructure, and basic research (since all these enhance advanced factors) and to adopt policies that promote strong competition within domestic markets (since this makes firms stronger international competitors, according to Porter’s findings).

Key Terms

free trade

new trade theory

mercantilism

zero-sum game

absolute advantage

constant returns to specialization

factor endowments

economies of scale

first-mover advantages

balance-of-payments accounts

current account

current account deficit

current account surplus

capital account

financial account

Summary

This chapter reviewed a number of theories that explain why it is beneficial for a country to engage in international trade and explained the pattern of international trade observed in the world economy. The theories of Smith, Ricardo, and Heckscher-Ohlin all make strong cases for unrestricted free trade. In contrast, the mercantilist doctrine and, to a lesser extent, the new trade theory can be interpreted to support government intervention to promote exports through subsidies and to limit imports through tariffs and quotas.

In explaining the pattern of international trade, this chapter shows that, with the exception of mercantilism, which is silent on this issue, the different theories offer largely complementary explanations. Although no one theory may explain the apparent pattern of international trade, taken together, the theory of comparative advantage, the Heckscher-Ohlin theory, the product life-cycle theory, the new trade theory, and Porter’s theory of national competitive advantage do suggest which factors are important. Comparative advantage tells us that productivity differences are important; Heckscher-Ohlin tells us that factor endowments matter; the product life-cycle theory tells us that where a new product is introduced is important; the new trade theory tells us that increasing returns to specialization and first-mover advantages matter; and Porter tells us that all these factors may be important insofar as they affect the four components of the national diamond. The chapter made the following points:

1. Mercantilists argued that it was in a country’s best interests to run a balance-of-trade surplus. They viewed trade as a zero-sum game, in which one country’s gains cause losses for other countries.

2. The theory of absolute advantage suggests that countries differ in their ability to produce goods efficiently. The theory suggests that a country should specialize in producing goods in areas where it has an absolute advantage and import goods in areas where other countries have absolute advantages.

3. The theory of comparative advantage suggests that it makes sense for a country to specialize in producing those goods that it can produce most efficiently, while buying goods that it can produce relatively less efficiently from other countries—even if that means buying goods from other countries that it could produce more efficiently itself.

4. The theory of comparative advantage suggests that unrestricted free trade brings about increased world production, that is, that trade is a positive-sum game.

5. The theory of comparative advantage also suggests that opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. The empirical evidence seems to be consistent with this claim.

6. The Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce.

7. The product life-cycle theory suggests that trade patterns are influenced by where a new product is introduced. In an increasingly integrated global economy, the product life-cycle theory seems to be less predictive than it once was.

8. New trade theory states that trade allows a nation to specialize in the production of certain goods, attaining scale economies and lowering the costs of producing those goods, while buying goods that it does not produce from other nations that are similarly specialized. By this mechanism, the variety of goods available to consumers in each nation is increased, while the average costs of those goods should fall.

9. New trade theory also states that in those industries where substantial economies of scale imply that the world market will profitably support only a few firms, countries may predominate in the export of certain products simply because they had a firm that was a first mover in that industry.

10. Some new trade theorists have promoted the idea of strategic trade policy. The argument is that government, by the sophisticated and judicious use of subsidies, might be able to increase the chances of domestic firms becoming first movers in newly emerging industries.

11. Porter’s theory of national competitive advantage suggests that the pattern of trade is influenced by four attributes of a nation: (a) factor endowments, (b) domestic demand conditions, (c) related and supporting industries, and (d) firm strategy, structure, and rivalry.

12. Theories of international trade are important to an individual business firm primarily because they can help the firm decide where to locate its various production activities.

13. Firms involved in international trade can and do exert a strong influence on government policy toward trade. By lobbying government, business firms can promote free trade or trade restrictions.

Critical Thinking and Discussion Questions

1. Mercantilism is a bankrupt theory that has no place in the modern world. Discuss.

2. Is free trade fair? Discuss!

3. Unions in developed nations often oppose imports from low-wage countries and advocate trade barriers to protect jobs from what they often characterize as “unfair” import competition. Is such competition “unfair”? Do you think that this argument is in the best interests of (a) the unions, (b) the people they represent, and/or (c) the country as a whole?

4. What are the potential costs of adopting a free trade regime? Do you think governments should do anything to reduce these costs? What?

5. Reread the Country Focus “Is China a Neomercantilist Nation?”

a. Do you think China is pursuing an economic policy that can be characterized as neo-mercantilist?

b. What should the United States, and other countries, do about this?

6. Reread the Country Focus on moving white-collar jobs offshore.

a. Who benefits from the outsourcing of skilled white-collar jobs to developing nations? Who are the losers?

b. Will developed nations like the United States suffer from the loss of high-skilled and high-paying jobs?

c. Is there a difference between the transference of high-paying white-collar jobs, such as computer programming and accounting, to developing nations, and low-paying blue-collar jobs? If so, what is the difference, and should government do anything to stop the flow of white-collar jobs out of the country to countries such as India?

7. Drawing upon the new trade theory and Porter’s theory of national competitive advantage, outline the case for government policies that would build national competitive advantage in biotechnology. What kinds of policies would you recommend that the government adopt? Are these policies at variance with the basic free trade philosophy?

8. The world’s poorest countries are at a competitive disadvantage in every sector of their economies. They have little to export. They have no capital; their land is of poor quality; they often have too many people given available work opportunities; and they are poorly educated. Free trade cannot possibly be in the interests of such nations. Discuss.

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Page 187Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. The World Trade Organization International Trade Statistics is an annual report that provides comprehensive, comparable, and updated statistics on trade in merchandise and commercial services. The report allows an assessment of world trade flows by country, region, and main product or service categories. Using the most recent statistics available, identify the top 10 countries that lead in the export and import of merchandise trade, respectively. Which countries appear in the top 10 in both exports and imports? Can you explain why these countries appear at the top of both lists?

2. Food in an integral part of understanding different countries, cultures, and lifestyles. You run a chain of high-end premium restaurants in the United States, and you are looking for unique Australian wines you can import. However, you must first identify which Australian suppliers can provide you with premium wines. After searching through the Australian supplier directory, identify three to four companies that can be potential suppliers. Then develop a list of criteria you would need to ask these companies to select which one to work with.

images The Rise of India’s Drug Industry closing case

One of the great success stories in international trade in recent years has been the strong growth of India’s pharmaceutical industry. The country used to be known for producing cheap knockoffs of patented drugs discovered by Western and Japanese pharmaceutical companies. This made the industry something of an international pariah. Because they made copies of patented products, and therefore violated intellectual property rights, Indian companies were not allowed to sell these products in developed markets. With no assurance that their intellectual property would be protected, foreign drug companies refused to invest in, partner with, or buy from their Indian counterparts, further limiting the business opportunities of Indian companies. In developed markets such as the United States, the best that Indian companies could do was to sell low-cost generic pharmaceuticals (generic pharmaceuticals are products whose patents have expired).

In 2005, however, India signed an agreement with the World Trade Organization that brought the country into compliance with WTO rules on intellectual property rights. Indian companies stopped producing counterfeit products. Secure in knowledge that their patents would be respected, foreign companies started to do business with their Indian counterparts. For India, the result has been dramatic growth in its pharmaceutical sector. The sector generated sales of close to $30 billion in 2012–2013, more than two and a half times the figure of 2005. Driving this growth have been surging exports, which grew at 15 percent per annum between 2006 and 2012. In 2000, pharmaceutical exports from India amounted to around $1 billion. By 2012–2013, the figure was around $14.7 billion!

Much of this growth has been the result of partnerships between Western and Indian firms. Western companies have been increasingly outsourcing manufacturing and packaging activities to India while scaling back some of these activities at home and in places such as Puerto Rico, which historically has been a major manufacturing hub for firms serving the U.S. market. India’s advantages in manufacturing and packaging include relatively low wage rates, an educated workforce, and the widespread use of English as a business language. Western companies have continued to perform high value-added R&D, marketing, and sales activities, and these remain located in their home markets.

During India’s years as an international pariah in the drug business, its nascent domestic industry set the foundations for today’s growth. Local start-ups invested in the facilities required to discover and produce pharmaceuticals, creating a market for pharmaceutical scientists and workers in India. In turn, this drove the expansion of pharmaceutical programs in the country’s universities, thereby increasing the supply of talent. Moreover, the industry’s experience in the generic drug business during the 1990s and early 2000s has given it expertise in dealing with regulatory agencies in the United States and European Union. After 2005, this know-how made Indian companies more attractive as partners for Western enterprises. Combined with low labor costs, all these factors came together to make India an increasingly attractive location for the manufacturing of pharmaceuticals.

Generic drugs manufactured by Indian firms help the country to emerge as a major exporter of pharmaceuticals.

Page 188The U.S. Federal Drug Administration (FDA) responded to the shift of manufacturing to India by opening two offices there to oversee manufacturing compliance and make sure safety was consistent with FDA-mandated standards. Today, the FDA has issued approvals to produce pharmaceuticals for sale in the United States to some 900 plants in India, giving Indian companies a legitimacy that potential rivals in places such as China lack.

For Western enterprises, the obvious attraction of outsourcing drug manufacturing to India is that it lowers their costs, enabling them to protect their earnings in an increasingly difficult domestic environment where government health care regulation and increased competition have put pressure on the pricing of many pharmaceuticals. Arguably, this also benefits consumers in the United States because lower pharmaceutical prices mean lower insurance costs, smaller copays, and ultimately lower out-of-pocket expenses than if those pharmaceuticals were still manufactured domestically. Offset against this economic benefit, of course, must be the cost of jobs lost in U.S. pharmaceutical manufacturing. Indicative of this trend, total manufacturing employment in this sector fell by 5 percent between 2008 and 2010.

Sources: H. Timmons, “A Pharmaceutical Future,” The New York Times, July 7, 2010, pp. B1, B4; K. K. Sharma, “On the World Stage,” Business Today, January 9, 2011, pp. 116–17; M. Velterop, “The Indian Perspective,” Pharmaceutical Technology Europe, September 2010, pp. 40–41; “Pharma Exports Expected to Touch Rs 75,000 in 2012–2013,” Business Standard, February 27, 2013; and Lynne Taylor, “India: Exports of Generics Growing 24% a Year,” PharmaTimes, October 21, 2013.

CASE DISCUSSION QUESTIONS

1. How might (a) U.S. pharmaceutical companies and (b) U.S. consumers benefit from the rise of the Indian pharmaceutical industry?

2. Who might have lost out as a result of the recent rise of the Indian pharmaceutical industry?

3. Do the benefits from trade with the Indian pharmaceutical sector outweigh the losses?

4. What international trade theory (or theories) best explain the rise of India as a major exporter of pharmaceuticals?

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Page 189International Trade and the Balance of Payments

International trade involves the sale of goods and services to residents in other countries (exports) and the purchase of goods and services from residents in other countries (imports). A country’s balance-of-payments accounts keep track of the payments to and receipts from other countries for a particular time period. These include payments to foreigners for imports of goods and services, and receipts from foreigners for goods and services exported to them. A summary copy of the U.S. balance-of-payments accounts for 2011 is given in Table A.1. Any transaction resulting in a payment to other countries is entered in the balance-of-payments accounts as a debit and given a negative (2) sign. Any transaction resulting in a receipt from other countries is entered as a credit and given a positive (1) sign. In this appendix, we briefly describe the form of the balance-of-payments accounts, and we discuss whether a current account deficit, often a cause of much concern in the popular press, is something to worry about.

Balance-of-Payments Accounts

National accounts that track both payments to and receipts from foreigners.

Balance-of-Payments Accounts

Balance-of-payments accounts are divided into three main sections: the current account, the capital account, and the financial account (to confuse matters, what is now called the capital account was until recently part of the current account, and the financial account used to be called the capital account). The current account records transactions that pertain to three categories, all of which can be seen in Table A.1. The first category, goods, refers to the export or import of physical goods (e.g., agricultural foodstuffs, autos, computers, and chemicals). The second category is the export or import of services (e.g., intangible products such as banking and insurance services). The third category, income receipts and payments, refers to income from foreign investments and payments that have to be made to foreigners investing in a country. For example, if a U.S. citizen owns a share of a Finnish company and receives a dividend payment of $5, that payment shows up on the U.S. current account as the receipt of $5 of investment income. Also included in the current account are unilateral current transfers, such as U.S. government grants to foreigners (including foreign aid) and private payments to foreigners (such as when a foreign worker in the United States sends money to his or her home country).

A current account deficit occurs when a country imports more goods, services, and income than it exports. A current account surplus occurs when a country exports more goods, services, and income than it imports. Table A.1 shows that in 2012 the United States ran a current account deficit of $534.7 billion. This is often a headline-grabbing figure and is widely reported in the news media. In recent years, the U.S. current account deficit has been quite large, primarily because America imports far more physical goods than it exports. (The United States typically runs a surplus on trade in services and is close to balance on income payments.)

Current Account

In the balance of payments, records transactions involving the export or import of goods and services.

Current Account Deficit

The current account of the balance of payments is in deficit when a country imports more goods and services than it exports.

Current Account Surplus

The current account of the balance of payments is in surplus when a country exports more goods and services than it imports.

The 2006 current account deficit of $803 billion was the largest on record and was equivalent to about 6.5 percent of the country’s GDP. The deficit has shrunk since then, in response to the economic crisis and prolonged recession of 2008–2009 as much as anything else. Many people find these figures disturbing, the common assumption being that high imports of goods displaces domestic production, causes unemployment, and reduces the growth of the U.S. economy. For example, The New York Times responded to the record current account deficit in 2006 by stating:

A growing trade deficit acts as a drag on overall economic growth. Economists said that they expect that, in light of the new numbers, the government will have to revise its estimate of the nation’s fourth quarter gross domestic product to show slightly slower expansion.39

However, the issue is somewhat more complex than implied by statements like this. Fully understanding the implications of a large and persistent deficit requires that we look at the rest of the balance-of-payments accounts.

The capital account records one-time changes in the stock of assets. As noted earlier, until recently this item was included in the current account. The capital account includes capital transfers, such as debt forgiveness and migrants’ transfers (the goods and financial assets that accompany migrants as they enter or leave the country). In the big scheme of things this is a relatively small figure amounting to $6,956 million in 2012.

Capital Account

In the balance of payments, records transactions involving one-time changes in the stock of assets.

Page 191Financial Account

In balance of payments, transactions that involve the purchase or sale of assets.

The financial account (formerly the capital account) records transactions that involve the purchase or sale of assets. Thus, when a German firm purchases stock in a U.S. company or buys a U.S. bond, the transaction enters the U.S. balance of payments as a credit on the capital account. This is because capital is flowing into the country. When capital flows out of the United States, it enters the capital account as a debit.

The financial account is comprised of a number of elements. The net change in U.S.-owned assets abroad includes the change in assets owned by the U.S. government (U.S. official reserve assets and U.S. government assets) and the change in assets owned by private individuals and corporations. As can be seen from Table A.1, in 2012 there was a 2$97.5 billion reduction in U.S. assets owned abroad due to a fall in the amount of foreign assets owned by the U.S. government and private individuals and corporations. In other words, these entities were selling off foreign assets, such as foreign bonds and currencies, during 2012.

Also included in the financial account are foreign-owned assets in the United States. These are divided into assets owned by foreign governments (foreign official assets) and assets owned by other foreign entities such as corporations and individuals (other foreign assets in the United States). As can be seen, in 2012 foreigners increased their holdings of U.S. assets, including Treasury bills, corporate stocks and bonds, and direct investments in the United States, by $544 billion. Some $394 billion of this was due to an increase in the holding of U.S. assets by foreign governments, while foreign private corporations and individuals increased their holdings of U.S. assets by $150 billion.

A basic principle of balance-of-payments accounting is double-entry bookkeeping. Every international transaction automatically enters the balance of payments twice—once as a credit and once as a debit. Imagine that you purchase a car produced in Japan by Toyota for $20,000. Because your purchase represents a payment to another country for goods, it will enter the balance of payments as a debit on the current account. Toyota now has the $20,000 and must do something with it. If Toyota deposits the money at a U.S. bank, Toyota has purchased a U.S. asset—a bank deposit worth $20,000—and the transaction will show up as a $20,000 credit on the financial account. Or Toyota might deposit the cash in a Japanese bank in return for Japanese yen. Now the Japanese bank must decide what to do with the $20,000. Any action that it takes will ultimately result in a credit for the U.S. balance of payments. For example, if the bank lends the $20,000 to a Japanese firm that uses it to import personal computers from the United States, then the $20,000 must be credited to the U.S. balance-of-payments current account. Or the Japanese bank might use the $20,000 to purchase U.S. government bonds, in which case it will show up as a credit on the U.S. balance-of-payments financial account.

Thus, any international transaction automatically gives rise to two offsetting entries in the balance of payments. Because of this, the sum of the current account balance, the capital account, and the financial account balance should always add up to zero. In practice, this does not always occur due to the existence of “statistical discrepancies,” the source of which need not concern us here (note that in 2012, the statistical discrepancy amounted to − $5.9 billion).

Does the Current Account Deficit Matter?

As discussed earlier, there is some concern when a country is running a deficit on the current account of its balance of payments.40 In recent years, a number of rich countries, including most notably the United States, have run persistent and growing current account deficits. When a country runs a current account deficit, the money that flows to other countries can then be used by those countries to purchase assets in the deficit country. Thus, when the United States runs a trade deficit with China, the Chinese use the money that they receive from U.S. consumers to purchase U.S. assets such as stocks, bonds, and the like. Put another way, a deficit on the current account is financed by selling assets to other countries; that is, by a surplus on the financial account. Thus, the persistent U.S. current account deficit is being financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to other countries. In short, countries that run current account deficits become net debtors.

For example, as a result of financing its current account deficit through asset sales, the United States must deliver a stream of interest payments to foreign bondholders, rents to Page 192foreign landowners, and dividends to foreign stockholders. One might argue that such payments to foreigners drain resources from a country and limit the funds available for investment within the country. Since investment within a country is necessary to stimulate economic growth, a persistent current account deficit can choke off a country’s future economic growth. This is the basis of the argument that persistent deficits are bad for an economy.

However, things are not this simple. For one thing, in an era of global capital markets money is efficiently directed toward its highest value uses, and over the past quarter of a century many of the highest value uses of capital have been in the United States. So even though capital is flowing out of the United States in the form of payments to foreigners, much of that capital finds its way right back into the country to fund productive investments in the United States. In short, it is not clear that the current account deficit chokes off U.S. economic growth. In fact, notwithstanding the 2008–2009 recession, the U.S. economy has grown substantially over the past 30 years, despite running a persistent current account deficit and despite financing that deficit by selling U.S. assets to foreigners. This is precisely because foreigners reinvest much of the income earned from U.S. assets, and from exports to the United States, right back into the United States. This revisionist view, which has gained in popularity in recent years, suggests that a persistent current account deficit might not be the drag on economic growth it was once thought to be.41

Having said this, there is still a nagging fear that at some point the appetite that foreigners have for U.S. assets might decline. If foreigners suddenly reduced their investments in the United States, what would happen? In short, instead of reinvesting the dollars that they earn from exports and investment in the United States back into the country, they would sell those dollars for another currency, European euros, Japanese yen, or Chinese yuan, for example, and invest in euro-, yen-, and yuan-denominated assets instead. This would lead to a fall in the value of the dollar on foreign exchange markets, and that in turn would increase the price of imports, and lower the price of U.S. exports, making them more competitive, which should reduce the overall level of the current account deficit. Thus, in the long run, the persistent U.S. current account deficit could be corrected via a reduction in the value of the U.S. dollar. The concern is that such adjustments may not be smooth. Rather than a controlled decline in the value of the dollar, the dollar might suddenly lose a significant amount of its value in a very short time, precipitating a “dollar crisis.”42 Because the U.S. dollar is the world’s major reserve currency, and is held by many foreign governments and banks, any dollar crisis could deliver a body blow to the world economy and at the very least trigger a global economic slowdown. That would not be a good thing.

Endnotes

1. H. W. Spiegel, The Growth of Economic Thought (Durham, NC: Duke University Press, 1991).

2. M. Solis, “The Politics of Self-Restraint: FDI Subsidies and Japanese Mercantilism,” The World Economy 26 (February 2003), pp. 153–70.

3. S. Hollander, The Economics of David Ricardo (Buffalo: University of Toronto Press, 1979).

4. D. Ricardo, The Principles of Political Economy and Taxation (Homewood, IL: Irwin, 1967, first published in 1817).

5. For example, R. Dornbusch, S. Fischer, and P. Samuelson, “Comparative Advantage: Trade and Payments in a Ricardian Model with a Continuum of Goods,” American Economic Review 67 (December 1977), pp. 823–39.

6. B. Balassa, “An Empirical Demonstration of Classic Comparative Cost Theory,” Review of Economics and Statistics, 1963, pp. 231–38.

7. See P. R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1 (Fall 1987), pp. 131–44.

8. P. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization,” Journal of Economic Perspectives 18, no. 3 (Summer 2004), pp. 135–46.

9. P. Samuelson, “The Gains from International Trade Once Again,” Economic Journal 72 (1962), pp. 820–29.

10. S. Lohr, “An Elder Challenges Outsourcing’s Orthodoxy,” The New York Times, September 9, 2004, p. C1.

11. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization,” p. 143.

12. D. H. Autor, D. Dorn, and Gordon H. Hanson, “The China Syndrome: Local Labor Market Effects of Import Competition in the United States,” MIT Working Paper, August 2011.

13. See A. Dixit and G. Grossman, “Samuelson Says Nothing about Trade Policy,” Princeton University, 2004, accessed from http://depts.washington.edu/teclass/ThinkEcon/readings/Kalles/Dixit%20and%20Grossman%20on%20Samuelson.pdf.

14. J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” The Wall Street Journal, January 18, 2012, p. B1.

15. For example, J. D. Sachs and A. Warner, “Economic Reform and the Process of Global Integration,” Brookings Papers on Economic Activity, 1995, pp. 1–96; J. A. Frankel and D. Romer, “Does Trade Cause Growth?” American Economic Review 89, no. 3 (June 1999), pp. 379–99; and D. Dollar and A. Kraay, “Trade, Growth and Poverty,” Working Paper, Development Research Group, World Bank, June 2001. Also, for an accessible discussion of the relationship between free trade and economic growth, see T. Taylor, “The Truth about Globalization,” Public Interest, Spring 2002, pp. 24–44; D. Acemoglu, S. Johnson, and J. Robinson, “The Rise of Europe: Atlantic Trade, Institutional Change and Economic Growth,” American Economic Review 95, no. 3 (2005), pp. 547–79; and T. Singh, “Does International Trade Cause Economic Growth?” The World Economy 33, no. 11 (2010), pp. 1517–64.

16. Sachs and Warner, “Economic Reform and the Process of Global Integration.”

17. Ibid., pp. 35–36.

18. R. Wacziarg and K. H. Welch, “Trade Liberalization and Growth: New Evidence,” National Bureau of Economic Research Working Paper Series, working paper no. 10152, December 2003.

19. Singh, “Does International Trade Cause Economic Growth?”

20. Frankel and Romer, “Does Trade Cause Growth?”

21. A recent skeptical review of the empirical work on the relationship between trade and growth questions these results. See Francisco Rodriguez and Dani Rodrik, “Trade Policy and Economic Growth: A Skeptic’s Guide to the Cross-National Evidence,” National Bureau of Economic Research Working Paper Series, working paper no. 7081, April 1999. Even these authors, however, cannot find any evidence that trade hurts economic growth or income levels.

22. B. Ohlin, Interregional and International Trade (Cambridge, MA: Harvard University Press, 1933). For a summary, see R. W. Jones and J. P. Neary, “The Positive Theory of International Trade,” in Handbook of International Economics, R. W. Jones and P. B. Kenen, eds. (Amsterdam: North Holland, 1984).

23. W. Leontief, “Domestic Production and Foreign Trade: The American Capital Position Re-examined,” Proceedings of the American Philosophical Society 97 (1953), pp. 331–49.

24. R. M. Stern and K. Maskus, “Determinants of the Structure of U.S. Foreign Trade,” Journal of International Economics 11 (1981), pp. 207–44.

25. See H. P. Bowen, E. E. Leamer, and L. Sveikayskas, “Multi-country, Multifactor Tests of the Factor Abundance Theory,” American Economic Review 77 (1987), pp. 791–809.

26. D. Trefler, “The Case of the Missing Trade and Other Mysteries,” American Economic Review 85 (December 1995), pp. 1029–46.

27. D. R. Davis and D. E. Weinstein, “An Account of Global Factor Trade,” American Economic Review, December 2001, pp. 1423–52.

28. R. Vernon, “International Investments and International Trade in the Product Life Cycle,” Quarterly Journal of Economics, May 1966, pp. 190–207; and R. Vernon and L. T. Wells, The Economic Environment of International Business, 4th ed. (Englewood Cliffs, NJ: Prentice Hall, 1986).

29. For a good summary of this literature, see E. Helpman and P. Krugman, Market Structure and Foreign Trade: Increasing Returns, Imperfect Competition, and the International Economy (Boston: MIT Press, 1985). Also see P. Krugman, “Does the New Trade Theory Require a New Trade Policy?” World Economy 15, no. 4 (1992), pp. 423–41.

30. M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 (Summer 1988), pp. 41–58; and W. T. Robinson and Sungwook Min, “Is the First to Market the First to Fail?” Journal of Marketing Research 29 (2002), pp. 120–28.

31. J. R. Tybout, “Plant and Firm Level Evidence on New Trade Theories,” National Bureau of Economic Research Working Paper Series, working paper no. 8418, August 2001 (paper available at www.nber.org); and S. Deraniyagala and B. Fine, “New Trade Theory versus Old Trade Policy: A Continuing Enigma,” Cambridge Journal of Economics 25 (November 2001), pp. 809–25.

32. A. D. Chandler, Scale and Scope (New York: Free Press, 1990).

33. Krugman, “Does the New Trade Theory Require a New Trade Policy?”

34. M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990). For a good review of this book, see R. M. Grant, “Porter’s Competitive Advantage of Nations: An Assessment,” Strategic Management Journal 12 (1991), pp. 535–48.

35. B. Kogut, ed., Country Competitiveness: Technology and the Organizing of Work (New York: Oxford University Press, 1993).

36. Porter, The Competitive Advantage of Nations, p. 121.

37. Lieberman and Montgomery, “First-Mover Advantages.” See also Robinson and Min, “Is the First to Market the First to Fail?”; W. Boulding and M. Christen, “First Mover Disadvantage,” Harvard Business Review, October 2001, pp. 20–21; and R. Agarwal and M. Gort, “First Mover Advantage and the Speed of Competitive Entry,” Journal of Law and Economics 44 (2001), pp. 131–59.

38. C. A. Hamilton, “Building Better Machine Tools,” Journal of Commerce, October 30, 1991, p. 8; and “Manufacturing Trouble,” The Economist, October 12, 1991, p. 71.

39. J. W. Peters, “U.S. Trade Deficit Grew to Another Record in 06,” The New York Times, February 14, 2007, p. 1.

40. P. Krugman, The Age of Diminished Expectations (Cambridge, MA: MIT Press, 1990).

41. D. Griswold, “Are Trade Deficits a Drag on U.S. Economic Growth?” Free Trade Bulletin, March 12, 2007; and O. Blanchard, “Current Account Deficits in Rich Countries,” National Bureau of Economic Research Working Paper Series, working paper no. 12925, February 2007.

42. S. Edwards, “The U.S. Current Account Deficit: Gradual Correction or Abrupt Adjustment?” National Bureau of Economic Research Working Paper Series, working paper no. 12154, April 2006.

The Political Economy of Internal

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Managing in the Global Marketplace

Much of this text is concerned with the challenges of managing in an international business. An international business is any firm that engages in international trade or investment. A firm does not have to become a multinational enterprise, investing directly in operations in other countries, to engage in international business, although multinational enterprises are international businesses. All a firm has to do is export or import products from other countries. As the world shifts toward a truly integrated global economy, more firms—both large and small—are becoming international businesses. What does this shift toward a global economy mean for managers within an international business?

International Business

Any firm that engages in international trade or investment.

As their organizations increasingly engage in cross-border trade and investment, managers need to recognize that the task of managing an international business differs from that of managing a purely domestic business in many ways. At the most fundamental level, the differences arise from the simple fact that countries are different. Countries differ in their cultures, political systems, economic systems, legal systems, and levels of economic development. Despite all the talk about the emerging global village, and despite the trend toward globalization of markets and production, as we shall see in this text, many of these differences are very profound and enduring.

Differences among countries require that an international business vary its practices country by country. Marketing a product in Brazil may require a different approach from marketing the product in Germany; managing U.S. workers might require different skills from managing Japanese workers; maintaining close relations with a particular level of government Page 30may be very important in Mexico and irrelevant in Great Britain; the business strategy pursued in Canada might not work in South Korea; and so on. Managers in an international business must not only be sensitive to these differences but also adopt the appropriate policies and strategies for coping with them. Much of this text is devoted to explaining the sources of these differences and the methods for successfully coping with them.

A further way in which international business differs from domestic business is the greater complexity of managing an international business. In addition to the problems that arise from the differences between countries, a manager in an international business is confronted with a range of other issues that the manager in a domestic business never confronts. The managers of an international business must decide where in the world to site production activities to minimize costs and to maximize value added. They must decide whether it is ethical to adhere to the lower labor and environmental standards found in many less developed nations. Then they must decide how best to coordinate and control globally dispersed production activities (which, as we shall see later in the text, is not a trivial problem). The managers in an international business also must decide which foreign markets to enter and which to avoid. They must choose the appropriate mode for entering a particular foreign country. Is it best to export its product to the foreign country? Should the firm allow a local company to produce its product under license in that country? Should the firm enter into a joint venture with a local firm to produce its product in that country? Or should the firm set up a wholly owned subsidiary to serve the market in that country? As we shall see, the choice of entry mode is critical because it has major implications for the long-term health of the firm.

Conducting business transactions across national borders requires understanding the rules governing the international trading and investment system. Managers in an international business must also deal with government restrictions on international trade and investment. They must find ways to work within the limits imposed by specific governmental interventions. As this text explains, even though many governments are nominally committed to free trade, they often intervene to regulate cross-border trade and investment. Managers within international businesses must develop strategies and policies for dealing with such interventions.

Cross-border transactions also require that money be converted from the firm’s home currency into a foreign currency and vice versa. Because currency exchange rates vary in response to changing economic conditions, managers in an international business must develop policies for dealing with exchange rate movements. A firm that adopts the wrong policy can lose large amounts of money, whereas one that adopts the right policy can increase the profitability of its international transactions.

In sum, managing an international business is different from managing a purely domestic business for at least four reasons: (1) countries are different, (2) the range of problems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business, (3) an international business must find ways to work within the limits imposed by government intervention in the international trade and investment system, and (4) international transactions involve converting money into different currencies.

In this text, we examine all these issues in depth, paying close attention to the different strategies and policies that managers pursue to deal with the various challenges created when a firm becomes an international business. Chapters 2, 3, and 4 explore how countries differ from each other with regard to their political, economic, legal, and cultural institutions. Chapter 5 takes a detailed look at the ethical issues that arise in international business. Chapters 6 through 9 look at the international trade and investment environment within which international businesses must operate. Chapters 10 and 11 review the international monetary system. These chapters focus on the nature of the foreign exchange market and the emerging global monetary system. Chapters 12 and 13 explore the strategy of international businesses. Chapters 14 through 17 look at the management of various functional operations within an international business, including production, marketing, and human relations. By the time you complete this text, you should have a good grasp of the issues that managers working within international business have to grapple with on a daily basis, and you should be familiar with the range of strategies and operating policies available to compete more effectively in today’s rapidly emerging global economy.

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Page 31Key Terms

globalization

globalization of markets

globalization of production

factors of production

General Agreement on Tariffs and Trade (GATT)

World Trade Organization (WTO)

International Monetary Fund (IMF)

World Bank

United Nations

Group of Twenty (G20)

international trade

foreign direct investment (FDI)

Moore’s law

stock of foreign direct investment

multinational enterprise (MNE)

international business

Summary

This chapter has shown how the world economy is becoming more global and reviewed the main drivers of globalization, arguing that they seem to be thrusting nation-states toward a more tightly integrated global economy. It looked at how the nature of international business is changing in response to the changing global economy, discussed concerns raised by rapid globalization, and reviewed implications of rapid globalization for individual managers. The chapter made the following points:

1. Over the past three decades, we have witnessed the globalization of markets and production.

2. The globalization of markets implies that national markets are merging into one huge marketplace. However, it is important not to push this view too far.

3. The globalization of production implies that firms are basing individual productive activities at the optimal world locations for the particular activities. As a consequence, it is increasingly irrelevant to talk about American products, Japanese products, or German products because these are being replaced by “global” products.

4. Two factors seem to underlie the trend toward globalization: declining trade barriers and changes in communication, information, and transportation technologies.

5. Since the end of World War II, barriers to the free flow of goods, services, and capital have been lowered significantly. More than anything else, this has facilitated the trend toward the globalization of production and has enabled firms to view the world as a single market.

6. As a consequence of the globalization of production and markets, in the last decade world trade has grown faster than world output, foreign direct investment has surged, imports have penetrated more deeply into the world’s industrial nations, and competitive pressures have increased in industry after industry.

7. The development of the microprocessor and related developments in communication and information processing technology have helped firms link their worldwide operations into sophisticated information networks. Jet air travel, by shrinking travel time, has also helped link the worldwide operations of international businesses. These changes have enabled firms to achieve tight coordination of their worldwide operations and to view the world as a single market.

8. In the 1960s, the U.S. economy was dominant in the world, U.S. firms accounted for most of the foreign direct investment in the world economy, U.S. firms dominated the list of large multinationals, and roughly half the world—the centrally planned economies of the communist world—was closed to Western businesses.

9. By the mid-1990s, the U.S. share of world output had been cut in half, with major shares now being accounted for by western European and Southeast Asian economies. The U.S. share of worldwide foreign direct investment had also fallen, by about two-thirds. U.S. multinationals were now facing competition from a large number of Japanese and European multinationals. In addition, the emergence of mini-multinationals was noted.

10. One of the most dramatic developments of the past 20 years has been the collapse of communism in eastern Europe, which has created enormous opportunities for international businesses. In addition, the move toward free market economies in China and Latin America is creating opportunities (and threats) for Western international businesses.

11. The benefits and costs of the emerging global economy are being hotly debated among businesspeople, economists, and politicians. The debate focuses on the impact of globalization on jobs, wages, the environment, working conditions, and national sovereignty.

12. Managing an international business is different from managing a domestic business for at least four reasons: (a) countries are different, (b) the range of problems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business, (c) managers in an international business must find ways to work within the limits imposed by governments’ intervention in the international trade and investment system, and (d) international transactions involve converting money into different currencies.

Foreign Direct Investment

THE CHANGING FOREIGN DIRECT INVESTMENT PICTURE Reflecting the dominance of the United States in the global economy, U.S. firms accounted for 66.3 percent of worldwide foreign direct investment flows in the 1960s. British firms were second, accounting for 10.5 percent, while Japanese firms were a distant eighth, with only 2 percent. The dominance of U.S. firms was so great that books were written about the economic threat posed to Europe by U.S. corporations.31 Several European governments, most notably France, talked of limiting inward investment by U.S. firms.

Page 17country FOCUS

India’s Software Sector

Some 25 years ago, a number of small software enterprises were established in Bangalore, India. Typical of these enterprises was Infosys Technologies, which was started by seven Indian entrepreneurs with about $1,000 among them. Infosys now has annual revenues of $7.4 billion and some 155,600 employees, but it is just one of more than a hundred software companies clustered around Bangalore, which has become the epicenter of India’s fast-growing information technology sector. From a standing start in the mid-1980s, by 2012 this sector was generating export sales of $68 billion in 2011–2012.

The growth of the Indian software sector has been based on four factors. First, the country has an abundant supply of engineering talent. Every year, Indian universities graduate some 400,000 engineers. Second, labor costs in India have historically been low. As recently as 2008, the cost to hire an Indian graduate was roughly 12 percent of the cost of hiring an American graduate (this is now changing, with salaries increasing in India). Third, many Indians are fluent in English, which makes coordination between Western firms and India easier. Fourth, due to time differences, Indians can work while Americans sleep.

Initially, Indian software enterprises focused on the low end of the software industry, supplying basic software development and testing services to Western firms. But as the industry has grown in size and sophistication, Indian firms have moved up the market. Today, the leading Indian companies compete directly with the likes of IBM and EDS for large software development projects, business process outsourcing contracts, and information technology consulting services. Over the past 15 years, these markets have boomed, with Indian enterprises capturing a large slice of the pie. One response of Western firms to this emerging competitive threat has been to invest in India to garner the same kind of economic advantages that Indian firms enjoy. IBM, for example, has invested $2 billion in its Indian operations and now has 150,000 employees located there, more than in any other country. Microsoft, too, has made major investments in India, including a research and development (R&D) center in Hyderabad that employs 4,000 people and was located there specifically to tap into talented Indian engineers who did not want to move to the United States.

Sources: “America’s Pain, India’s Gain: Outsourcing,” The Economist, January 11, 2003, p. 59; “The World Is Our Oyster,” The Economist, October 7, 2006, pp. 9–10; “IBM and Globalization: Hungry Tiger, Dancing Elephant,” The Economist, April 7, 2007, pp. 67–69; P. Mishra, “New Billing Model May Hit India’s Software Exports,” Live Mint, February 14, 2013; and “India’s Outsourcing Business: On the Turn,” The Economist, January 19, 2013.

However, as the barriers to the free flow of goods, services, and capital fell, and as other countries increased their shares of world output, non-U.S. firms increasingly began to invest across national borders. The motivation for much of this foreign direct investment by non-U.S. firms was the desire to disperse production activities to optimal locations and to build a direct presence in major foreign markets. Thus, beginning in the 1970s, European and Japanese firms began to shift labor-intensive manufacturing operations from their home markets to developing nations where labor costs were lower. In addition, many Japanese firms invested in North America and Europe—often as a hedge against unfavorable currency movements and the possible imposition of trade barriers. For example, Toyota, the Japanese automobile company, rapidly increased its investment in automobile production facilities in the United States and Europe during the late 1980s and early 1990s. Toyota executives believed that an increasingly strong Japanese yen would price Japanese automobile exports out of foreign markets; therefore, production in the most important foreign markets, as opposed to exports from Japan, made sense. Toyota also undertook these investments to head off growing political pressures in the United States and Europe to restrict Japanese automobile exports into those markets.

One consequence of these developments is illustrated in Figure 1.1, which shows how the stock of foreign direct investment by the world’s six most important national sources—the United States, the United Kingdom, Germany, the Netherlands, France, and Japan— changed between 1980 and 2012. [The stock of foreign direct investment (FDI) refers to the total cumulative value of foreign investments.] Figure 1.1 also shows the stock accounted for by firms from developing economies. The share of the total stock accounted for by U.S. firms declined from about 38 percent in 1980 to 22 percent in 2012. Meanwhile, the shares accounted for by the world’s developing nations increased markedly. The rise in the share of FDI stock accounted for by developing nations reflects a growing trend for firms from these countries to invest outside their borders. In 2012, firms based in developing nations accounted for 18.9 percent of the stock of foreign direct investment, up from around 1 percent Page 18in 1980. Firms based in Hong Kong, South Korea, Singapore, Taiwan, India, Brazil, and mainland China accounted for much of this investment.

Stock of Foreign Direct Investment

The total accumulated value of foreign-owned assets at a given time.

1.1 FIGURE

Percentage Share of Total FDI Stock, 1980–2012

Figure 1.2 illustrates two other important trends—the sustained growth in cross-border flows of foreign direct investment that occurred during the 1990s and the increasing importance of developing nations as the destination of foreign direct investment. Throughout the 1990s, the amount of investment directed at both developed and developing nations increased dramatically, a trend that reflects the increasing internationalization of business corporations. A surge in foreign direct investment from 1998 to 2000 was followed by a slump from 2001 to 2003, associated with a slowdown in global economic activity after the collapse of the financial bubble of the late 1990s and 2000. The growth of foreign direct investment resumed in 2004 and continued through 2007, when it hit record levels, only to slow again in 2008 and 2009 as the global financial crisis took hold. However, throughout this time period, the growth of foreign direct investment into developing nations remained robust. Among developing nations, the largest recipient has been China, which in 2004– 2012 received $60 billion to $100 billion a year in inflows, followed by the likes of Brazil, Mexico, and India. As we shall see later in this text, the sustained flow of foreign investment into developing nations is an important stimulus for economic growth in those countries, which bodes well for the future of countries such as China, Mexico, and Brazil—all leading beneficiaries of this trend.

1.2 FIGURE

FDI Inflows, 1980–2012

THE CHANGING NATURE OF THE MULTINATIONAL ENTERPRISE A multinational enterprise (MNE) is any business that has productive activities in two or more countries. Since the 1960s, two notable trends in the demographics of the multinational enterprise have been (1) the rise of non-U.S. multinationals and (2) the growth of mini-multinationals.

Multinational Enterprise (MNE)

A firm that owns business operations in more than one country.

Non-U.S. Multinationals In the 1960s, global business activity was dominated by large U.S. multinational corporations. With U.S. firms accounting for about two-thirds of foreign direct investment during the 1960s, one would expect most multinationals to be U.S. enterprises. According to the data summarized in Figure 1.3, in 1973, 48.5 percent of the world’s 260 largest multinationals were U.S. firms. The second-largest source country was the United Kingdom, with 18.8 percent of the largest multinationals. Japan accounted for 3.5 percent of the world’s largest multinationals at the time. The large number of U.S. multinationals reflected U.S. economic dominance in the three decades after World War II, while the large number of British multinationals reflected that country’s industrial dominance in the early decades of the twentieth century.

By 2012, things had shifted significantly. Some 22 of the world’s 100 largest nonfinancial multinationals were U.S. enterprises; 14 were British, 14 French, 10 were German, and 7 were from Japan.32 Although the 1973 data are not strictly comparable with the later data, they illustrate the trend (the 1973 figures are based on the largest 260 firms, whereas the later figures are based on the largest 100 multinationals). The globalization and growth of the world economy has resulted in a relative reduction in the dominance of U.S. firms in the global marketplace.

According to UN data, the ranks of the world’s largest 100 multinationals are still dominated by firms from developed economies.33 However, eight firms from developing economies had entered the UN’s list of the 100 largest multinationals by 2012. The largest was Hutchison Whampoa of Hong Kong, China, which ranked 26th.34 Firms from developing nations can be expected to emerge as important competitors in global markets, further shifting the axis of the world economy away from North America and western Europe and threatening the long dominance of Western companies. One such rising competitor, Hisense, one of China’s premier manufacturers of consumer appliances and telecommunications equipment, is profiled in the accompanying Management Focus.

The Rise of Mini-Multinationals Another trend in international business has been the growth of medium-size and small multinationals (mini-multinationals).35 When people Page 20think of international businesses, they tend to think of firms such as ExxonMobil, General Motors, Ford, Panasonic, Procter & Gamble, Sony, and Unilever—large, complex multinational corporations with operations that span the globe. Although most international trade and investment are still conducted by large firms, many medium-size and small businesses are becoming increasingly involved in international trade and investment. The rise of the Internet is lowering the barriers that small firms face in building international sales.

1.3 FIGURE

National Share of Largest Mulinationals, 1973 and 2012

Consider Lubricating Systems Inc. of Kent, Washington. Lubricating Systems, which manufactures lubricating fluids for machine tools, employs 25 people and generates sales of $6.5 million. It’s hardly a large, complex multinational, yet more than $2 million of the company’s sales are generated by exports to a score of countries, including Japan, Israel, and the United Arab Emirates. Lubricating Systems has also set up a joint venture with a German company to serve the European market.36 Consider also Lixi Inc., a small U.S. manufacturer of industrial X-ray equipment; 70 percent of Lixi’s $4.5 million in revenues comes from exports to Japan.37 Or take G. W. Barth, a manufacturer of cocoa-bean roasting machinery based in Ludwigsburg, Germany. Employing just 65 people, this small company has captured 70 percent of the global market for cocoa-bean roasting machines.38 International business is conducted not just by large firms but also by medium-size and small enterprises.

Which is More Important— Similarities or Differences?

International strategy has seen significant changes in recent years. Multinational enterprises now have to evaluate their core uniqueness and how they can drive their uniqueness to be leveraged in the global marketplace better. For some, such thinking may represent a major shift in thinking—to focus on similarities across nations and customers instead of differences. This could be an important shift because companies and their people are trained to look for differences and form strategies based on satisfying the needs of customers with slight or significant differences across the globe. In the future, we may be loking for similarities first, and then focusing on the similarities that outweigh the differences in tastes, wants, and needs. Do you agree that focusing on similarities across countries is a better way to developing strategy than focusing on differences?

Source: globalEDGE.msu.edu/content/gbr/gbr7-2.pdf.

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THE CHANGING WORLD ORDER Between 1989 and 1991, a series of democratic revolutions swept the communist world. For reasons that are explored in more detail in Chapter 3, in country after country throughout eastern Europe and eventually in the Soviet Union itself, Communist Party governments collapsed. The Soviet Union receded into history, having been replaced by 15 independent republics. Czechoslovakia divided itself into two states, while Yugoslavia dissolved into a bloody civil war, now thankfully over, among its five successor states.

Many of the former communist nations of Europe and Asia seem to share a commitment to democratic politics and free market economics. For half a century, these countries were essentially closed to Western international businesses. Now, they present a host of export and investment opportunities. Two decades later, the economies of many of the former communist states are still relatively undeveloped, and their continued commitment to democracy and market-based economic systems cannot be taken for granted. Disturbing signs of growing unrest and totalitarian tendencies continue to be seen in several eastern European and central Asian states, including Russia, which has shown signs of shifting back toward greater state involvement in economic activity and authoritarian government.39 Thus, the risks involved in doing business in such countries are high, but so may be the returns.

In addition to these changes, quieter revolutions have been occurring in China, other states in Southeast Asia, and Latin America. Their implications for international businesses may be just as profound as the collapse of communism in eastern Europe. China suppressed its own pro-democracy movement in the bloody Tiananmen Square massacre of 1989. Despite this, China continues to move progressively toward greater free market reforms. If what is occurring in China continues for two more decades, China may move from third-world to industrial superpower status even more rapidly than Japan did. If China’s GDP per capita grows by an average of 6 to 7 percent, which is slower than the 8 to 10 percent growth rate achieved during the past decade, then by 2020 this nation of 1.3 billion people could boast an average income per capita of about $13,000, roughly equivalent to that of Spain’s today.

Page 21The potential consequences for international business are enormous. On the one hand, China represents a huge and largely untapped market. Reflecting this, between 1983 and 2012, annual foreign direct investment in China increased from less than $2 billion to $100 billion annually. On the other hand, China’s new firms are proving to be very capable competitors, and they could take global market share away from Western and Japanese enterprises (e.g., see the Management Focus about Hisense). Thus, the changes in China are creating both opportunities and threats for established international businesses.

As for Latin America, both democracy and free market reforms have been evident there too. For decades, most Latin American countries were ruled by dictators, many of whom seemed to view Western international businesses as instruments of imperialist domination. Accordingly, they restricted direct investment by foreign firms. In addition, the poorly managed economies of Latin America were characterized by low growth, high debt, and hyper-inflation—all of which discouraged investment by international businesses. In the past two decades, much of this has changed. Throughout most of Latin America, debt and inflation are down, governments have sold state-owned enterprises to private investors, foreign investment is welcomed, and the region’s economies have expanded. Brazil, Mexico, and Chile have led the way. These changes have increased the attractiveness of Latin America, both as a market for exports and as a site for foreign direct investment. At the same time, given the long history of economic mismanagement in Latin America, there is no guarantee that these favorable trends will continue. Indeed, Bolivia, Ecuador, and most notably Venezuela have seen shifts back toward greater state involvement in industry in the past few years, and foreign investment is now less welcome than it was during the 1990s. In these nations, the government has seized control of oil and gas fields from foreign investors and has limited the rights of foreign energy companies to extract oil and gas from their nations. Thus, as in the case of eastern Europe, substantial opportunities are accompanied by substantial risks.

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China’s Hisense—An Emerging Multinational

Hisense is rapidly emerging as one of China’s leading multinationals. Like many other Chinese corporations, Hisense traces its origins back to a state-owned manufacturer, in this case Qingdao No. 2 Radio Factory, which was established in 1969 with just 10 employees. In the 1970s, the state-owned factory diversified into the manufacture of TV sets; by the 1980s, it was one of China’s leading manufacturers of color TVs, making sets designed by Matsushita under license. In 1992, a 35-year-old engineer named Zhou Houjian was appointed head of the enterprise. In 1994, the shackles of state ownership were relaxed when the Hisense Company Ltd. was established with Zhou as CEO (he is now chairman of the board).

Under Zhou’s leadership, Hisense entered a period of rapid growth, product diversification, and global expansion. By 2013, the company had sales of more than $15 billion and had emerged as one of China’s premier makers of TV sets, air conditioners, refrigerators, personal computers, and telecommunications equipment. Hisense sold more than 10 million TV sets, 3 million air conditioners, 4 million CDMA wireless phones, 6 million refrigerators, and 1 million personal computers. International sales accounted for more than 15 percent of total revenue. The company had established overseas manufacturing subsidiaries in Algeria, Hungary, Iran, Pakistan, and South Africa and was growing rapidly in developing markets, where it was taking share away from long-established consumer electronics and appliance makers.

Hisense’s ambitions are grand. It seeks to become a global enterprise with a world-class consumer brand. Although it is without question a low-cost manufacturer, Hisense believes its core strength is in rapid product innovation. The company believes that the only way to gain leadership in the highly competitive markets in which it competes is to continuously launch advanced, high-quality, and competitively priced products.

To this end, Hisense established its first R&D center in China in the mid-1990s. This was followed by a South African R&D center in 1997 and a European R&D center in 2007. The company also has plans for an R&D center in the United States. By 2008, these R&D centers filed for more than 600 patents.

Hisense’s technological prowess is evident in its digital TV business. It introduced set-top boxes in 1999, making it possible to browse the Internet from a TV. In 2002, Hisense introduced its first interactive digital TV set, and in 2005 it developed China’s first core digital processing chip for digital TVs, breaking the country’s reliance on foreign chip makers for this core technology. In 2006, Hisense launched an innovative line of multimedia TV sets that integrated digital high-definition technology, network technology, and flat-panel displays.

Sources: Harold L. Sirkin, “Someone May Be Gaining on Us,” Barron’s, February 5, 2007, p. 53; “Hisense Plans to Grab More International Sales,” Sino Cast China IT Watch, November 30, 2006; “Hisense’s Wonder Chip,” Financial Times Information Limited— Asian Intelligence Wire, October 30, 2006; and Hisense’s website, www.hisense.com

Page 22THE GLOBAL ECONOMY OF THE TWENTY-FIRST CENTURY As discussed, the past quarter-century has seen rapid changes in the global economy. Barriers to the free flow of goods, services, and capital have been coming down. As their economies advance, more nations are joining the ranks of the developed world. A generation ago, South Korea and Taiwan were viewed as second-tier developing nations. Now they boast large economies, and their firms are major players in many global industries, from shipbuilding and steel to electronics and chemicals. The move toward a global economy has been further strengthened by the widespread adoption of liberal economic policies by countries that had firmly opposed them for two generations or more. In short, current trends indicate the world is moving toward an economic system that is more favorable for international business.

But it is always hazardous to use established trends to predict the future. The world may be moving toward a more global economic system, but globalization is not inevitable. Countries may pull back from the recent commitment to liberal economic ideology if their experiences do not match their expectations. There are clear signs, for example, of a retreat from liberal economic ideology in Russia. If Russia’s hesitation were to become more permanent and widespread, the liberal vision of a more prosperous global economy based on free market principles might not occur as quickly as many hope. Clearly, this would be a tougher world for international businesses.

Also, greater globalization brings with it risks of its own. This was starkly demonstrated in 1997 and 1998 when a financial crisis in Thailand spread first to other East Asian nations and then to Russia and Brazil. Ultimately, the crisis threatened to plunge the economies of the developed world, including the United States, into a recession. We explore the causes and consequences of this and other similar global financial crises in Chapter 11. Even from a purely economic perspective, globalization is not all good. The opportunities for doing business in a global economy may be significantly enhanced, but as we saw in 1997–1998, the risks associated with global financial contagion are also greater. Indeed, during 2008–2009, a crisis that started in the financial sector of America, where banks had been too liberal in their lending policies to homeowners, swept around the world and plunged the global economy into its deepest recession since the early 1980s, illustrating once more that in an interconnected world a severe crisis in one region can affect the entire globe. Still, as explained later in this text, firms can exploit the opportunities associated with globalization while reducing the risks through appropriate hedging strategies.

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Explain the main arguments in the debate over the impact of globalization.

The Globalization Debate

Is the shift toward a more integrated and interdependent global economy a good thing? Many influential economists, politicians, and business leaders seem to think so.40 They argue that falling barriers to international trade and investment are the twin engines driving the global economy toward greater prosperity. They say increased international trade and cross-border investment will result in lower prices for goods and services. They believe that globalization stimulates economic growth, raises the incomes of consumers, and helps create jobs in all countries that participate in the global trading system. The arguments of those who support globalization are covered in detail in Chapters 6, 7, and 8. As we shall see, there are good theoretical reasons for believing that declining barriers to international trade and investment do stimulate economic growth, create jobs, and raise income levels. As described in Chapters 6, 7, and 8, empirical evidence lends support to the predictions of this theory. However, despite the existence of a compelling body of theory and evidence, globalization has its critics.41 Some of these critics have become increasingly vocal and active, taking to the streets to demonstrate their opposition to globalization. Here, we look at the nature of protests against globalization and briefly review the main themes of the debate concerning the merits of globalization. In later chapters, we elaborate on many of these points.

ANTIGLOBALIZATION PROTESTS Demonstrations against globalization date to December 1999, when more than 40,000 protesters blocked the streets of Seattle in an attempt to shut down a World Trade Organization meeting being held in the city. The demonstrators were protesting against a wide range of issues, including job losses in industries under attack from foreign competitors, downward pressure on the wage rates of unskilled workers, environmental degradation, and the cultural imperialism of global media and multinational enterprises, which was seen as being dominated by what some protesters called the “culturally impoverished” interests and values of the United States. All of these ills, the demonstrators claimed, could be laid at the feet of globalization. The World Trade Organization was meeting to try to launch a new round of talks to cut barriers to cross-border trade and investment. As such, it was seen as a promoter of globalization and a target for the protesters. The protests turned violent, transforming the normally placid streets of Seattle into a running battle between “anarchists” and Seattle’s bemused and poorly prepared police department. Pictures of brick-throwing protesters and armored police wielding their batons were duly recorded by the global media, which then circulated the images around the world. Meanwhile, the WTO meeting failed to reach agreement, and although the protests outside the meeting halls had little to do with that failure, the impression took hold that the demonstrators had succeeded in derailing the meetings.

Emboldened by the experience in Seattle, antiglobalization protesters now often turn up at major meetings of global institutions. Smaller-scale protests have occurred in several countries, such as France, where antiglobalization activists destroyed a McDonald’s restaurant in 1999 to protest the impoverishment of French culture by American imperialism (see the accompanying Country Focus for details). While violent protests may give the antiglobalization effort a bad name, it is clear from the scale of the demonstrations that support for the cause goes beyond a core of anarchists. Large segments of the population in many countries believe that globalization has detrimental effects on living standards and the environment, and the media have often fed on this fear. For example, former CNN news anchor Lou Dobbs ran TV shows that were highly critical of the trend by American companies to take advantage of globalization and “export jobs” overseas. As the world slipped into a recession in 2008, Dobbs stepped up his antiglobalization rhetoric (Dobbs left CNN in 2009).

Both theory and evidence suggest that many of these fears are exaggerated; both politicians and businesspeople need to do more to counter these fears. Many protests against globalization are tapping into a general sense of loss at the passing of a world in which barriers of time and distance, and vast differences in economic institutions, political institutions, and the level of development of different nations, produced a world rich in the diversity of human cultures. However, while the rich citizens of the developed world may have the luxury of mourning the fact that they can now see McDonald’s restaurants and Starbucks coffeehouses on their vacations to exotic locations such as Thailand, fewer complaints are heard from the citizens of those countries, who welcome the higher living standards that progress brings.

GLOBALIZATION, JOBS, AND INCOME One concern frequently voiced by globalization opponents is that falling barriers to international trade destroy manufacturing jobs in wealthy advanced economies such as the United States and western Europe. The critics argue that falling trade barriers allow firms to move manufacturing activities to countries where wage rates are much lower.42 Indeed, due to the entry of China, India, and states from eastern Europe into the global trading system, along with global population growth, estimates suggest that the pool of global labor may have quadrupled between 1985 and 2005, with most of the increase occurring after 1990.43 Other things being equal, we might conclude that this enormous expansion in the global labor force, when coupled with expanding international trade, would have depressed wages in developed nations.

This fear is supported by anecdotes. For example, D. L. Bartlett and J. B. Steele, two journalists for the Philadelphia Inquirer who gained notoriety for their attacks on free trade, Page 24cite the case of Harwood Industries, a U.S. clothing manufacturer that closed its U.S. operations, where it paid workers $9 per hour, and shifted manufacturing to Honduras, where textile workers received 48 cents per hour.44 Because of moves such as this, argue Bartlett and Steele, the wage rates of poorer Americans have fallen significantly over the past quarter of a century.

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Protesting Globalization in France

One night in August 1999, 10 men under the leadership of local sheep farmer and rural activist José Bové crept into the town of Millau in central France and vandalized a McDonald’s restaurant under construction, causing an estimated $150,000 in damage. These were no ordinary vandals, however, at least according to their supporters, for the “symbolic dismantling” of the McDonald’s outlet had noble aims, or so it was claimed. The attack was initially presented as a protest against unfair American trade policies. The European Union had banned imports of hormone-treated beef from the United States, primarily because of fears that it might lead to health problems (although EU scientists had concluded there was no evidence of this). After a careful review, the World Trade Organization stated the EU ban was not allowed under trading rules that the EU and United States were party to and that the EU would have to lift it or face retaliation. The EU refused to comply, so the U.S. government imposed a 100 percent tariff on imports of certain EU products, including French staples such as foie gras, mustard, and Roquefort cheese. On farms near Millau, Bové and others raised sheep whose milk was used to make Roquefort. They felt incensed by the American tariff and decided to vent their frustrations on McDonald’s.

Bové and his compatriots were arrested and charged. About the same time in the Languedoc region of France, California winemaker Robert Mondavi had reached agreement with the mayor and council of the village of Aniane and regional authorities to turn 125 acres of wooded hillside belonging to the village into a vineyard. Mondavi planned to invest $7 million in the project and hoped to produce top-quality wine that would sell in Europe and the United States for $60 a bottle. However, local environmentalists objected to the plan, which they claimed would destroy the area’s unique ecological heritage. José Bové, basking in sudden fame, offered his support to the opponents, and the protests started. In May 2001, the Socialist mayor who had approved the project was defeated in local elections in which the Mondavi project had become the major issue. He was replaced by a communist, Manuel Diaz, who denounced the project as a capitalist plot designed to enrich wealthy U.S. shareholders at the cost of his villagers and the environment. Following Diaz’s victory, Mondavi announced he would pull out of the project. A spokesman noted, “It’s a huge waste, but there are clearly personal and political interests at play here that go way beyond us.”

So are the French opposed to foreign investment? The experience of McDonald’s and Mondavi seems to suggest so, as does the associated news coverage, but look closer and a different reality seems to emerge. McDonald’s has more than 1,200 restaurants in France and continues to do very well there. In fact, France is one of the most profitable markets for McDonald’s. France has long been one of the most favored locations for inward foreign direct investment, receiving more than $385 billion of foreign investment between 2005 and 2010, more than any other European nation with the exception of Britain. American companies have always accounted for a significant percentage of this investment. Moreover, French enterprises have also been significant foreign investors; some 1,100 French multinationals account for about 8 percent of the global stock of foreign direct investment.

Sources: “Behind the Bluster,” The Economist, May 26, 2001; “The French Farmers’ Anti-global Hero,” The Economist, July 8, 2000; C. Trueheart, “France’s Golden Arch Enemy?” Toronto Star, July 1, 2000; J. Henley, “Grapes of Wrath Scare Off U.S. Firm,” The Economist, May 18, 2001, p. 11; and United Nations, World Investment Report, 2011 (New York and Geneva: United Nations, 2011).

In the past few years, the same fears have been applied to services, which have increasingly been outsourced to nations with lower labor costs. The popular feeling is that when corporations such as Dell, IBM, or Citigroup outsource service activities to lower-cost foreign suppliers—as all three have done—they are “exporting jobs” to low-wage nations and contributing to higher unemployment and lower living standards in their home nations (in this case, the United States). Some lawmakers in the United States have responded by calling for legal barriers to job outsourcing.

Supporters of globalization reply that critics of these trends miss the essential point about free trade—the benefits outweigh the costs.45 They argue that free trade will result in countries specializing in the production of those goods and services that they can produce most efficiently, while importing goods and services that they cannot produce as efficiently. When a country embraces free trade, there is always some dislocation—lost textile jobs at Harwood Industries or lost call-center jobs at Dell—but the whole economy is better off as a result. According to this view, it makes little sense for the United States to Page 25produce textiles at home when they can be produced at a lower cost in Honduras or China (which, unlike Honduras, is a major source of U.S. textile imports). Importing textiles from China leads to lower prices for clothes in the United States, which enables consumers to spend more of their money on other items. At the same time, the increased income generated in China from textile exports increases income levels in that country, which helps the Chinese to purchase more products produced in the United States, such as pharmaceuticals from Amgen, Boeing jets, microprocessors made by Intel, Microsoft software, and Cisco routers.

The same argument can be made to support the outsourcing of services to low-wage countries. By outsourcing its customer service call centers to India, Dell can reduce its cost structure, and thereby its prices for PCs. U.S. consumers benefit from this development. As prices for PCs fall, Americans can spend more of their money on other goods and services. Moreover, the increase in income levels in India allows Indians to purchase more U.S. goods and services, which helps create jobs in the United States. In this manner, supporters of globalization argue that free trade benefits all countries that adhere to a free trade regime.

If the critics of globalization are correct, three things must be shown. First, the share of national income received by labor, as opposed to the share received by the owners of capital (e.g., stockholders and bondholders), should have declined in advanced nations as a result of downward pressure on wage rates. Second, even though labor’s share of the economic pie may have declined, this does not mean lower living standards if the size of the total pie has increased sufficiently to offset the decline in labor’s share—in other words, if economic growth and rising living standards in advanced economies have offset declines in labor’s share (this is the position argued by supporters of globalization). Third, the decline in labor’s share of national income must be due to moving production to low-wage countries, as opposed to improvement in production technology and productivity.

Several studies shed light on these issues.46 First, the data suggest that over the past two decades, the share of labor in national income has declined. The decline in share is much more pronounced in Europe and Japan (about 10 percentage points) than in the United States and the United Kingdom (where it is 3 to 4 percentage points). However, detailed analysis suggests the share of national income enjoyed by skilled labor has actually increased, suggesting that the fall in labor’s share has been due to a fall in the share taken by unskilled labor. A study by the IMF suggested the earnings gap between workers in skilled and unskilled sectors has widened by 25 percent over the past two decades.47 The average income level of the richest 10 percent of the population in developed economies was nine times that of the poorest 10 percent, according to 2010 data. The ratio in the United States was among the highest, with the top 10 percent earning 14 times as much as the bottom 10 percent.48 These figures strongly suggest that unskilled labor in developed nations has seen its share of national income decline over the past two decades.

However, this does not mean that the living standards of unskilled workers in developed nations have declined. It is possible that economic growth in developed nations has offset the fall in the share of national income enjoyed by unskilled workers, raising their living standards. Evidence suggests that real labor compensation has expanded in most developed nations since the 1980s, including the United States. Several studies by the Organization for Economic Cooperation and Development (OECD), whose members include the 34 richest economies in the world, conclude that while the gap between the poorest and richest segments of society in OECD countries has widened, in most countries real income levels have increased for all, including the poorest segment. In a study published in 2011, the OECD found that between 1985 and 2008, real household income (adjusted for inflation) increased by 1.7 percent annually among its member-states. The real income level of the poorest 10 percent of the population increased at 1.4 percent on average, while that of the richest 10 percent increased by 2 percent annually (i.e., while everyone got richer, the gap between the most affluent and the poorest sectors of society widened). The differential in growth rates was more extreme in the United States than most other countries. The study found that the real income of the poorest 10 percent of the population grew by just 0.5 percent a year in the United States between 1985 and 2008, while that of the richest 10 percent grew by 1.9 percent annually.49

As noted earlier, globalization critics argue that the decline in unskilled wage rates is due to the migration of low-wage manufacturing jobs offshore and a corresponding reduction in demand for unskilled workers. However, supporters of globalization see a more complex picture. They maintain that the weak growth rate in real wage rates for unskilled workers owes far more to a technology-induced shift within advanced economies away from jobs where the only qualification was a willingness to turn up for work every day and toward jobs that require significant education and skills. They point out that many advanced economies report a shortage of highly skilled workers and an excess supply of unskilled workers. Thus, growing income inequality is a result of the wages for skilled workers being bid up by the labor market and the wages for unskilled workers being discounted. In fact, evidence suggests that technological change has had a bigger impact than globalization on the declining share of national income enjoyed by labor.50 This suggests that a solution to the problem of slow real income growth among the unskilled is to be found not in limiting free trade and globalization, but in increasing society’s investment in education to reduce the supply of unskilled workers.51

Finally, it is worth noting that the wage gap between developing and developed nations is closing as developing nations experience rapid economic growth. For example, one estimate suggests that wages in China will approach Western levels in two decades.52 To the extent that this is the case, any migration of unskilled jobs to low-wage countries is a temporary phenomenon representing a structural adjustment on the way to a more tightly integrated global economy.

GLOBALIZATION, LABOR POLICIES, AND THE ENVIRONMENT A second source of concern is that free trade encourages firms from advanced nations to move manufacturing facilities to less developed countries that lack adequate regulations to protect labor and the environment from abuse by the unscrupulous.53 Globalization critics often argue that adhering to labor and environmental regulations significantly increases the costs of manufacturing enterprises and puts them at a competitive disadvantage in the global marketplace vis-à-vis firms based in developing nations that do not have to comply with such regulations. Firms deal with this cost disadvantage, the theory goes, by moving their production facilities to nations that do not have such burdensome regulations or that fail to enforce the regulations they have.

If this were the case, we might expect free trade to lead to an increase in pollution and result in firms from advanced nations exploiting the labor of less developed nations.54 This argument was used repeatedly by those who opposed the 1994 formation of the North American Free Trade Agreement (NAFTA) among Canada, Mexico, and the United States. They painted a picture of U.S. manufacturing firms moving to Mexico in droves so that they would be free to pollute the environment, employ child labor, and ignore workplace safety and health issues, all in the name of higher profits.55

Supporters of free trade and greater globalization express doubts about this scenario. They argue that tougher environmental regulations and stricter labor standards go hand in hand with economic progress.56 In general, as countries get richer, they enact tougher environmental and labor regulations.57 Because free trade enables developing countries to increase their economic growth rates and become richer, this should lead to tougher environmental and labor laws. In this view, the critics of free trade have got it backward— free trade does not lead to more pollution and labor exploitation; it leads to less. By creating wealth and incentives for enterprises to produce technological innovations, the free market system and free trade could make it easier for the world to cope with pollution and population growth. Indeed, while pollution levels are rising in the world’s poorer countries, they have been falling in developed nations. In the United States, for example, the concentration of carbon monoxide and sulfur dioxide pollutants in the atmosphere decreased by 60 percent between 1978 and 1997, while lead concentrations decreased by 98 percent—and these reductions have occurred against a background of sustained economic expansion.58

A number of econometric studies have found consistent evidence of a hump-shaped relationship between income levels and pollution levels (see Figure 1.4).59 As an economy grows and income levels rise, initially pollution levels also rise. However, past some point, rising income levels lead to demands for greater environmental protection, and pollution levels Page 27then fall. A seminal study by Grossman and Krueger found that the turning point generally occurred before per capita income levels reached $8,000.60

1.4 FIGURE

Income Levels and Environmental Pollution

While the hump-shaped relationship depicted in Figure 1.4 seems to hold across a wide range of pollutants—from sulfur dioxide to lead concentrations and water quality—carbon dioxide emissions are an important exception, rising steadily with higher-income levels. Given that carbon dioxide is a heat-trapping gas, and given that there is good evidence that increased atmospheric carbon dioxide concentrations are a cause of global warming, this should be of serious concern. The solution to the problem, however, is probably not to roll back the trade liberalization efforts that have fostered economic growth and globalization, but to get the nations of the world to agree to policies designed to limit carbon emissions.61 Although UN-sponsored talks have had this as a central aim since the 1992 Earth Summit in Rio de Janeiro, there has been little success in moving toward the ambitious goals for reducing carbon emissions laid down in the Earth Summit and subsequent talks in Kyoto, Japan, in 1997 and in Copenhagen in 2009. In part, this is because the largest emitters of carbon dioxide, the United States and China, have failed to reach agreements about how to proceed. China, a country whose carbon emissions are increasing at an alarming rate, has so far shown little appetite to adopt tighter pollution controls. As for the United States, political divisions in Congress and a culture of denial have made it difficult for the country to even acknowledge, never mind move forward with, legislation designed to tackle climate change.

Notwithstanding this, supporters of free trade point out that it is possible to tie free trade agreements to the implementation of tougher environmental and labor laws in less developed countries. NAFTA, for example, was passed only after side agreements had been negotiated that committed Mexico to tougher enforcement of environmental protection regulations. Thus, supporters of free trade argue that factories based in Mexico are now cleaner than they would have been without the passage of NAFTA.62

They also argue that business firms are not the amoral organizations that critics suggest. While there may be some rotten apples, most business enterprises are staffed by managers who are committed to behave in an ethical manner and would be unlikely to move production offshore just so they could pump more pollution into the atmosphere or exploit labor. Furthermore, the relationship between pollution, labor exploitation, and production costs may not be that suggested by critics. In general, a well-treated labor force is productive, and it is productivity rather than base wage rates that often has the greatest influence on costs. The vision of greedy managers who shift production to low-wage countries to exploit their labor force may be misplaced.

GLOBALIZATION AND NATIONAL SOVEREIGNTY Another concern voiced by critics of globalization is that today’s increasingly interdependent global economy shifts economic power away from national governments and toward supranational Page 28organizations such as the World Trade Organization, the European Union, and the United Nations. As perceived by critics, unelected bureaucrats now impose policies on the democratically elected governments of nation-states, thereby undermining the sovereignty of those states and limiting the nation’s ability to control its own destiny.63

The World Trade Organization is a favorite target of those who attack the headlong rush toward a global economy. As noted earlier, the WTO was founded in 1995 to police the world trading system established by the General Agreement on Tariffs and Trade. The WTO arbitrates trade disputes between the 159 states that are signatories to the GATT. The arbitration panel can issue a ruling instructing a member-state to change trade policies that violate GATT regulations. If the violator refuses to comply with the ruling, the WTO allows other states to impose appropriate trade sanctions on the transgressor. As a result, according to one prominent critic, U.S. environmentalist, consumer rights advocate, and sometime presidential candidate Ralph Nader: Under the new system, many decisions that affect billions of people are no longer made by local or national governments but instead, if challenged by any WTO member nation, would be deferred to a group of unelected bureaucrats sitting behind closed doors in Geneva (which is where the headquarters of the WTO are located). The bureaucrats can decide whether or not people in California can prevent the destruction of the last virgin forests or determine if carcinogenic pesticides can be banned from their foods; or whether European countries have the right to ban dangerous biotech hormones in meat. . . . At risk is the very basis of democracy and accountable decision making.64

In contrast to Nader, many economists and politicians maintain that the power of supranational organizations such as the WTO is limited to what nation-states collectively agree to grant. They argue that bodies such as the United Nations and the WTO exist to serve the collective interests of member-states, not to subvert those interests. Supporters of supranational organizations point out that the power of these bodies rests largely on their ability to persuade member states to follow a certain action. If these bodies fail to serve the collective interests of member-states, those states will withdraw their support and the supranational organization will quickly collapse. In this view, real power still resides with individual nation-states, not supranational organizations.

GLOBALIZATION AND THE WORLD’S POOR Critics of globalization argue that despite the supposed benefits associated with free trade and investment, over the past hundred years or so the gap between the rich and poor nations of the world has gotten wider. In 1870, the average income per capita in the world’s 17 richest nations was 2.4 times that of all other countries. In 1990, the same group was 4.5 times as rich as the rest.65 While recent history has shown that some of the world’s poorer nations are capable of rapid periods of economic growth—witness the transformation that has occurred in some Southeast Asian nations such as South Korea, Thailand, and Malaysia—there appear to be strong forces for stagnation among the world’s poorest nations. A quarter of the countries with a GDP per capita of less than $1,000 in 1960 had growth rates of less than zero from 1960 to 1995, and a third had growth rates of less than 0.05 percent.66 Critics argue that if globalization is such a positive development, this divergence between the rich and poor should not have occurred.

Although the reasons for economic stagnation vary, several factors stand out, none of which has anything to do with free trade or globalization.67 Many of the world’s poorest countries have suffered from totalitarian governments, economic policies that destroyed wealth rather than facilitated its creation, endemic corruption, scant protection for property rights, and war. Such factors help explain why countries such as Afghanistan, Cuba, Haiti, Iraq, Libya, Nigeria, Sudan, Vietnam, and Zaire have failed to improve the economic lot of their citizens during recent decades. A complicating factor is the rapidly expanding populations in many of these countries. Without a major change in government, population growth may exacerbate their problems. Promoters of free trade argue that the best way for these countries to improve their lot is to lower their barriers to free trade and investment and to implement economic policies based on free market economics.68

Many of the world’s poorer nations are being held back by large debt burdens. Of particular concern are the 40 or so “highly indebted poorer countries” (HIPCs), which are home to some 700 million people. Among these countries, the average government debt burden has been as high as 85 percent of the value of the economy, as measured by gross domestic product, and the annual costs of serving government debt consumed 15 percent of the country’s export earnings.69 Servicing such a heavy debt load leaves the governments of these countries with little left to invest in important public infrastructure projects, such as education, health care, roads, and power. The result is the HIPCs are trapped in a cycle of poverty and debt that inhibits economic development. Free trade alone, some argue, is a necessary but not sufficient prerequisite to help these countries bootstrap themselves out of poverty. Instead, large-scale debt relief is needed for the world’s poorest nations to give them the opportunity to restructure their economies and start the long climb toward prosperity. Supporters of debt relief also argue that new democratic governments in poor nations should not be forced to honor debts that were incurred and mismanaged long ago by their corrupt and dictatorial predecessors.

In the late 1990s, a debt relief movement began to gain ground among the political establishment in the world’s richer nations.70 Fueled by high-profile endorsements from Irish rock star Bono (who has been a tireless and increasingly effective advocate for debt relief), the Dalai Lama, and influential Harvard economist Jeffrey Sachs, the debt relief movement was instrumental in persuading the United States to enact legislation in 2000 that provided $435 million in debt relief for HIPCs. More important perhaps, the United States also backed an IMF plan to sell some of its gold reserves and use the proceeds to help with debt relief. The IMF and World Bank have now picked up the banner and have embarked on a systematic debt relief program.

For such a program to have a lasting effect, however, debt relief must be matched by wise investment in public projects that boost economic growth (such as education) and by the adoption of economic policies that facilitate investment and trade. The rich nations of the world also can help by reducing barriers to the importation of products from the world’s poorer nations, particularly tariffs on imports of agricultural products and textiles. High-tariff barriers and other impediments to trade make it difficult for poor countries to export more of their agricultural production. The World Trade Organization has estimated that if the developed nations of the world eradicated subsidies to their agricultural producers and removed tariff barriers to trade in agriculture, this would raise global economic welfare by $128 billion, with $30 billion of that going to developing nations, many of which are highly indebted. The faster growth associated with expanded trade in agriculture could significantly reduce the number of people living in poverty according to the WTO.71

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Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go to learnsmartadvantage.com for help.

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Understand how the process of globalization is creating opportunities and challenges for business managers.

Managing in the Global Marketplace

Much of this text is concerned with the challenges of managing in an international business. An international business is any firm that engages in international trade or investment. A firm does not have to become a multinational enterprise, investing directly in operations in other countries, to engage in international business, although multinational enterprises are international businesses. All a firm has to do is export or import products from other countries. As the world shifts toward a truly integrated global economy, more firms—both large and small—are becoming international businesses. What does this shift toward a global economy mean for managers within an international business?

International Business

Any firm that engages in international trade or investment.

As their organizations increasingly engage in cross-border trade and investment, managers need to recognize that the task of managing an international business differs from that of managing a purely domestic business in many ways. At the most fundamental level, the differences arise from the simple fact that countries are different. Countries differ in their cultures, political systems, economic systems, legal systems, and levels of economic development. Despite all the talk about the emerging global village, and despite the trend toward globalization of markets and production, as we shall see in this text, many of these differences are very profound and enduring.

Differences among countries require that an international business vary its practices country by country. Marketing a product in Brazil may require a different approach from marketing the product in Germany; managing U.S. workers might require different skills from managing Japanese workers; maintaining close relations with a particular level of government Page 30may be very important in Mexico and irrelevant in Great Britain; the business strategy pursued in Canada might not work in South Korea; and so on. Managers in an international business must not only be sensitive to these differences but also adopt the appropriate policies and strategies for coping with them. Much of this text is devoted to explaining the sources of these differences and the methods for successfully coping with them.

A further way in which international business differs from domestic business is the greater complexity of managing an international business. In addition to the problems that arise from the differences between countries, a manager in an international business is confronted with a range of other issues that the manager in a domestic business never confronts. The managers of an international business must decide where in the world to site production activities to minimize costs and to maximize value added. They must decide whether it is ethical to adhere to the lower labor and environmental standards found in many less developed nations. Then they must decide how best to coordinate and control globally dispersed production activities (which, as we shall see later in the text, is not a trivial problem). The managers in an international business also must decide which foreign markets to enter and which to avoid. They must choose the appropriate mode for entering a particular foreign country. Is it best to export its product to the foreign country? Should the firm allow a local company to produce its product under license in that country? Should the firm enter into a joint venture with a local firm to produce its product in that country? Or should the firm set up a wholly owned subsidiary to serve the market in that country? As we shall see, the choice of entry mode is critical because it has major implications for the long-term health of the firm.

Conducting business transactions across national borders requires understanding the rules governing the international trading and investment system. Managers in an international business must also deal with government restrictions on international trade and investment. They must find ways to work within the limits imposed by specific governmental interventions. As this text explains, even though many governments are nominally committed to free trade, they often intervene to regulate cross-border trade and investment. Managers within international businesses must develop strategies and policies for dealing with such interventions.

Cross-border transactions also require that money be converted from the firm’s home currency into a foreign currency and vice versa. Because currency exchange rates vary in response to changing economic conditions, managers in an international business must develop policies for dealing with exchange rate movements. A firm that adopts the wrong policy can lose large amounts of money, whereas one that adopts the right policy can increase the profitability of its international transactions.

In sum, managing an international business is different from managing a purely domestic business for at least four reasons: (1) countries are different, (2) the range of problems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business, (3) an international business must find ways to work within the limits imposed by government intervention in the international trade and investment system, and (4) international transactions involve converting money into different currencies.

In this text, we examine all these issues in depth, paying close attention to the different strategies and policies that managers pursue to deal with the various challenges created when a firm becomes an international business. Chapters 2, 3, and 4 explore how countries differ from each other with regard to their political, economic, legal, and cultural institutions. Chapter 5 takes a detailed look at the ethical issues that arise in international business. Chapters 6 through 9 look at the international trade and investment environment within which international businesses must operate. Chapters 10 and 11 review the international monetary system. These chapters focus on the nature of the foreign exchange market and the emerging global monetary system. Chapters 12 and 13 explore the strategy of international businesses. Chapters 14 through 17 look at the management of various functional operations within an international business, including production, marketing, and human relations. By the time you complete this text, you should have a good grasp of the issues that managers working within international business have to grapple with on a daily basis, and you should be familiar with the range of strategies and operating policies available to compete more effectively in today’s rapidly emerging global economy.

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Use LearnSmart to help retain what you have learned. Access your instructor’s Connect course to check out LearnSmart or go to learnsmartadvantage.com for help.

Key Terms

globalization

globalization of markets

globalization of production

factors of production

General Agreement on Tariffs and Trade (GATT)

World Trade Organization (WTO)

International Monetary Fund (IMF)

World Bank

United Nations

Group of Twenty (G20)

international trade

foreign direct investment (FDI)

Moore’s law

stock of foreign direct investment

multinational enterprise (MNE)

international business

Summary

This chapter has shown how the world economy is becoming more global and reviewed the main drivers of globalization, arguing that they seem to be thrusting nation-states toward a more tightly integrated global economy. It looked at how the nature of international business is changing in response to the changing global economy, discussed concerns raised by rapid globalization, and reviewed implications of rapid globalization for individual managers. The chapter made the following points:

1. Over the past three decades, we have witnessed the globalization of markets and production.

2. The globalization of markets implies that national markets are merging into one huge marketplace. However, it is important not to push this view too far.

3. The globalization of production implies that firms are basing individual productive activities at the optimal world locations for the particular activities. As a consequence, it is increasingly irrelevant to talk about American products, Japanese products, or German products because these are being replaced by “global” products.

4. Two factors seem to underlie the trend toward globalization: declining trade barriers and changes in communication, information, and transportation technologies.

5. Since the end of World War II, barriers to the free flow of goods, services, and capital have been lowered significantly. More than anything else, this has facilitated the trend toward the globalization of production and has enabled firms to view the world as a single market.

6. As a consequence of the globalization of production and markets, in the last decade world trade has grown faster than world output, foreign direct investment has surged, imports have penetrated more deeply into the world’s industrial nations, and competitive pressures have increased in industry after industry.

7. The development of the microprocessor and related developments in communication and information processing technology have helped firms link their worldwide operations into sophisticated information networks. Jet air travel, by shrinking travel time, has also helped link the worldwide operations of international businesses. These changes have enabled firms to achieve tight coordination of their worldwide operations and to view the world as a single market.

8. In the 1960s, the U.S. economy was dominant in the world, U.S. firms accounted for most of the foreign direct investment in the world economy, U.S. firms dominated the list of large multinationals, and roughly half the world—the centrally planned economies of the communist world—was closed to Western businesses.

9. By the mid-1990s, the U.S. share of world output had been cut in half, with major shares now being accounted for by western European and Southeast Asian economies. The U.S. share of worldwide foreign direct investment had also fallen, by about two-thirds. U.S. multinationals were now facing competition from a large number of Japanese and European multinationals. In addition, the emergence of mini-multinationals was noted.

10. One of the most dramatic developments of the past 20 years has been the collapse of communism in eastern Europe, which has created enormous opportunities for international businesses. In addition, the move toward free market economies in China and Latin America is creating opportunities (and threats) for Western international businesses.

11. The benefits and costs of the emerging global economy are being hotly debated among businesspeople, economists, and politicians. The debate focuses on the impact of globalization on jobs, wages, the environment, working conditions, and national sovereignty.

12. Managing an international business is different from managing a domestic business for at least four reasons: (a) countries are different, (b) the range of problems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business, (c) managers in an international business must find ways to work within the limits imposed by governments’ intervention in the international trade and investment system, and (d) international transactions involve converting money into different currencies.

Page 32Critical Thinking and Discussion Questions

1. Describe the shifts in the world economy over the past 30 years. What are the implications of these shifts for international businesses based in Great Britain? North America? Hong Kong?

2. “The study of international business is fine if you are going to work in a large multinational enterprise, but it has no relevance for individuals who are going to work in small firms.” Evaluate this statement.

3. How have changes in technology contributed to the globalization of markets and production? Would the globalization of production and markets have been possible without these technological changes?

4. “Ultimately, the study of international business is no different from the study of domestic business. Thus, there is no point in having a separate course on international business.” Evaluate this statement.

5. How does the Internet affect international business activity and the globalization of the world economy?

6. If current trends continue, China may be the world’s largest economy by 2020. Discuss the possible implications of such a development for (a) the world trading system, (b) the world monetary system, (c) the business strategy of today’s European and U.S.-based global corporations, and (d) global commodity prices.

7. Reread the Management Focus on Vizio and answer the following questions:

a. Why is the manufacturing of flat-panel TVs migrating to different locations around the world?

b. Who benefits from the globalization of the flat-panel display industry? Who are the losers?

c. What would happen if the U.S. government required that flat-panel displays sold in the United States had to also be made in the United States? On balance, would this be a good or a bad thing?

d. What does the example of Vizio tell you about the future of production in an increasingly integrated global economy? What does it tell you about the strategies that enterprises must adopt to thrive in highly competitive global markets?

images Research Task http://globalEDGE.msu.edu

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises.

1. As the drivers of the globalization continue to pressure both the globalization of markets and globalization of production, we continue to see the impact of greater globalization on worldwide trade patterns. HSBC, a large global bank, analyzes these pressures and trends to identify opportunities across markets and sectors, through its trade forecasts. Visit the HSBC Global Connections site, and use the trade forecast tool to identify which export routes are forecasted to see the greatest growth over the next 15 to 20 years. What patterns do you see? What types of countries dominate these routes?

2. You are working for a company that is considering investing in a foreign country. Investing in countries with different traditions is an important element of your company’s long-term strategic goals. As such, management has requested a report regarding the attractiveness of alternative countries based on the potential return of FDI. Accordingly, the ranking of the top 25 countries in terms of FDI attractiveness is a crucial ingredient for your report. A colleague mentioned a potentially useful tool called the “Foreign Direct (FDI) Confidence Index.” The FDI Confidence Index is a regular survey of global executives conducted by A.T. Kearney. Find this index, and provide additional information regarding how the index is constructed.

images Who Makes the Apple iPhone? closing case

In its early days, Apple usually didn’t look beyond its own backyard to manufacture its devices. A few years after Apple started to make the Macintosh computer back in 1983, Steve Jobs bragged that it was “a machine that was made in America.” As late as the early 2000s, Apple still manufactured many of its computers at the company’s iMac plant in Elk Grove, California. Jobs often said that he was as proud of the Apple’s manufacturing plants as he was of the devices themselves.

By 2004, however, Apple had largely turned to foreign manufacturing. The shift to offshore manufacturing reached its peak with the iconic iPhone, which Apple first introduced in 2007. All iPhones contain hundreds of parts, an estimated 90 percent of which are manufactured abroad. Advanced semiconductors come from Germany and Taiwan, memory from Korea and Japan, display panels and circuitry from Korea and Taiwan, chip sets from Europe, and rare metals from Africa and Asia. Apple’s major subcontractor, Page 33the Taiwanese multinational firm, Foxconn, performs final assembly in China.

Apple still employs some 43,000 people in the United States, and it has kept important activities at home, including product design, software engineering, and marketing. Furthermore, Apple claims that its business supports another 254,000 jobs in the United States in engineering, manufacturing, and transportation. For example, the glass for the iPhone is manufactured at Corning’s U.S. plants in Kentucky and New York. But an additional 700,000 people are involved in the engineering, building, and final assembly of its products outside of the United States, and most of them work at subcontractors like Foxconn.

When explaining its decision to assemble the iPhone in China, Apple cites a number of factors. While it is true that labor costs are much lower in China, Apple executives point out that labor costs only account for a very small proportion of the total value of its products and are not the main driver of location decisions. Far more important, according to Apple, is the ability of its Chinese subcontractors to respond very quickly to requests from Apple to scale production up and down. In a famous illustration of this capability, back in 2007 Steve Jobs demanded that a glass screen replace the plastic screen on his prototype iPhone. Jobs didn’t like the look and feel of plastic screens, which at the time were standard in the industry, nor did he like the way they scratched easily. This last-minute change in the design of the iPhone put Apple’s market introduction date at risk. Apple had selected Corning to manufacture large panes of strengthened glass, but finding a manufacturer that could cut those panes into millions of iPhone screens wasn’t easy. Then a bid arrived from a Chinese factory. When the Apple team visited the factory, they found that the plant’s owners were already constructing a new wing to cut the glass and installing equipment. “This is in case you give us the contract,” the manager said. The plant also had a warehouse full of glass samples for Apple, and a team of engineers available to work with Apple. They had built onsite dormitories so that the factory could run three shifts seven days a week in order to meet Apple’s demanding production schedule. The Chinese company got the bid.

Another critical advantage of China for Apple was that it was much easier to hire engineers there. Apple calculated that about 8,700 industrial engineers were needed to oversee and guide the 200,000 assembly-line workers involved in manufacturing the iPhone. The company had estimated that it would take as long as nine months to find that many engineers in the United States. In China it took 15 days.

Also important is the clustering together of factories in China. Many of the factories providing components for the iPhone are located close to Foxconn’s assembly plant. As one executive noted, “The entire supply chain is in China. You need a thousand rubber gaskets? That’s the factory next door. You need a million screws? That factory is a block away. You need a screw made a little bit different? That will take three hours.”

Key Terms

globalization

globalization of markets

globalization of production

factors of production

General Agreement on Tariffs and Trade (GATT)

World Trade Organization (WTO)

International Monetary Fund (IMF)

World Bank

United Nations

Group of Twenty (G20)

international trade

foreign direct investment (FDI)

Moore’s law

stock of foreign direct investment

multinational enterprise (MNE)

international business

Summary

This chapter has shown how the world economy is becoming more global and reviewed the main drivers of globalization, arguing that they seem to be thrusting nation-states toward a more tightly integrated global economy. It looked at how the nature of international business is changing in response to the changing global economy, discussed concerns raised by rapid globalization, and reviewed implications of rapid globalization for individual managers. The chapter made the following points:

1. Over the past three decades, we have witnessed the globalization of markets and production.

2. The globalization of markets implies that national markets are merging into one huge marketplace. However, it is important not to push this view too far.

3. The globalization of production implies that firms are basing individual productive activities at the optimal world locations for the particular activities. As a consequence, it is increasingly irrelevant to talk about American products, Japanese products, or German products because these are being replaced by “global” products.

4. Two factors seem to underlie the trend toward globalization: declining trade barriers and changes in communication, information, and transportation technologies.

5. Since the end of World War II, barriers to the free flow of goods, services, and capital have been lowered significantly. More than anything else, this has facilitated the trend toward the globalization of production and has enabled firms to view the world as a single market.

6. As a consequence of the globalization of production and markets, in the last decade world trade has grown faster than world output, foreign direct investment has surged, imports have penetrated more deeply into the world’s industrial nations, and competitive pressures have increased in industry after industry.

7. The development of the microprocessor and related developments in communication and information processing technology have helped firms link their worldwide operations into sophisticated information networks. Jet air travel, by shrinking travel time, has also helped link the worldwide operations of international businesses. These changes have enabled firms to achieve tight coordination of their worldwide operations and to view the world as a single market.

8. In the 1960s, the U.S. economy was dominant in the world, U.S. firms accounted for most of the foreign direct investment in the world economy, U.S. firms dominated the list of large multinationals, and roughly half the world—the centrally planned economies of the communist world—was closed to Western businesses.

9. By the mid-1990s, the U.S. share of world output had been cut in half, with major shares now being accounted for by western European and Southeast Asian economies. The U.S. share of worldwide foreign direct investment had also fallen, by about two-thirds. U.S. multinationals were now facing competition from a large number of Japanese and European multinationals. In addition, the emergence of mini-multinationals was noted.

10. One of the most dramatic developments of the past 20 years has been the collapse of communism in eastern Europe, which has created enormous opportunities for international businesses. In addition, the move toward free market economies in China and Latin America is creating opportunities (and threats) for Western international businesses.

11. The benefits and costs of the emerging global economy are being hotly debated among businesspeople, economists, and politicians. The debate focuses on the impact of globalization on jobs, wages, the environment, working conditions, and national sovereignty.

12. Managing an international business is different from managing a domestic business for at least four reasons: (a) countries are different, (b) the range of problems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business, (c) managers in an international business must find ways to work within the limits imposed by governments’ intervention in the international trade and investment system, and (d) international transactions involve converting money into different currencies.

Page 32Critical Thinking and Discussion Questions

1. Describe the shifts in the world economy over the past 30 years. What are the implications of these shifts for international businesses based in Great Britain? North America? Hong Kong?

2. “The study of international business is fine if you are going to work in a large multinational enterprise, but it has no relevance for individuals who are going to work in small firms.” Evaluate this statement.

3. How have changes in technology contributed to the globalization of markets and production? Would the globalization of production and markets have been possible without these technological changes?

4. “Ultimately, the study of international business is no different from the study of domestic business. Thus, there is no point in having a separate course on international business.” Evaluate this statement.

5. How does the Internet affect international business activity and the globalization of the world economy?

6. If current trends continue, China may be the world’s largest economy by 2020. Discuss the possible implications of such a development for (a) the world trading system, (b) the world monetary system, (c) the business strategy of today’s European and U.S.-based global corporations, and (d) global commodity prices.

7. Reread the Management Focus on Vizio and answer the following questions:

a. Why is the manufacturing of flat-panel TVs migrating to different locations around the world?

b. Who benefits from the globalization of the flat-panel display industry? Who are the losers?

c. What would happen if the U.S. government required that flat-panel displays sold in the United States had to also be made in the United States? On balance, would this be a good or a bad thing?

d. What does the example of Vizio tell you about the future of production in an increasingly integrated global economy? What does it tell you about the strategies that enterprises must adopt to thrive in highly competitive global markets?

images Research Task http://globalEDGE.msu.edu

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises.

1. As the drivers of the globalization continue to pressure both the globalization of markets and globalization of production, we continue to see the impact of greater globalization on worldwide trade patterns. HSBC, a large global bank, analyzes these pressures and trends to identify opportunities across markets and sectors, through its trade forecasts. Visit the HSBC Global Connections site, and use the trade forecast tool to identify which export routes are forecasted to see the greatest growth over the next 15 to 20 years. What patterns do you see? What types of countries dominate these routes?

2. You are working for a company that is considering investing in a foreign country. Investing in countries with different traditions is an important element of your company’s long-term strategic goals. As such, management has requested a report regarding the attractiveness of alternative countries based on the potential return of FDI. Accordingly, the ranking of the top 25 countries in terms of FDI attractiveness is a crucial ingredient for your report. A colleague mentioned a potentially useful tool called the “Foreign Direct (FDI) Confidence Index.” The FDI Confidence Index is a regular survey of global executives conducted by A.T. Kearney. Find this index, and provide additional information regarding how the index is constructed.

images Who Makes the Apple iPhone? closing case

In its early days, Apple usually didn’t look beyond its own backyard to manufacture its devices. A few years after Apple started to make the Macintosh computer back in 1983, Steve Jobs bragged that it was “a machine that was made in America.” As late as the early 2000s, Apple still manufactured many of its computers at the company’s iMac plant in Elk Grove, California. Jobs often said that he was as proud of the Apple’s manufacturing plants as he was of the devices themselves.

By 2004, however, Apple had largely turned to foreign manufacturing. The shift to offshore manufacturing reached its peak with the iconic iPhone, which Apple first introduced in 2007. All iPhones contain hundreds of parts, an estimated 90 percent of which are manufactured abroad. Advanced semiconductors come from Germany and Taiwan, memory from Korea and Japan, display panels and circuitry from Korea and Taiwan, chip sets from Europe, and rare metals from Africa and Asia. Apple’s major subcontractor, Page 33the Taiwanese multinational firm, Foxconn, performs final assembly in China.

Apple still employs some 43,000 people in the United States, and it has kept important activities at home, including product design, software engineering, and marketing. Furthermore, Apple claims that its business supports another 254,000 jobs in the United States in engineering, manufacturing, and transportation. For example, the glass for the iPhone is manufactured at Corning’s U.S. plants in Kentucky and New York. But an additional 700,000 people are involved in the engineering, building, and final assembly of its products outside of the United States, and most of them work at subcontractors like Foxconn.

When explaining its decision to assemble the iPhone in China, Apple cites a number of factors. While it is true that labor costs are much lower in China, Apple executives point out that labor costs only account for a very small proportion of the total value of its products and are not the main driver of location decisions. Far more important, according to Apple, is the ability of its Chinese subcontractors to respond very quickly to requests from Apple to scale production up and down. In a famous illustration of this capability, back in 2007 Steve Jobs demanded that a glass screen replace the plastic screen on his prototype iPhone. Jobs didn’t like the look and feel of plastic screens, which at the time were standard in the industry, nor did he like the way they scratched easily. This last-minute change in the design of the iPhone put Apple’s market introduction date at risk. Apple had selected Corning to manufacture large panes of strengthened glass, but finding a manufacturer that could cut those panes into millions of iPhone screens wasn’t easy. Then a bid arrived from a Chinese factory. When the Apple team visited the factory, they found that the plant’s owners were already constructing a new wing to cut the glass and installing equipment. “This is in case you give us the contract,” the manager said. The plant also had a warehouse full of glass samples for Apple, and a team of engineers available to work with Apple. They had built onsite dormitories so that the factory could run three shifts seven days a week in order to meet Apple’s demanding production schedule. The Chinese company got the bid.

Another critical advantage of China for Apple was that it was much easier to hire engineers there. Apple calculated that about 8,700 industrial engineers were needed to oversee and guide the 200,000 assembly-line workers involved in manufacturing the iPhone. The company had estimated that it would take as long as nine months to find that many engineers in the United States. In China it took 15 days.

Also important is the clustering together of factories in China. Many of the factories providing components for the iPhone are located close to Foxconn’s assembly plant. As one executive noted, “The entire supply chain is in China. You need a thousand rubber gaskets? That’s the factory next door. You need a million screws? That factory is a block away. You need a screw made a little bit different? That will take three hours.”

Foxconn employees assemble electronic components in China.

All this being said, there are drawbacks to outsourcing to China. Several of Apple’s subcontractors have been targeted for their poor working conditions. Criticisms include low pay of line workers, long hours, mandatory overtime for little or no additional pay, and poor safety records. Some former Apple executives say that there is an unresolved tension within the company; executives want to improve working conditions within the factories of subcontractors such as Foxconn, but that dedication falters when it conflicts with crucial supplier relationships or the fast delivery of new products.

Sources: Gu Huini, “Human Costs Are Built into iPad in China,” The New York Times, January 26, 2012; C. Duhigg and K. Bradsher, “How U.S. Lost Out on iPhone Work,” The New York Times, January 22, 2012; and “Apple Takes Credit for Over Half a Million U.S. Jobs,” Apple Intelligence, March 2, 2012, http://9to5mac.com/2012/03/02/apple-takes-credit-for-514000-u-s-jobs/#more-142766.

CASE DISCUSSION QUESTIONS

1. What are the benefits to Apple of outsourcing the assembly of the iPhone to foreign countries, and particularly China? What are the potential costs and risks to Apple?

2. In addition to Apple, who else benefits from Apple’s decision to outsource assembly to China? Who are the potential losers here?

3. What are the potential ethical problems associated with outsourcing assembly jobs to Foxconn in China? How might Apple deal with these?

4. On balance, do you think that the kind of outsourcing undertaken by Apple is a good thing or a bad thing for the American economy? Explain your reasoning?

Endnotes

1. Figures from World Trade Organization, Statistics Database, 2013.

2. Thomas L. Friedman, The World Is Flat (New York: Farrar, Straus and Giroux, 2005).

3. Ibid.

4. T. Levitt, “The Globalization of Markets,” Harvard Business Review, May–June 1983, pp. 92–102.

5. U.S. Department of Commerce, Internal Trade Administration, “U.S. Exporters in 2011: A Statistical Overview,” July 29, 2013.

Page 346. C. M. Draffen, “Going Global: Export Market Proves Profitable for Region’s Small Businesses,” Newsday, March 19, 2001, p. C18.

7. B. Benoit and R. Milne, “Germany’s Best Kept Secret, How Its Exporters Are Betting the World,” Financial Times, May 19, 2006, p. 11.

8. See F. T. Knickerbocker, Oligopolistic Reaction and Multinational Enterprise (Boston: Harvard Business School Press, 1973); and R. E. Caves, “Japanese Investment in the U.S.: Lessons for the Economic Analysis of Foreign Investment,” The World Economy 16 (1993), pp. 279–300.

9. I. Metthee, “Playing a Large Part,” Seattle Post-Intelligencer, April 9, 1994, p. 13.

10. “Operating Profit,” The Economist, August 16, 2008, pp. 74–76.

11. R. B. Reich, The Work of Nations (New York: A. A. Knopf, 1991).

12. United Nations, “The UN in Brief,” www.un.org/Overview/brief.html.

13. J. A. Frankel, “Globalization of the Economy,” National Bureau of Economic Research, working paper no. 7858, 2000.

14. J. Bhagwati, Protectionism (Cambridge, MA: MIT Press, 1989).

15. F. Williams, “Trade Round Like This May Never Be Seen Again,” Financial Times, April 15, 1994, p. 8.

16. W. Vieth, “Major Concessions Lead to Success for WTO Talks,” Los Angeles Times, November 14, 2001, p. A1; and “Seeds Sown for Future Growth,” The Economist, November 17, 2001, pp. 65–66.

17. Ibid.

18. World Trade Organization press release, “Trade to Remain Subdued in 2013 after Sluggish Growth in 2012 as European Economies Continue to Struggle,” April 10, 2013; World Trade Organization, International Trade Statistics 2012 (Geneva: WTO 2012).

19. United Nations Conference on Trade and Investment, “Global FDI Rose by 11%” Global Investment Trends Monitor, January 20, 2014.

20. United Nations, World Investment Report, 2013 (New York and Geneva: United Nations, 2013).

21. Moore’s law is named after Intel founder Gordon Moore.

22. Data compiled from various sources and listed at www.internetworldstats.com/stats.htm.

23. From www.census.gov/mrts/www/ecomm.html. See also S. Fiegerman, “Ecommerce Is Now a Trillion Dollar Industry,” Mashable Business, February 5, 2013.

24. For a counterpoint, see “Geography and the Net: Putting It in Its Place,” The Economist, August 11, 2001, pp. 18–20.

25. International Chamber of Shipping, Key facts, www.ics-shipping.org/shipping-facts/key-facts.

26. Frankel, “Globalization of the Economy.”

27. R. Wile, “Here’s What It Costs to Ship 7 Everyday Goods Across the Ocean,” Business Insider, September 19, 2012.

28. Data from Bureau of Transportation Statistics, 2001.

29. Fernald and Greenfield, “The Fall and Rise of the Global Economy.” Chicago Fed Letter, April 2001, Number 164.

30. Data located at www.bts.gov/publications/us_international_trade_and_freight_transportation_trends/2003/index.html.

31. N. Hood and J. Young, The Economics of the Multinational Enterprise (New York: Longman, 1973).

32. United Nations, World Investment Report, 2013.

33. Ibid.

34. Ibid.

35. S. Chetty, “Explosive International Growth and Problems of Success among Small and Medium Sized Firms,” International Small Business Journal, February 2003, pp. 5–28.

36. R. A. Mosbacher, “Opening Up Export Doors for Smaller Firms,” Seattle Times, July 24, 1991, p. A7.

37. “Small Companies Learn How to Sell to the Japanese,” Seattle Times, March 19, 1992.

38. W. J. Holstein, “Why Johann Can Export, but Johnny Can’t.” BusinessWeek, November 3, 1991, Archived at http://www.businessweek.com/stories/1991-11-03/why-johann-can-export-but-johnny-cant.

39. N. Buckley and A. Ostrovsky, “Back to Business—How Putin’s Allies Are Turning Russia into a Corporate State,” Financial Times, June 19, 2006, p. 11.

40. J. E. Stiglitz, Globalization and Its Discontents (New York: W. W. Norton, 2003); J. Bhagwati, In Defense of Globalization (New York: Oxford University Press, 2004); and Friedman, The World Is Flat.

41. See, for example, Ravi Batra, The Myth of Free Trade (New York: Touchstone Books, 1993); William Greider, One World, Ready or Not: The Manic Logic of Global Capitalism (New York: Simon & Schuster, 1997); and D. Radrik, Has Globalization Gone Too Far? (Washington, DC: Institution for International Economics, 1997).

42. James Goldsmith, “The Winners and the Losers,” in The Case against the Global Economy, eds. J. Mander and E. Goldsmith (San Francisco: Sierra Club, 1996); and Lou Dobbs, Exporting America (New York: Time Warner Books, 2004).

43. For an excellent summary, see “The Globalization of Labor,” Chapter 5, in IMF, World Economic Outlook 2007 (Washington, DC: IMF, April 2007). Also see R. Freeman, “Labor Market Imbalances,” Harvard University working paper, www.bos.frb.org/economic/conf/conf51/conf51d.pdf.

44. D. L. Bartlett and J. B. Steele, “America: Who Stole the Dream,” Philadelphia Inquirer, September 9, 1996.

45. For example, see Paul Krugman, Pop Internationalism (Cambridge, MA: MIT Press, 1996).

46. For example, see B. Milanovic and L. Squire, “Does Tariff Liberalization Increase Wage Inequality?” National Bureau of Economic Research, working paper no. 11046, January 2005; and B. Milanovic, “Can We Discern the Effect of Globalization on Income Distribution?” World Bank Economic Review 19 (2005), pp. 21–44. Also see the summary in “The Globalization of Labor.”

47. See “The Globalization of Labor.”

48. The 2010 data are from an unpublished OECD study cited in S. Moffett, “Income Inequality Increases,” The Wall Street Journal, May 3, 2011.

Page 3549. M. Forster and M. Pearson, “Income Distribution and Poverty in the OECD Area,” OECD Economic Studies 34 (2002); Moffett, “Income Inequality Increases”; and OECD, “Growing Income Inequality in OECD Countries,” OECD Forum, May 2, 2011.

50. See “The Globalization of Labor.”

51. See Krugman, Pop Internationalism; and D. Belman and T. M. Lee, “International Trade and the Performance of U.S. Labor Markets,” in U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996).

52. Freeman, “Labor Market Imbalances.”

53. E. Goldsmith, “Global Trade and the Environment,” in The Case against the Global Economy, eds. J. Mander and E. Goldsmith (San Francisco: Sierra Club, 1996).

54. P. Choate, Jobs at Risk: Vulnerable U.S. Industries and Jobs under NAFTA (Washington, DC: Manufacturing Policy Project, 1993).

55. Ibid.

56. B. Lomborg, The Skeptical Environmentalist (Cambridge, UK: Cambridge University Press, 2001).

57. H. Nordstrom and S. Vaughan, Trade and the Environment, World Trade Organization Special Studies No. 4 (Geneva: WTO, 1999).

58. Figures are from “Freedom’s Journey: A Survey of the 20th Century. Our Durable Planet,” The Economist, September 11, 1999, p. 30.

59. For an exhaustive review of the empirical literature, see B. R. Copeland and M. Scott Taylor, “Trade, Growth and the Environment,” Journal of Economic Literature, March 2004, pp. 7–77.

60. G. M. Grossman and A. B. Krueger, “Economic Growth and the Environment,” Quarterly Journal of Economics 110 (1995), pp. 353–78.

61. For an economic perspective on climate change see William Nordhouse, The Climate Casino (Yale University Press, Princeton, NJ, 2013).

62. Krugman, Pop Internationalism.

63. R. Kuttner, “Managed Trade and Economic Sovereignty,” in U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996).

64. Ralph Nader and Lori Wallach, “GATT, NAFTA, and the Subversion of the Democratic Process,” in U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996), pp. 93–94.

65. Lant Pritchett, “Divergence, Big Time,” Journal of Economic Perspectives 11, no. 3 (Summer 1997), pp. 3–18.

66. Ibid.

67. W. Easterly, “How Did Heavily Indebted Poor Countries Become Heavily Indebted?” World Development, October 2002, pp. 1677–96; and J. Sachs, The End of Poverty (New York, Penguin Books, 2006).

68. See D. Ben-David, H. Nordstrom, and L. A. Winters, Trade, Income Disparity and Poverty. World Trade Organization Special Studies No. 5 (Geneva: WTO, 1999).

69. William Easterly, “Debt Relief,” Foreign Policy, November– December 2001, pp. 20–26.

70. Jeffrey Sachs, “Sachs on Development: Helping the World’s Poorest,” The Economist, August 14, 1999, pp. 17–20.

71. World Trade Organization, Annual Report 2003 (Geneva: WTO, 2004).