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Global Business Today

Charles W. L. Hill University of Washington

G. Tomas M. Hult Michigan State University

GLOBAL BUSINESS TODAY, NINTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2016 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2014, 2011, 2009 and 2008. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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Library of Congress Cataloging-in-Publication Data

Hill, Charles W. L. Global business today / Charles W. L. Hill, University of Washington, G. Tomas M. Hult, Michigan State University.—9e [edition]. pages cm ISBN 978-0-07-811291-1 (alk. paper)—ISBN 0-07-811291-5 (alk. paper) 1. International business enterprises—Management. 2. International trade. 3. Investments, Foreign. 4. Capital market. I. Hult, G. Tomas M. II. Title. HD62.4.H548 2016 658’.049—dc23

2014037047

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

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about the authors Charles W. L. Hill is the Hughes M. Blake Professor of International Business at the Foster School of Business, University of Washington. Professor Hill received his Ph.D. in industrial organi- zation economics in 1983 from the University of Manchester’s Institute of Science and Technology (UMIST) in Great Britain. In addition to his position at the University of Washington, he has served on the faculties of UMIST, Texas A&M University, and Michigan State University.

Professor Hill has published some 50 articles in peer-reviewed academic journals. He has also published four college textbooks, one on strategic management, one on principles of management, and the other two on international business (one of which you are now holding). He serves on the editorial boards of several academic journals and previously served as consulting editor at the Academy of Management Review.

Professor Hill teaches in the MBA and executive MBA programs at the University of Washington and has received awards for teaching excellence in both programs. He has also taught on several customized executive programs. He lives in Seattle with his wife, Lane, and his children.

G. Tomas M. Hult is the John W. Byington Endowed Chair, Professor of Marketing and Interna- tional Business, and Director of the International Business Center in the Eli Broad College of Business at Michigan State University. Dr. Hult is an Elected Fellow of the Academy of International Business (AIB) and serves as the Executive Director and Foundation President of AIB. He also serves on the U.S. District Export Council and holds board member positions of the International Trade Center of Mid-Michigan and the Sheth Foundation.

Several studies have ranked Professor Hult as one of the most cited scholars in the world in business and management (e.g., Thomson Reuters’ Essential Science Indicators). He has served as editor of Journal of the Academy of Marketing Science and has published 50 articles in premier business journals—Journal of International Business Studies, Academy of Management Journal, Strategic Management Journal, Journal of Management, Journal of Marketing, Journal of the Acad- emy of Marketing Science, Journal of Retailing, Journal of Operations Management, and Decision Sciences. Dr. Hult has also published several books, e.g., Global Supply Chain Management (2014), Total Global Strategy (2012), and Extending the Supply Chain (2005).

Professor Hult is a well-known keynote speaker on global supply chain management, global strategy, and marketing strategy. He teaches in doctoral, master’s, and undergraduate programs at Michigan State University, plus he is a visiting professor at Leeds University (United Kingdom) and Uppsala University (Sweden). He also teaches frequently in executive development programs and has developed a large clientele of the world’s top multinational corporations. Tomas Hult is a dual citizen of the United States and Sweden and lives in Okemos, Michigan, with his wife, Laurie, and their children, Daniel and Isabelle.

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brief contents

THE PROVEN CHOICE FOR INTERNATIONAL BUSINESS xiii

PART ONE Introduction and Overview 2 Chapter One Globalization 3

PART TWO National Differences 36 Chapter Two National Differences in Political, Economic, and Legal Systems 37 Chapter Three National Differences in Economic Development 61 Chapter Four Differences in Culture 89 Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 127

PART THREE The Global Trade and Investment Environment 158 Chapter Six International Trade Theory 159 Chapter Seven Government Policy and International Trade 195 Chapter Eight Foreign Direct Investment 223 Chapter Nine Regional Economic Integration 253

PART FOUR The Global Monetary System 284 Chapter Ten The Foreign Exchange Market 285 Chapter Eleven The International Monetary System 311

PART FIVE The Strategy of International Business 336 Chapter Twelve The Strategy of International Business 337 Chapter Thirteen Entering Foreign Markets 371

PART SIX International Business Functions 396 Chapter Fourteen Exporting, Importing, and Countertrade 397 Chapter Fifteen Global Production and Supply Chain Management 419 Chapter Sixteen Global Marketing and Research and Development 449 Chapter Seventeen Global Human Resource Management 487

GLOSSARY 512

PHOTO CREDITS 520

NAME INDEX 521

SUBJECT INDEX 522

ACRONYMS

COUNTRIES AND THEIR CAPITALS

WORLD MAP

Looking for a briefer text? Consider some of these alternate combined chapters to create a 14 chapter text with Hill and Hult’s marketleading content.

• Country Difference in Political Systems, Economic Systems and Development (Chapter 2 & 3 combined)

• International Trade Theory and Policy (Chapter 6 & 7 combined)

• Entering Foreign Markets (Chapter 13 & 14 combined) To preview this content and build your custom text, please visit www.mcgrawhillcreate.com/hill.

contents THE PROVEN CHOICE FOR INTERNATIONAL BUSINESS xiii

PART ONE Introduction and Overview 2

Chapter One Globalization 3 Opening Case: The Globalization of Production at Boeing 3 Introduction 4 What Is Globalization? 6

The Globalization of Markets 6

The Globalization of Production 7

The Emergence of Global Institutions 9 Drivers of Globalization 11

Declining Trade and Investment Barriers 11

The Role of Technological Change 13

The Changing Demographics of the Global Economy 15

The Changing World Output and World Trade Picture 15

The Changing Foreign Direct Investment Picture 16

The Changing Nature of the Multinational Enterprise 19

The Changing World Order 20

The Global Economy of the Twenty-First Century 22

The Globalization Debate 22 Antiglobalization Protests 22

Globalization, Jobs, and Income 23

Globalization, Labor Policies, and the Environment 26

Globalization and National Sovereignty 27

Globalization and the World’s Poor 28

Managing in the Global Marketplace 29 Key Terms 31 Summary 31 Critical Thinking and Discussion Questions 32 Research Task 32

Closing Case: Who Makes the Apple iPhone? 32 Endnotes 33

PART TWO National Differences 36

Chapter Two National Differences in Political, Economic, and Legal Systems 37

Opening Case: Putin’s Russia 37 Introduction 39 Political Systems 40

Collectivism and Individualism 40

Democracy and Totalitarianism 43

Economic Systems 44 Market Economy 45

Command Economy 46

Mixed Economy 46

Legal Systems 47 Different Legal Systems 47

Differences in Contract Law 48

Property Rights and Corruption 49

The Protection of Intellectual Property 52

Product Safety and Product Liability 54

Focus on Managerial Implications 55 Key Terms 55 Summary 56 Critical Thinking and Discussion Questions 56 Research Task 57

Closing Case: Ghana: An African Dynamo 57 Endnotes 58

Chapter Three National Differences in Economic Development 61

Opening Case: Political and Economic Reform in Myanmar 61 Introduction 62 Differences in Economic Development 63

Broader Conceptions of Development: Amartya Sen 66

Political Economy and Economic Progress 68

Innovation and Entrepreneurship Are the Engines of Growth 68

Innovation and Entrepreneurship Require a Market Economy 68

Innovation and Entrepreneurship Require Strong Property Rights 69

The Required Political System 69

Economic Progress Begets Democracy 70

Geography, Education, and Economic Development 71

States in Transition 72 The Spread of Democracy 72

The New World Order and Global Terrorism 74

The Spread of Market-Based Systems 75

The Nature of Economic Transformation 77 Deregulation 77

Privatization 77

Legal Systems 79

Implications of Changing Political Economy 79 Focus on Managerial Implications 80 Key Terms 84 Summary 84 Critical Thinking and Discussion Questions 85 Research Task 85

Closing Case: Revolution in Egypt 86 Endnotes 87

Chapter Four Differences in Culture 89 Opening Case: Best Buy and eBay in China 89 Introduction 91 What Is Culture? 92

Values and Norms 92

Culture, Society, and the Nation-State 94

The Determinants of Culture 95

Social Structure 95 Individuals and Groups 95

Social Stratification 97

Religious and Ethical Systems 100 Christianity 102

Islam 103

Hinduism 106

Buddhism 107

Confucianism 108

Language 109 Spoken Language 110

Unspoken Language 111

Education 111 Culture and Business 112 Cultural Change 115

Focus on Managerial Implications 117 Key Terms 120 Summary 120 Critical Thinking and Discussion Questions 121 Research Task 121

Closing Case: World Expo 2020 in Dubai, UAE 122 Endnotes 123

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 127

Opening Case: Making Toys Globally 127 Introduction 128 Ethical Issues in International Business 129

Employment Practices 130

Human Rights 130

Environmental Pollution 132

Corruption 134

Ethical Dilemmas 136 The Roots of Unethical Behavior 137

Personal Ethics 137

Decision-Making Processes 138

Organization Culture 139

Unrealistic Performance Goals 139

Leadership 139

Societal Culture 139

Philosophical Approaches to Ethics 140 Straw Men 140

Utilitarian and Kantian Ethics 142

Rights Theories 143

Justice Theories 144

Focus on Managerial Implications 145 Key Terms 152 Summary 153 Critical Thinking and Discussion Questions 153 Research Task 154

Closing Case: Bitcoin as an Ethical Dilemma 154 Endnotes 155

PART THREE The Global Trade and Investment Environment 158

Chapter Six International Trade Theory 159 Opening Case: Creating the World’s Biggest Free Trade Zone 159 Introduction 160 An Overview of Trade Theory 160

The Benefits of Trade 161

The Pattern of International Trade 162

Trade Theory and Government Policy 162

Contents vii

viii Contents

Mercantilism 163 Absolute Advantage 163 Comparative Advantage 166

The Gains from Trade 167

Qualifications and Assumptions 168

Extensions of the Ricardian Model 169

Heckscher-Ohlin Theory 174 The Leontief Paradox 174

The Product Life-Cycle Theory 175 Product Life-Cycle Theory in the Twenty-First Century 176

New Trade Theory 176 Increasing Product Variety and Reducing Costs 178

Economies of Scale, First-Mover Advantages, and the Pattern of Trade 179

Implications of New Trade Theory 179

National Competitive Advantage: Porter’s Diamond 180

Factor Endowments 181

Demand Conditions 182

Related and Supporting Industries 182

Firm Strategy, Structure, and Rivalry 182

Evaluating Porter’s Theory 183

Focus on Managerial Implications 183 Key Terms 185 Summary 185 Critical Thinking and Discussion Questions 186 Research Task 187

Closing Case: The Rise of India’s Drug Industry 187 Appendix A International Trade and the Balance of Payments 189 Endnotes 192

Chapter Seven Government Policy and International Trade 195

Opening Case: Sugar Subsidies Drive Candy Makers Abroad 195 Introduction 196 Instruments of Trade Policy 197

Tariffs 197

Subsidies 198

Import Quotas and Voluntary Export Restraints 199

Local Content Requirements 200

Administration Policies 201

Antidumping Policies 201

The Case for Government Intervention 202

Political Arguments for Intervention 203

Economic Arguments for Intervention 205

The Revised Case for Free Trade 207 Retaliation and Trade War 207

Domestic Policies 208

Development of the World Trading System 208 From Smith to the Great Depression 209

1947–1979: GATT, Trade Liberalization, and Economic Growth 209

1980–1993: Protectionist Trends 209

The Uruguay Round and the World Trade Organization 210

WTO: Experience to Date 211

The Future of the WTO: Unresolved Issues and the Doha Round 212

Focus on Managerial Implications 216 Key Terms 217 Summary 218 Critical Thinking and Discussion Questions 218 Research Task 219

Closing Case: China Limits Exports of Rare Earth Materials 219 Endnotes 220

Chapter Eight Foreign Direct Investment 223 Opening Case: Foreign Direct Investment in Nigeria 223 Introduction 224 Foreign Direct Investment in the World Economy 224

Trends in FDI 224

The Direction of FDI 225

The Source of FDI 226

The Form of FDI: Acquisitions versus Greenfield Investments 228

Theories of Foreign Direct Investment 228 Why Foreign Direct Investment? 228

The Pattern of Foreign Direct Investment 232

The Eclectic Paradigm 232

Political Ideology and Foreign Direct Investment 234

The Radical View 234

The Free Market View 234

Pragmatic Nationalism 235

Shifting Ideology 236

Benefits and Costs of FDI 237 Host-Country Benefits 237

Host-Country Costs 239

Home-Country Benefits 241

Contents ix

Home-Country Costs 241

International Trade Theory and FDI 241

Government Policy Instruments and FDI 242 Home-Country Policies 242

Host-Country Policies 243

International Institutions and the Liberalization of FDI 244

Focus on Managerial Implications 244 Key Terms 247 Summary 247 Critical Thinking and Discussion Questions 247 Research Task 248

Closing Case: Foreign Retailers in India 248 Endnotes 249

Chapter Nine Regional Economic Integration 253

Opening Case: Tomato Wars 253 Introduction 254 Levels of Economic Integration 256 The Case for Regional Integration 257

The Economic Case for Integration 258

The Political Case for Integration 258

Impediments to Integration 258

The Case against Regional Integration 259 Regional Economic Integration in Europe 260

Evolution of the European Union 260

Political Structure of the European Union 260

The Single European Act 263

The Establishment of the Euro 265

Enlargement of the European Union 269

Regional Economic Integration in the Americas 270

The North American Free Trade Agreement 270

The Andean Community 273

Mercosur 274

Central American Common Market, CAFTA, and CARICOM 274

Free Trade Area of the Americas 275

Regional Economic Integration Elsewhere 275 Association of Southeast Asian Nations 276

Asia-Pacific Economic Cooperation 277

Regional Trade Blocs in Africa 278

Focus on Managerial Implications 278 Key Terms 280 Summary 280 Critical Thinking and Discussion Questions 281 Research Task 281

Closing Case: I Want My Greek TV! 282 Endnotes 283

PART FOUR The Global Monetary System 284

Chapter Ten The Foreign Exchange Market 285 Opening Case: Embraer and the Wild Ride of the Brazilian Real 285 Introduction 286 The Functions of the Foreign Exchange Market 287

Currency Conversion 287

Insuring against Foreign Exchange Risk 289

The Nature of the Foreign Exchange Market 291 Economic Theories of Exchange Rate Determination 292

Prices and Exchange Rates 293

Interest Rates and Exchange Rates 298

Investor Psychology and Bandwagon Effects 299

Summary of Exchange Rate Theories 300

Exchange Rate Forecasting 300 The Efficient Market School 300

The Inefficient Market School 301

Approaches to Forecasting 301

Currency Convertibility 302 Focus on Managerial Implications 303 Key Terms 306 Summary 306 Critical Thinking and Discussion Questions 307 Research Task 307

Closing Case: The Rise (and Fall) of the Japanese Yen 308 Endnotes 309

Chapter Eleven The International Monetary System 311

Opening Case: The IMF and Iceland’s Economic Recovery 311 Introduction 312 The Gold Standard 313

Mechanics of the Gold Standard 313

Strength of the Gold Standard 314

The Period between the Wars, 1918–1939 314

The Bretton Woods System 315 The Role of the IMF 315

The Role of the World Bank 316

The Collapse of the Fixed Exchange Rate System 317

The Floating Exchange Rate Regime 318 The Jamaica Agreement 318

Exchange Rates since 1973 318

Fixed versus Floating Exchange Rates 322 The Case for Floating Exchange Rates 322

The Case for Fixed Exchange Rates 323

Who Is Right? 324

Exchange Rate Regimes in Practice 324 Pegged Exchange Rates 324

Currency Boards 325

Crisis Management by the IMF 326 Financial Crises in the Post–Bretton Woods Era 326

Evaluating the IMF’s Policy Prescriptions 328

Focus on Managerial Implications 330 Key Terms 333 Summary 333 Critical Thinking and Discussion Questions 334 Research Task 334

Closing Case: Currency Trouble in Malawi 334 Endnotes 335

PART FIVE The Strategy of International Business 336

Chapter Twelve The Strategy of International Business 337

Opening Case: IKEA 337 Introduction 338 Strategy and the Firm 339

Value Creation 339

Strategic Positioning 341

Operations: The Firm as a Value Chain 342

Global Expansion, Profitability, and Profit Growth 346

Expanding the Market: Leveraging Products and Competencies 347

Location Economies 348

Experience Effects 350

Leveraging Subsidiary Skills 352

Profitability and Profit Growth Summary 352

Cost Pressures and Pressures for Local Responsiveness 353 Pressures for Cost Reductions 353

Pressures for Local Responsiveness 354

Choosing a Strategy 357 Global Standardization Strategy 357

Localization Strategy 359

Transnational Strategy 359

International Strategy 360

The Evolution of Strategy 361

Strategic Alliances 362 The Advantages of Strategic Alliances 362

The Disadvantages of Strategic Alliances 363

Making Alliances Work 364 Key Terms 366 Summary 366 Critical Thinking and Discussion Questions 367 Research Task 367

Closing Case: Ford’s Global Strategy 367 Endnotes 368

Chapter Thirteen Entering Foreign Markets 371

Opening Case: Market Entry at Starbucks 371 Introduction 372 Basic Entry Decisions 373

Which Foreign Markets? 373

Timing of Entry 374

Scale of Entry and Strategic Commitments 376

Market Entry Summary 377

Entry Modes 377 Exporting 378

Turnkey Projects 379

Licensing 380

Franchising 382

Joint Ventures 383

Wholly Owned Subsidiaries 384

Selecting an Entry Mode 385 Core Competencies and Entry Mode 386

Pressures for Cost Reductions and Entry Mode 386

Greenfield Venture or Acquisition? 387 Pros and Cons of Acquisition 387

Pros and Cons of Greenfield Ventures 389

Greenfield Venture or Acquisition? 390 Key Terms 390 Summary 390 Critical Thinking and Discussion Questions 391 Research Task 392

Closing Case: JCB in India 392 Endnotes 393

PART SIX International Business Functions 396

Chapter Fourteen Exporting, Importing, and Countertrade 397

x Contents

Opening Case: Growing Through Exports 397 Introduction 398 The Promise and Pitfalls of Exporting 398 Improving Export Performance 401

An International Comparison 401

Information Sources 401

Utilizing Export Management Companies 402

Export Strategy 403

Export and Import Financing 405 Lack of Trust 405

Letter of Credit 406

Draft 407

Bill of Lading 408

A Typical International Trade Transaction 408

Export Assistance 409 Export–Import Bank 409

Export Credit Insurance 410

Countertrade 410 The Popularity of Countertrade 411

Types of Countertrade 411

Pros and Cons of Countertrade 413 Key Terms 413 Summary 414 Critical Thinking and Discussion Questions 414 Research Task 415

Closing Case: MD International 415 Endnotes 416

Chapter Fifteen Global Production and Supply Chain Management 419

Opening Case: Apple: The Best Supply Chain in the World? 419 Introduction 421 Strategy, Production, and Supply Chain Management 421 Where to Produce 424

Country Factors 424

Technological Factors 426

Production Factors 428

The Hidden Costs of Foreign Locations 431

Make-or-Buy Decisions 433 Global Supply Chain Functions 436

Global Logistics 436

Global Purchasing 438

Managing a Global Supply Chain 439 Role of Just-in-Time Inventory 440

Role of Information Technology 440

Coordination in Global Supply Chains 441

Interorganizational Relationships 441

Key Terms 443 Summary 443 Critical Thinking and Discussion Questions 444 Research Task 445

Closing Case: H&M: The Retail–Clothing Giant 445 Endnotes 446

Chapter Sixteen Global Marketing and Research and Development 449

Opening Case: Global Branding of Avengers and Iron Man 449 Introduction 450 Globalization of Markets and Brands 452 Market Segmentation 453 Product Attributes 455

Cultural Differences 455

Economic Development 456

Product and Technical Standards 456

Distribution Strategy 457 Differences Between Countries 457

Choosing a Distribution Strategy 460

Communication Strategy 461 Barriers to International Communication 461

Push Versus Pull Strategies 462

Global Advertising 464

Pricing Strategy 466 Price Discrimination 466

Strategic Pricing 468

Regulatory Influences on Prices 469

Configuring the Marketing Mix 469 International Market Research 472 Product Development 475

The Location of R&D 476

Integrating R&D, Marketing, and Production 477

Cross-Functional Teams 478

Building Global R&D Capabilities 478 Key Terms 480 Summary 480 Critical Thinking and Discussion Questions 481 Research Task 481

Closing Case: Domino’s Pizza Worldwide 482 Endnotes 483

Chapter Seventeen Global Human Resource Management 487

Opening Case: The Strategic Role of Human Resources at IBM 487

Contents xi

Introduction 488 The Strategic Role of International HRM 489 Staffing Policy 490

Types of Staffing Policy 490

Expatriate Managers 494

The Global Mindset 497

Training and Management Development 498 Training for Expatriate Managers 498

Repatriation of Expatriates 499

Management Development and Strategy 500

Performance Appraisal 501 Performance Appraisal Problems 501

Guidelines for Performance Appraisal 502

Compensation 502 National Differences in Compensation 502

Expatriate Pay 503

International Labor Relations 505

The Concerns of Organized Labor 505

The Strategy of Organized Labor 505

Approaches to Labor Relations 506 Key Terms 507 Summary 507 Critical Thinking and Discussion Questions 508 Research Task 508

Closing Case: MMC China 508 Endnotes 509

GLOSSARY 512 PHOTO CREDITS 520 NAME INDEX 521 SUBJECT INDEX 522 ACRONYMS COUNTRIES AND THEIR CAPITALS WORLD MAP

xii Contents

xiii

the proven choice for international business

Current. Application Rich. Relevant. Integrated. Global Business Today is intended for the first international business course at either the Undergraduate or MBA level. As the market leader, the goal in creating this package has been to set a new standard for international business teaching. We have attempted to cre- ate resources that

• Are comprehensive and up-to-date. • Go beyond an uncritical presentation and shallow explanation of the body of

knowledge. • Focus on rich applications of international business concepts. • Tightly integrate progression of topics among chapters. • Are fully integrated with results-driven technology.

Over the years, and through now nine editions, Dr. Charles Hill has worked hard to adhere to these goals. The ninth edition, with Dr. Tomas Hult as a co-author, follows the same ap- proach. It has not always been easy. An enormous amount has happened over the past de- cade, both in the real world of economics, politics, and business, and in the academic world of theory and empirical research. Often, we have had to significantly rewrite chapters, scrap old examples, bring in new ones, incorporate new theory and evidence into the material, and phase out older theories that are increasingly less relevant to the modern and dynamic world of international business. As noted later, there have been significant changes in this edition—and that will no doubt continue to be the case in the future. In deciding what changes to make, we have been guided not only by our own reading, teaching, and re- search, but also by the invaluable feedback we received from professors and students around the world who use the product, from reviewers, and from the editorial staff at McGraw-Hill. Our thanks go out to all of them.

xiv The Proven Choice for International Business

Comprehensive and Up-to-Date To be comprehensive, an international business package must

• Explain how and why the world’s countries differ. • Present a thorough review of the economics and politics of international trade and

investment. • Explain the functions and form of the global monetary system. • Examine the strategies and structures of international businesses. • Assess the special roles of an international business’s various functions.

This text has always endeavored to do all of these things. Too many other products have paid insufficient attention to the strategies and structures of international businesses and to the implications of international business for firms’ various functions. This omission has been a serious deficiency. Many of the students in these international business courses will soon be working in international businesses, and they will be expected to understand the implications of international business for their organization’s strategy, structure, and func- tions. This package pays close attention to these issues.

Comprehensiveness and relevance also require coverage of the major theories. It has always been a goal to incorporate the insights gleaned from recent academic work into the work. Consistent with this goal, over the past nine editions, insights from the following research have been incorporated:

• The new trade theory and strategic trade policy. • The work of Nobel Prize–winning economist Amartya Sen on economic development. • The work of Hernando de Soto on the link between property rights and economic

development. • Samuel Huntington’s influential thesis on the “clash of civilizations.” • The new growth theory of economic development championed by Paul Romer and

Gene Grossman. • Empirical work by Jeffrey Sachs and others on the relationship between international

trade and economic growth. • Michael Porter’s theory of the competitive advantage of nations. • Robert Reich’s work on national competitive advantage. • The work of Nobel Prize winner Douglass North and others on national institutional

structures and the protection of property rights. • The market imperfections approach to foreign direct investment that has grown out of

Ronald Coase and Oliver Williamson’s work on transaction cost economics. • Bartlett and Ghoshal’s research on the transnational corporation. • The writings of C. K. Prahalad and Gary Hamel on core competencies, global

competition, and global strategic alliances. • Insights for international business strategy that can be derived from the resource-based

view of the firm. • Paul Samuelson’s critique of free trade theory.

In addition to including leading-edge theory, in light of the fast-changing nature of the international business environment, we have made every effort to ensure that this product was as up-to-date as possible when it went to press. A significant amount has happened in the world since we began revisions of this book. By 2014, more than $3.5 trillion per day was flowing across national borders. The size of such flows fueled concern about the ability of short-term speculative shifts in global capital markets to destabilize the world economy. The World Wide Web emerged from nowhere to become the backbone of an emerging global network for electronic commerce. The world continued to become more global. Several Asian Pacific economies, most notably China, continued to grow their economies at a rapid rate. New multinationals continued to emerge from developing nations in addi- tion to the world’s established industrial powers. Increasingly, the globalization of the world economy affected a wide range of firms of all sizes, from the very large to the very

The Proven Choice for International Business xv

small. And unfortunately, in the wake of the terrorist attacks on the United States that took place September 11, 2001, global terrorism and the attendant geopolitical risks emerged as a threat to global economic integration and activity.

New in the Ninth Edition The most obvious change to the ninth edition of Global Business Today is the addition of a co-author, G. Tomas M. Hult. Professor Hult is the John W. Byington Endowed Chair, Professor of Marketing and International Business, and Director of the International Busi- ness Center in the Eli Broad College of Business at Michigan State University. He is a notable scholar in the area of international business, marketing and management, and a well-known expert on global supply chain management, global strategy, and marketing strategy. In addition, he has played a major role in the Academy of International Business, and is currently the Executive Director and Foundation President of the Academy of Inter- national Business.

I am delighted to have Tomas on the book. Tomas has been a long-term user of the book and has contributed end-of-chapter material to the book for many editions (he is responsi- ble for the Research Tasks that use Michigan State’s globalEDGE.msu.edu knowledge re- source). I believe that his skills complement my own. His energy, enthusiasm, and knowledge base should help make an already strong book even better. Tomas has made significant new contributions to all chapters in this edition, including most notably Chapters 4 and 5 on Culture and Ethics/CSR/Sustainability and Chapters 15 and 16 on Global Production and Supply Chain Management and Marketing and R&D.

The success of the first eight editions of Global Business Today was based in part upon the incorporation of leading-edge research into the text, the use of up-to-date examples and statistics to illustrate global trends and enterprise strategy, and the discussion of current events within the context of the appropriate theory. Building on these strengths, our goals for the ninth revision have been to:

1. Incorporate new insights from recent scholarly research wherever appropriate. 2. Make sure the content of the text covers all appropriate issues. 3. Make sure the text is as up-to-date as possible with regard to current events, statistics,

and examples. 4. Add new and insightful opening and closing cases in most chapters. 5. Add question-driven boxed materials in each chapter to motivate class discussion. 6. Incorporate value-added globalEDGE features in every chapter. 7. Connect every chapter to a focus on managerial implications.

As part of the overall revision process, changes have been made to every chapter in the book. All statistics have been updated to incorporate the most recently available data, which typ- ically refers to 2013. These data were mostly released by national and international agen- cies early in 2014. For example: New examples, cases, and boxes have been added and older examples updated to reflect new developments. For example, in Chapter 2, (1) the Opening Case looks at how the policies of Russian President Vladimir Putin have shaped the eco- nomic, political, and legal systems of that nation and affect the attractiveness of Russia as a destination for international business, (2) a new Management Focus feature discusses allega- tions that Walmart violated the Foreign Corrupt Practices Act while doing business in Mexico; and (3) a new Closing Case discusses the economic growth in Ghana.

New material has been inserted wherever appropriate to reflect recent academic work or important current events. Detailed discussion of the 2008–2009 global financial crisis and its aftermath, including the 2010–2013 sovereign debt crises in the Euro Zone and its implica- tions for international business, have been included in many chapters. Similarly, further discussion of the unrest that continues to sweep across the Middle East following the Arab Spring of 2011 and the ongoing turmoil in Egypt and Syria has been added to the book.

Importantly, for every chapter, the ninth edition of Global Business Today has two new features spearheaded by Tomas. First, we added question-driven materials in each chapter to motivate class discussion. These are four “boxes” per chapter that illustrate a specific

xvi The Proven Choice for International Business

situation and then ask students to “debate” the issue. These “question boxes” are great ways to practically illustrate the chapter material and get the students engaged. Second, we incorporated value-added globalEDGE features in every chapter. The Google number-one ranked globalEDGE.msu.edu site (for “international business resources”) is used in each chapter to add value to the chapter material and provide up-to-date data and information.

In addition to updating all statistics, figures, and maps to incorporate most recent pub- lished data major chapter-by-chapter changes include the following:

CHAPTER 1: GLOBALIZATION • New Opening Case: The Globalization of Production at Boeing. • New Closing Case: Who Makes the Apple iPhone?

CHAPTER 2: NATIONAL DIFFERENCES IN POLITICAL, ECONOMIC, AND LEGAL SYSTEMS • New Opening Case: Putin’s Russia. • Discussion of pseudo democracies added to section on democracy and totalitarianism.

These are countries that are democratic in name only where authoritarian elements have captured some or much of the machinery of state and use this in an attempt to deny basic political and civil liberties (e.g., as in Russia).

• New Management Focus: Did Walmart Violate the Foreign Corrupt Practices Act? • New Closing Case: Ghana: An African Dynamo.

CHAPTER 3: NATIONAL DIFFERENCES IN ECONOMIC DEVELOPMENT • New Opening Case: Political and Economic Reform in Myanmar. • Extended discussion of the 2008–2009 global financial crisis as an example of economic

risk. • New Closing Case: Revolution in Egypt.

CHAPTER 4: DIFFERENCES IN CULTURE • New Opening Case: Best Buy and eBay in China. • Deeper treatment of culture, values, and norms. • Social media issues inserted into the culture discussion. • Added four basic principles to social stratification. • Added depth and coverage of the economic implications of Buddhism. • Updated the Hofstede culture framework with new research. • New Closing Case: World Expo 2020 in Dubai, UAE.

CHAPTER 5: ETHICS, CORPORATE SOCIAL RESPONSIBILITY, AND SUSTAINABILITY • New Opening Case: Making Toys Globally. • Deeper treatment of corruption. • New focus on corporate social responsibility (CSR). • Added Management Focus on Stora Enso to illustrate CSR. • New focus on sustainability. • Added Management Focus on Umicore to illustrate global sustainability. • New Closing Case: Bitcoins as an Ethical Dilemma.

CHAPTER 6: INTERNATIONAL TRADE THEORY • New Opening Case: Creating the World’s Biggest Free Trade Zone. • New Closing Case: The Rise of India’s Drug Industry.

CHAPTER 7: GOVERNMENT POLICY AND INTERNATIONAL TRADE • New Opening Case: Sugar Subsidies Drive Candy Makers Abroad. • New Country Focus: Are the Chinese Illegally Subsidizing Auto Exports? • New Closing Case: China Limits Exports of Rare Earth Materials.

The Proven Choice for International Business xvii

CHAPTER 8: FOREIGN DIRECT INVESTMENT • New Opening Case: Foreign Direct Investment in Nigeria. • New Closing Case: Foreign Retailers in India.

CHAPTER 9: REGIONAL ECONOMIC INTEGRATION • New Opening Case: Tomato Wars. • New Closing Case: I Want My Greek TV!

CHAPTER 10: THE FOREIGN EXCHANGE MARKET • New Opening Case: Embraer and the Wild Ride of the Brazilian Real. • New Closing Case: The Rise (and Fall) of the Japanese Yen.

CHAPTER 11: THE INTERNATIONAL MONETARY SYSTEM • New Opening Case: The IMF and Iceland’s Economic Recovery. • New Closing case: Currency Trouble in Malawi.

CHAPTER 12: THE STRATEGY OF INTERNATIONAL BUSINESS • New Opening Case: IKEA. • Discussion of the rise of regionalism added to section on Pressures for Local

Responsiveness. • New Closing Case: Ford’s Global Strategy.

CHAPTER 13: ENTERING FOREIGN MARKETS • New Opening Case: Market Entry at Starbucks. • New Closing Case: JCB in India.

CHAPTER 14: EXPORTING, IMPORTING AND COUNTERTRADE • New Opening Case: Growing Through Exports. • New Closing Case: MD International.

CHAPTER 15: GLOBAL PRODUCTION AND SUPPLY CHAIN MANAGEMENT • New Opening Case: Apple: The Best Supply Chains in the World? • Integration of the complete supply chain (logistics, purchasing, production, and

operations). • New section on Strategic Roles for Production Facilities. • New section on Make-or-Buy Decisions. • New section on Global Supply Chain Functions. • New text for the Role of Information Technology. • New section on Coordination of Global Supply Chains. • New section on Interorganizational Relationships. • New Closing Case: H&M: The Retail Clothing Giant.

CHAPTER 16: GLOBAL MARKETING AND RESEARCH AND DEVELOPMENT • New Opening Case: Global Branding of Avengers and Iron Man. • Revised section on Globalization of Markets and Brands. • Revised section on Configuring the Marketing Mix, now with a new table with sample

measures. • New section on International Market Research, including company examples and six

basic steps. • Revised positioning of the Product Development section. • Heavily Revised Closing Case: Domino’s Pizza Worldwide.

xviii The Proven Choice for International Business

CHAPTER 17: GLOBAL HUMAN RESOURCE MANAGEMENT • New Opening Case: The Strategic Role of Human Resources at IBM. • New Closing Case: MMC China.

Beyond Uncritical Presentation and Shallow Explanation Many issues in international business are complex and thus necessitate considerations of pros and cons. To demonstrate this to students, we have adopted a critical approach that presents the arguments for and against economic theories, government policies, business strategies, organizational structures, and so on.

Related to this, we have attempted to explain the complexities of the many theories and phenomena unique to international business so the student might fully comprehend the statements of a theory or the reasons a phenomenon is the way it is. We believe that these theories and phenomena are explained in more depth in this work than they are in the com- petition, which seem to use the rationale that a shallow explanation is little better than no explanation. In international business, a little knowledge is indeed a dangerous thing.

Focuses on Rich Applications of International Business Concepts We have always believed that it is important to show students how the material covered in the text is relevant to the actual practice of international business. This is explicit in the later chapters of the book, which focus on the practice of international business, but it is not always obvious in the first half of the book, which considered many macroeconomic and political issues, from international trade theory and foreign direct investment flows to the IMF and the influence of inflation rates on foreign exchange quotations. Accordingly, at the end of each chapter in Parts Two, Three, and Four—where the focus is on the envi- ronment of international business, as opposed to particular firms—there is a section titled Focus on Managerial Implications. In this section, the managerial implications of the material discussed in the chapter are clearly explained.

FOCUS ON MANAGERIAL IMPLICATIONS

LO 2-4 Explain the implications for management practice of national differences in political economy.

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Did Walmart Violate the Foreign Corrupt Practices Act?

management FOCUS

hiL12915_ch02_036-059.indd Page 52 12/09/14 9:57 AM f-w-143 /207/MH02219/hiL12915_disk1of1/0078112915/hiL12915_pagefiles Another tool that I have used to focus on managerial implications are Management

Focus boxes. There is at least one Management Focus in most chapters. Like the opening cases, the purpose of these boxes is to illustrate the relevance of chapter material for the practice of international business.

The Proven Choice for International Business xix

In addition, each chapter begins with an Opening Case that sets the stage for the chap- ter content and familiarizes students with how real international companies conduct busi- ness. There is also a Closing Case to each chapter. These cases are also designed to illustrate the relevance of chapter material for the practice of international business as well as to provide continued insight into how real companies handle those issues.

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

1. You are preparing for a business trip to Chile where you will need to interact extensively with local professionals. Therefore, you would like to collect information regarding local culture and business practices prior to your departure. A colleague from Latin America recommends you visit the “Centre for Intercultural Learning” and read through the country

h d d f h l h

characteristics that may affect business interactions in this country.

2. Typically, cultural factors drive the differences in business etiquette encountered during international business travel. In fact, Middle Eastern cultures exhibit significant differences in business etiquette when compared to Western cultures. Prior to leaving for your first business trip to the region, a colleague informed you that a guide named Business Etiquette around the World may help you. Using this guide,

Research Task http://globalEDGE.msu.edu

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Connect® International Business is another tool that provides for application of con- cepts via the great variety of Interactive Application exercises included in this homework assignment and assessment system. For more information, see page xxi.

To help students go a step further in expanding their application level understanding of international business, each chapter incorporates a globalEdge feature authored by Tomas Hult, as well as two globalEDGE research tasks designed and written by Tunga Kiyak and the team at Michigan State University’s globalEDGE.msu.edu site to dovetail with the con- tent just covered.

opening case

The modern Russia state was born in 1991 after the dramatic collapse of the Soviet Union. Early in the post-Soviet era, Russia embraced ambitious policies designed to transform a communist dictatorship with a centrally planned economy into democratic state with a market based economic system. The policies, however, were imperfectly implemented. Political reform left Russia with a strong presidency

that—in hindsight—had the ability to subvert the democratic process. On the economic front, the privatiza-

tion of many state-owned enterprises was done in such a way as to leave large shareholdings in the hands

of the politically connected, many of whom were party officials and factory managers under the old Soviet

system. Corruption was also endemic, and organized crime was able to seize control of some newly priva-

tized enterprises. In 1998, the poorly managed Russian economy went through a financial crisis that nearly

Putin’s Russia

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ccccccloooooooosssiinnnngggggggggg cccccccaaassssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeeee

The West African nation of Ghana has emerged as one of the fastest- growing countries in sub-Saharan Africa during the last decade. Between 2000 and 2013, Ghana’s average annual growth rate in GDP was over 7.5 percent, making it the fastest-growing economy in Africa. In 2011, this country of 25 million people became Africa’s newest middle-income nation. Driving this growth has been strong demand for two of Ghana’s major exports—gold and cocoa—as well as the start of oil production in 2010. Indeed, due to recent oil discoveries, Ghana is set to become one of

states of eastern Europe. In addition, he was pressured by Western gov- ernments and the International Monetary Fund to embrace democratic reforms and economic liberalization policies (the IMF was lending money to Ghana).

Ghana: An African Dynamo

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Get Insights by Country

The “Get Insights by Country” section of globalEDGE (globalEDGE.msu. edu/global-insights/by/country) is your source for information and sta- tistical data for nearly every country around the world (more than 200 countries). As related to Chapter 2 of the text, globalEDGE has a wealth of information and data on national differences in political economy. These differences are available across a dozen menu categories in the

country sections (e.g., economy, history, government, culture, risk). The “Executive Memos” on each country page are also great for abbrevi- ated fingertip access to current information. At a minimum, we suggest that you take a look at the country pages of the United Kingdom and Sweden because the authors of this text are from those countries— have you figured out who is from the UK and who is from Sweden yet?

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xx The Proven Choice for International Business

Integrated Progression of Topics A weakness of many texts is that they lack a tight, integrated flow of topics from chapter to chapter. In Chapter 1 of this book, students will learn how the book’s topics are related to each other. We have achieved integration by organizing the material so that each chapter builds on the material of the previous ones in a logical fashion.

PART ONE Chapter 1 provides an overview of the key issues to be addressed and ex- plains the plan of the book.

PART TWO Chapters 2, 3, and 4 focus on national differences in political economy and culture, and Chapter 5 examines ethical issues in international business. Most international business textbooks place this material at a later point, but we believe it is vital to discuss national differences first. After all, many of the central issues in international trade and in- vestment, the global monetary system, international business strategy and structure, and international business operations arise out of national differences in political economy and culture. To fully understand these issues, students must first appreciate the differences in countries and cultures. Ethical issues are dealt with at this juncture primarily because many ethical dilemmas flow out of national differences in political systems, economic systems, and culture.

PART THREE Chapters 6 through 9 investigate the political economy of international trade and investment. The purpose of this part is to describe and explain the trade and in- vestment environment in which international business occurs.

PART FOUR Chapters 10 and 11 describe and explain the global monetary system, laying out in detail the monetary framework in which international business transactions are conducted.

PART FIVE In Chapters 12 and 13, attention shifts from the environment to the firm. Here the book examines the strategies that firms adopt to compete effectively in the inter- national business environment.

PART SIX Chapters 14 through 17 explain how firms can perform key functions— production, marketing, research and development, and human resource management to compete and succeed in the international business environment. Throughout the book, the relationship of new material to topics discussed in earlier chapters is pointed out to the students to reinforce their understanding of how the material comprises an inte- grated whole.

Accessible and Interesting The international business arena is fascinating and exciting, and we have tried to com- municate our enthusiasm for it to the student. Learning is easier and better if the sub- ject matter is communicated in an interesting, informative, and accessible manner. One technique we have used to achieve this is weaving interesting anecdotes into the narra- tive of the text, that is, stories that illustrate theory. Prepared by co-author Tomas Hult, of Michigan State University, the use of conversation starters also serve to present controversial questions and allow students to discuss and apply concepts from the chapter.

In addition to the conversation starters, most chapters also have a Country Focus box that provides background on the political, economic, social, or cultural aspects of countries grappling with an international business issue.

The Proven Choice for International Business xxi

Venezuela under Hugo Chávez, 1999–2013

In mid-2000, the world oil market bailed Chávez out of mounting economic difficulties. Oil prices started to surge from the low $20s in 2003, reaching $150 a barrel by mid-2008. Venezuela, the world’s fifth-largest producer, reaped a bonanza. On the back of surging oil exports, the economy grew at a robust rate. Chávez used the oil reve- nues to boost government spending on social programs, many of them modeled after programs in Cuba. In 2006, he announced plans to re- duce the stakes held by foreign companies in oil projects in the Orinoco regions and to give the state-run oil company a majority position.

country FOCUS

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Results-Driven Technology Across the country, instructors and students continue to raise an important question: How can international business courses further support students throughout the learning process to shape future global business leaders? While there is no one solution, Global Business Today, ninth edition, offers a seamless content and technology solution to improve student engage- ment and comprehension, automation of assignments and grading, and easy reporting to ensure that learning objectives are being met. Connect® International Business provides a wide array of tools and content to improve instructor productivity and student performance. In

How Important Are Intellectual Property Rights? Burundi is a landlocked country in the Great Lake region of Eastern Africa. Neighboring countries include Rwanda, Tanzania, and the Democratic Republic of the Congo. Burundi is hilly and mountainous, with access to Lac Tanganyika. The government system is a republic, with the chief of state and head of govern- ment being the president. Burundi has a traditional economic system in which the allocation of available resources is made on the basis of primitive methods, and many citizens engage in subsistence agriculture. At the same time, Burundi was last of the 131 countries ranked in the 2013 International Property Rights Index (IPRI). The IPRI is conducted by a partnership of 74 international organizations. The IPRI takes into account legal and political environment, physical property rights, and intel- lectual property rights. How much should companies focus on Intellectual Property Rights in making their decision on where to (1) produce their products and (2) sell their products? Does it differ if you produce or sell in the country?

Source: www.internationalpropertyrightsindex.org.

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xxii The Proven Choice for International Business

fact, the aggregated results of 34 Connect adoptions showed an 11 percent improvement in pass rates, a 16 percent improvement in retention, twice as many students receiving an A, and 77 percent reduction in instructor grading time.

McGraw-Hill Connect International Business Connect is an all-digital teaching and learning environment designed from the ground up to work with the way instructors and students think, teach, and learn. As a digital teaching, as- signment, and assessment platform, Connect strengthens the link among faculty, students, and coursework, helping everyone accomplish more in less time.

LearnSmart The smartest way to get from B to A McGraw-Hill LearnSmart is the first and most widely used intelligent adaptive learning resource. It is proven to strengthen memory recall, improve course retention, and boost grades by distinguishing between what students know and what they don’t know, and hon- ing in on the concepts that they are most likely to forget. LearnSmart continuously adapts to each student’s needs by building an individual learning path. As a result, students study smarter and retain more knowledge over time. LearnSmart is available within Connect as well as stand-alone for greater student access.

SmartBook A revolution in learning Fueled by LearnSmart, SmartBook is the first and only adaptive reading experience avail- able today. SmartBook personalizes content for each student in a continuously adapting reading experience. Reading is no longer a passive and linear experience, but an engaging and dynamic one where students are more likely to master and retain important concepts, coming to class better prepared.

Interactive Assignments A higher level of learning Throughout the chapter, students will be prompted to complete a variety of interactive as- signments that will require them to apply what they have learned in a real-world scenario. These online exercises will help students assess their understanding of the concepts.

• Apply concepts from the book to a video case.

The Proven Choice for International Business xxiii

• Make business decisions based on specific scenarios/cases from real-world companies.

• Analyze a case and apply chapter concepts. • Demonstrate problem-solving skills through complex examples and diagrams.

• Demonstrate knowledge about business models and processes.

McGraw-Hill Connect Plus with Integrated Media-Rich E-book McGraw-Hill reinvents the textbook-learning experience for today’s students with Connect Plus, providing students with a cost-saving alternative to the traditional textbook. A seamless integration of a media-rich e-book and Connect, Connect Plus provides all the Connect features plus the following:

• A web-optimized e-book, allowing for anytime, anywhere online access to the textbook. • Powerful search function to pinpoint and connect key concepts in a snap. • Highlighting and note-taking capabilities as well as access to shared instructors’ notations.

Teaching Support International Business offers you a complete package to prepare you for your course.

McGraw-Hill Connect McGraw-Hill Education’s Connect strengthens the link between faculty, students, and coursework, helping everyone accomplish more in less time.

xxiv The Proven Choice for International Business

Student Progress Tracking Connect keeps instructors informed about how each student, section, and class is performing, allowing more productive use of lecture and office hours. The progress tracking function enables instructors to:

• View scored work immediately and track individual or group performance with assignment and grade reports.

• Access an instant view of student or class performance relative to learning objectives.

• Collect data and generate reports required by many accreditation organizations, such as AACSB.

Instructor Library Connect’s instructor library serves as a one-stop, secure site for essential course materials, allowing you to save prep time before class. The instructor resources found in the library include:

Connect and LearnSmart allow me to present course material to students in more ways than just the explanations they hear from me directly. Because of this, students are processing the material in new ways, requiring them to think. I now have more students asking questions in class because the more we think, the more we question. Sharon Feaster, Instructor at Hinds Community College

• Instructor’s Manual. The Instructor’s Manual is a comprehensive resource designed to support you in effectively teaching your course. It includes course outlines; chapter teaching resources, including chapter overviews and outlines, teaching suggestions, chapter objectives, teaching suggestions for opening cases, lecture outlines, answers to critical discussion questions, teaching suggestions for the closing case, and two student activities (some with Internet components); and expanded video notes with discussion questions for each video. The answers to globalEDGE research tasks are included.

• Test Bank. Approximately 100 true-false, multiple-choice, and essay questions per chapter are included in the test bank. We’ve aligned our test bank questions with Bloom’s Taxonomy and AACSB guidelines, tagging each question according to its knowledge and skill areas. Each test bank question also maps to a specific chapter learning objective listed in the text. You can use our test bank software, EZ Test, to easily query for learning objectives that directly relate to the learning objectives for your course. You can use the reporting features of EZ Test to aggregate student results in a similar fashion, making the collection and presentation of assurance-of-learning data quick and easy.

• PowerPoint Presentations. The PowerPoint program consists of one set of slides for every chapter, featuring original materials not found in the text in addition to reproductions and illuminations of key text figures, tables, and maps. Quiz questions to keep students on their toes during classroom presentations are also included, along with instructor notes.

Efficient Administrative Capabilities Connect offers you, the instructor, auto-gradable material in an effort to facilitate teaching and learning.

The Proven Choice for International Business xxv

• McGraw-Hill offers the most current, diverse, and comprehensive video support for the international business classroom. Adopters can request our International Business Instructor Video DVD (ISBN 1259392015) from their McGraw-Hill sales representative. The DVD features 20 clips, selected based on their relevance to the text’s chapter material. Corresponding video notes are available. In addition to the DVD, we provide clips from a variety of online sources, updated monthly.

McGraw-Hill Customer Experience Group Contact Information At McGraw-Hill, we understand that getting the most from new technology can be chal- lenging. That’s why our services don’t stop after you purchase our products. You can e-mail our product specialists 24 hours a day to get product training online. Or you can search our knowledge bank of frequently asked questions on our support website. For customer support, call 800-331-5094, e-mail [email protected], or visit www.mhhe.com/support. One of our technical support analysts will be able to assist you in a timely fashion.

Course Design and Delivery cesim GlobalChallenge Simulation cesim is an international business simulation designed to develop student understanding of the interaction and complexity of various business disciplines and concepts in a rapidly evolving, competitive business environment. The simulation has a particular focus on creat- ing long-term, sustainable, and profitable growth of a global technology company. Student teams make decisions about technology-based product roadmaps and global market and production strategies involving economics, finance, human resources, accounting, procure- ment, production, logistics, research and innovation, and marketing. cesim improves the knowledge retention, business decision-making, and teamwork skills of students.

Create Instructors can now tailor their teaching resources to match the way they teach! With McGraw-Hill Create, www.mcgrawhillcreate.com/hill, instructors can easily rearrange alternate, combined chapters (see brief table to contents on page v). Combine material from other content sources, and quickly upload and integrate their own content, like course syllabi or teaching notes. Find the right content in Create by searching through thousands of leading McGraw-Hill textbooks. Arrange the material to fit your teaching style. Order a Create book, and receive a complimentary print review copy in 3–5 business days or a complimentary electronic review copy (echo) via e-mail within one hour. Go to www.mcgrawhillcreate.com/hill today and register.

Tegrity Campus Tegrity makes class time available 24/7 by automatically capturing every lecture in a search- able format for students to review when they study and complete assignments. With a sim- ple one-click start-and-stop process, you capture all computer screens and corresponding audio. Students can replay any part of any class with easy-to-use browser-based viewing on a PC or Mac. Educators know that the more students can see, hear, and experience class resources, the better they learn. In fact, studies prove it. With patented Tegrity “search any- thing” technology, students instantly recall key class moments for replay online, or on iPods and mobile devices. Instructors can help turn all their students’ study time into learning moments immediately supported by their lecture. To learn more about Tegrity, watch a two- minute Flash demo at http://tegritycampus.mhhe.com.

Blackboard® Partnership McGraw-Hill Education and Blackboard have teamed up to simplify your life. Now you and your students can access Connect and Create right from within your Blackboard course—all with one single sign-on. The grade books are seamless, so when a student completes an

xxvi The Proven Choice for International Business

integrated Connect assignment, the grade for that assignment automatically (and instantly) feeds your Blackboard grade center. Learn more at www.domorenow.com.

McGraw-Hill Campus™ McGraw-Hill Campus is a new one-stop teaching and learning experience available to users of any learning management system.

This institutional service allows faculty and students to enjoy single sign-on (SSO) access to all McGraw-Hill Education materials, including the award-winning McGraw-Hill Con- nect platform, from directly within the institution’s website. With McGraw-Hill Campus, faculty receive instant access to teaching materials (e.g., e-textbooks, test banks, PowerPoint slides, learning objects, etc.), allowing them to browse, search, and use any instructor ancil- lary content in our vast library at no additional cost to instructors or students. In addition, students enjoy SSO access to a variety of free content and subscription-based products (e.g., McGraw-Hill Connect). With McGraw-Hill Campus enabled, faculty and students will never need to create another account to access McGraw-Hill products and services. Learn more at www.mhcampus.com.

Assurance of Learning Ready Many educational institutions today focus on the notion of assurance of learning, an important element of some accreditation standards. International Business is designed spe- cifically to support instructors’ assurance of learning initiatives with a simple yet power- ful solution. Each test bank question for International Business maps to a specific chapter learning objective listed in the text. Instructors can use our test bank software, EZ Test and EZ Test Online, to easily query for learning objectives that directly relate to the learning outcomes for their course. Instructors can then use the reporting features of EZ Test to aggregate student results in similar fashion, making the collection and presenta- tion of assurance of learning data simple and easy.

AACSB Tagging McGraw-Hill Education is a proud corporate member of AACSB International. Under- standing the importance and value of AACSB accreditation, International Business recog- nizes the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the text and the test bank to the six general knowl- edge and skill guidelines in the AACSB standards. The statements contained in Interna- tional Business are provided only as a guide for the users of this textbook. The AACSB leaves content coverage and assessment within the purview of individual schools, the mission of the school, and the faculty. While the International Business teaching package makes no claim of any specific AACSB qualification or evaluation, we have within Inter- national Business labeled selected questions according to the six general knowledge and skills areas.

The Proven Choice for International Business xxvii

Acknowledgments Numerous people deserve to be thanked for their assistance in preparing this edition. First, we want to thank all the people at McGraw-Hill Education who have worked with us on this project:

Anke Weekes, Senior Brand Manager Andrea Scheive, Development Editor Michael Gedatus, Marketing Manager Elizabeth Steiner, Marketing Specialist Danielle Clement, Content Project Manager Matt Diamond, Designer Keri Johnson, Lead Content Licensing Specialist

Second, our thanks go to the reviewers, who provided good feedback that helped shape this edition:

Jacobus F. Boers, Georgia State University Peter Buckley, Leeds University Macgorine A. Cassell, Fairmont State University David Closs, Michigan State University Ping Deng, Maryville University of St. Louis Betty J. Diener, Barry University Pat Fox, Marion Technical College Connie Golden, Lakeland Community College Martin Grossman, Bridgewater State University Michael Harris, East Carolina University Kathy Hastings, Greenville Technical College Chip Izard, Richland College Jan Johanson, Uppsala University Candida Johnson, Holyoke Community College Sara B. Kimmel, Mississippi College Tunga Kiyak, Michigan State University Laura Kozloski Hart, Barry University Ruby Lee, Florida State University Vishakha Maskey, West Liberty University Shelly McCallum, Saint Mary’s University of Minnesota Emily A. Morad, Reading Area Community College Tim Muth, Florida Institute of Technology Dwight Shook, Catawba Valley Community College James Whelan, Manhattan College Man Zhang, Bowling Green State University

A special thanks to David Closs, and David Frayer for allowing us to borrow elements of the sections on Strategic Roles for Production Facilities; Make-or-Buy Decisions; Global Supply Chain Functions; Coordination in Global Supply Chains; and Interorganizational Relationships for chapter 15 of this text from Tomas Hult, David Closs, and David Frayer (2014), Global Supply Chain Management, New York: McGraw Hill.

Global Business Today

learning objectives

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1 I

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u c

ti o

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n d

O v e

rv ie

1-1 Understand what is meant by the term globalization.

1-2 Recognize the main drivers of globalization.

1-3 Describe the changing nature of the global economy.

1-4 Explain the main arguments in the debate over the impact of globalization.

1-5 Understand how the process of globalization is creating opportunities and challenges for business managers.

Globalization The Globalization of Production at Boeing

1c h

a pt

opening case

Executives at the Boeing Corporation, America’s largest exporter, like to say that building a large commercial jet aircraft like the 747 or 787 involves bringing together more than a million parts in flying formation. Forty-five years ago, when the early models of Boeing’s venerable 737 and 747 jets were rolling off the company’s Seattle area production lines, foreign suppliers accounted for only 5 percent

of those parts on average. Boeing was vertically integrated and manufactured many of the major compo-

nents that went into the planes. The largest parts produced by outside suppliers were the jet engines,

where two of the three suppliers were American companies. The lone foreign engine manufacturer was the

British company Rolls Royce.

Fast-forward to the modern era, and things look very different. In the case of its latest aircraft, the super

efficient 787 Dreamliner, 50 outside suppliers spread around the world account for 65 percent of the value

of the aircraft. Italian firm Alenia Aeronautica makes the center fuselage and horizontal stabilizer. Kawasaki

of Japan makes part of the forward fuselage and the fixed trailing edge of the wing. French firm Messier-

Dowty makes the aircraft’s landing gear. German firm Diehl Luftahrt Elektronik supplies the main cabin

lighting. Sweden’s Saab Aerostructures makes the access doors. Japanese company Jamco makes parts for

the lavatories, flight decks interiors, and galleys. Mitsubishi Heavy Industries of Japan makes the wings.

KAA of Korea makes the wing tips. And so on.

Why the change? One reason is that 80 percent of Boeing’s customers are foreign airlines, and to sell

into those nations, it often helps to be giving business to those nations. The trend started in 1974 when

Mitsubishi of Japan was given contracts to produce inboard wing flaps for the 747. The Japanese

reciprocated by placing big orders for Boeing jets. A second rationale was to disperse component part

production to those suppliers who are the best in the world at their particular activity. Over the years, for

example, Mitsubishi has acquired considerable expertise in the manufacture of wings, so it was logical for

Boeing to use Mitsubishi to make the wings for the 787. Similarly, the 787 is the first commercial jet

aircraft to be made almost entirely out of carbon fiber, so Boeing tapped Japan’s Toray industries, a

–continued

4 Part One Introduction and Overview

world-class expert in sturdy but light carbon-fiber composites, to supply materials for

the fuselage. A third reason for the extensive outsourcing on the 787 was that Boeing

wanted to unburden itself of some of the risks and costs associated with developing

production facilities for the 787. By outsourcing, it pushed some of those risks and costs

off onto suppliers, who had to undertake major investments in capacity to ramp up to

produce for the 787.

So what did Boeing retain for itself? Engineering design, marketing and sales, and

final assembly at its Everett plant north of Seattle, all activities where Boeing maintains

it is the best in the world. Of major component parts, Boeing only made the tail fin and

wing to body fairing (which attaches the wings to the fuselage of the plane). Everything

else was outsourced.

As the 787 moved through development in the 2000s, however, it became clear that

Boeing had pushed the outsourcing paradigm too far. Coordinating a globally dispersed

production system this extensive turned out to be very challenging. Parts turned up late,

some parts didn’t “snap together” the way Boeing had envisioned, and several suppliers

ran into engineering problems that slowed down the entire production process. As a

consequence, the date for delivery of the first jet was pushed back more than four years,

and Boeing had to take millions of dollars in penalties for late deliveries. The problems

at one supplier, Vought Aircraft in North Carolina, were so severe that Boeing ultimately

agreed to acquire the company and bring its production in-house. Vought was co-owned

by Alenia of Italy and made parts of the main fuselage.

There are now signs that Boeing is rethinking some of its global outsourcing policy.

For its next jet, a new version of its popular, wide-bodied 777 jet, the 777X, which will

use the same carbon-fiber technology as the 787, Boeing will bring wing production

back in-house. Mitsubishi and Kawasaki of Japan produce much of the wing structure for

the 787, and for the original version of the 777. However, recently Japan’s airlines have

been placing large orders with Airbus, breaking with their traditional allegiance to

Boeing. This seems to have given Boeing an opening to bring wing production back in-

house. Boeing executive also note that Boeing has lost much of its expertise in wing

production over the last 20 years due to outsourcing, and bringing it back in-house for

new carbon-fiber wings might enable Boeing to regain these important core skills and

strengthen the company’s competitive position. • Sources: K. Epstein and J. Crown, “Globalization Bites Boeing,” Bloomberg Businessweek, March 12, 2008; H. Mallick, “Out of Control Outsourcing Ruined Boeing’s Beautiful Dreamliner,” The Star, February 25, 2013; P. Kavilanz, “Dreamliner: Where in the World Its Parts Come From,” CNN Money, January 18, 2013; S. Dubois, “Boeing’s Dreamliner Mess: Simply Inevitable?” CNN Money, January 22, 2013; and A. Scott and T. Kelly, “Boeing’s Loss of a $9.5 Billion Deal Could Bring Jobs Back to the U.S.,” Business Insider, October 14, 2013.

.,”

Introduction Over the past four decades a fundamental shift has been occurring in the world economy. We have been moving away from a world in which national economies were relatively self- contained entities, isolated from each other by barriers to cross-border trade and invest- ment; by distance, time zones, and language; and by national differences in government regulation, culture, and business systems. We are moving toward a world in which barriers to cross-border trade and investment are declining; perceived distance is shrinking due to advances in transportation and telecommunications technology; material culture is starting to look similar the world over; and national economies are merging into an interdependent,

Chapter One Globalization 5

integrated global economic system. The process by which this transformation is occurring is commonly referred to as globalization.

The global dispersal of production for Boeing’s 787 Dreamliner, outlined in the open- ing case, is one example of the trend toward globalization. In 1970, independent suppliers produced only 5 percent of the value of a Boeing commercial jet. With the advent of the 787 Dreamliner, this figure reached 65 percent, and many of those suppliers were scat- tered around the globe. Part of Boeing’s rationale was that 80 percent of its sales went to foreign airlines, and winning orders in this global marketplace required that it outsource some production to other nations. Boeing also believed that it made sense to outsource production of component parts to independent suppliers if they were the best in the world at performing that particular activity, no matter where they were located. In Boeing’s view, the result of such a strategy would be greater efficiency and lower costs, which would help Boeing compete on price against its global rival in the commercial aircraft business, Airbus. As the case makes clear, however, there are risks involved in embracing globaliza- tion to the extent that Boeing did. Coordinating a globally dispersed supply chain turned out to be a logistical nightmare, and was partly responsible for delaying the launch of the 787 by more than four years, which cost Boeing dearly. The Boeing example illustrates, therefore, that managers need to carefully think through their strategy for competing in the global market place of the twenty-first century, balancing the benefits of embracing globalizations against the associated risks. This is a theme that we shall return to repeat- edly throughout this text.

More generally, globalization now has an impact upon almost everything we do. The average American, for example, might drive to work in a car that was designed in Germany and assembled in Mexico by Ford from components made in the United States and Japan, which were fabricated from Korean steel and Malaysian rubber. He may have filled the car with gasoline at a Shell service station owned by a British-Dutch multinational company. The gasoline could have been made from oil pumped out of a well off the coast of Africa by a French oil company that transported it to the United States in a ship owned by a Greek shipping line. While driving to work, the American might talk to his stockbroker (using a hands-free, in-car speaker) on an Apple iPhone that was designed in California and assem- bled in China using chip sets produced in Japan and Europe, glass made by Corning in Kentucky, and memory chips from South Korea. He could tell the stockbroker to purchase shares in Lenovo, a multinational Chinese PC manufacturer whose operational headquar- ters is in North Carolina.

This is the world in which we live. It is a world where the volume of goods, services, and investments crossing national borders has expanded faster than world output for more than half a century. It is a world where more than $5 trillion in foreign exchange transactions are made every day, where $18.3 trillion of goods and $4.3 trillion of services were sold across national borders in 2012.1 It is a world in which inter- national institutions such as the World Trade Organization and gatherings of leaders from the world’s most powerful economies have repeatedly called for even lower barriers to cross-border trade and investment. It is a world where the symbols of material and popular culture are increasingly global: from Coca-Cola and Starbucks to Sony PlayStations, Facebook, MTV shows, Disney films, IKEA stores, and Apple iPads and iPhones. It is also a world in which vigorous and vocal groups protest against globalization, which they blame for a list of ills from unemployment in developed na- tions to environmental degradation and the Americanization of local culture.

For businesses, this globalization process has produced many opportunities. Firms can expand their revenues by selling around the world and/or reduce their costs by pro- ducing in nations where key inputs, including labor, are

What Will Happen to the United States? The United States has the largest and most technologically pow- erful economy in the world, with a per capita GDP (gross domes- tic product) of $49,100. The 2013 GDP was valued at $16.72 trillion. Most of the labor force (79.4 percent) is employed in the services sector, with 19.5 percent employed in manufacturing industries, and only 1.1 percent in the agricultural area. China, India, and the European Union have a labor force larger than the United States, which ranks fourth in the world. Data show that the U.S. has become much more of a service economy over the years. Will the U.S. continue to increase its service sector at the cost of manufacturing and agriculture?

Source: U.S. Central Intelligence Agency, World Factbook, www.cia.gov, accessed March 3, 2014.

6 Part One Introduction and Overview

cheap. The global expansion of enterprises has been facilitated by favorable political and economic trends. Since the collapse of communism at the end of the 1980s, the pendulum of public policy in nation after nation has swung toward the free market end of the eco- nomic spectrum. Regulatory and administrative barriers to doing business in foreign nations have been reduced, while those nations have often transformed their economies, privatizing state-owned enterprises, deregulating markets, increasing competition, and welcoming in- vestment by foreign businesses. This has allowed businesses both large and small, from both advanced nations and developing nations, to expand internationally.

As globalization unfolds, it is transforming industries and creating anxiety among those who believed their jobs were protected from foreign competition. Historically, while many workers in manufacturing industries worried about the impact foreign competition might have on their jobs, workers in service industries felt more secure. Now, this too is changing. Advances in technology, lower transportation costs, and the rise of skilled workers in devel- oping countries imply that many services no longer need to be performed where they are delivered. The same is true of some accounting services. Today, many individual U.S. tax returns are compiled in India. Indian accountants, trained in U.S. tax rules, perform work for U.S. accounting firms.2 They access individual tax returns stored on computers in the United States, perform routine calculations, and save their work so that it can be inspected by a U.S. accountant, who then bills clients. As the best-selling author Thomas Friedman has argued, the world is becoming flat.3 People living in developed nations no longer have the playing field tilted in their favor. Increasingly, enterprising individuals based in India, China, or Brazil have the same opportunities to better themselves as those living in western Europe, the United States, or Canada.

In this text, we will take a close look at the issues introduced here and many more. We will explore how changes in regulations governing international trade and investment, when coupled with changes in political systems and technology, have dramatically altered the competitive playing field confronting many businesses. We will discuss the resulting oppor- tunities and threats and review the strategies that managers can pursue to exploit the op- portunities and counter the threats. We will consider whether globalization benefits or harms national economies. We will look at what economic theory has to say about the out- sourcing of manufacturing and service jobs to places such as India and China and look at the benefits and costs of outsourcing, not just to business firms and their employees but also to entire economies. First, though, we need to get a better overview of the nature and process of globalization, and that is the function of this first chapter.

What Is Globalization? As used in this text, globalization refers to the shift toward a more integrated and interde- pendent world economy. Globalization has several facets, including the globalization of markets and the globalization of production.

THE GLOBALIZATION OF MARKETS The globalization of markets re- fers to the merging of historically distinct and separate national markets into one huge global marketplace. Falling barriers to cross-border trade have made it easier to sell interna- tionally. It has been argued for some time that the tastes and preferences of consumers in different nations are beginning to converge on some global norm, thereby helping to create a global market.4 Consumer products such as Citigroup credit cards, Coca-Cola soft drinks, video games, McDonald’s hamburgers, Starbucks coffee, IKEA furniture, and Apple iPhones are frequently held up as prototypical examples of this trend. The firms that produce these products are more than just benefactors of this trend; they are also facilitators of it. By offer- ing the same basic product worldwide, they help create a global market.

A company does not have to be the size of these multinational giants to facilitate, and benefit from, the globalization of markets. In the United States, for example, according to the International Trade Administration, more than 302,000 small and medium-size firms with less than 500 employees exported in 2011, accounting for 98 percent of the companies that exported that year. More generally, exports from small and medium-size companies

LO 1-1 Understand what is meant by the term globalization.

Globalization Trend away from distinct national economic units and toward one huge global market.

Globalization of Markets Moving away from an economic system in which national markets are distinct entities, isolated by trade barriers and barriers of distance, time, and culture, and toward a system in which national markets are merging into one global market.

Chapter One Globalization 7

accounted for 19 percent of the value of U.S. exports of manufactured goods in 2011.5 Typical of these is B&S Aircraft Alloys, a New York company whose exports account for 40 percent of its $8 million annual revenues.6 The situation is similar in several other nations. For example, in Germany, the world’s largest exporter, a staggering 98 percent of small and midsize companies have exposure to international markets, via either exports or interna- tional production.7

Despite the global prevalence of Citigroup credit cards, McDonald’s hamburgers, Star- bucks coffee, and IKEA stores, it is important not to push too far the view that national markets are giving way to the global market. As we shall see in later chapters, significant dif- ferences still exist among national markets along many relevant dimensions, including con- sumer tastes and preferences, distribution channels, culturally embedded value systems, business systems, and legal regulations. These differences frequently require companies to customize marketing strategies, product features, and operating practices to best match con- ditions in a particular country.

The most global of markets are not typically markets for consumer products—where national differences in tastes and preferences can still be important enough to act as a brake on globalization—but markets for industrial goods and materials that serve universal needs the world over. These include the markets for commodities such as aluminum, oil, and wheat; for industrial products such as microprocessors, DRAMs (computer memory chips), and commercial jet aircraft; for computer software; and for financial assets from U.S. Trea- sury bills to Eurobonds and futures on the Nikkei index or the euro. That being said, it is increasingly evident that many newer high-technology consumer products, such as Apple’s iPhone, are being successfully sold the same way the world over.

In many global markets, the same firms frequently confront each other as competitors in nation after nation. Coca-Cola’s rivalry with PepsiCo is a global one, as are the rivalries between Ford and Toyota; Boeing and Airbus; Caterpillar and Komatsu in earthmoving equipment; General Electric and Rolls-Royce in aero engines; and Sony, Nintendo, and Microsoft in video-game consoles. If a firm moves into a nation not currently served by its rivals, many of those rivals are sure to follow to prevent their competitor from gaining an advantage.8 As firms follow each other around the world, they bring with them many of the assets that served them well in other national markets—their products, operating strategies, marketing strategies, and brand names—creating some homogeneity across markets. Thus, greater uniformity replaces diversity. In an increasing number of industries, it is no longer meaningful to talk about “the German market,” “the American market,” “the Brazilian mar- ket,” or “the Japanese market”; for many firms there is only the global market.

THE GLOBALIZATION OF PRODUCTION The globalization of pro- duction refers to the sourcing of goods and services from locations around the globe to take advantage of national differences in the cost and quality of factors of production (such as labor, energy, land, and capital). By doing this, companies hope to lower their overall cost structure or improve the quality or functionality of their product offering, thereby allowing

Globalization of Production Trend by individual firms to disperse parts of their productive processes to different locations around the globe to take advantage of differences in cost and quality of factors of production.

Factors of Production Inputs into the productive process of a firm, including labor, management, land, capital, and technological know-how.

International Business Resources

globalEDGE offers the latest and most comprehensive international business and trade content for a wide range of topics. Whether con- ducting extensive market research, looking to improve your interna- tional knowledge, or simply browsing, you’re sure to find what you need to sharpen your competitive edge in today’s rapidly changing global marketplace. The easy, convenient, and free globalEDGE web- site’s tagline is “Your Source for Global Business Knowledge.” It was

developed and is maintained by a 30-member team in the International Business Center at Michigan State University under the supervision of Tomas Hult, Tunga Kiyak, and Sarah Singer. For example, related to Chapter 1 on globalization, take a look at the always up-to-date infor- mation on “Globalization” resources on the site at globaledge.msu.edu/ global-resources/globalization. There is even a quick guide to the world history of globalization to browse!

8 Part One Introduction and Overview

them to compete more effectively. As we saw in the opening case, Boeing has made extensive use of outsourcing to foreign suppliers. Consider Boeing’s 777: eight Japanese suppliers make parts for the fuselage, doors, and wings; a supplier in Singapore makes the doors for the nose landing gear; three suppliers in Italy manufacture wing flaps; and so on.9 In total, some 30 percent of the 777, by value, is built by foreign companies. And, for its most recent jet airliner, the 787, Boeing has pushed this trend even further; some 65 percent of the total value of the aircraft is outsourced to foreign companies, 35 percent of which goes to three major Japanese companies.

As discussed earlier, part of Boeing’s rationale for outsourcing so much production to foreign suppliers is that these suppliers are the best in the world at their particular activity. A global web of suppliers yields a better final product, which enhances the chances of Boeing winning a greater share of total orders for aircraft than its global rival, Airbus. Boeing also outsources some production to foreign countries to increase the chance that it will win significant orders from airlines based in that country. For another example of a global web of activities, consider the example of Vizio profiled in the accompanying Man- agement Focus.

Early outsourcing efforts were primarily confined to manufacturing activities, such as those undertaken by Boeing, Apple, and Vizio; increasingly, however, companies are tak- ing advantage of modern communications technology, particularly the Internet, to out- source service activities to low-cost producers in other nations. The Internet has allowed hospitals to outsource some radiology work to India, where images from MRI scans and the like are read at night while U.S. physicians sleep; the results are ready for them in the morning. Many software companies, including IBM and Microsoft, now use Indian engi- neers to perform test functions on software designed in the United States. The time dif- ference allows Indian engineers to run debugging tests on software written in the United States when U.S. engineers sleep, transmitting the corrected code back to the United States over secure Internet connections so it is ready for U.S. engineers to work on the following day. Dispersing value-creation activities in this way can compress the time and lower the costs required to develop new software programs. Other companies, from com- puter makers to banks, are outsourcing customer service functions, such as customer call centers, to developing nations where labor is cheaper. In another example from health care, workers in the Philippines transcribe American medical files (such as audio files from doctors seeking approval from insurance companies for performing a procedure). Some estimates suggest the outsourcing of many administrative procedures in health care, such as customer service and claims processing, could reduce health care costs in America by as much as $70 billion.10

Robert Reich, who served as secretary of labor in the Clinton administration, has ar- gued that as a consequence of the trend exemplified by companies such as Boeing, Apple, IBM, and Vizio, in many cases it is becoming irrelevant to talk about American products, Japanese products, German products, or Korean products. Increasingly, according to Reich, the outsourcing of productive activities to different suppliers results in the creation of products that are global in nature, that is, “global products.”11 But as with the globaliza- tion of markets, companies must be careful not to push the globalization of production too far. As we will see in later chapters, substantial impediments still make it difficult for firms to achieve the optimal dispersion of their productive activities to locations around the globe. These impediments include formal and informal barriers to trade between countries, barriers to foreign direct investment, transportation costs, issues associated with economic and political risk, and the shear managerial challenge of coordinating a globally dispersed supply chain (which was an issue for Boeing with the 787—see the opening case). For example, government regulations ultimately limit the ability of hospi- tals to outsource the process of interpreting MRI scans to developing nations where radi- ologists are cheaper.

Nevertheless, the globalization of markets and production will probably continue. Mod- ern firms are important actors in this trend, their very actions fostering increased globaliza- tion. These firms, however, are merely responding in an efficient manner to changing conditions in their operating environment—as well they should.

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.

Chapter One Globalization 9

The Emergence of Global Institutions As markets globalize and an increasing proportion of business activity transcends national borders, institutions are needed to help manage, regulate, and police the global market- place and to promote the establishment of multinational treaties to govern the global business system. Over the past half century, a number of important global institutions have been created to help perform these functions, including the General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization (WTO); the International Monetary Fund (IMF) and its sister institution, the World Bank; and the United Nations (UN). All these institutions were created by voluntary agreement between individual nation-states, and their functions are enshrined in international treaties.

General Agreement on Tariffs and Trade (GATT) International treaty that committed signatories to lowering barriers to the free flow of goods across national borders and led to the WTO.

Vizio and the Market for Flat-Panel TVs

Operating sophisticated tooling in environments that must be kept ab- solutely clean, fabrication centers in South Korea, Taiwan, and Japan produce sheets of glass twice as large as king-size beds to exacting specifications. From there, the glass panels travel to Mexican plants located alongside the U.S. border. There, they are cut to size, combined with electronic components shipped in from Asia and the United States, assembled into finished flat-panel TVs, and loaded onto trucks bound for retail stores in the United States, where consumers spend more than $35 billion a year on flat-panel TVs.

The underlying technology for flat-panel displays was invented in the United States in the late 1960s by RCA. But after RCA and rivals Westinghouse and Xerox opted not to pursue the technology, the Japa- nese company Sharp made aggressive investments in flat-panel dis- plays. By the early 1990s, Sharp was selling the first flat-panel screens, but as the Japanese economy plunged into a decade-long recession, investment leadership shifted to South Korean companies such as Samsung. Then the 1997 Asian crisis hit Korea hard, and Taiwanese companies seized leadership. Today, Chinese companies are elbowing their way into the flat-panel display manufacturing business.

As production for flat-panel displays migrates its way around the globe to low-cost locations, there are clear winners and losers. U.S. consumers have benefited from the falling prices of flat-panel TVs and are snapping them up. Efficient manufacturers have taken advantage of globally dispersed supply chains to make and sell low-cost, high- quality, flat-panel TVs. Foremost among these has been the California- based company Vizio, founded by a Taiwanese immigrant. In just 10 years, sales of Vizio flat-panel TVs ballooned from nothing to around $3 billion by 2012. The privately held company is the largest provider to the U.S. market with an 18 to 19 percent share. Vizio, however, has reportedly fewer than 500 employees. Their focus is on final product design, sales, and customer service. Vizio outsources most of its engi- neering work, all of its manufacturing, and much of its logistics. For each of its models, Vizio assembles a team of supplier partners strung across the globe. Its 42-inch flat-panel TV, for example, contains a panel from South Korea, electronic components from China, and pro- cessors from the United States, and it is assembled in Mexico. Vizio’s managers scour the globe continually for the cheapest manufacturers of flat-panel displays and electronic components. They sell most of

their TVs to large discount retailers such as Costco and Sam’s Club. Good order visibility from retailers, coupled with tight management of global logistics, allows Vizio to turn over its inventory every three weeks, twice as fast as many of its competitors, which allows major cost savings in a business where prices are falling continually.

Sources: D. J. Lynch, “Flat Panel TVs Display Effects of Globalization,” USA Today, May 8, 2007, pp. 1B, 2B; P. Engardio and E. Woyke, “Flat Panels, Thin Margins,” BusinessWeek, February 26, 2007, p. 50; B. Womack, “Flat TV Seller Vizio Hits $600 Million in Sales, Growing,” Orange County Business Journal, September 4, 2007, pp. 1, 64; E. Taub, “Vizio’s Flat Panel Display Sales Are Anything but Flat,” The New York Times Online, May 12, 2009; and Greg Tarr, “HIS: Samsung Dusts Vizio in Q4 LCD TV Share in the U.S.,” This Week in Consumer Electronics, April 12, 2012, p. 12.

management FOCUS

Vizio’s flat-panel TVs are assembled in Mexico from components produced in many different countries.

10 Part One Introduction and Overview

The World Trade Organization (like the GATT be- fore it) is primarily responsible for policing the world trading system and making sure nation-states adhere to the rules laid down in trade treaties signed by WTO member states. As of 2013, 159 nations that collectively accounted for 98 percent of world trade were WTO mem- bers, thereby giving the organization enormous scope and influence. The WTO is also responsible for facilitating the establishment of additional multinational agreements among WTO member-states. Over its entire history, and that of the GATT before it, the WTO has promoted the lowering of barriers to cross-border trade and investment. In doing so, the WTO has been the instrument of its member-states, which have sought to create a more open global business system unencumbered by barriers to trade and investment between countries. Without an institution such as the WTO, the globalization of markets and pro- duction is unlikely to have proceeded as far as it has. How- ever, as we shall see in this chapter and in Chapter 7 when we look closely at the WTO, critics charge that the orga-

nization is usurping the national sovereignty of individual nation-states. The International Monetary Fund and the World Bank were both created in 1944 by

44 nations that met at Bretton Woods, New Hampshire. The IMF was established to main- tain order in the international monetary system; the World Bank was set up to promote economic development. In the more than six decades since their creation, both institutions have emerged as significant players in the global economy. The World Bank is the less con- troversial of the two sister institutions. It has focused on making low-interest loans to cash- strapped governments in poor nations that wish to undertake significant infrastructure investments (such as building dams or roads).

The IMF is often seen as the lender of last resort to nation-states whose economies are in turmoil and whose currencies are losing value against those of other nations. During the past two decades, for example, the IMF has lent money to the governments of trou- bled states, including Argentina, Indonesia, Mexico, Russia, South Korea, Thailand, and Turkey. More recently, the IMF has taken a proactive role in helping countries cope with some of the effects of the 2008–2009 global financial crisis. IMF loans come with strings attached, however; in return for loans, the IMF requires nation-states to adopt specific economic policies aimed at returning their troubled economies to stability and growth. These requirements have sparked controversy. Some critics charge that the IMF’s policy recommendations are often inappropriate; others maintain that by telling national gov- ernments what economic policies they must adopt, the IMF, like the WTO, is usurping the sovereignty of nation-states. We will look at the debate over the role of the IMF in Chapter 11.

The United Nations was established October 24, 1945, by 51 countries committed to preserving peace through international cooperation and collective security. Today, nearly every nation in the world belongs to the United Nations; membership now totals 193 countries. When states become members of the United Nations, they agree to accept the obligations of the UN Charter, an international treaty that establishes basic principles of international relations. According to the charter, the UN has four purposes: to maintain international peace and security, to develop friendly relations among nations, to cooper- ate in solving international problems and in promoting respect for human rights, and to be a center for harmonizing the actions of nations. Although the UN is perhaps best known for its peacekeeping role, one of the organization’s central mandates is the pro- motion of higher standards of living, full employment, and conditions of economic and social progress and development—all issues that are central to the creation of a vibrant global economy. As much as 70 percent of the work of the UN system is devoted to accomplishing this mandate. To do so, the UN works closely with other international

World Trade Organization (WTO) The organization that succeeded the General Agreement on Tariffs and Trade (GATT) as a result of the successful completion of the Uruguay Round of GATT negotiations.

International Monetary Fund (IMF) International institution set up to maintain order in the international monetary system.

World Bank International institution set up to promote general economic development in the world’s poorer nations.

United Nations An international organization made up of 193 countries headquartered in New York City, formed in 1945 to promote peace, security, and cooperation.

Can the International Court of Justice Be Effective? The International Court of Justice (www.icj-cij.org) is the princi- pal judicial organ of the United Nations (UN). Of the six principal organs of the UN, it is the only one not located in New York (United States); instead, the seat of the Court is at the Peace Palace in The Hague (Netherlands). The Court’s role is to settle, in accordance with international law, legal disputes submitted to it by countries and to give advisory opinions on legal questions referred to it by authorized United Nations organs and special- ized agencies. But, how effective can the UN International Court of Justice really be in the global marketplace with its many legal systems?

Source: www.icj-cij.org/court.

Chapter One Globalization 11

institutions such as the World Bank. Guiding the work is the belief that eradicating poverty and improving the well-being of people everywhere are necessary steps in creating conditions for lasting world peace.12

Another institution in the news is the Group of Twenty (G20). Established in 1999, the G20 comprises the finance ministers and central bank governors of the 19 largest economies in the world, plus representatives from the Eu- ropean Union and the European Central Bank. Collec- tively, the G20 represents 90 percent of global GDP and 80 percent of international global trade. Originally established to formulate a coordinated policy response to financial cri- ses in developing nations, in 2008 and 2009 it became the forum though which major nations attempted to launch a coordinated policy response to the global financial crisis that started in America and then rapidly spread around the world, ushering in the first serious global economic reces- sion since 1981.

Drivers of Globalization Two macro factors underlie the trend toward greater globalization.13 The first is the decline in barriers to the free flow of goods, services, and capital that has occurred since the end of World War II. The second factor is technological change, particularly the dramatic develop- ments in recent decades in communication, information processing, and transportation technologies.

DECLINING TRADE AND INVESTMENT BARRIERS During the 1920s and 1930s, many of the world’s nation-states erected formidable barriers to international trade and foreign direct investment. International trade occurs when a firm exports goods or services to consumers in another country. Foreign direct investment (FDI) occurs when a firm invests resources in business activities outside its home country. Many of the barriers to international trade took the form of high tariffs on imports of manufactured goods. The typical aim of such tariffs was to protect domestic industries from foreign competition. One consequence, however, was “beggar thy neighbor” retaliatory trade policies, with countries progressively raising trade barriers against each other. Ultimately, this depressed world de- mand and contributed to the Great Depression of the 1930s.

Having learned from this experience, the advanced industrial nations of the West com- mitted themselves after World War II to progressively reducing barriers to the free flow of goods, services, and capital among nations.14 This goal was enshrined in the General Agree- ment on Tariffs and Trade. Under the umbrella of GATT, eight rounds of negotiations among member states worked to lower barriers to the free flow of goods and services. The most recent negotiations to be completed, known as the Uruguay Round, were finalized in December 1993. The Uruguay Round further reduced trade barriers; extended GATT to cover services as well as manufactured goods; provided enhanced protection for patents, trademarks, and copyrights; and established the World Trade Organization to police the international trading system.15 Table 1.1 summarizes the impact of GATT agreements on average tariff rates for manufactured goods. As can be seen, average tariff rates have fallen significantly since 1950 and now stand at about 4 percent.

In late 2001, the WTO launched a new round of talks aimed at further liberalizing the global trade and investment framework. For this meeting, it picked the remote location of Doha in the Persian Gulf state of Qatar. At Doha, the member-states of the WTO staked out an agenda. The talks were scheduled to last three years, but, as of 2014, the talks are effectively stalled due to opposition from several key nations. The Doha agenda includes cutting tariffs on industrial goods, services, and agricultural products; phasing out subsidies

International Trade Occurs when a firm exports goods or services to consumers in another country.

Foreign Direct Investment (FDI) Direct investment in business operations in a foreign country.

Group of Twenty (G20) Established in 1999, the G20 comprises the finance ministers and central bank governors of the 19 largest economies in the world, plus representatives from the European Union and the European Central Bank.

LO 1-2 Recognize the main drivers of globalization.

How Important is the EU Among the Group of Twenty (G20)? There have been nine G20 Leaders’ Summits since they started in 2008. The Group of Twenty includes 19 prominent countries and the European Union. At the “Leaders’ Level,” following leader- ship by the United States, United Kingdom, Canada, South Korea, and France from 2008 to 2011, the more recent leadership has included three emerging markets (Mexico in 2012; Russia in 2013; Turkey in 2015) in a four-year span (with Australia the leader in 2014). G20 members represent about 85 percent of global GDP, 80 percent of global trade, and about two-thirds of the world’s population. Now, is it really right for the G20 to in- clude 19 countries and all of the EU countries, or should the EU countries be selected individually?

Source: www.g20.org/index.php/en/numeralia.

12 Part One Introduction and Overview

to agricultural producers; reducing barriers to cross-border investment; and limiting the use of antidumping laws. If the Doha talks are ever completed, the biggest gain may come from discussion on agricultural products; average agricultural tariff rates are still about 40 per- cent, and rich nations spend some $300 billion a year in subsidies to support their farm sec- tors. The world’s poorer nations have the most to gain from any reduction in agricultural tariffs and subsidies; such reforms would give them access to the markets of the developed world.16

In addition to reducing trade barriers, many countries have also been progressively re- moving restrictions to foreign direct investment. According to the United Nations, some 90 percent of the 2,700 changes made worldwide between 1992 and 2009 in the laws governing foreign direct investment created a more favorable environment for FDI.17

Such trends have been driving both the globalization of markets and the globalization of production. The lowering of barriers to international trade enables firms to view the world, rather than a single country, as their market. The lowering of trade and investment barriers also allows firms to base production at the optimal location for that activity. Thus, a firm might design a product in one country, produce component parts in two other countries, assemble the product in yet another country, and then export the finished product around the world.

According to WTO, the volume world trade in merchandised goods has grown at twice the rate of the world economy since 1950. As a consequence, by 2012 the volume of world trade was 32 times larger than in 1950, whereas the world economy was 8.9 times larger (these figures are in real terms, adjusted for inflation). This trend has continued into the modern era. Between 1992 and 2012, world trade grew at 5.3 percent per annum, whereas the world economy grew at 2.15 percent per annum after adjusting for inflation. Conse- quently, the volume of world-merchandised trade was three times larger in 2012 than it was in 1990, whereas the world economy was 1.62 times larger in real terms.18 Since the mid- 1980s, the value of international trade in services has also grown robustly and now accounts for about 19 percent of the value of all international trade. Increasingly, international trade in services has been driven by advances in communications, which allow corporations to outsource service activities to different locations around the globe. For example, many cor- porations in the developed world outsource customer service functions, from software test- ing to customer call centers, to developing nations where labor costs are lower.

The fact that the volume of world trade has been growing faster than world GDP implies several things. First, more firms are doing what Boeing does with the 777 and 787: dispers- ing parts of their production process to different locations around the globe to drive down production costs and increase product quality. Second, the economies of the world’s nation- states are becoming ever more intertwined. As trade expands, nations are becoming increas- ingly dependent on each other for important goods and services. Third, the world has become significantly wealthier since 1990. The implication is that rising trade is the engine that has helped pull the global economy along.

1.1 TABLE Average Tariff Rates on Manufactured Products as Percent of Value Sources: The 1913–1990 data are from “Who Wants to Be a Giant?” The Economist: A Survey of the Multinationals, June 24, 1995, pp. 3–4. Copyright © The Economist Books, Ltd. The 2010 data are from World Trade Organization, The World Trade Report 2011 (Geneva: WTO, 2011).

1913 1950 1990 2010

France 21% 18% 5.9% 3.9%

Germany 20 26 5.9 3.9

Italy 18 25 5.9 3.9

Japan 30 — 5.3 2.3

Holland 5 11 5.9 3.9

Sweden 20 9 4.4 3.9

Great Britain — 23 5.9 3.9

United States 44 14 4.8 3.2

Chapter One Globalization 13

Evidence also suggests that foreign direct investment is playing an increasing role in the global economy as firms increase their cross-border investments. The average yearly out- flow of FDI increased from $26.6 billion in 1975 to $1.5 trillion in 2013.19 Even though the 2013 figure was significantly below the peak of $2 billion in foreign direct investment re- corded in 2007, the long-term trends remain positive. As a result of the strong FDI flow, by 2012 the global stock of FDI was about $23.6 trillion. More than 80,000 parent companies had more than 800,000 affiliates in foreign markets that collectively employed more than 72 million people abroad and generated value accounting for about 11 percent of global GDP. The foreign affiliates of multinationals had $26 trillion in global sales, higher than the value of global exports of goods and services, which stood at close to $22.4 trillion.20

The globalization of markets and production and the resulting growth of world trade, foreign direct investment, and imports all imply that firms are finding their home markets under attack from foreign competitors. This is true in China, where U.S. companies such as Apple, General Motors, and Starbucks are expanding their presence. It is true in the United States, where Japanese automobile firms have taken market share away from General Motors and Ford over the past three decades, and it is true in Europe, where the once- dominant Dutch company Philips has seen its market share in the consumer electronics in- dustry taken by Japan’s Panasonic and Sony and Korea’s Samsung and LG. The growing integration of the world economy into a single, huge marketplace is increasing the intensity of competition in a range of manufacturing and service industries.

However, declining barriers to cross-border trade and investment cannot be taken for granted. As we shall see in subsequent chapters, demands for “protection” from foreign competitors are still often heard in countries around the world, including the United States. Although a return to the restrictive trade policies of the 1920s and 1930s is unlikely, it is not clear whether the political majority in the industrialized world favors further reductions in trade barriers. Indeed, the global financial crisis of 2008–2009 and the associated drop in global output that occurred led to more calls for trade barriers to protect jobs at home. If trade barriers decline no further, this may slow the rate of globalization of both markets and production.

THE ROLE OF TECHNOLOGICAL CHANGE The lowering of trade bar- riers made globalization of markets and production a theoretical possibility. Technological change has made it a tangible reality. Since the end of World War II, the world has seen major advances in communication, information processing, and transportation technology, including the explosive emergence of the Internet.

Microprocessors and Telecommunications Perhaps the single most impor- tant innovation has been development of the microprocessor, which enabled the explosive growth of high-power, low-cost computing, vastly increasing the amount of information that can be processed by individuals and firms. The microprocessor also underlies many recent advances in telecommunications technology. Over the past 30 years, global communications have been revolutionized by developments in satellite, optical fiber, wire- less technologies, and the Internet. These technologies rely on the microprocessor to en- code, transmit, and decode the vast amount of information that flows along these electronic highways. The cost of microprocessors continues to fall, while their power increases (a phe- nomenon known as Moore’s law, which predicts that the power of microprocessor technol- ogy doubles and its cost of production falls in half every 18 months).21

The Internet The explosive growth of the Internet since 1994 when the first web browser was introduced is the latest expression of this development. In 1990, fewer than 1 mil- lion users were connected to the Internet. By 1995, the figure had risen to 50 million. By 2012, the Internet had 2.4 billion users.22 The Internet has developed into the information backbone of the global economy. In North America alone, e-commerce retail sales reached $365 billion in 2012 (up from almost nothing in 1998), while global e-commerce sales surpassed $1 trillion for the first time in 2012.23 Viewed globally, the Internet has emerged as an equalizer. It rolls

Moore’s Law The power of microprocessor technology doubles and its costs of production fall in half every 18 months.

Commercial jet travel has reduced the time needed to get from one location to another, effectively shrinking the globe.

14 Part One Introduction and Overview

back some of the constraints of location, scale, and time zones.24 The Internet makes it much easier for buyers and sellers to find each other, wherever they may be located and whatever their size. It allows businesses, both small and large, to expand their global presence at a lower cost than ever before. Just as important, it enables enterprises to coordinate and control a globally dispersed production system in a way that was not possible 25 years ago.

Transportation Technology In addition to developments in communications tech- nology, several major innovations in transportation technology have occurred since World War II. In economic terms, the most important are probably the development of commer- cial jet aircraft and superfreighters and the introduction of containerization, which simplifies transshipment from one mode of transport to another. The advent of commercial jet travel, by reducing the time needed to get from one location to another, has effectively shrunk the globe. In terms of travel time, New York is now “closer” to Tokyo than it was to Philadelphia in the colonial days.

Containerization has revolutionized the transportation business, significantly lowering the costs of shipping goods over long distances. Because the international shipping industry is re- sponsible for carrying about 90 percent of the volume of world trade in goods, this has been an extremely important development.25 Before the advent of containerization, moving goods from one mode of transport to another was very labor intensive, lengthy, and costly. It could take days and several hundred longshoremen to unload a ship and reload goods onto trucks and trains. With the advent of widespread containerization in the 1970s and 1980s, the whole process can now be executed by a handful of longshoremen in a couple of days. As a result of the efficiency gains associated with containerization, transportation costs have plummeted, making it much more economical to ship goods around the globe, thereby helping drive the globalization of markets and production. Between 1920 and 1990, the average ocean freight and port charges per ton of U.S. export and import cargo fell from $95 to $29 (in 1990 dol- lars).26 Today, the typical cost of transporting a 20-foot container from Asia to Europe carrying more than 20 tons of cargo is about the same as the economy airfare for a single passenger on the same journey. As a result, in 2012 the shipping cost of a $700 TV set was just $10 and that of a $150 vacuum cleaner just $1.27 The cost of shipping freight per ton-mile on railroads in the United States also fell from 3.04 cents in 1985 to 2.3 cents in 2000, largely as a result of efficiency gains from the widespread use of containers.28 An increased share of cargo now goes by air. Between 1955 and 1999, average air transportation revenue per ton-kilometer fell by more than 80 percent.29 Reflecting the falling cost of airfreight, by the early 2000s air ship- ments accounted for 28 percent of the value of U.S. trade, up from 7 percent in 1965.30

Implications for the Globalization of Production As transportation costs associated with the globalization of production have declined, dispersal of production to geo- graphically separate locations has become more economical. As a result of the technological innovations discussed earlier, the real costs of information processing and communication have fallen dramatically in the past two decades. These developments make it possible for a firm to create and then manage a globally dispersed production system, further facilitating the globalization of production. A worldwide communications network has become essential for many international businesses. For example, Dell uses the Internet to coordinate and control a globally dispersed production system to such an extent that it holds only three days’ worth of inventory at its assembly locations. Dell’s Internet-based system records or- ders for computer equipment as they are submitted by customers via the company’s website and then immediately transmits the resulting orders for components to various suppliers around the world, which have a real-time look at Dell’s order flow and can adjust their pro- duction schedules accordingly. Given the low cost of airfreight, Dell can use air transporta- tion to speed up the delivery of critical components to meet unanticipated demand shifts without delaying the shipment of final product to consumers. Dell has also used modern communications technology to outsource its customer service operations to India. When U.S. customers call Dell with a service inquiry, they are routed to Bangalore in India, where English-speaking service personnel handle the call.

Chapter One Globalization 15

Implications for the Globalization of Markets In addition to the globaliza- tion of production, technological innovations have facilitated the globalization of markets. Low-cost global communications networks, including those built on top of the Internet, are helping to create electronic global marketplaces. As noted earlier, low-cost transportation has made it more economical to ship products around the world, thereby helping create global markets. In addition, low-cost jet travel has resulted in the mass movement of people between countries. This has reduced the cultural distance between countries and is bringing about some convergence of consumer tastes and preferences. At the same time, global com- munications networks and global media are creating a worldwide culture. U.S. television networks such as CNN, MTV, and HBO are now received in many countries, Hollywood films are shown the world over, while non-U.S. news networks such as the BBC and Al Jazeera also have a global footprint. In any society, the media are primary conveyors of cul- ture; as global media develop, we must expect the evolution of something akin to a global culture. A logical result of this evolution is the emergence of global markets for consumer products. Clear signs of this are apparent. It is now as easy to find a McDonald’s restaurant in Tokyo as it is in New York, to buy an iPad in Rio as it is in Berlin, and to buy Gap jeans in Paris as it is in San Francisco.

Despite these trends, we must be careful not to overemphasize their importance. While modern communications and transportation technologies are ushering in the “global village,” significant national differences remain in culture, consumer preferences, and business practices. A firm that ignores differences among countries does so at its peril. We shall stress this point repeatedly throughout this text and elaborate on it in later chapters.

The Changing Demographics of the Global Economy Hand in hand with the trend toward globalization has been a fairly dramatic change in the demographics of the global economy over the past 30 years. As late as the 1960s, four styl- ized facts described the demographics of the global economy. The first was U.S. dominance in the world economy and world trade picture. The second was U.S. dominance in world foreign direct investment. Related to this, the third fact was the dominance of large, multi- national U.S. firms on the international business scene. The fourth was that roughly half the globe—the centrally planned economies of the communist world—was off-limits to West- ern international businesses. As will be explained here, all four of these qualities either have changed or are now changing rapidly.

THE CHANGING WORLD OUTPUT AND WORLD TRADE PICTURE In the early 1960s, the United States was still by far the world’s dominant industrial power. In 1960, the United States accounted for 38.3 percent of world output, measured by gross domestic product (GDP). By 2012, the United States accounted for 23.1 percent of world output, still the world’s largest industrial power but down significantly in relative size (see Table 1.2). Nor was the United States the only developed nation to see its relative standing slip. The same occurred to Germany, France, and the United Kingdom—all nations that were among the first to industrialize. This change in the U.S. position was not an absolute decline because the U.S. economy grew significantly between 1960 and 2012 (the econo- mies of Germany, France, and the United Kingdom also grew during this time). Rather, it was a relative decline, reflecting the faster economic growth of several other economies, particularly in Asia. For example, as can be seen from Table 1.2, from 1960 to 2012, China’s share of world output increased from a trivial amount to 10.8 percent, making it the world’s second-largest economy. Other countries that markedly increased their share of world out- put included Japan, Thailand, Malaysia, Taiwan, Brazil, and South Korea.

By the end of the 1980s, the U.S. position as the world’s leading trading nation was threatened. Over the past 30 years, U.S. dominance in export markets has waned as Japan,

LO 1-3 Describe the changing nature of the global economy.

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.

16 Part One Introduction and Overview

Germany, and a number of newly industrialized countries such as South Korea and China have taken a larger share of world exports. During the 1960s, the United States routinely accounted for 20 percent of world exports of manufactured goods. But as Table 1.2 shows, the U.S. share of world exports of goods and services had slipped to 8.7 percent by 2012, behind that of China.

As emerging economies such as China, India, Russia, and Brazil continue to grow, a fur- ther relative decline in the share of world output and world exports accounted for by the United States and other long-established developed nations seems likely. By itself, this is not bad. The relative decline of the United States reflects the growing economic development and industrialization of the world economy, as opposed to any absolute decline in the health of the U.S. economy.

Most forecasts now predict a rapid rise in the share of world output accounted for by developing nations such as China, India, Russia, Indonesia, Thailand, South Korea, Mexico, and Brazil, and a commensurate decline in the share enjoyed by rich industrial- ized countries such as Great Britain, Germany, Japan, and the United States. If current trends continue, the Chinese economy could ultimately be larger than that of the United States on a purchasing power parity basis, while the economy of India will approach that of Germany. The World Bank has estimated that today’s developing nations may account for more than 60 percent of world economic activity by 2020, while today’s rich nations, which currently account for more than 55 percent of world economic activity, may account for only about 38 percent. Forecasts are not always correct, but these suggest that a shift in the economic geography of the world is now under way, although the magnitude of that shift is not totally evident. For international businesses, the implications of this changing economic geography are clear: Many of tomorrow’s economic opportunities may be found in the developing nations of the world, and many of tomorrow’s most capable competitors will probably also emerge from these regions. A case in point has been the dramatic expansion of India’s software sector, which is profiled in the accompa- nying Country Focus.

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.

1.2 TABLE The Changing Demographics of World Output and Trade Sources: Output data from World Bank database, February 2014. Trade data from WTO Statistical Database, 2014.

Country

Share of World Output, 1960 (%)

Share of World Output, 2012 (%)

Share of World Exports, 2012 (%)

United States 38.3 23.1 8.7

Germany 8.7 5.1 7.9

France 4.6 3.8 3.2

Italy 3.0 2.9 2.8

United Kingdom 5.3 3.4 2.6

Canada 3.0 2.5 2.5

Japan 3.3 8.5 4.6

China NA 10.8 11.5

Chapter One Globalization 17

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 cur- rency 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 ex- ecutives believed that an increasingly strong Japanese yen would price Japanese automobile exports out of foreign markets; therefore, production in the most important foreign mar- kets, as opposed to exports from Japan, made sense. Toyota also undertook these invest- ments 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 ac- counted for 18.9 percent of the stock of foreign direct investment, up from around 1 percent

Stock of Foreign Direct Investment The total accumulated value of foreign- owned assets at a given time.

India’s Software Sector

Some 25 years ago, a number of small software enterprises were established in Bangalore, India. Typical of these enterprises was In- fosys Technologies, which was started by seven Indian entrepre- neurs 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 bil- lion 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 tal- ent. Every year, Indian universities graduate some 400,000 engi- neers. 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 lead- ing 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. Mi- crosoft, too, has made major investments in India, including a research and development (R&D) center in Hyderabad that employs 4,000 peo- ple and was located there specifically to tap into talented Indian engi- neers 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.

country FOCUS

18 Part One Introduction and Overview

in 1980. Firms based in Hong Kong, South Korea, Singapore, Taiwan, India, Brazil, and mainland China accounted for much of this investment.

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 impor- tance 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.

1.1 FIGURE Percentage Share of Total FDI Stock, 1980–2012

19901980 2000 2012

45 40 35 30 25 20 15 10 5 0

Un ite

d St

ate s

Un ite

Kin gd

om Ja pa

Ge rm

an y

Fr an

Ne the

rla nd

De ve

lop ing

Ec on

om ies

1.2 FIGURE FDI Inflows, 1980–2012

2,500

2,000

1,500

1,000

500

19 88

–9 3

19 94

19 95

19 96

19 97

19 98

19 99

20 00

20 01

20 02

20 03

20 04

20 05

20 09

20 10

20 08

20 12

20 11

20 06

20 07

Developed Countries Developing Countries

$ b

ill io

Chapter One Globalization 19

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 multina- tional enterprise have been (1) the rise of non-U.S. multinationals and (2) the growth of mini-multinationals.

Non-U.S. Multinationals In the 1960s, global business activity was dominated by large U.S. multinational corporations. With U.S. firms accounting for about two-thirds of foreign direct investment during the 1960s, one would expect most multinationals to be U.S. enterprises. According to the data summarized in Figure 1.3, 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 domi- nance 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 larg- est 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 mar- kets, further shifting the axis of the world economy away from North America and west- ern 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

Multinational Enterprise (MNE) A firm that owns business operations in more than one country.

1.3 FIGURE National Share of Largest Mulinationals, 1973 and 2012

United States

Japan United Kingdom

France Germany Other

1973 2012

20 Part One Introduction and Overview

think of international businesses, they tend to think of firms such as ExxonMobil, General Motors, Ford, Pana- sonic, 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 increas- ingly involved in international trade and investment. The rise of the Internet is lowering the barriers that small firms face in building international sales.

Consider Lubricating Systems Inc. of Kent, Washington. Lubricating Systems, which manufactures lubricating fluids for machine tools, employs 25 people and generates sales of $6.5 million. It’s hardly a large, complex multina- tional, 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.

THE CHANGING WORLD ORDER Between 1989 and 1991, a series of dem- ocratic 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 it- self 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 commit- ment 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 commit- ment 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 sup- pressed its own pro-democracy movement in the bloody Tiananmen Square massacre of 1989. Despite this, China continues to move progressively toward greater free market re- forms. 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.

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 lever- aged 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 sat- isfying the needs of customers with slight or significant differ- ences across the globe. In the future, we may be loking for similarities first, and then focusing on the similarities that out- weigh 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.

Chapter One Globalization 21

The 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 man- aged 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 in- vestment 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 for- eign 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.

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 Fac- tory, 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 wire- less phones, 6 million refrigerators, and 1 million personal computers. International sales accounted for more than 15 percent of total reve- nue. The company had established overseas manufacturing subsidiar- ies 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 enter- prise with a world-class consumer brand. Although it is without ques- tion 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 busi- ness. 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 pro- cessing 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

management FOCUS

22 Part One Introduction and Overview

THE GLOBAL ECONOMY OF THE TWENTY-FIRST CENTURY As discussed, the past quarter-century has seen rapid changes in the global economy. Barri- ers to the free flow of goods, services, and capital have been coming down. As their econo- mies 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 ship- building 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 coun- tries 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 interna- tional 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 per- manent 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 demon- strated 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 re- gion 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.

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 ar- gue 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 ac- tive, 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 de- bate concerning the merits of globalization. In later chapters, we elaborate on many of these points.

LO 1-4 Explain the main arguments in the debate over the impact of globalization.

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.

Chapter One Globalization 23

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 indus- tries under attack from foreign competitors, downward pressure on the wage rates of un- skilled 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 pre- pared 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 restau- rant 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 politi- cians 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 bar- riers of time and distance, and vast differences in economic institutions, political institu- tions, 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 com- plaints are heard from the citizens of those countries, who welcome the higher living stan- dards that progress brings.

GLOBALIZATION, JOBS, AND INCOME One concern frequently voiced by globalization opponents is that falling barriers to international trade destroy manufac- turing 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 popula- tion 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,

24 Part One Introduction and Overview

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 con- struction, 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 be- cause of fears that it might lead to health problems (although EU scien- tists 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 Mon- davi project had become the major issue. He was replaced by a com- munist, 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 associ- ated 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 multina- tionals account for about 8 percent of the global stock of foreign di- rect 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).

country FOCUS

cite the case of Harwood Industries, a U.S. clothing manufacturer that closed its U.S. opera- tions, 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.

In the past few years, the same fears have been applied to services, which have increas- ingly 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 for- eign 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 call- ing 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 pro- duce 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

Chapter One Globalization 25

produce 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 consum- ers 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 phar- maceuticals 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 un- skilled 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 seg- ments 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

26 Part One Introduction and Overview

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 de- mand 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 short- age 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 increas- ing 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 envi- ronmental and labor regulations.57 Because free trade enables developing countries to in- crease 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 popula- tion 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 per- cent 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 rela- tionship 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

Chapter One Globalization 27

then fall. A seminal study by Grossman and Krueger found that the turning point generally occurred before per capita income levels reached $8,000.60

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 reduc- ing 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 diox- ide, 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 acknowl- edge, 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 devel- oped countries. NAFTA, for example, was passed only after side agreements had been nego- tiated 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 produc- tion 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 con- cern voiced by critics of globalization is that today’s increasingly interdependent global economy shifts economic power away from national governments and toward supranational

1.4 FIGURE Income Levels and Environmental Pollution

P o

llu ti

o n

Le ve

$8,000 Income per Capita

Other Pollutants

Carbon Dioxide Emissions

28 Part One Introduction and Overview

organizations such as the World Trade Organization, the European Union, and the United Nations. As perceived by critics, unelected bureaucrats now impose policies on the demo- cratically 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 supra- national 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 peri- ods 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 globaliza- tion 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 popula- tions 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

Chapter One Globalization 29

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 in- hibits 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 restruc- ture 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 establish- ment 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 re- lief 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 devel- oped 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

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 coun- tries. As the world shifts toward a truly integrated global economy, more firms—both large and small—are becoming international businesses. What does this shift toward a global economy mean for managers within an international business?

As their organizations increasingly engage in cross-border trade and investment, managers need to recognize that the task of managing an international business differs from that of manag- ing 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 sys- tems, 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 coun- try by country. Marketing a product in Brazil may require a different approach from market- ing 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

LO 1-5 Understand how the process of globalization is creating opportunities and challenges for business managers.

International Business Any firm that engages in international trade or investment.

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30 Part One Introduction and Overview

may be very important in Mexico and irrelevant in Great Britain; the business strategy pur- sued 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 poli- cies 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 manag- ers 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 pro- duce 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 busi- ness 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 de- velop 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 in- crease 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 con- fronted 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 interna- tional business must find ways to work within the limits imposed by government interven- tion 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 institu- tions. 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 interna- tional 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 com- pete more effectively in today’s rapidly emerging global economy.

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Chapter One Globalization 31

globalization, p. 6 globalization of markets, p. 6 globalization of production, p. 7 factors of production, p. 7 General Agreement on Tariffs and Trade (GATT), p. 9

World Trade Organization (WTO), p. 10 International Monetary Fund (IMF), p. 10 World Bank, p. 10 United Nations, p. 10 Group of Twenty (G20), p. 11 international trade, p. 11

foreign direct investment (FDI), p. 11 Moore’s law, p. 13 stock of foreign direct investment, p. 17 multinational enterprise (MNE), p. 19 international business, p. 29

Key Terms

Summary

This chapter has shown how the world economy is becom- ing more global and reviewed the main drivers of global- ization, 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 con- cerns raised by rapid globalization, and reviewed implica- tions 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 globali- zation: declining trade barriers and changes in commu- nication, 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 signif- icantly. 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.

Critical 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?

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.

Research Task http://globalEDGE.msu.edu

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 Ma- cintosh computer back in 1983, Steve Jobs bragged that it was “a ma- chine 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 man- ufacturing 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,

ccccccllooooooossssiinnnnnnggggggggggg ccccccaaaasssssssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeeWho Makes the Apple iPhone?

32 Part One Introduction and Overview

the 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 engi- neering, and marketing. Furthermore, Apple claims that its business sup- ports 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 Fox- conn’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.”

All this being said, there are drawbacks to outsourcing to China. Several of Apple’s subcontractors have been targeted for their poor working condi- tions. 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 com- pany; 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?

Foxconn employees assemble electronic components in China.

Chapter One Globalization 33

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 Administra- tion, “U.S. Exporters in 2011: A Statistical Overview,” July 29, 2013.

34 Part One Introduction and Overview

6. C. M. Draffen, “Going Global: Export Market Proves Profit- able 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 Multina- tional 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,” Interna- tional 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 Pu- tin’s Allies Are Turning Russia into a Corporate State,” Finan- cial 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, Export- ing 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 Globaliza- tion on Income Distribution?” World Bank Economic Review 19 (2005), pp. 21–44. Also see the summary in “The Global- ization 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.

49. M. Forster and M. Pearson, “Income Distribution and Pov- erty in the OECD Area,” OECD Economic Studies 34 (2002); Moffett, “Income Inequality Increases”; and OECD, “Grow- ing 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. Gold- smith (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, Princ- eton, 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 Be-

come Heavily Indebted?” World Development, October 2002, pp. 1677–96; and J. Sachs, The End of Poverty (New York, Pen- guin 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).

Chapter One Globalization 35

p a

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2 N

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fe re

n c

e s

2-1 Understand how the political systems of countries differ.

2-2 Understand how the economic systems of countries differ.

2-3 Understand how the legal systems of countries differ.

2-4 Explain the implications for management practice of national differences in political economy.

learning objectives

2c h

a pt

opening case

that—in hindsight—had the ability to subvert the democratic process. On the economic front, the privatiza-

tion of many state-owned enterprises was done in such a way as to leave large shareholdings in the hands

of the politically connected, many of whom were party officials and factory managers under the old Soviet

system. Corruption was also endemic, and organized crime was able to seize control of some newly priva-

tized enterprises. In 1998, the poorly managed Russian economy went through a financial crisis that nearly

bought the country to its knees.

Fast-forward to 2014, and Russia still has a long way to go before it resembles a modern democracy with

a functioning free market–based economic system. On the positive side, the economy grew at a healthy

clip during most of the 2000s, helped in large part by high prices for oil and gas, Russia’s largest exports

(in 2013 oil and gas accounted for 75 percent of all Russian exports). Between 2000 and 2013, Russia’s

gross domestic product (GDP) per capita more than doubled when measured by purchasing power parity.

The country now boasts the world’s seventh largest economy. Thanks to government oil revenues, public

debt is also low by international standards—at just 7.7 percent of GDP (in the United States, by comparison,

public debt amounts to 70 percent of GDP). Russia has been running a healthy trade surplus on the back

of strong oil and gas exports.

On the other hand, the economy is overly dependent upon commodities, particularly oil and gas. If

prices should fall significantly, Russia will face major economic headwinds. In the early 2000s, oil prices

were around $20 a barrel. Today, they are hovering at $100 a barrel, after hitting a high of $140 in 2008.

Much of Russia’s oil and gas production remains in the hands of enterprises in which the state still has a

significant ownership stake. The government has a controlling ownership position in Gazprom and Rosneft,

Putin’s Russia

National Differences in Political, Economic, and Legal Systems

–continued

38 Part Two National Differences

two of the country’s largest oil and gas companies. The government used the rise in oil

and gas revenues during the last decade or so to increase public spending through

state-led investment projects and increases in wages and pensions for government

workers. While this boosted private consumption, there has been a dearth of private

investment, and productivity growth remains low. This is particularly true among many

state-owned enterprises that collectively still account for about half of the Russian

economy.

Russian private enterprises are also hamstrung by bureaucratic red tape and endemic

corruption. The World Bank ranks Russia 92nd in the world in terms of the ease of doing

business and 88th when it comes to starting a business (for comparison, the United

States is ranked 4th and 20th, respectively). Transparency International, which ranks

countries by the extent of corruption, ranked Russia 127th out of 177 nations in 2013. The

state and state-owned enterprises are famous for pushing work to private enterprises

that are owned by political allies, which further subverts market-based processes.

On the political front, Russia is, at best, a highly imperfect pseudo-democracy. Since

1999, Vladimir Putin has exerted increasingly tight control over Russian politics, either as

president or as prime minister. Under Putin, potential opponents have been sidelined,

civil liberties have been progressively reduced, and the freedom of the press has been

diminished. For example, in response to opposition protests in 2011 and 2012, the Russian

government passed laws increasing its control over the Internet, dramatically raising

fines for participating in “unsanctioned” street protests, and expanded the definition of

treason to further limit opposition activities. Vocal opponents of the régime—from

business executives who do not tow the state line to protest groups such as the punk

rock protest band Pussy Riot—have found themselves jailed on dubious charges. To make

matters worse, Putin has recently been tightening his grip on the legal system. In late

2013, Russia’s parliament, which is dominated by Putin supporters, gave the president

more power to appoint and fire prosecutors, thereby diminishing the independence of

the legal system.

Freedom House, which produces an annual ranking tracking freedom in the world,

classifies Russia as “not free” and gives it low scores for political and civil liberties.

Freedom House notes that in the March 2012 presidential elections, Putin benefited from

preferential treatment by state-owned media, numerous abuses of incumbency, and

procedural “irregularities” during the vote count. Putin won 63.6 percent of the vote

against a field of weak, hand-chosen opponents, led by Communist Party leader

Gennadiy Zyuganove, with 17.2 percent of the vote. Under a Putin-inspired 2008

constitutional amendment, the term of the presidency was expanded from four years to

six. Putin will be eligible for another six-year term in 2018.

As long as oil and gas prices remain high, Putin will probably be able to remain in

control of Russia. However, the state has expanded public spending to such an extent

over the last decade that should oil and gas prices fall significantly, Russia could very

quickly be enveloped in a financial crisis. Russia also faces the twin problems of a falling

birthrate and an aging population, which means that demands on the state to fund

pensions and health care will increase in the future, further straining government

finances. • Sources: “Putin’s Russia: Sochi or Bust,” The Economist, February 1, 2014; “Russia’s Economy: The S Word,” The Economist, November 9, 2013; Freedom House, Freedom in the World 2014: Russia, www.freedomhouse.org/report/ freedom-world/2014/; and K. Hille, “Putin Tightens Grip on Legal System,” Financial Times, November 27, 2013.

Chapter Two National Differences in Political, Economic, and Legal Systems 39

Introduction International business is much more complicated than domestic business because countries differ in many ways. Countries have different political, economic, and legal systems. They vary significantly in their level of economic development and future economic growth tra- jectory. Cultural practices can vary dramatically, as can the education and skill levels of the population. All these differences can and do have major implications for the practice of in- ternational business. They have a profound impact on the benefits, costs, and risks associ- ated with doing business in different countries; the way in which operations in different countries should be managed; and the strategy international firms should pursue in different countries. The main function of this chapter and the next two is to develop an awareness of and appreciation for the significance of country differences in political systems, economic systems, legal systems, economic development, and societal culture. Another function of the three chapters is to describe how the political, economic, legal, and cultural systems of many of the world’s nation-states are evolving and to draw out the implications of these changes for the practice of international business.

The opening case illustrates some of the issues covered in this chapter and the next. A quarter of a century ago, Russia was a communist state with a centrally planned economy. After the collapse of the Soviet Union in 1991, there were a series of reforms in Russia aimed at creating a sustainable democracy with an economic system based upon free market principles. However, as the case makes clear, under the leadership of Vladimir Putin, Russia has progressively curtailed hard-won democratic freedoms. Moreover, although the econ- omy of Putin’s Russia is a long way removed from the central planning of the Soviet era, the state not only continues to account for around 50 percent of economic activity, the govern- ment has also extended its direct and indirect control over businesses in strategically impor- tant sectors—such as oil and gas—running them, in effect, as an extension of the government. Putin has also extended his control over the legal system, gaining new powers to appoint and dismiss prosecutors. Clearly the economic, political, and legal system that now prevails in Russia is different in many respects from that which we find in many advanced and devel- oping nations around the world. As will become clear in this chapter and the next, such dif- ferences have nontrivial implications for international business.

This chapter focuses on how the political, economic, and legal systems of countries differ. Collectively, we refer to these systems as constituting the political economy of a country. We use the term political economy to stress that the political, economic, and legal systems of a country are interdependent; they interact and influence each other, and in doing so, they affect the level of economic well-being. In Chapter 3, we build on the concepts discussed here to explore in detail how differences in political, economic, and legal systems influence the economic development of a nation-state and its likely future growth trajectory. In Chap- ter 4, we look at differences in societal culture and at how these differences influence the practice of international business. Moreover, as we will see in Chapter 4, societal culture has an influence on the political, economic, and legal systems in a nation, and thus its level of economic well-being. We also discuss how the converse may also occur—how political, eco- nomic, and legal systems may also shape societal culture.

Political Economy The political, economic, and legal systems of a country.

Get Insights by Country

40 Part Two National Differences

Political Systems The political system of a country shapes its economic and legal systems.1 As such, we need to understand the nature of different political systems before discussing economic and legal systems. By political system, we mean the system of government in a nation. Political sys- tems can be assessed according to two dimensions. The first is the degree to which they emphasize collectivism as opposed to individualism. The second is the degree to which they are democratic or totalitarian. These dimensions are interrelated; systems that emphasize collectivism tend to lean toward totalitarianism, whereas those that place a high value on individualism tend to be democratic. However, a large gray area exists in the middle. It is possible to have democratic societies that emphasize a mix of collectivism and individualism. Similarly, it is possible to have totalitarian societies that are not collectivist.

COLLECTIVISM AND INDIVIDUALISM Collectivism refers to a political system that stresses the primacy of collective goals over individual goals.2 When collectiv- ism is emphasized, the needs of society as a whole are generally viewed as being more im- portant than individual freedoms. In such circumstances, an individual’s right to do something may be restricted on the grounds that it runs counter to “the good of society” or to “the common good.” Advocacy of collectivism can be traced to the ancient Greek phi- losopher Plato (427–347 b.c.), who, in The Republic, argued that individual rights should be sacrificed for the good of the majority and that property should be owned in common. Plato did not equate collectivism with equality; he believed that society should be stratified into classes, with those best suited to rule (which for Plato, naturally, were philosophers and soldiers) administering society for the benefit of all. In modern times, the collectivist mantle has been picked up by socialists.

Socialism Modern socialists trace their intellectual roots to Karl Marx (1818–1883), although socialist thought clearly predates Marx (elements of it can be traced to Plato). Marx argued that the few benefit at the expense of the many in a capitalist society where individual freedoms are not restricted. While successful capitalists accumulate considerable wealth, Marx postulated that the wages earned by the majority of workers in a capitalist so- ciety would be forced down to subsistence levels. He argued that capitalists expropriate for their own use the value created by workers, while paying workers only subsistence wages in return. According to Marx, the pay of workers does not reflect the full value of their labor. To correct this perceived wrong, Marx advocated state ownership of the basic means of pro- duction, distribution, and exchange (i.e., businesses). His logic was that if the state owned the means of production, the state could ensure that workers were fully compensated for their labor. Thus, the idea is to manage state-owned enterprise to benefit society as a whole, rather than individual capitalists.3

In the early twentieth century, the socialist ideology split into two broad camps. The Communists believed that socialism could be achieved only through violent revolution and totalitarian dictatorship, whereas the social democrats committed themselves to achieving socialism by democratic means, turning their backs on violent revolution and dictatorship. Both versions of socialism waxed and waned during the twentieth century. The communist version of socialism reached its high point in the late 1970s, when the majority of the world’s population lived in communist states. The countries under Communist Party rule at that time included the former Soviet Union; its eastern European client nations (e.g., Poland, Czechoslovakia, Hungary); China; the Southeast Asian nations of Cambodia, Laos, and Vietnam; various African nations (e.g., Angola and Mozambique); and the Latin American nations of Cuba and Nicaragua. By the mid-1990s, however, communism was in retreat worldwide. The Soviet Union had collapsed and had been replaced by a collection of 15 republics, many of which were at least nominally structured as democracies. Communism was swept out of eastern Europe by the largely bloodless revolutions of 1989. Although China is still nominally a communist state with substantial limits to individual political free- dom, in the economic sphere, the country has moved sharply away from strict adherence to

LO 2-1 Understand how the political systems of countries differ.

Political System System of government in a nation.

Collectivism A political system that emphasizes collective goals as opposed to individual goals.

Socialist Someone who believes in public ownership of the means of production for the common good of society.

Communists Those who believe socialism can be achieved only through revolution and totalitarian dictatorship.

Social Democrats Those committed to achieving socialism by democratic means.

Chapter Two National Differences in Political, Economic, and Legal Systems 41

communist ideology. Other than China, communism hangs on only in a handful of small fringe states, such as North Korea and Cuba.

Social democracy also seems to have passed a high-water mark, although the ideology may prove to be more enduring than communism. Social democracy has had perhaps its greatest influence in a number of democratic Western nations, including Australia, France, Germany, Great Britain, Norway, Spain, and Sweden, where social democratic parties have often held political power. Other countries where social democracy has had an important influence include India and Brazil. Consistent with their Marxist roots, many social demo- cratic governments after World War II nationalized private companies in certain industries, transforming them into state-owned enterprises to be run for the “public good rather than private profit.” In Great Britain by the end of the 1970s, for example, state-owned compa- nies had a monopoly in the telecommunications, electricity, gas, coal, railway, and shipbuild- ing industries, as well as substantial interests in the oil, airline, auto, and steel industries.

However, experience demonstrated that state ownership of the means of production ran counter to the public interest. In many countries, state-owned companies performed poorly. Protected from competition by their monopoly position and guaranteed government finan- cial support, many became increasingly inefficient. Individuals paid for the luxury of state ownership through higher prices and higher taxes. As a consequence, a number of Western democracies voted many social democratic parties out of office in the late 1970s and early 1980s. They were succeeded by political parties, such as Britain’s Conservative Party and Germany’s Christian Democratic Party, that were more committed to free market econom- ics. These parties sold state-owned enterprises to private investors (a process referred to as privatization). Even where social democratic parties regained the levers of power, as in Great Britain in 1997 when the left-leaning Labor Party won control of the government, they too now seem committed to continued private ownership.

Individualism The opposite of collectivism, individualism refers to a philosophy that an individual should have freedom in his or her economic and political pursuits. In contrast to collectivism, individualism stresses that the interests of the individual should take prece- dence over the interests of the state. Like collectivism, individualism can be traced to an ancient Greek philosopher, in this case Plato’s disciple Aristotle (384–322 b.c.). In contrast to Plato, Aristotle argued that individual diversity and private ownership are desirable. In a passage that might have been taken from a speech by contemporary politicians who adhere to a free market ideology, he argued that private property is more highly productive than communal property and will thus stimulate progress. According to Aristotle, communal property receives little care, whereas property that is owned by an individual will receive the greatest care and therefore be most productive.

Individualism was reborn as an influential political phi- losophy in the Protestant trading nations of England and the Netherlands during the sixteenth century. The philoso- phy was refined in the work of a number of British philoso- phers, including David Hume (1711–1776), Adam Smith (1723–1790), and John Stuart Mill (1806–1873). Individual- ism exercised a profound influence on those in the American colonies who sought independence from Great Britain. In- deed, the concept underlies the ideas expressed in the Dec- laration of Independence. In the twentieth century, several Nobel Prize–winning economists—including Milton Fried- man, Friedrich von Hayek, and James Buchanan—have championed the philosophy.

Individualism is built on two central tenets. The first is an emphasis on the importance of guaranteeing individual freedom and self-expression. The second tenet of individu- alism is that the welfare of society is best served by letting people pursue their own economic self-interest, as opposed to some collective body (such as government) dictating

Privatization The sale of state-owned enterprises to private investors.

Individualism An emphasis on the importance of guaranteeing individual freedom and self-expression.

What About People’s Future Rights? Individualism versus collectivism is a century-old debate topic and an inherently interesting issue. For example, does an individual’s life belong to him or her or to the community, society, or country in which he or she resides? Most people have a direct and immedi- ate answer, but it is not a consensus on which answer depending on which country you reside in or which personal “compass” you subscribe to. Everyone has tendencies toward being both indi- vidualistic and collectivistic but prefers one way more than the other. So, which of these ideas—individualism or collectivism— do you think is correct, and which cultural belief do you prefer and why?

Source: www.theobjectivestandard.com, accessed March 3, 2014.

42 Part Two National Differences

what is in society’s best interest. Or, as Adam Smith put it in a famous passage from The Wealth of Nations, an individual who intends his own gain is led by an invisible hand to pro- mote an end that was no part of his intention. Nor is it always worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. This author has never known much good done by those who effect to trade for the public good.4

The central message of individualism, therefore, is that individual economic and political freedoms are the ground rules on which a society should be based. This puts individualism in conflict with collectivism. Collectivism asserts the primacy of the collective over the indi- vidual; individualism asserts the opposite. This underlying ideological conflict shaped much of the recent history of the world. The Cold War, for example, was in many respects a war between collectivism, championed by the former Soviet Union, and individualism, champi- oned by the United States. From the late 1980s until about 2005, the waning of collectivism was matched by the ascendancy of individualism. Democratic ideals and market economics replaced socialism and communism in many states. Since 2005, there have been some signs

Venezuela under Hugo Chávez, 1999–2013

On March 5, 2013, Hugo Chávez, the president of Venezuela, died after losing a battle against cancer. Chávez had been president of Venezuela since 1999. A former military officer who was once jailed for engineer- ing a failed coup attempt, Chávez was a self-styled democratic social- ist who won the presidential election by campaigning against corruption, economic mismanagement, and the “harsh realities” of global capitalism. When he took office in February 1999, Chávez claimed he had inherited the worst economic situation in the coun- try’s recent history. He wasn’t far off the mark. A collapse in the price of oil, which accounted for 70 percent of the country’s exports, left Venezuela with a large budget deficit and forced the economy into a deep recession.

Soon after taking office, Chávez worked to consolidate his hold over the apparatus of government. By 2012, Freedom House, which annually assesses political and civil liberties worldwide, concluded Venezuela was only “partly free” and that freedoms were being pro- gressively curtailed.

On the economic front, things remained rough. The economy shrank in the early 2000s, while unemployment remained persistently high (at 15 to 17 percent) and the poverty rate rose to more than 50 percent of the population. A 2003 study by the World Bank concluded Venezuela was one of the most regulated economies in the world and that state controls over business activities gave public officials ample opportunities to enrich themselves by demanding bribes in return for permission to expand operations or enter new lines of business. In- deed, despite Chávez’s anticorruption rhetoric, Transparency Interna- tional, which ranks the world’s nations according to the extent of public corruption, noted that corruption increased under Chávez. In 2012, Transparency International ranked Venezuela 165th out of 174 nations in terms of level of corruption. Consistent with his socialist rhetoric, Chávez progressively took various enterprises into state ownership and required that other enterprises be restructured as “workers’ coopera- tives” in return for government loans. In addition, the government has taken over large rural farms and ranches that Chávez claimed were not sufficiently productive and turned them into state-owned cooperatives.

Riding a wave of popularity at home, in December 2006 Chávez won reelection as president. He celebrated his victory by stepping on the revolutionary accelerator. Parliament gave him the power to legis- late by decree for 18 months. In late 2010, Chávez yet again persuaded the National Assembly, where his supporters dominated, to once more grant him the power to rule by decree for another 18 months.

Notwithstanding his ability to consolidate political power, on the eco- nomic front Venezuela’s performance under Chávez was decidedly mixed. His main achievements were to reduce poverty, which fell from 50 percent to 28 percent by 2012, and to bring down unemployment from 14.5 percent at the start of his rule to 7.6 percent in February 2013. State-owned enterprises helped Chávez achieve both these goals.

However, despite strong global demand and massive reserves, oil production in Venezuela fell by a third between 2000 and 2012 as for- eign oil companies exited the country. Inflation surged and was running at around 28 percent per annum between 2008 and 2012, one of the highest rates in the world. To compound matters, the budget deficit expanded to 17 percent of GDP in 2012 as the government spent heav- ily to support its social programs and various subsidies.

Sources: D. Luhnow and P. Millard, “Chavez Plans to Take More Control of Oil away from Foreign Firms,” The Wall Street Journal, April 24, 2006, p. A1; R. Gallego, “Chavez’s Agenda Takes Shape,” The Wall Street Journal, December 27, 2005, p. A12; “The Sickly Stench of Corruption: Venezuela,” The Economist, April 1, 2006, p. 50; “Chavez Squeezes the Oil Firms,” The Economist, November 12, 2005, p. 61; “Glimpsing the Bottom of the Barrel: Venezuela,” The Economist, February 3, 2007, p. 51; “The Wind Goes Out of the Revolution—Defeat for Hugo Chavez,” The Economist, December 8, 2007, pp. 30–32; “Oil Leak,” The Economist, February 26, 2011, p. 43; “Medieval Policies,” The Economist, August 8, 2011, p. 38; and “Now for the Reckoning,” The Economist, May 5, 2013.

country FOCUS

Chapter Two National Differences in Political, Economic, and Legal Systems 43

of a swing back toward left-leaning socialist ideas in several countries, including several Latin America nations such as Venezuela, Bolivia, and Paraguay, along with Russia (see the accompanying Country Focus, which details what has been occurring in Venezuela). Also, the global financial crisis of 2008–2009 may cause some reevaluation of the trends of the past two decades, and the pendulum might tilt back the other way for a while.

DEMOCRACY AND TOTALITARIANISM Democracy and totalitarianism are at different ends of a po- litical dimension. Democracy refers to a political system in which government is by the people, exercised either directly or through elected representatives. Totalitarianism is a form of government in which one person or political party exer- cises absolute control over all spheres of human life and pro- hibits opposing political parties. The democratic–totalitarian dimension is not independent of the individualism–collectiv- ism dimension. Democracy and individualism go hand in hand, as do the communist version of collectivism and totali- tarianism. However, gray areas exist; it is possible to have a democratic state in which collective values predominate, and it is possible to have a totalitarian state that is hostile to collectivism and in which some de- gree of individualism—particularly in the economic sphere—is encouraged. For example, China has seen a move toward greater individual freedom in the economic sphere, but the country is still ruled by a totalitarian dictatorship that constrains political freedom.

Democracy The pure form of democracy, as originally practiced by several city-states in ancient Greece, is based on a belief that citizens should be directly involved in decision making. In complex, advanced societies with populations in the tens or hundreds of millions, this is impractical. Most modern democratic states practice representative democracy. In a representative democracy, citizens periodically elect individuals to represent them. These elected representatives then form a government, whose function is to make decisions on behalf of the electorate. In a representative democracy, elected representatives who fail to perform this job adequately will be voted out of office at the next election.

To guarantee that elected representatives can be held accountable for their actions by the electorate, an ideal representative democracy has a number of safeguards that are typi- cally enshrined in constitutional law. These include (1) an individual’s right to freedom of expression, opinion, and organization; (2) a free media; (3) regular elections in which all eligible citizens are allowed to vote; (4) universal adult suffrage; (5) limited terms for elected representatives; (6) a fair court system that is independent from the political sys- tem; (7) a nonpolitical state bureaucracy; (8) a nonpolitical police force and armed service; and (9) relatively free access to state information.5

Totalitarianism In a totalitarian country, all the constitutional guarantees on which representative democracies are built—an individual’s right to freedom of expression and organization, a free media, and regular elections—are denied to the citizens. In most totali- tarian states, political repression is widespread, free and fair elections are lacking, media are heavily censored, basic civil liberties are denied, and those who question the right of the rulers to rule find themselves imprisoned, or worse.

Four major forms of totalitarianism exist in the world today. Until recently, the most widespread was communist totalitarianism. Communism, however, is in decline world- wide, and most of the Communist Party dictatorships have collapsed since 1989. Exceptions to this trend (so far) are China, Vietnam, Laos, North Korea, and Cuba, although most of these states exhibit clear signs that the Communist Party’s monopoly on political power is

Democracy Political system in which government is by the people, exercised either directly or through elected representatives.

Totalitarianism Form of government in which one person or political party exercises absolute control over all spheres of human life and opposing political parties are prohibited.

Representative Democracy A political system in which citizens periodically elect individuals to represent them in government.

Communist Totalitarianism A version of collectivism advocating that socialism can be achieved only through a totalitarian dictatorship.

Is Representative Democracy the Best Way? Chile is a country in South America that borders the South Pacific Sea. Neighboring countries include Argentina, Bolivia, and Peru— also representative democracies. Chile has a strategic location relative to sealanes between the Atlantic and Pacific Oceans, in- cluding the Strait of Magellan, the Beagle Channel, and the Drake Passage. Chile has a market-oriented economy in which the prices of goods and services are determined in a free price sys- tem. The government system is a republic (and it returned to a democracy in 1990). The chief of state and head of government is the president. Presidential and congressional elections are held periodically, with each election since the post-Pinochet era (which ended in 1988) being viewed as free and fair. How often do you believe elections should be held for the head of state?

Source: http://globalEDGE.msu.edu/countries/chile/government.

44 Part Two National Differences

retreating. In many respects, the governments of China, Vietnam, and Laos are communist in name only because those nations have adopted wide-ranging, market-based economic reforms. They remain, however, totalitarian states that deny many basic civil liberties to their populations. On the other hand, there are signs of a swing back toward communist totalitarian ideas in some states, such as Venezuela, where the late Hugo Chávez’s govern- ment displayed totalitarian tendencies (see the Country Focus).

A second form of totalitarianism might be labeled theocratic totalitarianism. Theo- cratic totalitarianism is found in states where political power is monopolized by a party, group, or individual that governs according to religious principles. The most common form of theocratic totalitarianism is based on Islam and is exemplified by states such as Iran and Saudi Arabia. These states limit freedom of political and religious expression with laws based on Islamic principles.

A third form of totalitarianism might be referred to as tribal totalitarianism. Tribal totalitarianism has arisen from time to time in African countries such as Zimbabwe, Tanzania, Uganda, and Kenya. The borders of most African states reflect the administrative boundar- ies drawn by the old European colonial powers rather than tribal realities. Consequently, the typical African country contains a number of tribes (e.g., in Kenya there are more than 40 tribes). Tribal totalitarianism occurs when a political party that represents the interests of a particular tribe (and not always the majority tribe) monopolizes power. In Kenya, for ex- ample, politicians from the Kikuyu tribe long dominated the political system.

A fourth major form of totalitarianism might be described as right-wing totalitarianism. Right-wing totalitarianism generally permits some individual economic freedom but re- stricts individual political freedom, frequently on the grounds that it would lead to the rise of communism. A common feature of many right-wing dictatorships is an overt hostility to socialist or communist ideas. Many right-wing totalitarian governments are backed by the military, and in some cases, the government may be made up of military officers. The fascist regimes that ruled Germany and Italy in the 1930s and 1940s were right-wing totalitarian states. Until the early 1980s, right-wing dictatorships, many of which were military dictator- ships, were common throughout Latin America. They were also found in several Asian countries, particularly South Korea, Taiwan, Singapore, Indonesia, and the Philippines. Since the early 1980s, however, this form of government has been in retreat. Most Latin American countries are now genuine multiparty democracies. Similarly, South Korea, Taiwan, and the Philippines have all become functioning democracies, as has Indonesia.

Pseudo-Democracies Many of the world’s nations are neither pure democracies nor iron-clad totalitarian states. Rather they lie between pure democracies and complete totalitarian systems of government. They might be described as imperfect or pseudo- democracies, where authoritarian elements have captured some or much of the machinery of state and use this in an attempt to deny basic political and civil liberties. In the Russia of Vladimir Putin, for example, elections are still held, people compete through the ballot box for political office, and the independent press does not always tow the official line. How- ever, Putin has used his position to systematically limit the political and civil liberties of opposition groups (see the opening case). His control is not yet perfect, though. Voices opposing Putin are still heard in Russia, and in theory, elections are still contested. But in practice, it is becoming increasingly difficult to challenge a man and régime that has sys- tematically extended its political, legal, and economic power over the past 14 years. A simi- lar process occurred in the Venezuela of Hugo Chávez (see the Country Focus). Chávez’s handpicked successor, Nicholas Maduro, seems to be continuing in the same vein.

Economic Systems It should be clear from the previous section that political ideology and economic systems are connected. In countries where individual goals are given primacy over collective goals, we are more likely to find market-based economic systems. In contrast, in countries where col- lective goals are given preeminence, the state may have taken control over many enterprises;

Theocratic Totalitarianism A political system in which political power is monopolized by a party, group, or individual that governs according to religious principles.

Tribal Totalitarianism A political system in which a party, group, or individual that represents the interests of a particular tribe (ethnic group) monopolizes political power.

Right-Wing Totalitarianism A political system in which political power is monopolized by a party, group, or individual that generally permits individual economic freedom but restricts individual political freedom, including free speech, often on the grounds that it would lead to the rise of communism.

LO 2-2 Understand how the economic systems of countries differ.

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.

Chapter Two National Differences in Political, Economic, and Legal Systems 45

markets in such countries are likely to be restricted rather than free. We can identify three broad types of economic systems—a market economy, a command economy, and a mixed economy.

MARKET ECONOMY In the archetypal pure market economy, all productive activities are privately owned, as opposed to being owned by the state. The goods and services that a country produces are not planned by anyone. Production is determined by the interac- tion of supply and demand and signaled to producers through the price system. If demand for a product exceeds supply, prices will rise, signaling producers to produce more. If supply ex- ceeds demand, prices will fall, signaling producers to produce less. In this system, consumers are sovereign. The purchasing patterns of consumers, as signaled to producers through the mechanism of the price system, determine what is produced and in what quantity.

For a market to work in this manner, supply must not be restricted. A supply restriction occurs when a single firm monopolizes a market. In such circumstances, rather than increase output in response to increased demand, a monopolist might restrict output and let prices rise. This allows the monopolist to take a greater profit margin on each unit it sells. Al- though this is good for the monopolist, it is bad for the consumer, who has to pay higher prices. It also is probably bad for the welfare of society. Because a monopolist has no com- petitors, it has no incentive to search for ways to lower production costs. Rather, it can sim- ply pass on cost increases to consumers in the form of higher prices. The net result is that the monopolist is likely to become increasingly inefficient, producing high-priced, low- quality goods, and society suffers as a consequence.

Given the dangers inherent in monopoly, the role of government in a market economy is to encourage vigorous free and fair competition between private producers. Governments do this by outlawing restrictive business practices designed to monopolize a market (anti- trust laws serve this function in the United States). Private ownership also encourages vigor- ous competition and economic efficiency. Private ownership ensures that entrepreneurs have a right to the profits generated by their own efforts. This gives entrepreneurs an incen- tive to search for better ways of serving consumer needs. That may be through introducing

Market Economy An economic system in which the interaction of supply and demand determines the quantity in which goods and services are produced.

Vietnam is currently in transition from a command economy to a mixed system with functioning markets in some sectors, such as textiles and agriculture.

46 Part Two National Differences

new products, by developing more efficient production processes, by pursuing better mar- keting and after-sale service, or simply through managing their businesses more efficiently than their competitors. In turn, the constant improvement in product and process that re- sults from such an incentive has been argued to have a major positive impact on economic growth and development.6

COMMAND ECONOMY In a pure command economy, the government plans the goods and services that a country produces, the quantity in which they are pro- duced, and the prices at which they are sold. Consistent with the collectivist ideology, the objective of a command economy is for government to allocate resources for “the good of society.” In addition, in a pure command economy, all businesses are state-owned, the rationale being that the government can then direct them to make investments that are in the best interests of the nation as a whole rather than in the interests of private individu- als. Historically, command economies were found in communist countries where collec- tivist goals were given priority over individual goals. Since the demise of communism in the late 1980s, the number of command economies has fallen dramatically. Some elements of a command economy were also evident in a number of democratic nations led by socialist-inclined governments. France and India both experimented with extensive gov- ernment planning and state ownership, although government planning has fallen into dis- favor in both countries.

While the objective of a command economy is to mobilize economic resources for the public good, the opposite often seems to have occurred. In a command economy, state- owned enterprises have little incentive to control costs and be efficient because they cannot go out of business. Also, the abolition of private ownership means there is no incentive for individuals to look for better ways to serve consumer needs; hence, dynamism and innova- tion are absent from command economies. Instead of growing and becoming more prosper- ous, such economies tend to stagnate.

MIXED ECONOMY Between market economies and command economies can be found mixed economies. In a mixed economy, certain sectors of the economy are left to private ownership and free market mechanisms, while other sectors have significant state ownership and government planning. Mixed economies were once common throughout much of the world, although they are becoming much less so. Until the 1980s, Great Britain, France, and Sweden were mixed economies, but extensive privatization has reduced state ownership of businesses in all three nations. A similar trend occurred in many other coun- tries where there was once a large state-owned sector, such as Brazil, Italy, and India (although there are still state-owned enterprises in all of these nations). As a counterpoint, the involvement of the state in economic activity has been on the rise again in countries such as Russia and Venezuela, where authoritarian regimes have seized control of the politi- cal structure, typically by first winning power through democratic means and then subvert- ing those same structures to maintain their grip on power.

In mixed economies, governments also tend to take into state ownership troubled firms whose continued operation is thought to be vital to national interests. For example, in 2008 the U.S. government took an 80 percent stake in AIG to stop that financial institution from collapsing, the theory being that if AIG did collapse, it would have very serious conse- quences for the entire financial system. The U.S. government usually prefers market- oriented solutions to economic problems, and in the AIG case, the intention was to sell the institution back to private investors as soon as possible. The United States also took similar action with respect to a number of other troubled private enterprises, including Citigroup and General Motors. In all these cases, the government stake was seen as nothing more than a short-term action designed to stave off economic collapse by injecting capital into trou- bled enterprises in highly unusually circumstances. As soon as it was able to, the government sold these stakes. In early 2010, for example, the U.S. government sold its stake in Citi- group. The government stake in AIG was sold off in 2012, and by 2014 it had also disposed of its stake in GM.

Command Economy An economic system where the allocation of resources, including determination of what goods and services should be produced, and in what quantity, is planned by the government.

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.

Chapter Two National Differences in Political, Economic, and Legal Systems 47

Legal Systems The legal system of a country refers to the rules, or laws, that regulate behavior along with the processes by which the laws are enforced and through which redress for grievances is obtained. The legal system of a country is of immense importance to international business. A country’s laws regulate business practice, define the manner in which business transactions are to be executed, and set down the rights and obligations of those involved in business transactions. The legal environments of countries differ in significant ways. As we shall see, differences in legal systems can affect the attractiveness of a country as an investment site or market.

Like the economic system of a country, the legal system is influenced by the prevailing political system (although it is also strongly influenced by historical tradition). The gov- ernment of a country defines the legal framework within which firms do business, and often the laws that regulate business reflect the rulers’ dominant political ideology. For example, collectivist-inclined totalitarian states tend to enact laws that severely restrict private enterprise, whereas the laws enacted by governments in democratic states where individualism is the dominant political philosophy tend to be pro-private enterprise and pro-consumer.

Here, we focus on several issues that illustrate how legal systems can vary—and how such variations can affect international business. First, we look at some basic differences in legal systems. Next we look at contract law. Third, we look at the laws governing property rights with particular reference to patents, copyrights, and trademarks. Then we discuss protection of intellectual property. Finally, we look at laws covering product safety and product liability.

DIFFERENT LEGAL SYSTEMS There are three main types of legal systems— or legal traditions—in use around the world: common law, civil law, and theocratic law.

Common Law The common law system evolved in England over hundreds of years. It is now found in most of Great Britain’s former colonies, including the United States. Common law is based on tradition, precedent, and custom. Tradition refers to a country’s legal history, precedent to cases that have come before the courts in the past, and custom to the ways in which laws are applied in specific situations. When law courts interpret common law, they do so with regard to these characteristics. This gives a common law system a degree of flexibility that other systems lack. Judges in a common law system have the power to interpret the law so that it applies to the unique circumstances of an individual case. In turn, each new inter- pretation sets a precedent that may be followed in future cases. As new precedents arise, laws may be altered, clarified, or amended to deal with new situations.

Civil Law A civil law system is based on a detailed set of laws organized into codes. When law courts interpret civil law, they do so with regard to these codes. More than 80 countries—including Germany, France, Japan, and Russia— operate with a civil law system. A civil law system tends to be less adversarial than a common law system because the judges rely upon detailed legal codes rather than interpret- ing tradition, precedent, and custom. Judges under a civil law system have less flexibility than those under a common law system. Judges in a common law system have the power to interpret the law, whereas judges in a civil law system have the power only to apply the law.

Legal System System of rules that regulate behavior and the processes by which the laws of a country are enforced and through which redress of grievances is obtained.

Common Law A system of law based on tradition, precedent, and custom; when law courts interpret common law, they do so with regard to these characteristics.

Civil Law System A system of law based on a very detailed set of written laws and codes.

LO 2-3 Understand how the legal systems of countries differ.

Do You Agree with the Unique System of Islamic Banking? How can a banking system operate without interest (riba in Arabic)? The basic economic idea is that commercial risk should be shared. In the Western approach, interest guarantees the banker a return, so on a collateralized loan, the banker avoids much of the commercial risk that’s inherent in business. No matter what happens to the business, the banker gets a return. In contrast, Islam requires that the banker share this commercial risk. If the business venture is successful, the banker shares the profit. If the venture doesn’t do well, neither does the banker. The value of community in Islam is stronger than the value of individual profit. As a result, Islamic Banking was born in the mid-1970s and has grown ever since, now to the point of having millions of clients, a resilient code of ethics, and engagement from many conventional banks around the world. What do you think? Should the banker be paid regardless of entrepreneurial success, or is the Islamic Banking system a better way to share commercial risk?

Source: www.dib.ae/islamic-banking.

48 Part Two National Differences

Theocratic Law A theocratic law system is one in which the law is based on reli- gious teachings. Islamic law is the most widely practiced theocratic legal system in the mod- ern world, although usage of both Hindu and Jewish law persisted into the twentieth century. Islamic law is primarily a moral rather than a commercial law and is intended to govern all aspects of life.7 The foundation for Islamic law is the holy book of Islam, the Ko- ran, along with the Sunnah, or decisions and sayings of the Prophet Muhammad, and the writings of Islamic scholars who have derived rules by analogy from the principles estab- lished in the Koran and the Sunnah. Because the Koran and Sunnah are holy documents, the basic foundations of Islamic law cannot be changed. However, in practice, Islamic jurists and scholars are constantly debating the application of Islamic law to the modern world. In reality, many Muslim countries have legal systems that are a blend of Islamic law and a com- mon or civil law system.

Although Islamic law is primarily concerned with moral behavior, it has been extended to cover certain commercial activities. An example is the payment or receipt of interest, which is considered usury and outlawed by the Koran. To the devout Muslim, acceptance of inter- est payments is seen as a grave sin; the giver and the taker are equally damned. This is not just a matter of theology; in several Islamic states, it has also become a matter of law. In the 1990s, for example, Pakistan’s Federal Shariat Court, the highest Islamic lawmaking body in the country, pronounced interest to be un-Islamic and therefore illegal and demanded that the government amend all financial laws accordingly. In 1999, Pakistan’s Supreme Court ruled that Islamic banking methods should be used in the country after July 1, 2001.8 By the late 2000s, some 500 Islamic financial institutions in the world collectively managed more than $500 billion in assets. In addition to Pakistan, Islamic financial institutions are found in many of the Gulf states, Egypt, Malaysia, and Iran.9

DIFFERENCES IN CONTRACT LAW The difference between common law and civil law systems can be illustrated by the approach of each to contract law (remember, most theocratic legal systems also have elements of common or civil law). A contract is a document that specifies the conditions under which an exchange is to occur and details the rights and obligations of the parties involved. Some form of contract regulates many busi- ness transactions. Contract law is the body of law that governs contract enforcement. The parties to an agreement normally resort to contract law when one party feels the other has violated either the letter or the spirit of an agreement.

Because common law tends to be relatively ill specified, contracts drafted under a com- mon law framework tend to be very detailed with all contingencies spelled out. In civil law systems, however, contracts tend to be much shorter and less specific because many of the issues are already covered in a civil code. Thus, it is more expensive to draw up contracts in a common law jurisdiction, and resolving contract disputes can be very adversarial in common law systems. But common law systems have the advantage of greater flexibility and allow judges to interpret a contract dispute in light of the prevailing situation. Inter- national businesses need to be sensitive to these differences; approaching a contract dis- pute in a state with a civil law system as if it had a common law system may backfire, and vice versa.

When contract disputes arise in international trade, there is always the question of which country’s laws to apply. To resolve this issue, a number of countries, including the United States, have ratified the United Nations Convention on Contracts for the International Sale of Goods (CIGS). The CIGS establishes a uniform set of rules gov- erning certain aspects of the making and performance of everyday commercial contracts between sellers and buyers who have their places of business in different nations. By adopting the CIGS, a nation signals to other adopters that it will treat the convention’s rules as part of its law. The CIGS applies automatically to all contracts for the sale of goods between different firms based in countries that have ratified the convention, unless the parties to the contract explicitly opt out. One problem with the CIGS, however, is that as of late 2013, only 80 nations have ratified the convention (the CIGS went into effect in 1988).10 Some of the world’s important trading nations, including the United Kingdom, have not ratified the CIGS.

Theocratic Law System A system of law based on religious teachings.

Contract A document that specifies the conditions under which an exchange is to occur and details the rights and obligations of the parties involved.

Contract Law The body of law that governs contract enforcement.

United Nations Convention on Contracts for the International Sale of Goods (CIGS) A set of rules governing certain aspects of the making and performance of commercial contracts between sellers and buyers who have their places of businesses in different nations.

Chapter Two National Differences in Political, Economic, and Legal Systems 49

When firms do not wish to accept the CIGS, they often opt for arbitration by a recog- nized arbitration court to settle contract disputes. The most well known of these courts is the International Court of Arbitration of the International Chamber of Commerce in Paris, which handles more than 500 requests per year from more than 100 countries.11

PROPERTY RIGHTS AND CORRUPTION In a legal sense, the term prop- erty refers to a resource over which an individual or business holds a legal title, that is, a resource that it owns. Resources include land, buildings, equipment, capital, mineral rights, businesses, and intellectual property (ideas, which are protected by patents, copy- rights, and trademarks). Property rights refer to the legal rights over the use to which a resource is put and over the use made of any income that may be derived from that re- source.12 Countries differ in the extent to which their legal systems define and protect property rights. Almost all countries now have laws on their books that protect property rights. Even China, still nominally a communist state, despite its booming market econ- omy, finally enacted a law to protect the rights of private property holders in 2007 (the law gives individuals the same legal protection for their property as the state has).13 However, in many countries, these laws are not enforced by the authorities, and property rights are violated. Property rights can be violated in two ways—through private action and through public action.

Private Action In terms of violating property rights, private action refers to theft, piracy, blackmail, and the like by private individuals or groups. Although theft occurs in all countries, a weak legal system allows a much higher level of criminal action. For example, in the chaotic period following the collapse of communism in Russia, an outdated legal system, coupled with a weak police force and judicial system, offered both domestic and foreign businesses scant protection from blackmail by the “Russian Mafia.” Successful business own- ers in Russia often had to pay “protection money” to the Mafia or face violent retribution, including bombings and assassinations (about 500 contract killings of businessmen occurred per year in the 1990s).14

Russia is not alone in having Mafia problems (and the situation in Russia has improved since the 1990s). The Mafia has a long history in the United States (Chicago in the 1930s was similar to Moscow in the 1990s). In Japan, the local version of the Mafia, known as the yakuza, runs protection rackets, particularly in the food and entertainment industries.15 However, there was a big difference between the magnitude of such activity in Russia in the 1990s and its limited impact in Japan and the United States. The difference arose because the legal enforcement apparatus, such as the police and court system, was weak in Russia following the collapse of communism. Many other countries from time to time have had problems similar to or even greater than those experienced by Russia.

Public Action and Corruption Public action to violate property rights occurs when public officials, such as politicians and government bureaucrats, extort income, re- sources, or the property itself from property holders. This can be done through legal mech- anisms such as levying excessive taxation, requiring expensive licenses or permits from property holders, taking assets into state ownership without compensating the owners, or redistributing assets without compensating the prior owners. It can also be done through illegal means, or corruption, by demanding bribes from businesses in return for the rights to operate in a country, industry, or location.16

Corruption has been well documented in every society, from the banks of the Congo River to the palace of the Dutch royal family, from Japanese politicians to Brazilian bankers, and from Indonesian government officials to the New York City Police Department. The government of the late Ferdinand Marcos in the Philippines was famous for demanding bribes from foreign businesses wishing to set up operations in that country. The same was true of government officials in Indonesia under the rule of former President Suharto. No society is immune to corruption. However, there are systematic differences in the extent of corruption. In some countries, the rule of law minimizes corruption. Corruption is seen and treated as illegal, and when discovered, violators are punished by the full force of the law. In

Property Rights Bundle of legal rights over the use to which a resource is put and over the use made of any income that may be derived from that resource.

Private Action The theft, piracy, blackmail, and the like by private individuals or groups.

Public Action The extortion of income or resources of property holders by public officials, such as politicians and government bureaucrats.

50 Part Two National Differences

other countries, the rule of law is weak and corruption by bureaucrats and politicians is rife. Corruption is so endemic in some countries that politicians and bureaucrats regard it as a perk of office and openly flout laws against corruption.

According to Transparency International, an independent nonprofit organization dedicated to exposing and fighting corruption, businesses and individuals spend some $400 billion a year worldwide on bribes related to government procurement contracts alone.17 Transparency International has also measured the level of corruption among public officials in different countries.18 As can be seen in Figure 2.1, the organization rated countries such as Denmark and Sweden as clean; it rated others, such as Russia, India, and Venezuela, as corrupt. Somalia ranked last out of all 175 countries in the survey (the country is often described as a “failed state”).

Economic evidence suggests that high levels of corruption significantly reduce the for- eign direct investment, level of international trade, and economic growth rate in a country.19 By siphoning off profits, corrupt politicians and bureaucrats reduce the returns to business investment and, hence, reduce the incentive of both domestic and foreign businesses to in- vest in that country. The lower level of investment that results hurts economic growth. Thus, we would expect countries with high levels of corruption such as Indonesia, Nigeria, and Russia to have a much lower rate of economic growth than might otherwise have been the case. A detailed example of the negative effect that corruption can have on economic progress is given in the accompanying Country Focus, which looks at the impact of corrup- tion on economic growth in Nigeria.

Foreign Corrupt Practices Act In the 1970s, the United States passed the Foreign Corrupt Practices Act following revelations that U.S. companies had bribed government

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

2.1 FIGURE Rankings of Corruption by Country, 2013 Source: Constructed by the author from raw data from Transparency International, Corruption Perceptions Index 2013.

0 10 20

Corruption Index (100 = clean; 0 = totally corrupt) 30 40 50 60 70 80 90 100

Venezuela

Zimbabawe

Nigeria

Russia

India

Columbia

China

South Africa

South Korea

Poland

Italy

Turkey

Brazil

France

USA

United Kingdom

Germany

Canada

Sweden

Denmark

Somalia

Chapter Two National Differences in Political, Economic, and Legal Systems 51

Corruption in Nigeria

When Nigeria gained independence from Great Britain in 1960, there were hopes that the country might emerge as an economic heavy- weight in Africa. Not only was Nigeria Africa’s most populous coun- try, but it also was blessed with abundant natural resources, particularly oil. Despite this, Nigeria remains one of the poorest countries in the world. According to the 2012 Human Development Index compiled by the United Nations, Nigeria had “low human development.” The country ranked 153rd out of 187 covered. Gross national income per capita was just $2,102; almost 40 percent of the adult population was illiterate; and life expectancy at birth was only 52.3 years.

What went wrong? Although there is no simple answer, a number of factors seem to have conspired to damage economic activity in Nigeria. The country is composed of several competing ethnic, tribal, and reli- gious groups, and the conflict among them has limited political stability and led to political strife, including a brutal civil war in the 1970s. With the legitimacy of the government always in question, political leaders often purchased support by legitimizing bribes and by raiding the national treasury to reward allies. Civilian rule after independence was followed by a series of military dictatorships, each of which seemed more corrupt and inept than the last (the country returned to civilian rule in 1999).

During the 1990s, the military dictator Sani Abacha openly and sys- tematically plundered the state treasury for his own personal gain. His most blatant scam was the Petroleum Trust Fund that he set up in the mid-1990s, ostensibly to channel extra revenue from an increase in fuel prices into much-needed infrastructure projects and other investments. The fund was not independently audited, and almost none of the money that passed through it was properly accounted for. It was, in fact, a ve- hicle for Abacha and his supporters to spend at will a sum that in 1996 was equivalent to some 25 percent of the total federal budget. Abacha, aware of his position as an unpopular and unelected leader, lavished money on personal security and handed out bribes to those whose sup- port he coveted. With examples like this at the very top of the govern- ment, it is not surprising that corruption could be found throughout the political and bureaucratic apparatus.

Has the situation in Nigeria improved since the country returned to civilian rule in 1999? In 2003, Olusegun Obasanjo was elected presi- dent on a platform that included a promise to fight corruption. By some accounts, progress has been seen. His anticorruption chief, Nuhu Rib- adu, claimed that whereas 70 percent of the country’s oil revenues were being stolen or wasted in 2002, by the mid-2000s the figure was “only” 40 percent. But in its most recent survey (2013), Transparency International still ranked Nigeria 144th out of 177, suggesting that the country still has a long way to go.

Sources: “A Tale of Two Giants,” The Economist, January 15, 2000, p. 5; J. Coolidge and S. Rose Ackerman, “High Level Rent Seeking and Corruption in African Regimes,” World Bank policy research working paper no. 1780, June 1997; D. L. Bevan, P. Collier, and J. W. Gunning, Nigeria and Indonesia: The Political Economy of Poverty, Equity and Growth (Oxford, UK: Oxford University Press, 1999); “Democracy and Its Discontents,” The Economist, January 29, 2005, p. 55; A. Field, “Can Reform Save Nigeria?” Journal of Commerce, November 21, 2005, p. 1; “A Blacklist to Bolster Democracy,” The Economist, February 17, 2007, p. 59; J. P. Luna, “Back on Track: Nigeria’s Hard Path towards Reform,” Harvard International Review 29, no. 3 (2007), p. 7; and Transparency International, Corruption Perceptions Index, 2012.

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Olusegun Obasanjo was elected President of Nigeria in 2003 on a platform that included a promise to fight corruption.

officials in foreign countries in an attempt to win lucrative contracts. This law makes it il- legal to bribe a foreign government official to obtain or maintain business over which that foreign official has authority, and it requires all publicly traded companies (whether or not they are involved in international trade) to keep detailed records that would reveal whether a violation of the act has occurred. In 2012, evidence emerged that in its eagerness to expand in Mexico, Walmart may have run afoul of the Foreign Corrupt Practices Act (for details, see the next Management Focus feature).

In 1997, trade and finance ministers from the member-states of the Organization for Economic Cooperation and Development (OECD), an association of 34 major economies including most Western economies (but not Russia, India or China), adopted the Conven- tion on Combating Bribery of Foreign Public Officials in International Business Transac- tions.20 The convention obliges member-states to make the bribery of foreign public officials a criminal offense.

52 Part Two National Differences

Did Walmart Violate the Foreign Corrupt Practices Act?

In the early 2000s, Walmart wanted to build a new store in San Juan Teotihuacan, Mexico, barely a mile from ancient pyramids that drew tourists from around the world. The owner of the land was happy to sell to Walmart, but one thing stood in the way of a deal—the city’s new zoning laws. These prohibited commercial development in the historic area. Not to be denied, executives at the headquarters of Walmart de Mexico found a way around the problem: They paid a $52,000 bribe to a local official to redraw the zoning area so that the property Walmart wanted to purchase was placed outside the commercial-free zone. Walmart then went ahead and built the store, despite vigorous local opposition, opening it in late 2004.

A former lawyer for Walmart de Mexico subsequently contacted Walmart executives at the company’s corporate headquarters in Ben- tonville, Arkansas. He told them that Walmart de Mexico routinely re- sorted to bribery, citing the altered zoning map as just one example. Alarmed, executives at Walmart started their own investigation. Faced with growing evidence of corruption in Mexico, top Walmart executives decided to engage in damage control, rather than coming clean. Walmart’s top lawyer shipped the case files back to Mexico and handed responsibility for the investigation over to the general council of Walmart de Mexico. This was an interesting choice as the very same general council was alleged to have authorized bribes. The general council quickly exonerated fellow Mexican executives, and the internal investigation was closed in 2006.

For several years nothing more happened; then, in April 2012, The New York Times published an article detailing bribery by Walmart. The Times cited the changed zoning map and several other examples of bribery by Walmart—for example, eight bribes totaling $341,000 en- abled Walmart to build a Sam’s Club in one of Mexico City’s most densely populated neighborhoods without a construction license, or an environmental permit, or an urban impact assessment, or even a traffic permit. Similarly, thanks to nine bribe payments totaling $765,000, Walmart built a vast refrigerated distribution center in an environmen- tally fragile flood basin north of Mexico City, in an area where electricity was so scarce that many smaller developers were turned away.

Walmart responded to The New York Times article by ramping up a second internal investigation into bribery that it had initiated in 2011. By mid-2013 there were reportedly more than 300 outside lawyers working on the investigation, and it had cost more than $300 million in fees. In addition, the U.S. Department of Justice and the Securities and Exchange Commission both announced that they had started investigations into Walmart’s practices. In November 2012, Walmart reported that its own investigation into violations had extended beyond Mexico to include China and India. Among other things, they were looking into the allega- tions by The Times that top executives at Walmart, including former CEO Lee Scott Jr., had deliberately squashed earlier investigations.

Sources: David Barstow, “Vast Mexican Bribery Case Hushed Up by Wal-Mart after Top Level Struggle,” The New York Times, April 21, 2012; Stephanie Clifford and David Barstow, “Wal-Mart Inquiry Reflects Alarm on Corruption,” The New York Times, November 15, 2012; and Nathan Vardi, “Why Justice Department Could Hit Wal-Mart Hard over Mexican Bribery Allegations,” Forbes, April 22, 2012.

management FOCUS

Both the U.S. law and OECD convention include language that allows exceptions known as facilitating or expediting payments (also called grease payments or speed money), the purpose of which is to expedite or to secure the performance of a routine governmental action.21 For example, they allow small payments made to speed up the issuance of permits or licenses, process paperwork, or just get vegetables off the dock and on their way to market. The explanation for this exception to general antibribery provisions is that while grease pay- ments are, technically, bribes, they are distinguishable from (and, apparently, less offensive than) bribes used to obtain or maintain business because they merely facilitate performance of duties that the recipients are already obligated to perform.

THE PROTECTION OF INTELLECTUAL PROPERTY Intellectual property refers to property that is the product of intellectual activity, such as computer software, a screenplay, a music score, or the chemical formula for a new drug. Patents, copyrights, and trademarks establish ownership rights over intellectual property. A patent grants the inventor of a new product or process exclusive rights for a defined period to the manufacture, use, or sale of that invention. Copyrights are the exclusive legal rights of au- thors, composers, playwrights, artists, and publishers to publish and disperse their work as they see fit. Trademarks are designs and names, officially registered, by which merchants or manufacturers designate and differentiate their products (e.g., Christian Dior clothes). In the high-technology “knowledge” economy of the twenty-first century, intellectual property has become an increasingly important source of economic value for businesses. Protecting intellectual property has also become increasingly problematic, particularly if it can be ren- dered in a digital form and then copied and distributed at very low cost via pirated DVDs or

Intellectual Property Products of the mind, ideas (e.g., books, music, computer software, designs, technological know-how); intellectual property can be protected by patents, copyrights, and trademarks.

Patent Grants the inventor of a new product or process exclusive rights to the manufacture, use, or sale of that invention.

Copyrights The exclusive legal rights of authors, composers, playwrights, artists, and publishers to publish and disperse their work as they see fit.

Trademarks The designs and names, often officially registered, by which merchants or manufacturers designate and differentiate their products.

Chapter Two National Differences in Political, Economic, and Legal Systems 53

over the Internet (e.g., computer software, music, and video recordings).22

The philosophy behind intellectual property laws is to reward the originator of a new invention, book, musical re- cord, clothes design, restaurant chain, and the like, for his or her idea and effort. Such laws stimulate innovation and cre- ative work. They provide an incentive for people to search for novel ways of doing things, and they reward creativity. For example, consider innovation in the pharmaceutical industry. A patent will grant the inventor of a new drug a 20-year monopoly in production of that drug. This gives pharmaceutical firms an incentive to undertake the expen- sive, difficult, and time-consuming basic research required to generate new drugs (it can cost $1 billion in R&D and take 12 years to get a new drug on the market). Without the guarantees provided by patents, companies would be un- likely to commit themselves to extensive basic research.23

The protection of intellectual property rights differs greatly from country to country. Although many countries have stringent intellectual property regulations on their books, the enforcement of these regulations has often been lax. This has been the case even among many of the 185 countries that are now members of the World Intel- lectual Property Organization, all of which have signed international treaties designed to protect intellectual property, including the oldest such treaty, the Paris Convention for the Protection of Industrial Property, which dates to 1883 and has been signed by more than 170 nations. Weak enforcement encourages the piracy (theft) of intellectual property. China and Thailand have often been among the worst offenders in Asia. Pirated computer software is widely available in China. Similarly, the streets of Bangkok, Thailand’s capital, are lined with stands selling pirated copies of Rolex watches, Levi’s jeans, DVDs, and computer software.

The computer software industry is an example of an industry that suffers from lax enforcement of intellectual property rights. Estimates suggest that violations of intellec- tual property rights cost personal computer software firms revenues equal to $63 billion in 2011.24 According to the Business Software Alliance, a software industry association, in 2011 some 42 percent of all software applications used in the world were pirated. One of the worst countries was China, where the piracy rate in 2011 ran at 77 percent and cost the industry more than $9.8 billion in lost sales, up from $444 million in 1995. The piracy rate in the United States was much lower at 19 percent; however, the value of sales lost was significant because of the size of the U.S. market, reaching an estimated $9.8 billion in 2011.25

International businesses have a number of possible responses to violations of their intel- lectual property. They can lobby their respective governments to push for international agreements to ensure that intellectual property rights are protected and that the law is en- forced. Partly as a result of such actions, international laws are being strengthened. As we shall see in Chapter 7, the most recent world trade agreement, signed in 1994, for the first time extends the scope of the General Agreement on Tariffs and Trade to cover intellectual property. Under the new agreement, known as the Trade-Related Aspects of Intellectual Property Rights (TRIPS), as of 1995 a council of the World Trade Organization is oversee- ing enforcement of much stricter intellectual property regulations. These regulations oblige WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years after the death of the author. Rich countries had to comply with the rules within a year. Poor countries, in which such protection generally was much weaker, had five years of grace, and the very poorest have 10 years.26 (For further details of the TRIPS agreement, see Chapter 7.)

World Intellectual Property Organization An international organization whose members sign treaties to agree to protect intellectual property.

Paris Convention for the Protection of Industrial Property International agreement to protect intellectual property.

Source: www.internationalpropertyrightsindex.org.

54 Part Two National Differences

In addition to lobbying governments, firms can file lawsuits on their own behalf. For example, Starbucks won a landmark trademark copyright case in China against a copycat that signaled a change in the approach in China (see the accompanying Management Focus for details). Firms may also choose to stay out of countries where intellectual property laws are lax, rather than risk having their ideas stolen by local entrepreneurs. Firms also need to be on the alert to ensure that pirated copies of their products pro- duced in countries with weak intellectual property laws don’t turn up in their home mar- ket or in third countries. U.S. computer software giant Microsoft, for example, discovered that pirated Microsoft software, produced illegally in Thailand, was being sold world- wide as the real thing.

PRODUCT SAFETY AND PRODUCT LIABILITY Product safety laws set certain safety standards to which a product must adhere. Product liability involves hold- ing a firm and its officers responsible when a product causes injury, death, or damage. Prod- uct liability can be much greater if a product does not conform to required safety standards. Both civil and criminal product liability laws exist. Civil laws call for payment and monetary damages. Criminal liability laws result in fines or imprisonment. Both civil and criminal liability laws are probably more extensive in the United States than in any other country, although many other Western nations also have comprehensive liability laws. Liability laws are typically the least extensive in less developed nations. A boom in product liability suits and awards in the United States resulted in a dramatic increase in the cost of liability insur- ance. Many business executives argue that the high costs of liability insurance make American businesses less competitive in the global marketplace.

In addition to the competitiveness issue, country differences in product safety and liabil- ity laws raise an important ethical issue for firms doing business abroad. When product safety laws are tougher in a firm’s home country than in a foreign country or when liability laws are more lax, should a firm doing business in that foreign country follow the more re- laxed local standards or should it adhere to the standards of its home country? While the ethical thing to do is undoubtedly to adhere to home-country standards, firms have been known to take advantage of lax safety and liability laws to do business in a manner that would not be allowed at home.

Product Safety Laws Set certain safety standards to which a product must adhere.

Product Liability Involves holding a firm and its officers responsible when a product causes injury, death, or damage.

Starbucks Wins Key Trademark Case in China

Starbucks has big plans for China. It believes the fast-growing nation will become the company’s second-largest market after the United States. Starbucks entered the country in 1999, and by the end of 2012 it had opened more than 400 stores. But in China, copycats of well- established Western brands are common. Starbucks faced competition from a look-alike, Shanghai Xing Ba Ke Coffee Shop, whose stores closely matched the Starbucks format, right down to a green-and- white Xing Ba Ke circular logo that mimics Starbucks’ ubiquitous logo. The name also mimics the standard Chinese translation for Starbucks. Xing means “star,” and Ba Ke sounds like “bucks.”

In 2003, Starbucks decided to sue Xing Ba Ke in Chinese court for trademark violations. Xing Ba Ke’s general manager responded by claiming it was just an accident that the logo and name were so similar to that of Starbucks. He claimed the right to use the logo and name because Xing Ba Ke had registered as a company in Shanghai in 1999, before Starbucks entered the city. “I hadn’t heard of Starbucks at the

time,” claimed the manager, “so how could I imitate its brand and logo?”

However, in January 2006 a Shanghai court ruled that Starbucks had precedence, in part because it had registered its Chinese name in 1998. The court stated that Xing Ba Ke’s use of the name and similar logo was “clearly malicious” and constituted improper competition. The court ordered Xing Ba Ke to stop using the name and to pay Starbucks $62,000 in compensation. While the money involved here may be small, the precedent is not. In a country where violation of trademarks has been common, the courts seem to be signaling a shift toward greater protection of intellectual property rights. This is perhaps not surprising because foreign governments and the World Trade Organiza- tion have been pushing China hard recently to start respecting intel- lectual property rights.

Sources: M. Dickie, “Starbucks Wins Case against Chinese Copycat,” Financial Times, January 3, 2006, p. 1; “Starbucks: Chinese Court Backs Company over Trademark Infringement,” The Wall Street Journal, January 2, 2006, p. A11; and “Starbucks Calls China Its Top Growth Focus,” The Wall Street Journal, February 14, 2006, p. 1.

management FOCUS

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.

Chapter Two National Differences in Political, Economic, and Legal Systems 55

FOCUS ON MANAGERIAL IMPLICATIONS

THE MACRO ENVIRONMENT INFLUENCES MARKET ATTRACTIVENESS The material discussed in this chapter has two broad implications for international busi- ness. First, the political, economic, and legal systems of a country raise important ethical issues that have implications for the practice of international business. For example, what ethical implications are associated with doing business in totalitarian countries where citi- zens are denied basic human rights, corruption is rampant, and bribes are necessary to gain permission to do business? Is it right to operate in such a setting? A full discussion of the ethical implications of country differences in political economy is reserved for Chapter 5, where we explore ethics in international business in much greater depth.

Second, the political, economic, and legal environments of a country clearly influence the attractiveness of that country as a market or investment site. The benefits, costs, and risks as- sociated with doing business in a country are a function of that country’s political, economic, and legal systems. The overall attractiveness of a country as a market or investment site depends on balancing the likely long-term benefits of doing business in that country against the likely costs and risks. Because this chapter is the first of two dealing with issues of political economy, we will delay a detailed discussion of how political economy impacts the benefits, costs, and risks of doing business in different nation-states until the end of the next chapter, when we have a full grasp of all the relevant variables that are important for assessing benefits, costs, and risks.

For now, other things being equal, a nation with democratic political institutions, a market- based economic system, and strong legal system that protects property rights and limits corrup- tion is clearly more attractive as a place in which to do business than a nation that lacks democratic institutions, where economic activity is heavily regulated by the state, and where corruption is rampant and the rule of law is not respected. On this basis, for example, Ghana is a better place in which to do business than the Venezuela of Hugo Chávez (see the Country Focus on Venezuela and closing case on Ghana). That being said, the reality is often more nuanced and complex. For example, China lacks democratic institutions, corruption is widespread, property rights are not always respected, and even though the country has embraced many market-based economic reforms, there are still large numbers of state-owned enterprises, yet many Western businesses feel that they must invest in China. They do so despite the risks because the market is large, the nation is moving toward a market-based system, economic growth is strong, legal pro- tection of property rights has been improving, and in the not too distant future China may be- come the largest economy in the world. Thus, China is becoming increasingly attractive as a place in which to do business, and given the future growth trajectory, significant opportunities may be lost by not investing in the country. We will explore how changes in political economy impact the attractiveness of a nation as a place in which to do business in the next chapter.

LO 2-4 Explain the implications for management practice of national differences in political economy.

political economy, p. 39 political system, p. 40 collectivism, p. 40 socialist, p. 40 communists, p. 40 social democrats, p. 40 privatization, p. 41 individualism, p. 41 democracy, p. 43

totalitarianism, p. 43 representative democracy, p. 43 communist totalitarianism, p. 43 theocratic totalitarianism, p. 44 tribal totalitarianism, p. 44 right-wing totalitarianism, p. 44 market economy, p. 45 command economy, p. 46 legal system, p. 47

common law, p. 47

civil law system, p. 47

theocratic law system, p. 48

contract, p. 48

contract law, p. 48

United Nations Convention on Contracts for the International Sale of Goods (CIGS), p. 48

property rights, p. 49

Key Terms

56 Part Two National Differences

private action, p. 49 public action, p. 49 Foreign Corrupt Practices Act, p. 50 intellectual property, p. 52

patent, p. 52 copyrights, p. 52 trademarks, p. 52 World Intellectual Property Organization, p. 53

Paris Convention for the Protection of Industrial Property, p. 53 product safety laws, p. 54 product liability, p. 54

Summary

This chapter has reviewed how the political, economic, and legal systems of countries vary. The potential benefits, costs, and risks of doing business in a country are a func- tion of its political, economic, and legal systems. The chap- ter made the following points:

1. Political systems can be assessed according to two dimensions: the degree to which they emphasize collectivism as opposed to individualism and the degree to which they are democratic or totalitarian.

2. Collectivism is an ideology that views the needs of society as being more important than the needs of the individual. Collectivism translates into an advocacy for state intervention in economic activity and, in the case of communism, a totalitarian dictatorship.

3. Individualism is an ideology that is built on an emphasis of the primacy of the individual’s freedoms in the political, economic, and cultural realms. Individualism translates into an advocacy for democratic ideals and free market economics.

4. Democracy and totalitarianism are at different ends of the political spectrum. In a representative democracy,

citizens periodically elect individuals to represent them, and political freedoms are guaranteed by a constitution. In a totalitarian state, political power is monopolized by a party, group, or individual, and basic political freedoms are denied to citizens of the state.

5. There are three broad types of economic systems: a market economy, a command economy, and a mixed economy. In a market economy, prices are free of controls, and private ownership is predominant. In a command economy, prices are set by central planners, productive assets are owned by the state, and private ownership is forbidden. A mixed economy has elements of both a market economy and a command economy.

6. Differences in the structure of law between countries can have important implications for the practice of international business. The degree to which property rights are protected can vary dramatically from country to country, as can product safety and product liability legislation and the nature of contract law.

Critical Thinking and Discussion Questions

1. Free market economies stimulate greater economic growth, whereas state-directed economies stifle growth. Discuss.

2. A democratic political system is an essential condition for sustained economic progress. Discuss.

3. What is the relationship between corruption in a country (i.e., government officials taking bribes) and economic growth? Is corruption always bad?

4. You are the CEO of a company that has to choose between making a $100 million investment in Russia or Poland. Both investments promise the same long-run return, so your choice is driven by risk considerations. Assess the various risks of doing business in each of these nations. Which investment would you favor and why?

5. Read the Country Focus on Venezuela under the leadership of Hugo Chávez; then answer the following questions: a. Under Chávez’s leadership, what kind of

economic system was put in place in Venezuela? How would you characterize the political system?

b. How do you think that Chávez’s unilateral changes to contracts with foreign oil companies will affect future investment by foreigners in Venezuela?

c. How will the high level of public corruption in Venezuela affect future growth rates?

d. Currently, Venezuela is benefiting from a boom in oil prices. What do you think might happen if oil prices retreat from their current high level?

e. In your estimation, what is the long-run prognosis for the Venezuelan economy? Is this a country that is attractive to international businesses?

6. Read the Management Focus feature: Did Walmart Violate the Foreign Corrupt Practices Act? What is your opinion? If you think it did, what do you think the consequences will be for Walmart?

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

1. The definition of words and political ideas can have different meanings in different contexts worldwide. In fact, the Freedom in the World survey published by Freedom House evaluates the state of political rights and civil liberties around the world. Provide a description of this survey and a ranking (in terms of “freedom”) of the world’s country leaders and laggards. What factors are taken into consideration in this survey?

2. As the chapter discusses, differences in political, economic, and legal systems have considerable impact on the benefits, costs, and risks of doing business in various countries. The World Bank’s “Doing Business Indicators” measure the extent of business regulations in countries round the world. Compare Brazil, Ghana, India, New Zealand, the United States, Sweden, and Turkey in terms of how easily contracts are enforced, how property can be registered, and how investors can be protected. Identify in which area you see the greatest variation from one country to the next.

Research Task http://globalEDGE.msu.edu

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It wasn’t always this way. Originally a British colony, Ghana gained in- dependence in 1957. For the next three decades, the country suffered from a long series of military coups that killed any hope for stable democratic government. Successive governments adopted a socialist ideology, often as a reaction to their colonial past. As a result, large portions of the Ghana economy were dominated by state-owned enterprises. Corruption was rampant and inflation often a problem, while the country’s dependence on cash crops for foreign currency earnings made it vulnerable to swings in commodity prices. It seemed like yet another failed state.

In 1981, an air force officer, Jerry Rawlings, led a military coup that deposed the president and put Rawlings in power. Rawlings started a vigorous anticorruption drive that made him very popular among ordi- nary Ghanaians. Rawlings initially pursued socialist policies and banned political parties, but in the early 1990s, he changed his views. He may well have been influenced by the wave of democratic change and eco- nomic liberalization that was then sweeping the formally communist

Presidential elections were held in 1992. Prior to the elections, the ban on political parties was lifted, restrictions on the press were removed, and all parties were given equal access to the media. Rawlings won the election, which foreign observers declared to be “free and fair.” Ghana has had a functioning democratic system since then. Rawlings won again in 1996 and retired in 2001. Beginning in 1992, Rawlings started to liber- alize the economy, privatizing state-owned enterprises, instituting market-based reforms, and opening Ghana up to foreign investors. Over the next decade, more than 300 state-owned enterprises were privatized, and the new, largely privately held economy was booming.

Following the discovery of oil in 2007, Ghana’s politicians studied oil revenue laws from other countries, including Norway and Trinidad. They put in place laws designed to limit the ability of corrupt officials to siphon off oil revenues from royalties to enrich themselves; something that has been a big problem in oil-rich Nigeria. Some oil revenues are slated to go directly into the national budget, while the rest will be split between a “stabilization fund” to support the budget should oil prices drop and a “heritage fund” to be spent only when the oil starts to run out.

Despite all of its progress over the last two decades, Ghana still has many issues to deal with. Although Ghana ranks better than most African nations, there is still a perception that corruption is a problem, particularly in the police force and the allocation of government contracts. Inflation

Ghana: An African Dynamo

Chapter Two National Differences in Political, Economic, and Legal Systems 57

58 Part Two National Differences

rose to greater than 13 percent in 2013, and the budget deficit widened to 12 percent of GDP as the ruling political party stepped up public spending in advance of presidential and general elections, which it narrowly won. Despite economic progress, as many as a third of Ghanaians still live on less than $2 a day, and Ghana still needs to upgrade its power, water, and road infrastructure. On the other hand, oil revenue is starting to flow, and will increase over time, which—if used wisely—will give Ghana a chance to fix some of its problems and solidify its gains.

Sources: D. Hinshaw, “In an African Dynamo’s Expansion, the Perils of Prosperity,” The Wall Street Journal, December 30, 2011, p. A9; “Dangerously Hopeful,” The Economist, January 2, 2010, p. 36; “Carats and Sticks,” The Economist, March 3, 2010, p. 68; “Rawlings: The Legacy,” BBC News, December 1, 2000, http://news. bbc.co.uk/2/hi/africa/1050310.stm; “Ghana GDP Expands 2.1% in Q4 2012,” Ghana Statistical Service, April 12, 2013; and “Ghana: Get a Grip,” The Economist, December 21, 2013.

CASE DISCUSSION QUESTIONS 1. After gaining independence from Britain, Ghana’s economy languished

for three decades. Why was this the case? What does the Ghana

experience teach you about the connection between economic and political systems and economic growth?

2. What where the main changes that Gerry Rawlings made in the Ghanaian political and economic systems? What were the consequences of these changes? What are the lessons here?

3. What external forces helped to persuade Rawlings to change political and economic practices in Ghana? Do you think he would have made the changes he did without these external forces?

4. If Ghana had discovered large oil reserves in the 1980s, instead of the 2000s, do you things might have played out differently? Why?

5. What is the difference between the approach of Nigeria toward oil revenues and that of Ghana (the Nigerian experience is documented in the Country Focus feature in this chapter)? Which approach is in the best long-run interests of the country?

6. What does Ghana need to do to remain on its current track of sustained economic growth?

Endnotes

1. As we shall see, there is not a strict one-to-one correspon- dence between political systems and economic systems. A. O. Hirschman, “The On-and-Off Again Connection between Political and Economic Progress,” American Economic Review 84, no. 2 (1994), pp. 343–48.

2. For a discussion of the roots of collectivism and individualism, see H. W. Spiegel, The Growth of Economic Thought (Durham, NC: Duke University Press, 1991). A discussion of collectiv- ism and individualism can be found in M. Friedman and R. Friedman, Free to Choose (London: Penguin Books, 1980).

3. For a classic summary of the tenets of Marxism, see A. Gid- dens, Capitalism and Modern Social Theory (Cambridge, UK: Cambridge University Press, 1971).

4. A. Smith, The Wealth of Nations, Vol. 1 (London: Penguin Book), p. 325.

5. R. Wesson, Modern Government—Democracy and Authoritari- anism, 2nd ed. (Englewood Cliffs, NJ: Prentice Hall, 1990).

6. For a detailed but accessible elaboration of this argument, see Friedman and Friedman, Free to Choose. Also see P. M. Romer, “The Origins of Endogenous Growth,” Journal of Economic Perspectives 8, no. 1 (1994), pp. 2–32.

7. T. W. Lippman, Understanding Islam (New York: Meridian Books, 1995).

8. “Islam’s Interest,” The Economist, January 18, 1992, pp. 33–34.

9. M. El Qorchi, “Islamic Finance Gears Up,” Finance and Development, December 2005, pp. 46–50; and S. Timewell, “Islamic Finance—Virtual Concept to Critical Mass,” The Banker, March 1, 2008, pp. 10–16.

10. This information can be found on the UN’s treaty website at www.uncitral.org/uncitral/en/uncitral_texts/sale_goods/ 1980CISG.html.

11. International Court of Arbitration, www.iccwbo.org/index_ court.asp.

12. D. North, Institutions, Institutional Change, and Economic Perfor- mance (Cambridge, UK: Cambridge University Press, 1991).

13. “China’s Next Revolution,” The Economist, March 10, 2007, p. 9.

14. P. Klebnikov, “Russia’s Robber Barons,” Forbes, November 21, 1994, pp. 74–84; C. Mellow, “Russia: Making Cash from Chaos,” Fortune, April 17, 1995, pp. 145–51; and “Mr. Tatum Checks Out,” The Economist, November 9, 1996, p. 78.

15. K. van Wolferen, The Enigma of Japanese Power (New York: Vintage Books, 1990), pp. 100–105.

16. P. Bardhan, “Corruption and Development: A Review of the Issues,” Journal of Economic Literature, September 1997, pp. 1320–46.

17. Transparency International, “Global Corruption Report, 2009,” www.transparency.org, 2009.

18. www.transparency.org.

19. J. Coolidge and S. Rose Ackerman, “High Level Rent Seek- ing and Corruption in African Regimes,” World Bank policy research working paper no. 1780, June 1997; K. Murphy, A. Shleifer, and R. Vishny, “Why Is Rent-Seeking So Costly to Growth?” AEA Papers and Proceedings, pp. 409–414, May 1993; M. Habib and L. Zurawicki, “Corruption and Foreign Direct Investment,” Journal of International Business Studies 33 (2002), pp. 291–307; J. E. Anderson and D. Marcouiller, “In- security and the Pattern of International Trade,” Review of Economics and Statistics 84 (2002), pp. 342–52; T. S. Aidt, “Economic Analysis of Corruption: A Survey,” The Economic Journal 113 (November 2003), pp. 632–53; and D. A. Hous- ton, “Can Corruption Ever Improve an Economy?” Cato In- stitute 27 (2007), pp. 325–43.

20. Details can be found at www.oecd.org/corruption/ oecdanti- briberyconvention.htm.

21. D. Stackhouse and K. Ungar, “The Foreign Corrupt Prac- tices Act: Bribery, Corruption, Record Keeping and More,” Indiana Lawyer, April 21, 1993.

22. For an interesting discussion of strategies for dealing with the low cost of copying and distributing digital information, see the chapter on rights management in C. Shapiro and H. R. Varian, Information Rules (Boston: Harvard Business School Press, 1999). Also see C. W. L. Hill, “Digital Piracy,” Asian Pacific Journal of Management, 2007, pp. 9–25.

23. Douglass North has argued that the correct specification of intellectual property rights is one factor that lowers the cost of doing business and, thereby, stimulates economic growth and development. See North, Institutions, Institutional Change, and Economic Performance.

24. Business Software Alliance, “Ninth Annual BSA Global Soft- ware Piracy Study,” May 2012, www.bsa.org.

25. Ibid.

26. “Trade Tripwires,” The Economist, August 27, 1994, p. 61.

Chapter Two National Differences in Political, Economic, and Legal Systems 59

p a

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2 N

a ti

o n

a l

D if

fe re

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e s

3-1 Explain what determines the level of economic development of a nation.

3-2 Identify the macropolitical and macroeconomic changes occurring worldwide.

3-3 Describe how transition economies are moving toward market-based systems.

3-4 Explain the implications for management practice of national difference in political economy.

learning objectives

3c h

a pt

opening case

For decades, the Southeast Asian nation of Myanmar (formerly known as Burma) was an interna-tional pariah. Ruled by a brutal military dictatorship since the 1960s, political dissent was not toler-ated, the press was tightly controlled, and opposition parties were shut down. Much economic activity was placed in the hands of the state—which effectively meant the hands of the military elite—who

siphoned off economic profits for their own benefit. Corruption was rampant. In the 1990s, America and

the European Union imposed sweeping economic sanctions on the country to punish the military junta for

stealing elections and jailing opponents. The de facto leader of the country’s democratic opposition

movement, Nobel Peace Prize–winner Aung San Suu Kyi, was repeatedly placed under house arrest from

1989 through 2010.

None of this was good for the country’s economy. Despite having a wealth of natural resources, including

timber, minerals, oil, and gas, the economy stagnated while its Southeast Asian neighbors flourished. By

2012, Myanmar’s GDP per capita was $1,400. In neighboring Thailand, it was $10,000 per capita. The

economy was still largely rural, with 70 percent of the country’s nearly 60 million people involved in

agriculture. This compares with 8.6 percent in Thailand. Few people own cars or cell phones, and there are

no major road or rail links between Myanmar and its neighbors—China, India, and Thailand.

In 2010, the military again won elections that were clearly rigged. Almost no one expected any changes,

but the new president, Thein Sein, was to defy expectations. The government released hundreds of political

prisoners, removed restrictions on the press, freed Aung San Suu Kyi, and allowed opposition parties to

contest seats in a series of by-elections. When Aung San Suu Kyi won a by-election, thrashing her military-

backed opponent, they let her take the seat, raising hopes that Myanmar was at last joining the modern

world. In response, both America and the European Union began to lift their sanctions.

Thein Sein also started to initiate much-needed economic reforms. Even before the 2010 elections, the

military had begun to quietly privatize state-owned enterprises, although many were placed in the hands

of cronies of the regime. In 2012, Thein Sein stated that the government would continue to reduce its role

Political and Economic Reform in Myanmar

National Differences in Economic Development

–continued

62 Part Two National Differences

opening casein a wide range of sectors, including energy, forestry, health care, finance, and telecommunications. The government also abandoned the official fixed exchange rate

for the Myanmar currency, the kyat, replacing it with a managed float. From 2001 to

2012, the official exchange rate for the kyat varied between 5.75 and 6.70 per U.S.

dollar, while the black-market rate was between 750 and 1,335 per U.S. dollar. The

official fixed exchange rate had effectively priced Myanmar’s exports out of the world

market, although it did benefit the military elite who were able to exchange their

worthless kyat for valuable U.S. dollars on very favorable terms. Implemented in April

2012, the managed float valued the kyat at 818 per U.S. dollar. The dramatic fall in the

value of the kyat is expected to stimulate demand for exports from Myanmar, and help

the economy grow.

To further encourage economic growth, the government has signaled that it will now

welcome foreign direct investment and is encouraging foreign enterprises to enter into

partnerships with domestic enterprises in its underdeveloped telecommunications sector.

General Electric and IBM are among the companies stating that they may invest in the

country. Land reforms are also under way.

Much clearly remains to be done. Observers predict that it will be decades before

Myanmar catches up with its Southeast Asian neighbors. The next big test for the

government of Thein Sein will occur in 2015, when general elections are scheduled to be

held. If current trends hold, the military-backed government could be swept out of

power, losing most of its parliamentary seats. It’s an open question as to whether the

military will allow this to happen. If it does, and power is passed on to the democratic

opposition, Myanmar may finally emerge from its isolation. • Sources: Lex Rieffel, “Myanmar’s Economy Confronts Tough Policy Challenges,” East Asian Forum, July 31, 2012; “Opening Soon: Myanmar Gets Ready for Business,” The Economist, March 3, 2012; “Myanmar on the Move,” The Economist, November 21, 2012; and The World Factbook (Washington, DC, CIA), www. cia.gov/library/publications/ the-world-factbook/geos/bm.html.

Introduction In the previous chapter, we described how countries differ with regard to their political sys- tems, economic systems, and legal systems. In this chapter, we build on this material to ex- plain how these differences influence the level of economic development of a nation and, thus, how attractive it is as a place for doing business. We also look at how economic, politi- cal, and legal systems are changing around the world and what the implications of this are for the future rate of economic development of nations and regions. The past three decades have seen a general move toward more democratic forms of government, market-based eco- nomic reforms, and adoption of legal systems that better enforce property rights. Taken to- gether, these trends have helped foster greater economic development around the world and have created a more favorable environment for international business. In the final section of this chapter, we pull all this material together to explore how differences in political, eco- nomic, and legal institutions affect the benefits, costs, and risks of doing business in different nations.

The opening case, which looks at recent changes in Myanmar, highlights many of the issues that we discuss here. For 50 years, Myanmar was run by military dictatorships that systematically plundered the country in the name of socialist ideology. The end result was that a country rich in natural resources, and located in one of the most economically dy- namic regions of the world, became one of the poorest nations on the planet. Things are now shifting in Myanmar. Since 2011, the country has moved toward becoming a function- ing democracy. The economy is also being liberalized to allow for greater free enterprise,

Chapter Three National Differences in Economic Development 63

state-owned businesses are being privatized, and foreign investment is now encouraged. If the evidence from a wide range of other countries is any guide, the long-term consequences of such reforms should include greater economic growth, rising living standards, and a more welcoming environment for international businesses.

Differences in Economic Development Different countries have dramatically different levels of economic development. One com- mon measure of economic development is a country’s gross national income (GNI) per head of population. GNI is regarded as a yardstick for the economic activity of a country; it measures the total annual income received by residents of a nation. Map 3.1 summarizes the GNI per capita of the world’s nations in 2012. As can be seen, countries such as Japan, Swe- den, Switzerland, the United States, and Australia are among the richest on this measure, whereas the large developing countries of China and India are significantly poorer. Japan, for example, had a 2012 GNI per capita of $47,880, but China achieved only $5,720 and India just $1,580.1

GNI per person figures can be misleading because they don’t consider differences in the cost of living. For example, although the 2012 GNI per capita of Switzerland at $80,970 exceeded that of the United States by a wide margin, which was $52,340, the higher cost of living in Switzerland meant that U.S. citizens could actually afford almost as many goods

LO 3-1 Explain what determines the level of economic development of a nation.

Gross National Income (GNI) The yardstick for measuring economic activity of a country, this measures the total annual income of a nation’s residents.

3.1 MAP GNI per Capita, 2012

64 Part Two National Differences

and services as the average Swiss citizen. To account for differences in the cost of living, one can adjust GNI per capita by purchasing power. Referred to as a purchasing power parity (PPP) adjustment, it allows a more direct comparison of living standards in different coun- tries. The base for the adjustment is the cost of living in the United States. The PPP for different countries is then adjusted (up or down) depending upon whether the cost of living is lower or higher than in the United States. For example, in 2012 the GNI per capita for China was $5,720, but the PPP per capita was $9,040, suggesting that the cost of living was lower in China and that $5,720 in China would buy as much as $9,040 in the United States. Table 3.1 gives the GNI per capita measured at PPP in 2012 for a selection of countries, along with their GNI per capita and their growth rate in gross domestic product (GDP) from 2003 to 2012. Map 3.2 summarizes the GNI PPP per capita in 2012 for the nations of the world.

As can be seen, there are striking differences in the standards of living among countries. Table 3.1 suggests the average Indian citizen can afford to consume only about 7.4 percent of the goods and services consumed by the average U.S. citizen on a PPP basis. Given this, we might conclude that despite having a population of 1.2 billion, India is unlikely to be a very lucrative market for the consumer products produced by many Western international businesses. However, this would be incorrect because India has a fairly wealthy middle class of close to 250 million people, despite its large number of poor citizens. In absolute terms, the Indian economy now rivals that of Russia.

To complicate matters, in many countries the “official” figures do not tell the entire story. Large amounts of economic activity may be in the form of unrecorded cash transactions, or barter agreements. People engage in such transactions to avoid paying taxes, and although the share of total economic activity accounted for by such transactions may be small in developed economies such as the United States, in some countries (India being an example), they are reportedly very significant. Known as the black economy or shadow economy, estimates suggest that in India it may be around 50 percent of GDP, which implies that the Indian economy is half as big again as the figures reported in Table 3.1. Estimates produced by the European Union suggest that in 2012 the shadow economy accounted for around 10 percent of GDP in the UK and France, but 24 percent in Greece and as much as 32 percent in Bulgaria.2

The GNI and PPP data give a static picture of development. They tell us, for example, that China is much poorer than the United States, but they do not tell us if China is closing the gap. To assess this, we have to look at the economic growth rates achieved by countries.

Purchasing Power Parity (PPP) An adjustment in gross domestic product per capita to reflect differences in the cost of living.

3.1 TABLE Economic Data for Select Countries Source: World Development Indicators Online, 2014.

Country

GNI per Capita, 2012 ($)

GNI PPP per Capita, 2012 ($)

Annual Average GDP Growth Rate, 2003–2012 (%)

Size of Economy GDP, 2012 ($ billions)

Brazil 11,630 11,530 3.60 2,253

China 5,720 9,040 10.46 8,227

Germany 44,260 42,230 1.24 3,428

India 1,580 3,910 7.66 1,842

Japan 47,880 36,300 0.87 5,960

Nigeria 1,440 2,450 9.69 263

Poland 12,660 21,170 4.29 490

Russia 12,700 22,720 4.72 2,015

Switzerland 80,970 55,090 1.87 631

United Kingdom 38,670 37,340 1.35 2,471

United States 52,340 52,610 1.84 16,244

Chapter Three National Differences in Economic Development 65

3.2 MAP GNI PPP per Capita, 2012

Table 3.1 gives the rate of growth in gross domestic product (GDP) achieved by a number of countries between 2003 and 2012. Map 3.3 summarizes the annual average percentage growth rate in GDP from 2003 to 2012. Although countries such as China and India are currently relatively poor, their economies are already large in absolute terms and growing far more rapidly than those of many advanced nations. They are already huge markets for the products of international businesses. In 2010, China overtook Japan to become the sec- ond-largest economy in the world after the United States. Indeed, if both China and the

Country Comparator

The “Country Comparator” tool on globalEDGE (globalEDGE.msu.edu/ comparator) includes data from as early as 1960 to the most recent year. Using this tool, it is easy to compare countries across a variety of macro variables to better understand the economic changes occurring in countries. As related to Chapter 3 of the text, the globalEDGE Country Comparator tool is an effective way to statistically get an overview of the political economy and economic development by country world-

wide. Comparisons of up to 20 countries at a time can be made in table format. Sometimes we talk about the BRIC countries when referring to Brazil, Russia, India, and China—in essence, we broadly classify them as “superstar” emerging markets, but are they really that similar? Us- ing the Country Comparator tool on globalEDGE, we find that the GDP adjusted for purchasing power parity is by far the greatest in Russia. Where do you think Brazil, India, and China fall on the GDP PPP scale?

66 Part Two National Differences

United States maintain their current economic growth rates, China will become the world’s largest economy sometime during the next decade. On current trends, In- dia too will be among the largest economies in the world. Given that potential, many international businesses are trying to establish a strong presence in these markets.

BROADER CONCEPTIONS OF DEVEL- OPMENT: AMARTYA SEN The Nobel Prize–winning economist Amartya Sen has argued that development should be assessed less by material output measures such as GNI per capita and more by the capa- bilities and opportunities that people enjoy.3 According to Sen, development should be seen as a process of expand- ing the real freedoms that people experience. Hence, de- velopment requires the removal of major impediments to freedom: poverty as well as tyranny, poor economic op- portunities as well as systematic social deprivation, and neglect of public facilities as well as the intolerance of re- pressive states. In Sen’s view, development is not just an economic process, but is a political one too, and to suc-

3.3 MAP Average Annual Growth Rate in GDP, 2003–2012

What If We Were a Community of 100 People? The “Miniature Earth” project was developed by Allysson Luca in 2001 as a way to better illustrate and create understanding of differences in the world. He thought that reducing the world’s population to a community of only 100 people would be a useful and easy-to-understand illustration of various dynamics in the global marketplace. And, this Miniature Earth captures a variety of issues related to the political economy and economic devel- opment that are discussed in the chapter of the text. At the basic level, if the earth were a community of 100 people, 61 people would be Asian, 13 African, 12 European, 8 North American, 5 South American, and 1 would be from Oceania. Twenty people own 75 percent of the financial wealth. If you could decide, how would you redistribute wealth among the 100 people: Make some richer or make the wealth among people more even, or let market forces distribute wealth as we have it now?

Source: www.miniature-earth.com.

Chapter Three National Differences in Economic Development 67

ceed requires the “democratization” of political communities to give citizens a voice in the important decisions made for the community. This perspective leads Sen to emphasize basic health care, especially for children, and basic education, especially for women. Not only are these factors desirable for their instrumental value in helping to achieve higher income levels, but they are also beneficial in their own right. People cannot develop their capabilities if they are chronically ill or woefully ignorant.

Sen’s influential thesis has been picked up by the United Nations, which has developed the Human Development Index (HDI) to measure the quality of human life in different nations. The HDI is based on three measures: life expectancy at birth (a function of health care); educational attainment (measured by a combination of the adult literacy rate and enrollment in primary, secondary, and tertiary education); and whether average incomes, based on PPP estimates, are sufficient to meet the basic needs of life in a country (adequate food, shelter, and health care). As such, the HDI comes much closer to Sen’s conception of how development should be measured than narrow economic measures such as GNI per capita—although Sen’s thesis suggests that political freedoms should also be included in the index, and they are not. The HDI is scaled from 0 to 1. Countries scoring less than 0.5 are classified as having low human development (the quality of life is poor); those scoring from 0.5 to 0.8 are classified as having medium human development; and those that score above 0.8 are classified as having high human development. Map 3.4 summarizes the HDI scores for 2012.

Human Development Index (HDI) An attempt by the UN to assess the impact of a number of factors on the quality of human life in a country.

3.4 MAP Human Development Index, 2012

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68 Part Two National Differences

Political Economy and Economic Progress It is often argued that a country’s economic development is a function of its economic and political systems. What then is the nature of the relationship between political economy and economic progress? Despite the long debate over this question among academics and policymakers, it is not possible to give an unambiguous answer. However, it is possible to untangle the main threads of the arguments and make a few generalizations as to the nature of the relationship between political economy and economic progress.

INNOVATION AND ENTREPRENEURSHIP ARE THE ENGINES OF GROWTH There is substantial agreement among economists that innovation and entrepreneurial activity are the engines of long-run economic growth.4 Those who make this argument define innovation broadly to include not just new products but also new pro- cesses, new organizations, new management practices, and new strategies. Thus, the Toys “R” Us strategy of establishing large warehouse-style toy stores and then engaging in heavy advertising and price discounting to sell the merchandise can be classified as an innovation because it was the first company to pursue this strategy. Similarly, the development of mass- market online retailing by Amazon.com can be seen as an innovation. Innovation and entre- preneurial activity help increase economic activity by creating new products and markets that did not previously exist. Moreover, innovations in production and business processes lead to an increase in the productivity of labor and capital, which further boosts economic growth rates.5

Innovation is also seen as the product of entrepreneurial activity. Often, entrepreneurs first commercialize innovative new products and processes, and entrepreneurial activity provides much of the dynamism in an economy. For example, the U.S. economy has bene- fited greatly from a high level of entrepreneurial activity, which has resulted in rapid in- novation in products and process. Firms such as Google, Facebook, Amazon, Cisco Systems, Dell, Microsoft, and Oracle were all founded by entrepreneurial individuals to exploit new technology. All these firms created significant economic value and boosted productivity by helping commercialize innovations in products and processes. Thus, we can conclude that if a country’s economy is to sustain long-run economic growth, the busi- ness environment must be conducive to the consistent production of product and process innovations and to entrepreneurial activity.

INNOVATION AND ENTREPRENEURSHIP REQUIRE A MARKET ECONOMY This leads logically to a further question: What is required for the busi- ness environment of a country to be conducive to innovation and entrepreneurial activity? Those who have considered this issue highlight the advantages of a market economy.6 It has been argued that the economic freedom associated with a market economy creates greater incentives for innovation and entrepreneurship than either a planned or a mixed economy. In a market economy, any individual who has an innovative idea is free to try to make money out of that idea by starting a business (by engaging in entrepreneurial activity). Similarly, existing businesses are free to improve their operations through innovation. To the extent that they are successful, both individual entrepreneurs and established businesses can reap rewards in the form of high profits. Thus, market economies contain enormous incentives to develop innovations.

In a planned economy, the state owns all means of production. Consequently, entrepre- neurial individuals have few economic incentives to develop valuable new innovations be- cause it is the state, rather than the individual, that captures most of the gains. The lack of economic freedom and incentives for innovation was probably a main factor in the eco- nomic stagnation of many former communist states and led ultimately to their collapse at the end of the 1980s. Similar stagnation occurred in many mixed economies in those sectors where the state had a monopoly (such as coal mining and telecommunications in Great Brit- ain). This stagnation provided the impetus for the widespread privatization of state-owned enterprises that we witnessed in many mixed economies during the mid-1980s and that is

Innovation Development of new products, processes, organizations, management practices, and strategies.

Entrepreneurs Those who first commercialize innovations.

Chapter Three National Differences in Economic Development 69

still going on today (privatization refers to the process of selling state-owned enterprises to private investors—see Chapter 2 for details).

A study of 102 countries over a 20-year period provided evidence of a strong relationship between economic freedom (as provided by a market economy) and economic growth.7 The study found that the more economic freedom a country had between 1975 and 1995, the more economic growth it achieved and the richer its citizens became. The six countries that had persistently high ratings of economic freedom from 1975 to 1995 (Hong Kong, Swit- zerland, Singapore, the United States, Canada, and Germany) were also all in the top 10 in terms of economic growth rates. In contrast, no country with persistently low economic freedom achieved a respectable growth rate. In the 16 countries for which the index of eco- nomic freedom declined the most during 1975 to 1995, gross domestic product fell at an annual rate of 0.6 percent.

INNOVATION AND ENTREPRENEURSHIP REQUIRE STRONG PROPERTY RIGHTS Strong legal protection of property rights is another require- ment for a business environment to be conducive to innovation, entrepreneurial activity, and hence economic growth.8 Both individuals and businesses must be given the opportunity to profit from innovative ideas. Without strong property rights protection, businesses and in- dividuals run the risk that the profits from their innovative efforts will be expropriated, ei- ther by criminal elements or by the state. The state can expropriate the profits from innovation through legal means, such as excessive taxation, or through illegal means, such as demands from state bureaucrats for kickbacks in return for granting an individual or firm a license to do business in a certain area (i.e., corruption). According to the Nobel Prize–win- ning economist Douglass North, throughout history many governments have displayed a tendency to engage in such behavior.9 Inadequately enforced property rights reduce the in- centives for innovation and entrepreneurial activity—because the profits from such activity are “stolen”—and hence reduce the rate of economic growth.

The influential Peruvian development economist Hernando de Soto has argued that much of the developing world will fail to reap the benefits of capitalism until property rights are better defined and protected.10 De Soto’s arguments are interesting because he says the key problem is not the risk of expropriation, but the chronic inability of property owners to establish legal title to the property they own. As an example of the scale of the problem, he cites the situation in Haiti, where individuals must take 176 steps over 19 years to own land legally. Because most property in poor countries is informally “owned,” the absence of legal proof of ownership means that property holders cannot convert their assets into capital, which could then be used to finance business ventures. Banks will not lend money to the poor to start businesses because the poor possess no proof that they own property, such as farmland, that can be used as collateral for a loan. By de Soto’s calculations, the total value of real estate held by the poor in third-world and former communist states amounted to more than $9.3 trillion in 2000. If those assets could be converted into capital, the result could be an economic revolution that would allow the poor to bootstrap their way out of poverty. Interestingly enough, the Chinese seem to have taken de Soto’s arguments to heart. Despite still being nominally a communist country, in October 2007 the government passed a law that gave private property owners the same rights as the state, which significantly improved the rights of urban and rural landowners to the land that they use (see the accompanying Country Focus).

THE REQUIRED POLITICAL SYSTEM Much debate surrounds which kind of political system best achieves a functioning market economy with strong protection for property rights.11 People in the West tend to associate a representative democracy with a market economic system, strong property rights protection, and economic progress. Build- ing on this, we tend to argue that democracy is good for growth. However, some totalitar- ian regimes have fostered a market economy and strong property rights protection and have experienced rapid economic growth. Five of the fastest growing economies of the past 30 years—China, South Korea, Taiwan, Singapore, and Hong Kong—had one thing in

70 Part Two National Differences

common at the start of their economic growth: undemocratic governments. At the same time, countries with stable democratic governments, such as India, experienced sluggish economic growth for long periods. In 1992, Lee Kuan Yew, Singapore’s leader for many years, told an audience, “I do not believe that democracy necessarily leads to develop- ment. I believe that a country needs to develop discipline more than democracy. The exuberance of democracy leads to undisciplined and disorderly conduct which is inimical to development.”12

However, those who argue for the value of a totalitarian regime miss an important point: If dictators made countries rich, then much of Africa, Asia, and Latin America should have been growing rapidly during 1960 to 1990, and this was not the case. Only a totalitarian regime that is committed to a market system and strong protection of prop- erty rights is capable of promoting economic growth. Also, there is no guarantee that a dictatorship will continue to pursue such progressive policies. Dictators are rarely benev- olent. Many are tempted to use the apparatus of the state to further their own private ends, violating property rights and stalling economic growth (as may have occurred in Myanmar—see the opening case). Given this, it seems likely that democratic regimes are far more conducive to long-term economic growth than are dictatorships, even benevo- lent ones. Only in a well-functioning, mature democracy are property rights truly se- cure.13 Nor should we forget Amartya Sen’s arguments reviewed earlier. Totalitarian states, by limiting human freedom, also suppress human development and therefore are detri- mental to progress.

ECONOMIC PROGRESS BEGETS DEMOCRACY While it is possible to argue that democracy is not a necessary precondition for a free market economy in which property rights are protected, subsequent economic growth often leads to establishment of a democratic regime. Several of the fastest-growing Asian economies adopted more demo- cratic governments during the past three decades, including South Korea and Taiwan. Thus, although democracy may not always be the cause of initial economic progress, it seems to be one consequence of that progress.

Emerging Property Rights in China

On October 1, 2007, a new property law took effect in China, granting rural and urban landholders far more secure property rights. The law was a much-needed response to how China’s economy has changed over the past 30 years as it transitions from a centrally planned system to a more dynamic market-based economy where two-thirds of eco- nomic activity is in the hands of private enterprises.

Although all land in China still technically belongs to the state—an ideological necessity in a country where the government still claims to be guided by Marxism—urban landholders had been granted 40- to 70-year leases to use the land, while rural farmers had 30-year leases. However, the lack of legal title meant that landholders were at the whim of the state. Large-scale appropriation of rural land for housing and factory construction had rendered millions of farmers landless. Many were given little or no compensation, and they drifted to the cit- ies where they added to a growing underclass. In both urban and rural areas, property and land disputes had become a leading cause of so- cial unrest. According to government sources, in 2006 there were about 23,000 “mass incidents” of social unrest in China, many related to disputes over property rights.

The 2007 law, which was 14 years in gestation due to a rearguard action fought by left-wing Communist Party activists who objected to it on ideological grounds, gives urban and rural land users the right to automatic renewal of their leases after the expiration of the 30- to 70- year terms. In addition, the law requires that land users be fairly com- pensated if the land is required for other purposes, and it gives individuals the same legal protection for their property as the state. Taken together with a 2004 change in China’s constitution, which stated that private property “was not to be encroached upon,” the new law significantly strengthens property rights in China.

Nevertheless, the law has its limitations; most notably, it still falls short of giving peasants marketable ownership rights to the land they farm. If they could sell their land, tens of millions of underemployed farm- ers might find more productive work elsewhere. Those who stayed could acquire bigger land holdings that could be used more efficiently. Also, farmers might be able to use their land holdings as security against which they could borrow funds for investments to boost productivity.

Sources: “China’s Next Revolution—Property Rights in China,” The Economist, March 10, 2007, p. 11; “Caught between the Right and Left,” The Economist, March 10, 2007, pp. 25–27; and Z. Keliang and L. Ping, “Rural Land Rights under the PRC Property Law,” China Law and Practice, November 2007, pp. 10–15.

country FOCUS

Chapter Three National Differences in Economic Development 71

A strong belief that economic progress leads to adop- tion of a democratic regime underlies the fairly permissive attitude that many Western governments have adopted to- ward human rights violations in China. Although China has a totalitarian government in which human rights are violated, many Western countries have been hesitant to criticize the country too much for fear that this might hamper the country’s march toward a free market system. The belief is that once China has a free market system, greater individual freedoms and democracy will follow. Whether this optimistic vision comes to pass remains to be seen.

GEOGRAPHY, EDUCATION, AND ECO- NOMIC DEVELOPMENT While a country’s political and economic systems are probably the big engine driving its rate of economic development, other factors are also important. One that has received attention is geogra- phy.14 But the belief that geography can influence eco- nomic policy, and hence economic growth rates, goes back to Adam Smith. The influential economist Jeffrey Sachs argues

throughout history, coastal states, with their long engagements in international trade, have been more supportive of market institutions than landlocked states, which have tended to organize themselves as hierarchical (and often militarised) societies. Moun- tainous states, as a result of physical isolation, have often neglected market-based trade. Temperate climes have generally supported higher densities of population and thus a more extensive division of labour than tropical regions.15

Sachs’s point is that by virtue of favorable geography, certain societies are more likely to engage in trade than others and are thus more likely to be open to and develop market- based economic systems, which in turn promotes faster economic growth. He also argues that, irrespective of the economic and political institutions a country adopts, adverse geographic conditions—such as the high rate of disease, poor soils, and hostile climate that afflict many tropical countries—can have a negative impact on development. Together with colleagues at Harvard’s Institute for International Development, Sachs tested for the impact of geography on a country’s economic growth rate between 1965 and 1990. He found that landlocked countries grew more slowly than coastal economies and that being entirely landlocked reduced a country’s growth rate by roughly 0.7 percent per year. He also found that tropical countries grew 1.3 percent more slowly each year than countries in the temper- ate zone.

Education emerges as another important determinant of economic development (a point that Amartya Sen emphasizes). The general assertion is that nations that invest more in edu- cation will have higher growth rates because an educated population is a more productive population. Anecdotal comparisons suggest this is true. In 1960, Pakistanis and South Kore- ans were on equal footing economically. However, just 30 percent of Pakistani children were enrolled in primary schools, while 94 percent of South Koreans were. By the mid-1980s, South Korea’s GNP per person was three times that of Pakistan.16 A survey of 14 statistical studies that looked at the relationship between a country’s investment in education and its subsequent growth rates concluded investment in education did have a positive and statisti- cally significant impact on a country’s rate of economic growth.17 Similarly, the work by Sachs discussed earlier suggests that investments in education help explain why some coun- tries in Southeast Asia, such as Indonesia, Malaysia, and Singapore, have been able to over- come the disadvantages associated with their tropical geography and grow far more rapidly than tropical nations in Africa and Latin America.

i i i l d

Democracy in the Arab World: New Realities in an Ancient Land? Democracy is finally making an appearance in the Ancient Lands of the Middle East, as witnessed by the recent uprisings known as the “The Arab Spring.” Wissam Yafi, an expert in technology and international development, believes geo-economic, geo- social, technological, and geo-political forces will lead to inevitable changes in the Arab world. Economic forces will make these governments cut many of the social services offered, putting people out of work, which will lead toward democratic alterna- tives. Technology is another major binding force connecting populations across the Middle East, which will mean less cen- sorship; something that has been widespread in many parts of the Arab world. People will continue to challenge the status quo as rapid urbanization, population growth, and movements to- ward self-determination grow. Wissam Yafi has a lot of guesses on what will happen. Do you agree with his forecasts?

Source: carnegieendowment.org/2012/04/18/inevitable-democracy-in-arab- world-new-realities-inancient-land/a7jk.

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72 Part Two National Differences

States in Transition The political economy of many of the world’s nation-states has changed radically since the late 1980s. Two trends have been evident. First, during the late 1980s and early 1990s, a wave of democratic revolutions swept the world. Totalitarian governments collapsed and were replaced by democratically elected governments that were typically more committed to free market capitalism than their predecessors had been. Second, there has been a strong move away from centrally planned and mixed economies and toward a more free market economic model.

THE SPREAD OF DEMOCRACY One notable development of the past 30 years has been the spread of democracy (and, by extension, the decline of totalitarianism). Map 3.5 reports on the extent of totalitarianism in the world as determined by Freedom House.18 This map charts political freedom in 2013, grouping countries into three broad groupings: free, partly free, and not free. In “free” countries, citizens enjoy a high degree of political and civil freedoms. “Partly free” countries are characterized by some restrictions on political rights and civil liberties, often in the context of corruption, weak rule of law, ethnic strife, or civil war. In “not free” countries, the political process is tightly controlled and basic freedoms are denied.

LO 3-2 Identify the macropolitical and macroeconomic changes occurring worldwide.

3.5 MAP Freedom in the World in 2013 From The Freedom House Survey Team, “Freedom in the World: 2014,” www.freedomhouse.org. Reprinted with permission.

Chapter Three National Differences in Economic Development 73

Freedom House classified some 88 countries as free in 2013, ac- counting for about 45 percent of the world’s nations and 40 percent of the global population. These countries respect a broad range of po- litical rights. Another 59 countries accounting for 30 percent of the world’s nations and 25 percent of the world’s population were classi- fied as partly free, while 48 countries representing approximately 24 percent of the world’s nations and 35 percent of the global population were classified as not free. The number of democracies in the world has increased from 69 nations in 1987 to 122 in 2012, slightly below the 2006 total of 123. But not all democracies are free, according to Freedom House, because some democracies still restrict certain po- litical and civil liberties. For example, Russia has consistently been rated “not free” since the early 2000s. According to Freedom House,

Russia’s step backwards into the Not Free category is the culmina- tion of a growing trend . . . to concentrate political authority, ha- rass and intimidate the media, and politicize the country’s law-enforcement system.19

Similarly, Freedom House argues that democracy was restricted in Venezuela under the leadership of the late Hugo Chávez.

Many of the newer democracies are to be found in eastern Europe and Latin America, although there also have been notable gains in Africa during this time, such as in South Africa and more recently Libya. Entrants into the ranks of the world’s democracies during the last 25 years include Mexico, which held its first fully free and fair presidential election in 2000 after free and fair parliamentary and state elections in 1997 and 1998; Senegal, where free and fair presidential elections led to a peaceful transfer of power; Ukraine, where popular unrest following widespread ballot fraud in the 2004 presidential election resulted in a second election, the victory of a reform candidate, and a marked improvement in civil liberties (although sadly, the reform candidate also proved to be corrupt); and Libya, which held successful elections in 2012 after the removal by popular revolt of that country’s long-standing dictator, Muammar Gaddafi.

Three main reasons account for the spread of democracy.20 First, many totalitarian re- gimes failed to deliver economic progress to the vast bulk of their populations. The collapse of communism in eastern Europe, for example, was precipitated by the growing gulf be- tween the vibrant and wealthy economies of the West and the stagnant economies of the communist East. In looking for alternatives to the socialist model, the populations of these countries could not have failed to notice that most of the world’s strongest economies were governed by representative democracies. Today, the economic success of many of the newer democracies—such as Poland and the Czech Republic in the former communist bloc, the Philippines and Taiwan in Asia, and Chile in Latin America—has strengthened the case for democracy as a key component of successful economic advancement.

Second, new information and communication technologies—including satellite televi- sion, fax machines, desktop publishing, and, most important, the Internet—have reduced a state’s ability to control access to uncensored information. These technologies have created new conduits for the spread of democratic ideals and information from free societies. Today, the Internet is allowing democratic ideals to penetrate closed societies as never before.21 Young people who utilized Facebook and Twitter to reach large numbers of people very quickly and coordinate their actions organized the demonstrations in 2011 that led to the overthrow of the Egyptian government.

Third, in many countries, economic advances have led to the emergence of increasingly prosperous middle and working classes that have pushed for democratic reforms. This was certainly a factor in the democratic transformation of South Korea. Entrepreneurs and other business leaders, eager to protect their property rights and ensure the dispassionate enforce- ment of contracts, are another force pressing for more accountable and open government.

Despite this, it would be naive to conclude that the global spread of democracy will continue unchallenged. Democracy is still rare in large parts of the world. In sub-Saharan

Libya is one of the newer democracies. Here, Libyan election officials sort ballots at a polling station during the first general election held in decades.

74 Part Two National Differences

Africa in 2013, only 10 countries were considered free, 19 were partly free, and 20 were not free. Among the post-communist countries in eastern and central Europe and the former Soviet Union, only 13 are classified as free (primarily in eastern Europe). And there is only 1 free state among the 18 nations of the Middle East and North Africa— although it remains to be seen how the wave of unrest that spread across the Middle East dur- ing 2011–2013 will change this. Moreover, there are dis- turbing signs that authoritarianism is gaining ground in several countries where political and civil liberties have been progressively limited in recent years, including Russia, Ukraine, Indonesia, and Venezuela. In Egypt, af- ter a brief flirtation with democracy, the military stepped in, removing the government of Mohamed Morsi, after Morsi and his political movement, the Muslim Brother- hood, had exhibited its own authoritarian tendencies. The military-backed government, however, has also acted in an authoritarian manner, effectively reversing much of the progress that had occurred after the revolu- tion of 2011.

THE NEW WORLD ORDER AND GLOBAL TERRORISM The end of the Cold War and the “new world order” that followed the collapse of communism in eastern Europe and the former Soviet Union, taken together with the demise of many authoritarian regimes in Latin America, gave rise to intense speculation about the future shape of global geopolitics. Author Francis Fukuyama argued, “We may be witnessing . . . the end of history as such: that is, the end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of human government.”22 Fukuyama goes on to say that the war of ideas may be at an end and that liberal democracy has triumphed.

Others questioned Fukuyama’s vision of a more harmonious world dominated by a universal civilization characterized by democratic regimes and free market capitalism. In a controversial book, the late influential political scientist Samuel Huntington argued there is no “universal” civilization based on widespread acceptance of Western liberal demo- cratic ideals.23 Huntington maintained that while many societies may be modernizing— they are adopting the material paraphernalia of the modern world, from automobiles to Coca-Cola and MTV—they are not becoming more Western. On the contrary, Huntington theorized that modernization in non-Western societies can result in a retreat toward the traditional, such as the resurgence of Islam in many traditionally Muslim societies. He wrote,

The Islamic resurgence is both a product of and an effort to come to grips with modernization. Its underlying causes are those generally responsible for indigeniza- tion trends in non-Western societies: urbanization, social mobilization, higher lev- els of literacy and education, intensified communication and media consumption, and expanded interaction with Western and other cultures. These developments undermine traditional village and clan ties and create alienation and an identity crisis. Islamist symbols, commitments, and beliefs meet these psychological needs, and Islamist welfare organizations, the social, cultural, and economic needs of Mus- lims caught in the process of modernization. Muslims feel a need to return to Islamic ideas, practices, and institutions to provide the compass and the motor of modernization.24

Thus, the rise of Islamic fundamentalism is portrayed as a response to the alienation pro- duced by modernization.

Is World Peace Through Commerce Possible? Interested in world peace? Business students worldwide can par- ticipate in Peace Through Commerce’s “Matrix of Peace,” an inte- grated program that shows how business schools can promote peace. The program is sponsored by the Association to Advance Collegiate Schools of Business (AACSB International), the global accrediting organization of business schools. Peace Through Commerce is built on the premise that peace is achieved and maintained by an interdependent system of commerce, con- sciousness, and laws and structure. As the AACSB puts it: “If we educate students that it is their responsibility to advance society; over a generation we may be able to have more impact than gov- ernments have had.” What do you think? Can business people advance global societies more than governments if educated ac- cording to the framework of the “Matrix of Peace”?

Source: www.peacethroughcommerce.com.

Chapter Three National Differences in Economic Development 75

In contrast to Fukuyama, Huntington envisioned a world split into different civilizations, each of which has its own value systems and ideology. Huntington predicted conflict be- tween the West and Islam and between the West and China. While some commentators originally dismissed Huntington’s thesis, in the aftermath of the terrorist attacks on the United States on September 11, 2001, Huntington’s views received new attention.

If Huntington’s views are even partly correct, they have important implications for inter- national business. They suggest many countries may be difficult places in which to do busi- ness, either because they are shot through with violent conflicts or because they are part of a civilization that is in conflict with an enterprise’s home country. Huntington’s views are speculative and controversial. More likely than his predictions coming to pass is the evolu- tion of a global political system that is positioned somewhere between Fukuyama’s universal global civilization based on liberal democratic ideals and Huntington’s vision of a fractured world. That would still be a world, however, in which geopolitical forces periodically limit the ability of business enterprises to operate in certain foreign countries.

In Huntington’s thesis, global terrorism is a product of the tension between civilizations and the clash of value systems and ideology. Others point to terrorism’s roots in long-standing conflicts that seem to defy political resolution—the Palestinian, Kashmir, and Northern Ireland conflicts being obvious examples. It should also be noted that a substantial amount of terrorist activity in some parts of the world, such as Colombia, has been interwoven with the illegal drug trade. As former U.S. Secretary of State Colin Powell has maintained, ter- rorism represents one of the major threats to world peace and economic progress in the twenty-first century.25

THE SPREAD OF MARKET-BASED SYSTEMS Paralleling the spread of democracy since the 1980s has been the transformation from centrally planned command economies to market-based economies. More than 30 countries that were in the former Soviet Union or the eastern European communist bloc have changed their economic sys- tems. A complete list of countries where change is now occurring also would include Asian states such as China and Vietnam, as well as African countries such as Angola, Ethiopia, and Mozambique.26 There has been a similar shift away from a mixed economy. Many states in

Rapid economic development has taken place in China and Vietnam since the shift toward a more market-based system.

76 Part Two National Differences

Asia, Latin America, and western Europe have sold state-owned businesses to private inves- tors (privatization) and deregulated their economies to promote greater competition.

The rationale for economic transformation has been the same the world over. In gen- eral, command and mixed economies failed to deliver the kind of sustained economic performance that was achieved by countries adopting market-based systems, such as the United States, Switzerland, Hong Kong, and Taiwan. As a consequence, even more states have gravitated toward the market-based model. Map 3.6, based on data from the Heri- tage Foundation, a politically conservative U.S. research foundation, gives some idea of the degree to which the world has shifted toward market-based economic systems (given that the Heritage Foundation has an overt political agenda and generally supports the “Tea Party” wing of the Republican Party, its work should be viewed with caution). The Heritage Foundation’s index of economic freedom is based on 10 indicators, including the extent to which the government intervenes in the economy, trade policy, the degree to which property rights are protected, foreign investment regulations, taxation rules, free- dom from corruption, and labor freedom. A country can score between 100 (most free) and 0 (least free) on each of these indicators. The higher a country’s average score across all 10 indicators, the more closely its economy represents the pure market model. Accord- ing to the 2013 index, which is summarized in Map 3.6, the world’s freest economies are (in rank order) Hong Kong, Singapore, Australia, Switzerland, New Zealand, Canada,

3.6 MAP Distribution of Economic Freedom, 2014 From The Freedom House Survey Team, “Freedom in the World: 2014,” www.freedomhouse.org. Reprinted with permission.

Chapter Three National Differences in Economic Development 77

Chile, Mauritius, Ireland, and Denmark. The United States came in at 12, Japan at 25, Mexico at 55, France at 70, Brazil at 114, India at 120, China at 137, and Russia at 140. The economies of Cuba, Iran, Venezuela, Zimbabwe, and North Korea are to be found at the bottom of the rankings.27

Economic freedom does not necessarily equate with political freedom, as detailed in Map 3.6. For example, the two top states in the Heritage Foundation index, Hong Kong and Singapore, cannot be classified as politically free. Hong Kong was reabsorbed into commu- nist China in 1997, and the first thing Beijing did was shut down Hong Kong’s freely elected legislature. Singapore is ranked as only partly free on Freedom House’s index of political freedom due to practices such as widespread press censorship.

The Nature of Economic Transformation The shift toward a market-based economic system often entails a number of steps: deregula- tion, privatization, and creation of a legal system to safeguard property rights.28

DEREGULATION Deregulation involves removing legal restrictions to the free play of markets, the establishment of private enterprises, and the manner in which pri- vate enterprises operate. Before the collapse of communism, the governments in most command economies exercised tight control over prices and output, setting both through detailed state planning. They also prohibited private enterprises from operating in most sectors of the economy, severely restricted direct investment by foreign enterprises, and limited international trade. Deregulation in these cases involved removing price con- trols, thereby allowing prices to be set by the interplay between demand and supply; abolishing laws regulating the establishment and operation of private enterprises; and relaxing or removing restrictions on direct investment by foreign enterprises and inter- national trade.

In mixed economies, the role of the state was more limited; but here, too, in certain sectors the state set prices, owned businesses, limited private enterprise, restricted in- vestment by foreigners, and restricted international trade. For these countries, deregu- lation has involved the same kind of initiatives that we have seen in former command economies, although the transformation has been easier because these countries often had a vibrant private sector. India is an example of a country that has substantially de- regulated its economy over the past two decades (see the accompanying Country Focus on India).

PRIVATIZATION Hand in hand with deregulation has come a sharp increase in privatization. Privatization, as we discussed in Chapter 2, transfers the ownership of state property into the hands of private individuals, frequently by the sale of state assets through an auction.29 Privatization is seen as a way to stimulate gains in economic efficiency by giv- ing new private owners a powerful incentive—the reward of greater profits—to search for increases in productivity, to enter new markets, and to exit losing ones.30

The privatization movement started in Great Britain in the early 1980s when then Prime Minister Margaret Thatcher started to sell state-owned assets such as the British telephone company, British Telecom (BT). In a pattern that has been repeated around the world, this sale was linked with the deregulation of the British telecommunications industry. By allow- ing other firms to compete head to head with BT, deregulation ensured that privatization did not simply replace a state-owned monopoly with a private monopoly. Since the 1980s, privatization has become a worldwide phenomenon. More than 8,000 acts of privatization were completed around the world between 1995 and 1999.31 Some of the most dramatic privatization programs occurred in the economies of the former Soviet Union and its eastern European satellite states. In the Czech Republic, for example, three-quarters of all state- owned enterprises were privatized between 1989 and 1996, helping push the share of gross domestic product accounted for by the private sector up from 11 percent in 1989 to 60 per- cent in 1995.32

LO 3-3 Describe how transition economies are moving toward market-based systems.

Deregulation Removal of government restrictions concerning the conduct of a business.

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78 Part Two National Differences

Despite this three-decade trend, large amounts of economic activity are still in the hands of state-owned enterprises in many nations. In China, for example, state-owned companies still dominate the banking, energy, telecom, health care, and technology sectors. Overall, they account for about 40 percent of the country’s GDP. In a report released in early 2012, the World Bank cautioned China that unless it reformed these sectors—liberalizing them and privatizing many state-owned enterprises—the country runs the risk of experiencing a serious economic crisis.33

As privatization has proceeded, it has become clear that simply selling state-owned assets to private investors is not enough to guarantee economic growth. Studies of privatization in central Europe have shown that the process often fails to deliver predicted benefits if the newly privatized firms continue to receive subsidies from the state and if they are protected from foreign competition by barriers to international trade and foreign direct investment.34 In such cases, the newly privatized firms are sheltered from competition and continue acting

India’s Economic Transformation

After gaining independence from Britain in 1947, India adopted a dem- ocratic system of government. The economic system that developed in India after 1947 was a mixed economy characterized by a large num- ber of state-owned enterprises, centralized planning, and subsidies. This system constrained the growth of the private sector. Private com- panies could expand only with government permission. It could take years to get permission to diversify into a new product. Much of heavy industry, such as auto, chemical, and steel production, was reserved for state-owned enterprises. Production quotas and high tariffs on im- ports also stunted the development of a healthy private sector, as did labor laws that made it difficult to fire employees.

By the early 1990s, it was clear this system was incapable of deliv- ering the kind of economic progress that many Southeast Asian nations had started to enjoy. In 1994, India’s economy was still smaller than Belgium’s, despite having a population of 950 million. Its GDP per cap- ita was a paltry $310, less than half the population could read, only 6 million had access to telephones, and only 14 percent had access to clean sanitation; the World Bank estimated that some 40 percent of the world’s desperately poor lived in India, and only 2.3 percent of the population had a household income in excess of $2,484.

The lack of progress led the government to embark on an ambitious economic reform program. Starting in 1991, much of the industrial li- censing system was dismantled, and several areas once closed to the private sector were opened, including electricity generation, parts of the oil industry, steelmaking, air transport, and some areas of the tele- communications industry. Investment by foreign enterprises, formerly allowed only grudgingly and subject to arbitrary ceilings, was suddenly welcomed. Approval was made automatic for foreign equity stakes of up to 51 percent in an Indian enterprise, and 100 percent foreign own- ership was allowed under certain circumstances. Raw materials and many industrial goods could be freely imported, and the maximum tar- iff that could be levied on imports was reduced from 400 percent to 65 percent. The top income tax rate was also reduced, and corporate tax fell from 57.5 percent to 46 percent in 1994, and then to 35 percent in 1997. The government also announced plans to start privatizing India’s state-owned businesses, some 40 percent of which were losing money in the early 1990s.

Judged by some measures, the response to these economic reforms has been impressive. The Indian economy expanded at an annual rate of about 6.3 percent from 1994 to 2004 and then accelerated to 7 to 8 per- cent annually during 2005–2013. Foreign investment, a key indicator of how attractive foreign companies thought the Indian economy was, jumped from $150 million in 1991 to $26 billion in 2012. Some economic sectors have done particularly well, such as the information technology sector, where India has emerged as a vibrant global center for software development with sales of $100 billion in 2012, up from $150 million in 1990. In pharmaceuticals, too, Indian companies are emerging as credible players in the global marketplace, primarily by selling low-cost, generic versions of drugs that have come off patent in the developed world.

However, the country still has a long way to go. Attempts to further reduce import tariffs have been stalled by political opposition from em- ployers, employees, and politicians, who fear that if barriers come down, a flood of inexpensive Chinese products will enter India. The privatization program continues to hit speed bumps—the latest in Sep- tember 2003 when the Indian Supreme Court ruled that the govern- ment could not privatize two state-owned oil companies without explicit approval from the parliament. State-owned firms still account for 38 percent of national output in the nonfarm sector, yet India’s pri- vate firms are 30 to 40 percent more productive than state-owned en- terprises. There has also been strong resistance to reforming many of India’s laws that make it difficult for private business to operate effi- ciently. For example, labor laws make it almost impossible for firms with more than 100 employees to fire workers, creating a disincentive for entrepreneurs to increase their enterprises beyond 100 employees. Other laws mandate that certain products can be manufactured only by small companies, effectively making it impossible for companies in these industries to attain the scale required to compete internationally.

Sources: “India’s Breakthrough Budget?” The Economist, March 3, 2001; Shankar Aiyar, “Reforms: Time to Just Do It,” India Today, January 24, 2000, p. 47; “America’s Pain, India’s Gain,” The Economist, January 11, 2003, p. 57; Joanna Slater, “In Once Socialist India, Privatizations Are Becoming More Like Routine Matters,” The Wall Street Journal, July 5, 2002, p. A8; “India’s Economy: Ready to Roll Again?” The Economist, September 20, 2003, pp. 39–40; Joanna Slater, “Indian Pirates Turned Partners,” The Wall Street Journal, November 13, 2003, p. A14; “The Next Wave: India,” The Economist, December 17, 2005, p. 67; M. Dell, “The Digital Sector Can Make Poor Nations Prosper,” Financial Times, May 4, 2006, p. 17; “What’s Holding India Back,” The Economist, March 8, 2008, p. 11; and “Battling the Babu Raj,” The Economist, March 8, 2008, pp. 29–31.

country FOCUS

Chapter Three National Differences in Economic Development 79

like state monopolies. When these circumstances prevail, the newly privatized entities often have little incentive to re- structure their operations to become more efficient. For privatization to work, it must also be accompanied by a more general deregulation and opening of the economy. Thus, when Brazil decided to privatize the state-owned telephone monopoly, Telebrás Brazil, the government also split the company into four independent units that were to compete with each other and removed barriers to foreign direct in- vestment in telecommunications services. This action en- sured that the newly privatized entities would face significant competition and thus would have to improve their operating efficiency to survive.

LEGAL SYSTEMS As noted in Chapter 2, a well- functioning market economy requires laws protecting pri- vate property rights and providing mechanisms for contract enforcement. Without a legal system that protects property rights, and without the machinery to enforce that system, the incentive to engage in economic activity can be reduced substantially by private and public entities, including orga- nized crime, that expropriate the profits generated by the efforts of private-sector entrepreneurs. For example, when communism collapsed in eastern Europe, many countries lacked the legal structure required to protect property rights, all property having been held by the state. Although many na- tions have made big strides toward instituting the required system, it may be years before the legal system is functioning as smoothly as it does in the West. For example, in most eastern European nations, the title to urban and agricultural property is often uncertain because of incomplete and inaccurate records, multiple pledges on the same property, and unsettled claims resulting from demands for restitution from owners in the pre-communist era. Also, although most countries have improved their commercial codes, institutional weaknesses still undermine contract enforcement. Court capacity is often inadequate, and procedures for resolving contract disputes out of court are often lacking or poorly devel- oped.35 Nevertheless, progress is being made. In 2004, for example, China amended its con- stitution to state that “private property was not to be encroached upon,” and in 2007 it enacted a new law on property rights that gave property holders many of the same protec- tions as those enjoyed by the state (see the earlier Country Focus on China’s emerging property rights).36

Implications of Changing Political Economy The global changes in political and economic systems discussed earlier have several implica- tions for international business. The long-standing ideological conflict between collectivism and individualism that defined the twentieth century is less in evidence today. The West won the Cold War, and Western ideology is now widespread. Although command economies re- main and totalitarian dictatorships can still be found around the world, the tide has been running in favor of free markets and democracy. It remains to be seen, however, whether the global financial crisis of 2008–2009, and the recession that followed, will lead to a retrench- ment. Certainly many commentators have blamed the problems that led to this crisis on a lack of regulation, and some reassessment of Western political ideology seems likely.

Notwithstanding the crisis of 2008–2009, the trends of the past 25 years have enormous implications for business. For nearly 50 years, half of the world was off-limits to Western businesses. Now much of that has changed. Many of the national markets of eastern Europe, Latin America, Africa, and Asia may still be underdeveloped, but they are potentially enor- mous. With a population of more than 1.3 billion, the Chinese market alone is potentially bigger than that of the United States, the European Union, and Japan combined. Similarly,

Is Selling in China a Good Strategy? If China and the United States continue to grow like they did in re- cent years, some estimates indicate that China will be the world’s largest economy by 2030. Let’s assume this is true. Then China is clearly a country to take a closer look at—not just to outsource from (i.e., build factories in the country, produce products, and then sell those products to other parts of the world), but also to sell into to target their increasing customer base with purchasing power. Between 2000 and 2011, for example, the U.S. increased exports to China by 542 percent, roughly three times that of the increase to Brazil (which was ranked second in increase during the same time period). Also, by 2020 China is expected to have some 190 million customers in the middle- and upper-income catego- ries, making this the largest population segment of any country’s middle-/upper-income citizens. If you were a global manager for a company, would you concentrate on selling your products in China without having a production facility in the country?

Source: solutions.mckinsey.com/insightschina.

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FOCUS ON MANAGERIAL IMPLICATIONS

BENEFITS, COSTS, RISKS, AND OVERALL ATTRACTIVENESS OF DOING BUSINESS INTERNATIONALLY As noted in the previous chapter, the political, economic, and legal environments of a coun- try clearly influence the attractiveness of that country as a market or investment site. In this chapter, we argued that countries with democratic regimes, market-based economic policies, and strong protection of property rights are more likely to attain high and sustained eco- nomic growth rates and are thus a more attractive location for international business. It follows that the benefits, costs, and risks associated with doing business in a country are a function of that country’s political, economic, and legal systems. The overall attractiveness of a country as a market or investment site depends on balancing the likely long-term ben- efits of doing business in that country against the likely costs and risks. Here, we consider the determinants of benefits, costs, and risks.

Benefits In the most general sense, the long-run monetary benefits of doing business in a country are a function of the size of the market, the present wealth (purchasing power) of consumers in that market, and the likely future wealth of consumers. While some markets are very large when measured by number of consumers (e.g., China and India), low living standards may imply limited purchasing power and therefore a relatively small market when measured in economic terms. International businesses need to be aware of this distinction, but they also need to keep in mind the likely future prospects of a country. In 1960, South Korea was viewed as just an- other impoverished third-world nation. By 2011, it had the world’s 15th-largest economy. In- ternational firms that recognized South Korea’s potential in 1960 and began to do business in that country may have reaped greater benefits than those that wrote off South Korea.

By identifying and investing early in a potential future economic star, international firms may build brand loyalty and gain experience in that country’s business practices. These will pay back substantial dividends if that country achieves sustained high economic growth rates. In contrast, late entrants may find that they lack the brand loyalty and experience necessary to achieve a significant presence in the market. In the language of business strat-

LO 3-4 Explain the implications for management practice of national difference in political economy.

India, with about 1.2 billion people, is a potentially huge market. Latin America has another 600 million potential consumers. It is unlikely that China, Russia, Vietnam, or any of the other states now moving toward a market system will attain the living standards of the West soon. Nevertheless, the upside potential is so large that companies need to consider making inroads now. For example, if China and the United States continue to grow at the rates they did during 1996–2012, China will surpass the United States to become the world’s largest national economy within the next 15 years.

Just as the potential gains are large, so are the risks. There is no guarantee that democ- racy will thrive in many of the world’s newer democratic states, particularly if these states have to grapple with severe economic setbacks. Totalitarian dictatorships could return, al- though they are unlikely to be of the communist variety. Although the bipolar world of the Cold War era has vanished, it may be replaced by a multipolar world dominated by a num- ber of civilizations. In such a world, much of the economic promise inherent in the global shift toward market-based economic systems may stall in the face of conflicts between civi- lizations. While the long-term potential for economic gain from investment in the world’s new market economies is large, the risks associated with any such investment are also sub- stantial. It would be foolish to ignore these. The financial system in China, for example, is not transparent, and many suspect that Chinese banks hold a high proportion of nonper- forming loans on their books. If true, these bad debts could trigger a significant financial crisis during the next decade in China, which would dramatically lower growth rates.

80 Part Two National Differences

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egy, early entrants into potential future economic stars may be able to reap substantial first- mover advantages, while late entrants may fall victim to late-mover disadvantages.37 (First-mover advantages are the advantages that accrue to early entrants into a market. Late-mover disadvantages are the handicaps that late entrants might suffer.) This kind of reasoning has been driving significant inward investment into China, which may become the world’s first-largest economy by the mid-2020s if it continues growing at current rates (China is already the world’s second-largest national economy). For more than two decades, China has been the largest recipient of foreign direct investment in the developing world as international businesses—including General Motors, Volkswagen, Coca-Cola, and Unilever— try to establish a sustainable advantage in this nation.

A country’s economic system and property rights regime are reasonably good predictors of economic prospects. Countries with free market economies in which property rights are protected tend to achieve greater economic growth rates than command economies or economies where property rights are poorly protected. It follows that a country’s economic system, property rights regime, and market size (in terms of population) probably constitute reasonably good indicators of the potential long-run benefits of doing business in a country. In contrast, countries where property rights are not well respected and where corruption is rampant tend to have lower levels of economic growth. We must be careful about general- izing too much from this, however, because both China and India have achieved high growth rates despite relatively weak property rights regimes and high levels of corruption. In both countries, the shift toward a market-based economic system has produced large gains de- spite weak property rights and endemic corruption.

Costs A number of political, economic, and legal factors determine the costs of doing business in a country. With regard to political factors, a company may have to pay off politically powerful entities in a country before the government allows it to do business there. The need to pay what are essentially bribes is greater in closed totalitarian states than in open democratic soci- eties where politicians are held accountable by the electorate (although this is not a hard-and- fast distinction). Whether a company should actually pay bribes in return for market access should be determined on the basis of the legal and ethical implications of such action. We discuss this consideration in Chapter 5, when we look closely at the issue of business ethics.

First-Mover Advantages Advantages accruing to the first to enter a market.

Late-Mover Disadvantages Handicaps experienced by being a late entrant in a market.

Chapter Three National Differences in Economic Development 81

Coca-Cola has ramped up spending on marketing and advertising in emerging markets such as China.

With regard to economic factors, one of the most important variables is the sophistication of a country’s economy. It may be more costly to do business in relatively primitive or undevel- oped economies because of the lack of infrastructure and supporting businesses. At the extreme, an international firm may have to provide its own infrastructure and supporting business, which obviously raises costs. When McDonald’s decided to open its first restaurant in Moscow, it found that to serve food and drink indistinguishable from that served in McDonald’s restau- rants elsewhere, it had to vertically integrate backward to supply its own needs. The quality of Russian-grown potatoes and meat was too poor. Thus, to protect the quality of its product, McDonald’s set up its own dairy farms, cattle ranches, vegetable plots, and food-processing plants within Russia. This raised the cost of doing business in Russia, relative to the cost in more sophisticated economies where high-quality inputs could be purchased on the open market.

As for legal factors, it can be more costly to do business in a country where local laws and regulations set strict standards with regard to product safety, safety in the workplace, envi- ronmental pollution, and the like (because adhering to such regulations is costly). It can also be more costly to do business in a country like the United States, where the absence of a cap on damage awards has meant spiraling liability insurance rates. It can be more costly to do business in a country that lacks well-established laws for regulating business practice (as is the case in many of the former communist nations). In the absence of a well-developed body of business contract law, international firms may find no satisfactory way to resolve contract disputes and, consequently, routinely face large losses from contract violations. Similarly, local laws that fail to adequately protect intellectual property can lead to the theft of an in- ternational business’s intellectual property and lost income.

Risks As with costs, the risks of doing business in a country are determined by a number of political, economic, and legal factors. Political risk has been defined as the likelihood that political forces will cause drastic changes in a country’s business environment that adversely affect the profit and other goals of a business enterprise.38 So defined, political risk tends to be greater in countries experiencing social unrest and disorder or in countries where the un- derlying nature of a society increases the likelihood of social unrest. Social unrest typically finds expression in strikes, demonstrations, terrorism, and violent conflict. Such unrest is more likely to be found in countries that contain more than one ethnic nationality, in coun- tries where competing ideologies are battling for political control, in countries where eco- nomic mismanagement has created high inflation and falling living standards, or in countries that straddle the “fault lines” between civilizations.

Social unrest can result in abrupt changes in government and government policy or, in some cases, in protracted civil strife. Such strife tends to have negative economic implications for the profit goals of business enterprises. For example, in the aftermath of the 1979 Islamic revolution in Iran, the Iranian assets of numerous U.S. companies were seized by the new Iranian government without compensation. Similarly, the violent disintegration of the Yugo- slavian federation into warring states, including Bosnia, Croatia, and Serbia, precipitated a collapse in the local economies and in the profitability of investments in those countries.

More generally, a change in political regime can result in the enactment of laws that are less favorable to international business. In Venezuela, for example, the populist socialist politician Hugo Chávez held power from 1998 until his death in 2013. Chávez declared himself to be a “Fidelista,” a follower of Cuba’s Fidel Castro. He pledged to improve the lot of the poor in Venezuela through government intervention in private business and frequently railed against American imperialism, all of which is of concern to Western enterprises doing business in the country. Among other actions, he increased the royalties that foreign oil companies operating in Venezuela have to pay the government from 1 to 30 percent of sales.

Other risks may arise from a country’s mismanagement of its economy. An economic risk can be defined as the likelihood that economic mismanagement will cause drastic changes in a country’s business environment that hurt the profit and other goals of a par- ticular business enterprise. Economic risks are not independent of political risk. Economic mismanagement may give rise to significant social unrest and, hence, political risk. Never- theless, economic risks are worth emphasizing as a separate category because there is not

Political Risk The likelihood that political forces will cause drastic changes in a country’s business environment that will adversely affect the profit and other goals of a particular business enterprise.

Economic Risk The likelihood that events, including economic mismanagement, will cause drastic changes in a country’s business environment that adversely affect the profit and other goals of a particular business enterprise.

82 Part Two National Differences

always a one-to-one relationship between economic mismanagement and social unrest. One visible indicator of economic mismanagement tends to be a country’s inflation rate. Another is the level of business and government debt in the country.

The global financial crisis that arose in 2008–2009 was a dramatic example of the nature of economic risks. The global financial crisis was caused in part by a housing bubble in the United States, which was triggered by the easy availability of mortgage debt, particularly ad- justable rate mortgages with lower “teaser” interest rates for the first year or so. Many of the mortgages written in the 2001–2007 period were of very low quality, but they were bundled into bonds containing thousands of mortgages and sold to investors as AAA-rated assets— which, in fact, they were not. By 2008, the market for mortgage-backed bonds and related as- sets, including the insurance on such securities, was worth trillions of dollars. When borrowers started to default on their mortgage payments in large numbers, the value of the bonds tum- bled, and holders—many of whom were major financial institutions themselves or national governments—found that the supposedly AAA bonds in their portfolios were actually junk. This decimated the balance sheets of many banks and more than a few local and national gov- ernments, precipitating a banking crisis that almost bought the global economy to its knees and ushered in a recession that the world was struggling to emerge from five years later.

With the benefit of hindsight, it is clear that economic mismanagement was a major cause of the crisis. The U.S. government and Federal Reserve had been pursuing a permis- sive monetary policy during the early 2000s, in part to counter the recessionary aftermath of the September 2001 terrorist attack on the United States. Easy monetary policy allowed for the unprecedented expansion of mortgage debt, which fed the bubble in housing prices — and the bubble in housing prices persuaded more and more people to buy houses that they could not afford, in the belief that as prices rose even further, they could make up any pay- ment shortfall by selling the house for a profit or by taking out a second mortgage secured on the hoped-for increase in the value of the equity in their home. To compound matters, the markets for mortgage-backed securities were poorly understood, largely unregulated, and not transparent. Consequently, many investors, including large financial institutions and local and national governments, were misled about, or did not begin to appreciate, the risk- iness of the mortgage-backed bonds they were buying. As a consequence, they invested too much money in poor-quality assets—and only realized this when it was too late and the value of those assets was plummeting through the floor. Had the U.S. government acted decisively to pop the housing bubble in the early 2000s by tightening monetary policy, had it made it more difficult for banks to issue poor-quality mortgages and to bundle those mortgages into bonds and pass them off as higher-quality assets, and had it insisted on greater transparency in the market for mortgage-backed debt, the crisis may have been avoided. But none of this happened. The consequence of this economic mismanagement was the worst economic recession since the Great Depression of the 1930s.

On the legal front, risks arise when a country’s legal system fails to provide adequate safe- guards in the case of contract violations or to protect property rights. When legal safeguards are weak, firms are more likely to break contracts or steal intellectual property if they per- ceive it as being in their interests to do so. Thus, a legal risk can be defined as the likelihood that a trading partner will opportunistically break a contract or expropriate property rights. When legal risks in a country are high, an international business might hesitate entering into a long-term contract or joint-venture agreement with a firm in that country. For example, in the 1970s when the Indian government passed a law requiring all foreign investors to enter into joint ventures with Indian companies, U.S. companies such as IBM and Coca-Cola closed their investments in India. They believed that the Indian legal system did not provide adequate protection of intellectual property rights, creating the very real danger that their Indian partners might expropriate the intellectual property of the American companies— which for IBM and Coca-Cola amounted to the core of their competitive advantage.

Overall Attractiveness The overall attractiveness of a country as a potential market or investment site for an interna- tional business depends on balancing the benefits, costs, and risks associated with doing business in that country (see Figure 3.1). Generally, the costs and risks associated with doing business in

Legal Risk The likelihood that a trading partner will opportunistically break a contract or expropriate intellectual property rights.

Chapter Three National Differences in Economic Development 83

a foreign country are typically lower in economically advanced and politically stable democratic nations and greater in less developed and politically unstable nations. The calculus is compli- cated, however, because the potential long-run benefits are dependent not only on a nation’s current stage of economic development or political stability, but also on likely future economic growth rates. Economic growth appears to be a function of a free market system and a country’s capacity for growth (which may be greater in less developed nations). This leads us to conclude that, other things being equal, the benefit–cost–risk trade-off is likely to be most favorable in politically stable developed and developing nations that have free market systems and no dra- matic upsurge in either inflation rates or private-sector debt. It is likely to be least favorable in politically unstable developing nations that operate with a mixed or command economy or in developing nations where speculative financial bubbles have led to excess borrowing.

3.1 FIGURE Country Attractiveness

Overall Attractiveness

Risks Political Risks: Social Unrest/Antibusiness Trends

Economic Risks: Economic Mismanagement Legal Risks: Failure to Safeguard Property Rights

Benefits Size of Economy

Likely Economic Growth

Costs Corruption

Lack of Infrastructure Legal Costs

84 Part Two National Differences

gross national income (GNI), p. 63 purchasing power parity (PPP), p. 64 Human Development Index (HDI), p. 67 innovation, p. 68

entrepreneurs, p. 68 deregulation, p. 77 first-mover advantages, p. 81 late-mover disadvantages, p. 81

political risk, p. 82 economic risk, p. 82 legal risk, p. 83

Key Terms

Summary

This chapter reviewed how the political, economic, and legal systems of countries vary. The potential benefits, costs, and risks of doing business in a country are a function of its political, economic, and legal systems. The chapter made the following points:

1. The rate of economic progress in a country seems to depend on the extent to which that country has a well-

functioning market economy in which property rights are protected.

2. Many countries are now in a state of transition. There is a marked shift away from totalitarian governments and command or mixed economic systems and toward democratic political institutions and free market economic systems.

Chapter Three National Differences in Economic Development 85

Critical Thinking and Discussion Questions

1. What is the relationship among property rights, corruption, and economic progress? How important are anticorruption efforts in the effort to improve a country’s level of economic development?

2. You are a senior manager in a U.S. automobile company considering whether to invest in production facilities in China, Russia, or Germany. These facilities will serve local market demand. Evaluate the benefits, costs, and risks associated with doing business in each nation. Which country seems the most attractive target for foreign direct investment? Why?

3. Reread the Country Focus on India, and answer the following questions: a. What kind of economic system did India operate

under during 1947–1990? What kind of system is it moving toward today? What are the impediments to completing this transformation?

b. How might widespread public ownership of businesses and extensive government regulations have affected (i) the efficiency of state and private

businesses and (ii) the rate of new business formation in India during the 1947–1990 time frame? How do you think these factors affected the rate of economic growth in India during this time frame?

c. How would privatization, deregulation, and the removal of barriers to foreign direct investment affect the efficiency of business, new business formation, and the rate of economic growth in India during the post-1990 time period?

d. India now has pockets of strengths in key high- technology industries such as software and pharmaceuticals. Why do you think India is developing strength in these areas? How might success in these industries help generate growth in the other sectors of the Indian economy?

e. Given what is now occurring in the Indian economy, do you think the country represents an attractive target for inward investment by foreign multinationals selling consumer products? Why?

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

1. Increased instability in the global marketplace can introduce unanticipated risks in a company’s daily transactions. As such, your company must evaluate these commercial transaction risks for its foreign operations in Argentina, China, Egypt, Poland, and South Africa. A risk analyst at your firm said that you could evaluate both the political and commercial risk of these countries simultaneously. Provide a commercial transaction risk overview of all five countries for top management. In your evaluation, indicate possible corrective measures in the

countries with considerably high political and/or commercial risk.

2. Managers at your firm are very concerned about the influence of terrorism on its long-term strategy. To counter this issue, the CEO has indicated you must identify the countries where terrorism threat and political risk are minimal. This will provide the basis for the development of future company facilities, which need to be built in all major continents in the world. Include recommendations on which countries in each continent would serve as a good candidate for your company to further analyze.

Research Task http://globalEDGE.msu.edu

3. The attractiveness of a country as a market and/or investment site depends on balancing the likely long- run benefits of doing business in that country against the likely costs and risks.

4. The benefits of doing business in a country are a function of the size of the market (population), its present wealth (purchasing power), and its future growth prospects. By investing early in countries that are currently poor but are nevertheless growing rapidly, firms can gain first-mover advantages that will pay back substantial dividends in the future.

5. The costs of doing business in a country tend to be greater where political payoffs are required to gain market access, where supporting infrastructure is lacking or underdeveloped, and where adhering to local laws and regulations is costly.

6. The risks of doing business in a country tend to be greater in countries that are politically unstable, subject to economic mismanagement, and lacking a legal system to provide adequate safeguards in the case of contract or property rights violations.

With 83 million people, Egypt is the most populous Arab state. On the face of it, Egypt made significant economic progress during the 2000s. In 2004, the gov- ernment of Hosni Mubarak enacted a series of economic reforms that included trade liberalization, cuts in import tariffs, tax cuts, deregulation, and changes in investment regulations that allowed for more foreign direct investment in the Egyptian economy. As a consequence, economic growth, which had been in the 2 to 4 percent range during the early 2000s, accelerated to around 7 per- cent a year. Exports almost tripled, from $9 billion in 2004 to more than $25 bil- lion by 2010. Foreign direct investment increased from $4 billion in 2004 to $11 billion in 2008, while unemployment fell from 11 percent to 8 percent.

By 2008, Egypt seemed to be displaying many of the features of other emerging economies. On Cairo’s outskirts, clusters of construction cranes could be seen where gleaming new offices were being built for companies such as Microsoft, Oracle, and Vodafone. Highways were being con- structed, hypermarkets were opening their doors, and sales of private cars quadrupled between 2004 and 2008. Things seemed to be improving.

But appearances can be deceiving. Underneath the surface, Egypt had major economic and political problems. Inflation, long a concern, remained high at 12.8 percent. As the global economic crisis took hold in 2008–2009, Egypt saw many of its growth drivers slow. In 2008, tourism brought some $11 billion into the country, accounting for 8.5 percent of gross domestic product, but it fell sharply in 2009 and 2010. Remittances from Egyptian expatriates working overseas, which amounted to $8.5 billion in 2008, de- clined sharply as construction projects in the Gulf, where many of them worked, were cut back or shut down. Earnings from the Suez Canal, which stood at $5.2 billion in 2008, declined by 25 percent in 2009 as the volume of world shipping slumped in the wake of the global economic slowdown.

Moreover, Egypt remained a country with a tremendous gap between the rich and the poor. Some 44 percent of Egyptians are classified as poor or extremely poor; the average wage is less than $100 a month. Some 2.6 million people are so destitute that their entire income cannot cover their basic food needs.

The gap between rich and poor, when coupled with a sharp economic slowdown, became a toxic mix. Nominally a stable democracy with a secu- lar government, Egypt was, in fact, an autocratic state. By 2011, President Hosni Mubarak had been in power for more than a quarter of a century. The government was highly corrupt. Mubarak and his family reportedly amassed personal fortunes amounting to billions of U.S. dollars, most of which were banked outside Egypt. Although elections were held, they were hardly free and fair. Opposition parties were kept in check by constant po- lice harassment, their leaders often jailed on trumped-up charges.

Given all of this, it is perhaps not surprising that in January 2011, popu- lar discontent spilled over into the streets. Led by technologically savvy young Egyptians—who harnessed the power of the Internet and social net- work media such as Facebook and Twitter to organize mass demonstra- tions—hundreds of thousands of Egyptians poured into Cairo’s Tahrir Square and demanded the resignation of the Mubarak government. There they stayed, their numbers only growing over time. For weeks, Mubarak refused to step down, while the demonstrations gained momentum and Egypt’s powerful military establishment stood on the sidelines. Foreign gov- ernments, including the Obama administration in the United States, long one of Egypt’s most important Western allies, joined the chorus of voices

calling for Mubarak to resign. In the end, his position became untenable, and he stepped down on February 11, 2011. The Egyptian military took the reins of power, vowing to do so for a short time while it organized a transi- tion to democratic elections in the fall of 2011. In March 2011, Egyptians voted on a set of proposed constitutional amendments designed to pave the way for the elections in late 2011. This was the first time in six decades that Egyptians had been offered a free choice on any public issues.

Does this mean that Egypt is now on the road to becoming a democratic state with a vibrant economy? That is still far from clear. In mid-2012, mod- erate Islamists from the Muslim Brotherhood won the most seats in the country’s first democratic election, and the Brotherhood candidate Mohamed Morsi won the presidential election. However, the Morsi govern- ment struggled. By 2013, the economy was in deep trouble. Unemployment was as high as 20 percent, the Egyptian currency was steadily losing value on foreign exchange markets, and inflation was increasing again. Tourism, which previously had accounted for 8 to 12 percent of GDP, evaporated. Foreign investment stalled, and the country’s foreign reserves were falling fast. Meanwhile, the Morsi government failed to enact any meaningful eco- nomic reforms. It was unwilling to remove politically popular food and fuel subsidies totaling $20 billion a year, even though the country clearly could not afford to pay for them. Government debt was increasing, and the annual budget deficit now accounted for more than 12 percent of GDP. Many suc- cessful businesspeople left the country, fearing reprisals for their role under the Mubarak regime. Court rulings overturned privatization deals from more than a decade ago, effectively moving several enterprises back into state hands. In June 2013, protestors again took to the streets, and with the backing of the still powerful Egyptian military, Morsi was removed from of- fice in early July 2013. As of early 2014, an “interim” government is now running the country, although in Egypt, unelected interim regimes have a history of becoming permanent authoritarian governments.

Sources: D. C. Kurtzer, “Where Is Egypt Headed?” Spero Forum, April 4, 2009, www.speroforum.com; “Yes They Can,” The Economist, March 26, 2011, pp. 55–56; “A Long March,” The Economist, February 18, 2012, pp. 49–51; and “Going to the Dogs,” The Economist, March 30, 2013.

CASE DISCUSSION QUESTIONS 1. What were the underlying causes, economic and political, of the

collapse of the Mubarak regime?

2. What do you think the Egyptian government needs to do in order to get the economy growing again and to attract foreign capital? What are the risks to the government of taking such actions?

3. What dangers do you see in the current trajectory of the Egyptian economy? What are the implications of these dangers for foreign companies that might consider doing business in Egypt? What do you think it would take to encourage more foreigners to visit, invest, and do business in Egypt? Would such inward investment be good for the Egyptian economy?

4. Political risks in Egypt seem to be increasing again, and the country seems to be retreating from democracy, largely due to intervention by the military. As a manager in an international business, how would the current turmoil and political uncertainty in Egypt influence your investment decisions, and what does this mean for the future of the Egyptian economy?

ccccccllooooooossssiinnnnnnggggggggggg ccccccaaaaaassssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeRevolution in Egypt

86 Part Two National Differences

Chapter Three National Differences in Economic Development 87

Endnotes

1. World Bank, World Development Indicators Online, 2014.

2. P. Sinha and N. Singh, “The Economy’s Black Hole,” The Times of India, March 22, 2010. EU estimates for 2012 can be found at http://ec.europa.eu/europe2020/pdf/themes/07_ shadow_economy.pdf.

3. A. Sen, Development as Freedom (New York: Alfred A. Knopf, 1999).

4. G. M. Grossman and E. Helpman, “Endogenous Innovation in the Theory of Growth,” Journal of Economic Perspectives 8, no. 1 (1994), pp. 23–44; and P. M. Romer, “The Origins of Endogenous Growth,” Journal of Economic Perspectives 8, no. 1 (1994), pp. 2–22.

5. W. W. Lewis, The Power of Productivity (Chicago: University of Chicago Press, 2004).

6. F. A. Hayek, The Fatal Conceit: Errors of Socialism (Chicago: University of Chicago Press, 1989).

7. J. Gwartney, R. Lawson, and W. Block, Economic Freedom of the World: 1975–1995 (London: Institute of Economic Af- fairs, 1996).

8. D. North, Institutions, Institutional Change, and Economic Per- formance (Cambridge, UK: Cambridge University Press, 1991). See also K. M. Murphy, A. Shleifer, and R. Vishney, “Why Is Rent Seeking So Costly to Growth?” American Eco- nomic Review 83, no. 2 (1993), pp. 409–14; and K. E. Maskus, “Intellectual Property Rights in the Global Economy,” Insti- tute for International Economics, 2000.

9. D. North, Institutions, Institutional Change and Economic Per- formance, Cambridge University Press, 1990.

10. H. de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books, 2000).

11. A. O. Hirschman, “The On-and-Off Again Connection be- tween Political and Economic Progress,” American Economic Review 84, no. 2 (1994), pp. 343–48; and A. Przeworski and F. Limongi, “Political Regimes and Economic Growth,” Journal of Economic Perspectives 7, no. 3 (1993), pp. 51–59.

12. Ibid.

13. For details of this argument, see M. Olson, “Dictatorship, Democracy, and Development,” American Political Science Re- view, September 1993.

14. For example, see Jared Diamond’s Pulitzer Prize–winning book, Guns, Germs, and Steel (New York: W. W. Norton, 1997). Also see J. Sachs, “Nature, Nurture and Growth,” The Economist, June 14, 1997, pp. 19–22; and J. Sachs, The End of Poverty (New York: Penguin Books, 2005).

15. Sachs, “Nature, Nurture and Growth.”

16. “What Can the Rest of the World Learn from the Class- rooms of Asia?” The Economist, September 21, 1996, p. 24.

17. J. Fagerberg, “Technology and International Differences in Growth Rates,” Journal of Economic Literature 32 (September 1994), pp. 1147–75.

18. See The Freedom House Survey Team, “Freedom in the World: 2014” and associated materials, www.freedomhouse.org.

19. “Russia Downgraded to Not Free,” Freedom House press re- lease, December 20, 2004, www.freedomhouse.org.

20. Freedom House, “Democracies Century: A Survey of Politi- cal Change in the Twentieth Century, 1999,” www.freedom- house.org.

21. L. Conners, “Freedom to Connect,” Wired, August 1997, pp. 105–6.

22. F. Fukuyama, “The End of History,” The National Interest 16 (Summer 1989), p. 18.

23. S. P. Huntington, The Clash of Civilizations and the Remaking of World Order (New York: Simon & Schuster, 1996).

24. Ibid., p. 116.

25. U.S. National Counterterrorism Center, Reports on Incidents of Terrorism, 2005, April 11, 2006.

26. S. Fisher, R. Sahay, and C. A. Vegh, “Stabilization and the Growth in Transition Economies: The Early Experience,” Journal of Economic Perspectives 10 (Spring 1996), pp. 45–66.

27. M. Miles et al., 2013 Index of Economic Freedom (Washington, DC: Heritage Foundation, 2013).

28. International Monetary Fund, World Economic Outlook: Focus on Transition Economies (Geneva: IMF, October 2000).

29. J. C. Brada, “Privatization Is Transition—Is It?” Journal of Economic Perspectives, Spring 1996, pp. 67–86.

30. See S. Zahra et al., “Privatization and Entrepreneurial Trans- formation,” Academy of Management Review 3, no. 25 (2000), pp. 509–24.

31. N. Brune, G. Garrett, and B. Kogut, “The International Monetary Fund and the Global Spread of Privatization,” IMF Staff Papers 51, no. 2 (2003), pp. 195–219.

32. S. Fischer, R. Sahay, and C. Vegh, “Stabilization and Growth in Transition Economies,” Journal of Economic Perspectives, Spring 1996, pp. 45–66.

33. “China 2030” (Washington, DC: The World Bank, 2012).

34. J. Sachs, C. Zinnes, and Y. Eilat, “The Gains from Privatiza- tion in Transition Economies: Is Change of Ownership Enough?” CAER discussion paper no. 63 (Cambridge, MA: Harvard Institute for International Development, 2000).

35. M. S. Borish and M. Noel, “Private Sector Development in the Visegrad Countries,” World Bank, March 1997.

36. “Caught between Right and Left,” The Economist, March 8, 2007.

37. For a discussion of first-mover advantages, see M. Liberman and D. Montgomery, “First-Mover Advantages,” Strategic Man- agement Journal 9 (Summer Special Issue, 1988), pp. 41–58.

38. S. H. Robock, “Political Risk: Identification and Assessment,” Columbia Journal of World Business, July–August 1971, pp. 6–20.

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4-1 Explain what is meant by the culture of a society.

4-2 Identify the forces that lead to differences in social culture.

4-3 Identify the business and economic implications of differences in culture.

4-4 Recognize how differences in social culture influence values in business.

4-5 Demonstrate an appreciation for the economic and business implications of cultural change.

learning objectives

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a pt

opening case

T he People’s Republic of China opened up to foreign investments in the late 1970s. Since that time, numerous companies have tried to establish operations and sell their products to customers in China. Many more companies will try in the years to come—China is expected to have some 190 million people in the middle- and upper-income categories by 2020. This is an increase from only about 17

million people in these income brackets as recently as in 2010. China’s purchasing power for virtually all

products and services has strong potential, and foreign companies will seek these market opportunities.

What have we learned culturally that can help Western-based companies in China’s marketplace?

Some background on China can serve as a starting point for better understanding the culture in China

and what some well-known companies such as Best Buy and eBay have done to target the Chinese

marketplace. The motivation for many foreign companies to enter China—beyond those that have been

there for a few decades for reasons of low-cost production—was the triple growth of the Chinese economy

that was seen from 2000 to 2010. China overtook Japan to become the second largest economy in the

world behind just the United States, and its large population makes for an enormous target market.

Investment from foreign companies was the largest driver of China’s growth in the decade from 2000 to

2010. However, many companies also increased their exports to China. The United States, for example, saw

its companies increase exports to China by 542 percent from 2000 to 2011 (from $16.2 billion to $103.9

billion), while total exports to the rest of the world increased only 80 percent in the same time period.

Interestingly, while foreign investments grew, domestic consumption as a share of the Chinese economy

declined from 46 percent in 2000 to 33 percent in 2010. This consumption decline—coupled with slower

growth globally and, ultimately, the worldwide economic downturn that started in 2008—raised questions

about China’s momentum. Right now, around 85 percent of mainstream Chinese consumers are living in

the top 100 wealthiest cities. By the year 2020, these advanced and developing cities will have relatively

few customers who are lower than the middle- and upper-income brackets. The expectation is that these

consumers will be able to afford a range of products and services, such as flat-screen televisions and

Best Buy and eBay in China

Differences in Culture

–continued

opening caseopening caseoverseas travel. This begs the question, can the unprecedented Chinese growth really continue, and would it come from increased consumption?

The resounding answer is yes according to research conducted by McKinsey &

Company. McKinsey found that barring another major economic shock similar to what

we saw in 2008, China’s gross domestic product (GDP) will continue to grow, albeit not

at the historic levels seen between 2000 and 2010 when it grew about 10.4 percent

annually. The growth from 2010 to 2020 is expected to be about 7.9 percent per year,

which is still far above the expected growth for the United States (2.8 percent annually),

Japan (1.2 percent annually), and Germany (1.7 percent annually) —the three countries

in the top four worldwide economies along with China. And, the key is that consumption

will now be the driving force behind the growth instead of foreign investment. The

consumption forecast opens up opportunities for foreign companies to engage with

Chinese consumers who are expected to have more purchasing power and discretionary

spending.

But culturally translating market success from one country or even a large number of

countries to the Chinese marketplace is not necessarily as straightforward as it may

seem. Often, a combination of naïveté, arrogance, and cultural misunderstanding have

led many well-known companies to fail in China. Lack of an understanding of issues such

as local demands, buying habits, values, and beliefs led to struggles for companies that

had been very successful elsewhere in the world. Let’s take a brief look at Best Buy and

eBay as two examples.

Best Buy, the mega-store mainly focused on consumer electronics, was founded in

1966 as an audio specialty store. Best Buy entered China in 2006 by acquiring a majority

interest in China’s fourth largest appliance retailer, Jiangsu Five Star Appliance, for

$180 million. But culture shock hit Best Buy, best described by Shaun Rein, the founder

of China Market Research Group. He pointed to a few reasons for this culture shock and

lack of success. First, the Chinese will not pay for Best Buy’s overly expensive products

unless they are a brand like Apple. Second, there is too much piracy in the Chinese

market, and this reduces demand for electronics products at competitive market prices.

Third, like many Europeans, the Chinese do not want to shop at huge mega-stores. So,

these three seemingly easy-to-understand cultural issues created difficulties for Best

Buy. Solving these issues, Best Buy believed that they would have to develop and

implement a different business model for the Chinese market than they have used, for

example, in the United States. Now, how far should a company go outside of its normal

business model to adhere to cultural values and beliefs of a new market? Strategically

moving forward, Best Buy opted to close all of its Best Buy–branded stores in China and

focus on its wholly owned local Jiangsu Five Star chain of stores. But will this new

strategic business model be successful with the new makeup of customers in China

expected by 2020?

eBay, the popular e-business site focused on consumer-to-consumer purchases, was

founded in 1995. The company was one of the true success stories that lived through the

dot-com bubble in the 1990s. It is now a multi-billion-dollar business with operations in

more than 30 countries. But China’s unique culture created problems for eBay in that

market. For eBay, contrary to the widespread cultural issues that faced Best Buy, one

company in particular (TaoBao) and one feature more specifically (built-in instant

messaging) shaped a lot of the problems that eBay ran into in China. Some 200 million

shoppers are using TaoBao to buy products, and the company accounts for almost

80 percent of online transaction value in China. Uniquely, TaoBao’s built-in instant

90 Part Two National Differences

Chapter Four Differences in Culture 91

messaging system has been cited as a main reason for its edge over eBay in China.

Basically, customers wanted to be able to identify a seller’s online status and

communicate with them directly and easily—a function not seamlessly incorporated into

eBay’s China system. Clearly, built-in instant text messaging is a solvable obstacle in

doing business in China. It sounds easy now when we know about it, but may not always

be the case when we take into account all the little things that are important in a

market. How can a foreign company entering China ensure that it tackles the most

important “little” things that end up being huge barriers to success as we approach the

year 2020 when China is expected to have significantly increased purchasing power

among its middle class? • Sources: B. Carlson, “Why Big American Businesses Fail in China,” GlobalPost, September 22, 2013; Y. Atsmon, M. Magni, L. Li, and W. Liao, “Meet the 2020 Chinese Consumer,” McKinsey Consumer & Shopper Insights, March 2012; “Exports to China by State 2000–2011,” The US-China Business Council, 2012; and A. Groth, “Best Buy’s Overseas Strategy is Failing in Europe and China,” Business Insider, November 4, 2011.

Introduction In Chapters 2 and 3, we saw how national differences in political, economic, and legal sys- tems influence the benefits, costs, and risks associated with doing business in different coun- tries. In this chapter, we explore how differences in culture across and within countries can affect international business strategies and operations of small, medium, and large compa- nies. Several themes run through this chapter. The first is that business success in a variety of countries requires cross-cultural literacy. By cross-cultural literacy, we mean an under- standing of how cultural differences across and within nations can affect the way business is practiced. Global communications, global brands, fast cycle times, worldwide markets, and global supply chains characterize today’s world. This is an era in which the global village seems to be just around the corner. At the same time, it is sometimes easy to forget just how different various cultures really are, even today.1 Underneath the veneer of modernism and globalization, deep cultural differences often remain.2

The opening case deals with precisely this point. We focused on two well-known and, by most standards, very successful global companies—Best Buy and eBay—and their venture into China. The failure of both companies in China was due in large part to their inability to come to grips with the cultural differences between China and the United States. Best Buy displayed a remarkable lack of cross-cultural literacy when it did not gauge the price sensitiv- ity of the Chinese consumers, when it did not account for very well-known issues related to piracy in the electronics market, and when it did not understand the type of shopping experi- ence Chinese customers really wanted. Previous success with their established business model directly led to Best Buy’s lack of success in the Chinese market. Likewise, but at a more fine- grained level, eBay ran into its own cultural issues in China. eBay failed to recognize the power of the established market leader (TaoBao) and the core feature provided by this market leader—built-in instant messaging. Customers valued, depended on, and saw instant messag- ing as an integral part of their shopping experience. Generalizing from the examples of Best Buy and eBay, in this chapter we argue that it is important for foreign businesses to gain an understanding of the culture that prevails in those countries where they do business and that success requires a foreign enterprise to adapt to the culture of its host country.3

Another theme developed in this chapter is that a relationship may exist between culture and the cost of doing business in a country or region. Different cultures are more or less supportive of the capitalist mode of production and may increase or lower the costs of doing business. For example, some observers have argued that cultural factors lowered the costs of doing business in Japan and helped explain Japan’s rapid economic ascent during the 1960s, 1970s, and 1980s.4 Similarly, cultural factors can sometimes raise the costs of doing business. Historically, class divisions were an important aspect of British culture, and for a long time,

Cross-Cultural Literacy Understanding how the culture of a country affects the way business is practiced.

92 Part Two National Differences

firms operating in Great Britain found it difficult to achieve cooperation between manage- ment and labor. Class divisions led to a high level of industrial disputes in that country dur- ing the 1960s and 1970s and raised the costs of doing business relative to the costs in countries such as Germany, Japan, Norway, Sweden, and Switzerland, where class conflict was historically less prevalent.

The British example, however, brings us to another theme we explore in this chapter. Culture is not static. It can and does evolve, although the rate at which culture can change is the subject of some dispute. Generally, culture evolves as behaviors of people become in- grained in their values and norms. This means that after some time, when a person has be- haved a certain way for a while, that person (and perhaps those around the person) adopts a cultural value mindset consistent with the type of behavior illustrated by the person’s ac- tions. Culture in society evolves when large population segments in a country or region adopt cultural values based on common ways of behaving. This cultural evolution is the reason important aspects of British culture have changed significantly over the past 30 years, and the changes have been reflected in weaker class distinctions and a lower level of indus- trial disputes.5 Finally, it is important to note that multinational enterprises can themselves be engines of cultural change. In India, for example, McDonald’s and other Western fast- food companies facilitated change in the dining culture of that nation, drawing them away from traditional restaurants and toward fast-food outlets.

What Is Culture? Scholars have never been able to agree on a simple definition of culture. In the 1870s, an- thropologist Edward Tylor defined culture as “that complex whole which includes knowl- edge, belief, art, morals, law, custom, and other capabilities acquired by man as a member of society.”6 Since then hundreds of other definitions have been offered. At the basic level, Florence Kluckhohn and Fred Strodtbeck’s values orientation theory illustrates that all cul- ture definitions must answer a limited number of universal problems, that the value-based solutions are limited in number and universally known, and that different cultures have dif- ferent preferences among them.7 Following their work, other prominent culture specialists have supported the idea of a universal set of human values serving as the basis for culture, such as Milton Rokeach with his work on “the nature of human values” and Shalom Schwartz with his work on the “theory of basic human values.”8 Also supportive of this finite set of human values, Geert Hofstede, an expert on cross-cultural differences and manage- ment, defined culture as “the collective programming of the mind which distinguishes the members of one human group from another. Culture, in this sense, includes systems of val- ues; and values are among the building blocks of culture.”9 Another complementary defini- tion of culture comes from sociologists Zvi Namenwirth and Robert Weber, who see culture as a system of ideas and argue that these ideas constitute a design for living.10

In our view, we subscribe to the definitions of both Hofstede and Namenwirth and We- ber by viewing culture as a system of values and norms that are shared among a group of people and that when taken together constitute a design for living. By values, we mean ab- stract ideas about what a group believes to be good, right, and desirable. Put differently, values are shared assumptions about how things ought to be.11 By norms, we mean the so- cial rules and guidelines that prescribe appropriate behavior in particular situations. We shall use the term society to refer to a group of people sharing a common set of values and norms. While a society may be equivalent to a country, some countries harbor several soci- eties or subcultures (i.e., they support multiple cultures), and some societies embrace more than one country (e.g., the Scandinavian countries of Denmark, Norway, and Sweden are often viewed as culturally being a part of one society in terms of the business marketplace).

VALUES AND NORMS Values form the bedrock of a culture. They provide the context within which a society’s norms are established and justified. They may include a society’s attitudes toward such concepts as individual freedom, democracy, truth, justice, honesty, loyalty, social obligations, collective responsibility, the role of women, love, sex,

LO 4-1 Explain what is meant by the culture of a society.

Culture A system of values and norms that are shared among a group of people and that when taken together constitute a design for living.

Values Abstract ideas about what a society believes to be good, right, and desirable.

Norms Social rules and guidelines that prescribe appropriate behavior in particular situations.

Society Group of people who share a common set of values and norms.

Chapter Four Differences in Culture 93

marriage, and so on. Values are not just abstract concepts; they are invested with considerable emotional significance. People argue, fight, and even die over values such as free- dom. Values are also often reflected in the political and eco- nomic systems of a society. As we saw in Chapter 2, democratic free market capitalism is a reflection of a philo- sophical value system that emphasizes individual freedom.12

Norms are the social rules that govern people’s actions toward one another. Norms can be subdivided further into two major categories: folkways and mores. Both of these terms were coined by William Graham Sumner, an early American sociologist, in 1906. Folkways are the routine conventions of everyday life. Generally, folkways are actions of little moral significance. Rather, they are social conven- tions concerning things such as the appropriate dress code in a particular situation, good social manners, eating with the correct utensils, neighborly behavior, and the like. Al- though folkways define the way people are expected to be- have, violation of them is not normally a serious matter. People who violate folkways may be thought of as eccentric or ill-mannered, but they are not usually considered to be evil or bad. In many countries, foreigners may initially be excused for violating folkways. However, with the increasing availability of information on folkways for the various countries in the world, businesspeople are increasingly expected to know about dress code in a particular situation, good social and professional manners, eating with the correct utensils, and general business etiquette. The evolution of norms now de- mand in many cases that business partners at least try to behave according to the folkways norms in the country in which they are doing business.

A good example of folkways concerns attitudes toward time in different countries. Peo- ple are keenly aware of the passage of time in the United States and northern European cultures such as Germany, Netherlands, and the Scandinavian countries. Businesspeople are very conscious about scheduling their time and are quickly irritated when their time is wasted because a business associate is late for a meeting or if they are kept waiting. They talk about time as though it were money, as something that can be spent, saved, wasted, and lost.13 Alternatively, in many Arabic, Latin, and African cultures, time has a more elastic character. Keeping to a schedule is viewed as less important than finishing an interaction with people. For example, an American businessperson might feel slighted if he or she is kept waiting for 30 minutes outside the office of a Latin American executive before a meet- ing. However, the Latin American person may simply be completing an interaction with an associate and view the information gathered from this as more important than sticking to a rigid schedule. The Latin American executive intends no disrespect, but due to a mutual misunderstanding about the importance of time, the American may see things differently. Similarly, Saudi Arabian attitudes toward time have been shaped by their nomadic Bedouin heritage, in which precise time played no real role and arriving somewhere tomorrow might mean next week. Like Latin Americans, many Saudis are unlikely to understand Westerners obsession with precise time and schedules, and they need to adjust their expec- tations accordingly.

Folkways also include rituals and symbolic behavior. Rituals and symbols are the most visible manifestations of a culture and constitute the outward expression of deeper values. For example, upon meeting a foreign business executive, a Japanese executive will hold his business card in both hands and bow while presenting the card to the foreigner.14 This ritual behavior is loaded with deep cultural symbolism. The card specifies the rank of the Japanese executive, which is a very important piece of information in a hierarchical society such as Japan. The bow is a sign of respect, and the deeper the angle of the bow, the greater the reverence one person shows for the other. The person receiving the card is expected to ex- amine it carefully (Japanese often have business cards with Japanese printed on one side and

Folkways Routine conventions of everyday life.

Planning on Doing Business Internationally? If a company is planning to start exporting a product, there are two basic questions that need to be asked. Is the product ready to be exported? And, is the company ready to export the product? Culturally, the product is either ready for a global market or not (and, if not, the company can modify it if the market is important enough). Company readiness is much more culturally sensitive. Having the appropriate cultural knowledge and skills are impor- tant. If you have the basic information about a company, you can use globalEDGE’s diagnostic tool called CORE (Company Readi- ness to Export) to assess both product and company readiness to be exported. Try it out; how much better do you think Microsoft, which is everywhere in the world, will score compared with Questcor Pharmaceuticals (questcor.com), which was ranked #1 on Forbes’ list of “America’s Best Small Companies” in 2013?

Source: globalEDGE’s CORE diagnostic tool, http://globalEDGE.msu.edu/tools- and-data, accessed March 8, 2014; and K. Badenhausen, “America’s Best Small Companies,” Forbes, October 9, 2013.

94 Part Two National Differences

English printed on the other), which is a way of returning respect and acknowledging the card giver’s position in the hierarchy. The foreigner is also expected to bow when taking the card and to return the greeting by presenting the Japanese executive with his or her own card, similarly bowing in the process. To not do so, and to fail to read the card that he or she has been given, instead casually placing it in a jacket, pocket, or purse, violates this impor- tant folkway and is considered rude.

Mores is a term that refers to norms that are more widely observed, have greater moral significance than other norms, and are central to the functioning of a society and to its social life. This means that mores have a much greater significance than folkways. Accordingly, violating mores can bring serious retribution, ill will, and collapse of any business deal in the making. Mores include such factors as indictments against theft, adultery, incest, and can- nibalism. In many societies, certain mores have been enacted into law. Specifically, all ad- vanced societies have laws against theft, incest, and cannibalism. However, there are also many differences among cultures. In the United States, for example, drinking alcohol is widely accepted, whereas in Saudi Arabia the consumption of alcohol is viewed as violating important social mores and is punishable by imprisonment (as some Western citizens work- ing in Saudi Arabia have discovered). In some way, mores are being implemented differently depending on where you are and who you are. For example, like Saudi Arabia, the United Arab Emirates have laws against drinking alcohol in public places, but alcohol is often pres- ent and a part of business relationships involving Westerners in Dubai and elsewhere in the country (especially in the bars of luxury hotels).

CULTURE, SOCIETY, AND THE NATION-STATE We have defined a society as a group of people that share a common set of values and norms; that is, people who are bound together by a common culture. There is not a strict one-to-one correspon- dence between a society and a nation-state. Nation-states are political creations. While these nation-states are often studied for their “national identity,” “national character,” and even “competitive advantage of nations,” in reality they may contain a single culture or several cultures.15 Representative of a single culture setting, the French nation can be thought of as the political embodiment of French culture. However, the nation of Canada has at least three cultures—an Anglo culture, a French-speaking “Quebecois” culture, and a Native American culture. Similarly, many of the 55 African nations have important cul- tural differences among tribal groups, as exhibited in the early 1990s when Rwanda dis- solved into a bloody civil war between two tribes, the Tutsis and Hutus. Africa is not alone in this regard. India, for example, is composed of many distinct cultural groups with their own rich history and traditions (e.g., Andhras, Gonds, Gujaratis, Marathas, Oriya, Rajputs, and Tamils).

At the other end of the scale are cultures that embrace several nations. Several scholars argue that we can speak of an Islamic society or culture that is shared by the citizens of many different nations in the Middle East, Asia, and Africa. As you will recall from the previous chapter, this view of expansive cultures that embrace several nations underpins Samuel Huntington’s view of a world that is fragmented into different civilizations, including West- ern, Islamic, and Sinic (Chinese).16

To complicate things further, it is also possible to talk about culture at different levels. It is reasonable to talk about “American society” and “American culture,” but there are several societies within America, each with its own culture. For example, in the United States of America, which is one country, one can talk about African American culture, Cajun culture, Chinese American culture, Hispanic culture, Indian culture, Irish American culture, and Southern culture. The relationship between culture and country is often ambiguous. Even if a country can be characterized as having a single homogeneous culture, often that national culture is a mosaic of subcultures. To abide by these cultural nuances, businesspeople should be aware of the delicate issues pertaining to folkways, as appropriate, and not violate mores in the country in which they intend to do business. Increased globalization has meant an increased number of business relationships across countries and cultures, but not necessarily an increased culturally homogeneity in all parts of the world. Culture is still a complex phe- nomenon with multiple dimensions and multiple levels.17

Mores Norms seen as central to the functioning of a society and to its social life.

Chapter Four Differences in Culture 95

THE DETERMINANTS OF CULTURE The values and norms of a culture do not emerge fully formed. They evolve over time in response to a number of factors, includ- ing prevailing political and economic philosophies, the social structure of a society, and the dominant religion, language, and education (see Figure 4.1). We discussed political and eco- nomic philosophies in Chapter 2. Such philosophies clearly influence the value systems of a society. For example, the values found in Communist North Korea toward freedom, justice, and individual achievement are clearly different from the values found in the United States, precisely because each society operates according to different political and economic phi- losophies. In the next sections of this chapter, we discuss the influence of social structure, religion, language, and education. The chain of causation runs both ways. While factors such as social structure and religion clearly influence the values and norms of a society, the values and norms of a society can influence social structure and religion.

Social Structure A society’s social structure refers to its basic social organization, and this social organiza- tion is both emergent from and determinant of the behaviors of individuals. Although social structure consists of many different aspects, two dimensions are particularly important when explaining differences among cultures. The first is the degree to which the basic unit of a social organization is the individual, as opposed to the group. In general, Western societies tend to emphasize the importance of the individual, whereas groups tend to figure much larger in many other societies. The second dimension is the degree to which a society is stratified into classes or castes. Some societies are characterized by a relatively high degree of social stratification and relatively low mobility between strata (e.g., Indian); other societ- ies are characterized by a low degree of social stratification and high mobility between strata (e.g., American).

INDIVIDUALS AND GROUPS A group is an association of two or more indi- viduals who have a shared sense of identity and who interact with each other in structured ways on the basis of a common set of expectations about each other’s behavior.18 Human social life is group life. Individuals are involved in families, work groups, social groups, rec- reational groups, and so on. In a way, social media has expanded the boundaries and what is included in group life and placed an added emphasis on what we can call the extended social groups. When research on social structure was developed, social media clearly did not enter

LO 4-2 Identify the forces that lead to differences in social culture.

Social Structure The basic social organization of a society.

Group An association of two or more individuals who have a shared sense of identity and who interact with each other in structured ways on the basis of a common set of expectations about each other’s behavior.

4.1 FIGURE The Determinants of Culture

Social Structure

Culture Norms and Value Systems

Language

Political Philosophy

Economic Philosophy

Education

Religion

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96 Part Two National Differences

into the equation of what was possible in terms of group life. This new form of social media group life has unique possibilities that affect both individuals within a social group and the group itself. For example, consumers are significantly more likely to buy from the brands they follow on Twitter and Facebook due to group influences. However, while groups are found in all societies, some societies differ according to the degree to which the group is viewed as the primary means of social organization.19 In some societies, individual attributes and achievements are viewed as being more important than group membership; in others, the reverse is true.

The Individual In Chapter 2, we discussed individualism as a political philosophy. However, individualism is more than just an abstract political philosophy. In many Western societies, the individual is the basic building block of social organization. This is reflected not just in the political and economic organization of society but also in the way people perceive themselves and relate to each other in social and business settings. The value sys- tems of many Western societies, for example, emphasize individual achievement. The social standing of individuals is not so much a function of whom they work for as of their indi- vidual performance in whatever work setting they choose. More and more, individuals are regarded as “independent contractors” even though they belong to and work for a com- pany. These individuals, in essence, build their personal brands by the knowledge, skills, and experience that they have; which often translates to increased salaries and promotions at the current company or another company that believes that it can benefit from that per- son’s capabilities. In science, the label “star scientist” has become synonymous with these individualistic high-producers of innovative products based on their knowledge, skills, and experience.20

The emphasis on individual performance in many Western societies has both benefi- cial and harmful aspects. In the United States, the emphasis on individual performance finds expression in an admiration of rugged individualism, entrepreneurship, and innova- tion. One benefit of this is the high level of entrepreneurial activity in the United States and other Western societies. Entrepreneurial individuals in the United States have cre- ated many new products and new ways of doing business (e.g., personal computers, pho- tocopiers, computer software, biotechnology, supermarkets, and discount retail stores). One can argue that the dynamism of the U.S. economy owes much to the philosophy of individualism. Highly individualistic societies are often synonymous with people who are capable and have the capacity to constantly innovate by their creative ideas for products and services.

Individualism also finds expression in a high degree of managerial mobility between companies, as our “personal brand” example illustrated earlier, and this is not always a good thing. Although moving from company to company may be good for in- dividual managers who are trying to build impressive résumés, it is not necessarily a good thing for compa- nies. The lack of loyalty and commitment to an individ- ual company, and the tendency to move on for a better offer, can result in managers who have good general skills but lack the knowledge, experience, and network of interpersonal contacts that come from years of work- ing within the same company. An effective manager draws on company-specific experience, knowledge, and a network of contacts to find solutions to current prob- lems, and companies may suffer if their managers lack these attributes. One positive aspect of high managerial mobility is that executives are exposed to different ways of doing business. The ability to compare business prac- tices helps executives identify how good practices and techniques developed in one firm might be profitably applied to other firms.

LO 4-3 Identify the business and economic implications of differences in culture.

Is Social Class Determined by Income? In the text, we said that a class system is a less rigid form of social stratification in which social mobility is possible. It is a form of open stratification in which the position a person has by birth can be changed through his or her own achievements or luck. Social class can broadly be divided into three levels, includ- ing upper (or rich), middle, and lower (or poor). These levels ap- pear to be tied to income, but does a high income automatically bring power and prestige? Is it the income that should determine social class, or is it the social class that will determine the in- come? Or, is income just a small portion of social class status?

Source: D. Francis, “Where Do You Fall in the American Economic Class System?” US News and World Report, September 13, 2012.

Chapter Four Differences in Culture 97

The Group In contrast to the Western emphasis on the individual, the group is the primary unit of social organization in many other societies. For example, in Japan, the social status of an individual has traditionally been determined as much by the standing of the group to which he or she belongs as by his or her individual performance.21 In traditional Japanese society, the group was the family or village to which an individual belonged. Today, the group has frequently come to be associated with the work team or business organization to which an individual belongs. In a now-classic study of Japanese society, Nakane noted how this expresses itself in everyday life:

When a Japanese faces the outside (confronts another person) and affixes some posi- tion to himself socially he is inclined to give precedence to institution over kind of occupation. Rather than saying, “I am a typesetter” or “I am a filing clerk,” he is likely to say, “I am from B Publishing Group” or “I belong to S company.”22

Nakane goes on to observe that the primacy of the group to which an individual belongs often evolves into a deeply emotional attachment in which identification with the group becomes all-important in one’s life. One central value of Japanese culture is the importance attached to group membership. This may have beneficial implications for business firms. Strong identification with the group is argued to create pressures for mutual self-help and collective action. If the worth of an individual is closely linked to the achievements of the group (e.g., firm), as Nakane maintains is the case in Japan, this creates a strong incentive for individual members of the group to work together for the common good. Some argue that the success of some Japanese enterprises in the global economy has been based partly on their ability to achieve close cooperation between individuals within a company and be- tween companies. This has found expression in the widespread diffusion of self-managing work teams within Japanese organizations; the close cooperation among different functions within Japanese companies (e.g., among manufacturing, marketing, and R&D); and the co- operation between a company and its suppliers on issues such as design, quality control, and inventory reduction.23 In all these cases, cooperation is driven by the need to improve the performance of the group (i.e., the business firm).

The primacy of the value of group identification also discourages managers and workers from moving from company to company. Lifetime employment in a particular company was long the norm in certain sectors of the Japanese economy (estimates suggest that between 20 and 40 percent of all Japanese employees have formal or informal lifetime employment guarantees). Over the years, managers and workers build up knowledge, experience, and a network of interpersonal business contacts. All these things can help managers perform their jobs more effectively and achieve cooperation with others.

However, the primacy of the group is not always beneficial. Just as U.S. society is charac- terized by a great deal of dynamism and entrepreneurship, reflecting the primacy of values associated with individualism, some argue that Japanese society is characterized by a corre- sponding lack of dynamism and entrepreneurship. Although the long-run consequences are unclear, one implication is that the United States could continue to create more new indus- tries than Japan and continue to be more successful at pioneering radically new products and new ways of doing business. By most estimates, the United States has led the world in innovation for some time, especially radically new products and services, and the country’s individualism is a strong contributor to this innovative mindset. At the same time, some group-oriented countries such as Japan also do well in innovation, especially nonradical “normal” innovations, according to the “GE Global Innovation Barometer.”24 This is an indication that multiple paths to being innovative exists in both individualistic and group- oriented cultures, drawing from the uniqueness of the particular culture and what core com- petencies are reflected in the culture.25

SOCIAL STRATIFICATION All societies are stratified on a hierarchical basis into social categories—that is, into social strata. These strata are typically defined on the basis of socioeconomic characteristics such as family background, occupation, and income. Individuals are born into a particular stratum. They become a member of the social category

LO 4-3 Identify the business and economic implications of differences in culture.

LO 4-2 Identify the forces that lead to differences in social culture.

Social Strata Hierarchical social categories often based on family background, occupation, and income.

98 Part Two National Differences

to which their parents belong. Individuals born into a stratum toward the top of the social hierarchy tend to have better life chances than those born into a stratum toward the bottom of the hierarchy. They are likely to have better education, health, standard of living, and work opportunities. Although all societies are stratified to some degree, they differ in two related ways. First, they differ from each other with regard to the degree of mobility be- tween social strata. Second, they differ with regard to the significance attached to social strata in business contexts. Overall, social stratification is based on four basic principles:26

1. Social stratification is a trait of society, not a reflection of individual differences. 2. Social stratification carries over a generation to the next generation. 3. Social stratification is generally universal but variable. 4. Social stratification involves not just inequality but also beliefs.

Social Mobility The term social mobility refers to the extent to which individuals can move out of the strata into which they are born. Social mobility varies significantly from society to society. The most rigid system of stratification is a caste system. A caste system is a closed system of stratification in which social position is determined by the family into which a person is born, and change in that position is usually not possible during an indi- vidual’s lifetime. Often, a caste position carries with it a specific occupation. Members of one caste might be shoemakers, members of another might be butchers, and so on. These occupations are embedded in the caste and passed down through the family to succeeding generations. Although the number of societies with caste systems diminished rapidly during

Social Mobility The extent to which individuals can move out of the social strata into which they are born.

Caste System A system of social stratification in which social position is determined by the family into which a person is born, and change in that position is usually not possible during an individual’s lifetime.

Using IT to Break India’s Caste System

Modern India is a country of dramatic contrasts. Its information tech- nology (IT) sector is among the most vibrant in the world with compa- nies such as Tata Consultancy Services, Cognizant Technology Solutions, Infosys, and Wipro emerging as powerful global players. Cognizant is an interesting company in that it was founded as a tech- nology arm of Dun & Bradstreet (USA) in 1994 but is typically consid- ered an Indian IT company because a majority of its employees are based in India. In fact, many IT companies locate or operate in India because of its strong IT knowledge, human capital, and culture.

Traditionally, India has had one of the strongest caste systems in the world. At the core, the caste system has no legality in India, and dis- crimination against lower castes is illegal. India has also enacted numerous new laws and social initiatives to protect and improve living conditions of lower castes in the country. Historically, however, India’s caste system was an impediment to social mobility. But, steadily the stranglehold on people’s socioeconomic conditions is becoming a fading memory among the educated, urban middle-class Indians who make up the majority of employees in the high-tech economy. Unfortunately, the same is not true in rural India, where some 70 percent of the nation’s population still resides. There caste remains a pervasive influence.

For example, a young female engineer at Infosys who grew up in a small rural village and is a dalit (sometimes called a “scheduled caste”) recounts how she never entered the house of a Brahmin, In- dia’s elite priestly caste, even though half of her village were Brah- mins. When a dalit was hired to cook at the school in her native village, Brahmins withdrew their children from the school. The engi- neer herself is the beneficiary of a charitable training scheme that

Infosys launched in 2006. Her caste, making up about 16 percent of the country (or around 165 million people), is among the poorest in India, with some 91 percent making less than $100 a month, com- pared to 65 percent of Brahmins.

To try to correct this historic inequality, politicians have talked for years about extending the employment quota system to private enter- prises. The government has told private companies to hire more dalits and members of tribal communities and warned that “strong mea- sures” will be taken if companies do not comply. Private employers are resisting attempts to impose quotas, arguing with some justification that people who are guaranteed a job by a quota system are unlikely to work very hard. At the same time, progressive employers realize they need to do something to correct the inequalities, and unless India taps into the lower castes, it may not be able to find the employees required to staff rapidly growing high-technology enterprises. Thus, the Confed- eration of Indian Industry recently introduced a package of dalit- friendly measures, including scholarships for bright lower-caste children. Building on this, Infosys is leading the way among high-tech enterprises. The company provides special training to low-caste engi- neering graduates who have failed to get a job in industry after gradu- ation. While the training does not promise employment, so far almost all graduates who completed the seven-month training program have been hired by Infosys and other enterprises.27 Infosys programs are privatized version of the education offered in India to try to break down India’s caste system.

Source: B. Hardzinski, S. Grillot, and M. Addison, “Breaking Down India’s Caste System Through Education,” KGOU, November 29, 2013, http://kgou.org/post/breaking-down- india-s-caste-system-through-education, accessed March 7, 2014.

country FOCUS

Chapter Four Differences in Culture 99

the twentieth century, one partial example still remains. India has four main castes and sev- eral thousand sub-castes. Even though the caste system was officially abolished in 1949, two years after India became independent, it is still a force in rural Indian society where occupa- tion and marital opportunities are still partly related to caste (for more details, see the ac- companying Country Focus on the caste system in India today).28

A class system is a less rigid form of social stratification in which social mobility is pos- sible. It is a form of open stratification in which the position a person has by birth can be changed through his or her own achievements or luck. Individuals born into a class at the bottom of the hierarchy can work their way up; conversely, individuals born into a class at the top of the hierarchy can slip down.

While many societies have class systems, social mobility within a class system varies from society to society. For example, some sociologists have argued that Britain has a more rigid class structure than certain other Western societies, such as the United States.29 Historically, British society was divided into three main classes: the upper class, which was made up of individuals whose families for generations had wealth, prestige, and occasionally power; the middle class, whose members were involved in professional, managerial, and clerical occupa- tions; and the working class, whose members earned their living from manual occupations. The middle class was further subdivided into the upper-middle class, whose members were involved in important managerial occupations and the prestigious professions (e.g., lawyers, accountants, doctors), and the lower-middle class, whose members were involved in clerical work (e.g., bank tellers) and the less prestigious professions (e.g., schoolteachers).

The British class system exhibited significant divergence between the life chances of members of different classes. The upper and upper-middle classes typically sent their chil- dren to a select group of private schools, where they wouldn’t mix with lower-class children and where they picked up many of the speech accents and social norms that marked them as being from the higher strata of society. These same private schools also had close ties with the most prestigious universities, such as Oxford and Cambridge. Until fairly recently, Oxford and Cambridge guaranteed a certain number of places for the graduates of these private schools. Having been to a prestigious university, the offspring of the upper and upper-middle classes then had an excellent chance of being offered a prestigious job in companies, banks, brokerage firms, and law firms run by members of the upper and upper- middle classes.

In contrast, the members of the British working and lower-middle classes typically went to state schools. The majority left at age 16, and those who went on to higher education found it more difficult to get accepted at the best universities. When they did, they found that their lower-class accent and lack of social skills marked them as being from a lower so- cial stratum, which made it more difficult for them to get access to the most prestigious jobs.

Because of this, the class system in Britain perpetuated itself from generation to genera- tion, and mobility was limited. Although upward mobility was possible, it could not nor- mally be achieved in one generation. While an individual from a working-class background may have established an income level that was consistent with membership in the upper- middle class, he or she may not have been accepted as such by others of that class due to accent and background. However, by sending his or her offspring to the “right kind of school,” the individual could ensure that his or her children were accepted.

According to some commentators, modern British society is now rapidly leaving this class structure behind and moving toward a classless society. However, sociologists continue to dispute this finding and present evidence that this is not the case. For example, one study reported that state schools in the London suburb of Islington, which has a population of 175,000, had only 79 candidates for university, while one prestigious private school alone, Eton, sent more than that number to Oxford and Cambridge.30 This, according to the study’s authors, implies that “money still begets money.” They argue that a good school means a good university, a good university means a good job, and merit has only a limited chance of elbowing its way into this tight little circle. In another recent survey of the em- pirical literature, a sociologist noted that class differentials in educational achievement have changed surprisingly little over the last few decades in many societies, despite assumptions to the contrary.31

Class System A system of social stratification in which social status is determined by the family into which a person is born and by subsequent socioeconomic achievements; mobility between classes is possible.

100 Part Two National Differences

The class system in the United States is less pronounced than in Britain and mobility is greater. Like Britain, the United States has its own upper, middle, and working classes. However, class membership is determined to a much greater degree by individual eco- nomic achievements, as opposed to background and schooling. Thus, an individual can, by his or her own economic achievement, move smoothly from the working class to the upper class in a lifetime. Successful individuals from humble origins are highly respected in American society.

Another society for which class divisions have historically been of some importance has been China, where there has been a long-standing difference between the life chances of the rural peasantry and urban dwellers. Ironically, this historic division was strengthened during the high point of communist rule because of a rigid system of household registration that restricted most Chinese to the place of their birth for their lifetime. Bound to collective farming, peasants were cut off from many urban privileges—compulsory education, quality schools, health care, public housing, varieties of foodstuffs, to name only a few—and they largely lived in poverty. Social mobility was thus very limited. This system crumbled follow- ing reforms of the late 1970s and early 1980s, and as a consequence, migrant peasant labor- ers have flooded into China’s cities looking for work. Sociologists now hypothesize that a new class system is emerging in China based less on the rural–urban divide and more on urban occupation.32

Significance From a business perspective, the stratification of a society is significant if it affects the operation of business organizations. In American society, the high degree of social mobility and the extreme emphasis on individualism limit the impact of class back- ground on business operations. The same is true in Japan, where most of the population perceives itself to be middle class. In a country such as Great Britain, however, the relative lack of class mobility and the differences between classes have resulted in the emergence of class consciousness. Class consciousness refers to a condition by which people tend to perceive themselves in terms of their class background, and this shapes their relationships with members of other classes.

This has been played out in British society in the traditional hostility between upper- middle-class managers and their working-class employees. Mutual antagonism and lack of respect historically made it difficult to achieve cooperation between management and labor in many British companies and resulted in a relatively high level of industrial disputes. How- ever, the past two decades have seen a dramatic reduction in industrial disputes, which bol- sters the arguments of those who claim that the country is moving toward a classless society. Alternatively, as noted earlier, class consciousness may be reemerging in urban China, and it may ultimately prove to be significant there.

An antagonistic relationship between management and labor classes, and the resulting lack of cooperation and high level of industrial disruption, tends to raise the costs of produc- tion in countries characterized by significant class divisions. In turn, this can make it more difficult for companies based in such countries to establish a competitive advantage in the global economy.

Religious and Ethical Systems Religion may be defined as a system of shared beliefs and rituals that are concerned with the realm of the sacred.33 Ethical systems refer to a set of moral principles, or values, that are used to guide and shape behavior.34 Most of the world’s ethical systems are the product of religions. Thus, we can talk about Christian ethics and Islamic ethics. However, there is a major exception to the principle that ethical systems are grounded in religion. Confucianism and Confucian ethics influence behavior and shape culture in parts of Asia, yet it is incorrect to characterize Confucianism as a religion.

The relationship among religion, ethics, and society is subtle and complex. Among the thousands of religions in the world today, four dominate in terms of numbers of adherents: Christianity with roughly 2.25 billion adherents, Islam with around 1.65 billion adherents,

LO 4-3 Identify the business and economic implications of differences in culture.

Class Consciousness A tendency for individuals to perceive themselves in terms of their class background.

LO 4-2 Identify the forces that lead to differences in social culture.

Religion A system of shared beliefs and rituals concerned with the realm of the sacred.

Ethical Systems A coherent collection of beliefs about the right way to behave in a society.

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Chapter Four Differences in Culture 101

Hinduism with 1.07 billion adherents (primarily in India), and Buddhism with about 500 million adherents (see Map 4.1). Although many other religions have an important in- fluence in certain parts of the modern world (e.g., Shintoism in Japan, with roughly 40 mil- lion followers, and Judaism, which has 18 million adherents and accounts for 75 percent of the population of Israel), their numbers pale in comparison with these dominant religions (although as the precursor of both Christianity and Islam, Judaism has an indirect influence that goes beyond its numbers). We review these four religions, along with Confucianism, focusing on their potential economic and business implications.

Some scholars have theorized that the most important business implications of religion center on the extent to which different religions shape attitudes toward work and entrepre- neurship and the degree to which the religious ethics affects the costs of doing business in a country. However, it is hazardous to make sweeping generalizations about the nature of the relationship between religion and ethical systems and business practice. While some schol- ars argue that there is a relationship between religious and ethical systems and business practice in a society, in a world where nations with Catholic, Protestant, Muslim, Hindu, and Buddhist majorities all show evidence of entrepreneurial activity and sustainable eco- nomic growth, it is important to view such proposed relationships with a degree of skepti- cism. The proposed relationships may exist, but their impact may be small compared with the impact of economic policy. On the other hand, research by economists Robert Barro and

4.1 MAP World Religions Source: From John L. Allen, Student Atlas of World Politics 10th edition, map 14. Copyright ©2013 by The McGraw-Hill Companies. Reproduced by permission of McGraw-Hill Contemporary Learning Series.

102 Part Two National Differences

Rachel McCleary does suggest that strong religious beliefs, particularly beliefs in heaven, hell, and an afterlife, have a positive impact on economic growth rates, irrespective of the particular religion in question.35 Barro and McCleary looked at religious beliefs and eco- nomic growth rates in 59 countries. Their conjecture was that higher religious beliefs stim- ulate economic growth because they help to sustain aspects of individual behavior that lead to higher productivity.

CHRISTIANITY Christianity is the most widely practiced religion in the world. The vast majority of Christians live in Europe and the Americas, although their numbers are growing rapidly in Africa. Christianity grew out of Judaism. Like Judaism, it is a monotheis- tic religion (monotheism is the belief in one God). A religious division in the eleventh cen- tury led to the establishment of two major Christian organizations—the Roman Catholic Church and the Orthodox Church. Today, the Roman Catholic Church accounts for more than half of all Christians, most of whom are found in southern Europe and Latin America. The Orthodox Church, while less influential, is still of major importance in several coun- tries (e.g., Greece and Russia). In the sixteenth century, the Reformation led to a further split with Rome; the result was Protestantism. The nonconformist nature of Protestantism has facilitated the emergence of numerous denominations under the Protestant umbrella (e.g., Baptist, Methodist, Calvinist).

Economic Implications of Christianity Several sociologists have argued that of the main branches of Christianity—Catholic, Orthodox, and Protestant—the latter has the most important economic implications. In 1904, prominent German sociologist, Max Weber, made a connection between Protestant ethics and “the spirit of capitalism” that has since become famous.36 Weber noted that capitalism emerged in western Europe, where

business leaders and owners of capital, as well as the higher grades of skilled labor, and even more the higher technically and commercially trained personnel of modern en- terprises, are overwhelmingly Protestant.37

Weber theorized that there was a relationship between Protestantism and the emergence of modern capitalism. He argued that Protestant ethics emphasizes the importance of hard work and wealth creation (for the glory of God) and frugality (abstinence from worldly pleasures). According to Weber, this kind of value system was needed to facilitate the devel- opment of capitalism. Protestants worked hard and systematically to accumulate wealth. However, their ascetic beliefs suggested that rather than consuming this wealth by indulg- ing in worldly pleasures, they should invest it in the expansion of capitalist enterprises. Thus, the combination of hard work and the accumulation of capital, which could be used to finance investment and expansion, paved the way for the development of capitalism in western Europe and subsequently in the United States. In contrast, Weber argued that the Catholic promise of salvation in the next world, rather than this world, did not foster the same kind of work ethic.

Protestantism also may have encouraged capitalism’s development in another way. By breaking away from the hierarchical domination of religious and social life that character- ized the Catholic Church for much of its history, Protestantism gave individuals signifi- cantly more freedom to develop their own relationship with God. The right to freedom of form of worship was central to the nonconformist nature of early Protestantism. This emphasis on individual religious freedom may have paved the way for the subsequent emphasis on individual economic and political freedoms and the development of indi- vidualism as an economic and political philosophy. As we saw in Chapter 2, such a phi- losophy forms the bedrock on which entrepreneurial free market capitalism is based. Building on this, some scholars claim there is a connection between individualism, as in- spired by Protestantism, and the extent of entrepreneurial activity in a nation.38 Again, we must be careful not to generalize too much from this historical sociological view. While nations with a strong Protestant tradition such as Britain, Germany, and the United States

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were early leaders in the industrial revolution, nations with Catholic or Orthodox majorities show significant and sustained entrepreneurial activity and economic growth in the modern world.

ISLAM With about 1.65 billion adherents, Islam is the second largest of the world’s major religions. Islam dates back to A.D. 610 when the Prophet Muhammad began spreading the word, although the Muslim calendar begins in a.d. 622 when, to escape growing opposition, Muhammad left Mecca for the oasis settlement of Yathrib, later known as Medina. Adherents of Islam are referred to as Muslims. Muslims constitute a majority in more than 40 countries and inhabit a nearly contiguous stretch of land from the northwest coast of Africa, through the Middle East, to China and Malaysia in the Far East.

Islam has roots in both Judaism and Christianity (Islam views Jesus Christ as one of God’s prophets). Like Christianity and Judaism, Islam is a monotheistic religion. The central prin- ciple of Islam is that there is but the one true omnipotent God (Allah). Islam requires un- conditional acceptance of the uniqueness, power, and authority of God and the understanding that the objective of life is to fulfill the dictates of His will in the hope of admission to paradise. According to Islam, worldly gain and temporal power are an illusion. Those who pursue riches on earth may gain them, but those who forgo worldly ambitions to seek the favor of Allah may gain the greater treasure—entry into paradise. Other major principles of Islam include (1) honoring and respecting parents, (2) respecting the rights of others, (3) being generous but not a squanderer, (4) avoiding killing except for justifiable causes, (5) not committing adultery, (6) dealing justly and equitably with others, (7) being of pure heart and mind, (8) safeguarding the possessions of orphans, and (9) being humble and unpretentious.39 Obvious parallels exist with many of the central principles of both Judaism and Christianity.

Islam is an all-embracing way of life governing the totality of a Muslim’s being.40 As God’s surrogate in this world, a Muslim is not a totally free agent but is circumscribed by religious principles—by a code of conduct for interpersonal relations—in social and eco- nomic activities. Religion is paramount in all areas of life. The Muslim lives in a social structure that is shaped by Islamic values and norms of moral conduct. The ritual nature of everyday life in a Muslim country is striking to a Western visitor. Among other things, orthodox Muslim ritual requires prayer five times a day (business meetings may be put on hold while the Muslim participants engage in their daily prayer ritual), demands that women should be dressed in a certain manner, and forbids the consumption of pork and alcohol.

Islamic Fundamentalism The past three decades have witnessed the growth of a social movement often referred to as Islamic fundamentalism.41 In the West, Islamic fun- damentalism is associated in the media with militants, terrorists, and violent upheavals, such as the bloody conflict occurring in Algeria, the killing of foreign tourists in Egypt, and the September 11, 2001, attacks on the World Trade Center and Pentagon in the United States. This characterization is misleading. Just as Christian fundamentalists are motivated by sincere and deeply held religious values firmly rooted in their faith, so are Islamic fundamentalists. A small minority of radical “fundamentalists” who have hijacked the religion to further their own political and violent ends perpetrates the violence that the Western media associates with Islamic fundamentalism. (Some Christian “fundamen- talists” have done exactly the same, including Jim Jones and David Koresh.) The vast majority of Muslims point out that Islam teaches peace, justice, and tolerance, not violence and intolerance, and that Islam explicitly repudiates the violence that a radical minority practices.

The rise of Islamic fundamentalism has no one cause. In part, it is a response to the social pressures created in traditional Islamic societies by the move toward modernization and by the influence of Western ideas, such as liberal democracy, materialism, equal rights for women, and attitudes toward sex, marriage, and alcohol. In many Muslim countries, mod- ernization has been accompanied by a growing gap between a rich urban minority and an

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impoverished urban and rural majority. For the impoverished majority, modernization has offered little in the way of tangible economic progress, while threatening the traditional value system. Thus, for a Muslim who cherishes his or her traditions and feels that his or her identity is jeopardized by the encroachment of alien Western values, Islamic fundamental- ism has become a cultural anchor.

Fundamentalists demand commitment to traditional religious beliefs and rituals. The result has been a marked increase in the use of symbolic gestures that confirm Islamic val- ues. In areas where fundamentalism is strong, women have resumed wearing floor-length, long-sleeved dresses and covering their hair; religious studies have increased in universities; the publication of religious tracts has increased; and public religious orations have risen.42 Also, the sentiments of some fundamentalist groups are often anti-Western. Rightly or wrongly, Western influence is blamed for a range of social ills, and many fundamentalists’ actions are directed against Western governments, cultural symbols, businesses, and even individuals.

In several Muslim countries, fundamentalists have gained political power and have used this to try to make Islamic law (as set down in the Koran, the bible of Islam) the law of the land. There are grounds for this in Islam doctrine. Islam makes no distinction between church and state. It is not just a religion; Islam is also the source of law, a guide to state- craft, and an arbiter of social behavior. Muslims believe that every human endeavor is within the purview of the faith—and this includes political activity—because the only purpose of any activity is to do God’s will.43 (Some Christian fundamentalists also share this view.) Muslim fundamentalists have been most successful in Iran, where a fundamen- talist party has held power since 1979, but they also have had an influence in many other countries, such as Afghanistan (where the Taliban established an extreme fundamentalist state until removed by the U.S.-led coalition in 2002), Algeria, Egypt, Pakistan, Saudi Arabia, and the Sudan.

Economic Implications of Islam The Koran establishes some explicit economic principles, many of which are pro–free enterprise.44 The Koran speaks approvingly of free enterprise and of earning legitimate profit through trade and commerce (the Prophet Mu- hammad himself was once a trader). The protection of the right to private property is also embedded within Islam, although Islam asserts that all property is a favor from Allah (God), who created and so owns everything. Those who hold property are regarded as trustees rather than owners in the Western sense of the word. As trustees, they are entitled to receive profits from the property but are admonished to use it in a righteous, socially beneficial, and prudent manner. This reflects Islam’s concern with social justice. Islam is critical of those who earn profit through the exploitation of others. In the Islamic view of the world, humans are part of a collective in which the wealthy and successful have obligations to help the dis- advantaged. Put simply, in Muslim countries, it is fine to earn a profit, so long as that profit is justly earned and not based on the exploitation of others for one’s own advantage. It also helps if those making profits undertake charitable acts to help the poor. Furthermore, Islam stresses the importance of living up to contractual obligations, of keeping one’s word, and of abstaining from deception. For a closer look at how Islam, capitalism, and globalization can coexist, see the accompanying Country Focus about the region around Kayseri in central Turkey.

Given the Islamic proclivity to favor market-based systems, Muslim countries are likely to be receptive to international businesses as long as those businesses behave in a manner that is consistent with Islamic ethics, customs, and business practices. Businesses that are perceived as making an unjust profit through the exploitation of others, by deception, or by breaking contractual obligations are unlikely to be welcomed in an Islamic country. In addi- tion, in Islamic countries where fundamentalism is on the rise, hostility toward Western- owned businesses is likely to increase.

One economic principle of Islam prohibits the payment or receipt of interest, which is considered usury. This is not just a matter of theology; in several Islamic states, it is also a matter of law. The Koran clearly condemns interest, which is called riba in Arabic, as ex- ploitative and unjust. For many years, banks operating in Islamic countries conveniently

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ignored this condemnation, but starting in the 1970s with the establishment of an Islamic bank in Egypt, Islamic banks opened in predominantly Muslim countries. Now there are hundreds of Islamic banks in more than 50 countries with assets of around $1.6 trillion; plus more than $1trillion is managed by mutual funds that adhere to Is- lamic principles.45 Even conventional banks are entering the market—both Citigroup and HSBC, two of the world’s largest financial institutions, now offer Islamic financial services. While only Iran and the Sudan enforce Islamic banking conventions, in an in- creasing number of countries customers can choose between conventional banks and Islamic banks.

Conventional banks make a profit on the spread between the interest rate they have to pay to depositors and the higher interest rate they charge borrowers. Because Islamic banks cannot pay or charge interest, they must find a different way of making money. Islamic banks have experimented with two different banking methods—the mudarabah and the murabaha.46

A mudarabah contract is similar to a profit-sharing scheme. Un- der mudarabah, when an Islamic bank lends money to a business, rather than charging that business interest on the loan, it takes a share in the profits that are derived from the investment. Simi- larly, when a business (or individual) deposits money at an Islamic bank in a savings account, the deposit is treated as an equity in- vestment in whatever activity the bank uses the capital for. Thus, the depositor receives a share in the profit from the bank’s invest- ment (as opposed to interest payments) according to an agreed- upon ratio. Some Muslims claim this is a more efficient system than the Western banking system because it encourages both

Islamic Capitalism in Turkey

For years now, Turkey has been lobbying the European Union to allow it to join the free trade bloc as a member-state. If the EU says yes, it will be the first Muslim state in the union. Many critics in the EU worry that Islam and Western-style capitalism do not mix well and that, as a con- sequence, allowing Turkey into the EU would be a mistake. However, a close look at what is going on in Turkey suggests this view may be misplaced. Consider the area around the city of Kayseri in central Tur- key. Many dismiss this poor, largely agricultural region of Turkey as a non-European backwater, far removed from the secular bustle of Istan- bul. It is a region where traditional Islamic values hold sway. And yet, it is a region that has produced so many thriving Muslim enterprises that it is sometimes called the “Anatolian Tiger.” Businesses based here include large food manufacturers, textile companies, furniture manu- facturers, and engineering enterprises, many of which export a sub- stantial percentage of their production.

Local business leaders attribute the success of companies in the region to an entrepreneurial spirit that they say is part of Islam. They point out that the Prophet Muhammad, who was himself a trader, preached merchant honor and commanded that 90 percent of a Mus- lim’s life be devoted to work in order to put food on the table. Outside observers have gone further, arguing that what is occurring around Kayseri is an example of Islamic Calvinism, a fusion of traditional

Islamic values and the work ethic often associated with Protestantism in general and Calvinism in particular.

However, not everyone agrees that Islam is the driving force behind the region’s success. Saffet Arslan, the managing director of Ipek, the largest furniture producer in the region (which exports to more than 30 countries), says another force is at work—globalization! According to Arslan, over the past three decades, local Muslims who once eschewed making money in favor of focusing on religion are now making busi- ness a priority. They see the Western world, and Western capitalism, as a model, not Islam, and because of globalization and the opportunities associated with it, they want to become successful.

If there is a weakness in the Islamic model of business that is emerging in places such as Kayseri, some say it can be found in tradi- tional attitudes toward the role of women in the workplace and the low level of female employment in the region. According to a report by the European Stability Initiative, the same group that holds up the Kayseri region as an example of Islamic Calvinism, the low participation of women in the local workforce is the Achilles’ heel of the economy and may stymie the attempts of the region to catch up with the countries of the European Union.

Sources: D. Bilefsky, “Turks Knock on Europe’s Door with Evidence That Islam and Capitalism Can Coexist,” The New York Times, August 27, 2006, p. 4; and European Stability Initiative, Islamic Calvinists, September 19, 2005, archived at www.esiweb.org.

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long-term savings and long-term investment. However, there is no hard evidence of this, and many believe that a mudarabah system is less efficient than a conventional Western banking system.

The second Islamic banking method, the murabaha contract, is the most widely used among the world’s Islamic banks, primarily because it is the easiest to implement. In a murabaha contract, when a firm wishes to purchase something using a loan—let’s say a piece of equipment that costs $1,000—the firm tells the bank after having negotiated the price with the equipment manufacturer. The bank then buys the equipment for $1,000, and the borrower buys it back from the bank at some later date for, say, $1,100, a price that includes a $100 markup for the bank. A cynic might point out that such a markup is functionally equivalent to an interest payment, and it is the similarity between this method and conventional banking that makes it so much easier to adopt.

HINDUISM Hinduism has approximately 1.07 billion adherents, most of them on the Indian subcontinent. Hinduism began in the Indus Valley in India more than 4,000 years ago, making it the world’s oldest major religion. Unlike Christianity and Islam, its founding is not linked to a particular person. Nor does it have an officially sanctioned sacred book such as the Bible or the Koran. Hindus believe that a moral force in society requires the acceptance of certain responsibilities, called dharma. Hindus believe in reincarnation, or rebirth into a different body, after death. Hindus also believe in karma, the spiritual pro- gression of each person’s soul. A person’s karma is affected by the way he or she lives. The moral state of an individual’s karma determines the challenges he or she will face in the next life. By perfecting the soul in each new life, Hindus believe that an individual can eventually achieve nirvana, a state of complete spiritual perfection that renders reincarna- tion no longer necessary. Many Hindus believe that the way to achieve nirvana is to lead a severe ascetic lifestyle of material and physical self-denial, devoting life to a spiritual rather than material quest.

Economic Implications of Hinduism Max Weber, famous for expounding on the Protestant work ethic, also argued that the ascetic principles embedded in Hinduism do not encourage the kind of entrepreneurial activity in pursuit of wealth creation that we find in Protestantism.47 According to Weber, traditional Hindu values emphasize that individuals should be judged not by their material achievements but by their spiritual achievements. Hindus perceive the pursuit of material well-being as making the attain- ment of nirvana more difficult. Given the emphasis on an ascetic lifestyle, Weber thought that devout Hindus would be less likely to engage in entrepreneurial activity than devout Protestants.

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Culture on globalEDGE

The “Culture” section of globalEDGE (globalEDGE.msu.edu/global- resources/culture) offers a variety of sources, information, and data on culture and international business. In addition, the “Insights by Coun- try” section (globalEDGE.msu.edu/global-insights/by/country), with coverage of more than 200 countries, has country-specific culture is- sues (e.g., what to do and not to do when visiting a country). These globalEDGE culture resources are nice complements to the material in Chapter 4. In this chapter, we cover a lot of material on culture, and

Geert Hofstede’s research has been the most influential on culture and business. globalEDGE has “The Hofstede Centre” as one of its cultural reference sources. This reference focuses on Hofstede’s research on cultural dimensions, including scores on countries, regions, charts, and graphs. Are you interested in the scores for a country we do not illus- trate in Table 4.1 see p. 114? If so, check out the “The Hofstede Cen- tre” and its “Culture Compass,” and see what the scores are for your favored country.

Chapter Four Differences in Culture 107

Mahatma Gandhi, the famous Indian nationalist and spiritual leader, was certainly the embodiment of Hindu asceticism. It has been argued that the values of Hindu asceticism and self-reliance that Gandhi advocated had a negative impact on the economic develop- ment of post-independence India.48 But we must be careful not to read too much into Weber’s rather old arguments. Modern India is a very dynamic entrepreneurial society, and millions of hardworking entrepreneurs form the economic backbone of the country’s rapidly growing economy, especially in the information technology sector.49

Historically, Hinduism also supported India’s caste system. The concept of mobility between castes within an individual’s lifetime makes no sense to traditional Hindus. Hindus see mobility between castes as something that is achieved through spiritual pro- gression and reincarnation. An individual can be reborn into a higher caste in his or her next life if he or she achieves spiritual development in this life. Although the caste system has been abolished in India, as discussed earlier in the chapter, it still casts a long shadow over Indian life.

BUDDHISM Buddhism was founded in the sixth century B.C. by Siddhartha Gautama, in what is now Nepal. Siddhartha renounced his wealth to pursue an ascetic lifestyle and spiritual perfection. His adherents claimed he achieved nirvana but decided to remain on earth to teach his followers how they, too, could achieve this state of spiritual enlightenment. Siddhartha became known as the Buddha (which means “the awakened one”). Today, most Buddhists are found in Central and Southeast Asia, China, Korea, and Japan. According to Buddhism, suffering originates in people’s desires for pleasure. Cessa- tion of suffering can be achieved by following a path for transformation. Siddhartha of- fered the Noble Eightfold Path as a route for transformation. This emphasizes right seeing, thinking, speech, action, living, effort, mindfulness, and meditation. Unlike Hinduism, Buddhism does not support the caste system. Nor does Buddhism advocate the kind of extreme ascetic behavior that is encouraged by Hinduism. Nevertheless, like Hindus, Buddhists stress the afterlife and spiritual achievement rather than involvement in this world.

Economic Implications of Buddhism The emphasis on wealth creation that is embedded in Protestantism is historically not found in Buddhism. Thus, in Buddhist societ- ies, we do not see the same kind of cultural stress on entrepreneurial behavior that Weber claimed could be found in the Protestant West. But unlike Hinduism, the lack of support for the caste system and extreme ascetic behavior suggests that a Buddhist society may repre- sent a more fertile ground for entrepreneurial activity than a Hindu culture. In effect, in- novative ideas and entrepreneurial activities may take hold throughout society independent of which caste a person may belong to, but again, each culture is uniquely oriented toward its own types of entrepreneurial behavior.

In Buddhism, societies were historically more deeply rooted to their local place in the natural world.50 This means that economies were more localized, with relations between people and also between culture and nature being relatively unmediated. In the modern economy, complex technologies and large-scale social institutions have led to a separa- tion between people and also between people and the natural world. Plus, as the econ- omy grows, it is difficult to understand and appreciate the potential effects people have on the natural world. Both of these separations are the antithetical to the Buddha’s teachings.

Interestingly, recent trends actually bring in the “Zen” orientation from Buddhism into business in the Western world.51 By 2013, there were 657 live trademarks containing the word “Zen” in them in the United States alone, according to the U.S. Patent and Trademark Office. “In business, ‘Zen’ is often a synonym for ordinary nothingness,” blogged Nancy Friedman, a corporate copywriter who consults with businesses on naming and branding. She said that “Zen can be combined with mail to describe ‘an incoming e-mail message with no message or attachments.’ Zen spin is a verb meaning ‘to tell a story without saying any- thing at all.’ And to zen a computing problem means to figure it out in an intuitive flash—

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perhaps while you’re plugged into the earphones of your ZEN MP3 player, now available from Creative with a 16Gb capacity.”52

CONFUCIANISM Confucianism was founded in the fifth century B.C. by K’ung-Fu-tzu, more generally known as Confucius. For more than 2,000 years until the 1949 communist revolution, Confucianism was the official ethical system of China. While observance of Confucian ethics has been weakened in China since 1949, many people still follow the teachings of Confucius, principally in China, Korea, and Japan. Confucianism teaches the importance of attaining personal salvation through right action. Although not a religion, Confucian ideology has become deeply embedded in the culture of these countries over the centuries and, through that, has an impact on the lives of many millions more.53 Confucianism is built around a comprehensive ethical code that sets down guidelines for relationships with others. High moral and ethical conduct and loyalty to others are central to Confucianism. Unlike religions, Confucianism is not con- cerned with the supernatural and has little to say about the concept of a supreme being or an afterlife.

Economic Implications of Confucianism Some scholars maintain that Con- fucianism may have economic implications as profound as those Weber argued were to be found in Protestantism, although they are of a different nature.54 Their basic thesis is that the influence of Confucian ethics on the culture of China, Japan, South Korea, and Taiwan, by lowering the costs of doing business in those countries, may help explain their economic success. In this regard, three values central to the Confucian system of ethics are of particular interest: loyalty, reciprocal obligations, and honesty in dealings with others.

In Confucian thought, loyalty to one’s superiors is regarded as a sacred duty—an abso- lute obligation. In modern organizations based in Confucian cultures, the loyalty that binds employees to the heads of their organization can reduce the conflict between man- agement and labor that we find in more class-conscious societies. Cooperation between management and labor can be achieved at a lower cost in a culture where the virtue of loyalty is emphasized in the value systems.

However, in a Confucian culture, loyalty to one’s superiors, such as a worker’s loyalty to management, is not blind loyalty. The concept of reciprocal obligations is important. Con- fucian ethics stresses that superiors are obliged to reward the loyalty of their subordinates by bestowing blessings on them. If these “blessings” are not forthcoming, then neither will be the loyalty. This Confucian ethic is central to the Chinese concept of guanxi, which re- fers to relationship networks supported by reciprocal obligations.55 Guanxi means relation- ships, although in business settings it can be better understood as connections. Today, Chinese will often cultivate a guanxiwang, or “relationship network,” for help. Reciprocal obligations are the glue that holds such networks together. If those obligations are not met—if favors done are not paid back or reciprocated—the reputation of the transgressor is tarnished, and the person will be less able to draw on his or her guanxiwang for help in the future. Thus, the implicit threat of social sanctions is often sufficient to ensure that favors are repaid, obligations are met, and relationships are honored. In a society that lacks a rule-based legal tradition, and thus legal ways of redressing wrongs such as violations of business agreements, guanxi is an important mechanism for building long-term business relationships and getting business done in China. For an example of the importance of guanxi, read the Management Focus on DMG-Shanghai.

A third concept found in Confucian ethics is the importance attached to honesty. Confu- cian thinkers emphasize that although dishonest behavior may yield short-term benefits for the transgressor, dishonesty does not pay in the long run. The importance attached to hon- esty has major economic implications. When companies can trust each other not to break contractual obligations, the costs of doing business are lowered. Expensive lawyers are not needed to resolve contract disputes. In a Confucian society, people may be less hesitant to commit substantial resources to cooperative ventures than in a society where honesty is less pervasive. When companies adhere to Confucian ethics, they can trust each other not to

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violate the terms of cooperative agreements. Thus, the costs of achieving cooperation be- tween companies may be lower in societies such as Japan relative to societies where trust is less pervasive.

For example, it has been argued that the close ties between the automobile compa- nies and their component parts suppliers in Japan are facilitated by a combination of trust and reciprocal obligations. These close ties allow the auto companies and their suppliers to work together on a range of issues, including inventory reduction, quality control, and design. The competitive advantage of Japanese auto companies such as Toyota may in part be explained by such factors.56 Similarly, the combination of trust and reciprocal obligations is central to the workings and persistence of guanxi networks in China.

Language One obvious way in which countries differ is language. By language, we mean both the spo- ken and the unspoken means of communication. Language is one of the defining character- istics of a culture.

DMG-Shanghai

In 1993, New Yorker Dan Mintz moved to China as a freelance film di- rector with no contacts, no advertising experience, and no Mandarin skills. By 2009, the company he subsequently founded in China, DMG, had emerged as one of China’s fastest-growing advertising agencies with a client list that includes Budweiser, Unilever, Sony, Nabisco, Audi, Volkswagen, China Mobile, and dozens of other Chinese brands. Mintz attributes his success in part to what the Chinese call guanxi.

Guanxi literally means relationships, although in business settings it can be better understood as connections. Guanxi has its roots in the Confucian philosophy of valuing social hierarchy and reciprocal obliga- tions. Confucian ideology has a 2,000-year-old history in China. Confu- cianism stresses the importance of relationships, both within the family and between master and servant. Confucian ideology teaches that people are not created equal. In Confucian thought, loyalty and obliga- tions to one’s superiors (or to family) is regarded as a sacred duty, but at the same time, this loyalty has its price. Social superiors are obli- gated to reward the loyalty of their social inferiors by bestowing “bless- ings” upon them; thus, the obligations are reciprocal. Chinese will often cultivate a guanxiwang, or “relationship network,” for help. There is a tacit acknowledgment that if you have the right guanxi, legal rules can be broken, or at least bent.

Mintz, who is now fluent in Mandarin, cultivated his guanxiwang by going into business with two young Chinese who had connections, Bing Wu and Peter Xiao. Wu, who works on the production side of the business, was a former national gymnastics champion, which translates into prestige and access to business and government officials. Xiao comes from a military family with major political con- nections. Together, these three have been able to open doors that long-established Western advertising agencies could not. They have done it in large part by leveraging the contacts of Wu and Xiao and by

backing up their connections with what the Chinese call Shi li, the ability to do good work.

A case in point was DMG’s campaign for Volkswagen, which helped the German company become ubiquitous in China. The ads used tradi- tional Chinese characters, which had been banned by Chairman Mao during the cultural revolution in favor of simplified versions. To get per- mission to use the characters in film and print ads—a first in modern China—the trio had to draw on high-level government contacts in Beijing. They won over officials by arguing that the old characters should be thought of not as “characters” but as art. Later, they shot TV spots for the ad on Shanghai’s famous Bund, a congested boulevard that runs along the waterfront of the old city. Drawing again on govern- ment contacts, they were able to shut down the Bund to make the shoot. Steven Spielberg had been able to close down only a portion of the street when he filmed Empire of the Sun there in 1986. DMG has also filmed inside Beijing’s Forbidden City, even though it is against the law to do so. Using his contacts, Mintz persuaded the government to lift the law for 24 hours. As Mintz has noted, “We don’t stop when we come across regulations. There are restrictions everywhere you go. You have to know how get around them and get things done.”

Today, DMG is a Chinese-based production and distribution com- pany. While it began as an advertising agency in 1993, the company started distributing non-Chinese movies in the Chinese market in the late 2000s as well as producing Chinese films, the first being The Founding of a Republic in 2009. This is a movie that marked the 60th anniversary of the People’s Republic of China. In these new activities, DMG is also enjoying guanxi in the country. Variety reported that DMG benefited from “strong connections” with Chinese government officials and the state-run China Film Group Corporation.

Sources: J. Bryan, “The Mintz Dynasty,” Fast Company, April 2006, pp. 56–62; M. Graser, “Featured Player,” Variety, October 18, 2004, p. 6.; and C. Coonan, “DMG’s Dan Mintz: Hollywood’s Man in China,” Variety, June 5, 2013, accessed March 7, 2014.

management FOCUS

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.

110 Part Two National Differences

SPOKEN LANGUAGE Language does far more than just enable people to communicate with each other. The nature of a language also structures the way we per- ceive the world. The language of a society can direct the attention of its members to certain features of the world rather than others. The classic illustration of this phe- nomenon is that whereas the English language has but one word for snow, the language of the Inuit (Eskimos) lacks a general term for it. Instead, because distinguishing different forms of snow is so important in the lives of the Inuit, they have 24 words that describe different types of snow (e.g., powder snow, falling snow, wet snow, drifting snow).57

Because language shapes the way people perceive the world, it also helps define culture. Countries with more than one language often have more than one culture. Canada has an English-speaking culture and a French- speaking culture. Tensions between the two can run quite high, with a substantial proportion of the French-speaking minority demanding independence from a Canada “dom- inated by English speakers.” The same phenomenon can be observed in many other countries. Belgium is divided into Flemish and French speakers, and tensions between the two groups exist; in Spain, a Basque-speaking minor- ity with its own distinctive culture has been agitating for independence from the Spanish-speaking majority for decades; on the Mediterranean island of Cyprus, the cul-

turally diverse Greek- and Turkish-speaking populations of the island engaged in open con- flict in the 1970s, and the island is now partitioned into two parts. While it does not necessarily follow that language differences create differences in culture and, therefore, separatist pressures (e.g., witness the harmony in Switzerland, where four languages are spoken), there certainly seems to be a tendency in this direction.58

Mandarin (Chinese) is the mother tongue of the largest number of people, followed by English and Hindi, which is spoken in India. However, the most widely spoken language in the world is English, followed by French, Spanish, and Mandarin (i.e., many people speak English as a second language). And, English is increasingly becoming the language of inter- national business. When Japanese and German businesspeople get together to do business, it is almost certain that they will communicate in English. However, although English is widely used, learning the local language yields considerable advantages. Most people prefer to converse in their own language, and being able to speak the local language can build rapport and goodwill, which may be very important for a business deal. International busi- nesses that do not understand the local language can make major blunders through im- proper translation.

For example, the Sunbeam Corporation used the English words for its “Mist-Stick” mist-producing hair-curling iron when it entered the German market, only to discover after an expensive advertising campaign that mist means excrement in German. General Motors was troubled by the lack of enthusiasm among Puerto Rican dealers for its new Chevrolet Nova. When literally translated into Spanish, nova means star. However, when spoken it sounds like “no va,” which in Spanish means “it doesn’t go.” General Motors changed the name of the car to Caribe.59 Ford made a similar and somewhat embarrassing mistake in Brazil. The Ford Pinto may well have been a good car but the Brazilians wanted no part of a car called “pinto” which is slang for tiny male genitals in Brazil. Even the world’s largest furniture manufacturer, IKEA from Sweden, ran into branding issues when it named a plant pot “Jättebra” (which means great or superbly good in Swedish). Unfor- tunately, Jättebra resembles the Thai slang word for sex! As one final example, and there

LO 4-2 Identify the forces that lead to differences in social culture.

Can You Speak the Most Important Languages? Mastering your own native language is critically important to do- ing business in your own home country. Mastering the language of a foreign country (or subcultures) with which you want to do business is also an added value in any cross-cultural relation- ship. English leads the way in terms of business languages, but which languages are important after English? Spanish? No, not necessarily. The three languages that are important for business after English are Mandarin Chinese, French, and Arabic. Spanish is fifth, so it is clearly important, but not as useful as English, Mandarin, French, and Arabic because of the number of people who speak these languages. Do you agree with the rank order of these languages? Why or why not? Did you know that you can now learn a new language online? Check out the Language Re- sources on globalEDGE (globalEDGE.msu.edu/global-resources/ language-resources), and learn a new language (including Man- darin, French, Arabic, and Spanish).

Source: S. Kim, “Top 3 Useful Foreign Languages for Business Excludes Spanish,” ABC News, September 1, 2011, http://abcnews.go.com/blogs/business/2011/09/ top-3-useful-foreign-languages-for-business-excludes-spanish, accessed March 8, 2014.

Chapter Four Differences in Culture 111

are numerous, of companies using product names, advertising slogans, and branding cam- paigns that translate poorly, Pepsi’s slogan “come alive with the Pepsi Generation” did not quite work in China. People in China took it literally to mean “bring your ancestors back from the grave.”

UNSPOKEN LANGUAGE Unspoken language refers to nonverbal communi- cation. We all communicate with each other by a host of nonverbal cues. The raising of eyebrows, for example, is a sign of recognition in most cultures, while a smile is a sign of joy. Many nonverbal cues, however, are culturally bound. A failure to understand the non- verbal cues of another culture can lead to a communication failure. For example, making a circle with the thumb and the forefinger is a friendly gesture in the United States, but it is a vulgar sexual invitation in Greece and Turkey. Similarly, while most Americans and Europeans use the thumbs-up gesture to indicate that “it’s all right,” in Greece the gesture is obscene.

Another aspect of nonverbal communication is personal space, which is the comfortable amount of distance between you and someone you are talking with. In the United States, the customary distance apart adopted by parties in a business discussion is five to eight feet. In Latin America, it is three to five feet. Consequently, many North Americans unconsciously feel that Latin Americans are invading their personal space and can be seen backing away from them during a conversation. Indeed, the American may feel that the Latin is being ag- gressive and pushy. In turn, the Latin American may interpret such backing away as aloof- ness. The result can be a regrettable lack of rapport between two businesspeople from different cultures.

Education Formal education plays a key role in a society. Formal education is the medium through which individuals learn many of the language, conceptual, and mathematical skills that are indispensable in a modern society. Formal education also supplements the family’s role in socializing the young into the values and norms of a society. Values and norms are taught both directly and indirectly. Schools generally teach basic facts about the social and political nature of a society. They also focus on the fundamental obligations of citizenship. Cultural norms are also taught indirectly at school. Respect for others, obedience to authority, hon- esty, neatness, being on time, and so on, are all part of the “hidden curriculum” of schools. The use of a grading system also teaches children the value of personal achievement and competition.60

From an international business perspective, one important aspect of education is its role as a determinant of national competitive advantage.61 The availability of a pool of skilled and educated workers seems to be a major determinant of the likely economic success of a country. In analyzing the competitive success of Japan since 1945, for example, Michael Porter notes that after the war, Japan had almost nothing except for a pool of skilled and educated human resources:

With a long tradition of respect for education that borders on reverence, Japan pos- sessed a large pool of literate, educated, and increasingly skilled human resources. . . . Japan has benefited from a large pool of trained engineers. Japanese universities grad- uate many more engineers per capita than in the United States. . . . A first-rate primary and secondary education system in Japan operates based on high standards and em- phasizes math and science. Primary and secondary education is highly competitive. . . . Japanese education provides most students all over Japan with a sound education for later education and training. A Japanese high school graduate knows as much about math as most American college graduates.62

Porter’s point is that Japan’s excellent education system is an important factor explain- ing the country’s postwar economic success. Not only is a good education system a deter- minant of national competitive advantage, but it is also an important factor guiding the

LO 4-2 Identify the forces that lead to differences in social culture.

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112 Part Two National Differences

location choices of international businesses. The recent trend to outsource information technology jobs to India, for example, is partly due to the presence of significant numbers of trained engineers in India, which in turn is a result of the Indian education system. By the same token, it would make little sense to base production facilities that require highly skilled labor in a country where the education system was so poor that a skilled labor pool wasn’t available, no matter how attractive the country might seem on other dimensions. It might make sense to base production operations that require only unskilled labor in such a country.

The general education level of a country is also a good index of the kind of products that might sell in a country and of the type of promotional material that should be used. As a direct example, a country where more than 70 percent of the population is illiterate is un- likely to be a good market for popular books. But perhaps more importantly, promotional material containing written descriptions of mass-marketed products is unlikely to have an effect in a country where almost three-quarters of the population cannot read. It is far better to use pictorial promotions in such circumstances.

Culture and Business Of considerable importance for an international business with operations in different countries is how a society’s culture affects the values found in the workplace. Management process and practices may need to vary according to culturally determined work-related values. For example, if the cultures of Brazil and Great Britain or the United States and Sweden result in different work-related values, an international business with operations in both countries should vary its management process and practices to account for these differences.

The most famous study of how culture relates to values in the workplace was undertaken by Geert Hofstede.63 As part of his job as a psychologist working for IBM, Hofstede col- lected data on employee attitudes and values for more than 116,000 individuals in 1968 and 1972; respondents were matched on occupation, age, and gender. These data enabled him to compare dimensions of culture across 50 countries. Hofstede initially isolated four dimen- sions that he claimed summarized different cultures64—power distance, uncertainty avoid- ance, individualism versus collectivism, and masculinity versus femininity—and then in 1991 he added a fifth dimension inspired by Confucianism called long-term versus short-term orientation.65

The fifth dimension was added as a function of the data obtained via the Chinese Value Survey (CVS), an instrument developed by Michael Harris Bond based on discussions with Hofstede in relation to a joint article they wrote.66 Bond used input from “Eastern minds” as Hofstede called it to develop CVS. (Bond references Chinese scholars as help- ing him create the values that exemplify this new long-term versus short-term orienta- tion.) In his original research, Bond called this new dimension “Confucian work dynamism” but Hofstede said that in practical terms the dimension refers to a long-term versus short-term orientation.

Hofstede’s power distance dimension focused on how a society deals with the fact that people are unequal in physical and intellectual capabilities. According to Hofstede, high power distance cultures were found in countries that let inequalities grow over time into inequalities of power and wealth. Low power distance cultures were found in societies that tried to play down such inequalities as much as possible.

The individualism versus collectivism dimension focused on the relationship between the individual and his or her fellows. In individualistic societies, the ties between individuals were loose, and individual achievement and freedom were highly valued. In societies where collectivism was emphasized, the ties between individuals were tight. In such societies, peo- ple were born into collectives, such as extended families, and everyone was supposed to look after the interest of his or her collective.

Hofstede’s uncertainty avoidance dimension measured the extent to which different cultures socialized their members into accepting ambiguous situations and tolerating uncer- tainty. Members of high uncertainty avoidance cultures placed a premium on job security,

LO 4-4 Recognize how differences in social culture influence values in business.

Power Distance Theory of how a society deals with the fact that people are unequal in physical and intellectual capabilities. High power distance cultures are found in countries that let inequalities grow over time into inequalities of power and wealth; low power distance cultures are found in societies that try to play down such inequalities as much as possible.

Individualism versus Collectivism Theory focusing on the relationship between the individual and his or her fellows; in individualistic societies, the ties between individuals are loose and individual achievement is highly valued; in societies where collectivism is emphasized, ties between individuals are tight, people are born into collectives, such as extended families, and everyone is supposed to look after the interests of his or her collective.

Uncertainty Avoidance Extent to which cultures socialize members to accept ambiguous situations and to tolerate uncertainty.

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Chapter Four Differences in Culture 113

career patterns, retirement benefits, and so on. They also had a strong need for rules and regulations; the manager was expected to issue clear instructions, and subordinates’ initia- tives were tightly controlled. Lower uncertainty avoidance cultures were characterized by a greater readiness to take risks and less emotional resistance to change.

Hofstede’s masculinity versus femininity dimension looked at the relationship between gender and work roles. In masculine cultures, sex roles were sharply differentiated, and tra- ditional “masculine values,” such as achievement and the effective exercise of power, deter- mined cultural ideals. In feminine cultures, sex roles were less sharply distinguished, and little differentiation was made between men and women in the same job.

The long-term versus short-term orientation dimension refers to the extent to which a culture programs its citizens to accept delayed gratification of their material, social, and emotional needs. It captures attitudes toward time, persistence, ordering by status, protec- tion of face, respect for tradition, and reciprocation of gifts and favors. The label refers to these “values” being derived from Confucian teachings.

Hofstede created an index score for each of these five dimensions that ranged from 0 to 100 and scored high for high individualism, high power distance, high uncertainty avoid- ance, high masculinity, and high for long-term orientation.67 He averaged the score for all employees from a given country. Interestingly, there is movement to add a sixth dimension to Hofstede’s work. Geert Hofstede, working with Michael Minkov’s analysis of the World Values Survey, added a promising new dimension called indulgence versus restraint (IND) in 2010.68 On January 17, 2011, Hofstede delivered a webinar for SIETAR Europe, called “new software of the mind,” to introduce the third edition of Cultures and Organizations, in which the research results of Minkov were included to support this sixth dimension. In ad- dition, in a keynote delivered at the annual meeting of the Academy of International Busi- ness (http://aib.msu.edu) in Istanbul, Turkey, on July 6, 2013, Hofstede again presented results and theoretical logic to support the indulgence versus restraint dimension. Indul- gence refers to a society that allows relatively free gratification of basic and natural human drives related to enjoying life and having fun. Restraint refers to a society that suppresses gratification of needs and regulates it by means of strict social norms.

Table 4.1 summarizes data for 15 selected countries for the five established dimensions of individualism versus collectivism, power distance, uncertainty avoidance, masculinity versus femininity, and long-term versus short-term orientation (the Hofstede data were collected for 50 countries and the Bond data were collected for 23 countries; since those two re- searchers’ data collection, numerous other researchers have also added to the country sam- ples). Western nations such as the United States, Canada, and Great Britain score high on the individualism scale and low on the power distance scale. At the other extreme are a group of Latin American and Asian countries that emphasize collectivism over individualism and score high on the power distance scale. Table 4.1 also reveals that Japan’s culture has strong uncertainty avoidance and high masculinity. This characterization fits the standard stereotype of Japan as a country that is male dominant and where uncertainty avoidance exhibits itself in the institution of lifetime employment. Sweden and Denmark stand out as countries that have both low uncertainty avoidance and low masculinity (high emphasis on “feminine” values).

Hofstede’s results are interesting for what they tell us in a very general way about differ- ences between cultures. Many of Hofstede’s findings are consistent with standard Western stereotypes about cultural differences. For example, many people believe Americans are more individualistic and egalitarian than the Japanese (they have a lower power distance), who in turn are more individualistic and egalitarian than Mexicans. Similarly, many might agree that Latin countries place a higher emphasis on masculine value—they are machismo cultures—than the Nordic countries of Denmark and Sweden.

As might be expected, East Asian countries such as Japan and Thailand scored high on long-term orientation, while nations such as the United States and Canada scored low. Hofstede and his associates went on to argue that their evidence suggested that nations with higher economic growth rates scored high on long-term orientation and low on in- dividualism—the implication being Confucianism is good for growth. However, subse- quent studies have shown that this finding does not hold up under more sophisticated

Masculinity versus Femininity Theory of the relationship between gender and work roles. In masculine cultures, sex roles are sharply differentiated and traditional “masculine values” such as achievement and the effective exercise of power determine cultural ideals; in feminine cultures, sex roles are less sharply distinguished, and little differentiation is made between men and women in the same job.

Long-term versus Short-term Orientation The theory of the extent to which a culture programs its citizens to accept delayed gratification of their material, social, and emotional needs. It captures attitudes toward time, persistence, ordering by status, protection of face, respect for tradition, and reciprocation of gifts and favors.

114 Part Two National Differences

statistical analysis.69 Since the economy has come back from the downturn in 2008, coun- tries with high individualism and short-term orientation such as the United States have attained high growth rates, while some Confucian cultures such as Japan have had stag- nant economic growth.

However, we should be careful about reading too much into Hofstede’s research. It has been criticized on a number of points.70 First, Hofstede assumes there is a one-to-one cor- respondence between culture and the nation-state, but as we discussed earlier, many coun- tries have more than one culture. Hofstede’s results do not capture this distinction. Second, the research may have been culturally bound. The research team was composed of Europe- ans and Americans. The questions they asked of IBM employees—and their analysis of the answers—may have been shaped by their own cultural biases and concerns. So it is not sur- prising that Hofstede’s results confirm Western stereotypes because it was Westerners who undertook the research. The later addition of the long-term versus short-term dimension illustrates this point.

Third, Hofstede’s informants worked not only within a single industry, the computer industry, but also within one company, IBM. At the time, IBM was renowned for its own strong corporate culture and employee selection procedures, making it possible that the employees’ values were different in important respects from the values of the cultures from which those employees came. Also, certain social classes (such as unskilled manual workers) were excluded from Hofstede’s sample. A final caution is that Hofstede’s work is now beginning to look dated. Cultures do not stand still; they evolve, albeit slowly. What was a reasonable characterization in the late 1960s and early 1970s may not be so today.

Still, just as it should not be accepted without question, Hofstede’s work should not be dismissed either. As such, it represents a starting point for managers trying to figure out how cultures differ and what that might mean for management practices. Also, several other scholars have found strong evidence that differences in culture affect values and prac- tices in the workplace, and Hofstede’s basic results have been replicated using more diverse

4.1 TABLE Work-Related Values for 15 Selected Countries Source: From Geert Hofstede, “The Cultural Relativity of Organizational Practices and Theories, Journal of International Business Studies, 14, Fall 1983, pp. 75–89. Reprinted by permission of Dr. Geert Hofstede.

Power Distance

Uncertainty Avoidance Individualism Masculinity

Long-Term Orientation

Australia 36 51 90 61 31

Brazil 69 76 38 49 65

Canada 39 48 80 52 23

Germany (F.R.) 35 65 67 66 31

Great Britain 35 35 89 66 25

India 77 40 48 56 61

Japan 54 92 46 95 80

Netherlands 38 53 80 14 44

New Zealand 22 49 79 58 30

Pakistan 55 70 14 50 00

Philippines 94 44 32 64 19

Singapore 74 8 20 48 48

Sweden 31 29 71 5 33

Thailand 64 64 20 34 56

United States 40 46 91 62 29

Chapter Four Differences in Culture 115

samples of individuals in different settings.71 Nevertheless, managers should use the results with caution. One reason for caution is the plethora of new cultural values surveys and data points that are starting to become important addi- tions to Hofstede’s work. However, in many cases, they build on or are related to Hofstede’s tone-setting work. Two additional cultural values frameworks that have been exam- ined and have been related to work-related and/or business- related issues are the Global Leadership and Organizational Behavior Effectiveness Instrument and the World Values Survey.

The Global Leadership and Organizational Behavior Effectiveness (GLOBE) instrument is designed to address the notion that a leader’s effectiveness is contextual.72 It is embedded in the societal and organizational norms, values, and beliefs of the people being led. The initial GLOBE findings from 62 societies involving 17,300 middle managers from 951 organizations build on findings by Hofstede and other culture researchers. The GLOBE research established nine cultural dimensions: power distance, uncertainty avoid- ance, humane orientation, institutional collectivism, in- group collectivism, assertiveness, gender egalitarianism, future orientation, and performance orientation.

The World Values Survey (WVS) is a research project spanning more than 100 countries that explores people’s values and norms, how they change over time, and what impact they have in society and business.73 The WVS includes dimensions for support for democracy; tolerance of foreigners and ethnic minorities; support for gender equal- ity; the role of religion and changing levels of religiosity; the impact of globalization; attitudes toward the environment, work, family, politics, national identity, culture, diversity, and insecurity; and subjective well- being.

Despite Hofstede’s work along with findings from GLOBE, WVS, and others, culture is just one of many factors that might influence the economic success of a nation. While culture’s importance should not be ignored, neither should it be overstated. The Hofstede framework is the most significant and studied framework of culture as it relates to work values and business that we have ever seen. But some of the newer culture frameworks (e.g., GLOBE, WVS) are also becoming popular in the literature, and they have poten- tial to complement and perhaps even supplant Hofstede’s work with additional validation and connection to work-related values, business, and marketplace issues. At the same time, the factors discussed in Chapters 2 and 3—economic, political, and legal systems— are probably more important than culture in explaining differential economic growth rates over time.

Cultural Change An important point we want to make in this chapter on culture is that culture is not a con- stant; it evolves over time.74 Changes in value systems can be slow and painful for a society. In the 1960s, for example, American values toward the role of women, love, sex, and mar- riage underwent significant changes. Much of the social turmoil of that time reflected these changes. Change, however, does occur and can often be quite profound. For example, at the beginning of the 1960s, the idea that women might hold senior management positions in major corporations was not widely accepted. Many scoffed at the idea. Today, it is a reality. For example, in 2012 Virginia Rometty became the CEO of IBM and in 2014 Mary T. Barra became the CEO of General Motors. No one in the mainstream of American society now

LO 4-5 Demonstrate an appreciation for the economic and business implications of cultural change.

How Strong Is Your National Identity? As we have found out in this chapter, a lot of measures exist to assess cultural values and norms. Self-assessment is one of the best ways to better know yourself, and we encourage you to take a rigorous cultural personality test such as what Hofstede has developed. But let’s have some easy fun! How strong is your personal national identity? On a scale from 1 to 7, with 1 being “strongly disagree” and 7 being “strongly agree” (and with scores of 2, 3, 4, 5, and 6 being in between those two extremes), rate yourself on these four questions:

1. My country has a strong historical heritage (national heritage). 2. People from my country are proud of their nationality (cul-

tural homogeneity). 3. A true native of my country would never reject their religious

beliefs (belief system). 4. It is always best to purchase products made from my home

country (consumer ethnocentrism).

If you scored above 23 in total for the four questions, you have a strong “national identity”; if you scored below 9 you have a weak “national identity.” Most people fall in between these two extremes.

Sources: B. Keillor and T. Hult, “A Five-Country Study of National Identity: Implica- tions for International Marketing Research and Practice,” International Marketing Review, 1999, pp. 65–82; B. Keillor, T. Hult, R. Erffmeyer, and E. Babakus, “NATID: The Development and Application of a National Identity Measure for Use in Inter- national Marketing,” Journal of International Marketing 4 (1996).

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116 Part Two National Differences

questions the development or the capability of women in the business world. American culture has changed (although it is still more difficult for women to gain senior manage- ment positions than men).

For another illustration of cultural change, consider Japan. Some academics argue that a major cultural shift has been occurring in Japan, with a move toward greater indi- vidualism.75 The model Japanese office worker, or “salaryman,” is characterized as being loyal to his boss and the organization to the point of giving up evenings, weekends, and vacations to serve the organization, which is the collective the employee is a member of. However, a new generation of office workers may not fit this model. An individual from the new generation is likely to be more direct than the traditional Japanese. He acts more like a Westerner, a gaijin. He does not live for the company and will move on if he gets the offer of a better job. He is not keen on overtime, especially if he has a date. He has his own plans for his free time, and they may not include drinking or playing golf with the boss.76

Several studies have suggested that economic advancement and globalization may be important factors in societal change.77 There is evidence that economic progress is accompanied by a shift in values away from collectivism and toward individualism.78 Thus, as Japan has become richer, the cultural emphasis on collectivism has declined and greater individualism is being witnessed. One reason for this shift may be that richer societies exhibit less need for social and material support structures built on collectives, whether the collective is the extended family or the paternalistic company. People are better able to take care of their own needs. As a result, the importance attached to col- lectivism declines, while greater economic freedoms lead to an increase in opportunities for expressing individualism.

The culture of societies may also change as they become richer because economic prog- ress affects a number of other factors, which in turn influence culture. For example, in- creased urbanization and improvements in the quality and availability of education are both a function of economic progress, and both can lead to declining emphasis on the traditional values associated with poor rural societies. The World Values Survey, which we mentioned earlier, has documented how values change. The study linked these changes in values to changes in a country’s level of economic development.79 According to this research, as coun- tries get richer, a shift occurs away from “traditional values” linked to religion, family, and country, and toward “secular rational” values. Traditionalists say religion is important in their lives. They have a strong sense of national pride; they also think that children should be taught to obey and that the first duty of a child is to make his or her parents proud. They say abortion, euthanasia, divorce, and suicide are never justified. At the other end of this spectrum are secular rational values.

Another category in the World Values Survey is quality of life attributes. At one end of this spectrum are “survival values,” the values people hold when the struggle for survival is of paramount importance. These values tend to stress that economic and physical security are more important than self-expression. People who cannot take food or safety for granted tend to be xenophobic, are wary of political activity, have authoritarian tenden- cies, and believe that men make better political leaders than women. “Self-expression” or “well-being” values stress the importance of diversity, belonging, and participation in po- litical processes.

As countries get richer, there seems to be a shift from “traditional” to “secular rational” values, and from “survival values” to “well-being” values. The shift, however, takes time, primarily because individuals are socialized into a set of values when they are young and find it difficult to change as they grow older. Substantial changes in values are linked to generations, with younger people typically being in the vanguard of a significant change in values.

With regard to globalization, some have argued that advances in transportation and communication technologies; the dramatic increase in trade that we have witnessed since World War II; and the rise of global corporations such as Hitachi, Disney, Microsoft, IBM, Google, and Levi Strauss (whose products and operations can be found around the globe)

It was once unheard of for a woman to head a major organization, but it is becoming commonplace. Yahoo CEO Marissa Mayer speaks at the World Economic Forum.

are helping create conditions for the merging or convergence of cultures.80 With McDon- ald’s hamburgers in China, The Gap in India, iPods in South Africa, and MTV everywhere helping foster a ubiquitous youth culture, and with countries around the world climbing the ladder of economic progress, some argue that the conditions for less cultural variation have been created. There may be, in other words, a slow but steady convergence occurring across different cultures toward some universally accepted values and norms: This is known as the convergence hypothesis.81

Having said this, we must not ignore important countertrends, such as the shift toward Islamic fundamentalism in several countries; the continual separatist movement in Quebec, Canada; or ethnic strains and separatist movements in Russia. Such countertrends in many ways are a reaction to the pressures for cultural convergence. In an increasingly modern and materialistic world, some societies are trying to reemphasize their cultural roots and unique- ness. Cultural change is not unidirectional, with national cultures converging toward some homogeneous global entity. It is also important to note that while some elements of culture change quite rapidly—particularly the use of material symbols—other elements change slowly if at all. Thus, just because people the world over wear jeans, eat at McDonald’s, use smartphones, watch their national version of American Idol, and drive Ford cars to work down freeways, we should not assume that they have also adopted American (or Western) values—for often they have not.82 To illustrate, consider that many Westerners eat Chinese food, watch Chinese martial arts movies, and take classes in kung fu, but their values are still those of Westerners. Thus, a distinction needs to be made between the visible material as- pects of culture and the deep structure, particularly core social values and norms. The deep structure changes only slowly, and differences here are often far more persistent than we might suppose.

FOCUS ON MANAGERIAL IMPLICATIONS

CROSS-CULTURAL LITERACY AND COMPETITIVE ADVANTAGE International business is different from national business because countries and societies are different. In this chapter, we have seen just how different societies can be. Societies differ because their cultures vary. Their cultures vary because of profound differences in social structure, religion, language, education, economic philosophy, and political philosophy. Three important implications for international business flow from these dif- ferences. The first is the need to develop cross-cultural literacy. There is a need not only to appreciate that cultural differences exist but also to appreciate what such differences mean for international business. A second implication centers on the connection between culture and national competitive advantage. A third implication looks at the connection between culture and ethics in decision making. In this section, we explore the first two of these issues in depth. The connection between culture and ethics is explored in the next chapter.

Cross-Cultural Literacy One of the biggest dangers confronting a company that goes abroad for the first time is the danger of being ill-informed. International businesses that are ill-informed about the prac- tices of another culture are likely to fail. Doing business in different cultures requires adap- tation to conform to the value systems and norms of that culture. Adaptation can embrace all aspects of an international firm’s operations in a foreign country. The way in which deals are negotiated, the appropriate incentive pay systems for salespeople, the structure of the

Chapter Four Differences in Culture 117

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organization, the name of a product, the tenor of relations between management and labor, the manner in which the product is promoted, and so on, are all sensitive to cultural differ- ences. What works in one culture might not work in another (see the opening case on Best Buy and eBay in China, for example).

To combat the danger of being ill-informed, international businesses should consider employing local citizens to help them do business in a particular culture. They must also ensure that home-country executives are cosmopolitan enough to understand how differ- ences in culture affect the practice of business. Transferring executives overseas at regular intervals to expose them to different cultures will help build a cadre of cosmopolitan execu- tives. An international business must also be constantly on guard against the dangers of ethnocentric behavior. Ethnocentrism is a belief in the superiority of one’s own ethnic group or culture. Hand in hand with ethnocentrism goes a disregard or contempt for the culture of other countries. Unfortunately, ethnocentrism is all too prevalent; many Americans are guilty of it, as are many French people, Japanese people, British people, and so on. Ugly as it is, ethnocentrism is a fact of life, one that international businesses must be on guard against.

Simple examples illustrate how important cross-cultural literacy can be. Anthropologist Edward T. Hall has described how Americans, who tend to be informal in nature, react strongly to being corrected or reprimanded in public.83 This can cause problems in Ger- many, where a cultural tendency toward correcting strangers can shock and offend most Americans. For their part, Germans can be a bit taken aback by the tendency of Americans to call people by their first name. This is uncomfortable enough among executives of the same rank, but it can be seen as insulting when a young and junior American executive ad- dresses an older and more senior German manager by his first name without having been invited to do so. Hall concludes it can take a long time to get on a first-name basis with a German; if you rush the process, you will be perceived as overfriendly and rude—and that may not be good for business.

Hall also notes that cultural differences in attitude to time can cause myriad problems. He notes that in the United States, giving a person a deadline is a way of increasing the urgency or relative importance of a task. However, in the Middle East, giving a deadline can have exactly the opposite effect. The American who insists an Arab business associate make his mind up in a hurry is likely to be perceived as overly demanding and exerting undue pressure. The result may be exactly the opposite of what the American intended, with the Arab going slow as a reaction to the American’s arrogance and rudeness. For his part, the American may believe that an Arab associate is being rude if he shows up late to a meeting because he met a friend in the street and stopped to talk. The American, of course, is very concerned about time and scheduling. But for the Arab, who lives in a society where social networks are a major source of information and maintaining relationships is impor- tant, finishing the discussion with a friend is more important than adhering to a strict schedule. Indeed, the Arab may be puzzled as to why the American attaches so much importance to time and schedule.

Culture and Competitive Advantage One theme that surfaces in this chapter is the relationship between culture and national competitive advantage.84 Put simply, the value systems and norms of a country influence the costs of doing business in that country. The costs of doing business in a country in- fluence the ability of firms to establish a competitive advantage in the global market- place. We have seen how attitudes toward cooperation between management and labor, toward work, and toward the payment of interest are influenced by social structure and religion. It can be argued that the class-based conflict between workers and management in class-conscious societies, when it leads to industrial disruption, raises the costs of do- ing business in that society. Similarly, we have seen how some sociologists have argued that the ascetic “other-worldly” ethics of Hinduism may not be as supportive of capital- ism as the ethics embedded in Protestantism and Confucianism. Also, Islamic laws ban- ning interest payments may raise the costs of doing business by constraining a country’s banking system.

Ethnocentrism Behavior that is based on the belief in the superiority of one’s own ethnic group or culture; often shows disregard or contempt for the culture of other countries.

118 Part Two National Differences

Japan presents an interesting case study of how culture can influence competitive advan- tage. Some scholars have argued that the culture of modern Japan lowers the costs of doing business relative to the costs in most Western nations. Japan’s emphasis on group affiliation, loyalty, reciprocal obligations, honesty, and education all boost the competitiveness of Japa- nese companies. The emphasis on group affiliation and loyalty encourages individuals to identify strongly with the companies in which they work. This tends to foster an ethic of hard work and cooperation between management and labor “for the good of the company.” Similarly, reciprocal obligations and honesty help foster an atmosphere of trust between companies and their suppliers. This encourages them to enter into long-term relationships with each other to work on inventory reduction, quality control, and design—all of which have been shown to improve an organization’s competitiveness. This level of cooperation has often been lacking in the West, where the relationship between a company and its sup- pliers tends to be a short-term one structured around competitive bidding rather than one based on long-term mutual commitments. In addition, the availability of a pool of highly skilled labor, particularly engineers, has helped Japanese enterprises develop cost-reducing process innovations that have boosted their productivity.85 Thus, cultural factors may help explain the success enjoyed by many Japanese businesses in the global marketplace. Most notably, it has been argued that the rise of Japan as an economic power during the second half of the twentieth century may be in part attributed to the economic consequences of its culture.86

It also has been argued that the Japanese culture is less supportive of entrepreneurial ac- tivity than, say, American society. In many ways, entrepreneurial activity is a product of an individualistic mindset, not a classic characteristic of the Japanese. This may explain why American enterprises, rather than Japanese corporations, dominate industries where entre- preneurship and innovation are highly valued, such as computer software and biotechnol- ogy. Of course, obvious and significant exceptions to this generalization exist. Masayoshi Son recognized the potential of software far faster than any of Japan’s corporate giants; set up his company, Softbank, in 1981; and over the past 30 years has built it into Japan’s top software distributor. Similarly, dynamic entrepreneurial individuals established major Japa- nese companies such as Sony and Matsushita. But these examples may be the exceptions that prove the rule, for as yet there has been no surge in entrepreneurial high-technology enter- prises in Japan equivalent to what has occurred in the United States.

For international business, the connection between culture and competitive advantage is important for two reasons. First, the connection suggests which countries are likely to pro- duce the most viable competitors. For example, we might argue that U.S. enterprises are likely to see continued growth in aggressive, cost-efficient competitors from those Pacific Rim nations where a combination of free market economics, Confucian ideology, group- oriented social structures, and advanced education systems can all be found (e.g., South Korea, Taiwan, Japan, and, increasingly, China).

Second, the connection between culture and competitive advantage has important impli- cations for the choice of countries in which to locate production facilities and do business. Consider a hypothetical case when a company has to choose between two countries, A and B, for locating a production facility. Both countries are characterized by low labor costs and good access to world markets. Both countries are of roughly the same size (in terms of population), and both are at a similar stage of economic development. In country A, the education system is undeveloped, the society is characterized by a marked stratification be- tween the upper and lower classes, and there are six major linguistic groups. In country B, the education system is well developed, social stratification is lacking, group identification is valued by the culture, and there is only one linguistic group. Which country makes the best investment site?

Country B probably does. In country A, conflict between management and labor, and between different language groups, can be expected to lead to social and industrial disrup- tion, thereby raising the costs of doing business.87 The lack of a good education system also can be expected to work against the attainment of business goals.

The same kind of comparison could be made for an international business trying to de- cide where to push its products, country A or B. Again, country B would be the logical

Chapter Four Differences in Culture 119

120 Part Two National Differences

choice because cultural factors suggest that in the long run, country B is the nation most likely to achieve the greatest level of economic growth.

But as important as culture is to people, companies, and society, it is probably less im- portant than economic, political, and legal systems in explaining differential economic growth between nations. Cultural differences are significant, but we should not overem- phasize their importance in the economic sphere. For example, earlier we noted that Max Weber argued that the ascetic principles embedded in Hinduism do not encourage entre- preneurial activity. While this is an interesting academic thesis, recent years have seen an increase in entrepreneurial activity in India, particularly in the information technology sector, where India is rapidly becoming an important global player. The ascetic principles of Hinduism and caste-based social stratification have apparently not held back entrepre- neurial activity in this sector.

cross-cultural literacy, p. 91 culture, p. 92 values, p. 92 norms, p. 92 society, p. 92 folkways, p. 93 mores, p. 94 social structure, p. 95

group, p. 95 social strata, p. 97 social mobility, p. 98 caste system, p. 98 class system, p. 99 class consciousness, p. 100 religion, p. 100 ethical systems, p. 100

power distance, p. 112 individualism versus collectivism, p. 112 uncertainty avoidance, p. 112 masculinity versus femininity, p. 113 long-tern versus short-term orientation, p. 113 ethnocentrism, p. 118

Key Terms

Summary

This chapter looked at the nature of social culture and studied some implications for business practice. The chap- ter made the following points:

1. Culture is a complex whole that includes knowledge, beliefs, art, morals, law, customs, and other capabilities acquired by people as members of society.

2. Values and norms are the central components of a culture. Values are abstract ideals about what a society believes to be good, right, and desirable. Norms are social rules and guidelines that prescribe appropriate behavior in particular situations.

3. Values and norms are influenced by political and economic philosophy, social structure, religion, language, and education.

4. The social structure of a society refers to its basic social organization. Two main dimensions along which social structures differ are the individual–group dimension and the stratification dimension.

5. In some societies, the individual is the basic building block of social organization. These societies emphasize individual achievements above all else. In other societies, the group is the basic building block

of social organization. These societies emphasize group membership and group achievements above all else.

6. All societies are stratified into different classes. Class-conscious societies are characterized by low social mobility and a high degree of stratification. Less class-conscious societies are characterized by high social mobility and a low degree of stratification.

7. Religion may be defined as a system of shared beliefs and rituals that is concerned with the realm of the sacred. Ethical systems refer to a set of moral principles, or values, that are used to guide and shape behavior. The world’s major religions are Christianity, Islam, Hinduism, and Buddhism. Although not a religion, Confucianism has an impact on behavior that is as profound as that of many religions. The value systems of different religious and ethical systems have different implications for business practice.

8. Language is one defining characteristic of a culture. It has both spoken and unspoken dimensions. In countries with more than one spoken language, we tend to find more than one culture.

Chapter Four Differences in Culture 121

9. Formal education is the medium through which individuals learn skills and are socialized into the values and norms of a society. Education plays an important role in the determination of national competitive advantage.

10. Geert Hofstede studied how culture relates to values in the workplace. He isolated five dimensions that he claimed summarized different cultures: power distance, uncertainty avoidance, individualism versus collectivism, masculinity versus femininity, and long- term versus short-term orientation.

11. Culture is not a constant; it evolves. Economic progress and globalization seem to be two important engines of cultural change.

12. One danger confronting a company that goes abroad for the first time is being ill-informed. To develop cross-cultural literacy, international businesses need to employ host-country nationals, build a cadre of cosmopolitan executives, and guard against the dangers of ethnocentric behavior.

13. The value systems and norms of a country can affect the costs of doing business in that country.

Critical Thinking and Discussion Questions

1. Outline why the culture of a country might influence the costs of doing business in that country. Illustrate your answer with examples.

2. Do you think that business practices in an Islamic country are likely to differ from business practices in a Christian country? If so, how?

3. What are the implications for international business of differences in the dominant religion or ethical system of a country?

4. Choose two countries that appear to be culturally diverse. Compare the cultures of those countries, and then indicate how cultural differences influence (a) the costs of doing business in each country, (b) the likely future economic development of that country, and (c) business practices.

5. Reread the Country Focus about Islamic capitalism in Turkey. Then, answer the following questions: a. Can you see anything in the values and norms of

Islam that is hostile to business?

b. What does the experience of the region around Kayseri teach about the relationship between Islam and business?

c. What are the implications of Islamic values toward business for the participation of a country such as Turkey in the global economy or becoming a member of the European Union?

6. Reread the Management Focus on DMG-Shanghai and answer the follow questions: a. Why do you think it is so important to cultivate

guanxi and guanxiwang in China? b. What does the experience of DMG tells us about

the way things work in China? What would likely happen to a business that obeyed all the rules and regulations, rather than trying to find a way around them as Dan Mintz apparently does?

c. What ethical issues might arise when drawing upon guanxiwang to get things done in China? What does this suggest about the limits of using guanxiwang for a Western business committed to high ethical standards?

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

characteristics that may affect business interactions in this country.

Research Task http://globalEDGE.msu.edu

The United Arab Emirates (UAE) was established in 1971 and is a country located in the Middle East. The country is often called “the Emirates” or simply “UAE.” UAE borders the Gulf of Oman and the Persian Gulf. Neigh- boring countries include Oman and Saudi Arabia, and UAE also shares sea borders with Quatar, Iran, and Pakistan. Strategically, UAE is in an impor- tant location along the southern approaches to the Strait of Hormuz, a tran- sit point for the world’s crude oil. UAE is also in the top 10 countries for the largest oil reserves in the world.

The geography of UAE includes lots of rolling sand dunes of desert and also mountains in the eastern part of the country. The government consists of a federation with specified powers delegated to the UAE federal govern- ment and other powers reserved to the member emirates (equivalent to principalities). The chief of state is the president and the head of govern- ment is the prime minister. UAE has an open-market economy in which the prices of products and services are set using a free price system.

The foundation for this market economy lies in the collaboration be- tween the seven emirates that are part of the UAE. They include the emir- ates of Abu Dhabi, Ajman, Dubai, Fujairah, Ras al-Khaimah, Sharjah, and Umm al-Quwain. Each emirate is governed by a hereditary emir, similar to succession planning in countries with royalty (king or queen) as the head of state. These emirs jointly make up the Federal Supreme Council, which serves as the highest legislative and executive body in the UAE. One of the seven emirs is selected as the president of the United Arab Emirates. The capital of the country is Abu Dhabi, Islam is the official religion, and Arabic is the official language. Most people have heard of Abu Dhabi and Dubai because they are the country’s centers of commercial and cultural activi- ties. Dubai is UAE’s most populous city, with more than 2 million people, and it has emerged as a true global city with an eclectic cultural makeup. It also has a strategic location as a business gateway for the Middle East and Africa for multinational enterprises from all of the world’s continents.

Dubai has frequently been rated as one of the best places to live in the Middle East (although it is also one of the most expensive). The emirate of Dubai has been ruled by the Al Maktoum family since 183; the emirate is considered a constitutional monarchy. In 2013, the Norway-based Global Network for Rights and Development ranked UAE as the 14th country in its annual International Human Rights Indicator report. This was a first among Arab countries, with the next Arab country on the list, Tunisia, at a distant 72nd place. Only about 10 percent of the population in Dubai are Arabs, with the remaining 90 percent being expatriates. Most of the expatriates are from Asia, with India (50 percent) and Pakistan (16 percent) prominently featured. The largest group of Westerners is from the United Kingdom.

With this eclectic cultural background, Dubai’s bid to host the World Expo 2020 with a theme of “connecting minds, creating the future” makes sense both logically and strategically. The theme resonates well with is- sues related to culture. In essence, the theme illustrates and acknowl- edges differences in culture (as does this chapter), and the theme supports the notion that we strive to emphasize similarities across the globe. This point was illustrated in Chapter 1 when we asked in one of the Alternative Perspectives boxes, “Which is more important—similarities or differ- ences?” The idea is that today, multinational enterprises have to evaluate their core uniqueness and how they can leverage this strategic uniqueness

in the global marketplace. The leveraging of the uniqueness typically re- quires a focus on similarities across cultures instead of differences. Con- necting minds is a great way to illustrate how people, companies, and countries can stress the importance of looking for similarities first and then focus on the similarities that outweigh the differences in creating strategic options.

As with any World Expo, the expectation is that the world will be treated to an important event in the year 2020 in Dubai. The Expo on “connecting minds, creating the future” will span six months, following World Expo 2015 in Milan, Italy, and World Expo 2017 in Astana, Kazakhstan. The ex- pectation is also that countries will showcase who they are and what they can do in the spirit of today’s era of “nation branding.” Tracing history, the best known first World Expo was held in the Crystal Palace in Hyde Park, London (United Kingdom) in 1851 under the title of “Great Exhibition of the Works of Industry of All Nations.” Since 1928, the Bureau International des Expositions (International Exhibitions Bureau) has served as an interna- tional sanctioning body for the World Expo. These Expo showcases have generally gone through three eras: the era of industrialization (1851– 1938), the era of cultural exchange (1939–1987), and the era of nation branding (1988–present).

The theme for Dubai’s World Expo 2020 is a direct connection to its cultural values and beliefs in facilitating connections and pioneering new ideas. The organizers expect 70 percent of the 25 million visitors to origi- nate outside UAE, making it the most globally oriented World Expo in its long history. The idea is that the global community will come together and explore creative and pioneering solutions to three key drivers of global development: sustainability, mobility, and opportunity. As viewed by the World Expo 2020 organizing team, sustainability centers on lasting sources of energy and water. Mobility focuses on smart systems of logis- tics and transportation. And opportunity refers to new paths to economic development.

Sources: Expo 2020, expo2020dubai.ae/en, accessed March 5, 2014; globalEDGE— United Arab Emirates, http://globaledge.msu.edu/countries/united-arab-emirates, accessed March 5, 2014; A. Ahmed, “After Winning Expo, Emirate Fumes at Allies It Says Didn’t Back It,” The New York Times, January 6, 2014; S. Potter, “Expo 2020 Win to Boost Dubai Sukuk on Spending: Islamic Finance,” Bloomberg Businessweek, November 27, 2013; and “Dubai—It’s Bouncing Back,” The Economist, November 23, 2013.

CASE DISCUSSION QUESTIONS 1. What forces shaped the culture in the country of UAE and Dubai in

particular? How similar or different are these forces from those that shaped the culture of Western nations?

2. What kinds of misunderstanding, if any, are likely to arise between Western-based visitors and people from the UAE during World Expo 2020?

3. If you were in a position to advise a Western company that was considering doing business in UAE for the first time, what would your advice be?

4. Using Dubai as an example, do you believe that cultural similarities among people can outweigh cultural differences that exist in terms of doing business together in the future?

ccccccllooooooossssiinnnnnnggggggggggg ccccccaaaasssssssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeeWorld Expo 2020 in Dubai, UAE

122 Part Two National Differences

Chapter Four Differences in Culture 123

Endnotes

1. D. Barry, Exporters! The Wit and Wisdom of Small Businesspeople Who Sell Globally (Washington, DC: International Trade Ad- ministration, U.S. Department of Commerce, 2013); T. Hult, D. Ketchen, D. Griffith, C. Finnegan, T. Padron-Gonzalez, F. Harmancioglu, Y. Huang, M. Talay, and S. Cavusgil, “Data Equivalence in Cross-Cultural International Business Re- search: Assessment and Guidelines,” Journal of International Business Studies, 2008, pp. 1027–44; and S. Ronen and O. Shenkar, “Mapping World Cultures: Cluster Formation, Sources, and Implications,” Journal of International Business Studies, 2013, pp. 867–97.

2. This is a point made effectively by K. Leung, R. S. Bhagat, N. R. Buchan, M. Erez, and C. B. Gibson, “Culture and Interna- tional Business: Recent Advances and Their Implications for Future Research,” Journal of International Business Studies, 2005, pp. 357–78. Several research articles and books also support the notion that significant cultural differences still exist in the world; for example, T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill, 2014).

3. M. Y. Brannen, “When Micky Loses Face: Recontextualiza- tion, Semantic Fit, and the Semiotics of Foreignness,” Acad- emy of Management Review, 2004, pp. 593–616.

4. See R. Dore, Taking Japan Seriously (Stanford, CA: Stanford University Press, 1987).

5. Data come from J. Monger, “International Comparison of Labor Disputes in 2004,” Labor Market Trends, April 2006, pp. 117–28.

6. E. B. Tylor, Primitive Culture (London: Murray, 1871).

7. F. Kluckhohn and F. Strodtbeck, Variations in Value Orienta- tions (Evanston, IL: Row, Peterson, 1961); and C. Kluckhohn, “Values and Value Orientations in the Theory of Action,” in T. Parsons and E. A. Shils (Eds.), Toward a General Theory of Action (Cambridge, MA: Harvard University Press, 1951).

8. M. Rokeach, The Nature of Human Values (New York: The Free Press, 1973); and S. Schwartz, “Universals in the Con- tent and Structure of Values: Theory and Empirical Tests in 20 Countries,” in M. Zanna (Ed.), Advances in Experimental Social Psychology, Vol. 25, pp. 1–65, (New York: Academic Press, 1992).

9. G. Hofstede, Culture’s Consequences: International Differences in Work-Related Values (Beverly Hills, CA: Sage Publications, 1984), p. 21.

10. J. Z. Namenwirth and R. B. Weber, Dynamics of Culture (Boston: Allen & Unwin, 1987), p. 8.

11. R. Mead, International Management: Cross-Cultural Dimensions (Oxford: Blackwell Business, 1994), p. 7.

12. G. Hofstede, Culture’s Consequences: Comparing Values, Beliefs, Behaviors, Institutions and Organizations Across Nations (Thou- sand Oaks, CA: Sage Publications, 2001).

13. E. T. Hall and M. R. Hall, Understanding Cultural Differences (Yarmouth, ME: Intercultural Press, 1990).

14. E. T. Hall and M. R. Hall, Hidden Differences: Doing Business with the Japanese (New York: Doubleday, 1987).

15. B. Keillor and T. Hult, “A Five-Country Study of National Identity: Implications for International Marketing Research and Practice,” International Marketing Review, 1999, pp. 65–82; T. Clark, “International Marketing and National Character: A Review and Proposal for an Integrative Theory,” Journal of Marketing, 1990, pp. 66–79; and M. E. Porter, The Competitive Advantage of Nations (New York: The Free Press, 1990).

16. S. P. Huntington, The Clash of Civilizations (New York: Simon & Schuster, 1996).

17. F. Vijver, D. Hemert, and Y. Poortinga, Multilevel Analysis of Individuals and Cultures (New York: Taylor & Francis, 2010).

18. M. Thompson, R. Ellis, and A. Wildavsky, Cultural Theory (Boulder, CO: Westview Press, 1990).

19. M. Douglas, In the Active Voice (London: Routledge, 1982), pp. 183–254.

20. L. Zucker and M. Darby, “Star-Scientist Linkages to Firms in APEC and European Countries: Indicators of Regional Insti- tutional Differences Affecting Competitive Advantage,” In- ternational Journal of Biotechnology, 1999, pp. 119–131.

21. C. Nakane, Japanese Society (Berkeley: University of California Press, 1970).

22. Ibid.

23. For details, see M. Aoki, Information, Incentives, and Bargain- ing in the Japanese Economy (Cambridge, UK: Cambridge University Press, 1988); and M. L. Dertouzos, R. K. Lester, and R. M. Solow, Made in America (Cambridge, MA: MIT Press, 1989).

24. Global Innovation Barometer 2013 is a product by Ideas Lab and supported by General Electric (GE). The GE Global In- novation Barometer explores how business leaders around the world view innovation and how those perceptions are in- fluencing business strategies in an increasingly complex and globalized environment. It is the largest global survey of business executives dedicated to innovation. GE expanded the global study in 2013, surveying more than 3,000 execu- tives in 25 countries. www.ideaslaboratory.com/projects/ innovation-barometer-2013/

25. P. Skarynski and R. Gibson, Innovation to the Core: A Blueprint for Transforming the Way Your Company Innovates (Boston, MA: Harvard Business School Press, 2008); L. Edvinsson and M. Malone, Intellectual Capital: Realizing Your Company’s True Value by Finding Its Hidden Brainpower (New York: Harper Collins, 1997); and T. Davenport and L. Prusak, Working Knowledge: How Organizations Manage What They Know (Bos- ton, MA: Harvard Business School Press, 1998).

26. G. Macionis and L. John, Sociology (Toronto, Ontario: Pear- son Canada Inc., 2010), pp. 224–225.

27. “With Reservations: Business and Caste in India,” The Econo- mist, October 6, 2007, pp. 81–83; and Eric Bellman, “Rever- sal of Fortune Isolates India’s Brahmins,” The Wall Street Journal, December 24, 2007, p. 4.

124 Part Two National Differences

28. E. Luce, The Strange Rise of Modern India (Boston: Little Brown, 2006); and D. Pick and K. Dayaram, “Modernity and Tradition in the Global Era: The Re-invention of Caste in India,” International Journal of Sociology and Social Policy, 2006, pp. 284–301.

29. For an excellent historical treatment of the evolution of the English class system, see E. P. Thompson, The Making of the English Working Class (London: Vintage Books, 1966). See also R. Miliband, The State in Capitalist Society (New York: Basic Books, 1969), especially Chapter 2. For more recent studies of class in British societies, see Stephen Brook, Class: Knowing Your Place in Modern Britain (London: Victor Gollancz, 1997); A. Adonis and S. Pollard, A Class Act: The Myth of Britain’s Classless Society (London: Hamish Hamilton, 1997); and J. Gerteis and M. Savage, “The Salience of Class in Britain and America: A Comparative Analysis,” British Journal of Sociology, June 1998.

30. Adonis and Pollard, A Class Act.

31. J. H. Goldthorpe, “Class Analysis and the Reorientation of Class Theory: The Case of Persisting Differentials in Educa- tion Attainment,” British Journal of Sociology, 2010, pp. 311–35.

32. Y. Bian, “Chinese Social Stratification and Social Mobility,” Annual Review of Sociology 28 (2002), pp. 91–117.

33. N. Goodman, An Introduction to Sociology (New York: Harper- Collins, 1991).

34. O. C. Ferrell, J. Fraedrich, and L. Ferrell, Business Ethics: Ethi- cal Decision Making and Cases (Mason, OH: Cengage Learn- ing, 2012).

35. R. J. Barro and R. McCleary, “Religion and Economic Growth across Countries,” American Sociological Review, Oc- tober 2003, pp. 760–82; and R. McCleary and R. J. Barro, “Religion and Economy,” Journal of Economic Perspectives, Spring 2006, pp. 49–72.

36. M. Weber, The Protestant Ethic and the Spirit of Capitalism (New York: Charles Scribner’s Sons, 1958, original 1904–1905). For an excellent review of Weber’s work, see A. Giddens, Capitalism and Modern Social Theory (Cambridge, UK: Cambridge Uni- versity Press, 1971).

37. Weber, The Protestant Ethic and the Spirit of Capitalism, p. 35.

38. A. S. Thomas and S. L. Mueller, “The Case for Comparative Entrepreneurship,” Journal of International Business Studies 31, no. 2 (2000), pp. 287–302; and S. A. Shane, “Why Do Some Societies Invent More than Others?” Journal of Business Venturing 7 (1992), pp. 29–46.

39. See S. M. Abbasi, K. W. Hollman, and J. H. Murrey, “Islamic Economics: Foundations and Practices,” International Journal of Social Economics 16, no. 5 (1990), pp. 5–17; and R. H. Dekmejian, Islam in Revolution: Fundamentalism in the Arab World (Syracuse, NY: Syracuse University Press, 1995).

40. T. W. Lippman, Understanding Islam (New York: Meridian Books, 1995).

41. Dekmejian, Islam in Revolution.

42. M. K. Nydell, Understanding Arabs (Yarmouth, ME: Intercul- tural Press, 1987).

43. Lippman, Understanding Islam.

44. The material in this section is based largely on Abbasi et al., “Islamic Economics.”

45. “Sharia Calling,” The Economist, November 12, 2010; N. Popper, “Islamic Banks, Stuffed with Cash, Explore Partner- ships in West,” New York Times, December 26, 2013.

46. “Forced Devotion,” The Economist, February 17, 2001, pp. 76–77.

47. For details of Weber’s work and views, see Giddens, Capital- ism and Modern Social Theory.

48. See, for example, the views expressed in “A Survey of India: The Tiger Steps Out,” The Economist, January 21, 1995.

49. “High-tech Entrepreneurs Flock to India,” PBS News Hour, February 9, 2014, www.pbs.org/newshour/bb/high-tech-en- trepreneurs-flock-india, accessed March 7, 2014.

50. H. Norberg-Hodge, “Buddhism in the Global Economy,” In- ternational Society for Ecology and Culture, www.localfutures. org/publications/online-articles/buddhism-in-the-global- economy, accessed March 7, 2014.

51. P. Clark, “Zen and the Art of Startup Naming,” Bloomberg Businessweek, August 30, 2013. www.businessweek.com/ articles/2013-08-30/zen-and-the-art-of-startup-naming, accessed March 7, 2014.

52. Ibid.

53. Hofstede, Culture’s Consequences.

54. See Dore, Taking Japan Seriously; and C. W. L. Hill, “Transac- tion Cost Economizing as a Source of Comparative Advan- tage: The Case of Japan,” Organization Science 6 (1995).

55. C. C. Chen, Y. R. Chen, and K. Xin, “Guanxi Practices and Trust in Management,” Organization Science 15, no. 2 (March–April 2004), pp. 200–10.

56. See Aoki, Information, Incentives, and Bargaining; and J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).

57. This hypothesis dates back to two anthropologists, Edward Sapir and Benjamin Lee Whorf. See E. Sapir, “The Status of Linguistics as a Science,” Language 5 (1929), pp. 207–14; and B. L. Whorf, Language, Thought, and Reality (Cambridge, MA: MIT Press, 1956).

58. The tendency has been documented empirically. See A. Annett, “Social Fractionalization, Political Instability, and the Size of Government,” IMF Staff Papers 48 (2001), pp. 561–92.

59. D. A. Ricks, Big Business Blunders: Mistakes in Multinational Marketing (Homewood, IL: Dow Jones–Irwin, 1983).

60. Goodman, An Introduction to Sociology.

61. Porter, The Competitive Advantage of Nations.

62. Ibid., pp. 395–97.

63. G. Hofstede, “The Cultural Relativity of Organizational Practices and Theories,” Journal of International Business Stud- ies, Fall 1983, pp. 75–89; Hofstede, Cultures and Organiza- tions; Hofstede, Culture’s Consequences.

64. Hofstede, “The Cultural Relativity of Organizational Prac- tices and Theories”; Hofstede, Cultures and Organizations.

65. Hofstede, Culture’s Consequences.

Chapter Four Differences in Culture 125

66. G. Hofstede and M. Bond, “Hofstede’s Culture Dimensions: An Independent Validation Using Rokeach’s Value Survey,” Journal of Cross-Cultural Psychology, 15 (December 1984), pp. 417–33.

67. The factor scores for the long-term versus short-term orien- tation, using Bond’s survey, were brought into a 0–100 range by a linear transformation (LTO 5 50 3 F 1 50, in which F is the factor score). However, the data for China came in after Hofstede and Bond had standardized the scale, and they put China outside the range at LTO 5 118 (which indicates a very strong long-term orientation).

68. G. Hofstede, G. J. Hofstede, and M. Minkov, Cultures and Organizations: Software of the Mind, 3rd ed. (New York: McGraw-Hill, 2010).

69. R. S. Yeh and J. J. Lawrence, “Individualism and Confucian Dynamism,” Journal of International Business Studies 26, no. 3 (1995), pp. 655–66.

70. For a more detailed critique, see Mead, International Manage- ment, pp. 73–75.

71. For example, see W. J. Bigoness and G. L. Blakely, “A Cross- National Study of Managerial Values,” Journal of International Business Studies, December 1996, p. 739; D. H. Ralston, D. H. Holt, R. H. Terpstra, and Y. Kai-Cheng, “The Impact of Na- tional Culture and Economic Ideology on Managerial Work Values,” Journal of International Business Studies 28, no. 1 (1997), pp. 177–208; P. B. Smith, M. F. Peterson, and Z. Ming Wang, “The Manager as a Mediator of Alternative Mean- ings,” Journal of International Business Studies 27, no. 1 (1996), pp. 115–37; and L. Tang and P. E. Koves, “A Framework to Update Hofstede’s Cultural Value Indices,” Journal of Interna- tional Business Studies 39 (2008), pp. 1045–63.

72. R. House, P. Hanges, M. Javidan, P. Dorfman, and V. Gupta, Culture, Leadership, and Organizations: The GLOBE Study of 62 Societies (Thousand Oaks, CA: Sage Publications, 2004); and J. Chhokar, F. Brodbeck, and R. House, Culture and Leadership across the World: The GLOBE Book of In-Depth Studies of 25 Societies (New York: Routledge2012).

73. R. Inglehart, Modernization and Postmodernization: Cultural, Economic, and Political Change in 43 Societies (Princeton, NJ: Princeton University Press, 1997). Information and data on the World Values Survey can be found at www.worldvalues- survey.org.

74. For evidence of this, see R. Inglehart, “Globalization and Postmodern Values,” The Washington Quarterly, Winter 2000, pp. 215–28.

75. Mead, International Management, chap. 17.

76. “Free, Young, and Japanese,” The Economist, December 21, 1991.

77. Namenwirth and Weber, Dynamics of Culture; and Inglehart, “Globalization and Postmodern Values.”

78. G. Hofstede, “National Cultures in Four Dimensions,” Inter- national Studies of Management and Organization 13, no. 1 (1983), pp. 46–74; and Tang and Koves, “A Framework to Update Hofstede’s Cultural Value Indices.”

79. See Inglehart, “Globalization and Postmodern Values.” For updates, go to http://wvs.isr.umich.edu/index.html.

80. Hofstede, “National Cultures in Four Dimensions.”

81. D. A. Ralston, D. H. Holt, R. H. Terpstra, and Y. Kai-Chung, “The Impact of National Culture and Economic Ideology on Managerial Work Values,” Journal of International Business Studies, 2007, pp. 1–19.

82. See Leung, et al., “Culture and International Business.”

83. Hall and Hall, Understanding Cultural Differences.

84. Porter, The Competitive Advantage of Nations.

85. See Aoki, Information, Incentives, and Bargaining; Dertouzos et al., Made in America; and Porter, The Competitive Advantage of Nations, pp. 395–97.

86. See Dore, Taking Japan Seriously; and Hill, “Transaction Cost Economizing as a Source of Comparative Advantage.”

87. For empirical work supporting such a view, see Annett, “So- cial Fractionalization, Political Instability, and the Size of Government.”

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5-1 Understand the ethical issues faced by international businesses.

5-2 Recognize an ethical dilemma.

5-3 Identify the causes of unethical behavior by managers.

5-4 Describe the different philosophical approaches to ethics.

5-5 Explain how managers can incorporate ethical considerations into their decision making.

learning objectives

c h

a pt

opening case

T oys 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., chil-

dren 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,

Making Toys Globally

Ethics, Corporate Social Responsibility, and Sustainability

–continued

128 Part Two National Differences

but 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? • 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. do- mestic 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.

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 129

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 met- als 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 cor- porate social responsibility practices and sustainability initiatives can be traced to the ethical foundation of its employees and other stakeholders such as customers, shareholders, suppli- ers, 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 busi- ness 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 responsibil- ity. The chapter closes by reviewing the different processes that managers can adopt to make sure that ethical considerations are incorporated into decision making in interna- tional business.

Ethical Issues in International Business 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,

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.

LO 5-1 Understand the ethical issues faced by international businesses.

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 top- ics focus on management, marketing, supply chain management, and

finance). Achieving the industry-leading NASBITE CGBP credential as- sures that employees are able to practice global business at the pro- fessional 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 understand- ing of the main issues in international ethics and your readiness to achieve the CGBP credential.

130 Part Two National Differences

managers 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 ap- plied? 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 devel- oped 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 chap- ter. For now, note that establishing minimal acceptable standards that safeguard the basic rights and dignity of employees, auditing foreign subsidiaries and subcontractors on a regu- lar 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 prob- lems 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 de- veloped 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 uni- versally 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 oper- ated 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

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 131

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 Afri- can 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 impor- tant foreign investors.

After 10 years, Leon Sullivan concluded that simply following the principles was not suf- ficient to break down the apartheid regime and that any American company, even those ad- hering 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, in- cluding Exxon, General Motors, Kodak, IBM, and Xerox. At the same time, many state pen- sion 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, adopt- ing an ethical stance was argued to have helped improve human rights in South Africa.5

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 Preci- sion 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 com- pany-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 Pre- cision Industry, was reportedly China’s largest export manufacturer with overseas sales totaling $14.5 billion. Hongfujin is owned by Fox- conn, a large Taiwanese conglomerate, whose customers (in addition to Apple) include Intel, Dell, and Sony Corporation. The Hongfujin fac- tory 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, pledg- ing to audit the operations to make sure Hongfujin was complying with Apple’s code on labor standards for subcontractors. Managers at Hongfu- jin 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 manage- ment of Hongfujin was trying to send a message to the journalist com- munity—criticism would be costly. The suit sent a chill through the Chinese journalist community because Chinese courts have shown a ten- dency 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, commit- ting 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 jour- nalists 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 condi- tions 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.

management FOCUS

132 Part Two National Differences

Although 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 dis- cussed in Chapter 2, when we noted that economic progress in a nation could create pres- sure 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 devel- oped 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 al- though the country is not a democracy, continuing inward investment will help boost eco- nomic 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 re- pressive 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 con- trast, the accompanying Management Focus looks at the controversy surrounding one com- pany, 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

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.

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 133

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 Thai- land. 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 govern- ment, 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. How- ever, as far as Unocal’s management was concerned, the giant infra- structure project would generate healthy returns for the company and, by boosting economic growth, a better life for Myanmar’s now 53 mil- lion 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 con- tractually obliged to clear a corridor for the pipeline through Myanmar’s tropical forests and to protect the pipeline from attacks by the govern- ment’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 hus- band 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 al- leged 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 ap- pealed, 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.

management FOCUS

of toxic chemicals, the use of toxic materials in the workplace, and so on. Those regula- tions 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.

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 peo- ple 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 advan- tage, or make sure that foreign subsidiaries adhere to common standards regarding pol- lution 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, re- sulting 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 com- mons 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

134 Part Two National Differences

commons could handle. The result was overgrazing, degradation of the commons, and the loss of this much- needed supplement.7

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 re- sponsibility. 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 data- bases 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 ev- ery 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. of- ficials 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 gov- ernment 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 immedi- ately 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 pay- ments to obtain exclusive preferential treatment. Rather they are payments to ensure re- ceiving the standard treatment that a business ought to receive from a foreign government,

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

Should 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 inves- tigation, 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. Meet- ings, 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.

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 135

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).

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.

While facilitating payments, or speed money, are excluded from both the Foreign Cor- rupt 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 in- vestment creates jobs where none existed and assuming the practice is not illegal). Sev- eral 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 Cor- rupt Practices Act.

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.

Corruption at Daimler

In 1998, Daimler, one of the world’s largest manufacturers of automo- biles, 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 resi- dential 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. De- partment of Justice (DOJ) and began an investigation.

The investigation took eight years. During that time, investiga- tors 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 enti- ties 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 pay- ments 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 prac- tices, but instead they permitted or were directly involved in the com- pany’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 subsid- iaries 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.

management FOCUS

136 Part Two National Differences

In contrast, other economists have argued that corruption reduces the returns on busi- ness 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, man- agement 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 gen- eralization 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 develop- ment, but yes, there are also cases where side payments to government officials can re- move 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 bene- fits 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 alterna- tive,” 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 busi- ness guidelines” altogether, so our assumption has to be that the company is taking a stron- ger zero-tolerance approach at this time.

Dow Corning may have simply realized that the nuances between a bribe and a facilitat- ing 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

Ethical Dilemmas 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 Europe- ans find the American approach barbaric. For a more business-oriented example, con- sider 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.

LO 5-2 Recognize an ethical dilemma.

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Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 137

Managers often confront very real ethical dilemmas where the ap- propriate 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 vio- lation 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.

Had the visiting American understood the gravity of the girl’s sit- uation, 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

The Roots of Unethical Behavior 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 psycho- logically and geographically distant from the parent company. They may be based in a cul- ture 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

Ethical Dilemma A situation in which there is no ethically acceptable solution.

LO 5-3 Identify the causes of unethical behavior by managers.

Child labor is still common in many poor nations.

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138 Part Two National Differences

that can only be fulfilled by cutting corners or acting unethically. For example, to meet cen- trally 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 behav- ior. Due to its geographic distance, the parent company may be unable to see how expatriate managers are meeting goals or may choose not to see how they are doing so, allowing such behavior to flourish and persist.

DECISION-MAKING PROCESSES Several studies of unethical behavior in a business setting have concluded that businesspeople sometimes do not realize they are behaving unethically, primarily because they simply fail to ask, “Is this decision or action ethical?”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 cho- sen 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 as- sumed 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

5.1 FIGURE Determinants of Ethical Behavior

Ethical Behavior

Unrealistic Performance

Goals

Leadership

Decision-Making Processes

Organization Culture

Societal Culture

Personal Ethics

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 139

individual 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 cul- ture 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.

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 be- havior 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 legiti- mizes 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 rein- force 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 be- having 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

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

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140 Part Two National Differences

where corruption is endemic, are more likely to engage in unethical behavior than enter- prises headquartered in Scandinavia.

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 dis- missed 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 interna- tional 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 deci- sion making in a multinational enterprise. Four such approaches to business ethics are com- monly discussed in the literature. These approaches can be characterized as the Friedman doctrine, cultural relativism, the righteous moralist, and the naive immoralist. All these ap- proaches have some inherent value, but all are unsatisfactory in important ways. Neverthe- less, 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 effi- cient running of a business. For example, his arguments suggest that improving working

LO 5-4 Describe the different philosophical approaches to ethics.

“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 Busi- ness Ethics,” May 6, 2010, http://ethicalbusinessethics.blogspot.com/2010/05/ when-in-rome-should-you-do-as-romans-do.html, accessed March 9, 2014.

conditions beyond the level required by the law and nec- essary 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 cor- porate executive is an employee of the owners of the business. He has direct responsibility to his em- ployers. That responsibility is to conduct the busi- ness in accordance with their desires, which generally will be to make as much money as possi- ble while conforming to the basic rules of the soci- ety, 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

Although Friedman is talking about social responsibility and “ethical custom,” rather than business ethics per se, many business ethics scholars equate social responsibility

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 141

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 conse- quences of such pollution, which may have serious health effects for the surrounding popu- lation, 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 sup- ports slavery, it is okay to use slave labor in a country. Clearly, it is not! Cultural relativism implicitly rejects the idea that universal notions of morality transcend different cultures, but, as we argue later in the chapter, some universal notions of morality are found across cultures.

While dismissing cultural relativism in its most sweeping form, some ethicists argue there is residual value in this approach.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

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

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.

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 Offi cial Site of the Nobel Prize,” www.nobelprize.org/nobel_prizes/peace, accessed March 9, 2014.

with ethical behavior and thus believe Friedman is also ar- guing 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 state- ments 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 decep- tion or fraud.27

In other words, Friedman states that businesses should be- have 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 estab- lished 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

142 Part Two National Differences

bank’s profits for income tax purposes.30 The manager insisted that the bank report its earn- ings 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, reflect- ing 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 maintain- ing 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.

The 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 al- ways 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 multina- tional 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.

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 ethi- cally justified.

UTILITARIAN AND KANTIAN ETHICS In contrast to the straw men just discussed, most moral philosophers see value in utilitarian and Kantian approaches to busi- ness 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.

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.

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.

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

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 143

Many businesses have adopted specific tools such as cost–benefit analysis and risk assess- ment 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 frag- ile 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 fertiliz- ers. The risks include the possibility that Monsanto’s insect-resistant crops might make mat- ters 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 in- terests 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 re- spected 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 in- complete—for example, his system has no place for moral emotions or sentiments such as sympathy or caring—the notion that people should be respected and treated with dignity resonates in the modern world.

RIGHTS THEORIES Developed in the twentieth century, rights theories recog- nize 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 pre- cedence 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 consen- sus.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 com- ponent. More precisely, they should not pursue actions that violate these rights.

The notion that there are fundamental rights that transcend national borders and cul- tures 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 declara- tion 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.

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

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

Universal Declaration of Human Rights A United Nations document that lays down the basic principles of human rights that should be adhered to.

144 Part Two National Differences

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 sub- sistence 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 develop- ment 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 shoul- ders 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 funda- mental 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 equi- table. 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 philoso- pher 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.

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, ev- eryone 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.

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

FOCUS ON MANAGERIAL IMPLICATIONS

MAKING ETHICAL DECISIONS INTERNATIONALLY 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 ethi- cal 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 in- ternational 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 promot- ing 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 deci- sion-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 cour- age; (6) make corporate social responsibility a cornerstone of enterprise policy; and (7) pur- sue strategies that are sustainable.

LO 5-5 Explain how managers can incorporate ethical considerations into their decision making.

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 145

The 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 distri- bution 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 per- spective. Managers could ask themselves whether the policies they adopt in foreign opera- tions 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 man- agers 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 deg- radation of these commons. Thus, Rawls’s veil of ignorance is a conceptual tool that contrib- utes to the moral compass that managers can use to help them navigate through difficult ethical dilemmas.

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Hiring and Promotion It seems obvious that businesses should strive to hire people who have a strong sense of personal ethics and would not engage in unethical or illegal behavior. Similarly, you 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 subse- quently 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 pro- spective 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 organiza- tion 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 per- sonal 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 estab- lished 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 ethi- cal 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

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 associa- tion. 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 accu- rately 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 substan- dard working conditions, use child labor, or give bribes under any circumstances. Note also

Code of Ethics A business’s formal statement of ethical priorities.

146 Part Two National Differences

the reference to respecting the dignity of employees, a statement that is grounded in Kan- tian ethics. Unilever’s principles send a very clear message about appropriate ethics to man- agers and employees.

Having articulated values in a code of ethics or some other document, leaders in the busi- ness 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 impor- tance 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 inde- pendent 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 re- quires 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, di- viding 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, businesspeo- ple 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 busi- nessperson 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

All stakeholders are in an exchange relationship with the company.43 Each stakeholder group supplies the organization with important resources (or contributions), and in ex- change 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

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.

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 147

that are responsible citizens and seek some assurance that the quality of life will be improved as a result of the business firm’s existence.

Stakeholder analysis involves a certain amount of what has been called moral imagina- tion.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 subcontrac- tors, managers might need to ask themselves how it might feel to be working under substan- dard health conditions for long hours.

Step 2 involves judging the ethics of the proposed strategic decision, given the infor- mation 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 enti- tlement 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 errone- ous) 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 prin- ciples, 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 in- dividuals—often referred to as ethics officers—are responsible for managing their organiza- tions 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 main- taining 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 govern- ment 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 busi- nesses ethics officers act as an internal ombudsperson with responsibility for handling

148 Part Two National Differences

confidential inquiries from employees, investigating complaints from employees or oth- ers, 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 offi- cers). 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 profit- able 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 individu- als 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 superi- ors, 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 speci- fied 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 manda- tory 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 confi- dence 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 con- strained 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 en- able them to prosper and grow. The concept of corporate social responsibility (CSR) re- fers 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, cor- porate 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 re- sponsibility of successful enterprises. This has long been recognized by many businesspeople, resulting in a substantial and venerable history of corporate giving to society, with busi- nesses 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.

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 149

Power itself is morally neutral; how power is used is what matters. It can be used in a positive way to increase social welfare, which is ethical, or it can be used in a manner that is ethically and morally suspect. Managers at some multinationals have acknowledged a moral obligation to use their power to enhance social welfare in the communities where they do business. BP, one of the world’s largest oil companies, has made it part of the company pol- icy 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 respon- sibility into strategic actions, many are gravitating toward strategies that are viewed as sustain- able. 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.

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 em- ployees so little that it forces them into poverty, for ex- ample, 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 com- pany that drives down the prices it pays to its suppliers so far that the suppliers cannot make enough money to in- vest 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.

Stora Enso, profiled in the Management Focus fea- ture, is in essence pursuing sustainable strategies be- cause, 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 exam- ple, 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

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.

150 Part Two National Differences

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 try- ing 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. Mean- while, 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 auto- mobile, 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/?p5940, accessed March 9, 2014; and “Global Reporting Initiative,” www.globalreporting. org, accessed March 9, 2014.

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 produc- tion methods. As a result of these policies, by 2012, some 93 percent of Starbucks coffee beans were ethically sourced.

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, there- fore, 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 strength- ens 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 sharehold- ers, the environment, suppliers, local communities, employees, and customers. Business

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 Con- solidated 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 produc- tion capacity. However, the North American operations were sold in 2007 to NewPage Corporation.

Stora Enso has a long-standing tradition of corporate social respon- sibility 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 posi- tions the company as though it has always been attending to the “so- cially responsible” needs of doing good for the people and the planet. It illustrates this by maintaining that it has created and enhanced com- munities 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, govern- ments, and local communities near its mills.

Tracing to its past and reflecting on its future, Stora Enso has ad- opted 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 for- ests and land use, it focuses on an innovative and responsible ap- proach 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 Per- formance Indicators (KPI). Targets are publicly listed in a document ti- tled “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, eth- ics 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 dimen- sions cover climate and energy, material efficiency, and process water discharges. The “Targets and Performance” document also lists per- formance 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.

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152 Part Two National Differences

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 com- pany to compete more effectively in the global market place. Good ethical practices are good for business!

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 presi- dent of research at Corporate Knights, a Toronto-based media com- pany, 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 respon- sible 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 re- fining 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, Per- formance Materials, and Recycling. Catalysis is involved with abate- ment 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. Per- formance 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 sustain- ability objectives and goals, which address market orientation, multiple stakeholders, and corporate social responsibility. The company’s finan- cial objective is to achieve double-digit revenue growth, with the goal of generating an average return on capital employed of more than 15 per- cent 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 emis- sions on water and air by 20 percent, and investing in tools to better un- derstand and measure life cycles of its products. Socially, Umicore focuses on achieving zero lost-time accidents, reducing body concentra- tions of metals to which employees have exposure, and individual em- ployee 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.

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business ethics, p. 129 ethical strategy, p. 129 Foreign Corrupt Practices Act, p. 134 Convention on Combating Bribery of Foreign Public Officials in International Business Transactions, p. 135 ethical dilemma, p. 137 organizational culture, p. 139

cultural relativism, p. 141 righteous moralist, p. 141 naive immoralist, p. 142 utilitarian approach to ethics, p. 142 Kantian ethics, p. 143 rights theories, p. 143 Universal Declaration of Human Rights, p. 143

just distribution, p. 144 code of ethics, p. 146 stakeholders, p. 147 internal stakeholders, p. 147 external stakeholders, p. 147 corporate social responsibility, p. 149 sustainable strategies, p. 150

Key Terms

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 153

Summary

This chapter discussed the source and nature of ethical is- sues in international businesses, the different philosophical approaches to business ethics, and the steps managers can take to ensure that ethical issues are respected in interna- tional 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

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

ccccccllooooooossssiinnnnnnggggggggggg ccccccaaaaaassssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeBitcoin as an Ethical Dilemma

154 Part Two National Differences

the decisions of a large oil multinational toward environmental protection and (b) influence the policies of a clothing company in their potential decision of outsourcing 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?

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?

Research Task http://globalEDGE.msu.edu

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 155

unclear why bitcoin should be a stable store of value.” Joining in the dis- cussion, Charlie Stross, the British writer of science fiction, says that “bit- coin 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 cur- rencies, 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 dol- lars 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 interven- tion. 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 min- ing process is intentionally designed to be resource-intensive and diffi- cult. 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 computa- tional 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 cen- tral 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 Un- safe 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 in- fluence on the South African economy. For a counterview see S. H. Teoh, I. Welch, and C. P. Wazzan, “The Effect of So- cially 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).

156 Part Two National Differences

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 Eco- nomic 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 Man- agement 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 In- crease 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. Beau- champ 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 interna- tional 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 Revolu- tionary,” 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.

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 157

46. 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 Per- formance–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 Man- agement 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.

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6-1 Understand why nations trade with each other.

6-2 Summarize the different theories explaining trade flows between nations.

6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

6-5 Understand the important implications that international trade theory holds for business practice.

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Creating the World’s Biggest Free Trade Zone

International Trade Theory

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, ac- counting for about half of global GDP and one-third of all international trade. Nevertheless, the announce-

ment 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

–continued

160 Part Three The Global Trade and Investment Environment

estimates 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. • 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.

Introduction The proposed free trade deal between the United States and the European Union is an ex- ample 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 unemploy- ment 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 argu- ments concerning the benefits of free trade in goods and services are not abstract aca- demic 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 interna- tional 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 benefi- cial 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 en- courage exports and discourage imports. Although mercantilism is an old and largely dis- credited 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 influ- ence 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 re- view. One is the theory of comparative advantage, advanced by the nineteenth-century Eng- lish economist David Ricardo. This theory is the intellectual basis of the modern argument

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

Chapter Six International Trade Theory 161

for unrestricted free trade. In the twentieth century, Ricardo’s work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher-Ohlin theory.

THE BENEFITS OF TRADE The great strength of the theories of Smith, Ri- cardo, and Heckscher-Ohlin is that they identify with precision the specific benefits of in- ternational trade. Common sense suggests that some international trade is beneficial. For example, nobody would suggest that Iceland should grow its own oranges. Iceland can ben- efit 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 no- tion, 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 pro- duced 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 coun- try, 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 re- quires 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 popula- tion 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.

Trade Tutorials

In Chapter 6, we discuss benefits and costs associated with free trade, discuss the benefits of international trade, and explain the pat- tern 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 prod- uct 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 com- panies 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 re- sources include export tutorials, online course modules, glossary, free trade agreement tariff tool, and much more. The glossary in- cludes lots of terms related to trade. For example, “trade surplus” is defined as a situation in which a country’s exports exceeds its im- ports (i.e., it represents a net inflow of domestic currency from for- eign markets). The opposite is called trade deficit and is considered a net outflow, but how is it really defined—the globalEDGE glossary can help.

L0 6-1 Understand why nations trade with each other.

162 Part Three The Global Trade and Investment Environment

THE PATTERN OF INTERNATIONAL TRADE The theories of Smith, Ricardo, and Heckscher-Ohlin help explain the pattern of international trade that we ob- serve 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 pat- tern 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 inter- national differences in labor productivity. The more sophisticated Heckscher-Ohlin the- ory 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 as- sumption 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 Ver- non, 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 orig- inal 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 com- petitive advantage that is subsequently difficult to challenge. Thus, the observed pat- tern 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 competi- tive advantage that has subsequently been difficult for firms from countries with equally favorable factor endowments to challenge (al- though 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 ex- plain why particular nations achieve international success in particular industries. In addition to factor endowments, Porter points out the im- portance of country factors such as domestic demand and domestic ri- valry 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 govern- ment policy. Mercantilism makes a crude case for government involve- ment 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 con- trols and export incentives (such as subsidies) are self-defeating and result

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.

Chapter Six International Trade Theory 163

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.

Mercantilism The 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 con- sume 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 mer- cantilist 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, how- ever, 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 be- coming 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. Unfortu- nately, 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 simulta- neously boost exports and limit imports.2 For example, critics charge that China long pur- sued 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).

Absolute Advantage In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assump- tion 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,

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

Zero-Sum Game A situation in which an economic gain by one country results in an economic loss by another.

L0 6-2 Summarize the different theories explaining trade flows between nations.

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.

164 Part Three The Global Trade and Investment Environment

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.

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 argu- ment, 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 produc- tion 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 co- coa 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 GG9 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

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.

Is 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 eco- nomic 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 domes- tic 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 discourag- ing imports and encouraging exports in order to increase its trade sur- plus 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 im- ports 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.

country FOCUS

Chapter Six International Trade Theory 165

different combinations available to South Korea are represented by the line KK9 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.

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 co- coa 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 coun- try 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 special- izing, the production of both goods could be increased. Pro- duction 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 spe- cialization and trade and 1 ton more rice. Similarly, South Korea’s final consumption after trade would be 6 tons of co- coa 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 con- sumers in both nations would be able to consume more. Thus, we can see that trade is a positive-sum game; it pro- duces net gains for all involved.

6.1 FIGURE The Theory of Absolute Advantage

5 10 15 200 Rice

G20

10 A

K' C

o co

2.5

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 conceptu- alized by David Ricardo and then refined by Eli Heckscher and Bertil Ohlin? Comparative advantage theory argues that a coun- try 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 effi- cient as possible (engage in international trade when advanta- geous) 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 pro- duce them more efficiently?

166 Part Three The Global Trade and Investment Environment

Comparative Advantage David Ricardo took Adam Smith’s theory one step further by exploring what might hap- pen 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 GG9 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 KK9 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

L0 6-2 Summarize the different theories explaining trade flows between nations.

6.1 TABLE Absolute Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa Rice

Ghana 10 20

South Korea 40 10

Production and Consumption Without Trade

Ghana 10.0 5.0

South Korea 2.5 10.0

Total production 12.5 15.0

Production with Specialization

Ghana 20.0 0.0

South Korea 0.0 20.0

Total production 20.0 20.0

Consumption after Ghana Trades 6 Tons of Cocoa for 6 Tons of South Korean Rice

Ghana 14.0 6.0

South Korea 6.0 14.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 4.0 1.0

South Korea 3.5 4.0

Chapter Six International Trade Theory 167

can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice.

Without trade the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade each country must consume what it pro- duces. 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 advan- tage 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 con- sume 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 spe- cialization 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 partici- pate 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.

6.2 FIGURE The Theory of Comparative Advantage

5 7.53.75 10 15 200 Rice

10C o

co a

2.5

168 Part Three The Global Trade and Investment Environment

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 ex- tended to the real world of many countries, many goods, positive transportation costs, vola- tile 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

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

6.2 TABLE Comparative Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa Rice

Ghana 10 13.33

South Korea 40 20

Production and Consumption Without Trade

Ghana 10.0 7.5

South Korea 2.5 5.0

Total production 12.5 12.5

Production with Specialization

Ghana 15.0 3.75

South Korea 0.0 10.0

Total production 15.0 13.75

Consumption after Ghana Trades 4 Tons of Cocoa for 4 Tons of South Korean Rice

Ghana 11.0 7.75

South Korea 4.0 6.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 1.0 0.25

South Korea 1.5 1.0

Chapter Six International Trade Theory 169

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

However, once all the assumptions are dropped, the case for unrestricted free trade, while still positive, has been argued by some economists associated with the “new trade theory” to lose some of its strength.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 con- sider 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, re- sources 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 as- sumes 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. How- ever, 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 addi- tional unit. While 10 units of resources may be sufficient to increase Ghana’s output of co- coa 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. Di- minishing 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.

170 Part Three The Global Trade and Investment Environment

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 in- creasingly 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 pro- duction. 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 specializa- tion suggest that the gains from specialization are likely to be exhausted before specializa- tion 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 con- clusion 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 appar- ent 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 re- sources. Gains in the efficiency of resource utilization could arise from a number of factors.

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

6.3 FIGURE Ghana’s PPF under Diminishing Returns

C o

co a

Rice 0

Chapter Six International Trade Theory 171

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 phe- nomenon has arguably been occurring in the once-protected markets of eastern Europe, where many former state monopolies have had to increase the efficiency of their operations to survive in the competitive world market.

Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized will cause a country’s PPF to shift outward. This is illustrated in Fig- ure 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. How- ever, 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 introduc- tion of a free trade regime may not be enough to produce a net gain for the U.S. econ- omy 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

6.4 FIGURE The Influence of Free Trade on the PPF

C o

co a

Rice 0

PPF2

PPF1

172 Part Three The Global Trade and Investment Environment

Moving U.S. White-Collar Jobs Offshore

Economists have long argued that free trade produces gains for all countries that participate in a free trading system. As the next wave of globalization sweeps through the U.S. economy, many people are won- dering if this is true. During the 1980s and 1990s, free trade was as- sociated 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 Philip- pines, 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 as- sociated 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 ques- tioning this assumption. Many American companies have been mov- ing 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 technol- ogy specialists, driving annual salaries to more than $100,000. How- ever, 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 Tech- nologies 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 applica- tions for U.S. mortgage companies. Nearby in the offices of another Indian firm, Wipro Ltd., radiologists interpret 30 CT scans a day for Massachusetts General Hospital that are sent over the Internet. At yet another Bangalore business, engineers earn $10,000 a year designing leading-edge semiconductor chips for Texas Instruments. Nor is India the only beneficiary of these changes.

Some architectural work also is being outsourced to lower-cost locations. Flour Corp., a California-based construction company, em- ploys some 1,200 engineers and draftsmen in the Philippines, Poland, and India to turn layouts of industrial facilities into detailed specifica- tions. 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 en- gineers 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 in- ception. 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.

country FOCUS

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

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.

Having said this, it should be noted that Samuelson concedes that free trade has histori- cally 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

Chapter Six International Trade Theory 173

may turn out pragmatically to be still best for each region in comparison to lobbyist- induced tariffs and quotas which involve both a perversion of democracy and non-subtle deadweight distortion losses.”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 ex- posure 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, sig- nificantly reduce the gains from trade.

Other economists have dismissed Samuelson’s fears.13 While not questioning his anal- ysis, 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. How- ever, such rebuttals are at odds with recent data suggesting that Asian countries are rap- idly 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 mea- sure of how “open” to international trade an economy was and then looked at the relation- ship 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 econo- mies 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 com- pared 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 na- tion 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 econ- omy, 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

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

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174 Part Three The Global Trade and Investment Environment

Heckscher-Ohlin Theory Ricardo’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 de- pends on how productively it uses its resources. Ricardo stressed labor productivity and ar- gued 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 com- parative 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 at- tempts 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. Un- like Ricardo’s theory, however, the Heckscher-Ohlin theory argues that the pattern of inter- national 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 im- porter 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 assump- tions. Because of its influence, the theory has been subjected to many empirical tests. Begin-

ning 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 be- cause 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. im- ports. Because this result was at variance with the predic- tions of the theory, it has become known as the Leontief paradox.

No one is quite sure why we observe the Leontief par- adox. 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 tech- nology has had time to mature and become suitable for mass production. Thus, the United States may be export- ing goods that heavily use skilled labor and innovative en- trepreneurship, such as computer software, while importing heavy manufacturing products that use large

L0 6-2 Summarize the different theories explaining trade flows between nations.

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

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 pro- duces 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 hav- ing 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?

Chapter Six International Trade Theory 175

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

This leaves economists with a difficult dilemma. They prefer the Heckscher-Ohlin the- ory 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 endow- ments 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 abun- dance of capital but also on its development of innovative manufacturing technology that enabled it to achieve higher productivity levels in automobile production than other coun- tries that also had abundant capital. More recent empirical work suggests that this theoreti- cal 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 Ver- non’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, photocopi- ers, 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 con- sumer products. In addition, the high cost of U.S. labor gave U.S. firms an incentive to de- velop 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 pro- duced 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 in- herent 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 de- mand 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.

L0 6-2 Summarize the different theories explaining trade flows between nations.

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176 Part Three The Global Trade and Investment Environment

As the market in the United States and other advanced nations matures, the product be- comes 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., Thai- land) 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 explana- tion 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 ex- ceptions. 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 pro- duced 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 implica- tions for international trade.29 Economies of scale are unit cost reductions associated

L0 6-2 Summarize the different theories explaining trade flows between nations.

Economies of Scale Cost advantages associated with large- scale production.

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Chapter Six International Trade Theory 177

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 special- ized 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

6.5 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.

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$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 pro- ducing a high volume of automobiles from an assembly line where each employee has a specialized task.

New trade theory makes two important points: First, through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods. Second, in those industries 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 impor- tant, 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. Accord- ingly, those products may not be produced, thereby limiting the variety of products avail- able 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 endow-

ments 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 (mod- els) 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 pro- ducing 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 re- alize scale economies. Consumers in this case benefit from having access to a product (sports cars) that was not

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

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 equip- ment. Economies of scale have been a major source of cost re- ductions 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 cus- tomers. 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?

Chapter Six International Trade Theory 179

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.

ECONOMIES OF SCALE, FIRST-MOVER ADVANTAGES, AND THE PATTERN OF TRADE A second theme in new trade theory is that the pat- tern 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 substan- tial 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 air- craft 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 im- portant 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 pro- duce 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 com- mercial 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 domi- nance of America and Europe in the trade of midsize and large jet aircraft. This domi- nance 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

First-Mover Advantages Advantages accruing to the first to enter a market.

L0 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

180 Part Three The Global Trade and Investment Environment

(e.g., Mitsubishi Heavy Industries is a major subcontractor for Boeing on the 777 and 787 programs).

New trade theory is at variance with the Heckscher-Ohlin theory, which suggests a coun- try 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 mov- ers 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 aver- age 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 advan- tages. 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 ex- porter of commercial jet aircraft. Boeing’s innovativeness was demonstrated by its indepen- dent 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 sophisti- cated 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 appar- ently 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 re- viewed so far. We consider the policy implications of this issue in Chapter 7.

National Competitive Advantage: Porter’s Diamond Michael Porter, the famous Harvard strategy professor, has also written extensively on in- ternational 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 ex- plain 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

L0 6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

L0 6-2 Summarize the different theories explaining trade flows between nations.

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Chapter Six International Trade Theory 181

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.

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 favor- able. 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 im- portant 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 ad- vantage. For example, regulation can alter home demand conditions, antitrust policies can influence the intensity of rivalry within an industry, and government investments in educa- tion 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, loca- tion, and demographics) and advanced factors (e.g., communication infrastructure, so- phisticated 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

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.

Demand Conditions

Factor Endowments

Related and Supporting Industries

Firm Strategy, Structure, and Rivalry

182 Part Three The Global Trade and Investment Environment

and 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 pro- vide an initial advantage that is subsequently reinforced and extended by investment in ad- vanced 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 ar- able land and mineral deposits and yet through investment has built a substantial endow- ment 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 up- grading 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 con- sumers 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 Japa- nese 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 elec- tronic 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 sec- tor, 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 regu- lar conferences or workshops.35

FIRM STRATEGY, STRUCTURE, AND RIVALRY The fourth broad at- tribute 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 pre- dominance 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 pro- cesses 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 engi- neering-based industries where manufacturing processes and product design issues are all- important (e.g., the automobile industry).

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 func- tion of the combined impact of factor endowments, domes- tic 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 sup- porting 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. Por- ter’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 ad- vantage, and the Heckscher-Ohlin theory. It may be that each of these theories, which com- plement each other, explains something about the pattern of international trade.

L0 6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

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. Educa- tion-related endowments such as skilled labor, research facili- ties, 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 envi- ronmental well-being of countries (i.e., countries adopt sustain- ability 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 edu- cation 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 Benefi ts of Educating Women,” Bloomberg Businessweek, March 7, 2013.

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 inter- national businesses of the material discussed in this chapter: location implications, first- mover implications, and government policy implications.

L0 6-5 Understand the important implications that international trade theory holds for business practice.

Chapter Six International Trade Theory 183

Porter’s second point is that there is a strong association between vigorous domestic rivalry and the creation and per- sistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competi- tors. Domestic rivalry creates pressures to innovate, to im- prove quality, to reduce costs, and to invest in upgrading advanced factors. All this helps create world-class competi- tors. 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 en- gage in a continuing struggle to outdo each other. Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings mea- sure which companies are most popular with univer- sity graduates. The rate of new product and process development is breathtaking.36

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184 Part Three The Global Trade and Investment Environment

Location 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, ac- cording to the theory of international trade, they can be performed most efficiently. If de- sign 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 Singa- pore, 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 lo- cations around the globe depending on considerations of comparative advantage, factor en- dowments, 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 commit- ments 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 be- fore 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 inter- national trade, businesses can exert a strong influence on government trade policy, lobby- ing 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 Com- puter 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).

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As predicted by international trade theory, many of these agreements have been self-de- feating, 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 implica- tions. 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 re- search (since all these enhance advanced factors) and to adopt policies that promote strong competition within domestic markets (since this makes firms stronger international com- petitors, according to Porter’s findings).

free trade, p. 160 new trade theory, p. 162 mercantilism, p. 163 zero-sum game, p. 163 absolute advantage, p. 164

constant returns to specialization, p. 169 factor endowments, p. 174 economies of scale, p. 176 first-mover advantages, p. 179 balance-of-payments accounts, p. 189

current account, p. 189 current account deficit, p. 189 current account surplus, p. 189 capital account, p. 190 financial account, p. 191

Key Terms

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 ob- served in the world economy. The theories of Smith, Ricardo, and Heckscher-Ohlin all make strong cases for unrestricted free trade. In contrast, the mercantilist doc- trine and, to a lesser extent, the new trade theory can be interpreted to support government intervention to pro- mote 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 advan- tage, 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 pro- ductivity differences are important; Heckscher-Ohlin tells us that factor endowments matter; the product life- cycle theory tells us that where a new product is intro- duced 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 fac- tors may be important insofar as they affect the four com- ponents 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.

186 Part Three The Global Trade and Investment Environment

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 Neo- mercantilist 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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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 indus- try something of an international pariah. Because they made copies of pat- ented 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, for- eign 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 Or- ganization that brought the country into compliance with WTO rules on in- tellectual property rights. Indian companies stopped producing counterfeit products. Secure in knowledge that their patents would be respected, for- eign 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 West- ern and Indian firms. Western companies have been increasingly outsourc- ing 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 phar- maceuticals, 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. More- over, 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

The Rise of India’s Drug Industry

Chapter Six International Trade Theory 187

Use 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.

Research Task http://globalEDGE.msu.edu

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

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.

The U.S. Federal Drug Administration (FDA) responded to the shift of manufacturing to India by opening two offices there to oversee manufactur- ing 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 com- panies 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 gov- ernment health care regulation and increased competition have put pres- sure 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 be- tween 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?

188 Part Three The Global Trade and Investment Environment

Chapter Six International Trade Theory 189

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International Trade and the Balance of Payments International trade involves the sale of goods and services to residents in other countries (exports) and the purchase of goods and services from residents in other countries (imports). A country’s balance-of-payments accounts keep track of the payments to and receipts from other countries for a particular time period. 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 bal- ance-of-payments accounts as a debit and given a negative (2) sign. Any transaction result- ing 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 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 ex- port or import of physical goods (e.g., agricultural foodstuffs, autos, computers, and chemi- cals). 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 in- come 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

Balance-of-Payments Accounts National accounts that track both payments to and receipts from foreigners.

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.

190 Part Three The Global Trade and Investment Environment

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.)

The 2006 current account deficit of $803 billion was the largest on record and was equiv- alent to about 6.5 percent of the country’s GDP. The deficit has shrunk since then, in re- sponse 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 cur- rent 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.

A.1 TABLE U.S. Balance-of-Payments Accounts, 2012 Source: Bureau of Economic Analysis.

Current Account $ Millions

Exports of goods, services, and income receipts 2,986,949

Goods 1,561,239

Services 649,346

Income receipts 776,364

Imports of goods, services, and income payments 23,297,677

Goods 22,302,714

Services 2442,527

Income payments 2552,437

Unilateral current transfers (net) 2126,688

Current account balance 2534,656

Capital Account

Capital account transactions (net) 6,956

Financial Account

U.S.-owned assets abroad (net) 297,469

U.S. official reserve assets 24,460

U.S. government assets 85,331

U.S. private assets 2178,341

Foreign-owned assets in the United States 543,884

Foreign official assets in the United States 393,922

Other foreign assets in the United States 149,962

Statistical discrepancy 25,891

Chapter Six International Trade Theory 191

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 individu- als and corporations. As can be seen from Table A.1, in 2012 there was a 2$97.5 billion reduc- tion 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 as- sets owned by other foreign entities such as corporations and individuals (other foreign as- sets 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 hold- ing of U.S. assets by foreign governments, while foreign private corporations and individu- als 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 pay- ments. 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 pur- chase 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 ac- count, 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 2$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

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

192 Part Three The Global Trade and Investment Environment

foreign landowners, and dividends to foreign stockholders. One might argue that such pay- ments to foreigners drain resources from a country and limit the funds available for invest- ment 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 foreign- ers 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 ex- ample, 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 Re- view 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 Global- ization,” 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 Global- ization,” p. 143.

12. D. H. Autor, D. Dorn, and Gordon H. Hanson, “The China Syndrome: Local Labor Market Effects of Import Competi- tion 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.

Chapter Six International Trade Theory 193

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 acces- sible discussion of the relationship between free trade and economic growth, see T. Taylor, “The Truth about Globaliza- tion,” 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,” Ameri- can 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 rela- tionship 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 au- thors, 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 Fac- tor 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 Re- turns, 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 Ad- vantages,” 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 Re- search 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 As- sessment,” Strategic Management Journal 12 (1991), pp. 535–48.

35. B. Kogut, ed., Country Competitiveness: Technology and the Or- ganizing 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 Disad- vantage,” 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 Trou- ble,” 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 Eco- nomic Research Working Paper Series, working paper no. 12154, April 2006.

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learning objectives

7-1 Identify the policy instruments used by governments to influence international trade flows.

7-2 Understand why governments sometimes intervene in international trade.

7-3 Summarize and explain the arguments against strategic trade policy.

7-4 Describe the development of the world trading system and the current trade issue.

7-5 Explain the implications for managers of developments in the world trading system.

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opening case

Back in the 1930s at the height of the Great Depression, the U.S. government stepped in to support the U.S. sugar industry with a combination of subsidies, price supports, import quotas, and tariffs. These actions were meant to be temporary, but as of 2014, they are still in place. Under policies approved in the 2008 farm bill, the government guarantees 85 percent of the market for U.S. producers,

primarily farmers growing sugar beets and cane. The remaining 15 percent is allocated for imports from

certain countries at a preferential tariff rate. The government also sets a floor price for sugar. If the price

falls below the floor, the government steps in to purchase excess supply, driving the price back up again.

The surplus is then sold at a loss to producers of ethanol. A significant U.S. sugar harvest in 2013 required

the government to spend some $300 million to prop up U.S. sugar prices. As a result of these policies, be-

tween 2010 and 2013, the U.S. sugar price has averaged between 64 percent and 92 percent higher than

the world price of sugar.

American sugar producers say that the federal programs are necessary to keep big sugar producing

countries like Brazil, India, and Thailand from flooding the U.S. market and driving them out of business.

Opponents of the practice include numerous small candy producers. Many of them complain about the

high U.S. price for sugar. Increasingly, they have responded by moving production offshore. For example,

the Spangler Candy Company, the maker of Dum Dums, has moved 200 jobs from Ohio to Juarez, Mexico,

where it makes candy canes that are then imported back into the United States. Similarly, Adams & Brooks,

a California-based candy company, has shifted two-thirds of its production across the border to Mexico in

response to higher U.S. sugar prices.

A recent academic study suggests that the U.S. sugar policies primarily benefit 4,700 sugar producers,

while imposing costs of $2.9 billion to $3.5 billion per annum on U.S. consumers due to higher sugar

prices. The same research predicts that removing the support programs would lead to the net creation

of 17,000 to 20,000 new jobs in the United States, while dramatically reducing imports of products

containing sugar.

Sugar Subsidies Drive Candy Makers Abroad

Government Policy and International Trade

–continued

196 Part Three The Global Trade and Investment Environment

Given the benefits of removing sugar support programs, and all the talk about

deregulation and reducing the budget deficit in Congress, many observers thought that

2013 would be the year that the sugar programs were finally abandoned. The farm bill

was up for renewal, and the sugar support programs were held up as an example of how

wasteful government subsidies are. However, sugar producers spent some $20 million on

political lobbying between 2011 and 2013. Partly due to their influence, the U.S. Senate

voted 54 to 45 against any reform in the sugar programs. The majority included 20 out

of 45 Republican senators, most of who publicly rail against this kind of government

intervention. Apparently however, political expediency required that they support

intervention in this case. • Sources: G. F. Will, “Congress Needs to Stop Subsidies to Sugar Farmers,” Washington Post, June 7, 2013; R. Nixon, “American Candy Makers, Pinched by Inflated Sugar Prices, Look Abroad,” New York Times, October 30, 2013; and J. B. A. Elobeid, “The Impact of the U.S. Sugar Program Redux,” Iowa State Working Paper 13-WP 538, May 2013, www.card.iastate.edu/publications/dbs/pdffiles/13wp538.pdf.

Introduction The review of the classical trade theories of Smith, Ricardo, and Heckscher-Ohlin in Chapter 6 showed that in a world without trade barriers, trade patterns are determined by the relative productivity of different factors of production in different countries. Coun- tries will specialize in products that they can make most efficiently, while importing prod- ucts that they can produce less efficiently. Chapter 6 also laid out the intellectual case for free trade. Remember, free trade refers to a situation in which a government does not attempt to restrict what its citizens can buy from or sell to another country. As we saw in Chapter 6, the theories of Smith, Ricardo, and Heckscher-Ohlin predict that the conse- quences of free trade include both static economic gains (because free trade supports a higher level of domestic consumption and more efficient utilization of resources) and dynamic economic gains (because free trade stimulates economic growth and the creation of wealth).

This chapter looks at the political reality of international trade. Although many na- tions are nominally committed to free trade, they tend to intervene in international trade to protect the interests of politically important groups or promote the interests of key domestic producers. The opening case illustrates one such situation. Even though suc- cessive U.S. administrations have often promoted free trade policies, the government still has a long history of intervening in markets to protect some domestic producers. U.S. sugar producers are a case in point. There is little doubt that policies put in place in the 1930s to support the U.S. sugar industry are now out of date. They lead to higher sugar prices in the United States, effectively imposing a tax on U.S. consumers, while creating an incentive for U.S. candy manufacturers to move production offshore where sugar prices are lower, which leads to job losses in the United States. However, due to effective political lobbying by sugar producers, the policies seem likely to continue in place for some time to come.

This chapter explores the political and economic reasons that governments have for intervening in international trade. When governments intervene, they often do so by re- stricting imports of goods and services into their nation, while adopting policies that pro- mote domestic production and exports. Normally, their motives are to protect domestic producers. In recent years, social issues have intruded into the decision-making calculus. In the United States, for example, a movement is growing to ban imports of goods from coun- tries that do not abide by the same labor, health, and environmental regulations as the United States.

This chapter starts by describing the range of policy instruments that governments use to intervene in international trade. A detailed review of governments’ various political and

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

Chapter Seven Government Policy and International Trade 197

economic motives for intervention follows. In the third section of this chapter, we consider how the case for free trade stands up in view of the various justifications given for govern- ment intervention in international trade. Then we look at the emergence of the modern international trading system, which is based on the General Agreement on Tariffs and Trade (GATT) and its successor, the WTO. The GATT and WTO are the creations of a series of multinational treaties. The final section of this chapter discusses the implications of this material for management practice.

Instruments of Trade Policy Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary export restraints, local content requirements, administrative policies, and antidumping duties. Tar- iffs are the oldest and simplest instrument of trade policy. As we shall see later in this chap- ter, they are also the instrument that the GATT and WTO have been most successful in limiting. A fall in tariff barriers in recent decades has been accompanied by a rise in nontar- iff barriers, such as subsidies, quotas, voluntary export restraints, and antidumping duties.

TARIFFS A tariff is a tax levied on imports (or exports). Tariffs fall into two categories. Specific tariffs are levied as a fixed charge for each unit of a good imported (e.g., $3 per barrel of oil). Ad valorem tariffs are levied as a proportion of the value of the imported good. In most cases, tariffs are placed on imports to protect domestic producers from for- eign competition by raising the price of imported goods. However, tariffs also produce rev- enue for the government. Until the income tax was introduced, for example, the U.S. government received most of its revenues from tariffs.

The important thing to understand about an import tariff is who suffers and who gains. The government gains, because the tariff increases government revenues. Domestic produc- ers gain, because the tariff affords them some protection against foreign competitors by in- creasing the cost of imported foreign goods. Consumers lose because they must pay more for certain imports. For example, in 2002 the U.S. government placed an ad valorem tariff of 8 to 30 percent on imports of foreign steel. The idea was to protect domestic steel pro- ducers from cheap imports of foreign steel. The effect, however, was to raise the price of steel products in the United States between 30 and 50 percent. A number of U.S. steel con- sumers, ranging from appliance makers to automobile companies, objected that the steel tariffs would raise their costs of production and make it more difficult for them to compete in the global marketplace. Whether the gains to the govern- ment and domestic producers exceed the loss to consumers depends on various factors, such as the amount of the tariff, the importance of the imported good to domestic consum- ers, the number of jobs saved in the protected industry, and so on. In the steel case, many argued that the losses to steel consumers apparently outweighed the gains to steel produc- ers. In November 2003, the World Trade Organization de- clared that the tariffs represented a violation of the WTO treaty, and the United States removed them in December of that year.

In general, two conclusions can be derived from eco- nomic analysis of the effect of import tariffs.1 First, tariffs are generally pro-producer and anticonsumer. While they protect producers from foreign competitors, this restric- tion of supply also raises domestic prices. For example, a study by Japanese economists calculated that tariffs on im- ports of foodstuffs, cosmetics, and chemicals into Japan cost the average Japanese consumer about $890 per year in the form of higher prices. Almost all studies find that im- port tariffs impose significant costs on domestic consumers in the form of higher prices. Second, import tariffs reduce

General Agreement on Tariffs and Trade (GATT) International treaty that committed signatories to lowering barriers to the free flow of goods across national borders and led to the WTO.

LO 7-1 Identify the policy instruments used by governments to influence international trade flows.

Tariff A tax levied on imports.

Specific Tariff Tariff levied as a fixed charge for each unit of good imported.

Ad Valorem Tariff A tariff levied as a proportion of the value of an imported good.

Which Country Is Really the Most Globally Competitive? The World Economic Forum is an independent international organization committed to improving the state of the world by engaging business, political, academic, and other leaders of society to shape global, regional, and industry agendas. The World Economic Forum also conducts global economic research and annually publishes country competitive rankings. Over the years, northern and western European countries have dominated the top 10 most globally competitive nations. The United States and Japan typically also hold strong positions. But is it really fair that the “global competitiveness” ranking indicates that rela- tively small Nordic countries such as Finland and Sweden are viewed as being as competitive as the United States and Japan? Should larger countries, with more people and a larger economy, be given preferential treatment in ranking such as when the topic is on “global competitiveness”?

Source: www.weforum.org.

198 Part Three The Global Trade and Investment Environment

the overall efficiency of the world economy. They reduce efficiency because a protective tariff encourages domestic firms to produce products at home that, in theory, could be produced more efficiently abroad. The consequence is an inefficient utilization of resources.

Sometimes tariffs are levied on exports of a product from a country. Export tariffs are less common than import tariffs. In general, export tariffs have two objectives: first, to raise revenue for the government, and second, to reduce exports from a sector, often for political reasons. For example, in 2004 China imposed a tariff on textile exports. The primary objective was to moderate the growth in exports of textiles from China, thereby alleviating tensions with other trading partners.

SUBSIDIES A subsidy is a government payment to a domestic producer. Subsidies take many forms, including cash grants, low-interest loans, tax breaks, and government eq- uity participation in domestic firms. By lowering production costs, subsidies help domestic producers in two ways: (1) competing against foreign imports and (2) gaining export mar- kets. Agriculture tends to be one of the largest beneficiaries of subsidies in most countries. The European Union has been paying out about €44 billion annually ($55 billion) in farm subsidies. The farm bill that passed the U.S. Congress in 2007 contained subsidies of $289 billion for the next 10 years. The Japanese also have a long history of supporting inef- ficient domestic producers with farm subsidies. According to the World Trade Organization, in mid-2000 countries spent some $300 billion on subsidies, $250 billion of which was spent by 21 developed nations.2 In response to a severe sales slump following the global financial crisis, between mid-2008 and mid-2009, some developed nations gave $45 billion in subsi- dies to their automobile makers. While the purpose of the subsidies was to help them sur- vive a very difficult economic climate, one of the consequences was to give subsidized companies an unfair competitive advantage in the global auto industry. Somewhat ironically given the government bailouts of U.S. auto companies during the global financial crisis, in 2012 the Obama administration filed a complaint with the WTO arguing that the Chinese were illegally subsidizing exports of autos and auto parts. Details are given in the Country Focus feature.

Subsidy Government financial assistance to a domestic producer.

Are the Chinese Illegally Subsidizing Auto Exports?

In late 2012, during the presidential election campaign, the Obama ad- ministration filed a complaint against China with the World Trade Orga- nization. The complaint claims that China is providing export subsidies to its auto and auto parts industries. The subsidies include cash grants for exporting, grants for R&D, subsidies to pay interest on loans, and preferential tax treatment.

The United States estimates the value of the subsidies to be at least $1 billion between 2009 and 2011. The complaint also points out that in the years 2002 through 2011, the value of China’s exports of autos and auto parts increased more than ninefold from $7.4 billion to $69.1 billion. The United States was China’s largest market for exports of auto parts during this period. The United States is asserting that, to some degree, this growth may have been helped by subsidies. The complaint goes on to claim that these subsidies have hurt producers of automobiles and auto parts in the United States. This is a large industry in the United States, employing over 800,000 people and generating some $350 billion in sales.

While some in the labor movement applauded the move, the re- sponse from U.S. auto companies and auto parts producers was muted. One reason for this is that many U.S. producers do business in China and, in all probability, want to avoid retaliation from the Chinese gov- ernment. GM, for example, has a joint venture and two wholly owned subsidiaries in China and is doing very well there. In addition, some U.S. producers benefit by purchasing cheap Chinese auto parts, so any retaliatory tariffs imposed on those imports might actually raise their costs.

More cynical observers saw the move as nothing more than politi- cal theater. The week before the complaint was filed, the Republican presidential candidate, Mitt Romney, had accused the Obama admin- istration of “failing American workers” by not labeling China a cur- rency manipulator. So perhaps the complaint was in part simply another move on the presidential campaign chessboard. In any event, the WTO does not move and at the time of writing no ruling has yet been issued.

Sources: James Healey, “U.S. Alleges Unfair China Auto Subsidies in WTO Action,” USA Today, September 17, 2012; and M. A. Memoli, “Obama to Tell WTO That China Illegally Subsidizes Auto Imports,” Los Angeles Times, September 17, 2012.

country FOCUS

Chapter Seven Government Policy and International Trade 199

The main gains from subsidies accrue to domestic producers, whose international com- petitiveness is increased as a result. Advocates of strategic trade policy (which, as you will recall from Chapter 6, is an outgrowth of the new trade theory) favor subsidies to help do- mestic firms achieve a dominant position in those industries in which economies of scale are important and the world market is not large enough to profitably support more than a few firms (aerospace and semiconductors are two such industries). According to this argument, subsidies can help a firm achieve a first-mover advantage in an emerging industry (just as U.S. government subsidies, in the form of substantial R&D grants, allegedly helped Boeing). If this is achieved, further gains to the domestic economy arise from the employment and tax revenues that a major global company can generate. However, government subsidies must be paid for, typically by taxing individuals and corporations.

Whether subsidies generate national benefits that exceed their national costs is debatable. In practice, many subsidies are not that successful at increasing the international competitive- ness of domestic producers. Rather, they tend to protect the inefficient and promote excess production. One study estimated that if advanced countries abandoned subsidies to farmers, global trade in agricultural products would be 50 percent higher and the world as a whole would be better off by $160 billion.3 Another study estimated that removing all barriers to trade in agriculture (both subsidies and tariffs) would raise world income by $182 billion.4 This increase in wealth arises from the more efficient use of agricultural land.

IMPORT QUOTAS AND VOLUNTARY EXPORT RESTRAINTS An import quota is a direct restriction on the quantity of some good that may be imported into a country. The restriction is usually enforced by issuing import licenses to a group of indi- viduals or firms. For example, the United States has a quota on cheese imports. The only firms allowed to import cheese are certain trading companies, each of which is allocated the right to import a maximum number of pounds of cheese each year. In some cases, the right to sell is given directly to the governments of exporting countries. Historically, this was the case for textile imports in the United States. However, the international agreement govern- ing the imposition of import quotas on textiles, the Multi-fiber Agreement, expired on Janu- ary 1, 2005.

A common hybrid of a quota and a tariff is known as a tariff rate quota. Under a tariff rate quota, a lower tariff rate is applied to imports within the quota than those over the quota. For example, as illustrated in Figure 7.1, an ad valorem tariff rate of 10 percent might be levied on 1 million tons of rice imports into South Korea, after which an out-of-quota

Import Quota A direct restriction on the quantity of a good that can be imported into a country.

Tariff Rate Quota Lower tariff rates applied to imports within the quota than those over the quota.

7.1 FIGURE Hypothetical Tariff Rate Quota

80%

10%

Tariff Rate % Quota Limit

In quota

Out of quota

2 million1 million Tons of Rice Imported0

200 Part Three The Global Trade and Investment Environment

rate of 80 percent might be applied. Thus, South Korea might import 2 million tons of rice, 1 million at a 10 percent tariff rate and another 1 million at an 80 percent tariff. Tariff rate quotas are common in agriculture, where their goal is to limit imports over quota.

A variant on the import quota is the voluntary export restraint. A voluntary export restraint (VER) is a quota on trade imposed by the exporting country, typically at the re- quest of the importing country’s government. One of the most famous historical examples is the limitation on auto exports to the United States enforced by Japanese automobile pro- ducers in 1981. A response to direct pressure from the U.S. government, this VER limited Japanese imports to no more than 1.68 million vehicles per year. The agreement was revised in 1984 to allow 1.85 million Japanese vehicles per year. The agreement was allowed to lapse in 1985, but the Japanese government indicated its intentions at that time to continue to restrict exports to the United States to 1.85 million vehicles per year.5 In 2012, Brazil im- posed what amounts to voluntary export restraints on shipments of vehicles from Mexico to Brazil. The two countries have a decade-old free trade agreement, but a surge in vehicles heading to Brazil from Mexico prompted Brazil to raise its protectionist walls. Mexico has agreed to quotas on Brazil-bound vehicle exports for the next three years.6 Foreign produc- ers agree to VERs because they fear more damaging punitive tariffs or import quotas might follow if they do not. Agreeing to a VER is seen as a way to make the best of a bad situation by appeasing protectionist pressures in a country.

As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting import competition. As with all restrictions on trade, quotas do not benefit con- sumers. An import quota or VER always raises the domestic price of an imported good. When imports are limited to a low percentage of the market by a quota or VER, the price is bid up for that limited foreign supply. The automobile industry VER mentioned earlier in- creased the price of the limited supply of Japanese imports. According to a study by the U.S. Federal Trade Commission, the automobile VER cost U.S. consumers about $1 billion per year between 1981 and 1985. That $1 billion per year went to Japanese producers in the form of higher prices.7 The extra profit that producers make when supply is artificially lim- ited by an import quota is referred to as a quota rent.

If a domestic industry lacks the capacity to meet demand, an import quota can raise prices for both the domestically produced and the imported good. This happened in the U.S. sugar

industry, in which a tariff rate quota system has long lim- ited the amount foreign producers can sell in the U.S. market. According to one study, import quotas have caused the price of sugar in the United States to be as much as 40 percent greater than the world price.8 These higher prices have translated into greater profits for U.S. sugar producers, which have lobbied politicians to keep the lucrative agreement. They argue U.S. jobs in the sugar industry will be lost to foreign producers if the quota system is scrapped.

LOCAL CONTENT REQUIREMENTS A local content requirement is a requirement that some specific fraction of a good be produced domestically. The requirement can be expressed either in physical terms (e.g., 75 percent of component parts for this product must be produced locally) or in value terms (e.g., 75 per- cent of the value of this product must be produced lo- cally). Local content regulations have been widely used by developing countries to shift their manufacturing base from the simple assembly of products whose parts are manufactured elsewhere into the local manufacture of component parts. They have also been used in developed countries to try to protect local jobs and industry from foreign competition. For example, a little-known law in

Voluntary Export Restraint (VER) A quota on trade imposed from the exporting country’s side, instead of the importer’s; usually imposed at the request of the importing country’s government.

Quota Rent Extra profit producers make when supply is artificially limited by an import quota.

Local Content Requirement A requirement that some specific fraction of a good be produced domestically.

Is Having a Local Content Requirement a Good Idea? Local content requirements refer to a specific fraction of a prod- uct that needs to be manufactured domestically. Basically, LCRs establish a minimum level of local content required under trade law when giving foreign companies the right to manufacture in a particular place. In the wake of the economic downturn in 2008, many economists feared that some governments would institute protectionist policies similar to the tariff escalations during the Great Depression of the 1930s. However, most public policy officials avoided traditional forms of protection (e.g., tariffs, quo- tas). This led some observers to underestimate the degree of protectionism. Instead, what had happened was that so-called nontariff barriers in the form of local content requirements (LCR) had become increasingly popular. As a (1) citizen of a specific country and (2) as a global customer, do you think local content requirements help you as a citizen of a country, as a global cus- tomer, as both, or as neither?

Source: G. C. Hufbauer and J. J. Scott, Local Content Requirements: A Global Problem Washington, DC; Peterson Institute for Global Economics, 2013.

Chapter Seven Government Policy and International Trade 201

the United States, the Buy America Act, specifies that government agencies must give pref- erence to American products when putting contracts for equipment out to bid unless the foreign products have a significant price advantage. The law specifies a product as “Ameri- can” if 51 percent of the materials by value are produced domestically. This amounts to a local content requirement. If a foreign company, or an American one for that matter, wishes to win a contract from a U.S. government agency to provide some equipment, it must en- sure that at least 51 percent of the product by value is manufactured in the United States.

Local content regulations provide protection for a domestic producer of parts in the same way an import quota does: by limiting foreign competition. The aggregate economic effects are also the same; domestic producers benefit, but the restrictions on imports raise the prices of imported components. In turn, higher prices for imported components are passed on to consumers of the final product in the form of higher final prices. So as with all trade policies, local content regulations tend to benefit producers and not consumers.

ADMINISTRATIVE POLICIES In addition to the formal instruments of trade policy, governments of all types sometimes use informal or administrative policies to restrict imports and boost exports. Administrative trade policies are bureaucratic rules designed to make it difficult for imports to enter a country. It has been argued that the Japanese are the masters of this trade barrier. In recent decades, Japan’s formal tariff and nontariff barri- ers have been among the lowest in the world. However, critics charge that the country’s in- formal administrative barriers to imports more than compensate for this. For example, at one point the Netherlands exported tulip bulbs to almost every country in the world except Japan. In Japan, customs inspectors insisted on checking every tulip bulb by cutting it verti- cally down the middle, and even Japanese ingenuity could not put any back together. Fed- eral Express also initially had a tough time expanding its global express shipping services into Japan because Japanese customs inspectors insist on opening a large proportion of ex- press packages to check for pornography, a process that delayed an “express” package for days. As with all instruments of trade policy, administrative instruments benefit producers and hurt consumers, who are denied access to possibly superior foreign products.

ANTIDUMPING POLICIES In the context of international trade, dumping is variously defined as selling goods in a foreign market at below their costs of production or as selling goods in a foreign market at below their “fair” market value. There is a difference between these two definitions; the fair market value of a good is normally judged to be greater than the costs of producing that good because the former includes a “fair” profit margin. Dumping is viewed as a method by which firms unload excess production in foreign markets. Some dumping may be the result of predatory behavior, with producers using sub- stantial profits from their home markets to subsidize prices in a foreign market with a view to driving indigenous competitors out of that market. Once this has been achieved, so the argument goes, the predatory firm can raise prices and earn substantial profits.

An alleged example of dumping occurred in 1997, when two South Korean manufacturers of semiconductors, LG Semicon and Hyundai Electronics, were accused of selling dynamic random access memory (DRAM) chips in the U.S. market at below their costs of production. This action occurred in the middle of a worldwide glut of chip-making capacity. It was alleged that the firms were trying to unload their excess production in the United States.

Antidumping policies are designed to punish foreign firms that engage in dumping. The ultimate objective is to protect domestic producers from unfair foreign competition. Although antidumping policies vary from country to country, the majority are similar to those used in the United States. If a domestic producer believes that a foreign firm is dump- ing production in the U.S. market, it can file a petition with two government agencies, the Commerce Department and the International Trade Commission (ITC). In the Korean DRAM case, Micron Technology, a U.S. manufacturer of DRAM chips, filed the petition. The government agencies then investigate the complaint. If a complaint has merit, the Commerce Department may impose an antidumping duty on the offending foreign imports (antidumping duties are often called countervailing duties). These duties, which represent a special tariff, can be fairly substantial and stay in place for up to five years. For example,

Administrative Trade Policies Administrative policies, typically adopted by government bureaucracies, that can be used to restrict imports or boost exports.

Dumping Selling goods in a foreign market for less than their cost of production or below their “fair” market value.

Antidumping Policies Designed to punish foreign firms that engage in dumping and thus protect domestic producers from unfair foreign competition.

Countervailing Duties Antidumping duties.

202 Part Three The Global Trade and Investment Environment

after reviewing Micron’s complaint, the Commerce Department imposed 9 percent and 4 percent countervailing duties on LG Semicon and Hyundai DRAM chips, respectively. The accompanying Management Focus discusses another example of how a firm, U.S. Magne- sium, used antidumping legislation to gain protection from unfair foreign competitors.

The Case for Government Intervention Now that we have reviewed the various instruments of trade policy that governments can use, it is time to look at the case for government intervention in international trade. Argu- ments for government intervention take two paths: political and economic. Political argu- ments for intervention are concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consumers), or with achieving some political objective that lies outside the sphere of economic relation- ships, such as protecting the environment or human rights. Economic arguments for inter- vention are typically concerned with boosting the overall wealth of a nation (to the benefit of all, both producers and consumers).

LO 7-2 Understand why governments sometimes intervene in international trade.

Protecting U.S. Magnesium

In February 2004, U.S. Magnesium, the sole surviving U.S. producer of magnesium, a metal that is primarily used in the manufacture of cer- tain automobile parts and aluminum cans, filed a petition with the U.S. International Trade Commission contending that a surge in imports had caused material damage to the U.S. industry’s employment, sales, market share, and profitability. According to U.S. Magnesium, Russian and Chinese producers had been selling the metal at prices signifi- cantly below market value. During 2002 and 2003, imports of magne- sium into the United States rose 70 percent, while prices fell by 40 percent, and the market share accounted for by imports jumped to 50 percent from 25 percent.

“The United States used to be the largest producer of magnesium in the world,” a U.S. Magnesium spokesperson said at the time of the filing. “What’s really sad is that you can be state of the art and have modern technology, and if the Chinese, who pay people less than 90 cents an hour, want to run you out of business, they can do it. And that’s why we are seeking relief.”

During a yearlong investigation, the ITC solicited input from various sides in the dispute. Foreign producers and consumers of magnesium in the United States argued that falling prices for magnesium during 2002 and 2003 simply reflected an imbalance between supply and de- mand due to additional capacity coming on stream not from Russia or China but from a new Canadian plant that opened in 2001 and from a planned Australian plant. The Canadian plant shut down in 2003, the Australian plant never came on stream, and prices for magnesium rose again in 2004.

Magnesium consumers in the United States also argued to the ITC that imposing antidumping duties on foreign imports of magnesium would raise prices in the United States significantly above world lev- els. A spokesperson for Alcoa, which mixes magnesium with alumi- num to make alloys for cans, predicted that if antidumping duties were imposed, high magnesium prices in the United States would

force Alcoa to move some production out of the United States. Alcoa also noted that in 2003, U.S. Magnesium was unable to supply all of Alcoa’s needs, forcing the company to turn to imports. Consumers of magnesium in the automobile industry asserted that high prices in the United States would drive engineers to design magnesium out of automobiles, or force manufacturing elsewhere, which would ulti- mately hurt everyone.

The six members of the ITC were not convinced by these argu- ments. In March 2005, the ITC ruled that both China and Russia had been dumping magnesium in the United States. The government de- cided to impose duties ranging from 50 percent to more than 140 per- cent on imports of magnesium from China. Russian producers faced duties ranging from 19 percent to 22 percent. The duties were to be levied for five years, after which the ITC would revisit the situation. The ITC revoked the antidumping order on Russia in February 2011 but decided to continue placing them on Chinese producers, and as of 2014 they are still in place.

According to U.S. Magnesium, the favorable ruling would allow the company to reap the benefits of nearly $50 million in investments made in its manufacturing plant and enable the company to boost its capacity by 28 percent by the end of 2005. Commenting on the favor- able ruling, a U.S. Magnesium spokesperson noted, “Once unfair trade is removed from the marketplace we’ll be able to compete with any- one.” U.S. Magnesium’s customers and competitors, however, did not view the situation as one of unfair trade. While the imposition of anti- dumping duties no doubt will help to protect U.S. Magnesium and the 400 people it employs from foreign competition, magnesium consum- ers in the United States are left wondering if they will be the ultimate losers.

Sources: D. Anderton, “U.S. Magnesium Lands Ruling on Unfair Imports,” Desert News, October 1, 2004, p. D10; “U.S. Magnesium and Its Largest Consumers Debate before U.S. ITC,” Platt’s Metals Week, February 28, 2005, p. 2; and S. Oberbeck, “U.S. Magnesium Plans Big Utah Production Expansion,” Salt Lake Tribune, March 30, 2005; “US to keep anti-dumping duty on China pure magnesium,” Chinadaily.com, September 13th, 2012.

management FOCUS

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Chapter Seven Government Policy and International Trade 203

POLITICAL ARGUMENTS FOR INTERVENTION Political arguments for government intervention cover a range of issues, including preserving jobs, protecting industries deemed important for national security, retaliating against unfair foreign compe- tition, protecting consumers from “dangerous” products, furthering the goals of foreign policy, and advancing the human rights of individuals in exporting countries.

Protecting Jobs and Industries Perhaps the most common political argument for government intervention is that it is necessary for protecting jobs and industries from unfair foreign competition. The tariffs placed on imports of foreign steel by President George W. Bush in 2002 were designed to do this (many steel producers were located in states that Bush needed to win reelection in 2004). A political motive also underlay establishment of the Common Agricultural Policy (CAP) by the European Union. The CAP was designed to protect the jobs of Europe’s politically powerful farmers by restricting imports and guaran- teeing prices. However, the higher prices that resulted from the CAP have cost Europe’s consumers dearly. This is true of many attempts to protect jobs and industries through gov- ernment intervention. For example, the imposition of steel tariffs in 2002 raised steel prices for American consumers, such as automobile companies, making them less competitive in the global marketplace.

National Security Countries sometimes argue that it is necessary to protect certain industries because they are important for national security. Defense-related industries often get this kind of attention (e.g., aerospace, advanced electronics, and semiconductors). Although not as common as it used to be, this argument is still made. Those in favor of protecting the U.S. semiconductor industry from foreign competition, for example, argue that semiconduc- tors are now such important components of defense products that it would be dangerous to rely primarily on foreign producers for them. In 1986, this argument helped persuade the federal government to support Sematech, a consortium of 14 U.S. semiconductor companies that accounted for 90 percent of the U.S. industry’s revenues. Sematech’s mission was to con- duct joint research into manufacturing techniques that could be parceled out to members. The government saw the venture as so critical that Sematech was specially protected from antitrust laws. Initially, the U.S. government provided Sematech with $100 million per year in subsidies. By the mid-1990s, however, the U.S. semiconductor industry had regained its leading market position, largely through the personal computer boom and demand for microprocessor chips made by Intel. In 1994, the consortium’s board voted to seek an end to federal funding, and since 1996 the consortium has been funded entirely by private money.9

Retaliation Some argue that governments should use the threat to intervene in trade policy as a bargaining tool to help open foreign markets and force trading partners to “play by the rules of the game.” The U.S. government has used the threat of punitive trade sanctions to

Trade Law

Government policy and international trade is the core focus of Chap- ter 7. This topic area has far-ranging implications, such as trade policy, free trade, and the world’s international trading system. Basically, we are talking about a lot of legalistic aspects starting at the government level and moving all the way to what organizations and even individu- als can and cannot do globally when trading. The globalEDGE section on “Trade Law” (globaledge.msu.edu/global-resources/trade-law) is a unique compilation of globalEDGE partner-designed “compendiums of trade laws,” country and region-specific trade law, free online learning

modules created for globalEDGE on various aspects of trade law, and much more. One fascinating resource related to trade law is the “A-CAPPP” program (Anti-Counterfeiting and Product Protection Program). A-CAPPP includes counterfeiting-related webinars, presen- tations, and research-related materials and working papers. Do you know what counterfeiting is? Take a look at the Trade Law section of globalEDGE and, especially, the A-CAPPP site to become more familiar with the topic. (Is China really as bad as many think in the international community?)

204 Part Three The Global Trade and Investment Environment

try to get the Chinese government to enforce its intellectual property laws. Lax enforcement of these laws had given rise to massive copyright infringements in China that had been costing U.S. companies such as Microsoft hundreds of millions of dollars per year in lost sales reve- nues. After the United States threatened to impose 100 percent tariffs on a range of Chinese imports, and after harsh words between officials from the two countries, the Chinese agreed to tighter enforcement of intellectual property regulations.10

If it works, such a politically motivated rationale for government intervention may liber- alize trade and bring with it resulting economic gains. It is a risky strategy, however. A coun- try that is being pressured may not back down and instead may respond to the imposition of punitive tariffs by raising trade barriers of its own. This is exactly what the Chinese govern- ment threatened to do when pressured by the United States, although it ultimately did back down. If a government does not back down, the results could be higher trade barriers all around and an economic loss to all involved.

Protecting Consumers Many governments have long had regulations to protect con- sumers from unsafe products. The indirect effect of such regulations often is to limit or ban the importation of such products. For example, in 2003 several countries, including Japan and South Korea, decided to ban imports of American beef after a single case of mad cow disease was found in Washington State. The ban was motivated to protect consumers from what was

Trade in Hormone-Treated Beef

In the 1970s, scientists discovered how to synthesize certain hormones and use them to accelerate the growth rate of livestock animals, re- duce the fat content of meat, and increase milk production. Bovine so- matotropin (BST), a growth hormone produced by cattle, was first synthesized by the biotechnology firm Genentech. Injections of BST could be used to supplement an animal’s own hormone production and increase its growth rate. These hormones became popular among farmers, who found they could cut costs and help satisfy consumer demands for leaner meat. Although these hormones occurred naturally in animals, consumer groups in several countries soon raised concerns about the practice. They argued that the use of hormone supplements was unnatural and that the health consequences of consuming hor- mone-treated meat were unknown but might include hormonal irregu- larities and cancer.

The European Union responded to these concerns in 1989 by ban- ning the importation of hormone-treated meat and the use of growth- promoting hormones in the production of livestock. The ban was controversial because a reasonable consensus existed among scien- tists that the hormones posed no health risk. Although the EU banned hormone-treated meat, many other countries did not, including big meat-producing countries such as Australia, Canada, New Zealand, and the United States. The use of hormones soon became widespread in these countries. According to trade officials outside the EU, the Euro- pean ban constituted an unfair restraint on trade. As a result of this ban, exports of meat to the EU fell. For example, U.S. red meat exports to the EU declined from $231 million in 1988 to $98 million in 1994. The complaints of meat exporters were bolstered in 1995 when Codex Alimentarius, the international food standards body of the UN’s Food and Agriculture Organization and the World Health Organization, ap- proved the use of growth hormones. In making this decision, Codex reviewed the scientific literature and found no evidence of a link

between the consumption of hormone-treated meat and human health problems, such as cancer.

Fortified by such decisions, in 1995 the United States pressed the EU to drop the import ban on hormone-treated beef. The EU refused, citing “consumer concerns about food safety.” In response, Canada and the United States filed formal complaints with the World Trade Or- ganization. They were soon joined by a number of other countries, in- cluding Australia and New Zealand. The WTO created a trade panel of three independent experts. After reviewing evidence and hearing from a range of experts and representatives of both parties, the panel in May 1997 ruled that the EU ban on hormone-treated beef was illegal be- cause it had no scientific justification.

This ruling left the EU in a difficult position. Legally, the EU had to lift the ban or face punitive sanctions, but the ban had wide public support in Europe. The EU feared that lifting the ban could produce a consumer backlash. Instead the EU did nothing. In February 1999 the United States asked the WTO for permission to impose punitive sanctions on the EU. The WTO responded by allowing the United States to impose punitive tariffs valued at $125 million on EU exports to the United States. The EU decided to accept these tariffs rather than lift the ban on hormone-treated beef. In 2012, the EU struck a deal with the United States that allowed it to keep the ban in place, in return for increasing its import quota of high-quality non-hormone-treated beef from the United States. In response, the U.S. lifted its punitive tariffs on EU food exports, thereby ending one of the longest running trade disputes in history.

Sources: C. Southey, “Hormones Fuel a Meaty EU Row,” Financial Times, September 7, 1995, p. 2; E. L. Andrews, “In Victory for U.S., European Ban on Treated Beef Is Ruled Illegal,” The New York Times, May 9, 1997, p. A1; R. Baily, “Food and Trade: EU Fear Mongers’ Lethal Harvest,” Los Angeles Times, August 18, 2002, p. M3; Scott Miller, “EU Trade Sanctions Have Dual Edge,” The Wall Street Journal, February 26, 2004, p. A3; and G. Reilhac, “Lawmakers Approve Rise in Imports of Hormone Free Beef,” Reuters, March 14, 2012.

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seen to be an unsafe product. Together, Japan and South Korea accounted for about $2 billion of U.S. beef sales, so the ban had a significant impact on U.S. beef producers. After two years, both countries lifted the ban, although they placed stringent requirements on U.S. beef im- ports to reduce the risk of importing beef that might be tainted by mad cow disease (e.g., Japan required that all beef must come from cattle under 21 months of age). The accompanying Country Focus describes how the European Union banned the sale and importation of hor- mone-treated beef. The ban was motivated by a desire to protect European consumers from the possible health consequences of eating meat from animals treated with growth hormones.

Furthering Foreign Policy Objectives Governments sometimes use trade pol- icy to support their foreign policy objectives.11 A government may grant preferential trade terms to a country with which it wants to build strong relations. Trade policy has also been used several times to pressure or punish “rogue states” that do not abide by international law or norms. Iraq labored under extensive trade sanctions after the UN coalition defeated the country in the 1991 Gulf War until the 2003 invasion of Iraq by U.S.-led forces. The theory is that such pressure might persuade the rogue state to mend its ways, or it might hasten a change of government. In the case of Iraq, the sanctions were seen as a way of forcing that country to comply with several UN resolutions. The United States has main- tained long-running trade sanctions against Cuba. Their principal function is to impover- ish Cuba in the hope that the resulting economic hardship will lead to the downfall of Cuba’s Communist government and its replacement with a more democratically inclined (and pro-U.S.) regime. The United States has also had trade sanctions in place against Libya and Iran, both of which were accused of supporting terrorist action against U.S. in- terests and building weapons of mass destruction. In late 2003, the sanctions against Libya seemed to yield some returns when that country announced it would terminate a program to build nuclear weapons. The U.S. government responded by relaxing those sanctions. Similarly, the U.S. government used trade sanctions to pressure the Iranian government to halt its alleged nuclear weapons program, with limited success as of 2013.

Other countries can undermine unilateral trade sanctions. The U.S. sanctions against Cuba, for example, have not stopped other Western countries from trading with Cuba. The U.S. sanctions have done little more than help create a vacuum into which other trading na- tions, such as Canada and Germany, have stepped.

Protecting Human Rights Protecting and promoting human rights in other coun- tries is an important element of foreign policy for many democracies. Governments some- times use trade policy to try to improve the human rights policies of trading partners. For example, as discussed in Chapter 5, the U.S. government long had trade sanctions in place against the nation of Myanmar, in no small part due to the poor human rights practices in that nation. In late 2012 the U.S. said that it would ease trade sanctions against Myanmar in response to democratic reforms in that country. Similarly, in the 1980s and 1990s, Western governments used trade sanctions against South Africa as a way of pressuring that nation to drop its apartheid policies, which were seen as a violation of basic human rights.

ECONOMIC ARGUMENTS FOR INTERVENTION With the develop- ment of the new trade theory and strategic trade policy (see Chapter 6), the economic argu- ments for government intervention have undergone a renaissance in recent years. Until the early 1980s, most economists saw little benefit in government intervention and strongly advocated a free trade policy. This position has changed at the margins with the develop- ment of strategic trade policy, although as we will see in the next section, there are still strong economic arguments for sticking to a free trade stance.

The Infant Industry Argument The infant industry argument is by far the oldest economic argument for government intervention. Alexander Hamilton proposed it in 1792. According to this argument, many developing countries have a potential comparative advan- tage in manufacturing, but new manufacturing industries cannot initially compete with estab- lished industries in developed countries. To allow manufacturing to get a toehold, the

Infant Industry Argument New industries in developing countries must be temporarily protected from international competition to help them reach a position where they can compete in world markets with the firms of developed nations.

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argument is that governments should temporarily support new industries (with tariffs, import quotas, and subsidies) until they have grown strong enough to meet international competition.

This argument has had substantial appeal for the governments of developing nations during the past 50 years, and the GATT has recognized the infant industry argument as a legitimate reason for protectionism. Nevertheless, many economists remain critical of this argument for two main reasons. First, protection of manufacturing from foreign competi- tion does no good unless the protection helps make the industry efficient. In case after case, however, protection seems to have done little more than foster the development of ineffi- cient industries that have little hope of ever competing in the world market. Brazil, for ex- ample, built the world’s tenth-largest auto industry behind tariff barriers and quotas. Once those barriers were removed in the late 1980s, however, foreign imports soared, and the in- dustry was forced to face up to the fact that after 30 years of protection, the Brazilian auto industry was one of the world’s most inefficient.12

Second, the infant industry argument relies on an assumption that firms are unable to make efficient long-term investments by borrowing money from the domestic or interna- tional capital market. Consequently, governments have been required to subsidize long- term investments. Given the development of global capital markets over the past 20 years, this assumption no longer looks as valid as it once did. Today, if a developing country has a potential comparative advantage in a manufacturing industry, firms in that country should be able to borrow money from the capital markets to finance the required investments. Given financial support, firms based in countries with a potential comparative advantage have an incentive to endure the necessary initial losses in order to make long-run gains without requiring government protection. Many Taiwanese and South Korean firms did this in industries such as textiles, semiconductors, machine tools, steel, and shipping. Thus, given efficient global capital markets, the only industries that would require government protec- tion would be those that are not worthwhile.

Strategic Trade Policy Some new trade theorists have proposed the strategic trade policy argument.13 We reviewed the basic argument in Chapter 6 when we considered the new trade theory. The new trade theory argues that in industries in which the existence of

Even though the United States holds trade sanctions with Cuba, other Western countries continue to trade with the island nation.

Chapter Seven Government Policy and International Trade 207

substantial economies of scale implies that the world market will profitably support only a few firms, countries may predominate in the export of certain products simply because they have firms that were able to capture first-mover advantages. The long-term dominance of Boeing in the commercial aircraft industry has been attributed to such factors.

The strategic trade policy argument has two components. First, it is argued that by appropriate actions, a government can help raise national income if it can somehow ensure that the firm or firms that gain first-mover advantages in an industry are domestic rather than foreign enterprises. Thus, according to the strategic trade policy argument, a govern- ment should use subsidies to support promising firms that are active in newly emerging in- dustries. Advocates of this argument point out that the substantial R&D grants that the U.S. government gave Boeing in the 1950s and 1960s probably helped tilt the field of competi- tion in the newly emerging market for passenger jets in Boeing’s favor. (Boeing’s first com- mercial jet airliner, the 707, was derived from a military plane.) Similar arguments have been made with regard to Japan’s dominance in the production of liquid crystal display screens (used in computers). Although these screens were invented in the United States, the Japanese government, in cooperation with major electronics companies, targeted this industry for research support in the late 1970s and early 1980s. The result was that Japanese firms, not U.S. firms, subsequently captured first-mover advantages in this market.

The second component of the strategic trade policy argument is that it might pay a govern- ment to intervene in an industry by helping domestic firms overcome the barriers to entry cre- ated by foreign firms that have already reaped first-mover advantages. This argument underlies government support of Airbus, Boeing’s major competitor. Formed in 1966 as a consortium of four companies from Great Britain, France, Germany, and Spain, Airbus had less than 5 percent of the world commercial aircraft market when it began production in the mid-1970s. By 2012, it had increased its share to 45 percent, threatening Boeing’s long-term dominance of the mar- ket. How did Airbus achieve this? According to the U.S. government, the answer is a $15 billion subsidy from the governments of Great Britain, France, Germany, and Spain.14 Without this subsidy, Airbus would never have been able to break into the world market.

If these arguments are correct, they support a rationale for government intervention in international trade. Governments should target technologies that may be important in the future and use subsidies to support development work aimed at commercializing those tech- nologies. Furthermore, government should provide export subsidies until the domestic firms have established first-mover advantages in the world market. Government support may also be justified if it can help domestic firms overcome the first-mover advantages en- joyed by foreign competitors and emerge as viable competitors in the world market (as in the Airbus and semiconductor examples). In this case, a combination of home-market pro- tection and export-promoting subsidies may be needed.

The Revised Case for Free Trade The strategic trade policy arguments of the new trade theorists suggest an economic justifi- cation for government intervention in international trade. This justification challenges the rationale for unrestricted free trade found in the work of classic trade theorists such as Adam Smith and David Ricardo. In response to this challenge to economic orthodoxy, a number of economists—including some of those responsible for the development of the new trade theory, such as Paul Krugman—point out that although strategic trade policy looks appeal- ing in theory, in practice it may be unworkable. This response to the strategic trade policy argument constitutes the revised case for free trade.15

RETALIATION AND TRADE WAR Krugman argues that a strategic trade policy aimed at establishing domestic firms in a dominant position in a global industry is a beggar-thy-neighbor policy that boosts national income at the expense of other countries. A country that attempts to use such policies will probably provoke retaliation. In many cases, the resulting trade war between two or more interventionist governments will leave all countries involved worse off than if a hands-off approach had been adopted in the first place. If the U.S. government were to respond to the Airbus subsidy by increasing its own subsidies

Strategic Trade Policy Government policy aimed at improving the competitive position of a domestic industry and/or domestic firm in the world market.

LO 7-3 Summarize and explain the arguments against strategic trade policy.

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208 Part Three The Global Trade and Investment Environment

to Boeing, for example, the result might be that the subsidies would cancel each other out. In the process, both European and U.S. taxpayers would end up supporting an expensive and pointless trade war, and both Europe and the United States would be worse off.

Krugman may be right about the danger of a strategic trade policy leading to a trade war. The problem, however, is how to respond when one’s competitors are already being sup- ported by government subsidies; that is, how should Boeing and the United States respond to the subsidization of Airbus? According to Krugman, the answer is probably not to engage in retaliatory action but to help establish rules of the game that minimize the use of trade- distorting subsidies. This is what the World Trade Organization seeks to do.

DOMESTIC POLICIES Governments do not always act in the national interest when they intervene in the economy; politically important interest groups often influence them. The European Union’s support for the Common Agricultural Policy (CAP), which arose because of the political power of French and German farmers, is an example. The CAP benefits inefficient farmers and the politicians who rely on the farm vote, but not consumers in the EU, who end up paying more for their foodstuffs. Thus, a further reason for not embracing strategic trade policy, according to Krugman, is that such a policy is almost certain to be captured by special-interest groups within the economy, which will distort it to their own ends. Krugman concludes that in the United States,

To ask the Commerce Department to ignore special-interest politics while formulat- ing detailed policy for many industries is not realistic; to establish a blanket policy of free trade, with exceptions granted only under extreme pressure, may not be the opti- mal policy according to the theory but may be the best policy that the country is likely to get.16

Development of the World Trading System Strong economic arguments support unrestricted free trade. While many governments have recognized the value of these arguments, they have been unwilling to unilaterally lower their trade barriers for fear that other nations might not follow suit. Consider the problem that two neighboring countries, say, Brazil and Argentina, face when deciding whether to lower trade barriers between them. In principle, the government of Brazil might favor lowering trade barriers, but it might be unwilling to do so for fear that Argentina will not do the same. Instead, the government might fear that the Argentineans will take advantage of Brazil’s low barriers to enter the Brazilian market while continuing to shut Brazilian products out of their market through high trade barriers. The Argentinean government might believe that it faces

the same dilemma. The essence of the problem is a lack of trust. Both governments recognize that their respective nations will benefit from lower trade barriers between them, but neither government is willing to lower barriers for fear that the other might not follow.17

Such a deadlock can be resolved if both countries nego- tiate a set of rules to govern cross-border trade and lower trade barriers. But who is to monitor the governments to make sure they are playing by the trade rules? And who is to impose sanctions on a government that cheats? Both governments could set up an independent body to act as a referee. This referee could monitor trade between the countries, make sure that no side cheats, and impose sanc- tions on a country if it does cheat in the trade game.

While it might sound unlikely that any government would compromise its national sovereignty by submitting to such an arrangement, since World War II an interna- tional trading framework has evolved that has exactly these features. For its first 50 years, this framework was

LO 7-4 Describe the development of the world trading system and the current trade issue.

Do You Believe in Free Trade Agreements? The benefits of free trade agreements are often hard to see. At the same time, the benefits of protecting certain industries and/ or companies from foreign competition are often very visible. Given these scenarios, many people often argue that free trade agreements are bad for their country. Perhaps as a result, many governments impose many tariffs, quotas, and other nontariff barriers to trade. For example, the common perception is that by establishing trade barriers, a country keeps the jobs at home instead of jobs being shipped overseas. But is this really true?

Source: D. J. Boudreaux, “The Benefi ts of Free Trade: Addressing the Myths” Washington, DC; Mercatus Center, George Mason University, 2013.

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Chapter Seven Government Policy and International Trade 209

known as the General Agreement on Tariffs and Trade (GATT). Since 1995, it has been known as the World Trade Organization. Here, we look at the evolution and workings of the GATT and WTO.

FROM SMITH TO THE GREAT DEPRESSION As noted in Chapter 5, the theoretical case for free trade dates to the late eighteenth century and the work of Adam Smith and David Ricardo. Free trade as a government policy was first officially embraced by Great Britain in 1846, when the British Parliament repealed the Corn Laws. The Corn Laws placed a high tariff on imports of foreign corn. The objectives of the Corn Laws tariff were to raise government revenues and to protect British corn producers. There had been annual motions in Parliament in favor of free trade since the 1820s when David Ricardo was a member. However, agricultural protection was withdrawn only as a result of a protracted debate when the effects of a harvest failure in Great Britain were compounded by the imminent threat of famine in Ireland. Faced with considerable hardship and suffering among the populace, Parliament narrowly reversed its long-held position.

During the next 80 years or so, Great Britain, as one of the world’s dominant trading powers, pushed the case for trade liberalization, but the British government was a voice in the wilderness. Its major trading partners did not reciprocate the British policy of unilateral free trade. The only reason Britain kept this policy for so long was that as the world’s largest exporting nation, it had far more to lose from a trade war than did any other country.

By the 1930s, the British attempt to stimulate free trade was buried under the economic rubble of the Great Depression. Economic problems were compounded in 1930 when the U.S. Congress passed the Smoot-Hawley tariff. Aimed at avoiding rising unemployment by protecting domestic industries and diverting consumer demand away from foreign products, the Smoot-Hawley Act erected an enormous wall of tariff barriers. Almost every industry was rewarded with its “made-to-order” tariff. The Smoot-Hawley Act had a damaging effect on employment abroad. Other countries reacted by raising their own tariff barriers. U.S. exports tumbled in response, and the world slid further into the Great Depression.18

1947–1979: GATT, TRADE LIBERALIZATION, AND ECONOMIC GROWTH Economic damage caused by the beggar-thy-neighbor trade policies that the Smoot-Hawley Act ushered in exerted a profound influence on the economic institu- tions and ideology of the post–World War II world. The United States emerged from the war both victorious and economically dominant. After the debacle of the Great Depression, opinion in the U.S. Congress had swung strongly in favor of free trade. Under U.S. leader- ship, the GATT was established in 1947.

The GATT was a multilateral agreement whose objective was to liberalize trade by elim- inating tariffs, subsidies, import quotas, and the like. From its foundation in 1947 until it was superseded by the WTO, the GATT’s membership grew from 19 to more than 120 nations. The GATT did not attempt to liberalize trade restrictions in one fell swoop; that would have been impossible. Rather, tariff reduction was spread over eight rounds.

In its early years, the GATT was by most measures very successful. For example, the av- erage tariff declined by nearly 92 percent in the United States between the Geneva Round of 1947 and the Tokyo Round of 1973–1979. Consistent with the theoretical arguments first advanced by Ricardo and reviewed in Chapter 5, the move toward free trade under the GATT appeared to stimulate economic growth.

1980–1993: PROTECTIONIST TRENDS During the 1980s and early 1990s, the trading system erected by the GATT came under strain as pressures for greater protec- tionism increased around the world. There were three reasons for the rise in such pressures during the 1980s. First, the economic success of Japan during that time strained the world trading system (much as the success of China has created strains today). Japan was in ruins when the GATT was created. By the early 1980s, however, it had become the world’s sec- ond-largest economy and its largest exporter. Japan’s success in such industries as automo- biles and semiconductors might have been enough to strain the world trading system. Things were made worse by the widespread perception in the West that despite low tariff

Smoot-Hawley Act Enacted in 1930 by the U.S. Congress, this act erected a wall of tariff barriers against imports into the United States.

210 Part Three The Global Trade and Investment Environment

rates and subsidies, Japanese markets were closed to imports and foreign investment by ad- ministrative trade barriers.

Second, the world trading system was strained by the persistent trade deficit in the world’s largest economy, the United States. The consequences of the U.S. deficit included painful adjustments in industries such as automobiles, machine tools, semiconductors, steel, and textiles, where domestic producers steadily lost market share to foreign competitors. The resulting unemployment gave rise to renewed demands in the U.S. Congress for pro- tection against imports.

A third reason for the trend toward greater protectionism was that many countries found ways to get around GATT regulations. Bilateral voluntary export restraints (VERs) circum- vent GATT agreements, because neither the importing country nor the exporting country complains to the GATT bureaucracy in Geneva—and without a complaint, the GATT bureaucracy can do nothing. Exporting countries agreed to VERs to avoid more damaging punitive tariffs. One of the best-known examples is the automobile VER between Japan and the United States, under which Japanese producers promised to limit their auto imports into the United States as a way of defusing growing trade tensions. According to a World Bank study, 16 percent of the imports of industrialized countries in 1986 were subjected to nontariff trade barriers such as VERs.19

THE URUGUAY ROUND AND THE WORLD TRADE ORGANIZA- TION Against the background of rising pressures for protectionism, in 1986 GATT members embarked on their eighth round of negotiations to reduce tariffs, the Uruguay Round (so named because it occurred in Uruguay). This was the most ambitious round of negotiations yet. Until then, GATT rules had applied only to trade in manufactured goods and commodities. In the Uruguay Round, member countries sought to extend GATT rules to cover trade in services. They also sought to write rules governing the protection of intel- lectual property, to reduce agricultural subsidies, and to strengthen the GATT’s monitoring and enforcement mechanisms.

The Uruguay Round dragged on for seven years before an agreement was reached on December 15, 1993. It went into effect July 1, 1995. The Uruguay Round contained the fol- lowing provisions:

1. Tariffs on industrial goods were to be reduced by more than one-third, and tariffs were to be scrapped on more than 40 percent of manufactured goods.

2. Average tariff rates imposed by developed nations on manufactured goods were to be reduced to less than 4 percent of value, the lowest level in modern history.

3. Agricultural subsidies were to be substantially reduced. 4. GATT fair trade and market access rules were to be extended to cover a wide range of

services. 5. GATT rules also were to be extended to provide enhanced protection for patents,

copyrights, and trademarks (intellectual property). 6. Barriers on trade in textiles were to be significantly reduced over 10 years. 7. The World Trade Organization was to be created to implement the GATT agreement.

The World Trade Organization The WTO acts as an umbrella organization that encompasses the GATT along with two new sister bodies, one on services and the other on intellectual property. The WTO’s General Agreement on Trade in Services (GATS) has taken the lead to extending free trade agreements to services. The WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) is an attempt to narrow the gaps in the way intellectual property rights are protected around the world and to bring them under common international rules. WTO has taken over responsibility for arbitrating trade disputes and monitoring the trade policies of member countries. While the WTO operates on the basis of consensus as the GATT did, in the area of dispute settlement, mem- ber countries are no longer able to block adoption of arbitration reports. Arbitration panel reports on trade disputes between member countries are automatically adopted by the WTO unless there is a consensus to reject them. Countries that have been found by the

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arbitration panel to violate GATT rules may appeal to a permanent appellate body, but its verdict is binding. If offenders fail to comply with the recommendations of the arbitration panel, trading partners have the right to compensation or, in the last resort, to impose (com- mensurate) trade sanctions. Every stage of the procedure is subject to strict time limits. Thus, the WTO has something that the GATT never had—teeth.20

WTO: EXPERIENCE TO DATE By 2014, the WTO had 159 members, including China, which joined at the end of 2001, and Russia, which joined in 2012. WTO members collectively account for 98 percent of world trade. Since its formation, the WTO has remained at the forefront of efforts to promote global free trade. Its creators expressed the belief that the enforcement mechanisms granted to the WTO would make it more effective at policing global trade rules than the GATT had been. The great hope was that the WTO might emerge as an effective advocate and facilitator of future trade deals, particularly in areas such as ser- vices. The experience so far has been encouraging, although the collapse of WTO talks in Seattle in late 1999, slow progress with the next round of trade talks (the Doha Round), and a shift back toward some limited protectionism following the global financial crisis of 2008– 2009 have raised a number of questions about the future direction of the WTO.

WTO as Global Police The first two decades in the life of the WTO suggests that its policing and enforcement mechanisms are having a positive effect.21 Between 1995 and 2013, more than 400 trade disputes between member countries were brought to the WTO.22 This record compares with a total of 196 cases handled by the GATT over almost half a century. Of the cases brought to the WTO, three-fourths have been resolved by informal consulta- tions between the disputing countries. Resolving the remainder has involved more formal procedures, but these have been largely successful. In general, countries involved have adopted the WTO’s recommendations. The fact that countries are using the WTO repre- sents an important vote of confidence in the organization’s dispute resolution procedures.

Expanding Trade Agreements As explained earlier, the Uruguay Round of GATT negotiations extended global trading rules to cover trade in services. The WTO was given the role of brokering future agreements to open up global trade in services. The WTO was also encouraged to extend its reach to encompass regulations governing foreign direct investment, something the GATT had never done. Two of the first industries targeted for reform were the global telecommunication and financial services industries.

In February 1997, the WTO brokered a deal to get coun- tries to agree to open their telecommunication markets to competition, allowing foreign operators to purchase owner- ship stakes in domestic telecommunication providers and establishing a set of common rules for fair competition. Most of the world’s biggest markets—including the United States, European Union, and Japan—were fully liberalized by January 1, 1998, when the pact went into effect. All forms of basic telecommunication service are covered, including voice telephone, data, and satellite and radio communica- tions. Many telecommunication companies responded posi- tively to the deal, pointing out that it would give them a much greater ability to offer their business customers one- stop shopping—a global, seamless service for all their corpo- rate needs and a single bill.

This was followed in December 1997 with an agreement to liberalize cross-border trade in financial services. The deal covered more than 95 percent of the world’s financial services market. Under the agreement, which took effect at the beginning of March 1999, 102 countries pledged to

Should a Standard Process Be in Place for Import Licenses? Import licenses are permits granted before a product is imported. The administrative procedures for obtaining the licenses should be simple, neutral, equitable, and transparent. Where possible, they should be given automatically and quickly, and even if they are nonautomatic, they should not obstruct trade unnecessarily. Australia, Turkey, the European Union, Norway, Thailand, the United States, New Zealand, Costa Rica, Colombia, Peru, Chinese Taipei, Japan, the Republic of Korea, Switzerland, and Canada said their producers and traders reported that exports to Argentina have declined or been delayed by Argentina’s licens- ing processes and requirements, which some described as “pro- tectionist.” Should there be a standardized process and timeline for processing import licenses in member countries of the World Trade Organization?

Source: “Members Continue to Criticize Argentina’s Import Licensing,” 2012, www.wto.org/english/news_e/news12_e/impl_27apr12_e.htm.

212 Part Three The Global Trade and Investment Environment

open (to varying degrees) their banking, securities, and insurance sectors to foreign compe- tition. In common with the telecommunication deal, the accord covers not just cross-border trade but also foreign direct investment. Seventy countries agreed to dramatically lower or eradicate barriers to foreign direct investment in their financial services sector. The United States and the European Union (with minor exceptions) are fully open to inward investment by foreign banks, insurance, and securities companies. As part of the deal, many Asian coun- tries made important concessions that allow significant foreign participation in their finan- cial services sectors for the first time.

THE FUTURE OF THE WTO: UNRESOLVED ISSUES AND THE DOHA ROUND Since the successes of the 1990s, the World Trade Organization has struggled to make progress on the international trade front. Confronted by a slower grow- ing world economy after 2001, many national governments have been reluctant to agree to a fresh round of policies designed to reduce trade barriers. Political opposition to the WTO has been growing in many nations. As the public face of globalization, some politicians and nongovernmental organizations blame the WTO for a variety of ills, including high unem- ployment, environmental degradation, poor working conditions in developing nations, fall- ing real wage rates among the lower paid in developed nations, and rising income inequality. The rapid rise of China as a dominant trading nation has also played a role here. Like senti- ments regarding Japan 20 years ago, many perceive China as failing to play by the interna- tional trading rules, even as it embraces the WTO.

Against this difficult political backdrop, much remains to be done on the international trade front. Four issues at the forefront of the current agenda of the WTO are antidumping policies, the high level of protectionism in agriculture, the lack of strong protection for in- tellectual property rights in many nations, and continued high tariff rates on nonagricultural goods and services in many nations. We shall look at each in turn before discussing the latest round of talks between WTO members aimed at reducing trade barriers, the Doha Round, which began in 2001 and is still ongoing.

Antidumping Actions Antidumping actions proliferated during the 1990s. WTO rules allow countries to impose antidumping duties on foreign goods that are being sold cheaper than at home, or below their cost of production, when domestic producers can show that they are being harmed. Unfortunately, the rather vague definition of what consti- tutes “dumping” has proved to be a loophole that many countries are exploiting to pursue protectionism.

Between 1995 and 2012, WTO members had reported implementation of some 4,230 antidumping actions to the WTO. India initiated the largest number of antidumping actions, some 667; the EU initiated 451 over the same period, and the United States, 469. China accounted for 916 complaints, South Korea for 306, the United States for 244, Taiwan for 234, and Japan for 171. Antidumping actions seem to be concentrated in certain sectors of the economy, such as basic metal industries (e.g., aluminum and steel), chemicals, plastics, and machinery and electrical equipment.23 These sectors account for approximately 70 per- cent of all antidumping actions reported to the WTO. Since 1995, these four sectors have been characterized by periods of intense competition and excess productive capacity, which have led to low prices and profits (or losses) for firms in those industries. It is not unreason- able, therefore, to hypothesize that the high level of antidumping actions in these industries represents an attempt by beleaguered manufacturers to use the political process in their na- tions to seek protection from foreign competitors, which they claim are engaging in unfair competition. While some of these claims may have merit, the process can become very po- liticized as representatives of businesses and their employees lobby government officials to “protect domestic jobs from unfair foreign competition,” and government officials, mindful of the need to get votes in future elections, oblige by pushing for antidumping actions. The WTO is clearly worried by the use of antidumping policies, suggesting that it reflects per- sistent protectionist tendencies and pushing members to strengthen the regulations govern- ing the imposition of antidumping duties.

Chapter Seven Government Policy and International Trade 213

Protectionism in Agriculture Another focus of the WTO has been the high level of tariffs and subsidies in the agricultural sector of many economies. Tariff rates on agricul- tural products are generally much higher than tariff rates on manufactured products or services. For example, the average tariff rates on nonagricultural products among developed nations are around 4 percent. On agricultural products, however, the average tariff rates are 21.2 percent for Canada, 15.9 percent for the European Union, 18.6 percent for Japan, and 10.3 percent for the United States.24 The implication is that consumers in these countries are paying significantly higher prices than necessary for agricultural products imported from abroad, which leaves them with less money to spend on other goods and services.

The historically high tariff rates on agricultural products reflect a desire to protect do- mestic agriculture and traditional farming communities from foreign competition. In addi- tion to high tariffs, agricultural producers also benefit from substantial subsidies. According to estimates from the Organization for Economic Cooperation and Development (OECD), government subsidies on average account for about 17 percent of the cost of agricultural production in Canada, 21 percent in the United States, 35 percent in the European Union, and 59 percent in Japan.25 OECD countries spend more than $300 billion a year in agricul- tural subsidies.

Not surprisingly, the combination of high tariff barriers and subsidies introduces signifi- cant distortions into the production of agricultural products and international trade of those products. The net effect is to raise prices to consumers, reduce the volume of agricultural trade, and encourage the overproduction of products that are heavily subsidized (with the government typically buying the surplus). Because global trade in agriculture currently amounts to 10.5 percent of total merchandized trade, the WTO argues that removing tariff barriers and subsidies could significantly boost the overall level of trade, lower prices to consumers, and raise global economic growth by freeing consumption and investment re- sources for more productive uses. According to estimates from the International Monetary Fund, removal of tariffs and subsidies on agricultural products would raise global economic welfare by $128 billion annually.26 Others suggest gains as high as $182 billion.27

The biggest defenders of the existing system have been the advanced nations of the world, which want to protect their agricultural sectors from competition by low-cost pro- ducers in developing nations. In contrast, developing nations have been pushing hard for

Removing barriers to trade and subsidies in agricultural products should benefit consumers.

214 Part Three The Global Trade and Investment Environment

reforms that would allow their producers greater access to the protected markets of the de- veloped nations. Estimates suggest that removing all subsidies on agricultural production alone in OECD countries could return to the developing nations of the world three times more than all the foreign aid they currently receive from the OECD nations.28 In other words, free trade in agriculture could help jump-start economic growth among the world’s poorer nations and alleviate global poverty.

Protecting Intellectual Property Another issue that has become increasingly im- portant to the WTO has been protecting intellectual property. The 1995 Uruguay agree- ment that established the WTO also contained an agreement to protect intellectual property (the Trade-Related Aspects of Intellectual Property Rights, or TRIPS, agreement). The TRIPS regulations oblige WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years. Rich countries had to comply with the rules within a year. Poor countries, in which such protection was generally much weaker, had 5 years’ grace, and the very poorest had 10 years. The basis for this agreement was a strong belief among signatory nations that the protection of intellectual property through patents, trade- marks, and copyrights must be an essential element of the international trading system. In- adequate protections for intellectual property reduce the incentive for innovation. Because innovation is a central engine of economic growth and rising living standards, the argument has been that a multilateral agreement is needed to protect intellectual property.

Without such an agreement it is feared that producers in a country—let’s say, India— might market imitations of patented innovations pioneered in a different country—say, the United States. This can affect international trade in two ways. First, it reduces the export opportunities in India for the original innovator in the United States. Second, to the extent that the Indian producer is able to export its pirated imitation to additional countries, it also reduces the export opportunities in those countries for the U.S. inventor. Also, one can ar- gue that because the size of the total world market for the innovator is reduced, its incentive to pursue risky and expensive innovations is also reduced. The net effect would be less in- novation in the world economy and less economic growth.

Market Access for Nonagricultural Goods and Services Although the WTO and the GATT have made big strides in reducing the tariff rates on nonagricultural products, much work remains. Although most developed nations have brought their tariff rates on industrial products down to an average of 3.8 percent of value, exceptions still remain. In particular, while average tariffs are low, high tariff rates persist on certain imports into de- veloped nations, which limit market access and economic growth. For example, Australia and South Korea, both OECD countries, still have bound tariff rates of 15.1 percent and 24.6 percent, respectively, on imports of transportation equipment (bound tariff rates are the highest rate that can be charged, which is often, but not always, the rate that is charged). In contrast, the bound tariff rates on imports of transportation equipment into the United States, EU, and Japan are 2.7 percent, 4.8 percent, and 0 percent, respectively. A particular area for concern is high tariff rates on imports of selected goods from developing nations into developed nations.

In addition, tariffs on services remain higher than on industrial goods. The average tariff on business and financial services imported into the United States, for example, is 8.2 percent, into the EU it is 8.5 percent, and into Japan it is 19.7 percent.29 Given the rising value of cross- border trade in services, reducing these figures can be expected to yield substantial gains.

The WTO would like to bring down tariff rates still further and reduce the scope for the selective use of high tariff rates. The ultimate aim is to reduce tariff rates to zero. Although this might sound ambitious, 40 nations have already moved to zero tariffs on information technology goods, so a precedent exists. Empirical work suggests that further reductions in average tariff rates toward zero would yield substantial gains. One estimate by economists at the World Bank suggests that a broad global trade agreement coming out of the current Doha negotiations could increase world income by $263 billion annually, of which $109 bil- lion would go to poor countries.30 Another estimate from the OECD suggests a figure closer to $300 billion annually.31 See the accompanying Country Focus for estimates of the benefits to the American economy from free trade.

Chapter Seven Government Policy and International Trade 215

Looking further out, the WTO would like to bring down tariff rates on imports of non- agricultural goods into developing nations. Many of these nations use the infant industry argument to justify the continued imposition of high tariff rates; however, ultimately these rates need to come down for these nations to reap the full benefits of international trade. For example, the bound tariff rates of 53.9 percent on imports of transportation equipment into India and 33.6 percent on imports into Brazil, by raising domestic prices, help protect inefficient domestic producers and limit economic growth by reducing the real income of consumers who must pay more for transportation equipment and related services.

A New Round of Talks: Doha In 2001, the WTO launched a new round of talks between member-states aimed at further liberalizing the global trade and investment framework. For this meeting, it picked the remote location of Doha in the Persian Gulf state of Qatar. The talks were originally scheduled to last three years, although they have already gone on for 12 years and are currently stalled.

The Doha agenda includes cutting tariffs on industrial goods and services, phasing out subsidies to agricultural producers, reducing barriers to cross-border investment, and limiting the use of antidumping laws. The talks are currently ongoing. They have been characterized by halting progress punctuated by significant setbacks and missed deadlines. A September 2003 meeting in Cancún, Mexico, broke down, primarily because there was no agreement on how to proceed with reducing agricultural subsidies and tariffs; the EU, United States, and India, among others, proved less than willing to reduce tariffs and subsidies to their politically important farmers, while countries such as Brazil and certain West African nations wanted free trade as quickly as possible. In 2004, both the United States and the EU made a determined push to start the talks again. Since then, however, little progress has been made, and the talks are in deadlock, primarily because of disagreements over how deep the cuts in subsidies to agricultural producers should be. As of early 2013, the goal was to reduce tariffs for manufac- tured and agricultural goods by 60 to 70 percent and to cut subsidies to half of their current level—but getting nations to agree to these goals was proving exceedingly difficult. In re- sponse the apparent failure of the Doha Round negotiations to progress, many nations have pushed forward with bilateral free trade agreements. These include the United States and the EU, which in 2013 launched bilateral talks aimed at reducing trade barriers between them.

Estimating the Gains from Trade for America

A study published by the Institute for International Economics tried to estimate the gains to the American economy from free trade. According to the study, due to reductions in tariff barriers under the GATT and WTO since 1947, by 2003 the gross domestic product (GDP) of the United States was 7.3 percent higher than would otherwise be the case. The benefits of that amounted to roughly $1 trillion a year, or $9,000 extra income for each American household per year.

The same study tried to estimate what would happen if America concluded free trade deals with all its trading partners, reducing tariff barriers on all goods and services to zero. Using several methods to estimate the impact, the study concluded that additional annual gains of between $450 billion and $1.3 trillion could be realized. This final march to free trade, according to the authors of the study, could safely be expected to raise incomes of the average American household by an additional $4,500 per year.

The authors also tried to estimate the scale and cost of employ- ment disruption that would be caused by a move to universal free

trade. Jobs would be lost in certain sectors and gained in others if the country abolished all tariff barriers. Using historical data as a guide, they estimated that 226,000 jobs would be lost every year due to ex- panded trade, although some two-thirds of those losing jobs would find reemployment after a year. Reemployment, however, would be at a wage that was 13 to 14 percent lower. The study concluded that the disruption costs would total some $54 billion annually, primarily in the form of lower lifetime wages to those whose jobs were disrupted as a result of free trade. Offset against this, however, must be the higher economic growth resulting from free trade, which creates many new jobs and raises household incomes, creating another $450 billion to $1.3 trillion annually in net gains to the economy. In other words, the estimated annual gains from trade are far greater than the estimated annual costs associated with job disruption, and more people benefit than lose as a result of a shift to a universal free trade regime.

Sources: S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “The Payoff to America from Global Integration,” in The United States and the World Economy: Foreign Policy for the Next Decade, C. F. Bergsten, ed. (Washington, DC: Institute for International Economics, 2005).

country FOCUS

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.

FOCUS ON MANAGERIAL IMPLICATIONS

TRADE BARRIERS, POLICY ISSUES, AND FIRM STRATEGY What are the implications of all this for business practice? Why should the international manager care about the political economy of free trade or about the relative merits of argu- ments for free trade and protectionism? There are two answers to this question. The first concerns the impact of trade barriers on a firm’s strategy. The second concerns the role that business firms can play in promoting free trade or trade barriers.

TRADE BARRIERS AND FIRM STRATEGY To understand how trade barriers affect a firm’s strategy, consider first the material in Chap- ter 6. Drawing on the theories of international trade, we discussed how it makes sense for the firm to disperse its various production activities to those countries around the globe where they can be performed most efficiently. Thus, it may make sense for a firm to design and engineer its product in one country, to manufacture components in another, to perform final assembly operations in yet another country, and then export the finished product to the rest of the world.

Clearly, trade barriers constrain a firm’s ability to disperse its productive activities in such a manner. First and most obvious, tariff barriers raise the costs of exporting products to a country (or of exporting partly finished products between countries). This may put the firm at a competitive disadvantage to indigenous competitors in that country. In response, the firm may then find it economical to locate production facilities in that country so that it can compete on an even footing. Second, quotas may limit a firm’s ability to serve a country from locations outside of that country. Again, the response by the firm might be to set up production facilities in that country—even though it may result in higher production costs. Such reasoning was one of the factors behind the rapid expansion of Japanese automaking capacity in the United States during the 1980s and 1990s. This followed the establishment of a VER agreement between the United States and Japan that limited U.S. imports of Japa- nese automobiles.

Third, to conform to local content regulations, a firm may have to locate more pro- duction activities in a given market than it would otherwise. Again, from the firm’s per- spective, the consequence might be to raise costs above the level that could be achieved if each production activity was dispersed to the optimal location for that activity. And finally, even when trade barriers do not exist, the firm may still want to locate some pro- duction activities in a given country to reduce the threat of trade barriers being imposed in the future.

All these effects are likely to raise the firm’s costs above the level that could be achieved in a world without trade barriers. The higher costs that result need not translate into a sig- nificant competitive disadvantage relative to other foreign firms, however, if the countries imposing trade barriers do so to the imported products of all foreign firms, irrespective of their national origin. But when trade barriers are targeted at exports from a particular na- tion, firms based in that nation are at a competitive disadvantage to firms of other nations. The firm may deal with such targeted trade barriers by moving production into the country imposing barriers. Another strategy may be to move production to countries whose exports are not targeted by the specific trade barrier.

Finally, the threat of antidumping action limits the ability of a firm to use aggressive pricing to gain market share in a country. Firms in a country also can make strategic use of antidumping measures to limit aggressive competition from low-cost foreign produc- ers. For example, the U.S. steel industry has been very aggressive in bringing antidumping actions against foreign steelmakers, particularly in times of weak global demand for steel and excess capacity. In 1998 and 1999, the United States faced a surge in low-cost steel imports as a severe recession in Asia left producers there with excess capacity. The U.S. producers filed several complaints with the International Trade Commission. One argued

LO 7-5 Explain the implications for managers of developments in the world trading system.

216 Part Three The Global Trade and Investment Environment

Chapter Seven Government Policy and International Trade 217

that Japanese producers of hot rolled steel were selling it at below cost in the United States. The ITC agreed and levied tariffs ranging from 18 percent to 67 percent on im- ports of certain steel products from Japan (these tariffs are separate from the steel tariffs discussed earlier).32

POLICY IMPLICATIONS As noted in Chapter 6, business firms are major players on the international trade scene. Because of their pivotal role in international trade, firms can and do exert a strong influence on government policy toward trade. This influence can encourage protectionism, or it can encourage the government to support the WTO and push for open markets and freer trade among all nations. Government policies with regard to international trade can have a direct impact on business.

Consistent with strategic trade policy, examples can be found of government interven- tion in the form of tariffs, quotas, antidumping actions, and subsidies helping firms and industries establish a competitive advantage in the world economy. In general, however, the arguments contained in this chapter and in Chapter 6 suggest that government interven- tion has three drawbacks. Intervention can be self-defeating because it tends to protect the inefficient rather than help firms become efficient global competitors. Intervention is dan- gerous; it may invite retaliation and trigger a trade war. Finally, intervention is unlikely to be well executed, given the opportunity for such a policy to be captured by special-interest groups. Does this mean that business should simply encourage government to adopt a laissez-faire free trade policy?

Most economists would probably argue that the best interests of international busi- ness are served by a free trade stance, but not a laissez-faire stance. It is probably in the best long-run interests of the business community to encourage the government to aggressively promote greater free trade by, for example, strengthening the WTO. Busi- ness probably has much more to gain from government efforts to open protected markets to imports and foreign direct investment than from government efforts to support cer- tain domestic industries in a manner consistent with the recommendations of strategic trade policy.

This conclusion is reinforced by a phenomenon we touched on in Chapter 1—the in- creasing integration of the world economy and internationalization of production that has occurred over the past two decades. We live in a world where many firms of all national origins increasingly depend for their competitive advantage on globally dispersed produc- tion systems. Such systems are the result of freer trade. Freer trade has brought great ad- vantages to firms that have exploited it and to consumers who benefit from the resulting lower prices. Given the danger of retaliatory action, business firms that lobby their gov- ernments to engage in protectionism must realize that by doing so they may be denying themselves the opportunity to build a competitive advantage by constructing a globally dispersed production system. By encouraging their governments to engage in protection- ism, their own activities and sales overseas may be jeopardized if other governments re- taliate. This does not mean a firm should never seek protection in the form of antidumping actions and the like, but it should review its options carefully and think through the larger consequences.

free trade, p. 196 General Agreement on Tariffs and Trade (GATT), p. 197 tariff, p. 197 specific tariff, p. 197 ad valorem tariff, p. 197 subsidy, p. 198

import quota, p. 199 tariff rate quota, p. 199 voluntary export restraint (VER), p. 200 quota rent, p. 200 local content requirement, p. 200 administrative trade policies, p. 201

dumping, p. 201 antidumping policies, p. 201 countervailing duties, p. 201 infant industry argument, p. 205 strategic trade policy, p. 207 Smoot-Hawley Act, p. 209

Key Terms

218 Part Three The Global Trade and Investment Environment

Critical Thinking and Discussion Questions

1. Do you think governments should consider human rights when granting preferential trading rights to countries? What are the arguments for and against taking such a position?

2. Whose interests should be the paramount concern of government trade policy—the interests of producers (businesses and their employees) or those of consumers?

Summary

This chapter described how the reality of international trade deviates from the theoretical ideal of unrestricted free trade reviewed in Chapter 6. In this chapter, we re- ported the various instruments of trade policy, reviewed the political and economic arguments for government in- tervention in international trade, reexamined the economic case for free trade in light of the strategic trade policy argument, and looked at the evolution of the world trading framework. While a policy of free trade may not always be the theoretically optimal policy (given the arguments of the new trade theorists), in practice it is probably the best policy for a government to pursue. In particular, the long- run interests of business and consumers may be best served by strengthening international institutions such as the WTO. Given the danger that isolated protectionism might escalate into a trade war, business probably has far more to gain from government efforts to open protected markets to imports and foreign direct investment (through the WTO) than from government efforts to protect domestic industries from foreign competition. The chapter made the following points:

1. Trade policies such as tariffs, subsidies, antidumping regulations, and local content requirements tend to be pro-producer and anticonsumer. Gains accrue to producers (who are protected from foreign competitors), but consumers lose because they must pay more for imports.

2. There are two types of arguments for government intervention in international trade: political and economic. Political arguments for intervention are concerned with protecting the interests of certain groups, often at the expense of other groups, or with promoting goals with regard to foreign policy, human rights, consumer protection, and the like. Economic arguments for intervention are about boosting the overall wealth of a nation.

3. A common political argument for intervention is that it is necessary to protect jobs. However, political intervention often hurts consumers, and it can be self- defeating. Countries sometimes argue that it is important to protect certain industries for reasons of national security. Some argue that government should

use the threat to intervene in trade policy as a bargaining tool to open foreign markets. This can be a risky policy; if it fails, the result can be higher trade barriers.

4. The infant industry argument for government intervention contends that to let manufacturing get a toehold, governments should temporarily support new industries. In practice, however, governments often end up protecting the inefficient.

5. Strategic trade policy suggests that with subsidies, government can help domestic firms gain first-mover advantages in global industries where economies of scale are important. Government subsidies may also help domestic firms overcome barriers to entry into such industries.

6. The problems with strategic trade policy are twofold: (a) Such a policy may invite retaliation, in which case all will lose, and (b) strategic trade policy may be captured by special-interest groups, which will distort it to their own ends.

7. The GATT was a product of the postwar free trade movement. The GATT was successful in lowering trade barriers on manufactured goods and commodities. The move toward greater free trade under the GATT appeared to stimulate economic growth.

8. The completion of the Uruguay Round of GATT talks and the establishment of the World Trade Organization have strengthened the world trading system by extending GATT rules to services, increasing protection for intellectual property, reducing agricultural subsidies, and enhancing monitoring and enforcement mechanisms.

9. Trade barriers act as a constraint on a firm’s ability to disperse its various production activities to optimal locations around the globe. One response to trade barriers is to establish more production activities in the protected country.

10. Business may have more to gain from government efforts to open protected markets to imports and foreign direct investment than from government efforts to protect domestic industries from foreign competition.

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

1. You work for a pharmaceuticals company that hopes to provide products and services in New Zealand. Yet management’s current knowledge of this country’s trade policies and barriers is limited. After searching a resource that summarizes the import and export regulation, outline the most important foreign trade barriers your firm’s managers must keep in mind while developing a strategy for entry into New Zealand’s pharmaceutical market.

2. The number of member nations of the World Trade Organization has increased considerably in recent years. In addition, some nonmember countries have observer status in the WTO. Such status requires accession negotiations to begin within five years of attaining this preliminary position. Visit WTO’s website to identify a list of current members and observers. Identify the last five countries that joined the WTO as members. Also, examine the list of current observer countries. Do you notice anything in particular about the countries that have recently joined or have observer status?

Research Task http://globalEDGE.msu.edu

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Rare earth metals are a set of 17 chemical elements in the periodic table and include scandium, yttrium, cerium, and lanthanum. Small concentra- tions of these metals are a crucial ingredient in the manufacture of a wide range of high-technology products, including wind turbines, iPhones, in- dustrial magnets, and the batteries used in hybrid cars. Extracting rare earth metals can be a dirty process due to the toxic acids that are used during the refining process. As a consequence, strict environmental regu- lations have made it extremely expensive to extract and refine rare earth metals in many countries.

Environmental restrictions in countries such as Australia, Canada, and the United States have opened the way for China to become the world’s leading producer and exporter of rare earth metals. In 1990, China ac- counted for 27 percent of global rare earth production. By 2010, this figure had surged to 97 percent. In 2010, China sent shock waves through the high-tech manufacturing community when it imposed tight quotas on the exports of rare earths. In 2009, it exported around 50,000 tons of rare earths. The 2010 quota limited exports to 30,000 tons. The quota remained in effect for 2011 and was increased marginally to around 31,000 tons in 2012 and 2013.

The reason offered by China for imposing the export quota is that sev- eral of its own mining companies didn’t meet environmental standards and had to be shut down. The effect, however, was to dramatically increase prices for rare earth metals outside of China, putting foreign manufacturers at a cost disadvantage. Many observers quickly concluded that the imposi- tion of export quotas was an attempt by China to give its domestic manu- facturers a cost advantage and to encourage foreign manufacturers to move more production to China so that they could get access to lower-cost supplies of rare earths. As news magazine The Economist concluded, “Slashing their exports of rare earth metals has little to do with dwindling supplies or environmental concerns. It’s all about moving Chinese manu- facturers up the supply chain, so they can sell valuable finished goods to the world rather than lowly raw materials.” In other words, China may have been using trade policy to support its industrial policy.

Developed countries cried foul, claiming that the export quotas violate China’s obligations under World Trade Organization rules. In July 2012, the WTO responded by launching its own investigation. Commenting on the investigation, a U.S. administration official said that the export quotas were part of a “deeply rooted industrial policy aimed at providing substantial

China Limits Exports of Rare Earth Materials

3. Given the arguments relating to the new trade theory and strategic trade policy, what kind of trade policy should business be pressuring government to adopt?

4. You are an employee of a U.S. firm that produces personal computers in Thailand and then exports them to the United States and other countries for sale. The personal computers were originally produced in Thailand to take advantage of relatively low labor costs and a skilled workforce. Other possible locations considered at the time were Malaysia and Hong Kong. The U.S. government decides to impose punitive

100 percent ad valorem tariffs on imports of computers from Thailand to punish the country for administrative trade barriers that restrict U.S. exports to Thailand. How should your firm respond? What does this tell you about the use of targeted trade barriers?

5. Reread the Management Focus, “Protecting U.S. Magnesium.” Who gains most from the antidumping duties levied by the United States on imports of magnesium from China and Russia? Who are the losers? Are these duties in the best national interests of the United States?

Chapter Seven Government Policy and International Trade 219

220 Part Three The Global Trade and Investment Environment

competitive advantages for Chinese manufacturers at the expense of non- Chinese manufacturers.”

In the meantime, the world is not sitting still. In response to the high prices for rare earth metals, many companies have been redesigning their products to use substitute materials. Toyota, Renault, and Tesla, for example—all major automotive consumers of rare earth products—have stated that they plan to stop using parts that have rare earth elements in their cars. Governments have also tried to encourage private mining com- panies to expand their production of rare earth metals. By 2012, there were some 350 rare earth mine projects under development outside of China and India. An example, Molycorp, a U.S. mining company, is quickly boosting its rare earth production at a California mine. As a consequence of such actions, by early 2014, China’s share of rare earth output had slipped to 80 percent. This did not stop China from announcing quota limits in 2014 that seemed to be in line with those of 2013.

Sources: Chuin-Wei Yap, “China Revamps Rare-Earth Exports,” The Wall Street Journal, December 28, 2011, p. C3; “The Difference Engine: More Precious than Gold,” The Economist, September 17, 2010; “Of Metals and Market Forces,” The Economist, February 4, 2012; and J. T. Areddy and C. W. Yap, “China Raises Rare- Earth Export Quota,” The Wall Street Journal, August 22, 2012.

CASE DISCUSSION QUESTIONS 1. Which groups benefitted the most from China imposing an export

quota on rare earth metals? Did it give the Chinese domestic manufacturers a significant cost advantage? Did it result in dramatically increased quality and environmental standards?

2. Given that 97 percent of rare earth metal production is now done in China, an increase from 27 percent to 97 percent between 1990 and 2010, do you think countries such as Australia, Canada, and the United States should reconsider their environmental restrictions on product of such metals?

3. The restrictions imposed by China on rare earth metals has resulted in some companies (e.g., Toyota, Renault, Tesla) starting to look for alternatives. They plan to use parts that do not include rare earth metals. Is this a good solution?

Endnotes

1. For a detailed welfare analysis of the effect of a tariff, see P. R. Krugman and M. Obstfeld, International Economics: Theory and Policy (New York: HarperCollins, 2000), Ch. 8.

2. World Trade Organization, World Trade Report 2006 (Geneva: WTO, 2006).

3. The study was undertaken by Kym Anderson of the Univer- sity of Adelaide. See “A Not So Perfect Market,” The Econo- mist; Survey of Agriculture and Technology, March 25, 2000, pp. 8–10.

4. K. Anderson, W. Martin, and D. van der Mensbrugghe, “Dis- tortions to World Trade: Impact on Agricultural Markets and Farm Incomes,” Review of Agricultural Economics 28 (Summer 2006), pp. 168–94.

5. R. W. Crandall, Regulating the Automobile (Washington, DC: Brookings Institution, 1986).

6. J. B. Teece, “Voluntary Export Restraints Are Back; They Didn’t Work the Last Time,” Automotive News, April 23, 2012.

7. Krugman and Obstfeld, International Economics.

8. G. Hufbauer and Z. A. Elliott, Measuring the Costs of Protec- tionism in the United States (Washington, DC: Institute for International Economics, 1993).

9. Alan Goldstein, “Sematech Members Facing Dues Increase; 30% Jump to Make Up for Loss of Federal Funding,” Dallas Morning News, July 27, 1996, p. 2F.

10. N. Dunne and R. Waters, “U.S. Waves a Big Stick at Chinese Pirates,” Financial Times, January 6, 1995, p. 4.

11. Peter S. Jordan, “Country Sanctions and the International Business Community,” American Society of International Law Proceedings of the Annual Meeting 20, no. 9 (1997), pp. 333–42.

A worker in China dries products containing rare earth elements.

Chapter Seven Government Policy and International Trade 221

12. “Brazil’s Auto Industry Struggles to Boost Global Competi- tiveness,” Journal of Commerce, October 10, 1991, p. 6A.

13. For reviews, see J. A. Brander, “Rationales for Strategic Trade and Industrial Policy,” in Strategic Trade Policy and the New International Economics, P. R. Krugman, ed. (Cambridge, MA: MIT Press, 1986); P. R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1 (1987), pp. 131–44; and P. R. Krugman, “Does the New Trade Theory Require a New Trade Policy?” World Economy 15, no. 4 (1992), pp. 423–41.

14. “Airbus and Boeing: The Jumbo War,” The Economist, June 15, 1991, pp. 65–66.

15. For details see Krugman, “Is Free Trade Passé?”; and Brander, “Rationales for Strategic Trade and Industrial Policy.”

16. Krugman, “Is Free Trade Passé?”

17. This dilemma is a variant of the famous prisoner’s dilemma, which has become a classic metaphor for the difficulty of achieving cooperation between self-interested and mutually suspicious entities. For a good general introduction, see A. Dixit and B. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: W. W. Norton & Co., 1991).

18. Note that the Smoot-Hawley Act did not cause the Great Depression. However, the beggar-thy-neighbor trade policies that it ushered in certainly made things worse. See J. Bhag- wati, Protectionism (Cambridge, MA: MIT Press, 1988).

19. World Bank, World Development Report (New York: Oxford University Press, 1987).

20. Frances Williams, “WTO—New Name Heralds New Powers,” Financial Times, December 16, 1993, p. 5; and Frances

Williams, “GATT’s Successor to Be Given Real Clout,” Financial Times, April 4, 1994, p. 6.

21. W. J. Davey, “The WTO Dispute Settlement System: The First Ten Years,” Journal of International Economic Law, March 2005, pp. 17–28.

22. Information provided on WTO website, www.wto.org/english/ tratop_e/dispu_e/dispu_status_e.htm.

23. Data at www.wto.org/english/tratop_e/adp_e/adp_e.htm.

24. Annual Report by the Director General 2003 (Geneva: World Trade Organization, 2003).

25. Ibid.

26. Ibid.

27. Anderson, Martin, and van der Mensbrugghe, “Distortions to World Trade.”

28. World Trade Organization, Annual Report 2002 (Geneva: WTO, 2002).

29. S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “The Payoff to America from Global Integration,” in The United States and the World Economy: Foreign Policy for the Next Decade, C. F. Bergsten, ed. (Washington, DC: Institute for Interna- tional Economics, 2005).

30. World Bank, Global Economic Prospects 2005 (Washington, DC: World Bank, 2005).

31. “Doha Development Agenda,” OECD Observer, September 2006, pp. 64–67.

32. “Punitive Tariffs Are Approved on Imports of Japanese Steel,” The New York Times, June 12, 1999, p. A3.

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learning objectives

8-1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.

8-2 Explain the different theories of FDI.

8-3 Understand how political ideology shapes a government’s attitudes toward FDI.

8-4 Describe the benefits and costs of FDI to home and host countries.

8-5 Explain the range of policy instruments that governments use to influence FDI.

8-6 Identify the implications for managers of the theory and government policies associated with FDI.

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opening case

For years the economy of Nigeria, Africa’s most populous nation, was held back by political instability, poor government policies, a lack of infrastructure, and endemic corruption. This started to change in the 2000s. In halting steps, Nigeria has moved toward a more stable democratic form of government. In 2007, for the first time in the history of the country, there was a peaceful transfer of civilian power fol-

lowing general elections. Since then, the government has pursued market-orientated reforms, including the

removal of subsidies, privatization of some state-run businesses, lowering trade barriers, and deregulation.

The government has tried to rid itself of corruption, albeit with mixed success. There has also been some

attempt to improve the country’s poor transportation and power infrastructure.

The reforms have had a positive impact. The GDP of Nigerian purchasing power parity almost tripled

from $170 billion in 2000 to $451 billion in 2012. When estimates of the “informal” or “black economy”

sector are taken into account, GDP may have been as large as $630 billion in 2012. The economy grew at

around 7 percent per annum during the 2010–2012 period. Powering this growth have been high oil prices.

Nigeria is a significant oil producer, and high oil prices have helped to improve government finances, but

the industrial and agricultural sectors of the economy are also growing.

One of the major engines of growth has been foreign direct investment. For years, foreign investors

stayed away from Nigeria—scared off by the political instability and high levels of corruption—but that too

is starting to change. Encouraged by better economic management and the promise of a large domestic

market, inward foreign investment in Nigeria increased from $1.2 billion in 2000 to a peak of almost $9

billion in both 2011 and 2012. Among recent investors has been General Electric, which announced in 2013

that it would put more than $1 billion into Nigeria over the next five years. The investments include building

a manufacturing plant to support the power generation and oil extraction industries and a service center

for supporting GE equipment. GE believes that its investment will create 2,300 jobs.

While the majority of investments are still targeted at Nigeria’s large energy sector, there are signs that

this too is beginning to shift. A case in point is Procter & Gamble, which in 2012 invested $250 million to

Foreign Direct Investment in Nigeria

Foreign Direct Investment

–continued

224 Part Three The Global Trade and Investment Environment

construct a state-of-the-art plant to manufacture disposable diapers in Nigeria.

Explaining the investment, a P&G spokesperson noted that “Nigeria has a very strong,

dynamic and growing population of now over 167 million people with over 40 percent

less than 15 years old. By 2050, Nigeria is projected to have the third largest population

in the world. This represents a rapidly growing number of consumers and a wonderful

opportunity to serve.” The P&G spokesperson also indicated that P&G would increase its

investment if the Nigeria government was successful in further lowering import tariffs

and consumption taxes and resolved some of the infrastructure problems that were

currently holding the country back. • Sources: K. Aderinokun, “Nigeria: We Want to Make Nigeria the Hub of Procter and Gamble’s West African Operations,” AllAfrica, August 21, 2012; N. Mazen, “General Electric Plans $1 Billion Investment in Nigerian Power,” Bloomberg, January 31, 2013; and CIA, The World Factbook: Nigeria, updated January 7, 2014.

Introduction Foreign direct investment (FDI) occurs when a firm invests directly in facilities to pro- duce or market a product in a foreign country. According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of 10 percent or more in a foreign business entity. Once a firm undertakes FDI, it becomes a multinational enterprise. Two examples of FDI are given in the opening case— the recent investments by General Electric and Procter & Gamble in production facilities in Nigeria.

FDI takes on two main forms. The first is a greenfield investment, which involves the establishment of a new operation in a foreign country. The second involves acquir- ing or merging with an existing firm in the foreign country. Both GE’s and P&G’s investments in Nigeria were greenfield investments. Acquisitions can be a minority (where the foreign firm takes a 10 to 49 percent interest in the firm’s voting stock), majority (foreign interest of 50 to 99 percent), or full outright stake (foreign interest of 100 percent).1

This chapter opens by looking at the importance of foreign direct investment in the world economy. Next, it reviews the theories that have been used to explain foreign direct investment. The chapter then moves on to look at government policy toward foreign direct investment and closes with a section on implications for business.

Foreign Direct Investment in the World Economy When discussing foreign direct investment, it is important to distinguish between the flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI under- taken over a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. We also talk of outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, the flow of FDI into a country.

TRENDS IN FDI The past 35 years have seen a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from $25 billion in 1975 to $1.4 trillion in 2012 (see Figure 8.1).2 Over the past 30 years the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1992 and 2012, the total flow of FDI from all countries increased around ninefold while world trade by value grew fourfold and world output by around 55 percent.3 As a

Greenfield Investment The establishment of a new operation in a foreign country.

LO 8-1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.

Flow of FDI The amount of foreign direct investment undertaken over a given time period (normally one year).

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

Outflows of FDI Flow of foreign direct investment out of a country.

Inflows of FDI Flow of foreign direct investment into a country.

Chapter Eight Foreign Direct Investment 225

result of the strong FDI flows, by 2012 the global stock of FDI was about $22.8 trillion. The foreign affiliates of multinationals had more than $27.9 trillion in global sales and accounted for one-third of all cross-border trade in goods and services.4 Clearly by any measure, FDI is a very important phenomenon.

FDI has grown more rapidly than world trade and world output for several reasons. First, despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world’s developing nations. The general shift toward democratic political institutions and free market economies that we discussed in Chapter 3 has encouraged FDI. Across much of Asia, eastern Europe, and Latin America, economic growth, economic deregulation, privatization programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more attractive to foreign multinationals. According to the United Nations, some 90 percent of the 2,700 changes made worldwide between 1992 and 2009 in the laws governing foreign direct investment created a more favorable envi- ronment for FDI.5

The globalization of the world economy is also having a positive effect on the volume of FDI. Many firms see the whole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence in many regions of the world. For reasons that we explore later in this book, many firms now believe it is important to have production facilities close to their major customers. This too creates pressure for greater FDI.

THE DIRECTION OF FDI Historically, most FDI has been directed at the devel- oped nations of the world as firms based in advanced countries invested in the others’ mar- kets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favorite target for FDI inflows. The United States has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors include firms based in Great Britain, Japan, Germany, Holland, and France. Inward investment into the United States remained high during the 2000s and stood at $167 billion in 2012. The developed nations of the European Union have also been recipients of significant FDI inflows, princi- pally from the United States and other member-states of the EU. In 2012, inward invest- ment into the EU was $276 billion. The United Kingdom and France have historically been the largest recipients of inward FDI.6

8.1 FIGURE FDI Outflows, 1980–2012 ($ billions) Source: UNCTAD Statistical Data Set, http:// unctadstat.unctad.org/ReportFolders/ reportFolders.aspx.

19 80

19 84

19 86

19 88

19 90

19 92

19 94

19 96

19 98

20 00

20 02

20 04

20 06

20 08

20 10

20 12

19 82

500

1,000

1,500

2,000

2,500

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226 Part Three The Global Trade and Investment Environment

Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations and the transition economies of eastern Europe and the old Soviet Union have increased markedly (see Figure 8.2). Most recent inflows into devel- oping nations have been targeted at the emerging economies of Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI, which attracted about $60 billion of FDI in 2004 and rose steadily to hit a record $124 billion in 2011 followed by $121 billion in 2012.7 The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America is the next most important region in the developing world for FDI inflows. In 2012, total inward investments into this region reached $244 billion. Brazil has histori- cally been the top recipient of inward FDI in Latin America. At the other end of the scale, Africa has long received the smallest amount of inward investment, $50 billion in 2012. In recent years, Chinese enterprises have emerged as major investors in Africa, particularly in extraction industries where they seem to be trying to ensure future sup- plies of valuable raw materials. The inability of Africa to attract greater investment is in part a reflection of the political unrest, armed conflict, and frequent changes in economic policy in the region.8

THE SOURCE OF FDI Since World War II, the United States has consistently been the largest source country for FDI. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries accounted for 60 percent of all FDI outflows for 1998–2012 (see Figure 8.3). As might be expected, these countries also predominate in rankings of the world’s largest mul- tinationals.9 These nations dominate primarily because they were the most developed na- tions with the largest economies during much of the postwar period and therefore home to many of the largest and best capitalized enterprises. Many of these countries also had a long history as trading nations and naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises based there have been at the forefront of foreign investment trends.

That being said, it is noteworthy that Chinese firms have started to emerge as major for- eign investors. In 2005, Chinese firms invested some $12 billion internationally. Since then, the figure has risen steadily, reaching $84 billion in 2012. Firms based in Hong Kong accounted for another $84 billion of outward FDI in 2012. Much of the outward investment by Chinese firms has been directed at extractive industries in less developed nations (e.g., China has been a major investor in African countries). A major motive for these investments has been to gain access to raw materials, of which China is one of the world’s largest

8.2 FIGURE FDI Inflows by Region, 1995–2012 ($ billions) Source: Calculated by the author from United Nations World Investment Report, various editions.

19 95

19 97

19 98

19 99

20 00

20 01

20 02

20 03

20 04

20 05

20 06

20 07

20 08

20 09

20 10

20 11

20 12

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Developed Nations Developing Nations Transition Economies

Chapter Eight Foreign Direct Investment 227

Foreign Direct Investment in China

Beginning in late 1978, China’s leadership decided to move the econ- omy away from a centrally planned socialist system to one that was more market driven. The result has been 35 years of sustained high economic growth rates of around 8–10 percent, compounded annu- ally. This growth attracted substantial foreign investment. Starting from a tiny base, foreign investment increased to an annual average rate of $2.7 billion between 1985 and 1990 and then surged to $40 billion annually in the late 1990s, making China the second- biggest recipient of FDI inflows in the world after the United States. The growth has continued, with inward investments into China hitting a record $124 billion in 2011 (with another $83 billion going into Hong Kong). Over the past 20 years, this inflow has resulted in the estab- lishment of more than 300,000 foreign-funded enterprises in China. The total stock of FDI in mainland China grew from almost nothing in 1978 to $832 billion in 2012 (another $1.4 trillion of FDI stock was in Hong Kong).

The reasons for this investment are fairly obvious. With a popula- tion of more than 1.3 billion people, China represents the world’s largest market. Historically, import tariffs made it difficult to serve this market via exports, so FDI was required if a company wanted to tap into the country’s huge potential. China joined the World Trade Organization in 2001. As a result, average tariff rates on imports have fallen from 15.4 percent to about 8 percent today, and reducing the tariff became a motive for investing in China (although at 8 percent, tariffs are still above the average of 3.5 percent found in many devel- oped nations). Notwithstanding tariff rates, many foreign firms be- lieve that doing business in China requires a substantial presence in the country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combination of relatively inex- pensive labor and tax incentives, particularly for enterprises that establish themselves in special economic zones, makes China an

attractive base from which to serve Asian or world markets with exports (although rising labor costs in China are now making this less important).

Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. China may have a huge popu- lation, but despite decades of rapid growth, it is still relatively poor. The lack of purchasing power translates into a relatively immature market for many Western consumer goods outside of affluent urban areas such as Shanghai. Other problems include a highly regulated environ- ment, which can make it problematic to conduct business transactions, and shifting tax and regulatory regimes. Then there are problems with local joint-venture partners that are inexperienced, opportunistic, or simply operate according to different goals. One U.S. manager ex- plained that when he laid off 200 people to reduce costs, his Chinese partner hired them all back the next day. When he inquired why they had been hired back, the Chinese partner, which was government- owned, explained that as an agency of the government, it had an “obli- gation” to reduce unemployment.

To continue to attract foreign investment, in late 2000 the Chinese government had committed itself to invest more than $800 billion in infrastructure projects over 10 years. Further commitments were made in the late 2000s. These investments have improved the nation’s poor highway system. They have been pursuing a macroeconomic policy that includes an emphasis on maintaining steady economic growth, low inflation, and a stable currency—all of which are attractive to for- eign investors. Given these developments, it seems likely that the country will continue to be an important magnet for foreign investors well into the future.

Sources: Interviews by the author while in China; United Nations, World Investment Report, 2012; Linda Ng and C. Tuan, “Building a Favorable Investment Environment: Evidence for the Facilitation of FDI in China,” The World Economy, 2002, pp. 1095–114; and S. Chan and G. Qingyang, “Investment in China Migrates Inland,” Far Eastern Economic Review, May 2006, pp. 52–57.

country FOCUS

8.3 FIGURE Cumulative FDI Outflows, 1998–2012 ($ billions) Source: Calculted by the author from United Nations World Investment Report, various editions.

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228 Part Three The Global Trade and Investment Environment

consumers. There are signs, however, that Chinese firms are starting to turn their attention to more advanced na- tions. In 2012, Chinese firms invested $6.5 billion in the United States, up from $146 million in 2003.10

THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS FDI can take the form of a greenfield investment in a new facility or an acquisition of or a merger with an existing local firm. UN estimates indicate that some 40 to 80 per- cent of all FDI inflows were in the form of mergers and acquisitions between 1998 and 2012.11 However, FDI flows into developed nations differ markedly from those into developing nations. In the case of developing na- tions, only about one-third or less of FDI is in the form of cross-border mergers and acquisitions. The lower per- centage of mergers and acquisitions may simply reflect the fact that there are fewer target firms to acquire in de- veloping nations.

When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments? We consider this question in depth in Chap- ter 13. For now, we will make a few basic observations. First, mergers and acquisitions are quicker to execute than greenfield investments. This is an important consid- eration in the modern business world where markets

evolve very rapidly. Many firms apparently believe that if they do not acquire a desirable target firm, then their global rivals will. Second, foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trade- marks or patents, distribution systems, production systems, and the like. It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through a greenfield investment. Third, firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or man- agement skills (see the next Management Focus on Cemex for an example). However, as we discuss in Chapter 13, there is evidence that many mergers and acquisitions fail to realize their anticipated gains.12

Theories of Foreign Direct Investment In this section, we review several theories of foreign direct investment. These theories approach the various phenomena of foreign direct investment from three complementary perspectives. One set of theories seeks to explain why a firm will favor direct investment as a means of entering a foreign market when two other alternatives, exporting and licensing, are open to it. Another set of theories seeks to explain why firms in the same industry often undertake foreign direct investment at the same time and why they favor certain locations over others as targets for foreign direct investment. Put differently, these theories attempt to explain the observed pattern of foreign direct investment flows. A third theoretical per- spective, known as the eclectic paradigm, attempts to combine the two other perspectives into a single holistic explanation of foreign direct investment (this theoretical perspective is eclectic because the best aspects of other theories are taken and combined into a single explanation).

WHY FOREIGN DIRECT INVESTMENT? Why do firms go to the trouble of establishing operations abroad through foreign direct investment when two alternatives, exporting and licensing, are available to them for exploiting the profit opportunities in a

LO 8-2 Explain the different theories of FDI.

Eclectic Paradigm Argument that combining location specific assets or resource endowments and the firm’s own unique assets often requires FDI; it requires the firm to establish production facilities where those foreign assets or resource endowments are located.

Which Is Better, an Acquisition or a Greenfield Investment? A greenfield investment is an establishment of a new operation in a foreign country (i.e., a parent company starts a new venture in a foreign country by building new production facilities from the ground up). The acquisition approach refers to buying or merging operations with an existing firm in a foreign country. In the text of Chapters 8 and 13, we discuss reasons for greenfield and acquisition-based investments in a foreign country. While mergers and acquisitions (M&A) are typically quicker to execute than building something from literally the ground up, M&A often fail to gain the advantages expected. The failure rate of M&A is somewhere between 50 and 83 percent. At the same time, the trend shows that both the number of M&A and the sums of money spent on M&A are increasingly consistently every year. If you were making the decision, would you prefer to make a greenfield investment or engage in either a merger or acquisi- tion in a foreign country?

Source: Y. Weber, C. Oberg, and S. Tarba, “The M&A Paradox: Factors of Success and Failure in Mergers and Acquisitions,” Comprehensive Guide to Mergers & Acquisitions, A: Managing the Critical Success Factors Across Every Stage of the M&A Process (Upper Saddle River, NJ: FT Press, 2013).

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.

Chapter Eight Foreign Direct Investment 229

foreign market? Exporting involves producing goods at home and then shipping them to the receiving country for sale. Licensing involves granting a foreign entity (the licensee) the right to produce and sell the firm’s product in return for a royalty fee on every unit sold. The question is important, given that a cursory examination of the topic suggests that for- eign direct investment may be both expensive and risky compared with exporting and li- censing. FDI is expensive because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because of the problems associated with doing business in a different culture where the rules of the game may be very different. Relative to indigenous firms, there is a greater probability that a for- eign firm undertaking FDI in a country for the first time will make costly mistakes due to its ignorance. When a firm exports, it need not bear the costs associated with FDI, and it can reduce the risks associated with selling abroad by using a native sales agent. Similarly, when a firm allows another enterprise to produce its products under license, the licensee bears the

Exporting Sale of products produced in one country to residents of another country.

Licensing Occurs when a firm (the licensor) licenses the right to produce its product, use its production processes, or use its brand name or trademark to another firm (the licensee). In return for giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells.

Foreign Direct Investment by Cemex

Since the early 1990s, Mexico’s largest cement manufacturer, Cemex, has transformed itself from a primarily Mexican operation into the third-largest cement company in the world behind Holcim of Switzerland and Lafarge Group of France. Cemex has long been a powerhouse in Mexico and currently controls more than 60 percent of the market for cement in that country. Cemex’s domestic success has been based in large part on an obsession with efficient manufacturing and a focus on customer service that is tops in the industry.

Cemex is a leader in using information technology to match pro- duction with consumer demand. The company sells ready-mixed ce- ment that can survive for only about 90 minutes before solidifying, so precise delivery is important. But Cemex can never predict with total certainty what demand will be on any given day, week, or month. To better manage unpredictable demand patterns, Cemex developed a system of seamless information technology—including truck-mounted global positioning systems, radio transmitters, satellites, and computer hardware—that allows it to control the production and distribution of cement like no other company can, responding quickly to unantici- pated changes in demand and reducing waste. The results are lower costs and superior customer service, both differentiating factors for Cemex.

Cemex’s international expansion strategy was driven by a number of factors. First, the company wished to reduce its reliance on the Mex- ican construction market, which was characterized by very volatile demand. Second, the company realized there was tremendous demand for cement in many developing countries, where significant construc- tion was being undertaken or needed. Third, the company believed that it understood the needs of construction businesses in developing na- tions better than the established multinational cement companies, all of which were from developed nations. Fourth, Cemex believed that it could create significant value by acquiring inefficient cement compa- nies in other markets and transferring its skills in customer service, marketing, information technology, and production management to those units.

The company embarked in earnest on its international expansion strategy in the early 1990s. Initially, Cemex targeted other developing

nations, acquiring established cement makers in Venezuela, Colombia, Indonesia, the Philippines, Egypt, and several other countries. It also purchased two stagnant companies in Spain and turned them around. Bolstered by the success of its Spanish ventures, Cemex began to look for expansion opportunities in developed nations. In 2000, Cemex pur- chased Houston-based Southland, one of the largest cement companies in the United States, for $2.5 billion. Following the Southland acquisition, Cemex had 56 cement plants in 30 countries, most of which were gained through acquisitions. In all cases, Cemex devoted great attention to transferring its technological, management and marketing know-how to acquired units, thereby improving their performance.

In 2004, Cemex made another major foreign investment move, pur- chasing RMC of Great Britain for $5.8 billion. RMC was a huge multina- tional cement firm with sales of $8 billion, only 22 percent of which were in the United Kingdom, and operations in more than 20 other na- tions, including many European nations where Cemex had no pres- ence. Finalized in March 2005, the RMC acquisition had transformed Cemex into a global powerhouse in the cement industry with more than $15 billion in annual sales and operations in 50 countries. Only about 15 percent of the company’s sales was now generated in Mexico. Fol- lowing the acquisition of RMC, Cemex found that the RMC plant in Rugby was running at only 70 percent of capacity, partly because re- peated production problems kept causing a kiln shutdown. Cemex brought in an international team of specialists to fix the problem and quickly increased production to 90 percent of capacity. Going forward, Cemex has made it clear that it will continue to expand and is eyeing opportunities in the fast-growing economies of China and India where currently it lacks a presence and where its global rivals are already expanding.

Sources: C. Piggott, “Cemex’s Stratospheric Rise,” Latin Finance, March 2001, p. 76; J. F. Smith, “Making Cement a Household Word,” Los Angeles Times, January 16, 2000, p. C1; D. Helft, “Cemex Attempts to Cement Its Future,” The Industry Standard, November 6, 2000; Diane Lindquist, “From Cement to Services,” Chief Executive, November 2002, pp. 48–50; “Cementing Global Success,” Strategic Direct Investor, March 2003, p. 1; M. T. Derham, “The Cemex Surprise,” Latin Finance, November 2004, pp. 1–2; “Holcim Seeks to Acquire Aggregate,” The Wall Street Journal, January 13, 2005, p. 1; J. Lyons, “Cemex Prowls for Deals in Both China and India,” The Wall Street Journal, January 27, 2006, p. C4; and S. Donnan, “Cemex Sells 25 Percent Stake in Semen Gresik,” FT.com, May 4, 2006, p. 1.

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230 Part Three The Global Trade and Investment Environment

costs or risks. So why do so many firms apparently prefer FDI over either exporting or li- censing? The answer can be found by examining the limitations of exporting and licensing as means for capitalizing on foreign market opportunities.

Limitations of Exporting The viability of an exporting strategy is often constrained by transportation costs and trade barriers. When transportation costs are added to produc- tion costs, it becomes unprofitable to ship some products over a large distance. This is par- ticularly true of products that have a low value-to-weight ratio and that can be produced in almost any location. For such products, the attractiveness of exporting decreases, relative to either FDI or licensing. This is the case, for example, with cement. Thus, Cemex, the large Mexican cement maker, has expanded internationally by pursuing FDI, rather than export- ing (see the accompanying Management Focus). For products with a high value-to-weight ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software, etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI.

Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods, governments can increase the cost of exporting relative to foreign direct investment and licensing. Similarly, by limiting imports through quotas, governments in- crease the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese auto companies in the United States during the 1980s and 1990s was partly driven by pro- tectionist threats from Congress and by quotas on the importation of Japanese cars. For Japanese auto companies, these factors decreased the profitability of exporting and increased that of foreign direct investment. In this context, it is important to understand that trade barriers do not have to be physically in place for FDI to be favored over exporting. Often, the desire to reduce the threat that trade barriers might be imposed is enough to justify foreign direct investment as an alternative to exporting.

Limitations of Licensing A branch of economic theory known as internalization theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign markets (this approach is also known as the market imperfec- tions approach).13 According to internalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities. First, licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor. For example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks associated with foreign direct investment. However, Matsushita and Sony quickly

Internalization Theory Marketing imperfection approach to foreign direct investment.

Market Imperfections Imperfections in the operation of the market mechanism.

Rankings

Cross-border investments have been ramped up to a relatively large degree in the last decade. Even with the economic downturn that started in 2008, the world continued to see a great deal of foreign direct investment by companies in the last decade. Now, when the economic prosperity is likely to be better, given that we are removed from those downturn days, the expectation is that more foreign direct investment will be considered by companies. On globalEDGE, there are myriad opportunities to gain more knowl- edge about foreign direct investment or, FDI, as it is typically called.

The “Rankings” section is a great starting point (globaledge.msu. edu/global-resources/rankings). In the Rankings section, glo- balEDGE features several reports by A.T. Kearney—with one of them squarely centered on foreign direct investment and a “confi- dence index” for FDI. The companies that participate in the regular study account for more than $2 trillion in annual global revenue! Which countries are in the top three in the investment confidence index, and do you agree that the three countries are the best ones to invest in if you were running a company?

Chapter Eight Foreign Direct Investment 231

assimilated RCA’s technology and used it to enter the U.S. market to compete directly against RCA. As a result, RCA is now a minor player in its home market, while Matsushita and Sony have a much bigger market share.

A second problem is that licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to maximize its profitability. With licensing, control over manufacturing, marketing, and strategy are granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. The rationale for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition, be- cause it would likely reduce the licensee’s profit, or it might even cause the licensee to take a loss.

The rationale for wanting control over the operations of a foreign entity is that the firm might wish to take advantage of differences in factor costs across countries, producing only part of its final product in a given country, while importing other parts from elsewhere where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement, since it would limit the licensee’s autonomy. Thus, for these reasons, when tight control over a foreign entity is desirable, foreign direct investment is preferable to licensing.

A third problem with licensing arises when the firm’s competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products. The problem here is that such capabilities are often not amenable to licensing. While a foreign licensee may be able to physically reproduce the firm’s product under license, it often may not be able to do so as efficiently as the firm could itself. As a result, the licensee may not be able to fully exploit the profit potential inherent in a foreign market.

For example, consider Toyota, a company whose competitive advantage in the global auto industry is acknowledged to come from its superior ability to manage the overall process of designing, engineering, manufacturing, and selling automobiles—that is, from its management and organizational capabilities. Indeed, Toyota is credited with pioneer- ing the development of a new production process, known as lean production, that enables it to produce higher-quality automobiles at a lower cost than its global rivals.14 Although Toyota could license certain products, its real competitive advantage comes from its man- agement and process capabilities. These kinds of skills are difficult to articulate or codify; they certainly cannot be written down in a simple licensing contract. They are organiza- tionwide and have been developed over the years. They are not embodied in any one individual but instead are widely dispersed throughout the company. Put another way, Toyota’s skills are embedded in its organizational culture, and culture is something that cannot be licensed. Thus, if Toyota were to allow a foreign entity to produce its cars under license, the chances are that the entity could not do so as efficiently as could Toyota. In turn, this would limit the ability of the foreign entity to fully develop the market potential of that product. Such reasoning underlies Toyota’s preference for direct investment in foreign markets, as opposed to allowing foreign automobile companies to produce its cars under license.

All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm’s skills and know-how are not amenable to licensing.

Advantages of Foreign Direct Investment It follows that a firm will favor foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favor foreign direct investment over licensing (or franchising) when it wishes to maintain control over its

232 Part Three The Global Trade and Investment Environment

technological know-how, or over its operations and business strategy, or when the firm’s capabilities are simply not amenable to licensing, as may often be the case.

THE PATTERN OF FOREIGN DIRECT INVESTMENT Observation suggests that firms in the same industry often undertake foreign direct investment at about the same time. Also, firms tend to direct their investment activities toward the same target markets. The two theories we consider in this section attempt to explain the patterns that we observe in FDI flows.

Strategic Behavior One theory is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F. T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopolistic industries.15 An oligopoly is an industry composed of a limited num- ber of large firms (e.g., an industry in which four firms control 80 percent of a domestic market would be defined as an oligopoly). A critical competitive feature of such industries is interdependence of the major players: What one firm does can have an immediate impact on the major competitors, forcing a response in kind. By cutting prices, one firm in an oli- gopoly can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share. Thus, the interdependence between firms in an oligopoly leads to imitative behavior; rivals often quickly imitate what a firm does in an oligopoly.

Imitative behavior can take many forms in an oligopoly. One firm raises prices, and the others follow; one expands capacity, and the rivals imitate lest they be left at a disadvantage in the future. Knickerbocker argued that the same kind of imitative behavior characterizes FDI. Consider an oligopoly in the United States in which three firms—A, B, and C—domi- nate the market. Firm A establishes a subsidiary in France. Firms B and C decide that if successful, this new subsidiary may knock out their export business to France and give a first-mover advantage to firm A. Furthermore, firm A might discover some competitive asset in France that it could repatriate to the United States to torment firms B and C on their native soil. Given these possibilities, firms B and C decide to follow firm A and establish operations in France.

Studies that have looked at FDI by U.S. firms show that firms based in oligopolistic industries tended to imitate each other’s FDI.16 The same phenomenon has been ob- served with regard to FDI undertaken by Japanese firms.17 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by under- taking their own FDI in the United States and Europe. Research has also shown that models of strategic behavior in a global oligopoly can explain the pattern of FDI in the global tire industry.18

Knickerbocker’s theory can be extended to embrace the concept of multipoint competi- tion. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.19 Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other’s moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets.

Although Knickerbocker’s theory and its extensions can help explain imitative FDI be- havior by firms in oligopolistic industries, it does not explain why the first firm in an oli- gopoly decides to undertake FDI rather than to export or license. Internalization theory addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, internalization theory addresses the efficiency issue. For these reasons, many economists favor internalization theory as an explanation for FDI, although most would agree that the imitative explanation tells an important part of the story.

THE ECLECTIC PARADIGM The eclectic paradigm has been championed by the British economist John Dunning.20 Dunning argues that in addition to the various

Oligopoly An industry composed of a limited number of large firms.

Multipoint Competition Arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.

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factors discussed earlier, location-specific advantages are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment. By location-specific advantages, Dunning means the advantages that arise from utilizing resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm’s technological, mar- keting, or management capabilities). Dunning accepts the argument of internalization the- ory that it is difficult for a firm to license its own unique capabilities and know-how. Therefore, he argues that combining location-specific assets or resource endowments with the firm’s own unique capabilities often requires foreign direct investment. That is, it re- quires the firm to establish production facilities where those foreign assets or resource en- dowments are located.

An obvious example of Dunning’s arguments are natural resources, such as oil and other minerals, which are by their character specific to certain locations. Dunning suggests that to exploit such foreign resources, a firm must undertake FDI. Clearly, this explains the FDI undertaken by many of the world’s oil companies, which have to invest where oil is located in order to combine their technological and managerial capabilities with this valuable location- specific resource. Another obvious example is valuable human resources, such as low-cost, highly skilled labor. The cost and skill of labor varies from country to country. Because labor is not internationally mobile, according to Dunning it makes sense for a firm to locate pro- duction facilities in those countries where the cost and skills of local labor are most suited to its particular production processes.

However, Dunning’s theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semiconductor industry. Many of the world’s major computer and semiconductor companies—such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs there. According to Dunning’s arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is avail- able nowhere else in the world. To be sure, that knowledge is commercialized as it diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning’s language, this means that Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part it arises from a network of infor- mal contacts that allows firms to benefit from each other’s knowledge generation. Econo- mists refer to such knowledge “spillovers” as externalities, and there is a well-established theory suggesting that firms can benefit from such externalities by locating close to their source.21

Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, production facilities so they too can learn about and utilize valuable new knowledge before those based elsewhere, thereby giving them a competitive advan- tage in the global marketplace.22 Evidence suggests that European, Japanese, South Korean, and Taiwanese com- puter and semiconductor firms are investing in the Silicon Valley region precisely because they wish to benefit from the externalities that arise there.23 Others have argued that direct investment by foreign firms in the U.S. biotechnol- ogy industry has been motivated by desires to gain access to the unique location-specific technological knowledge of U.S. biotechnology firms.24 Dunning’s theory, therefore, seems to be a useful addition to those outlined previously, because it helps explain how location factors affect the direction of FDI.25

Location-Specific Advantages Advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm’s technological, marketing, or management know-how).

Externalities Knowledge spillovers.

Silicon Valley, where Google is based, has long been known as the epicenter of the computer and semiconductor industry.

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.

234 Part Three The Global Trade and Investment Environment

Political Ideology and Foreign Direct Investment Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance that is hostile to all inward FDI at one extreme to an adherence to the nonin- terventionist principle of free market economics at the other. Between these two extremes is an approach that might be called pragmatic nationalism.

THE RADICAL VIEW The radical view traces its roots to Marxist political and economic theory. Radical writers argue that the multinational enterprise (MNE) is an in- strument of imperialist domination. They see the MNE as a tool for exploiting host coun- tries to the exclusive benefit of their capitalist-imperialist home countries. They argue that MNEs extract profits from the host country and take them to their home country, giving nothing of value to the host country in exchange. They note, for example, that key technology is tightly controlled by the MNE and that important jobs in the foreign subsidiaries of MNEs go to home-country nationals rather than to citizens of the host country. Because of this, according to the radical view, FDI by the MNEs of advanced capitalist nations keeps the less developed countries of the world relatively backward and dependent on advanced capitalist nations for investment, jobs, and technology. Thus, according to the extreme version of this view, no country should ever permit foreign cor- porations to undertake FDI, because they can never be instruments of economic develop- ment, only of economic domination. Where MNEs already exist in a country, they should be immediately nationalized.26

From 1945 until the 1980s, the radical view was very influential in the world economy. Until the collapse of communism between 1989 and 1991, the countries of eastern Europe were opposed to FDI. Similarly, communist countries elsewhere—such as China, Cambodia, and Cuba—were all opposed in principle to FDI (although, in practice, the Chinese started to allow FDI in mainland China in the 1970s). Many socialist countries—particularly in Africa, where one of the first actions of many newly independent states was to nationalize

foreign-owned enterprises—also embraced the radical position. Countries whose political ideology was more nationalistic than socialistic further embraced the radical position. This was true in Iran and India, for example, both of which adopted tough policies restricting FDI and nationalized many foreign-owned enterprises. Iran is a particularly interesting case because its Islamic govern- ment, while rejecting Marxist theory, has essentially em- braced the radical view that FDI by MNEs is an instrument of imperialism.

By the early 1990s, the radical position was in retreat almost everywhere. There seem to be three reasons for this: (1) the collapse of communism in eastern Europe; (2) the generally abysmal economic performance of those countries that embraced the radical position, and a grow- ing belief by many of these countries that FDI can be an important source of technology and jobs and can stimu- late economic growth; and (3) the strong economic per- formance of those developing countries that embraced capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan).

THE FREE MARKET VIEW The free mar- ket view traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo (see Chapter 6). The intellectual case for this view has been strengthened by the internalization

LO 8-3 Understand how political ideology shapes a government’s attitudes toward FDI.

Are They Friends or Not—India and Pakistan? For many years, since the partition of British India in 1947 and the creation of India and Pakistan, these two South Asian coun- tries have been involved in numerous wars, border skirmishes, and military stand-offs. The dispute for Kashmir has been the main reason in most interactions, with a notable exception be- ing the Indo-Pakistani War of 1971, when the conflict started because of turmoil in East Pakistan (now called Bangladesh). However, in trying to improve the economic ties between the two nations, India recently announced that it will allow FDI from Pakistan, paving the way for industries from the neighboring country to set up businesses in the growing Indian market. While this is a prime example of how free markets are promot- ing trade between countries that have not traditionally enjoyed stable political relationships with each other, the question is also on what grounds cross-border interaction is founded. What do you think? Can countries that have been long-standing ene- mies normalize their relationship simply based on foreign direct investment opportunities?

Source: www.hindustantimes.com/business-news/WorldEconomy/India-to-allow- FDI-from-Pakistan-Anand-Sharma/Article1-839942.aspx.

Chapter Eight Foreign Direct Investment 235

explanation of FDI. The free market view argues that international production should be distributed among countries according to the theory of comparative advantage. Countries should specialize in the production of those goods and services that they can produce most efficiently. Within this framework, the MNE is an instrument for dispers- ing the production of goods and services to the most efficient locations around the globe. Viewed this way, FDI by the MNE increases the overall efficiency of the world economy.

Imagine that Dell decided to move assembly operations for many of its personal comput- ers from the United States to Mexico to take advantage of lower labor costs in Mexico. According to the free market view, moves such as this can be seen as increasing the overall efficiency of resource utilization in the world economy. Mexico, due to its lower labor costs, has a comparative advantage in the assembly of PCs. By moving the production of PCs from the United States to Mexico, Dell frees U.S. resources for use in activities in which the United States has a comparative advantage (e.g., the design of computer software, the man- ufacture of high value-added components such as microprocessors, or basic R&D). Also, consumers benefit because the PCs cost less than they would if they were produced domes- tically. In addition, Mexico gains from the technology, skills, and capital that the computer company transfers with its FDI. Contrary to the radical view, the free market view stresses that such resource transfers benefit the host country and stimulate its economic growth. Thus, the free market view argues that FDI is a benefit to both the source country and the host country.

PRAGMATIC NATIONALISM In practice, many countries have adopted nei- ther a radical policy nor a free market policy toward FDI, but instead a policy that can best be described as pragmatic nationalism.27 The pragmatic nationalist view is that FDI has both benefits and costs. FDI can benefit a host country by bringing capital, skills, technol- ogy, and jobs, but those benefits come at a cost. When a foreign company rather than a domestic company produces products, the profits from that investment go abroad. Many countries are also concerned that a foreign-owned manufacturing plant may import many components from its home country, which has negative implications for the host country’s balance-of-payments position.

Recognizing this, countries adopting a pragmatic stance pursue policies designed to maximize the national benefits and minimize the national costs. According to this view, FDI should be allowed so long as the benefits outweigh the costs. Japan offers an example of pragmatic nationalism. Until the 1980s, Japan’s policy was probably one of the most restrictive among countries adopting a pragmatic nationalist stance. This was due to Japan’s perception that direct entry of foreign (especially U.S.) firms with ample managerial resources into the Japanese markets could hamper the development and growth of its own industry and technology.28 This belief led Japan to block the majority of applications to invest in Japan. However, there were always exceptions to this policy. Firms that had important technology were often permitted to undertake FDI if they insisted that they would neither license their technology to a Japanese firm nor enter into a joint venture with a Japanese enterprise. IBM and Texas Instruments were able to set up wholly owned subsidiaries in Japan by adopting this negotiating position. From the perspective of the Japanese government, the benefits of FDI in such cases—the stimulus that these firms might impart to the Japanese economy—outweighed the perceived costs.

Another aspect of pragmatic nationalism is the tendency to aggressively court FDI believed to be in the national interest by, for example, offering subsidies to foreign MNEs in the form of tax breaks or grants. The countries of the European Union often seem to be competing with each other to attract U.S. and Japanese FDI by offering large tax breaks and subsidies. Britain has been the most successful at attracting Japanese invest- ment in the automobile industry. Nissan, Toyota, and Honda now have major assembly plants in Britain and use the country as their base for serving the rest of Europe—with obvious employment and balance-of-payments benefits for Britain.

236 Part Three The Global Trade and Investment Environment

SHIFTING IDEOLOGY Recent years have seen a marked decline in the number of countries that adhere to a radical ideology. Although few countries have adopted a pure free market policy stance, an increasing number of countries are gravitating toward the free mar- ket end of the spectrum and have liberalized their foreign investment regime. This includes many countries that less than two decades ago were firmly in the radical camp (e.g., the former communist countries of eastern Europe, many of the socialist countries of Africa, and India) and several countries that until recently could best be described as pragmatic nationalists with regard to FDI (e.g., Japan, South Korea, Italy, Spain, and most Latin Amer- ican countries). One result has been the surge in the volume of FDI worldwide, which, as we noted earlier, has been growing twice as fast as the growth in world trade. Another result has been an increase in the volume of FDI directed at countries that have recently liberalized their FDI regimes, such as China, India, and Vietnam.

As a counterpoint, there is some evidence of a shift to a more hostile approach to foreign direct investment in some nations. Venezuela and Bolivia have become increasingly hostile to foreign direct investment. In 2005 and 2006, the governments of both nations unilater- ally rewrote contracts for oil and gas exploration, raising the royalty rate that foreign enterprises had to pay the government for oil and gas extracted in their territories. Follow- ing his election victory in 2006, Bolivian President Evo Morales nationalized the nation’s gas fields and stated that he would evict foreign firms unless they agreed to pay about 80 percent of their revenues to the state and relinquish production oversight. In some de- veloped nations, there is increasing evidence of hostile reactions to inward FDI as well. In Europe in 2006, there was a hostile political reaction to the attempted takeover of Europe’s largest steel company, Arcelor, by Mittal Steel, a global company controlled by the Indian entrepreneur Lakshmi Mittal. In mid-2005, China National Offshore Oil Company with- drew a takeover bid for Unocal of the United States after highly negative reaction in Congress about the proposed takeover of a “strategic asset” by a Chinese company. Similarly, as detailed in the accompanying Management Focus, in 2006 a Dubai-owned

DP World and the United States

In February 2006, DP World, a ports operator with global reach owned by the government of Dubai, a member of the United Arab Emirates and a staunch U.S. ally, paid $6.8 billion to acquire P&O, a British firm that runs a global network of marine terminals. With P&O came the man- agement operations of six U.S. ports: Miami, Philadelphia, Baltimore, New Orleans, New Jersey, and New York. The acquisition had already been approved by U.S. regulators when it suddenly became front-page news. Upon hearing about the deal, several prominent U.S. senators raised concerns about the acquisition. Their objections were twofold. First, they raised questions about the security risks associated with management operations in key U.S. ports being owned by a foreign enterprise that was based in the Middle East. The implication was that terrorists could somehow take advantage of the ownership arrange- ment to infiltrate U.S. ports. Second, they were concerned that DP World was a state-owned enterprise and argued that foreign govern- ments should not be in a position of owning key “U.S. strategic assets.”

The Bush administration was quick to defend the takeover, stating it posed no threat to national security. Others noted that DP World was a respected global firm with an American chief operating officer and an American-educated chairman; the head of the global ports

management operation would also be an American. DP World would not own the U.S. ports in question, just manage them, while security issues would remain in the hands of American customs officials and the U.S. Coast Guard. Dubai was also a member of America’s Con- tainer Security Initiative, which allows American customs officials to inspect cargo in foreign ports before it leaves for the United States. Most of the DP World employees at American ports would be U.S. citizens, and any UAE citizen transferred to DP World would be sub- ject to American visa approval.

These arguments fell on deaf ears. With several U.S. senators threatening to pass legislation to prohibit foreign ownership of U.S. port operations, DP World bowed to the inevitable and announced it would sell off the right to manage the six U.S. ports for about $750 million. Looking forward, however, DP World stated it would seek an initial pub- lic offering in 2007, and the then-private firm would in all probability continue to look for ways to enter the United States. In the words of the firm’s CEO, “This is the world’s largest economy. How can you just ignore it?”

Sources: “Trouble at the Waterfront,” The Economist, February 25, 2006, p. 48; “Paranoia about Dubai Ports Deals Is Needless,” Financial Times, February 21, 2006, p. 16; and “DP World: We’ll Be Back,” Traffic World, May 29, 2006, p. 1.

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company withdrew its planned takeover of some operations at six U.S. ports after negative political reactions. So far, these countertrends are nothing more than isolated incidents, but if they become more widespread, the 30-year movement toward lower barriers to cross- border investment could be in jeopardy.

Benefits and Costs of FDI To a greater or lesser degree, many governments can be considered pragmatic national- ists when it comes to FDI. Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI. Here, we explore the benefits and costs of FDI, first from the perspective of a host (receiving) country and then from the perspective of the home (source) country. In the next section, we look at the policy instruments governments use to manage FDI.

HOST-COUNTRY BENEFITS The main benefits of inward FDI for a host country arise from resource-transfer effects, employment effects, balance-of-payments ef- fects, and effects on competition and economic growth.

Resource-Transfer Effects Foreign direct investment can make a positive contri- bution to a host economy by supplying capital, technology, and management resources that would otherwise not be available and thus boost that country’s economic growth rate (as described in the opening case, the Indian government has come around to this view and has adopted a more permissive attitude to inward investment).29

With regard to capital, many MNEs, by virtue of their large size and financial strength, have access to financial resources not available to host-country firms. These funds may be available from internal company sources, or, because of their reputation, large MNEs may find it easier to borrow money from capital markets than host-country firms would.

As for technology, you will recall from Chapter 3 that technology can stimulate economic development and industrialization. Technology can take two forms, both of which are valu- able. Technology can be incorporated in a production process (e.g., the technology for dis- covering, extracting, and refining oil), or it can be incorporated in a product (e.g., personal computers). However, many countries lack the research and development resources and skills required to develop their own indigenous product and process technology. This is particularly true in less developed nations. Such countries must rely on advanced industrialized nations for much of the technology required to stimulate economic growth, and FDI can provide it.

Research supports the view that multinational firms often transfer significant technology when they invest in a foreign country.30 For example, a study of FDI in Sweden found that foreign firms increased both the labor and total factor pro- ductivity of Swedish firms that they acquired, suggesting that significant technology transfers had occurred (technol- ogy typically boosts productivity).31 Also, a study of FDI by the Organization for Economic Cooperation and Develop- ment (OECD) found that foreign investors invested signifi- cant amounts of capital in R&D in the countries in which they had invested, suggesting that not only were they trans- ferring technology to those countries but they may also have been upgrading existing technology or creating new tech- nology in those countries.32

Foreign management skills acquired through FDI may also produce important benefits for the host country.

LO 8-4 Describe the benefits and costs of FDI to home and host countries.

Does Foreign Direct Investment Promote Growth? There are multiple reasons for companies to make foreign direct investments. Lowering the cost of production, increasing capac- ity (volume) of production, and strategically locating production facilities to serve world regions are some of the many reasons for FDI by a company. For the host countries that receive the in- vestment by multinational corporations, the logic is that the in- flux of capital and increase in tax revenues will benefit the host country in the form of new infrastructure, increased knowledge, and general economic development. However, the evidence so far is very mixed on the value of FDI to the host, ranging from beneficial to detrimental. What do you think? Does FDI promote growth in the host country?

Source: L. Alfaro, A. Chanda, S. Kalemli-Ozcan, and S. Sayek, “Does Foreign Direct Investment Promote Growth? Exploring the Role of Financial Markets on Linkages,” Cambridge, MA; Harvard Business School, 2009. www.people.hbs.edu/ lalfaro/fdiandlinkages.pdf.

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238 Part Three The Global Trade and Investment Environment

Foreign managers trained in the latest management techniques can often help improve the efficiency of operations in the host country, whether those operations are acquired or greenfield de- velopments. Beneficial spin-off effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help establish indigenous firms. Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own man- agement skills.

Employment Effects Another beneficial employment effect claimed for FDI is that it brings jobs to a host country that would otherwise not be created there. The effects of FDI on employ- ment are both direct and indirect. Direct effects arise when a for- eign MNE employs a number of host-country citizens. Indirect

effects arise when jobs are created in local suppliers as a result of the investment and when jobs are created because of increased local spending by employees of the MNE. The indirect employment effects are often as large as, if not larger than, the direct effects. For example, when Toyota decided to open a new auto plant in France, estimates suggested the plant would create 2,000 direct jobs and perhaps another 2,000 jobs in support industries.33

Cynics argue that not all the “new jobs” created by FDI represent net additions in em- ployment. In the case of FDI by Japanese auto companies in the United States, some argue that the jobs created by this investment have been more than offset by the jobs lost in U.S.- owned auto companies, which have lost market share to their Japanese competitors. As a consequence of such substitution effects, the net number of new jobs created by FDI may not be as great as initially claimed by an MNE. The issue of the likely net gain in employ- ment may be a major negotiating point between an MNE wishing to undertake FDI and the host government.

When FDI takes the form of an acquisition of an established enterprise in the host economy as opposed to a greenfield investment, the immediate effect may be to reduce employment as the multinational tries to restructure the operations of the acquired unit to improve its operating efficiency. However, even in such cases, research suggests that once the initial period of restructuring is over, enterprises acquired by foreign firms tend to increase their employment base at a faster rate than domestic rivals. An OECD study found that foreign firms created new jobs at a faster rate than their domestic counterparts.34

Balance-of-Payments Effects FDI’s effect on a country’s balance-of-payments accounts is an important policy issue for most host governments. A country’s balance-of-payments accounts track both its payments to and its receipts from other countries. Governments normally are concerned when their country is running a deficit on the current account of their balance of payments. The current account tracks the export and import of goods and services. A current account deficit, or trade deficit as it is often called, arises when a country is importing more goods and services than it is exporting. Governments typically prefer to see a current account surplus than a deficit. The only way in which a current account deficit can be supported in the long run is by selling off assets to foreigners (for a detailed explanation of why this is the case, see the appendix to Chapter 6). For example, the persistent U.S. current account deficit since the 1980s has been financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to foreigners. Because national governments invariably dislike seeing the assets of their country fall into foreign hands, they prefer their nation to run a current account surplus. There are two ways in which FDI can help a country achieve this goal.

Balance-of-Payments Accounts National accounts that track both payments to and receipts from foreigners.

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

Job creation is a result of FDI. These French workers assemble cars at Toyota’s Valenciennes manufacturing plant.

Chapter Eight Foreign Direct Investment 239

First, if the FDI is a substitute for imports of goods or services, the effect can be to improve the current account of the host country’s balance of payments. Much of the FDI by Japanese automobile companies in the United States and Europe, for example, can be seen as substituting for imports from Japan. Thus, the current account of the U.S. balance of pay- ments has improved somewhat because many Japanese companies are now supplying the U.S. market from production facilities in the United States, as opposed to facilities in Japan. Insofar as this has reduced the need to finance a current account deficit by asset sales to foreigners, the United States has clearly benefited.

A second potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries. According to a UN report, inward FDI by foreign multinationals has been a major driver of export-led economic growth in a number of devel- oping and developed nations.35 For example, in China exports increased from $26 billion in 1985 to more than $250 billion by 2001 and $1.9 trillion in 2012. Much of this dramatic export growth was due to the presence of foreign multinationals that invested heavily in China during the 1990s.

Effect on Competition and Economic Growth Economic theory tells us that the efficient functioning of markets depends on an adequate level of competition between producers. When FDI takes the form of a greenfield investment, the result is to establish a new enterprise, increasing the number of players in a market and thus con- sumer choice. In turn, this can increase the level of competition in a national market, thereby driving down prices and increasing the economic welfare of consumers. Increased competition tends to stimulate capital investments by firms in plant, equipment, and R&D as they struggle to gain an edge over their rivals. The long-term results may include in- creased productivity growth, product and process innovations, and greater economic growth.36 Such beneficial effects seem to have occurred in the South Korean retail sector following the liberalization of FDI regulations in 1996. FDI by large Western discount stores—including Walmart, Costco, Carrefour, and Tesco—seems to have encouraged in- digenous discounters such as E-Mart to improve the efficiency of their own operations. The results have included more competition and lower prices, which benefit South Korean consumers.

FDI’s impact on competition in domestic markets may be particularly important in the case of services, such as telecommunications, retailing, and many financial services, where exporting is often not an option because the service has to be produced where it is deliv- ered.37 For example, under a 1997 agreement sponsored by the World Trade Organization, 68 countries accounting for more than 90 percent of world telecommunications revenues pledged to start opening their markets to foreign investment and competition and to abide by common rules for fair competition in telecommunications. Before this agreement, most of the world’s telecommunications markets were closed to foreign competitors, and in most countries the market was monopolized by a single carrier, which was often a state-owned enterprise. The agreement has dramatically increased the level of competition in many na- tional telecommunications markets, producing two major benefits. First, inward investment has increased competition and stimulated investment in the modernization of telephone networks around the world, leading to better service. Second, the increased competition has resulted in lower prices.

HOST-COUNTRY COSTS Three costs of FDI concern host countries. They arise from possible adverse effects on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy.

Adverse Effects on Competition Host governments sometimes worry that the subsidiaries of foreign MNEs may have greater economic power than indigenous competi- tors. If it is part of a larger international organization, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive

240 Part Three The Global Trade and Investment Environment

indigenous companies out of business and allow the firm to monopolize the market. Once the market is monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harmful effects on the economic welfare of the host na- tion. This concern tends to be greater in countries that have few large firms of their own (generally, less developed countries). It tends to be a relatively minor concern in most ad- vanced industrialized nations.

In general, while FDI in the form of greenfield investments should increase competi- tion, it is less clear that this is the case when the FDI takes the form of acquisition of an established enterprise in the host nation, as was the case when Cemex acquired RMC in Britain (see the Management Focus). Because an acquisition does not result in a net in- crease in the number of players in a market, the effect on competition may be neutral. When a foreign investor acquires two or more firms in a host country, and subsequently merges them, the effect may be to reduce the level of competition in that market, create monopoly power for the foreign firm, reduce consumer choice, and raise prices. For ex- ample, in India, Hindustan Lever Ltd., the Indian subsidiary of Unilever, acquired its main local rival, Tata Oil Mills, to assume a dominant position in the bath soap (75 percent) and detergents (30 percent) markets. Hindustan Lever also acquired several local companies in other markets, such as the ice cream makers Dollops, Kwality, and Milkfood. By combining these companies, Hindustan Lever’s share of the Indian ice cream market went from zero in 1992 to 74 percent in 1997.38 However, although such cases are of obvious concern, there is little evidence that such developments are widespread. In many nations, domestic competition authorities have the right to review and block any mergers or acquisitions that they view as having a detrimental impact on competition. If such institutions are operating effectively, this should be sufficient to make sure that foreign entities do not monopolize a country’s markets.

Adverse Effects on the Balance of Payments The possible adverse effects of FDI on a host country’s balance-of-payments position are twofold. First, set against the initial capital inflow that comes with FDI must be the subsequent outflow of earnings from the foreign subsidiary to its parent company. Such outflows show up as capital outflow on balance-of-payments accounts. Some governments have responded to such outflows by restricting the amount of earnings that can be repatriated to a foreign subsid- iary’s home country. A second concern arises when a foreign subsidiary imports a substan- tial number of its inputs from abroad, which results in a debit on the current account of the host country’s balance of payments. One criticism leveled against Japanese-owned auto assembly operations in the United States, for example, is that they tend to import many component parts from Japan. Because of this, the favorable impact of this FDI on the current account of the U.S. balance-of-payments position may not be as great as initially supposed. The Japanese auto companies responded to these criticisms by pledg- ing to purchase 75 percent of their component parts from U.S.-based manufacturers (but not necessarily U.S.-owned manufacturers). When the Japanese auto company Nissan in- vested in the United Kingdom, Nissan responded to concerns about local content by pledging to increase the proportion of local content to 60 percent and subsequently rais- ing it to more than 80 percent.

National Sovereignty and Autonomy Some host governments worry that FDI is accompanied by some loss of economic independence. The concern is that key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control. Most economists dismiss such concerns as groundless and irrational. Political scien- tist Robert Reich has noted that such concerns are the product of outmoded thinking be- cause they fail to account for the growing interdependence of the world economy.39 In a world in which firms from all advanced nations are increasingly investing in each other’s markets, it is not possible for one country to hold another to “economic ransom” without hurting itself.

Chapter Eight Foreign Direct Investment 241

HOME-COUNTRY BENEFITS The benefits of FDI to the home (source) country arise from three sources. First, the home country’s balance of payments benefits from the inward flow of foreign earnings. FDI can also benefit the home country’s balance of payments if the foreign sub- sidiary creates demands for home-country exports of capital equipment, intermediate goods, complementary products, and the like.

Second, benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the for- eign subsidiary creates demand for home-country exports. Thus, Toyota’s investment in auto assembly operations in Europe has benefited both the Japanese balance-of-pay- ments position and employment in Japan, because Toyota imports some component parts for its European-based auto assembly operations directly from Japan.

Third, benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home coun- try. This amounts to a reverse resource-transfer effect. Through its exposure to a foreign market, an MNE can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country, contributing to the home country’s economic growth rate.40

HOME-COUNTRY COSTS Against these benefits must be set the apparent costs of FDI for the home (source) country. The most important concerns center on the balance- of-payments and employment effects of outward FDI. The home country’s balance of pay- ments may suffer in three ways. First, the balance of payments suffers from the initial capital outflow required to finance the FDI. This effect, however, is usually more than offset by the subsequent inflow of foreign earnings. Second, the current account of the balance of pay- ments suffers if the purpose of the foreign investment is to serve the home market from a low-cost production location. Third, the current account of the balance of payments suffers if the FDI is a substitute for direct exports. Thus, insofar as Toyota’s assembly operations in the United States are intended to substitute for direct exports from Japan, the current ac- count position of Japan will deteriorate.

With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production. This was the case with Toyota’s investments in the United States and Europe. One obvious result of such FDI is reduced home-country employment. If the labor market in the home country is already tight, with little unemployment, this concern may not be that great. However, if the home country is suffering from unemployment, con- cern about the export of jobs may arise. For example, one objection frequently raised by U.S. labor leaders to the free trade pact among the United States, Mexico, and Canada (see the next chapter) is that the United States would lose hundreds of thousands of jobs as U.S. firms in- vest in Mexico to take advantage of cheaper labor and then export back to the United States.41

INTERNATIONAL TRADE THEORY AND FDI When assessing the costs and benefits of FDI to the home country, keep in mind the lessons of international trade theory (see Chapter 6). International trade theory tells us that home-country concerns about the negative economic effects of offshore production may be misplaced. The term offshore production refers to FDI undertaken to serve the home market. Far from reducing home- country employment, such FDI may actually stimulate economic growth (and hence em- ployment) in the home country by freeing home-country resources to concentrate on

Offshore Production FDI undertaken to serve the home market.

Is FDI a Form of Colonialism or Ethical Investing? Some critics of globalization suggest that FDI is an advanced form of colonialism that destroys local cultures in developing countries. What these critics say may have some limited validity, but it isn’t the whole picture. Take Freeport McMoRan, a U.S.- based mining company with operations in West Papua (the for- mer Irian Jaya), Indonesia, where the world’s largest gold, mineral, and copper reserves have been found. Freeport formed a joint venture with the Indonesian government to mine a con- cession, an isolated tract of land the size of Massachusetts on a remote island, half of which is the country of Papua New Guinea. Freeport has brought education, Internet connections, world- class health care, and the modern world to the isolated local tribes in West Papua, nomadic peoples who wear loincloths and hunt in the forest. Their traditional, subsistence way of life is threatened, while at the same time, they gain from their share of the operation’s profits, from their increased health care and edu- cation, and from local employment opportunities with FCX. Is this colonialism or a kind of ethical investing?

Source: www.corpwatch.org

242 Part Three The Global Trade and Investment Environment

activities where the home country has a comparative advantage. In addition, home-country consumers benefit if the price of the particular product falls as a result of the FDI. Also, if a company were prohibited from making such investments on the grounds of negative em- ployment effects while its international competitors reaped the benefits of low-cost produc- tion locations, it would undoubtedly lose market share to its international competitors. Under such a scenario, the adverse long-run economic effects for a country would probably outweigh the relatively minor balance-of-payments and employment effects associated with offshore production.

Government Policy Instruments and FDI We have now reviewed the costs and benefits of FDI from the perspective of both home country and host country. We now turn our attention to the policy instruments that home (source) countries and host countries can use to regulate FDI.

HOME-COUNTRY POLICIES Through their choice of policies, home coun- tries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include foreign risk insurance, capital assistance, tax incentives, and political pressure. Then we will look at policies designed to restrict out- ward FDI.

Encouraging Outward FDI Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. The types of risks insurable through these programs include the risks of expropriation (nationalization), war losses, and the inability to transfer profits back home. Such programs are particularly use- ful in encouraging firms to undertake investments in politically unstable countries.42 In addition, several advanced countries also have special funds or banks that make govern- ment loans to firms wishing to invest in developing countries. As a further incentive to encourage domestic firms to undertake FDI, many countries have eliminated double taxa- tion of foreign income (i.e., taxation of income in both the host country and the home country). Last, and perhaps most significant, a number of investor countries (including the United States) have used their political influence to persuade host countries to relax their restrictions on inbound FDI. For example, in response to direct U.S. pressure, Japan re- laxed many of its formal restrictions on inward FDI in the 1980s. Now, in response to further U.S. pressure, Japan has moved toward relaxing its informal barriers to inward FDI. One beneficiary of this trend has been Toys “R” Us, which, after five years of inten- sive lobbying by company and U.S. government officials, opened its first retail stores in Japan in December 1991. By 2012, Toys “R” Us had more than 170 stores in Japan, and its Japanese operation, in which Toys “R” Us retained a controlling stake, had a listing on the Japanese stock market.

Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One policy has been to limit capital outflows out of concern for the country’s balance of payments. From the early 1960s until 1979, for example, Britain had exchange-control regulations that lim- ited the amount of capital a firm could take out of the country. Although the main intent of such policies was to improve the British balance of payments, an important secondary intent was to make it more difficult for British firms to undertake FDI.

In addition, countries have occasionally manipulated tax rules to try to encourage their firms to invest at home. The objective behind such policies is to create jobs at home rather than in other nations. At one time, Britain adopted such policies. The British advanced corporation tax system taxed British companies’ foreign earnings at a higher rate than their domestic earnings. This tax code created an incentive for British companies to invest at home.

LO 8-5 Explain the range of policy instruments that governments use to influence FDI.

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Chapter Eight Foreign Direct Investment 243

Finally, countries sometimes prohibit national firms from investing in certain countries for political reasons. Such restrictions can be formal or informal. For example, formal U.S. rules prohibited U.S. firms from investing in countries such as Cuba and Iran, whose politi- cal ideology and actions are judged to be contrary to U.S. interests. Similarly, during the 1980s, informal pressure was applied to dissuade U.S. firms from investing in South Africa. In this case, the objective was to pressure South Africa to change its apartheid laws, which happened during the early 1990s.

HOST-COUNTRY POLICIES Host countries adopt policies designed both to restrict and to encourage inward FDI. As noted earlier in this chapter, political ideology has determined the type and scope of these policies in the past. In the last decade of the twenti- eth century, many countries moved quickly away from adhering to some version of the radical stance and prohibiting much FDI, and toward a situation where a combination of free market objectives and pragmatic nationalism took hold.

Encouraging Inward FDI It is common for governments to offer incentives to for- eign firms to invest in their countries. Such incentives take many forms, but the most com- mon are tax concessions, low-interest loans, and grants or subsidies. Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI. They are also motivated by a desire to capture FDI away from other potential host countries. For example, in the mid-1990s, the governments of Britain and France competed with each other on the incentives they offered Toyota to invest in their respective countries. In the United States, state governments often compete with each other to attract FDI. For example, Kentucky offered Toyota an incentive package worth $147 million to persuade it to build its U.S. au- tomobile assembly plants there. The package included tax breaks, new state spending on infrastructure, and low-interest loans.43

Restricting Inward FDI Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are ownership restraints and perfor- mance requirements. Ownership restraints can take several forms. In some countries, for- eign companies are excluded from specific fields. They are excluded from tobacco and mining in Sweden and from the development of certain natural resources in Brazil, Finland, and Morocco. In other industries, foreign ownership may be permitted although a signifi- cant proportion of the equity of the subsidiary must be owned by local investors. Foreign ownership is restricted to 25 percent or less of an airline in the United States. In India, for- eign firms were prohibited from owning media businesses until 2001, when the rules were relaxed, allowing foreign firms to purchase up to 26 percent of an Indian newspaper. As de- scribed in the opening case, foreign firms are still restricted from owning retail establish- ments in India.44

The rationale underlying ownership restraints seems to be twofold. First, foreign firms are often excluded from certain sectors on the grounds of national security or competi- tion. Particularly in less developed countries, the feeling seems to be that local firms might not be able to develop unless foreign competition is restricted by a combination of import tariffs and controls on FDI. This is a variant of the infant industry argument dis- cussed in Chapter 7.

Second, ownership restraints seem to be based on a belief that local owners can help maximize the resource-transfer and employment benefits of FDI for the host country. Until the early 1980s, the Japanese government prohibited most FDI but allowed joint ventures between Japanese firms and foreign MNEs if the MNE had a valuable technology. The Japanese government clearly believed such an arrangement would speed up the subsequent diffusion of the MNE’s valuable technology throughout the Japanese economy.

Performance requirements can also take several forms. Performance requirements are controls over the behavior of the MNE’s local subsidiary. The most common perfor- mance requirements are related to local content, exports, technology transfer, and local participation in top management. As with certain ownership restrictions, the logic

underlying performance requirements is that such rules help maximize the benefits and minimize the costs of FDI for the host country. Many countries employ some form of performance requirements when it suits their objectives. However, performance re- quirements tend to be more common in less developed countries than in advanced in- dustrialized nations.45

INTERNATIONAL INSTITUTIONS AND THE LIBERALIZATION OF FDI Until the 1990s, there was no consistent involvement by multinational institu- tions in the governing of FDI. This changed with the formation of the World Trade Orga- nization in 1995. The WTO embraces the promotion of international trade in services. Because many services have to be produced where they are sold, exporting is not an option (e.g., one cannot export McDonald’s hamburgers or consumer banking services). Given this, the WTO has become involved in regulations governing FDI. As might be expected for an institution created to promote free trade, the thrust of the WTO’s efforts has been to push for the liberalization of regulations governing FDI, particularly in services. Under the auspices of the WTO, two extensive multinational agreements were reached in 1997 to liberalize trade in telecommunications and financial services. Both these agreements con- tained detailed clauses that require signatories to liberalize their regulations governing in- ward FDI, essentially opening their markets to foreign telecommunications and financial services companies. The WTO has had less success trying to initiate talks aimed at estab- lishing a universal set of rules designed to promote the liberalization of FDI. Led by Malaysia and India, developing nations have so far rejected efforts by the WTO to start such discussions.

FOCUS ON MANAGERIAL IMPLICATIONS

FDI AND GOVERNMENT POLICY Several implications for business are inherent in the material discussed in this chapter. In this section, we deal first with the implications of the theory and then turn our attention to the implications of government policy.

THE THEORY OF FDI The implications of the theories of FDI for business practice are straightforward. First, the location-specific advantages argument associated with John Dunning does help explain the direction of FDI. However, the location-specific advantages argument does not explain why firms prefer FDI to licensing or to exporting. In this regard, from both an explanatory and a business perspective, perhaps the most useful theories are those that focus on the limitations of exporting and licensing—that is, internalization theories. These theories are useful because they identify with some precision how the relative profitability of foreign direct investment, exporting, and licensing vary with circum- stances. The theories suggest that exporting is preferable to licensing and FDI so long as transportation costs are minor and trade barriers are trivial. As transportation costs or trade barriers increase, exporting becomes unprofitable, and the choice is between FDI and licensing. Because FDI is more costly and more risky than licensing, other things being equal, the theories argue that licensing is preferable to FDI. Other things are seldom equal, however. Although licensing may work, it is not an attractive option when one or more of the following conditions exist: (1) The firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) the firm needs tight control

LO 8-6 Identify the implications for managers of the theory and government policies associated with FDI.

244 Part Three The Global Trade and Investment Environment

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over a foreign entity to maximize its market share and earnings in that country, and (3) a firm’s skills and capabilities are not amenable to licensing. Figure 8.4 presents these considerations as a decision tree.

Firms for which licensing is not a good option tend to be clustered in three types of industries:

1. High-technology industries in which protecting firm-specific expertise is of paramount importance and licensing is hazardous.

2. Global oligopolies, in which competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors.

3. Industries in which intense cost pressures require that multinational firms maintain tight control over foreign operations (so that they can disperse manufacturing to locations around the globe where factor costs are most favorable in order to minimize costs).

Although empirical evidence is limited, the majority seems to support these conjec- tures.46 In addition, licensing is not a good option if the competitive advantage of a firm is based upon managerial or marketing knowledge that is embedded in the routines of the firm or the skills of its managers, and that is difficult to codify in a “book of blueprints.” This would seem to be the case for firms based in a fairly wide range of industries.

8.4 FIGURE A Decision FrameworkExport

FDI

Then License

Low

High

Yes

Is Tight Control over Foreign Operation Required?

How High Are Transportation Costs and Tariffs?

Is Know-how Amenable to Licensing?

Can Know-how Be Protected by Licensing Contract?

Chapter Eight Foreign Direct Investment 245

Firms for which licensing is a good option tend to be in industries whose conditions are opposite to those just specified. That is, licensing tends to be more common, and more profitable, in fragmented, low-technology industries in which globally dispersed manufac- turing is not an option. A good example is the fast-food industry. McDonald’s has expanded globally by using a franchising strategy. Franchising is essentially the service-industry ver- sion of licensing, although it normally involves much longer-term commitments than licensing. With franchising, the firm licenses its brand name to a foreign firm in return for a percentage of the franchisee’s profits. The franchising contract specifies the conditions that the franchisee must fulfill if it is to use the franchisor’s brand name. Thus, McDonald’s allows foreign firms to use its brand name so long as they agree to run their restaurants on exactly the same lines as McDonald’s restaurants elsewhere in the world. This strategy makes sense for McDonald’s because (1) like many services, fast food cannot be exported; (2) franchising economizes the costs and risks associated with opening up foreign markets; (3) unlike technological know-how, brand names are relatively easy to protect using a con- tract; (4) there is no compelling reason for McDonald’s to have tight control over franchi- sees; and (5) McDonald’s know-how, in terms of how to run a fast-food restaurant, is amenable to being specified in a written contract (e.g., the contract specifies the details of how to run a McDonald’s restaurant).

Finally, it should be noted that the product life-cycle theory and Knickerbocker’s theory of FDI tend to be less useful from a business perspective. The problem with these two theories is that they are descriptive rather than analytical. They do a good job of describing the historical evolution of FDI, but they do a relatively poor job of identi- fying the factors that influence the relative profitability of FDI, licensing, and export- ing. Indeed, the issue of licensing as an alternative to FDI is ignored by both these theories.

GOVERNMENT POLICY A host government’s attitude toward FDI should be an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment. Other things being equal, investing in countries that have permissive policies toward FDI is clearly preferable to investing in countries that restrict FDI.

However, often the issue is not this straightforward. Despite the move toward a free market stance in recent years, many countries still have a rather pragmatic stance toward FDI. In such cases, a firm considering FDI must often negotiate the specific terms of the investment with the country’s government. Such negotiations center on two broad issues. If the host government is trying to attract FDI, the central issue is likely to be the kind of incentives the host government is prepared to offer to the MNE and what the firm will commit in exchange. If the host government is uncertain about the benefits of FDI and might choose to restrict access, the central issue is likely to be the concessions that the firm must make to be allowed to go forward with a proposed investment.

To a large degree, the outcome of any negotiated agreement depends on the relative bargaining power of both parties. Each side’s bargaining power depends on three factors:

• The value each side places on what the other has to offer. • The number of comparable alternatives available to each side. • Each party’s time horizon.

From the perspective of a firm negotiating the terms of an investment with a host government, the firm’s bargaining power is high when the host government places a high value on what the firm has to offer, the number of comparable alternatives open to the firm is greater, and the firm has a long time in which to complete the negotia- tions. The converse also holds. The firm’s bargaining power is low when the host govern- ment places a low value on what the firm has to offer, the number of comparable alternatives open to the firm is fewer, and the firm has a short time in which to complete the negotiations.47

246 Part Three The Global Trade and Investment Environment

Chapter Eight Foreign Direct Investment 247

greenfield investment, p. 224 flow of FDI, p. 224 stock of FDI, p. 224 outflows of FDI, p. 224 inflows of FDI, p. 224 eclectic paradigm, p. 228

exporting, p. 229 licensing, p. 229 internalization theory, p. 230 market imperfections, p. 230 oligopoly, p. 232 multipoint competition, p. 232

location-specific advantages, p. 233 externalities, p. 233 balance-of-payments accounts, p. 238 current account, p. 238 offshore production, p. 241

Key Terms

Summary

This chapter reviewed theories that attempt to explain the pattern of FDI between countries and to examine the in- fluence of governments on firms’ decisions to invest in for- eign countries. The chapter made the following points:

1. Any theory seeking to explain FDI must explain why firms go to the trouble of acquiring or establishing operations abroad when the alternatives of exporting and licensing are available to them.

2. High transportation costs or tariffs imposed on imports help explain why many firms prefer FDI or licensing over exporting.

3. Firms often prefer FDI to licensing when (a) a firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) a firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country, and (c) a firm’s skills and capabilities are not amenable to licensing.

4. Knickerbocker’s theory suggests that much FDI is explained by imitative behavior by rival firms in an oligopolistic industry.

5. Dunning has argued that location-specific advantages are of considerable importance in explaining the nature and direction of FDI. According to Dunning, firms undertake FDI to exploit resource endowments or assets that are location specific.

6. Political ideology is an important determinant of government policy toward FDI. Ideology ranges from a radical stance that is hostile to FDI to a

noninterventionist, free market stance. Between the two extremes is an approach best described as pragmatic nationalism.

7. Benefits of FDI to a host country arise from resource- transfer effects, employment effects, and balance-of- payments effects.

8. The costs of FDI to a host country include adverse effects on competition and balance of payments and a perceived loss of national sovereignty.

9. The benefits of FDI to the home (source) country include improvement in the balance of payments as a result of the inward flow of foreign earnings, positive employment effects when the foreign subsidiary creates demand for home-country exports, and benefits from a reverse resource-transfer effect. A reverse resource-transfer effect arises when the foreign subsidiary learns valuable skills abroad that can be transferred back to the home country.

10. The costs of FDI to the home country include adverse balance-of-payments effects that arise from the initial capital outflow and from the export substitution effects of FDI. Costs also arise when FDI exports jobs abroad.

11. Home countries can adopt policies designed to both encourage and restrict FDI. Host countries try to attract FDI by offering incentives, and try to restrict FDI by dictating ownership restraints and requiring that foreign MNEs meet specific performance requirements.

Critical Thinking and Discussion Questions

1. In 2008, inward FDI accounted for some 63.7 percent of gross fixed capital formation in Ireland, but only 4.1 percent in Japan (gross fixed capital formation refers to investments in fixed assets such as factories, warehouses, and retail stores). What do you think explains this difference in FDI inflows into the two countries?

2. Compare and contrast these explanations of FDI: internalization theory and Knickerbocker’s theory of FDI. Which theory do you think offers the best explanation of the historical pattern of FDI? Why?

3. What are the strengths of the eclectic theory of FDI? Can you see any shortcomings? How does the eclectic theory influence management practice?

4. Read the Management Focus on Cemex, and then answer the following questions: a. Which theoretical explanation, or explanations, of

FDI best explains Cemex’s FDI? b. What is the value that Cemex brings to a host

economy? Can you see any potential drawbacks of inward investment by Cemex in an economy?

c. Cemex has a strong preference for acquisitions over greenfield ventures as an entry mode. Why?

5. You are the international manager of a U.S. business that has just developed a revolutionary new personal

computer that can perform the same functions as existing PCs but costs only half as much to manufacture. Several patents protect the unique design of this computer. Your CEO has asked you to formulate a recommendation for how to expand into western Europe. Your options are (a) to export from the United States, (b) to license a European firm to manufacture and market the computer in Europe, or (c) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative, and suggest a course of action to your CEO.

For years now, there has been intense debate in India about the wisdom of relaxing the country’s restrictions on foreign direct investment into its retail sector. The Indian retailing sector is highly fragmented and dominated by small enterprises. Estimates suggest that barely 6 percent of India’s al- most $500 billion in retail sales take place in organized retail establish- ments. The rest takes place in small shops, most of which are unincorpo- rated businesses run by individuals or households. In contrast, organized retail establishments account for more than 20 percent of sales in China, 36 percent of sales in Brazil, and 85 percent of all retail sales in the United States. In total, retail establishments in India employ some 34 million peo- ple, accounting for more than 7 percent of the workforce.

Advocates of opening up retailing in India to large foreign enterprises such as Walmart, Carrefour, Ikea, and Tesco, make a number of arguments. They believe that foreign retailers can be a positive force for improving the efficiency of India’s distribution systems. Companies like Walmart and Tesco are experts in supply chain management. Applied to India, such know-how could take significant costs out of the economy. Logistics costs are around 14 percent of GDP in India, much higher than the 8 percent in the United States. While this is partly due to a poor road system, it is also

the case that most distribution is done by small trucking enterprises, often with a single truck, that have few economies of scale or scope. Large for- eign retailers tend to establish their own trucking operations and can reap significant gains from tight control of their distribution system.

Foreign retailers will also probably make major investments in distri- bution infrastructure such as cold storage facilities and warehouses. Currently, there is a chronic lack of cold storage facilities in India. Esti- mates suggest that about 25 to 30 percent of all fruits and vegetables spoil before they reach the market due to inadequate cold storage. Similarly, there is a lack of warehousing capacity. A lot of wheat, for example, is simply stored under tarpaulins, where it is at risk of rotting. Such problems raise foods costs to consumers and impose significant losses on farmers.

Farmers have emerged as significant advocates of reform. This is not surprising because they stand to benefit from working with foreign retail- ers. Similarly, reform-minded politicians argue that foreign retailers will help to keep food processing in check, which benefits all. Ranged against them is a powerful coalition of small shop owners and left-wing politi- cians, who argue that the entry of large, well-capitalized foreign retailers

ccccccllooooooossssiinnnnnnggggggggggg ccccccaaaasssssssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeeForeign Retailers in India

248 Part Three The Global Trade and Investment Environment

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

1. The World Investment Report published annually by UNCTAD provides a summary of recent trends in FDI as well as quick access to comprehensive investment statistics. Identify the table of largest transnational corporations from developing and transition countries. The ranking is based on the foreign assets each corporation owns. Based only at the top 20 companies, provide a summary of the countries and industries represented. Do you notice any common traits from your analysis? Did any industries or countries in the top 20 surprise you? Why?

2. An integral part of successful foreign direct investment is to understand the target market opportunities as well as the nature of the risk inherent in possible investment projects, particularly in developing countries. You work for a company that builds wastewater and sanitation infrastructure in such countries. The Multilateral Investment Guarantee Agency (MIGA) provides insurance for risky projects in these markets. Identify the sector brief for the water and wastewater sector, and prepare a report to identify the major risks projects in this sector tend to face and how MIGA can assist in such projects.

Research Task http://globalEDGE.msu.edu

Chapter Eight Foreign Direct Investment 249

will result in the significant job losses and force many small retailers out of businesses.

In 1997, it looked as if the reformers had the upper hand when they succeeded in changing the rules to allow foreign enterprises to participate in wholesale trading. Taking advantage of this reform, in 2009 Walmart started to open up wholesale stores in India under the name Best Price. The stores are operated by a joint venture with Bharti, an Indian conglom- erate. These stores are only allowed to sell to other businesses, such as hotels, restaurants, and small retailers. By 2012, the venture had 20 stores in India. Customers of these stores note that unlike many local competi- tors, they always have products in stock, and they are not constantly changing their prices. Farmers, too, like the joint venture because it has worked closely with farmers to secure consistent supplies and has made investments in warehouses and cold storage. The joint venture also pays farmers better prices—something it can afford to do because far less pro- duce goes to waste in its system.

For its part, in 2011 the Indian government indicated that it would soon introduce legislation to allow foreign enterprises like Walmart entry into the retail sector. On the basis on this promise, Walmart and Bharti were plan- ning to expand downstream from wholesale into retail establishments, but their plans were put on hold in late 2011 when the Indian government announced that the legislation had been shelved for the time being. Appar- ently, opposition to such reform had reached such a pitch that implementing it was not worth the political risk. Opponents argued that global experience showed that FDI leads to job losses, although they cited no data to support this claim. Whether India will further relax regulations limiting inward FDI into retail remains to be seen.

Sources: V. Bajaj, “Wal-Mart Debate Rages in India,” The New York Times, December 6, 2011, pp. B1, B2; S. G. Mozumder, “Walmart Is Not Coming to India Just to Sell,” India Abroad, December 16, 2011, pp. A18–A19; and R. Kohli and J. Bhaqwati, “Organized Retailing in India: Issues and Outlook,” Columbia Program on Indian Economic Policies, working paper no. 2011-1, January 22, 2011.

CASE DISCUSSION QUESTIONS 1. Why do you think that the Indian retail sector is so fragmented?

2. What are the potential benefits to India of entry by foreign retail establishments?

3. Who stands to lose as a result of foreign entry into the Indian retail sector?

4. Why do you think reform of FDI regulations in India has been so difficult?

Endnotes

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

2. United Nations, World Investment Report, 2013; and United Nations Conference on Trade and Investment, “Global Flows of Foreign Direct Investment Exceeding Pre-Crisis Levels in 2011,” Global Investment Trends Monitor, January 24, 2012.

3. World Trade Organization, International Trade Statistics, 2012 (Geneva: WTO, 2012); and United Nations, World Investment Report, 2012.

4. United Nations, World Investment Report, 2013.

5. United Nations, World Investment Report, 2010 (New York and Geneva: United Nations, 2010).

6. United Nations, World Investment Report, 2013; and UN Con- ference on Trade and Investment, “Global Flows of Foreign Direct Investment.”

7. Ibid.

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

9. United Nations, World Investment Report, 2013.

10. M. Caruso-Cabrera, “Chinese Investment in US May Break Record in 2013,” CNBC, January 2, 2013.

11. United Nations, World Investment Report, 2012.

12. See D. J. Ravenscraft and F. M. Scherer, Mergers, Selloffs and Economic Efficiency (Washington, DC: The Brookings

Shoppers at a supermarket in Mumbai, India have an array of fruits and vegetables to choose from.

250 Part Three The Global Trade and Investment Environment

Institution, 1987); and A. Seth, K. P. Song, and R. R. Pettit, “Value Creation and Destruction in Cross-Border Acquisi- tions,” Strategic Management Journal 23 (2002), pp. 921–40.

13. For example, see S. H. Hymer, The International Operations of National Firms: A Study of Direct Foreign Investment (Cambridge, MA: MIT Press, 1976); A. M. Rugman, Inside the Multinationals: The Economics of Internal Markets (New York: Columbia University Press, 1981); D. J. Teece, “Multi- national Enterprise, Internal Governance, and Industrial Organization,” American Economic Review 75 (May 1983), pp. 233–38; C. W. L. Hill and W. C. Kim, “Searching for a Dynamic Theory of the Multinational Enterprise: A Transac- tion Cost Model,” Strategic Management Journal 9 (special issue, 1988), pp. 93–104; A. Verbeke, “The Evolutionary View of the MNE and the Future of Internalization Theory,” Journal of International Business Studies 34 (2003), pp. 498–501; and J. H. Dunning, “Some Antecedents of Internalization Theory,” Journal of International Business Studies 34 (2003), pp. 108–28.

14. J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).

15. The argument is most often associated with F. T. Knicker- bocker, Oligopolistic Reaction and Multinational Enterprise (Boston: Harvard Business School Press, 1973).

16. The studies are summarized in R. E. Caves, Multinational Enterprise and Economic Analysis, 2nd ed. (Cambridge, UK: Cambridge University Press, 1996).

17. See R. E. Caves, “Japanese Investment in the US: Lessons for the Economic Analysis of Foreign Investment,” The World Economy 16 (1993), pp. 279–300; B. Kogut and S. J. Chang, “Technological Capabilities and Japanese Direct Investment in the United States,” Review of Economics and Statistics 73 (1991), pp. 401–43; and J. Anand and B. Kogut, “Technologi- cal Capabilities of Countries, Firm Rivalry, and Foreign Direct Investment,” Journal of International Business Studies, 1997, pp. 445–65.

18. K. Ito and E. L. Rose, “Foreign Direct Investment Location Strategies in the Tire Industry,” Journal of International Busi- ness Studies 33 (2002), pp. 593–602.

19. H. Haveman and L. Nonnemaker, “Competition in Multiple Geographical Markets,” Administrative Science Quarterly 45 (2000), pp. 232–67; and L. Fuentelsaz and J. Gomez, “Multi- point Competition, Strategic Similarity and Entry into Geo- graphic Markets,” Strategic Management Journal 27 (2006), pp. 447–57.

20. J. H. Dunning, Explaining International Production (London: Unwin Hyman, 1988).

21. P. Krugman. “Increasing Returns and Economic Geography,” Journal of Political Economy 99, no. 3 (1991), pp. 483–99.

22. J. M. Shaver and F. Flyer, “Agglomeration Economies, Firm Heterogeneity, and Foreign Direct Investment in the United States,” Strategic Management Journal 21 (2000), pp. 1175–93.

23. J. H. Dunning and R. Narula, “Transpacific Foreign Direct Investment and the Investment Development Path,” South Carolina Essays in International Business, May 1995.

24. W. Shan and J. Song, “Foreign Direct Investment and the Sourcing of Technological Advantage: Evidence from the

Biotechnology Industry,” Journal of International Business Studies, 1997, pp. 267–84.

25. For some additional evidence, see L. E. Brouthers, K. D. Brouthers, and S. Warner, “Is Dunning’s Eclectic Framework Descriptive or Normative?” Journal of International Business Studies 30 (1999), pp. 831–44.

26. For elaboration, see S. Hood and S. Young, The Economics of the Multinational Enterprise (London: Longman, 1979); and P. M. Sweezy and H. Magdoff, “The Dynamics of U.S. Capi- talism,” Monthly Review Press, 1972.

27. For an example of this policy as practiced in China, see L. G. Branstetter and R. C. Freenstra, “Trade and Foreign Direct Investment in China: A Political Economy Approach,” Jour- nal of International Economics 58 (December 2002), pp. 335–58.

28. M. Itoh and K. Kiyono, “Foreign Trade and Direct Invest- ment,” in Industrial Policy of Japan, ed. R. Komiya, M. Okuno, and K. Suzumura (Tokyo: Academic Press, 1988).

29. R. E. Lipsey, “Home and Host Country Effects of FDI,” National Bureau of Economic Research Working Paper Series, paper no. 9293, October 2002; and X. Li and X. Liu, “For- eign Direct Investment and Economic Growth,” World Devel- opment 33 (March 2005), pp. 393–413.

30. X. J. Zhan and T. Ozawa, Business Restructuring in Asia: Cross Border M&As in Crisis Affected Countries (Copenhagen: Co- penhagen Business School, 2000); I. Costa, S. Robles, and R. de Queiroz, “Foreign Direct Investment and Technological Capabilities,” Research Policy 31 (2002), pp. 1431–43; B. Potterie and F. Lichtenberg, “Does Foreign Direct Investment Transfer Technology across Borders?” Review of Economics and Statistics 83 (2001), pp. 490–97; and K. Saggi, “Trade, Foreign Direct Investment and International Technology Transfer,” World Bank Research Observer 17 (2002), pp. 191–235.

31. K. M. Moden, “Foreign Acquisitions of Swedish Companies: Effects on R&D and Productivity,” Research Institute of International Economics, 1998, mimeo.

32. “Foreign Friends,” The Economist, January 8, 2000, pp. 71–72.

33. A. Jack, “French Go into Overdrive to Win Investors,” Finan- cial Times, December 10, 1997, p. 6.

34. “Foreign Friends,” The Economist, January 8, 2000, pp. 71–72.

35. United Nations, World Investment Report, 2014 (New York and Geneva: United Nations, 2002).

36. R. Ram and K. H. Zang, “Foreign Direct Investment and Economic Growth,” Economic Development and Cultural Change 51 (2002), pp. 205–25.

37. United Nations, World Investment Report, 2014 (New York and Geneva: United Nations, 1998).

38. United Nations, World Investment Report, 2000 (New York and Geneva: United Nations, 2000).

39. R. B. Reich, The Work of Nations: Preparing Ourselves for the 21st Century (New York: Alfred A. Knopf, 1991).

40. This idea has been articulated, although not quite in this form, by C. A. Bartlett and S. Ghoshal, Managing across

Chapter Eight Foreign Direct Investment 251

Borders: The Transnational Solution (Boston: Harvard Business School Press, 1989).

41. P. Magnusson, “The Mexico Pact: Worth the Price?” Busi- nessWeek, May 27, 1991, pp. 32–35.

42. C. Johnston, “Political Risk Insurance,” in Assessing Corporate Political Risk, ed. D. M. Raddock (Totowa, NJ: Rowan & Littlefield, 1986).

43. M. Tolchin and S. Tolchin, Buying into America: How Foreign Money Is Changing the Face of Our Nation (New York: Times Books, 1988).

44. S. Rai, “India to Ease Limits on Foreign Ownership of Media and Tea,” The New York Times, June 26, 2002, p. W1.

45. L. D. Qiu and Z. Tao, “Export, Foreign Direct Investment and Local Content Requirements,” Journal of Development Economics 66 (October 2001), pp. 101–25.

46. See R. E. Caves, Multinational Enterprise and Economic Analysis (Cambridge, UK: Cambridge University Press, 1982).

47. For a good general introduction to negotiation strategy, see M. H. Bazerman and M. A. Neale, Negotiating Rationally (New York: Free Press, 1992); A. Dixit and B. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: W. W. Norton, 1991); and H. Raiffa, The Art and Science of Negotiation (Cambridge, MA: Harvard University Press, 1982).

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learning objectives

9-1 Describe the different levels of regional economic integration.

9-2 Understand the economic and political arguments for regional economic integration.

9-3 Understand the economic and political arguments against regional economic integration.

9-4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

9-5 Understand the implications for business that are inherent in regional economic integration agreements.

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opening case

W hen the North America Free Trade Agreement (NAFTA) went into effect in December 1992 and tariffs on imported tomatoes were dropped, U.S. tomato producers in Florida feared that they would lose business to lower-cost producers in Mexico. So they lobbied the government to set a minimum floor price for tomatoes imported from Mexico. The idea was to stop Mexican producers from

cutting prices below the floor to gain share in the U.S. market. In 1996 the United States and Mexico agreed

on the basic floor price of 21.69 cents a pound. At the time, both sides declared themselves to be happy

with the deal.

As it turns out, the deal didn’t offer much protection for U.S. tomato growers. In 1992, the year before

NAFTA was passed, Mexican producers exported 800 million pounds of tomatoes to the United States. By

2011 they were exporting 2.8 billion pounds of tomatoes, an increase of 3.5-fold. The value of Mexican

tomato exports almost tripled to $2 billion during the same period. In contrast, tomato production in

Florida has fallen by 41 percent since NAFTA went into effect. Florida growers complained that they could

not compete against low wages and lax environmental oversight in Mexico. They also alleged that Mexican

growers were dumping tomatoes in the United States market at below the cost of production, with the goal

of driving U.S. producers out of business. In 2012, Florida growers petitioned the U.S. Department of

Commerce to scrap the 1996 minimum-price agreement, which would then allow them to file an

antidumping case against Mexican producers. In September 2012 the Commerce Department announced

a preliminary decision to scrap the agreement.

At first glance, it looked as if the Florida growers were going to get their way. It soon became apparent,

however, that the situation was more complex than it appeared at first glance. Some 370 business and

trade groups in the United States wrote or signed letters to the Commerce Department in favor of

continuing the 1996 agreement. Among the letter writers was Kevin Ahern, the CEO of Ahern Agribusiness

in San Diego, a company that sells about $20 million a year in tomato seeds and transplants to Mexican

farmers. In a letter sent to The New York Times, Ahern said, “Yes, Mexico produces their tomatoes on

Tomato Wars

Regional Economic Integration

–continued

254 Part Three The Global Trade and Investment Environment

average at a lower cost than Florida; that’s what we call competitive advantage.” Ahern

claimed that without the agreement, his business would suffer. Another U.S. company,

NatureSweet Ltd., grows cherry and grape tomatoes under 1,200 acres of greenhouses

in Mexico for the U.S. market. It employs 5,000 people, although all but 100 work in

Mexico. The CEO, Bryant Ambelang, said that his company couldn’t survive without

NAFTA. In his view, Mexican-grown tomatoes were more competitive because of lower

labor costs, good weather, and more than a decade of investment in greenhouse

technology. In a similar vein, Scott DeFife, a representative of the U.S. National Restaurant

Association, stated that “people want tomato-based dishes all the time. You plan over

the course of the year where you are going to get your supply in the winter, the spring,

the fall.” De Fife stated that without tomatoes from Mexico, a winter freeze in Florida,

for example, would send prices shooting up.

Faced with a potential backlash from U.S. importers and U.S. producers with interests

in Mexico, the Commerce Department pulled back from its initial conclusion that the

agreement should be scrapped. Instead, in early 2013 it reached an agreement with

Mexican growers to raise the minimum floor price from 21.69 cents a pound to 31 cents

a pound. The new agreement also established even higher prices for specialty tomatoes

and tomatoes grown in controlled environments. This was clearly aimed at Mexican

growers, who have invested billions to grow tomatoes in greenhouses. Florida tomatoes

are largely picked green and treated with gas to change their color. • Sources: E. Malkin, “Mexico Finds Unlikely Allies in Trade Fight,” The New York Times, December 25, 2012, p. B1; S. Strom, “United States and Mexico Reach Tomato Deal, Averting a Trade War,” The New York Times, February 3, 2013; and J. Margolis, “NAFTA 20 Years After: Florida’s Tomato Growers Struggling,” The World, December 17, 2012.

Introduction This chapter takes a close look at the arguments for regional economic integration through the establishment of trading blocs such as the European Union (EU) and the North American Free Trade Agreement (NAFTA). By regional economic integration we mean agree- ments among countries in a geographic region to reduce, and ultimately remove, tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other. The opening case illustrates some of the issues surrounding the creation of a trading bloc. By creating a single market, NAFTA aimed to lower the price for goods and services in the United States, Canada, and Mexico. Such a policy is good for consumers, because it low- ers prices, but it presents challenges to some producers who have to adapt to a more com- petitive environment. As the opening case explains, while NAFTA has resulted in a surge in tomato imports from Mexico, which has arguably benefited U.S. consumers, food produc- ers, and retailers, it has hurt tomato growers in Florida, who have steadily lost business to Mexican producers.

The past two decades have witnessed an unprecedented proliferation of regional trade blocs that promote regional economic integration. World Trade Organization (WTO) members are required to notify the WTO of any regional trade agreements in which they participate. By 2013, nearly all the WTO’s members had notified the organization of par- ticipation in one or more regional trade agreements. The total number of regional trade agreements currently in force is more than 500.1

Consistent with the predictions of international trade theory and particularly the theory of comparative advantage (see Chapter 6), agreements designed to promote freer trade within regions are believed to produce gains from trade for all member countries. As we saw in Chapter 7, the General Agreement on Tariffs and Trade (GATT) and its successor, the

Regional Economic Integration Agreements among countries in a geographic region to reduce and ultimately remove tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other.

Chapter Nine Regional Economic Integration 255

World Trade Organization, also seek to reduce trade barriers. However, the WTO has a global perspective and 159 members, which can make reaching an agreement extremely dif- ficult. By entering into regional agreements, groups of countries aim to reduce trade barri- ers more rapidly than can be achieved under the auspices of the WTO. This has become an increasingly important policy approach in recent years given the failure of the WTO to make any progress with its latest round of trade talks, the Doha Round, which were initiated in 2001 but are currently in limbo (see Chapter 7 for details). Given the failure of the Doha Round, national governments have felt, not unreasonably, that they can better advance their trade agenda through multilateral agreements than through the WTO.

Nowhere has the movement toward regional economic integration been more successful than in Europe. On January 1, 1993, the European Union formally removed many barriers to doing business across borders within the EU in an attempt to create a single market with 340 million consumers. Today, the EU has a population of more than 500 million and a gross domestic product of more than $17 trillion, making it slightly larger than the United States in economic terms.

Similar moves toward regional integration are being pursued elsewhere in the world. Canada, Mexico, and the United States have implemented NAFTA. Ultimately, this aims to remove all barriers to the free flow of goods and services among the three countries. While the implementation of NAFTA has resulted in job losses in some sectors of the U.S. economy, in aggregate and consistent with the predictions of international trade theory, most economists argue that the benefits of greater regional trade outweigh any costs (see the opening case). South America too has moved toward regional integration. In 1991, Argentina, Brazil, Paraguay, and Uruguay implemented an agreement known as Mercosur to start reducing barriers to trade between each other, and although progress within Mercosur has been halting, the institution is still in place. There are also active attempts at regional economic integration in Central America, the Andean region of South America, Southeast Asia, and parts of Africa.

While the move toward regional economic integration is generally seen as a good thing, some worry that it will lead to a world in which regional trade blocs compete against each other. In this future scenario, free trade will exist within each bloc, but each bloc will protect its market from outside competition with high tariffs. The specter of the EU and NAFTA turning into economic fortresses that shut out foreign producers through high tariff barriers is worrisome to those who believe in unrestricted free trade. If such a situation were to ma- terialize, the resulting decline in trade between blocs could more than offset the gains from free trade within blocs.

With these issues in mind, this chapter explores the economic and political debate sur- rounding regional economic integration, paying particular attention to the economic and po- litical benefits and costs of integration; reviews progress toward regional economic integration

Regional Trade Agreements

Regional economic integration is the focus of Chapter 9, and the value-added portion of globalEDGE that captures the ongoing devel- opment of major trade agreements worldwide is called “Regional Trade Agreements” (globaledge.msu.edu/global-resources/regional- trade-agreements). In this section of globalEDGE, the most critical agreements of the some 300 that exist today are included, with direct access to the homepages for each agreement. The landing page for the “Regional Trade Agreements” also includes globalEDGE’s own “Trade Bloc Insights,” which takes the user to a wealth of information and data (e.g., overview of each agreement, its history, countries

included in the membership, related agreements, online resources, statistics, and an executive summary of what the agreement entails). In Chapter 9, we cover several of the trade agreements to provide an overview of the global marketplace. But, which agreements are not covered in detail in the book and which ones are covered on glo- balEDGE? (Hint: African trade agreements.) What do you know about, for example, ECOWAS and SADC? How many members are in ECOWAS and SADC, respectively, and are any of them overlapping? When were the treaties (trade agreements) of ECOWAS and SADC started?

256 Part Three The Global Trade and Investment Environment

around the world; and maps the important implications of regional economic integration for the practice of international business. Before tackling these objectives, we first need to exam- ine the levels of integration that are theoretically possible.

Levels of Economic Integration Several levels of economic integration are possible in theory (see Figure 9.1). From least integrated to most integrated, they are a free trade area, a customs union, a common market, an economic union, and, finally, a full political union.

In a free trade area, all barriers to the trade of goods and services among member countries are removed. In the theoretically ideal free trade area, no discriminatory tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade between members. Each country, however, is allowed to determine its own trade policies with re- gard to nonmembers. Thus, for example, the tariffs placed on the products of nonmember countries may vary from member to member. Free trade agreements are the most popular form of regional economic integration, accounting for almost 90 percent of regional agreements.2

The most enduring free trade area in the world is the European Free Trade Association (EFTA). Established in January 1960, the EFTA currently joins four countries—Norway, Iceland, Liechtenstein, and Switzerland—down from seven in 1995 (three EFTA members, Austria, Finland, and Sweden, joined the EU on January 1, 1996). The EFTA was founded by those western European countries that initially decided not to be part of the European Community (the forerunner of the EU). Its original members included Austria, Great Britain, Denmark, Finland, and Sweden, all of which are now members of the EU. The emphasis of the EFTA has been on free trade in industrial goods. Agriculture was left out of the arrange- ment, each member being allowed to determine its own level of support. Members are also free to determine the level of protection applied to goods coming from outside the EFTA. Other free trade areas include the North American Free Trade Agreement, which we discuss in depth later in the chapter.

The customs union is one step farther along the road to full economic and political integration. A customs union eliminates trade barriers between member countries and adopts a common external trade policy. Establishment of a common external trade policy

LO 9-1 Describe the different levels of regional economic integration.

Free Trade Area A group of countries committed to removing all barriers to the free flow of goods and services between each other, but pursuing independent external trade policies.

European Free Trade Association (EFTA) A free trade association including Norway, Iceland, and Switzerland.

Customs Union A group of countries committed to (1) removing all barriers to the free flow of goods and services between each other and (2) the pursuit of a common external trade policy.

9.1 FIGURE Levels of Economic Integration

Customs Union

Common Market

Economic Union

Political Union

NAFTA

X Level of Integration

Free Trade Area

EU 2003

Chapter Nine Regional Economic Integration 257

necessitates significant administrative machinery to over- see trade relations with nonmembers. Most countries that enter into a customs union desire even greater economic integration down the road. The EU began as a customs union, but it has now moved beyond this stage. Other cus- toms unions include the current version of the Andean Community (formerly known as the Andean Pact) among Bolivia, Colombia, Ecuador, and Peru. The Andean Community established free trade between member coun- tries and imposes a common tariff, of 5 to 20 percent, on products imported from outside.3

The next level of economic integration, a common market, has no barriers to trade among member countries, includes a common external trade policy, and allows factors of production to move freely among members. Labor and capital are free to move because there are no restrictions on immigration, emigration, or cross-border flows of capital among member countries. Establishing a common market demands a significant degree of harmony and cooperation on fiscal, monetary, and employment policies. Achieving this degree of cooperation has proved very difficult. For years, the European Union functioned as a common market, although it has now moved beyond this stage. Mercosur— the South American grouping of Argentina, Brazil, Paraguay, and Uruguay—hopes to eventually establish itself as a com- mon market. Venezuela was accepted as a full member of Mercosur subject to ratification by the governments of the four existing members. As of early 2013, Paraguay has yet to ratify Venezuela’s membership.

An economic union entails even closer economic integration and cooperation than a common market. Like the common market, an economic union involves the free flow of products and factors of production among member countries and the adoption of a common external trade policy, but it also requires a common currency, harmonization of members’ tax rates, and a common monetary and fiscal policy. Such a high degree of integration de- mands a coordinating bureaucracy and the sacrifice of significant amounts of national sov- ereignty to that bureaucracy. The EU is an economic union, although an imperfect one because not all members of the EU have adopted the euro, the currency of the EU; differ- ences in tax rates and regulations across countries still remain; and some markets, such as the market for energy, are still not fully deregulated.

The move toward economic union raises the issue of how to make a coordinating bureaucracy accountable to the citizens of member nations. The answer is through political union in which a central political apparatus coordinates the economic, social, and foreign policy of the member-states. The EU is on the road toward at least partial political union. The European Parliament, which is playing an ever more important role in the EU, has been directly elected by citizens of the EU countries since the late 1970s. In addition, the Council of Ministers (the controlling, decision-making body of the EU) is composed of government ministers from each EU member. The United States provides an example of even closer political union; in the United States, independent states are effectively combined into a single nation. Ultimately, the EU may move toward a similar federal structure.

The Case for Regional Integration The case for regional integration is both economic and political, and it is typically not ac- cepted by many groups within a country, which explains why most attempts to achieve re- gional economic integration have been contentious and halting. In this section, we examine the economic and political cases for integration and two impediments to integration. In the next section, we look at the case against integration.

Common Market A group of countries committed to (1) removing all barriers to the free flow of goods, services, and factors of production between each other and (2) the pursuit of a common external trade policy.

Economic Union A group of countries committed to (1) removing all barriers to the free flow of goods, services, and factors of production between each other; (2) the adoption of a common currency; (3) the harmonization of tax rates; and (4) the pursuit of a common external trade policy.

Political Union A central political apparatus coordinates economic, social, and foreign policy.

LO 9-2 Understand the economic and political arguments for regional economic integration.

Should Regional Economic Integration Be Based on Culture? A free trade area is a group of countries committed to removing all barriers to the free flow of goods and services while at the same time pursuing independent external trade policies. A free trade area can be of the form of a customs union, common market, economic union, or political union. The European Union is an economic union—although some would say that the EU is striving for the approach of a political union as well. The EU, in reality, is an imperfect economic union because not all mem- bers of the EU have adopted the common currency, the euro, and countries differ in a variety of economic measures (e.g., taxes, regulations). But the most obvious reason the EU is an imperfect market is that the cultures of the independent coun- tries in many cases are very different, from the Nordic countries to the southern European countries to the former eastern bloc European countries, and so on. Do you think regional economic integration should be more based on similarity in culture of the nations involved, or are market-based economic indicators the most appropriate?

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258 Part Three The Global Trade and Investment Environment

THE ECONOMIC CASE FOR INTEGRATION The economic case for regional integration is straightforward. We saw in Chapter 6 how economic theories of in- ternational trade predict that unrestricted free trade will allow countries to specialize in the production of goods and services that they can produce most efficiently. The result is greater world production than would be possible with trade restrictions. That chapter also revealed how opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. Chapter 8 detailed how foreign direct investment (FDI) can transfer tech- nological, marketing, and managerial know-how to host nations. Given the central role of knowledge in stimulating economic growth, opening a country to FDI also is likely to stim- ulate economic growth. In sum, economic theories suggest that free trade and investment is a positive-sum game, in which all participating countries stand to gain.

Given this, the theoretical ideal is an absence of barriers to the free flow of goods, ser- vices, and factors of production among nations. However, as we saw in Chapters 7 and 8, a case can be made for government intervention in international trade and FDI. Because many governments have accepted part or all of the case for intervention, unrestricted free trade and FDI have proved to be only an ideal. Although international institutions such as the WTO have been moving the world toward a free trade regime, success has been less than total. In a world of many nations and many political ideologies, it is very difficult to get all countries to agree to a common set of rules.

Against this background, regional economic integration can be seen as an attempt to achieve additional gains from the free flow of trade and investment between countries be- yond those attainable under global agreements such as the WTO. It is easier to establish a free trade and investment regime among a limited number of adjacent countries than among the world community. Coordination and policy harmonization problems are largely a func- tion of the number of countries that seek agreement. The greater the number of countries involved, the more perspectives that must be reconciled, and the harder it will be to reach agreement. Thus, attempts at regional economic integration are motivated by a desire to exploit the gains from free trade and investment.

THE POLITICAL CASE FOR INTEGRATION The political case for regional economic integration also has loomed large in several attempts to establish free trade areas, customs unions, and the like. Linking neighboring economies and making them increasingly dependent on each other creates incentives for political cooperation between the neighboring states and reduces the potential for violent conflict. In addition, by grouping their economies, the countries can enhance their political weight in the world.

These considerations underlay the 1957 establishment of the European Community (EC), the forerunner of the EU. Europe had suffered two devastating wars in the first half of the twentieth century, both arising out of the unbridled ambitions of nation- states. Those who have sought a united Europe have always had a desire to make another war in Europe unthinkable. Many Europeans also believed that after World War II, the European nation-states were no longer large enough to hold their own in world markets and politics. The need for a united Europe to deal with the United States and the politi- cally alien Soviet Union loomed large in the minds of many of the EC’s founders.4 A long-standing joke in Europe is that the European Commission should erect a statue to Joseph Stalin, for without the aggressive policies of the former dictator of the old Soviet Union, the countries of western Europe may have lacked the incentive to cooperate and form the EC.

IMPEDIMENTS TO INTEGRATION Despite the strong economic and political arguments in support, integration has never been easy to achieve or sustain for two main reasons. First, although economic integration aids the majority, it has its costs. While a nation as a whole may benefit significantly from a regional free trade agreement, certain groups may lose. Moving to a free trade regime involves painful adjustments. Due to the establishment of NAFTA, some Canadian and U.S. workers in such industries as textiles,

Chapter Nine Regional Economic Integration 259

which employ low-cost, low-skilled labor, lost their jobs as Canadian and U.S. firms moved production to Mexico. The promise of significant net benefits to the Canadian and U.S. economies as a whole is little comfort to those who lose as a result of NAFTA. Such groups have been at the forefront of opposition to NAFTA and will continue to oppose any widen- ing of the agreement.

A second impediment to integration arises from concerns over national sovereignty. For example, Mexico’s concerns about maintaining control of its oil interests resulted in an agreement with Canada and the United States to exempt the Mexican oil industry from any liberalization of foreign investment regulations achieved under NAFTA. Concerns about national sovereignty arise because close economic integration demands that countries give up some degree of control over such key issues as monetary policy, fiscal policy (e.g., tax policy), and trade policy. This has been a major stumbling block in the EU. To achieve full economic union, the EU introduced a common currency, the euro, controlled by a central EU bank. Although most member-states have signed on, Great Britain remains an impor- tant holdout. A politically important segment of public opinion in that country opposes a common currency on the grounds that it would require relinquishing control of the coun- try’s monetary policy to the EU, which many British perceive as a bureaucracy run by for- eigners. In 1992, the British won the right to opt out of any single currency agreement, and as of 2014, the British government has yet to reverse its decision—and it does not seem likely to do so, given the sovereign debt crisis in Europe and the strains it has placed on the euro (more on this later).

The Case against Regional Integration Although the tide has been running in favor of regional free trade agreements in recent years, some economists have expressed concern that the benefits of regional integration have been oversold, while the costs have often been ignored.5 They point out that the ben- efits of regional integration are determined by the extent of trade creation, as opposed to trade diversion. Trade creation occurs when high-cost domestic producers are replaced by low-cost producers within the free trade area. It may also occur when higher-cost external producers are replaced by lower-cost external producers within the free trade area. Trade diversion occurs when lower-cost external suppliers are replaced by higher-cost suppliers within the free trade area. A regional free trade agreement will benefit the world only if the amount of trade it creates exceeds the amount it diverts.

Suppose the United States and Mexico imposed tariffs on imports from all countries, and then they set up a free trade area, scrapping all trade barriers between themselves but main- taining tariffs on imports from the rest of the world. If the United States began to import textiles from Mexico, would this change be for the better? If the United States previously produced all its own textiles at a higher cost than Mexico, then the free trade agreement has shifted production to the cheaper source. According to the theory of comparative advantage, trade has been created within the regional grouping, and there would be no decrease in trade with the rest of the world. Clearly, the change would be for the better. If, however, the United States previously imported textiles from Costa Rica, which produced them more cheaply than either Mexico or the United States, then trade has been diverted from a low- cost source—a change for the worse.

In theory, WTO rules should ensure that a free trade agreement does not result in trade diversion. These rules allow free trade areas to be formed only if the members set tariffs that are not higher or more restrictive to outsiders than the ones previously in effect. However, as we saw in Chapter 7, GATT and the WTO do not cover some non- tariff barriers. As a result, regional trade blocs could emerge whose markets are protected from outside competition by high nontariff barriers. In such cases, the trade diversion effects might outweigh the trade creation effects. The only way to guard against this pos- sibility, according to those concerned about this potential, is to increase the scope of the WTO so it covers nontariff barriers to trade. There is no sign that this is going to occur anytime soon, however, so the risk remains that regional economic integration will result in trade diversion.

LO 9-3 Understand the economic and political arguments against regional economic integration.

Trade Creation Trade created due to regional economic integration; occurs when high-cost domestic producers are replaced by low-cost foreign producers within a free trade area.

Trade Diversion Trade diverted due to regional economic integration; occurs when low-cost foreign suppliers outside a free trade area are replaced by higher-cost suppliers within a free trade area.

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260 Part Three The Global Trade and Investment Environment

Regional Economic Integration in Europe Europe has two trade blocs—the European Union and the European Free Trade Associa- tion. Of the two, the EU is by far the more significant, not just in terms of membership (the EU currently has 28 members; the EFTA has 4), but also in terms of economic and political influence in the world economy. Many now see the EU as an emerging economic and political superpower of the same order as the United States. Accordingly, we will concen- trate our attention on the EU.6

EVOLUTION OF THE EUROPEAN UNION The European Union (EU) is the product of two political factors: (1) the devastation of western Europe during two world wars, and the desire for a lasting peace, and (2) the European nations’ desire to hold their own on the world’s political and economic stage. In addition, many Europeans were aware of the potential economic benefits of closer economic integration of the countries.

The forerunner of the EU, the European Coal and Steel Community, was formed in 1951 by Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands. Its ob- jective was to remove barriers to intragroup shipments of coal, iron, steel, and scrap metal. With the signing of the Treaty of Rome in 1957, the European Community was estab- lished. The name changed again in 1993 when the European Community became the Euro- pean Union following the ratification of the Maastricht Treaty (discussed later).

The Treaty of Rome provided for the creation of a common market. Article 3 of the treaty laid down the key objectives of the new community, calling for the elimination of internal trade barriers and the creation of a common external tariff and requiring member-states to abolish obstacles to the free movement of factors of production among the members. To facilitate the free movement of goods, services, and factors of production, the treaty provided for any necessary harmonization of the member-states’ laws. Furthermore, the treaty com- mitted the EC to establish common policies in agriculture and transportation.

The community grew in 1973, when Great Britain, Ireland, and Denmark joined. These three were followed in 1981 by Greece; in 1986 by Spain and Portugal; and in 1995 by Austria, Finland, and Sweden—bringing the total membership to 15 (East Germany became part of the EC after the reunification of Germany in 1990). Another 10 countries joined the EU on May 1, 2004—8 of them from eastern Europe plus the small Mediterranean nations of Malta and Cyprus. Bulgaria and Romania joined in 2007 and Croatia in 2013, bringing the total number of member-states to 28 (see Map 9.1). Through these enlargements, the EU has become a global superpower.

POLITICAL STRUCTURE OF THE EUROPEAN UNION The eco- nomic policies of the EU are formulated and implemented by a complex and still-evolving political structure. The four main institutions in this structure are the European Commis- sion, the Council of the European Union, the European Parliament, and the Court of Justice.7

The European Commission is responsible for proposing EU legislation, implementing it, and monitoring compliance with EU laws by member-states. Headquartered in Brussels, Belgium, it is run by a group of commissioners appointed by each member country for five- year renewable terms. There are 28 commissioners, one from each member-state. A presi- dent of the commission is chosen by member-states, and the president then chooses other members in consultation with the states. The entire commission has to be approved by the European Parliament before it can begin work. The commission has a monopoly in propos- ing European Union legislation. The commission makes a proposal, which goes to the Council of the European Union and then to the European Parliament. The council cannot legislate without a commission proposal in front of it. The commission is also responsible for implementing aspects of EU law, although in practice much of this must be delegated to member-states. Another responsibility of the commission is to monitor member-states to make sure they are complying with EU laws. In this policing role, the commission will nor- mally ask a state to comply with any EU laws that are being broken. If this persuasion is not sufficient, the commission can refer a case to the Court of Justice.

LO 9-4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

European Union An economic and political union of 28 countries (2014) that are located in Europe.

Treaty of Rome The 1957 treaty that established the European Community.

European Commission Responsible for proposing EU legislation, implementing it, and monitoring compliance.

Chapter Nine Regional Economic Integration 261

The European Commission’s role in competition policy has become increasingly impor- tant to business in recent years. Since 1990 when the office was formally assigned a role in competition policy, the EU’s competition commissioner has been steadily gaining influence as the chief regulator of competition policy in the member nations of the EU. As with anti- trust authorities in the United States, which include the Federal Trade Commission and the Department of Justice, the role of the competition commissioner is to ensure that no one enterprise uses its market power to drive out competitors and monopolize markets. In 2009, for example, the commission fined Intel a record €1.06 billion for abusing its market power in the computer chip market. (See the Management Focus for details.) The previous record for a similar abuse was €497 billion imposed on Microsoft in 2004 for blocking competition in markets for server computers and media software. The commissioner also reviews pro- posed mergers and acquisitions to make sure they do not create a dominant enterprise with substantial market power.8 For example, in 2000 a proposed merger between Time Warner of the United States and EMI of the United Kingdom, both music recording companies, was withdrawn after the commission expressed concerns that the merger would reduce the number of major record companies from five to four and create a dominant player in the $40 billion global music industry. Similarly, the commission blocked a proposed merger between two U.S. telecommunication companies, WorldCom and Sprint, because their combined holdings of Internet infrastructure in Europe would give the merged companies

262 Part Three The Global Trade and Investment Environment

so much market power that the commission argued the combined company would dominate that market.

The European Council represents the interests of member-states. It is clearly the ulti- mate controlling authority within the EU because draft legislation from the commission can become EU law only if the council agrees. The council is composed of one representative from the government of each member-state. The membership, however, varies depending on the topic being discussed. When agricultural issues are being discussed, the agriculture ministers from each state attend council meetings; when transportation is being discussed, transportation ministers attend; and so on. Before 1987, all council issues had to be decided by unanimous agreement among member-states. This often led to marathon council ses- sions and a failure to make progress or reach agreement on commission proposals. In an attempt to clear the resulting logjams, the Single European Act formalized the use of major- ity voting rules on issues “which have as their object the establishment and functioning of a single market.” Most other issues, however, such as tax regulations and immigration policy, still require unanimity among council members if they are to become law. The votes that a country gets in the council are related to the size of the country. For example, Britain, a large country, has 29 votes, whereas Denmark, a much smaller state, has 7 votes.

The European Parliament, which as of 2014 has 754 members, is directly elected by the populations of the member-states. The parliament, which meets in Strasbourg, France, is primarily a consultative rather than legislative body. It debates legislation proposed by the commission and forwarded to it by the council. It can propose amendments to that legisla- tion, which the commission and ultimately the council are not obliged to take up but often will. The power of the parliament recently has been increasing, although not by as much as parliamentarians would like. The European Parliament now has the right to vote on the appointment of commissioners as well as veto some laws (such as the EU budget and single- market legislation).

One major debate waged in Europe during the past few years is whether the council or the parliament should ultimately be the most powerful body in the EU. Some in Europe expressed concern over the democratic accountability of the EU bureaucracy. One side argued that the answer to this apparent democratic deficit lay in increasing the power of the parliament, while others think that true democratic legitimacy lies with elected govern- ments, acting through the Council of the European Union.9 After significant debate, in

European Council The heads of state of EU members and the president of the European Commission.

European Parliament Elected EU body that provides consultation on issues proposed by European Commission.

The European Commission and Intel

In May 2009, the European Commission announced that it had im- posed a record €1.06 billion ($1.45 billion) fine on Intel for anticom- petitive behavior. This fine was the result of an investigation into Intel’s competitive conduct during the period from October 2002 to December 2007. During this time period, Intel’s market share of microprocessor sales to personal computer manufacturers consistently exceeded 70 percent. According to the commission, Intel illegally used its market power to ensure that its major rival, AMD, was at a competitive disad- vantage, thereby harming “millions of European consumers.”

The commission charged that Intel granted major rebates to PC manufacturers—including Acer, Dell, Hewlett-Packard, Lenovo, and NEC—on the condition that they purchased all or almost all their supplies from Intel. Intel also made payments to some manufacturers in exchange for them postponing, canceling, or putting restrictions on the introduction or distribution of AMD-based products. Intel also

apparently made payments to Media Saturn Holdings, the owner of Media Markt chain of superstores, for only selling Intel-based computers in Germany, Belgium, and other countries.

Under the order, Intel had to change its practices immediately, pending any appeal. The company was also required to write a bank guarantee for the fine, although that guarantee is held in a bank until the appeal process is exhausted.

For its part, Intel immediately appealed the ruling. The company in- sisted that it had never coerced computer makers and retailers with in- ducements and maintained that Intel had never paid to stop AMD products from reaching the market in Europe. Although Intel acknowledges that it did offer rebates, it claimed that they were never conditional on specific actions by manufacturers and retailers aimed to limit AMD. As of early 2014, the appeal was still working its way through the judicial process.

Sources: M. Hachman, “EU Hits Intel with $1.45 Billion Fine for Antitrust Violations,” PCMAG.com, May 13, 2009; and J. Kanter, “Europe Fines Intel $1.45 billion in Antitrust Case,” The New York Times, May 14, 2009.

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December 2007 the member-states signed a new treaty, the Treaty of Lisbon, under which the power of the European Parliament was increased. When it took effect in December 2009, for the first time in history the European Parliament was the co-equal legislator for almost all European laws.10 The Treaty of Lisbon also created a new position, a president of the European Council, who serves a 30-month term and represents the nation-states that make up the EU.

The Court of Justice, which is comprised of one judge from each country, is the supreme appeals court for EU law. Like commissioners, the judges are required to act as independent officials, rather than as representatives of national interests. The commission or a member country can bring other members to the court for failing to meet treaty obligations. Simi- larly, member countries, member companies, or member institutions can bring the commis- sion or council to the court for failure to act according to an EU treaty.

THE SINGLE EUROPEAN ACT The Single European Act was born of a frus- tration among members that the community was not living up to its promise. By the early 1980s, it was clear that the EC had fallen short of its objectives to remove barriers to the free flow of trade and investment among member countries and to harmonize the wide range of technical and legal standards for doing business. Against this background, many of the EC’s prominent businesspeople mounted an energetic campaign in the early 1980s to end the EC’s economic divisions. The EC responded by creating the Delors Commission. Under the chairmanship of Jacques Delors, the commission proposed that all impediments to the formation of a single market be eliminated by December 31, 1992. The result was the Single European Act, which became EC law in 1987.

The Objectives of the Act The purpose of the Single European Act was to have one market in place by December 31, 1992. The act proposed the following changes:11

• Remove all frontier controls among EC countries, thereby abolishing delays and reducing the resources required for complying with trade bureaucracy.

• Apply the principle of “mutual recognition” to product standards. A standard developed in one EC country should be accepted in another, provided it met basic requirements in such matters as health and safety.

• Institute open public procurement to nonnational suppliers, reducing costs directly by allowing lower-cost suppliers into national economies and indirectly by forcing national suppliers to compete.

• Lift barriers to competition in the retail banking and insurance businesses, which should drive down the costs of financial services, including borrowing, throughout the EC.

• Remove all restrictions on foreign exchange transactions between member countries by the end of 1992.

• Abolish restrictions on cabotage—the right of foreign truckers to pick up and deliver goods within another member-state’s borders—by the end of 1992. Estimates suggested this would reduce the cost of haulage within the EC by 10 to 15 percent.

All those changes were expected to lower the costs of doing business in the EC, but the single-market program was also expected to have more complicated supply-side effects. For example, the expanded market was predicted to give EC firms greater opportunities to exploit economies of scale. In addition, it was thought that the increase in competi- tive intensity brought about by removing internal barriers to

Treaty of Lisbon A European Union–sanctioned treaty that will allow the European Parliament to become the co-equal legislator for almost all European laws.

Court of Justice Supreme appeals court for EU law.

Is Greece a Good Member of the European Union? In April 2014, Greece held its first bond sale since 2010, raising about $4.2 billion as investors flocked to secure bonds from the hard-hit country. Greece stopped issuing bonds in 2010 amid their country’s economic crisis. The 2014 bonds sale was hailed as a sign that Greece is recovering and heading in the right direc- tion. As most observers agree, Greece has struggled to deal with its financial crisis, and has, among many measures, taken on more than $330 billion worth of bailouts and implemented vari- ous austerity measures to fix the country’s finances. The govern- ment’s bond sale is a return to international markets for Greece and a step toward the country reducing its dependence on for- eign aid—a crucial step to regain confidence from investors and other countries. The bond sale’s success is a reason for optimism in Greece and throughout Europe, especially the European Union countries, as it not only shows investors renewed confidence in the Greek economy, but perhaps also in the euro zone’s recovery in general. Do you think that the European Union is only as strong as its weakest link or as strong as its strongest country?

Source: T. Ford, “globalEDGE Blog: High Demand for Greece’s Return to Bond Market,” April 11, 2014, http://globalEDGE.msu.edu.

264 Part Three The Global Trade and Investment Environment

trade and investment would force EC firms to become more efficient. To signify the impor- tance of the Single European Act, the European Community also decided to change its name to the European Union once the act took effect.

Impact The Single European Act has had a significant impact on the EU economy.12 The act provided the impetus for the restructuring of substantial sections of European in- dustry. Many firms have shifted from national to pan-European production and distribution systems in an attempt to realize scale economies and better compete in a single market. The results have included faster economic growth than would otherwise have been the case.

However, 20 years after the formation of a single market, the reality still falls short of the ideal. An example is given in the accompanying Country Focus, which describes the slow progress toward establishing a fully functioning single market for financial services in the EU. Thus, although the EU is undoubtedly moving toward a single marketplace, estab- lished legal, cultural, and language differences among nations mean that implementation has been uneven.

Creating a Single Market in Financial Services

The European Union in 1999 embarked upon an ambitious action plan to create a single market in financial services by January 1, 2005. Launched a few months after the euro, the EU’s single currency, the goal was to dismantle barriers to cross-border activity in financial ser- vices, creating a continentwide market for banking services, insurance services, and investment products. In this vision of a single Europe, a citizen of France might use a German firm for basic banking services, borrow a home mortgage from an Italian institution, buy auto insurance from a Dutch enterprise, and keep her savings in mutual funds man- aged by a British company. Similarly, an Italian firm might raise capital from investors across Europe and use a German firm as its lead under- writer to issue stock for sale through stock exchanges in London and Frankfurt.

One main benefit of a single market, according to its advocates, would be greater competition for financial services, which would give consumers more choices, lower prices, and require financial service firms in the EU to become more efficient, thereby increasing their global competitiveness. Another major benefit would be the creation of a single European capital market. The increased liquidity of a larger capital market would make it easier for firms to borrow funds, lowering their cost of capital (the price of money) and stimulating business in- vestment in Europe, which would create more jobs. A European Com- mission study suggested that the creation of a single market in financial services would increase the EU’s gross domestic product by 1.1 percent a year, creating an additional €130 billion in wealth over a decade. Total business investment would increase by 6 percent annu- ally in the long run, private consumption by 0.8 percent, and total em- ployment by 0.5 percent a year.

Creating a single market has been anything but easy. The financial markets of different EU member-states have historically been seg- mented from each other, and each has its own regulatory framework. In the past, EU financial services firms rarely did business across

national borders because of a host of different national regulations with regard to taxation, oversight, accounting information, cross-border takeovers, and the like—all of which had to be harmonized. To compli- cate matters, long-standing cultural and linguistic barriers complicated the move toward a single market. While in theory an Italian might ben- efit by being able to purchase homeowners insurance from a British company, in practice he might be predisposed to purchase it from a local enterprise, even if the price were higher.

By 2014, the EU had made significant progress. More than 40 mea- sures designed to create a single market in financial services had become EU law, and others were in the pipeline. The new rules embraced issues as diverse as the conduct of business by investment firms, stock exchanges, and banks; disclosure standards for listing companies on public exchanges; and the harmonization of accounting standards across nations. However, there had also been some significant setbacks. Most notably, legislation designed to make it easier for firms to make hostile cross-border acquisitions was defeated, primarily due to opposition from German members of the European Parliament, making it more difficult for financial service firms to build pan-European operations. In addition, national governments have still reserved the right to block even friendly cross-border mergers between financial service firms.

The critical issue now is enforcement of the rules that have been put in place. Some believe that it will be years before the full benefits of the new regulations become apparent. In the meantime, the changes may impose significant costs on financial institutions as they attempt to deal with the new raft of regulations.

Sources: C. Randzio-Plath, “Europe Prepares for a Single Financial Market,” Intereconomic, May–June 2004, pp. 142–46; T. Buck, D. Hargreaves, and P. Norman, “Europe’s Single Financial Market,” Financial Times, January 18, 2005, p. 17; “The Gate- Keeper,” The Economist, February 19, 2005, p. 79; P. Hofheinz, “A Capital Idea: The European Union Has a Grand Plan to Make Its Financial Markets More Efficient,” The Wall Street Journal, October 14, 2002, p. R4; “Banking on McCreevy: Europe’s Single Market,” The Economist, November 26, 2005, p. 91; and The European Commission, “A New Financial System for Europe; Financial Reform at the Service of Growth; State of Play 06.01.2014,” http://ec.europa.eu/internal_market/publications/docs/financial-reform-for- growth_en.pdf.

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THE ESTABLISHMENT OF THE EURO In February 1992, EC members signed the Maastricht Treaty, which committed them to adopting a common currency by January 1, 1999.13 The euro is now used by 18 of the 28 member-states of the European Union; these 17 states are members of what is often referred to as the euro zone. It encom- passes 330 million EU citizens and includes the powerful economies of Germany and France. Many of the countries that joined the EU on May 1, 2004, and the two that joined in 2007, originally planned to adopt the euro when they fulfilled certain economic criteria— a high degree of price stability, a sound fiscal situation, stable exchange rates, and con- verged long-term interest rates (the current members had to meet the same criteria). However, the events surrounding the EU sovereign debt crisis of 2010–2012 persuaded many of these countries to put their plans on hold, at least for the time being (further details provided later).

Establishment of the euro was an amazing political feat with few historical precedents. It required participating national governments to give up their own currencies and national control over monetary policy. Governments do not routinely sacrifice national sovereignty for the greater good, indicating the importance that the Europeans attach to the euro. By adopting the euro, the EU has created the second most widely traded currency in the world after that of the U.S. dollar. Some believe that the euro could come to rival the dollar as the most important currency in the world.

Three long-term EU members—Great Britain, Denmark, and Sweden—are still sitting on the sidelines. The countries agreeing to the euro locked their exchange rates against each other January 1, 1999. Euro notes and coins were not actually issued until January 1, 2002. In the interim, national currencies circulated in each participating state. However, in each country the national currency stood for a defined amount of euros. After January 1, 2002, euro notes and coins were issued and the national currencies were taken out of circu- lation. By mid-2002, all prices and routine economic transactions within the euro zone were in euros.

Benefits of the Euro Europeans decided to establish a single currency in the EU for a number of reasons. First, they believe that businesses and individuals realize significant savings from having to handle one currency, rather than many. These savings come from lower foreign exchange and hedging costs. For example, people going from Germany to France no longer have to pay a commission to a bank to change German deutsche marks into French francs. Instead, they are able to use euros. According to the European Commis- sion, such savings amount to 0.5 percent of the European Union’s GDP.

Second, and perhaps more important, the adoption of a common currency makes it easier to compare prices across Europe. This has been increasing competition because it has be- come easier for consumers to shop around. For example, if a German finds that cars sell for less in France than Germany, he may be tempted to purchase from a French car dealer rather than his local car dealer. Alternatively, traders may engage in arbitrage to exploit such price differentials, buying cars in France and reselling them in Germany. The only way that German car dealers will be able to hold onto business in the face of such competitive pres- sures will be to reduce the prices they charge for cars. As a consequence of such pressures, the introduction of a common currency has led to lower prices, which translates into sub- stantial gains for European consumers.

Third, faced with lower prices, European producers have been forced to look for ways to reduce their production costs to maintain their profit margins. The introduction of a com- mon currency, by increasing competition, has produced long-run gains in the economic ef- ficiency of European companies.

Fourth, the introduction of a common currency has given a boost to the development of a highly liquid pan-European capital market. Over time, the development of such a capital market should lower the cost of capital and lead to an increase in both the level of invest- ment and the efficiency with which investment funds are allocated. This could be especially helpful to smaller companies that have historically had difficulty borrowing money from domestic banks. For example, the capital market of Portugal is very small and illiquid, which makes it extremely difficult for bright Portuguese entrepreneurs with a good idea to borrow

Maastricht Treaty Treaty agreed to in 1992, but not ratified until January 1, 1994, that committed the 12 member-states of the European Community to a closer economic and political union.

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money at a reasonable price. However, in theory, such companies can now tap a much more liquid pan-European capital market.

Finally, the development of a pan-European, euro- denominated capital market will increase the range of investment options open to both individuals and institu- tions. For example, it will now be much easier for indi- viduals and institutions based in, let’s say, Holland to invest in Italian or French companies. This will enable European investors to better diversify their risk, which again lowers the cost of capital, and should also increase the efficiency with which capital resources are allocated.14

Costs of the Euro The drawback, for some, of a single currency is that national authorities have lost con- trol over monetary policy. Thus, it is crucial to ensure that the EU’s monetary policy is well managed. The Maastricht Treaty called for establishment of the inde- pendent European Central Bank (ECB), similar in some respects to the U.S. Federal Reserve, with a clear mandate to manage monetary policy so as to ensure price stability. The ECB, based in Frankfurt, is meant to be independent from political pressure—although critics question this. Among other things, the ECB sets interest rates and de-

termines monetary policy across the euro zone. The implied loss of national sovereignty to the ECB underlies the decision by Great

Britain, Denmark, and Sweden to stay out of the euro zone. Many in these countries are suspicious of the ECB’s ability to remain free from political pressure and to keep inflation under tight control.

In theory, the design of the ECB should ensure that it remains free of political pressure. The ECB is modeled on the German Bundesbank, which historically has been the most in- dependent and successful central bank in Europe. The Maastricht Treaty prohibits the ECB from taking orders from politicians. The executive board of the bank, which consists of a president, vice president, and four other members, carries out policy by issuing instructions to national central banks. The policy itself is determined by the governing council, which consists of the executive board plus the central bank governors from the 17 euro zone coun- tries. The governing council votes on interest rate changes. Members of the executive board are appointed for eight-year nonrenewable terms, insulating them from political pressures to get reappointed. Nevertheless, the jury is still out on the issue of the ECB’s indepen- dence, and it will take some time for the bank to establish its credentials.

According to critics, another drawback of the euro is that the EU is not what econo- mists would call an optimal currency area. In an optimal currency area, similarities in the underlying structure of economic activity make it feasible to adopt a single currency and use a single exchange rate as an instrument of macroeconomic policy. Many of the European economies in the euro zone, however, are very dissimilar. For example, Finland and Portugal have different wage rates, tax regimes, and business cycles, and they may react very differently to external economic shocks. A change in the euro exchange rate that helps Finland may hurt Portugal. Obviously, such differences complicate macroeco- nomic policy. For example, when euro economies are not growing in unison, a common monetary policy may mean that interest rates are too high for depressed regions and too low for booming regions.

One way of dealing with such divergent effects within the euro zone is for the EU to engage in fiscal transfers, taking money from prosperous regions and pumping it into de- pressed regions. Such a move, however, opens a political can of worms. Would the citizens of Germany forgo their “fair share” of EU funds to create jobs for underemployed Greece workers? Not surprisingly, there is strong political opposition to such practices.

Optimal Currency Area Region in which similarities in economic activity make a single currency and exchange rate feasible instruments of macroeconomic policy.

Can the Euro Survive? It seems like experts and interested observers are always debat- ing the merits of the euro and its likelihood of survival. The an- swers lie in examining several interesting facts of the European Union. First, the lack of a European treasury is a missing piece of the puzzle. Without it, the ECB is limited in the assistance it can provide to euro zone member-states. In theory, the European Central Bank (ECB) could bail out those member-states bur- dened with excessive debt by printing more money. However, that would require the approval of all of the EU member coun- tries (not just the countries that that use the euro as their na- tional currency). Germany is typically opposed to any measure that may light the fires of inflation. Some of the EU members also think it is unfair to bail out those states that have lived be- yond their means for many years. It is difficult to compare the difficulties within the EU to those of other nations that have faced similar problems and survived. But the basic question re- mains, will the euro survive?

Source: http://seekingalpha.com/article/565381-can-the-euro-survive-2012.

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The Euro Experience: 1999 to the Sovereign Debt Crisis Since its estab- lishment January 1, 1999, the euro has had a volatile trading history against the world’s major currency, the U.S. dollar. After starting life in 1999 at €1 5 $1.17, the euro steadily fell until it reached a low of €1 5 $0.83 in October 2000, leading critics to claim the euro was a failure. A major reason for the fall in the euro’s value was that international investors were investing money in booming U.S. stocks and bonds and taking money out of Europe to finance this investment. In other words, they were selling euros to buy dollars so that they could invest in dollar-denominated assets. This increased the demand for dollars and de- creased the demand for the euro, driving the value of the euro down.

The fortunes of the euro began improving in late 2001 when the dollar weakened; the currency stood at a robust all-time high of €1 5 $1.54 in early March 2008. One reason for the rise in the value of the euro was that the flow of capital into the United States stalled as the U.S. financial markets fell during 2007 and 2008. Many investors were now taking money out of the United States by selling dollar-denominated assets such as U.S. stocks and bonds and purchasing euro-denominated assets. Falling demand for U.S. dollars and rising demand for euros translated into a fall in the value of the dollar against the euro. Furthermore, in a vote of confidence in both the euro and the ability of the ECB to manage monetary policy within the euro zone, many foreign central banks added more euros to their supply of foreign currencies. In the first three years of its life, the euro never reached the 13 percent of global reserves made up by the deutsche mark and other former euro zone currencies. The euro didn’t jump that hurdle until early 2002, but by 2011 it stood at 26.3 percent.15

Since 2008 however, the euro has weakened, reflecting persistent concerns over slow economic growth and large budget deficits among several EU member-states, particularly Greece, Portugal, Ireland, Italy, and Spain. During the 2000s, all these governments had sharply increased their government debt to finance public spending. Government debt as a percentage of GDP hit record levels in many of these nations. By 2010, private investors became increasingly concerned that these nations would not be able to service their sover- eign debt, particularly given the economic slowdown following the 2008–2009 global finan- cial crisis. They sold off government bonds of troubled nations, driving down bond prices and driving up the cost of government borrowing (bond prices and interest rates are

The weakened value of the Euro against the U.S. dollar has been a cause for concern among many nations.

268 Part Three The Global Trade and Investment Environment

inversely related). This led to fears that several national governments, particularly Greece, might default on their sovereign debt, plunging the euro zone into an economic crisis. To try and stave off such a sovereign debt crisis, in May 2010 the euro zone nations and the International Monetary Fund (IMF) agreed to a €110 billion bailout package to help rescue Greece. In November 2010, the EU and IMF agreed to a bailout package for Ireland of €85 billion; in May 2011, euro zone countries and the IMF instituted a €78 billion bailout plan for Portugal. In return for these loans, all three countries had to agree to sharp reductions in government spending, which meant slower economic growth and high unemployment until government debt was reduced to more sustainable levels. While Italy and Spain did not re- quest bailout packages, both countries were forced by falling bond prices to institute auster- ity programs that required big reductions in government spending. The euro zone nations also set up a permanent bailout fund—the European Stability Mechanism—worth about €500 billion, which was designed to restore confidence in the euro. As detailed in the next Country Focus, by 2012 Greece had been granted two more bailout packages in an attempt to forestall a full-blown default on payment of its sovereign debt.

The Greek Sovereign Debt Crisis

When the euro was established, some critics worried that free-spending countries in the euro zone (such as Italy and Greece) might borrow excessively, running up large public-sector deficits that they could not finance. This would then rock the value of the euro, requiring their more sober brethren, such as Germany or France, to step in and bail out the profligate nation. In 2010, this worry became a reality as a financial crisis in Greece hit the value of the euro.

The financial crisis had its roots in a decade of free spending by the Greek government, which ran up a high level of debt to finance exten- sive spending in the public sector. Much of the spending increase could be characterized as an attempt by the government to buy off powerful interest groups in Greek society, from teachers and farmers to public- sector employees, rewarding them with high pay and extensive bene- fits. To make matters worse, the government misled the international community about the level of its indebtedness. In October 2009, a new government took power and quickly announced that the 2009 public- sector deficit, which had been projected to be around 5 percent, would actually be 12.7 percent. The previous government had apparently been cooking the books.

This shattered any faith that international investors might have had in the Greek economy. Interest rates on Greek government debt quickly surged to 7.1 percent, about 4 percentage points higher than the rate on German bonds. Two of the three international rating agencies also cut their ratings on Greek bonds and warned that further downgrades were likely. The main concern now was that the Greek government might not be able to refinance some €20 billion of debt that would mature in April or May 2010. A further concern was that the Greek government might lack the political willpower to make the large cuts in public spending necessary to bring down the deficit and restore investor confidence.

Nor was Greece alone in having large public-sector deficits. Three other euro zone countries—Spain, Portugal, and Ireland—also had large debt loads, and interest rates on their bonds surged as investors sold out. This raised the specter of financial contagion, with large-scale defaults among the weaker members of the euro zone. If this did occur, the EU and IMF would most certainly have to step in and rescue the

troubled nations. With this possibility, once considered very remote, investors started to move money out of euros, and the value of the euro started to fall on the foreign exchange market.

Recognizing that the unthinkable might happen—and that without external help, Greece might default on its government debt, pushing the EU and the euro into a major crisis—in May 2010 the euro zone coun- tries, led by Germany, along with the IMF agreed to lend Greece up to €110 billion. These loans were judged sufficient to cover Greece’s financ- ing needs for three years. In exchange, the Greek government agreed to implement a series of strict austerity measures. These included tax in- creases, major cuts in public-sector pay, reductions in benefits enjoyed by public-sector employees (e.g., the retirement age was increased to 65 from 61, and limits were placed on pensions), and reductions in the num- ber of public-sector enterprises from 6,000 to 2,000. However, the Greek economy contracted so fast in 2010 and 2011 that tax revenues plunged. By the end of 2011, the Greek economy was almost 29 percent smaller than it had been in 2005, while unemployment approached 20 percent. The contracting tax base limited the ability of the government to pay down debt. By early 2012, yields on 10-year Greek government debt reached 34 percent, indicating that many investors now expected Greece to default on its sovereign debt. This forced the Greek government to seek further aid from the euro zone countries and the IMF. As a condition for a fresh €130 billion bailout plan, the Greek government had to get holders of Greek government bonds to agree to the biggest sovereign debt restructuring in history, In effect, bondholders agreed to write off 53.5 percent of the debt they held. While the Greek government did not technically default on its sovereign debt, to many it seemed as if the EU and IMF had orchestrated an orderly partial default. By early 2014, it looked as if the Greek economy had finally turned a corner and was on the way to recovery. Yields on 10-year bonds had fallen blow 8 percent, and the government was running a budget surplus before interest pay- ments. With fears of default now receding, the question is whether the Greek economy can start to grow again.

Sources: “A Very European Crisis,” The Economist, February 6, 2010, pp. 75–77; L. Thomas, “Is Debt Trashing the Euro?” The New York Times, February 7, 2010, pp. 1, 7; “Bite the Bullet,” The Economist, January 15, 2011, pp. 77–79; “The Wait Is Over,” The Economist, March 17, 2012, pp. 83–84; and “Aegean Stables,” The Economist, January 11, 2014.

country FOCUS

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As might be expected, the economic turmoil led to a decline in the value of the euro. By early 2014, the dollar-euro exchange rate stood at €1 5 $1.35, some way below its 2008 level but still significantly better than the exchange rate in early 2000. The euro also declined by 20 to 30 percent against most of the world’s other major currencies between late 2008 and early 2014.

More troubling perhaps for the long-run success of the euro, many of the newer EU nations that had committed to adopting the euro put their plans on hold. Countries like Poland and the Czech Republic had no desire to join the euro zone and then have their taxpayers help bail out the profligate governments of countries like Italy and Greece. To compound matters, the sovereign debt crisis had exposed a deep flaw in the euro zone— it was difficult for fiscally more conservative nations like Germany to limit profligate spending by the governments of other nations that might subsequently create strains and impose costs on the entire euro zone. The Germans in particular found themselves in the unhappy position of having to underwrite loans to bail out the governments of Greece, Portugal, and Ireland. This started to erode support for the euro in the stronger EU states. To try to correct this flaw, 25 of the then 27 countries in the EU signed a fiscal pact in January 2012 that made it more difficult for member-states to break tight new rules on government deficits (the UK and Czech Republic abstained, Croatia joined in 2013). Whether such actions will be sufficient to get the euro back on track remains to be seen.

ENLARGEMENT OF THE EUROPEAN UNION A major issue facing the EU over the past few years has been that of enlargement. Enlargement of the EU into eastern Europe has been a possibility since the collapse of communism at the end of the 1980s, and by the end of the 1990s, 13 countries had applied to become EU members. To qualify for EU membership, the applicants had to privatize state assets, deregulate markets, restructure industries, and tame inflation. They also had to enshrine complex EU laws into their own systems, establish stable democratic governments, and respect human rights.16 In December 2002, the EU formally agreed to accept the applications of 10 countries, and they joined May 1, 2004. The new members included the Baltic countries, the Czech Republic, and the larger nations of Hungary and Poland. The only new mem- bers not in eastern Europe were the Mediterranean island nations of Malta and Cyprus. Their inclusion in the EU expanded the union to 25 states, stretching from the Atlantic to the borders of Russia; added 23 percent to the landmass of the EU; brought 75 million new citizens into the EU, building an EU with a population of 450 million people; and created a single continental economy with a GDP of close to €11 trillion. In 2007, Bulgaria and Romania joined, and in 2013 Croatia joined, bringing total membership to 28 nations.

The new members were not able to adopt the euro for several years, and free move- ment of labor among the new and existing members was prohibited until then. Consis- tent with theories of free trade, the enlargement should create added benefits for all members. However, given the small size of the eastern European economies (together they amount to only 5 percent of the GDP of current EU members), the initial impact will probably be small. The biggest notable change might be in the EU bureaucracy and decision-making processes, where budget negotiations among 28 nations are bound to prove more problematic than negotiations among 15 nations.

Left standing at the door is Turkey. Turkey, which has long lob- bied to join the union, presents the EU with some difficult issues. The country has had a customs union with the EU since 1995, and about half its international trade is already with the EU. However, full membership has been denied because of concerns over human rights issues (particularly Turkish policies toward its Kurdish minority). In addition, some on the Turkish side suspect the EU is not eager to let a primarily Muslim nation of 74 million people,

Croatia is the 28th nation to join the EU.

270 Part Three The Global Trade and Investment Environment

which has one foot in Asia, join the EU. The EU formally indicated in December 2002 that it would allow the Turkish application to proceed with no further delay in December 2004 if the country improved its human rights record to the satisfaction of the EU. In December 2004, the EU agreed to allow Turkey to start accession talks in October 2005, but those talks are not moving along rapidly, and at this point, it is unclear when the nation will join.

Regional Economic Integration in the Americas No other attempt at regional economic integration comes close to the EU in its boldness or its potential implications for the world economy, but regional economic integration is on the rise in the Americas. The most significant attempt is the North American Free Trade Agreement. In addition to NAFTA, several other trade blocs are in the offing in the Americas (see Map 9.2), the most significant of which appear to be the Andean Community and Mercosur. Also, negotiations are under way to establish a hemispherewide Free Trade Area of the Americas (FTAA), although currently they seem to be stalled.

THE NORTH AMERICAN FREE TRADE AGREEMENT The govern- ments of the United States and Canada in 1988 agreed to enter into a free trade agreement,

LO 9-4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

9.2 MAP Economic Integration in the Americas

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.

Chapter Nine Regional Economic Integration 271

which took effect January 1, 1989. The goal of the agreement was to eliminate all tariffs on bilateral trade between Canada and the United States by 1998. This was followed in 1991 by talks among the United States, Canada, and Mexico aimed at establishing a North American Free Trade Agreement for the three countries. The talks concluded in August 1992 with an agreement in principle, and the following year the agreement was ratified by the govern- ments of all three countries. The agreement became law January 1, 1994.17

NAFTA’S Contents The contents of NAFTA include the following:

• Abolition by 2004 of tariffs on 99 percent of the goods traded among Mexico, Canada, and the United States.

• Removal of most barriers on the cross-border flow of services, allowing financial institutions, for example, unrestricted access to the Mexican market by 2000.

• Protection of intellectual property rights. • Removal of most restrictions on foreign direct investment among the three member

countries, although special treatment (protection) will be given to Mexican energy and railway industries, American airline and radio communications industries, and Canadian culture.

• Application of national environmental standards, provided such standards have a scientific basis. Lowering of standards to lure investment is described as being inappropriate.

• Establishment of two commissions with the power to impose fines and remove trade privileges when environmental standards or legislation involving health and safety, minimum wages, or child labor are ignored.

The Case for NAFTA Proponents of NAFTA have argued that the free trade area should be viewed as an opportunity to create an enlarged and more efficient productive base for the entire region. Advocates acknowledge that one effect of NAFTA would be that some U.S. and Canadian firms would move production to Mexico to take advantage of lower labor costs. (In 2004, the average hourly labor cost in Mexico was still one-tenth of that in the United States and Canada.) Movement of production to Mexico, they argued, was most likely to occur in low-skilled, labor-intensive manufacturing industries where Mexico might have a comparative advantage. Advocates of NAFTA argued that many would benefit from such a trend. Mexico would benefit from much-needed inward investment and employment. The United States and Canada would benefit because the increased incomes of the Mexicans would allow them to import more U.S. and Canadian goods, thereby increasing demand and making up for the jobs lost in industries that moved production to Mexico. U.S. and Canadian consumers would benefit from the lower prices of products made in Mexico. In addition, the international competitiveness of U.S. and Canadian firms that moved production to Mexico to take advantage of lower labor costs would be enhanced, enabling them to better compete with Asian and European rivals.

The Case against NAFTA Those who opposed NAFTA claimed that ratification would be followed by a mass exodus of jobs from the United States and Canada into Mexico as employers sought to profit from Mexico’s lower wages and less strict environ- mental and labor laws. According to one extreme opponent, Ross Perot, up to 5.9 million U.S. jobs would be lost to Mexico after NAFTA in what he famously characterized as a “giant sucking sound.” Most economists, however, dismissed these numbers as being absurd and alarmist. They argued that Mexico would have to run a bilateral trade surplus with the United States of close to $300 billion for job loss on such a scale to occur—and $300 billion was the size of Mexico’s GDP. In other words, such a scenario seemed implausible.

More sober estimates of the impact of NAFTA ranged from a net creation of 170,000 jobs in the United States (due to increased Mexican demand for U.S. goods and ser- vices) and an increase of $15 billion per year to the joint U.S. and Mexican GDP, to a net loss of 490,000 U.S. jobs. To put these numbers in perspective, employment in the

North American Free Trade Agreement (NAFTA) Free trade area among Canada, Mexico, and the United States.

272 Part Three The Global Trade and Investment Environment

U.S. economy was predicted to grow by 18 million from 1993 to 2003. As most economists repeatedly stressed, NAFTA would have a small impact on both Canada and the United States. It could hardly be any other way, because the Mexican economy was only 5 percent of the size of the U.S. economy. Signing NAFTA required the largest leap of economic faith from Mexico rather than Canada or the United States. Falling trade barriers would expose Mexican firms to highly efficient U.S. and Canadian competitors that, when compared to the average Mexican firm, had far greater capital resources, access to highly educated and skilled workforces, and much greater technological sophistication. The short-run outcome was likely to be painful economic restructuring and unemployment in Mexico. But advocates of NAFTA claimed there would be long-run dynamic gains in the efficiency of Mexican firms as they adjusted to the rigors of a more competi- tive marketplace. To the extent that this occurred, they argued, Mexico’s economic growth rate would acceler- ate, and Mexico might become a major market for Canadian and U.S. firms.18

Environmentalists also voiced concerns about NAFTA. They pointed to the sludge in the Rio Grande and the smog in the air over Mexico City and warned that Mexico could degrade clean air and toxic waste standards across the continent. They pointed out that the lower Rio Grande was the most polluted river in the United States and that, with NAFTA, chemical waste and sewage would increase along its course from El Paso, Texas, to the Gulf of Mexico.

There was also opposition in Mexico to NAFTA from those who feared a loss of national sovereignty. Mexican critics argued that their country would be dominated by U.S. firms that would not really contribute to Mexico’s economic growth, but instead would use Mexico as a low-cost assembly site while keeping their high-paying, high-skilled jobs north of the border.

NAFTA: The Results Studies of NAFTA’s impact suggest its initial effects were at best muted, and both advocates and detractors may have been guilty of exaggeration.19 On aver- age, studies indicate that NAFTA’s overall impact has been small but positive.20 From 1993 to 2005, trade among NAFTA’s partners grew by 250 percent.21 Today, Canada and Mexico are now among the top three trading partners of the United States (the other is China), sug- gesting the economies of the three NAFTA nations have become more closely integrated. In 1990, U.S. trade with Canada and Mexico accounted for about a quarter of total U.S. trade. By 2005, the figure was close to one-third. Canada’s trade with its NAFTA partners increased from about 70 percent to more than 80 percent of all Canadian foreign trade be- tween 1993 and 2005, while Mexico’s trade with NAFTA increased from 66 percent to 80 percent over the same period. America’s trade with Mexico increased 506 percent be- tween 1993 and 2012, compared with 279 percent for non-NAFTA countries. All three countries also experienced strong productivity growth since 1993. In Mexico, labor produc- tivity has increased by 50 percent since 1993, and the passage of NAFTA may have contrib- uted to this. However, estimates suggest that employment effects of NAFTA have been small. The most pessimistic estimates suggest the United States lost 110,000 jobs per year due to NAFTA between 1994 and 2000—and many economists dispute this figure—which is tiny compared to the more than 2 million jobs a year created in the United States during the same period.

As NAFTA Nurtures Mexican Economy, Illegal Immigration Dwindles? The large wave of immigration from Mexico to the United States that began four decades ago, most of it unauthorized, has to a large degree ended. As a report from the Pew Hispanic Center confirms, net migration from Mexico to the United States sank to about zero in the past five years. Did the North American Free Trade Agreement (NAFTA) play a role? Yes and no. Actually, the number of Mexicans living illegally in the United States shot up from 2.5 million in 1995, the year after NAFTA took effect, to 11 million in 2013. The main reason was the booming U.S. econ- omy, which generated huge demands for labor just as the share of Mexico’s population aged 15 to 39, prime migration years, was peaking at about 75 percent. Migration plummeted after 2005 because of reduced U.S. demand for labor and the slowing of Mexican population growth, but also because NAFTA started to pay off in the form of dynamic new export industries in Mexico, such as automobile manufacturing. Do you think there will be continued decline in immigration of people from Mexico to the United States in future years because of the NAFTA agree- ment, or will the immigration decline (or potential increase) be due to factors that are not tied to NAFTA?

Source: www.lehighvalleylive.com/opinion/index.ssf/2012/04/editorial_as_nafta_ nurtures_me.html.

Chapter Nine Regional Economic Integration 273

Perhaps the most significant impact of NAFTA has not been economic, but political. Many observers credit NAFTA with helping create the background for increased politi- cal stability in Mexico. For most of the post-NAFTA period, Mexico has been viewed as a stable democratic nation with a steadily growing economy, something that is beneficial to the United States, which shares a 2,000-mile border with the country.22 However, recent events have cast a cloud over Mexico’s future. In late 2006, newly elected Mexican President Felipe Calderón initiated a crackdown on Mexico’s increasingly powerful drug cartels (whose main business has been the illegal trafficking of drugs across the border into the United States). Calderón sent 6,500 troops into the Mexican state of Michoacan to end escalating drug violence there. The cartels responded by escalating their own violence, and the country is now gripped in what amounts to an all-out war. Fueled by the lucrative business of selling drugs to the United States and armed with guns purchased in the United States, the cartels have been fighting each other and the Mexican authorities in an increasingly brutal conflict that claimed more than 60,000 lives since 2006.23

Enlargement One issue confronting NAFTA is that of enlargement. A number of other Latin American countries have indicated their desire to eventually join NAFTA. The governments of both Canada and the United States are adopting a wait-and-see attitude with regard to most countries. Getting NAFTA approved was a bruising political experience, and neither government is eager to repeat the process soon. Nevertheless, the Canadian, Mexican, and U.S. governments began talks in 1995 regarding Chile’s possible entry into NAFTA. As of 2011, however, these talks had yielded little progress, partly be- cause of political opposition in the U.S. Congress to expanding NAFTA. In December 2002, however, the United States and Chile did sign a bilateral free trade pact.

THE ANDEAN COMMUNITY Bolivia, Chile, Ecuador, Colombia, and Peru signed an agreement in 1969 to create the Andean Pact. The Andean Community was largely based on the EU model, but was far less successful at achieving its stated goals. The integration steps begun in 1969 included an internal tariff reduction program, a common external tariff, a transportation policy, a common industrial policy, and special concessions for the smallest members, Bolivia and Ecuador.

By the mid-1980s, the Andean Pact had all but collapsed and had failed to achieve any of its stated objectives. There was no tariff-free trade among member countries, no common external tariff, and no harmonization of economic policies. Political and economic prob- lems seem to have hindered cooperation among member countries. The countries of the Andean Pact have had to deal with low economic growth, hyperinflation, high unemploy- ment, political unrest, and crushing debt burdens. In addition, the dominant political ideol- ogy in many of the Andean countries during this period tended toward the radical-socialist end of the political spectrum. Because such an ideology is hostile to the free market eco- nomic principles on which the Andean Pact was based, progress toward closer integration could not be expected.

The tide began to turn in the late 1980s when, after years of economic decline, the governments of Latin America began to adopt free market economic policies. In 1990, the heads of the five current members of the Andean Community—Bolivia, Ecuador, Peru, Colombia, and Venezuela—met in the Galápagos Islands. The resulting Galápagos Declaration effectively relaunched the Andean Pact, which was renamed the Andean Community in 1997. The declaration’s objectives included the establishment of a free trade area by 1992, a customs union by 1994, and a common market by 1995. This last milestone has not been reached. A customs union was implemented in 1995—although Peru opted out and Bolivia received preferential treatment until 2003. The Andean Community now operates as a customs union. In December 2005, it signed an agreement with Mercosur to restart stalled negotiations on the creation of a free trade area between the two trading blocs. Those negotiations are proceeding at a slow pace. In late 2006, Venezuela withdrew from the Andean Community as part of that country’s attempts to join Mercosur.

Andean Community A 1969 agreement among Bolivia, Chile, Ecuador, Colombia, and Peru to establish a customs union.

274 Part Three The Global Trade and Investment Environment

MERCOSUR Mercosur originated in 1988 as a free trade pact between Brazil and Argentina. The modest reductions in tariffs and quotas accompanying this pact reportedly helped bring about an 80 percent increase in trade between the two countries in the late 1980s.24 This success encouraged the expansion of the pact in March 1990 to include Paraguay and Uruguay. In 2006, the pact was further expanded when Venezuela joined Mercosur, although it may take years for Venezuela to become fully integrated into the pact. As of early 2014, Paraguay had yet to ratify the agreement allowing Venezuela to become a full member of Mercosur.

The initial aim of Mercosur was to establish a full free trade area by the end of 1994 and a common market sometime thereafter. In December 1995, Mercosur’s members agreed to a five-year program under which they hoped to perfect their free trade area and move to- ward a full customs union—something that has yet to be achieved.25 For its first eight years or so, Mercosur seemed to be making a positive contribution to the economic growth rates of its member-states. Trade among the four core members quadrupled between 1990 and 1998. The combined GDP of the four member-states grew at an annual average rate of 3.5 percent between 1990 and 1996, a performance that is significantly better than the four attained during the 1980s.26

However, Mercosur had its critics, including Alexander Yeats, a senior economist at the World Bank, who wrote a stinging critique.27 According to Yeats, the trade diversion effects of Mercosur outweigh its trade creation effects. Yeats pointed out that the fastest- growing items in intra-Mercosur trade were cars, buses, agricultural equipment, and other capital-intensive goods that are produced relatively inefficiently in the four member countries. In other words, Mercosur countries, insulated from outside competition by tariffs that run as high as 70 percent of value on motor vehicles, are investing in factories that build products that are too expensive to sell to anyone but themselves. The result, according to Yeats, is that Mercosur countries might not be able to compete globally once the group’s external trade barriers come down. In the meantime, capital is being drawn away from more efficient enterprises. In the near term, countries with more efficient man- ufacturing enterprises lose because Mercosur’s external trade barriers keep them out of the market.

Mercosur hit a significant roadblock in 1998 when its member-states slipped into reces- sion and intrabloc trade slumped. Trade fell further in 1999 following a financial crisis in Brazil that led to the devaluation of the Brazilian real, which immediately made the goods of other Mercosur members 40 percent more expensive in Brazil, their largest export mar- ket. At this point, progress toward establishing a full customs union all but stopped. Things deteriorated further in 2001 when Argentina, beset by economic stresses, suggested the customs union be temporarily suspended. Argentina wanted to suspend Mercosur’s tariff so that it could abolish duties on imports of capital equipment, while raising those on con- sumer goods to 35 percent (Mercosur had established a 14 percent import tariff on both sets of goods). Brazil agreed to this request, effectively halting Mercosur’s quest to become a fully functioning customs union.28 Hope for a revival arose in 2003 when new Brazilian President Lula da Silva announced his support for a revitalized and expanded Mercosur modeled after the EU with a larger membership, a common currency, and a democratically elected Mercosur parliament.29 In 2010, the members of Mercosur did agree on a common customs code to avoid outside goods having to pay tariffs more than once, an important step toward achieving a full customs union. Since 2010, however, Mercosur has made little forward progress, and the jury is still out on whether it will become a fully functioning customs union.

CENTRAL AMERICAN COMMON MARKET, CAFTA, AND CARICOM Two other trade pacts in the Americas have not made much progress. In the early 1960s, Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua attempted to set up a Central American Common Market. It collapsed in 1969 when war broke out between Honduras and El Salvador after a riot at a soccer match between teams from the two countries. Since then, the member countries have made some progress toward reviving

Mercosur Pact among Argentina, Brazil, Paraguay, and Uruguay to establish a free trade area.

Central American Common Market A trade pact among Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua, which began in the early 1960s but collapsed in 1969 due to war.

Chapter Nine Regional Economic Integration 275

their agreement (the five founding members were joined by the Dominican Republic). The proposed common market was given a boost in 2003 when the United States signaled its intention to enter into bilateral free trade negotiations with the group. These culminated in a 2004 agreement to establish a free trade agreement between the six countries and the United States. Known as the Central America Free Trade Agreement (CAFTA), the aim is to lower trade barriers between the United States and the six countries for most goods and services.

A customs union was to have been created in 1991 between the English-speaking Caribbean countries under the auspices of the Caribbean Community. Referred to as CARICOM, it was established in 1973. However, it repeatedly failed to progress toward economic integration. A formal commitment to economic and monetary union was adopted by CARICOM’s member-states in 1984, but since then little progress has been made. In October 1991, the CARICOM governments failed, for the third consecutive time, to meet a deadline for establishing a common external tariff. Despite this, CARICOM expanded to 15 members by 2005. In early 2006, six CARICOM members established the Caribbean Single Market and Economy (CSME). Modeled on the EU’s single market, CSME’s goal is to lower trade barriers and harmonize macroeconomic and monetary policy between member-states.30

FREE TRADE AREA OF THE AMERICAS At a hemispherewide Summit of the Americas in December 1994, a Free Trade Area of the Americas (FTAA) was proposed. It took more than three years for the talks to start, but in April 1998, 34 heads of state trav- eled to Santiago, Chile, for the second Summit of the Americas, where they formally inau- gurated talks to establish an FTAA by January 1, 2005—something that didn’t occur. The continuing talks have addressed a wide range of economic, political, and environmental is- sues related to cross-border trade and investment. Although both the United States and Brazil were early advocates of the FTAA, support from both countries seems to be mixed at this point. Because the United States and Brazil have the largest economies in North and South America, respectively, strong U.S. and Brazilian support is a precondition for estab- lishment of the free trade area.

The major stumbling blocks so far have been twofold. First, the United States wants its southern neighbors to agree to tougher enforcement of intellectual property rights and lower manufacturing tariffs, which they do not seem to be eager to embrace. Second, Brazil and Argentina want the United States to reduce its subsidies to U.S. agricultural producers and scrap tariffs on agricultural imports, which the U.S. government does not seem inclined to do. For progress to be made, most observers agree that the United States and Brazil have to first reach an agreement on these crucial issues.31 If the FTAA is eventually established, it will have major implications for cross-border trade and investment flows within the hemi- sphere. The FTAA would open a free trade umbrella over 850 million people, who ac- counted for some $18 trillion in GDP in 2008.

Currently, however, FTAA is very much a work in progress, and the progress has been slow. The most recent attempt to get talks going again, in November 2005 at a summit of 34 heads of state from North and South America, failed when opponents, led by Venezuela’s populist President Hugo Chávez, blocked efforts by the Bush administration to set an agenda for further talks on FTAA. In voicing his opposition, Chávez condemned the U.S. free trade model as a “perversion” that would unduly benefit the United States to the detri- ment of poor people in Latin America, who Chávez claimed have not benefited from free trade details.32 Such views make it unlikely that there will be much progress establishing an FTAA in the near term.

Regional Economic Integration Elsewhere Numerous attempts at regional economic integration have been tried throughout Asia and Africa. However, few exist in anything other than name. Perhaps the most significant is the Association of Southeast Asian Nations (ASEAN). In addition, the Asia-Pacific

Central America Free Trade Agreement (CAFTA) The agreement of the member-states of the Central American Common Market joined by the Dominican Republic to trade freely with the United States.

CARICOM An association of English-speaking Caribbean states that are attempting to establish a customs union.

Caribbean Single Market and Economy (CSME) The six CARICOM members that agreed to lower trade barriers and harmonize macroeconomic and monetary policies.

LO 9-4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

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276 Part Three The Global Trade and Investment Environment

Economic Cooperation (APEC) forum has recently emerged as the seed of a potential free trade region.

ASSOCIATION OF SOUTHEAST ASIAN NATIONS Formed in 1967, the Association of Southeast Asian Nations (ASEAN) includes Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam. Laos, Myanmar, Vietnam, and Cambodia have all joined recently, creating a regional grouping of 600 million people with a combined GDP of some $2 trillion (see Map 9.3). The basic objective of ASEAN is to foster freer trade among member countries and to achieve coop- eration in their industrial policies. Progress so far has been limited, however.

Until recently, only 5 percent of intra-ASEAN trade consisted of goods whose tariffs had been reduced through an ASEAN preferential trade arrangement. This may be changing. In 2003, an ASEAN Free Trade Area (AFTA) among the six original members of ASEAN came into full effect. The AFTA has cut tariffs on manufacturing and agricultural products to less

Association of Southeast Asian Nations (ASEAN) Formed in 1967, an attempt to establish a free trade area among Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Vietnam, and Thailand.

9.3 MAP ASEAN Countries Source: Reprinted with permission, www.asean.org.

Chapter Nine Regional Economic Integration 277

than 5 percent. However, there are some significant exceptions to this tariff reduction. Malaysia, for example, refused to bring down tariffs on imported cars until 2005 and then agreed to lower the tariff only to 20 percent, not the 5 percent called for under the AFTA. Malaysia wanted to protect Proton, an inefficient local carmaker, from foreign competition. Similarly, the Philippines has refused to lower tariff rates on petrochemicals, and rice, the largest agricultural product in the region, will remain subject to higher tariff rates until at least 2020.33

Notwithstanding such issues, ASEAN and AFTA are at least progressing toward estab- lishing a free trade zone. Vietnam joined the AFTA in 2006, Laos and Myanmar in 2008, and Cambodia in 2010. The goal was to reduce import tariffs among the six original mem- bers to zero by 2010 and to do so by 2015 for the newer members (although important ex- ceptions to that goal, such as tariffs on rice, will persist).

ASEAN signed a free trade agreement with China that removes tariffs on 90 percent of traded goods. This went into effect January 1, 2010. Trade between China and ASEAN members more than tripled during the first decade of the twenty-first century, and this agreement should spur further growth.34

ASIA-PACIFIC ECONOMIC COOPERATION The Asia-Pacific Eco- nomic Cooperation (APEC) was founded in 1990 at the suggestion of Australia. APEC currently has 21 member-states, including such economic powerhouses as the United States, Japan, and China (see Map 9.4). Collectively, the member-states account for about

9.4 MAP APEC Members Source: Courtesy of the APEC Secretariat, www.apec.org. Reprinted with permission.

54 percent of the world’s GNP, 54 percent of world trade. The stated aim of APEC is to increase multilateral cooperation in view of the economic rise of the Pacific nations and the growing interdependence within the region. U.S. support for APEC was also based on the belief that it might prove a viable strategy for heading off any moves to create Asian group- ings from which it would be excluded.

Interest in APEC was heightened considerably in November 1993 when the heads of APEC member-states met for the first time at a two-day conference in Seattle. Debate be- fore the meeting speculated on the likely future role of APEC. One view was that APEC should commit itself to the ultimate formation of a free trade area. Such a move would transform the Pacific Rim from a geographic expression into the world’s largest free trade area. Another view was that APEC would produce no more than hot air and lots of photo opportunities for the leaders involved. As it turned out, the APEC meeting produced little more than some vague commitments from member-states to work together for greater eco- nomic integration and a general lowering of trade barriers. However, member-states did not rule out the possibility of closer economic cooperation in the future.35 The heads of state have met again on a number of occasions. However, the vague plan committed APEC to doing no more than holding further talks, which is all that has been accomplished to date.

REGIONAL TRADE BLOCS IN AFRICA African countries have been ex- perimenting with regional trade blocs for half a century. There are now nine trade blocs on the African continent. Many countries are members of more than one group. Although the number of trade groups is impressive, progress toward the establishment of meaningful trade blocs has been slow.

Many of these groups have been dormant for years. Significant political turmoil in sev- eral African nations has persistently impeded any meaningful progress. Also, deep suspicion of free trade exists in several African countries. The argument most frequently heard is that because these countries have less developed and less diversified economies, they need to be “protected” by tariff barriers from unfair foreign competition. Given the prevalence of this argument, it has been hard to establish free trade areas or customs unions.

The most recent attempt to reenergize the free trade movement in Africa occurred in early 2001, when Kenya, Uganda, and Tanzania, member-states of the East African Com- munity (EAC), committed themselves to relaunching their bloc, 24 years after it collapsed. The three countries, with 80 million inhabitants, intend to establish a customs union, re- gional court, legislative assembly, and, eventually, a political federation.

Their program includes cooperation on immigration, road and telecommunication net- works, investment, and capital markets. However, while local business leaders welcomed the relaunch as a positive step, they were critical of the EAC’s failure in practice to make progress on free trade. At the EAC treaty’s signing in November 1999, members gave themselves four years to negotiate a customs union, with a draft slated for the end of 2001. But that fell far short of earlier plans for an immediate free trade zone, shelved after Tanzania and Uganda, fearful of Kenyan competition, expressed concerns that the zone could create imbalances similar to those that contributed to the breakup of the first com- munity.36 Nevertheless, in 2005 the EAC did start to implement a customs union. In 2007, Burundi and Rwanda joined the EAC. The EAC established a common market in 2010 and is now striving toward an eventual goal of monetary union.

FOCUS ON MANAGERIAL IMPLICATIONS

REGIONAL ECONOMIC INTEGRATION THREATS Currently, the most significant developments in regional economic integration are occur- ring in the EU and NAFTA. Although some of the Latin American trade blocs, ASEAN, and the proposed FTAA may have economic significance in the future, developments in the EU

LO 9-5 Understand the implications for business that are inherent in regional economic integration agreements.

278 Part Three The Global Trade and Investment Environment

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and NAFTA currently have more profound implications for business practice. Accordingly, in this section, we concentrate on the business implications of those two groups. Similar conclusions, however, could be drawn with regard to the creation of a single market any- where in the world.

OPPORTUNITIES The creation of a single market through regional economic integration offers significant opportunities because markets that were formerly protected from foreign competition are increasingly open. Additional opportunities arise from the inherent lower costs of doing business in a single market—as opposed to 28 national markets in the case of the EU or 3 national markets in the case of NAFTA. Free movement of goods across borders, harmo- nized product standards, and simplified tax regimes make it possible for firms based in the EU and the NAFTA countries to realize potentially significant cost economies by central- izing production in those EU and NAFTA locations where the mix of factor costs and skills is optimal. Rather than producing a product in each of the 28 EU countries or the 3 NAFTA countries, a firm may be able to serve the whole EU or North American market from a single location. This location must be chosen carefully, of course, with an eye on local factor costs and skills.

Even after the removal of barriers to trade and investment, enduring differences in culture and competitive practices often limit the ability of companies to realize cost econ- omies by centralizing production in key locations and producing a standardized product for a single multiple-country market. Consider the case of Atag Holdings NV, a Dutch maker of kitchen appliances.37 Atag thought it was well placed to benefit from the single market, but found it tough going. Atag’s plant is just 1 mile from the German border and near the center of the EU’s population. The company thought it could cater to both the “potato” and “spaghetti” belts—marketers’ terms for consumers in northern and southern Europe—by producing two main product lines and selling these standardized “euro- products” to “euro-consumers.” The main benefit of doing so is the economy of scale derived from mass production of a standardized range of products. Atag quickly discov- ered that the “euro-consumer” was a myth. Consumer preferences vary much more across nations than Atag had thought. Consider ceramic cooktops: Atag planned to market just 2 varieties throughout the EU but found it needed 11. Belgians, who cook in huge pots, require extra-large burners. Germans like oval pots and burners to fit. The French need small burners and very low temperatures for simmering sauces and broths. Germans like oven knobs on the top; the French want them on the front. Most Germans and French prefer black and white ranges; the British demand a range of colors including peach, pigeon blue, and mint green.

THREATS Just as the emergence of single markets creates opportunities for business, it also presents a number of threats. For one thing, the business environment within each grouping has become more competitive. The lowering of barriers to trade and investment among coun- tries has led to increased price competition throughout the EU and NAFTA. Over time, price differentials across nations will decline in a single market. This is a direct threat to any firm doing business in EU or NAFTA countries. To survive in the tougher single- market environment, firms must take advantage of the opportunities offered by the cre- ation of a single market to rationalize their production and reduce their costs. Otherwise, they will be at a severe disadvantage.

A further threat to firms outside these trading blocs arises from the likely long-term improvement in the competitive position of many firms within the areas. This is particu- larly relevant in the EU, where many firms have historically been limited by a high-cost structure in their ability to compete globally with North American and Asian firms. The creation of a single market and the resulting increased competition in the EU produced serious attempts by many EU firms to reduce their cost structure by rationalizing produc- tion. This transformed many EU companies into more efficient global competitors. The

Chapter Nine Regional Economic Integration 279

280 Part Three The Global Trade and Investment Environment

message for non-EU businesses is that they need to respond to the emergence of more capable European competitors by reducing their own cost structures.

Another threat to firms outside of trading areas is the threat of being shut out of the single market by the creation of a “trade fortress.” The charge that regional economic inte- gration might lead to a fortress mentality is most often leveled at the EU. Although the free trade philosophy underpinning the EU theoretically argues against the creation of any for- tress in Europe, occasional signs indicate the EU may raise barriers to imports and invest- ment in certain “politically sensitive” areas, such as autos. Non-EU firms might be well advised, therefore, to set up their own EU operations. This could also occur in the NAFTA countries, but it seems less likely.

Finally, the emerging role of the European Commission in competition policy suggests the EU is increasingly willing and able to intervene and impose conditions on companies proposing mergers and acquisitions. This is a threat insofar as it limits the ability of firms to pursue the corporate strategy of their choice. The commission may require significant con- cessions from businesses as a precondition for allowing proposed mergers and acquisitions to proceed. While this constrains the strategic options for firms, it should be remembered that in taking such action, the commission is trying to maintain the level of competition in Europe’s single market, which should benefit consumers.

regional economic integration, p. 254 free trade area, p. 256 European Free Trade Association (EFTA), p. 256 customs union, p. 256 common market, p. 257 economic union, p. 257 political union, p. 257 trade creation, p. 259 trade diversion, p. 259 European Union, p. 260

Treaty of Rome, p. 260 European Commission, p. 260 European Council, p. 262 European Parliament, p. 262 Treaty of Lisbon, p. 263 Court of Justice, p. 263 Maastricht Treaty, p. 265 optimal currency area, p. 266 North American Free Trade Agreement (NAFTA), p. 271 Andean Community, p. 273

Mercosur, p. 274 Central American Common Market, p. 274 Central America Free Trade Agreement (CAFTA), p. 275 CARICOM, p. 275 Caribbean Single Market and Economy (CSME), p. 275 Association of Southeast Asian Nations (ASEAN), p. 276

Key Terms

Summary

This chapter pursued three main objectives: to examine the economic and political debate surrounding regional economic integration; to review the progress toward regional economic integration in Europe, the Americas, and elsewhere; and to distinguish the important implica- tions of regional economic integration for the practice of international business. The chapter made the following points:

1. A number of levels of economic integration are possible in theory. In order of increasing integration, they include a free trade area, a customs union, a common market, an economic union, and full political union.

2. In a free trade area, barriers to trade among member countries are removed, but each country determines its own external trade policy. In a customs union, internal barriers to trade are removed, and a

common external trade policy is adopted. A common market is similar to a customs union, except that a common market also allows factors of production to move freely among countries. An economic union involves even closer integration, including the establishment of a common currency and the harmonization of tax rates. A political union is the logical culmination of attempts to achieve ever-closer economic integration.

3. Regional economic integration is an attempt to achieve economic gains from the free flow of trade and investment between neighboring countries.

4. Integration is not easily achieved or sustained. Although integration brings benefits to the majority, it is never without costs for the minority. Concerns over national sovereignty often slow or stop integration attempts.

Chapter Nine Regional Economic Integration 281

5. Regional integration will not increase economic welfare if the trade creation effects in the free trade area are outweighed by the trade diversion effects.

6. The Single European Act sought to create a true single market by abolishing administrative barriers to the free flow of trade and investment among EU countries.

7. Seventeen EU members now use a common currency, the euro. The economic gains from a common currency come from reduced exchange costs, reduced risk associated with currency fluctuations, and increased price competition within the EU.

8. Increasingly, the European Commission is taking an activist stance with regard to competition policy, intervening to restrict mergers and acquisitions that it believes will reduce competition in the EU.

9. Although no other attempt at regional economic integration comes close to the EU in terms of potential economic and political significance, various other attempts are being made in the world. The

most notable include NAFTA in North America, the Andean Community and Mercosur in Latin America, ASEAN in Southeast Asia, and perhaps APEC.

10. The creation of single markets in the EU and North America means that many markets that were formerly protected from foreign competition are now more open. This creates major investment and export opportunities for firms within and outside these regions.

11. The free movement of goods across borders, the harmonization of product standards, and the simplification of tax regimes make it possible for firms based in a free trade area to realize potentially enormous cost economies by centralizing production in those locations within the area where the mix of factor costs and skills is optimal.

12. The lowering of barriers to trade and investment among countries within a trade group will probably be followed by increased price competition.

Critical Thinking and Discussion Questions

1. NAFTA has produced significant net benefits for the Canadian, Mexican, and U.S. economies. Discuss.

2. What are the economic and political arguments for regional economic integration? Given these arguments, why don’t we see more substantial examples of integration in the world economy?

3. What in general was the effect of the creation of a single market and a single currency within the EU on competition within the EU? Why?

4. Do you think it is correct for the European Commission to restrict mergers between American companies that do business in Europe? (For example, the European Commission vetoed the proposed merger between WorldCom and Sprint, both U.S. companies, and it carefully reviewed the merger between AOL and Time Warner, again both U.S. companies.)

5. What were the causes of the 2010–2012 sovereign debt crisis in the EU? What does this crisis tell us about the

weaknesses of the euro? Do you think the euro will survive the sovereign debt crisis?

6. How should a U.S. firm that currently exports only to ASEAN countries respond to the creation of a single market in this regional grouping?

7. How should a firm with self-sufficient production facilities in several ASEAN countries respond to the creation of a single market? What are the constraints on its ability to respond in a manner that minimizes production costs?

8. After a promising start, Mercosur, the major Latin American trade agreement, has faltered and made little progress since 2000. What problems are hurting Mercosur? What can be done to solve these problems?

9. Would establishment of a Free Trade Area of the Americas (FTAA) be good for the two most advanced economies in the hemisphere, the United States and Canada? How might the establishment of the FTAA affect the strategy of North American firms?

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

1. The World Trade Organization maintains a database of regional trade agreements. You can search this database to identify all agreements that a specific country

participates in. Search the database to identify the trade agreements that Japan currently participates in. What patterns do you see? Which region(s) of the world does Japan seem to be focusing on in its trade endeavors?

Research Task http://globalEDGE.msu.edu

It’s now almost two decades since the member-states of the European Union (EU) started to implement a treaty calling for the establishment of a single market for goods and services across the union, and yet progress toward this goal is still not complete. A case in point: the TV broadcasts of Premier League soccer. The English Premier League, which is one of the most lucrative broadcasting sports franchises in Europe, if not the world, has for years segmented Europe into different national markets, charging different prices for broadcasting rights depending on local demand. Not surprisingly, the rights are most expensive in the United Kingdom, where the league has contracted with British Sky Broadcasting Group and ESPN to screen games.

Karen Murphy, the owner of the Red, White & Blue pub in Portsmouth, England, didn’t want to pay the £7,000 annual subscription fee that Sky demanded for access to the Premier League feed. Instead, she purchased a TV signal decoder card and used it to unscramble the feed from a Greek TV broadcaster, Nova, which had purchased the rights to broadcast Pre- mier League soccer in Greece. This cost her just £800 a year. In 2005, it also brought a lawsuit from the Premier League. The initial judgment in a British court upheld the right of the Premier League to segment the market and charge a higher price to UK subscribers. Murphy was fined £8,000. She appealed the ruling, claiming the practice violated the EU’s Single Market Act, which the United Kingdom had signed in 1992.

The case eventually landed in the European Court of Justice, the EU’s highest court. The Premier League argued before the court that the EU needs individual national TV markets to satisfy the “cultural preferences” of viewers. The court did not agree. In a bombshell for the Premier League,

on February 3, 2011, the court stated, “Territorial exclusivity agreements relating to the transmission of football matches are contrary to European Union law. European law does not make it possible to prohibit the live transmission of Premier League matches in pubs by means of foreign de- coder cards.” In short, Murphy can continue to purchase her feed from Nova. This decision was a legal opinion prepared by the court’s advocate general, so technically it is still possible that the full court might overturn it, but in four out of five cases this does not happen.

This was not the first time the EU court had issued a ruling that af- fected Premier League soccer. In 1995, the court upheld the right of a Belgian soccer player to play in another EU country, stating athletes had the same freedom of movement as other EU workers. Ironically, this ruling, which also affirmed the principle of a single market, benefited Premier League clubs, enabling them to sign foreign players, rapidly transforming the league into the best in the world. The new ruling, however, creates significant challenges for the league. Revenue from broadcasting is a ma- jor source of income for Premier League clubs. The current deal giving British broadcasting rights to Sky and ESPN is worth some £1.782 billion to the league between 2010 and 2013.

In February 2012 the EU court affirmed the ruling. Many consumers may now follow Murphy and buy TV decoders so that they can watch lower-cost feeds. If enough do this, the income loss from arbitrage by con- sumers may force the Premier League to move toward pan-European broadcasting and pricing. This will reduce income to the clubs, which could have a profound impact on the players they can recruit and the wages they can afford. In short, the ruling, while benefiting consumers such as Murphy and her customers at the Red, White & Blue pub, is a dark cloud hanging over the future of British soccer.

Sources: O. Gibson, “Round One to the Pub Lady,” The Guardian, February 4, 2011, p. 5; J. W. Miller, “European TV Market for Sports Faces Turmoil from Legal Ruling,” The Wall Street Journal, February 4, 2011; J. Wilson, “What the Legal Wrangle Means for Armchair Fans,” The Daily Telegraph, February 4, 2011, p. 8; and “Portsmouth pub landlady Karen Murphy has Premier League TV conviction quashed,” Metro, February 24th, 2012.

CASE DISCUSSION QUESTIONS 1. Why do you think the English Premier League has historically charged

different prices for broadcasting rights in different European markets?

2. Do you think the European Court of Justice was right to rule that the league could not stop people from buying Premier League soccer feeds from other countries? Explain your reasoning?

3. Who benefits from the EU ruling? Who will the losers be?

4. If you were running the English Premier League, what would your strategy be on broadcast rights going forward?

ccccccllooooooosssssiinnnnnggggggggggg ccccccaaaasssssssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeI Want My Greek TV!

Customers watching soccer in a British pub.

2. Your company has assigned you with the task of investigating the various trade blocs in Africa to see if your company can benefit from these trade agreements while expanding into African markets. The first trade bloc you come across is COMESA.

Prepare a short executive summary for your company, explaining the level of integration the bloc has currently achieved, the level it aspires to accomplish, and the relationships it has with other African trade blocs.

282 Part Three The Global Trade and Investment Environment

Chapter Nine Regional Economic Integration 283

Endnotes

1. Information taken from World Trade Organization website and current as of April 2012, www.wto.org.

2. Ibid. 3. The Andean Community has been through a number of

changes since its inception. The latest version was established in 1991. See “Free-Trade Free for All,” The Economist, January 4, 1991, p. 63.

4. D. Swann, The Economics of the Common Market, 6th ed. (London: Penguin Books, 1990).

5. See J. Bhagwati, “Regionalism and Multilateralism: An Over- view,” Columbia University Discussion Paper 603, Depart- ment of Economics, Columbia University, New York; A. de la Torre and M. Kelly, “Regional Trade Arrangements,” Occa- sional Paper 93, Washington, DC: International Monetary Fund, March 1992; J. Bhagwati, “Fast Track to Nowhere,” The Economist, October 18, 1997, pp. 21–24; Jagdish Bhagwati, Free Trade Today (Princeton and Oxford: Princeton University Press, 2002); and B. K. Gordon, “A High Risk Trade Policy,” Foreign Affairs 82 no. 4 (July–August 2003), pp. 105–15.

6. N. Colchester and D. Buchan, Europower: The Essential Guide to Europe’s Economic Transformation in 1992 (London: The Econo- mist Books, 1990); and Swann, Economics of the Common Market.

7. Swann, Economics of the Common Market; Colchester and Bu- chan, Europower; “The European Union: A Survey,” The Econ- omist, October 22, 1994; “The European Community: A Survey,” The Economist, July 3, 1993; and the European Union website at http://europa.eu.int.

8. E. J. Morgan, “A Decade of EC Merger Control,” International Journal of Economics and Business, November 2001, pp. 451–73.

9. “The European Community: A Survey,” 1993. 10. Tony Barber, “The Lisbon Reform Treaty,” FT.com, December

13, 2007. 11. “One Europe, One Economy,” The Economist, November 30,

1991, pp. 53–54; and “Market Failure: A Survey of Business in Europe,” The Economist, June 8, 1991, pp. 6–10.

12. Alan Riley, “The Single Market Ten Years On,” European Policy Analyst, December 2002, pp. 65–72.

13. See C. Wyploze, “EMU: Why and How It Might Happen,” Journal of Economic Perspectives 11 (1997), pp. 3–22; and M. Feldstein, “The Political Economy of the European Eco- nomic and Monetary Union,” Journal of Economic Perspectives 11 (1997), pp. 23–42.

14. “One Europe, One Economy;” and Feldstein, “The Political Economy of the European Economic and Monetary Union.”

15. “Euro Still the World’s Second Reserve Currency,” The Eco- nomic Times, July 22, 2011.

16. Details regarding conditions of membership and the progres- sion of enlargement negotiations can be found at http://europa. eu.int/comm/enlargement/index.htm.

17. “What Is NAFTA?” Financial Times, November 17, 1993, p. 6; and S. Garland, “Sweet Victory,” BusinessWeek, November 29, 1993, pp. 30–31.

18. “NAFTA: The Showdown,” The Economist, November 13, 1993, pp. 23–36.

19. N. C. Lustog, “NAFTA: Setting the Record Straight,” The World Economy, 1997, pp. 605–14; and G. C. Hufbauer and J. J. Schott, NAFTA Revisited: Achievements and Challenges (Washington, DC: Institute for International Economics, 2005).

20. W. Thorbecke and C. Eigen-Zucchi, “Did NAFTA Cause a Giant Sucking Sound?” Journal of Labor Research, Fall 2002, pp. 647–58; G. Gagne, “North American Free Trade, Canada, and U.S. Trade Remedies: An Assessment after Ten Years,” The World Economy, 2000, pp. 77–91; Hufbauer and Schott, NAFTA Revisited; and J. Romalis, “NAFTA’s and Custfa’s Impact on International Trade,” Review of Economics and Statis- tics 98, no. 3 (2007), pp. 416–35. “NAFTA at 20: Ready to Take Off Again?” The Economist, January 4, 2014.

21. All trade figures from U.S. Department of Commerce Trade Stat Express website at http://tse.export.gov/.

22. J. Cavanagh et al., “Happy Ever NAFTA?” Foreign Policy, September–October 2002, pp. 58–65.

23. “Mexican Daily: Nearly 60,000 Drug War Deaths under Calderon,” Fox News Latino, November 1, 2012.

24. “The Business of the American Hemisphere,” The Economist, August 24, 1991, pp. 37–38.

25. “NAFTA Is Not Alone,” The Economist, June 18, 1994, pp. 47–48.

26. “Murky Mercosur,” The Economist, July 26, 1997, pp. 66–67. 27. See M. Philips, “South American Trade Pact under Fire,” The

Wall Street Journal, October 23, 1996, p. A2; A. J. Yeats, Does Mercosur’s Trade Performance Justify Concerns about the Global Welfare-Reducing Effects of Free Trade Arrangements? Yes! (Washington, DC: World Bank, 1996); and D. M. Leipziger et al., “Mercosur: Integration and Industrial Policy,” The World Economy, 1997, pp. 585–604.

28. “Another Blow to Mercosur,” The Economist, March 31, 2001, pp. 33–34.

29. “Lula Lays Out Mercosur Rescue Mission,” Latin America Newsletters, February 4, 2003, p. 7.

30. “CARICOM Single Market Begins,” EIU Views, February 3, 2006.

31. M. Esterl, “Free Trade Area of the Americas Stalls,” The Econ- omist, January 19, 2005, p. 1.

32. M. Moffett and J. D. McKinnon, “Failed Summit Casts Shadow on Global Trade Talks,” The Wall Street Journal, November 7, 2005, p. A1.

33. “Every Man for Himself: Trade in Asia,” The Economist, November 2, 2002, pp. 43–44.

34. L. Gooch, “Asian Free-Trade Zone Raises Hopes,” The New York Times, January 1, 2010, p. B3.

35. “Aimless in Seattle,” The Economist, November 13, 1993, pp. 35–36.

36. M. Turner, “Trio Revives East African Union,” Financial Times, January 16, 2001, p. 4.

37. T. Horwitz, “Europe’s Borders Fade,” The Wall Street Journal, May 18, 1993, pp. A1, A12; “A Singular Market,” The Economist, October 22, 1994, pp. 10–16; and “Something Dodgy in Europe’s Single Market,” The Economist, May 21, 1994, pp. 69–70.

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10-1 Describe the functions of the foreign exchange market.

10-2 Understand what is meant by spot exchange rates.

10-3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

10-4 Understand the different theories explaining how currency exchange rates are determined and their relative merits.

10-5 Identify the merits of different approaches toward exchange rate forecasting.

10-6 Compare and contrast the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.

learning objectives

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a pt

opening case

For many years Brazil was a country battered by persistently high inflation. As a result the value of its currency, the real, depreciated steadily against the U.S. dollar. This changed in the early 2000s when the Brazilian government was successful in bringing down annual inflation rates into the single digits. Lower inflation, coupled with policies that paved the way for the expansion of the Brazilian economy, re-

sulted in a steady appreciation of the real against the U.S. dollar. In May 2004, 1 real bought $0.3121; by

August 2008, 1 real bought $0.65, an appreciation of more than 100 percent.

The appreciation of the real against the dollar was a mixed bag for Embraer, the world’s largest

manufacturer of regional jets of up to 110 seats and one of Brazil’s most prominent industrial companies.

Embraer purchases many of the parts that go into its jets, including the engines and electronics, from U.S.

manufacturers. As the real appreciated against the dollar, these parts cost less when translated into reals,

which benefited Embraer’s profit margins. However, the company also prices its aircraft in U.S. dollars, as

do all manufacturers in the global market for commercial jet aircraft. So, as the real appreciated against

the dollar, Embraer’s dollar revenues were compressed when exchanged back into reals.

To try and deal with the impact of currency appreciation on its revenues, in the mid-2000s Embraer

started to hedge against future appreciation of the real by buying forward contracts (forward contracts

give the holder the right to exchange one currency—in this case dollars—for another—in this case reals—at

some point in the future at a predetermined exchange rate). If the real had continued to appreciate, this

would have been a great strategy for Embraer because the company could have locked in the rate at which

sales made in dollars were exchanged back into reals. Unfortunately for Embraer, as the global financial

crisis unfolded in 2008, investors fled to the dollar, which they viewed as a safe haven, and the real

depreciated against the dollar. Between August 2008 and November 2008, the value of the real fell by

almost 40 percent against the dollar. But for the hedging, this depreciation would have actually increased

Embraer’s revenues in reals. Embraer, however, had locked itself into a much higher real/dollar exchange

rate, and the company was forced to take a $121million loss on what was essentially a bad currency bet.

Embraer and the Wild Ride of the Brazilian Real

The Foreign Exchange Market

–continued

286 Part Four The Global Monetary System

Since the shock of 2008, Embraer has cut back on currency hedging, and most of its

dollar sales and purchases are not hedged. This makes Embraer’s sales revenues very

sensitive to the real/dollar exchange rate. By 2010, the Brazilian real was once more

appreciating against the U.S. dollar, which pressured Embraer’s revenues. By 2012,

however, the Brazilian economy was stagnating, while inflation was starting to increase

again. This led to a sustained fall in the value of the real, which fell from 1 real 5 $0.644

in July 2011 to 1 real 5 $0.40 by January 2014, a depreciation of 38 percent. What was

bad for the Brazilian currency, however, was good for Embraer, whose stock price surged

to the highest price since February 2008 on speculation that the decline on the real

would lead to a boost in Embraer’s revenues when expressed in reals. • Sources: D. Godoy, “Embraer Rallies as Brazilian Currency Weakens,” Bloomberg, May 31, 2013; K. Kroll, “Embraer Fourth Quarter Profits Plunge 44% on Currency Woes,” Cleveland.com, March 27, 2009; “A fall from Grace: Brazil’s Mediocre Economy,” The Economist, June 8, 2013; and “Brazil’s Economy: The Deterioration,” The Economist, December 7, 2013.

Introduction Like many enterprises in the global economy, the Brazilian aircraft manufacturer Embraer is affected by changes in the value of currencies on the foreign exchange market. As de- scribed in the opening case, Embraer’s revenues are helped when the Brazilian currency is weak against the U.S. dollar, and vice versa. The case illustrates that what happens in the foreign exchange market can have a fundamental impact on the sales, profits, and strategy of an enterprise. Accordingly, it is very important for managers to understand the foreign ex- change market, and what the impact of changes in currency exchange rates might be for their enterprise.

This chapter has three main objectives. The first is to explain how the foreign exchange market works. The second is to examine the forces that determine exchange rates and to discuss the degree to which it is possible to predict future exchange rate movements. The third objective is to map the implications for international business of exchange rate move- ments. This chapter is the first of two that deal with the international monetary system and its relationship to international business. The next chapter explores the institutional struc- ture of the international monetary system. The institutional structure is the context within which the foreign exchange market functions. As we shall see, changes in the institutional structure of the international monetary system can exert a profound influence on the devel- opment of foreign exchange markets.

The foreign exchange market is a market for converting the currency of one country into that of another country. An exchange rate is simply the rate at which one currency is converted into another. For example, Toyota uses the foreign exchange market to convert the dollars it earns from selling cars in the United States into Japanese yen. Without the foreign exchange market, international trade and international investment on the scale that we see today would be impossible; companies would have to resort to barter. The foreign exchange market is the lubricant that enables companies based in countries that use differ- ent currencies to trade with each other.

We know from earlier chapters that international trade and investment have their risks. Some of these risks exist because future exchange rates cannot be perfectly predicted. The rate at which one currency is converted into another can change over time. For example, at the start of 2001, one U.S. dollar bought 1.065 euros, but by early 2014 one U.S. dollar only bought 0.74 euro. The dollar had fallen sharply in value against the euro. This made Amer- ican goods cheaper in Europe, boosting export sales. At the same time, it made European goods more expensive in the United States, which hurt the sales and profits of European companies that sold goods and services to the United States.

Foreign Exchange Market A market for converting the currency of one country into that of another country.

Exchange Rate The rate at which one currency is converted into another.

Chapter Ten The Foreign Exchange Market 287

One function of the foreign exchange market is to provide some insurance against the risks that arise from such volatile changes in exchange rates, commonly referred to as foreign exchange risk. Although the foreign exchange market offers some insurance against foreign exchange risk, it cannot provide complete insurance. It is not unusual for international busi- nesses to suffer losses because of unpredicted changes in exchange rates. Currency fluctua- tions can make seemingly profitable trade and investment deals unprofitable, and vice versa.

We begin this chapter by looking at the functions and the form of the foreign exchange market. This includes distinguishing among spot exchanges, forward exchanges, and cur- rency swaps. Then we consider the factors that determine exchange rates. We also look at how foreign trade is conducted when a country’s currency cannot be exchanged for other currencies, that is, when its currency is not convertible. The chapter closes with a discussion of these things in terms of their implications for business.

The Functions of the Foreign Exchange Market The foreign exchange market serves two main functions. The first is to convert the currency of one country into the currency of another. The second is to provide some insurance against foreign exchange risk, or the adverse consequences of unpredictable changes in exchange rates.1

CURRENCY CONVERSION Each country has a currency in which the prices of goods and services are quoted. In the United States, it is the dollar ($); in Great Britain, the pound (£); in France, Germany, and the other 15 members of the euro zone it is the euro (€); in Japan, the yen (¥); and so on. In general, within the borders of a particular country, one must use the national currency. A U.S. tourist cannot walk into a store in Edinburgh, Scotland, and use U.S. dollars to buy a bottle of Scotch whisky. Dollars are not recognized as legal tender in Scotland; the tourist must use British pounds. Fortunately, the tourist can go to a bank and exchange her dollars for pounds. Then she can buy the whisky.

When a tourist changes one currency into another, she is participating in the foreign exchange market. The ex- change rate is the rate at which the market converts one currency into another. For example, an exchange rate of €1 5 $1.30 specifies that 1 euro buys 1.30 U.S. dollars.

LO 10-1 Describe the functions of the foreign exchange market.

Foreign Exchange Risk The risk that changes in exchange rates will hurt the profitability of a business deal.

globalEDGE Database of International Business Statistics

With Chapter 10, we begin a two-chapter series focused on issues re- lated to what we call the “global money system.” The broad topics that are covered include the foreign exchange market and international monetary system. These are critically important topics that can have a significant effect on how companies operate globally. Often times, companies have to deal with exchange rates, monetary systems, and the capital market on both country and regional levels. But the influ- ences of countries on the regional and global money system are sig- nificant (i.e., countries set the tone for the parameters of the foreign

exchange market and the international monetary system). The globalEDGE Database of International Business Statistics (DIBS) in- cludes time-series data beginning in the 1990s until today and covers more than 200 countries and more than 5,000 data variables. Coun- tries, regions, and the world use these types of data points to drive the global money system, and everyone who is interested in better under- standing the global capital market needs to know about them! Register free on globalEDGE to gain access to the DIBS database right now; students have free access to DIBS!

Should Countries Be Free to Set Currency Policy? Exchange rates are critically important in the global economy. They affect the price of every country’s imports and exports, com- panies’ foreign direct investment, and—directly or indirectly— people’s spending behaviors. In recent years, disagreements among countries over exchange rates have become much more widespread. Some government officials and analysts even sug- gest that there is a “currency war” among certain countries. The main issue is whether or not some countries are using exchange rate policies to undermine free currency markets and whether they intentionally, in essence, devalue their currency to gain a trade advantage at the expense of other countries. A weaker currency makes exports inexpensive (or at least cheaper) to foreigners, which can lead to higher exports and job creation in the export sector.

Source: R. M. Nelson, “Current Debates over Exchange Rates: Overview and Issues for Congress,” Congressional Research Service, November 12, 2013.

288 Part Four The Global Monetary System

The exchange rate allows us to compare the relative prices of goods and services in different countries. Our U.S. tourist wishing to buy a bottle of Scotch whisky in Edinburgh may find that she must pay £30 for the bottle, knowing that the same bottle costs $45 in the United States. Is this a good deal? Imagine the current pound/dollar exchange rate is £1.00 5 $2.00 (i.e., one British pound buys $2.00). Our intrepid tourist takes out her calculator and converts £30 into dollars. (The calculation is 30 3 2.) She finds that the bottle of Scotch costs the equivalent of $60. She is surprised that a bottle of Scotch whisky could cost less in the United States than in Scotland (alcohol is taxed heavily in Great Britain).

Tourists are minor participants in the foreign exchange market; com- panies engaged in international trade and investment are major ones. In- ternational businesses have four main uses of foreign exchange markets. First, the payments a company receives for its exports, the income it re- ceives from foreign investments, or the income it receives from licensing agreements with foreign firms may be in foreign currencies. To use those funds in its home country, the company must convert them to its home country’s currency. Consider the Scotch distillery that exports its whisky to the United States. The distillery is paid in dollars, but because those dollars cannot be spent in Great Britain, they must be converted into British pounds. Similarly, Toyota sells its cars in the United States for dol- lars; it must convert the U.S. dollars it receives into Japanese yen to use them in Japan.

Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its coun- try’s currency. For example, Dell buys many of the components for its

computers from Malaysian firms. The Malaysian companies must be paid in Malaysia’s cur- rency, the ringgit, so Dell must convert money from dollars into ringgit to pay them.

Third, international businesses also use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets. For example, consider a U.S. company that has $10 million it wants to invest for three months. The best interest rate it can earn on these funds in the United States may be 2 percent. Investing in a South Korean money market account, however, may earn 6 percent. Thus, the company may change its $10 million into Korean won and invest it in South Korea. Note, however, that the rate of return it earns on this investment depends not only on the Korean interest rate but also on the changes in the value of the Korean won against the dollar in the intervening period.

Currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. Consider again a U.S. company with $10 million to invest for three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/yen exchange rate is $1 5 ¥120. The company exchanges its $10 million into yen, receiving ¥1.2 billion ($10 million 3 120 5 ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 5 ¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds that it has $12 million. The company has made a $2 million profit on currency speculation in three months on an initial investment of $10 million! In general, however, companies should beware, for speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. While a speculator may profit handsomely if his speculation about future currency movements turns out to be correct, he can also lose vast amounts of money if he turns out to be wrong.

A kind of speculation that has become more common in recent years is known as the carry trade. The carry trade involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high. For example, if the interest rate on borrowings in Japan is 1 percent, but the interest rate on deposits in American banks is 6 percent, it can make sense to borrow in Japanese yen,

Currency Speculation Involves short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates.

Carry Trade A kind of speculation that involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high.

Every time a tourist changes money in a foreign country they are participating in the foreign exchange market.

Chapter Ten The Foreign Exchange Market 289

convert the money into U.S. dollars, and deposit it in an American bank. The trader can make a 5 percent margin by doing so, minus the transaction costs associated with changing one currency into another. The speculative element of this trade is that its success is based on a belief that there will be no adverse movement in exchange rates (or interest rates for that matter) that will make the trade unprofitable. However, if the yen were to rapidly in- crease in value against the dollar, then it would take more U.S. dollars to repay the original loan, and the trade could fast become unprofitable. The dollar/yen carry trade was actually very significant during the mid-2000s, peaking at more than $1 trillion in 2007, when some 30 percent of trade on the Tokyo foreign exchange market was related to the carry trade.2 This carry trade declined in importance during 2008–2009 because interest rate differentials were falling as U.S. rates came down, making the trade less profitable.

INSURING AGAINST FOREIGN EXCHANGE RISK A second function of the foreign exchange market is to provide insurance against foreign exchange risk, which is the possibility that unpredicted changes in future exchange rates will have adverse conse- quences for the firm. When a firm insures itself against foreign exchange risk, it is engaging in hedging. To explain how the market performs this function, we must first distinguish among spot exchange rates, forward exchange rates, and currency swaps.

Spot Exchange Rates When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as a spot exchange. Exchange rates governing such “on the spot” trades are referred to as spot exchange rates. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Thus, when our U.S. tourist in Edinburgh goes to a bank to convert her dollars into pounds, the exchange rate is the spot rate for that day.

Spot exchange rates are reported on a real-time basis on many financial websites. An ex- change rate can be quoted in two ways: as the amount of foreign currency one U.S. dollar will buy or as the value of a dollar for one unit of foreign currency. Thus, on January 20, 2014, at 1:11 p.m., Eastern Standard Time, one U.S. dollar bought €0.74, and one euro bought $1.36.

Spot rates change continually, often on a minute-by-minute basis (although the magni- tude of changes over such short periods is usually small). The value of a currency is deter- mined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies. For example, if lots of people want U.S. dollars and dollars are in short supply, and few people want British pounds and pounds are in plentiful supply, the spot exchange rate for converting dollars into pounds will change. The dollar is likely to appreciate against the pound (or the pound will depreciate against the dollar). Imagine the spot exchange rate is £1 5 $2.00 when the market opens. As the day progresses, dealers demand more dollars and fewer pounds. By the end of the day, the spot exchange rate might be £1 5 $1.98. Each pound now buys fewer dollars than at the start of the day. The dollar has appreciated, and the pound has depreciated.

Forward Exchange Rates Changes in spot exchange rates can be problematic for an international business. For example, a U.S. company that imports high-end cameras from Japan knows that in 30 days it must pay yen to a Japanese supplier when a shipment arrives. The company will pay the Japanese supplier ¥200,000 for each camera, and the current dollar/yen spot exchange rate is $1 5 ¥120. At this rate, each camera costs the importer $1,667 (i.e., 1,667 5 200,000y120). The importer knows she can sell the camera the day they arrive for $2,000 each, which yields a gross profit of $333 on each ($2,000 2 $1,667). However, the importer will not have the funds to pay the Japanese supplier until the cameras are sold. If, over the next 30 days, the dollar unexpectedly depreciates against the yen, say, to $1 5 ¥95, the importer will still have to pay the Japanese company ¥200,000 per camera, but in dollar terms that would be equivalent to $2,105 per camera, which is more than she can sell the cameras for. A depreciation in the value of the dollar against the yen from $1 5 ¥120 to $1 5 ¥95 would transform a profitable deal into an unprofitable one.

LO 10-2 Understand what is meant by spot exchange rates.

Spot Exchange Rate The exchange rate at which a foreign exchange dealer will convert one currency into another that particular day.

LO 10-3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

290 Part Four The Global Monetary System

To insure or hedge against this risk, the U.S. importer might want to engage in a forward exchange. A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Exchange rates governing such future transactions are referred to as forward exchange rates. The Brazilian aircraft manufacturer Embraer entered into a forward exchange when it tried to hedge against further apprecia- tion of the Brazilian real against the U.S. dollar (see the opening case). For most major cur- rencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future. In some cases, it is possible to get forward exchange rates for several years into the future. Returning to our camera importer example, let us assume the 30-day forward exchange rate for converting dollars into yen is $1 5 ¥110. The importer enters into a 30-day forward exchange transaction with a foreign exchange dealer at this rate and is guaranteed that she will have to pay no more than $1,818 for each camera (1,818 5 200,000y110). This guaran- tees her a profit of $182 per camera ($2,000 2 $1,818). She also insures herself against the possibility that an unanticipated change in the dollar/yen exchange rate will turn a profit- able deal into an unprofitable one.

In this example, the spot exchange rate ($1 5 ¥120) and the 30-day forward rate ($1 5 ¥110) differ. Such differences are normal; they reflect the expectations of the foreign exchange market about future currency movements. In our example, the fact that $1 bought more yen with a spot exchange than with a 30-day forward exchange indicates foreign ex- change dealers expected the dollar to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a discount on the 30-day forward market (i.e., it is worth less than on the spot market). Of course, the opposite can also occur. If the 30-day forward exchange rate were $1 5 ¥130, for example, $1 would buy more yen with a forward exchange than with a spot exchange. In such a case, we say the dollar is selling at a premium on the 30-day forward market. This reflects the foreign exchange dealers’ expectations that the dollar will appreciate against the yen over the next 30 days.

In sum, when a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprof- itable by the time that transaction has been executed. Although many firms routinely enter

into forward exchange contracts to hedge their foreign exchange risk, there are some spectacular examples of what happens when firms don’t take out this insurance. An example is given in the accompanying Management Focus, which explains how a failure to fully insure against foreign exchange risk cost Volkswagen dearly.

Currency Swaps The preceding discussion of spot and forward exchange rates might lead you to conclude that the option to buy forward is very important to com- panies engaged in international trade—and you would be right. According to the most recent data, forward instru- ments account for almost two-thirds of all foreign ex- change transactions, while spot exchanges account for about one-third.3 However, the vast majority of these for- ward exchanges are not forward exchanges of the type we have been discussing, but rather a more sophisticated in- strument known as currency swaps.

A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two differ- ent value dates. Swaps are transacted between interna- tional businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk. A common kind of swap is spot against forward. Consider a company such as Apple Computer. Apple assembles laptop computers in

Forward Exchange When two parties agree to exchange currency and execute a deal at some specific date in the future.

Forward Exchange Rate The exchange rates governing forward exchange transactions.

Currency Swap Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

Should Currency Speculation Be Allowed? Currency speculation involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. Sometimes this speculation is done as what is called a carry trade. As we describe in Chapter 10, this involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high. In effect, it can be argued that cur- rency speculation tactics may have a strong negative effect on some countries’ economic foundation (e.g., Iceland, Thailand). For years, Iceland was a respected country for its unmatchable stan- dards of living. The 2008 economic turmoil threw the island nation’s currency off the cliff. The hedge funds closed in, and the government had to try to fight off the predators. Several years later, Iceland is still feeling the effect of these currency woes, al- beit the country is now in recovery mode and progressing in a positive direction. But, the issue remains that large-scale cur- rency speculation has the potential to adversely affect global markets. So, should currency speculation be allowed?

Source: A. Jung and C. Pauly, “Currency Woes: Crashing the Party of Icelandic Prosperity,” Spiegel Online International, April 10, 2008.

Chapter Ten The Foreign Exchange Market 291

the United States, but the screens are made in Japan. Apple also sells some of the finished laptops in Japan. So, like many companies, Apple both buys from and sells to Japan. Imagine Apple needs to change $1 million into yen to pay its supplier of laptop screens today. Apple knows that in 90 days it will be paid ¥120 million by the Japanese importer that buys its finished laptops. It will want to convert these yen into dollars for use in the United States. Let us say today’s spot exchange rate is $1 5 ¥120 and the 90-day forward exchange rate is $1 5 ¥110. Apple sells $1 million to its bank in return for ¥120 million. Now Apple can pay its Japanese supplier. At the same time, Apple enters into a 90-day forward exchange deal with its bank for converting ¥120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (¥120 million/110 5 $1.09 million). Because the yen is trading at a premium on the 90-day forward market, Apple ends up with more dollars than it started with (although the opposite could also occur). The swap deal is just like a conventional forward deal in one important respect: It enables Apple to insure itself against foreign exchange risk. By engaging in a swap, Apple knows today that the ¥120 million payment it will receive in 90 days will yield $1.09 million.

The Nature of the Foreign Exchange Market The foreign exchange market is not located in any one place. It is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. When companies wish to convert currencies, they typically go through their own banks rather than entering the market directly. The foreign exchange market has been growing at a rapid pace, reflecting a general growth in the volume of cross-border trade and investment (see Chapter 1). In March 1986, the average total value of global foreign exchange trading

Volkswagen’s Hedging Strategy

In January 2004, Volkswagen, Europe’s largest carmaker, reported a 95 percent drop in 2003 fourth-quarter profits, which slumped from €1.05 billion to a mere €50 million. For all of 2003, Volkswagen’s oper- ating profit fell by 50 percent from the record levels attained in 2002. Although the profit slump had multiple causes, two factors were the focus of much attention—the sharp rise in the value of the euro against the dollar during 2003 and Volkswagen’s decision to only hedge 30 percent of its foreign currency exposure, as opposed to the 70 per- cent it had traditionally hedged. In total, currency losses due to the dollar’s rise are estimated to have reduced Volkswagen’s operating profits by some €1.2 billion ($1.5 billion).

The rise in the value of the euro during 2003 took many companies by surprise. Since its introduction January 1, 1999, when it became the currency unit of 12 members of the European Union, the euro had re- corded a volatile trading history against the U.S. dollar. In early 1999, the exchange rate stood at €1 5 $1.17, but by October 2000 it had slumped to €1 5 $0.83. Although it recovered, reaching parity of €1 5 $1.00 in late 2002, few analysts predicted a rapid rise in the value of the euro against the dollar during 2003. As so often happens in the foreign exchange markets, the experts were wrong; by late 2003, the exchange rate stood at €1 5 $1.25. For Volkswagen, which made cars in Germany and exported them to the United States, the fall in the value of the dollar against the euro during 2003 was devastating. To understand what happened, consider a Volkswagen Jetta built in Germany for export to the United States.

Volkswagen could have insured against this adverse movement in exchange rates by entering the foreign exchange market in late 2002 and buying a forward contract for dollars at an exchange rate of around $1 5 €1 (a forward contract gives the holder the right to exchange one currency for another at some point in the future at a predetermined exchange rate). Called hedging, the financial strategy of buying forward guarantees that at some future point, such as 180 days, Volkswagen would have been able to exchange the dollars it got from selling Jettas in the United States into euros at $1 5 €1, irrespective of what the actual exchange rate was at that time. In 2003, such a strategy would have been good for Volkswagen. How- ever, hedging is not without its costs. For one thing, if the euro had declined in value against the dollar, instead of appreciating as it did, Volkswagen would have made even more profit per car in euros by not hedging (a dollar at the end of 2003 would have bought more euros than a dollar at the end of 2002). For another thing, hedging is expensive because foreign exchange dealers will charge a high com- mission for selling currency forward. Volkswagen decided to hedge just 30 percent of its anticipated U.S. sales in 2003 through forward contracts, rather than the 70 percent it had historically hedged. The decision cost the company more than €1 billion. For 2004, the company reverted back to hedging 70 percent of its foreign currency exposure.

Sources: Mark Landler, “As Exchange Rates Swing, Car Makers Try to Duck,” The New York Times, January 17, 2004, pp. B1, B4; N. Boudette, “Volkswagen Posts 95% Drop in Net,” The Wall Street Journal, February 19, 2004, p. A3; and “Volkswagen’s Financial Mechanic,” Corporate Finance, June 2003, p. 1.

management FOCUS

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292 Part Four The Global Monetary System

was about $200 billion per day. By April 2013, it had hit $5.3 trillion a day.4 The most important trading centers are London (37 percent of activity), New York (18 percent of activity), and Zurich, Tokyo, and Singapore (all with around 5 to 6 percent of activity).5 Major secondary trading centers include Frankfurt, Paris, Hong Kong, and Sydney.

London’s dominance in the foreign exchange market is due to both history and geogra- phy. As the capital of the world’s first major industrial trading nation, London had become the world’s largest center for international banking by the end of the nineteenth century, a position it has retained. Today, London’s central position between Tokyo and Singapore to the east and New York to the west has made it the critical link between the East Asian and New York markets. Due to the particular differences in time zones, London opens soon after Tokyo closes for the night and is still open for the first few hours of trading in New York.6

Two features of the foreign exchange market are of particular note. The first is that the market never sleeps. Tokyo, London, and New York are all shut for only 3 hours out of every 24. During these three hours, trading continues in a number of minor centers, particularly San Francisco and Sydney, Australia. The second feature of the market is the integration of the various trading centers. High-speed computer linkages among trading centers around the globe have effectively created a single market. The integration of financial centers im- plies there can be no significant difference in exchange rates quoted in the trading centers. For example, if the yen/dollar exchange rate quoted in London at 3 p.m. is ¥120 5 $1, the yen/dollar exchange rate quoted in New York at the same time (10 a.m. New York time) will be identical. If the New York yen/dollar exchange rate were ¥125 5 $1, a dealer could make a profit through arbitrage, buying a currency low and selling it high. For example, if the prices differed in London and New York as given, a dealer in New York could take $1 mil- lion and use that to purchase ¥125 million. She could then immediately sell the ¥125 million for dollars in London, where the transaction would yield $1.041666 million, allowing the trader to book a profit of $41,666 on the transaction. If all dealers tried to cash in on the opportunity, however, the demand for yen in New York would rise, resulting in an apprecia- tion of the yen against the dollar such that the price differential between New York and London would quickly disappear. Because foreign exchange dealers are always watching their computer screens for arbitrage opportunities, the few that arise tend to be small, and they disappear in minutes.

Another feature of the foreign exchange market is the important role played by the U.S. dollar. Although a foreign exchange transaction can involve any two currencies, most transactions involve dollars on one side. This is true even when a dealer wants to sell a nondollar currency and buy another. A dealer wishing to sell Korean won for Brazilian real, for example, will usually sell the won for dollars and then use the dollars to buy real. Although this may seem a roundabout way of doing things, it is actually cheaper than try- ing to find a holder of real who wants to buy won. Because the volume of international transactions involving dollars is so great, it is not hard to find dealers who wish to trade dollars for won or real.

Due to its central role in so many foreign exchange deals, the dollar is a vehicle currency. In 2013, 87 percent of all foreign exchange transactions involved dollars on one side of the transaction. After the dollar, the most important vehicle currencies were the euro (33 per- cent), the Japanese yen (23 percent), and the British pound (12 percent)—reflecting the historical importance of these trading entities in the world economy.

Economic Theories of Exchange Rate Determination At the most basic level, exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another. For example, if the demand for dol- lars outstrips the supply of them and if the supply of Japanese yen is greater than the de- mand for them, the dollar/yen exchange rate will change. The dollar will appreciate against the yen (or the yen will depreciate against the dollar). However, while differences in relative

Arbitrage The purchase of securities in one market for immediate resale in another to profit from a price discrepancy.

LO 10-4 Understand the different theories explaining how currency exchange rates are determined and their relative merits.

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Chapter Ten The Foreign Exchange Market 293

demand and supply explain the determination of exchange rates, they do so only in a super- ficial sense. This simple explanation does not reveal what factors underlie the demand for and supply of a currency. Nor does it tell us when the demand for dollars will exceed the supply (and vice versa) or when the supply of Japanese yen will exceed demand for them (and vice versa). Neither does it show under what conditions a currency is in demand or under what conditions it is not demanded. In this section, we will review economic theory’s answers to these questions. This will give us a deeper understanding of how exchange rates are determined.

If we understand how exchange rates are determined, we may be able to forecast exchange rate movements. Because future exchange rate movements influence export opportunities, the profitability of international trade and investment deals, and the price competitiveness of foreign imports, this is valuable information for an international business. Unfortunately, there is no simple explanation. The forces that determine exchange rates are complex, and no theoretical consensus exists, even among academic economists who study the phenomenon every day. Nonetheless, most economic theories of exchange rate movements seem to agree that three factors have an important impact on future exchange rate movements in a coun- try’s currency: the country’s price inflation, its interest rate, and market psychology.7

PRICES AND EXCHANGE RATES To understand how prices are related to exchange rate movements, we first need to discuss an economic proposition known as the law of one price. Then we will discuss the theory of purchasing power parity (PPP), which links changes in the exchange rate between two countries’ currencies to changes in the countries’ price levels.

The Law of One Price The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in differ- ent countries must sell for the same price when their price is expressed in terms of the same currency.8 For example, if the exchange rate between the British pound and the dollar is £1 5 $2.00, a jacket that retails for $80 in New York should sell for £40 in London (because $80/2.00 5 £40). Consider what would happen if the jacket cost £30 in London ($60 in U.S. currency). At this price, it would pay a trader to buy jackets in London and sell them in New York (an example of arbitrage). The company initially could make a profit of $20 on each jacket by purchasing it for £30 ($60) in London and selling it for $80 in New York (we are assuming away transportation costs and trade barriers). However, the increased demand for jackets in London would raise their price in London, and the increased supply of jackets in New York would lower their price there. This would continue until prices were equalized. Thus, prices might equalize when the jacket cost £35 ($70) in London and $70 in New York (assuming no change in the exchange rate of £1 5 $2.00).

Purchasing Power Parity If the law of one price were true for all goods and ser- vices, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products in different currencies, it would be possible to determine the “real” or PPP exchange rate that would exist if markets were effi- cient. (An efficient market has no impediments to the free flow of goods and services, such as trade barriers.)

A less extreme version of the PPP theory states that given relatively efficient markets— that is, markets in which few impediments to international trade exist—the price of a “bas- ket of goods” should be roughly equivalent in each country. To express the PPP theory in symbols, let P$ be the U.S. dollar price of a basket of particular goods and P¥ be the price of the same basket of goods in Japanese yen. The PPP theory predicts that the dollar/yen ex- change rate, E$/¥, should be equivalent to

E$y¥ 5 P$yP¥ Thus, if a basket of goods costs $200 in the United States and ¥20,000 in Japan, PPP theory predicts that the dollar/yen exchange rate should be $200y¥20,000 or $0.01 per Japanese yen (i.e., $1 5 ¥100).

Law of One Price In competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in the same currency.

Efficient Market A market where prices reflect all available information.

294 Part Four The Global Monetary System

Every year, the newsmagazine The Economist pub- lishes its own version of the PPP theorem, which it re- fers to as the “Big Mac Index.” The Economist has selected McDonald’s Big Mac as a proxy for a “basket of goods” because it is produced according to more or less the same recipe in about 120 countries. The Big Mac PPP is the exchange rate that would have hamburgers costing the same in each country. According to The Economist, comparing a country’s actual exchange rate with the one predicted by the PPP theorem based on relative prices of Big Macs is a test of whether a currency is underval- ued or not. This is not a totally serious exercise, as The Economist admits, but it does provide a useful illustration of the PPP theorem.

To calculate the index, The Economist converts the price of a Big Mac in a country into dollars at current exchange rates and divides that by the average price of a Big Mac in America. According to the PPP theorem, the prices should be the same. If they are not, it implies that the cur- rency is either overvalued against the dollar or underval- ued. For example, on July 11, 2013, the average price of a Big Mac in the United States was $4.56, while it was $5.82 in Brazil, $7.51 in Norway, and $2.61 in China. This suggests that the Brazilian real is overvalued by 16 percent and the Norwegian krona by 21 percent, while the Chinese currency is undervalued by 43 percent!

The next step in the PPP theory is to argue that the exchange rate will change if relative prices change. For

example, imagine there is no price inflation in the United States, while prices in Japan are increasing by 10 percent a year. At the beginning of the year, a basket of goods costs $200 in the United States and ¥20,000 in Japan, so the dollar/yen exchange rate, according to PPP theory, should be $1 5 ¥100. At the end of the year, the basket of goods still costs $200 in the United States, but it costs ¥22,000 in Japan. PPP theory predicts that the exchange rate should change as a result. More precisely, by the end of the year:

E$y¥ 5 $200y¥22,000

Thus, ¥1 5 $0.0091 (or $1 5 ¥110). Because of 10 percent price inflation, the Japanese yen has depreciated by 10 percent against the dollar. One dollar will buy 10 percent more yen at the end of the year than at the beginning.

Money Supply and Price Inflation In essence, PPP theory predicts that changes in relative prices will result in a change in exchange rates. Theoretically, a country in which price inflation is running wild should expect to see its currency depreciate against that of countries in which inflation rates are lower. If we can predict what a country’s future infla- tion rate is likely to be, we can also predict how the value of its currency relative to other currencies—its exchange rate—is likely to change. The growth rate of a country’s money supply determines its likely future inflation rate.9 Thus, in theory at least, we can use infor- mation about the growth in money supply to forecast exchange rate movements.

Inflation is a monetary phenomenon. It occurs when the quantity of money in circulation rises faster than the stock of goods and services—that is, when the money supply increases faster than output increases. Imagine what would happen if everyone in the country was suddenly given $10,000 by the government. Many people would rush out to spend their extra money on those things they had always wanted—new cars, new furniture, better clothes, and so on. There would be a surge in demand for goods and services. Car dealers, department stores, and other providers of goods and services would respond to this upsurge in demand by raising prices. The result would be price inflation.

China Renminbi as Reserve Currency: Yuan a Bet? Given China’s importance in international trade, it is very likely that the role of the yuan will continue to expand in the foreign exchange market. A study from the Brookings Institution sug- gests that in the long run, the ascendance of the yuan to reserve-currency standing is likely. A so-called reserve currency is a currency that is held in significant quantities by govern- ments and institutions as a part of their foreign exchange re- serves and that is commonly used in international financial transactions. China is the only country whose currency does not have reserve status. Getting there will require overcoming two main challenges. First, it will take exchange rate flexibility and financial market development to improve the cost–benefit trade- off of the yuan. Second, it will take strengthening the Chinese banking system. The potential costs of having a reserve cur- rency include reduced control of the currency’s external value and possibly a more volatile exchange rate. Given these chal- lenges and constraints, do you think the yuan will become a re- serve currency that can compete with, for example, the U.S. dollar and the euro (which make up about 90 percent of allo- cated currency reserves globally)?

Source: http://blogs.reuters.com/macroscope/2012/02/08/china-renminbi-as- reserve-currency-yuan-a-bet/.

Chapter Ten The Foreign Exchange Market 295

A government increasing the money supply is analogous to giving people more money. An increase in the money supply makes it easier for banks to borrow from the government and for individuals and companies to borrow from banks. The resulting increase in credit causes increases in demand for goods and services. Unless the output of goods and services is growing at a rate similar to that of the money supply, the result will be inflation. This re- lationship has been observed time after time in country after country.

So now we have a connection between the growth in a country’s money supply, price in- flation, and exchange rate movements. Put simply, when the growth in a country’s money supply is faster than the growth in its output, price inflation is fueled. The PPP theory tells us that a country with a high inflation rate will see depreciation in its currency exchange rate. In one of the clearest historical examples, in the mid-1980s, Bolivia experienced hyperinflation—an explosive and seemingly uncontrollable price inflation in which money loses value very rap- idly. Table 10.1 presents data on Bolivia’s money supply, inflation rate, and its peso’s exchange rate with the U.S. dollar during the period of hyperinflation. The exchange rate is actually the “black market” exchange rate, because the Bolivian government prohibited converting the peso to other currencies during the period. The data show that the growth in money supply, the rate of price inflation, and the depreciation of the peso against the dollar all moved in step with each other. This is just what PPP theory and monetary economics

10.1 TABLE Macroeconomic Data for Bolivia, April 1984 to October 1985 Source: From Juan-Antonio Morales, “Inflation Stabilization in Bolivia” from Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, edited by Michael Bruno et al., MIT Press, 1988. Reprinted with permission.

Month Money Supply (billions of pesos)

Price Level Relative to 1982 (average 5 1)

Exchange Rate (pesos per dollar)

1984

April 270 21.1 3,576

May 330 31.1 3,512

June 440 32.3 3,342

July 599 34.0 3,570

August 718 39.1 7,038

September 889 53.7 13,685

October 1,194 85.5 15,205

November 1,495 112.4 18,469

December 3,296 180.9 24,515

1985

January 4,630 305.3 73,016

February 6,455 863.3 141,101

March 9,089 1,078.6 128,137

April 12,885 1,205.7 167,428

May 21,309 1,635.7 272,375

June 27,778 2,919.1 481,756

July 47,341 4,854.6 885,476

August 74,306 8,081.0 1,182,300

September 103,272 12,647.6 1,087,440

October 132,550 12,411.8 1,120,210

296 Part Four The Global Monetary System

predict. Between April 1984 and July 1985, Bolivia’s money supply increased by 17,433 percent, prices increased by 22,908 percent, and the value of the peso against the dollar fell by 24,662 percent! In October 1985, the Bolivian government instituted a dramatic stabili- zation plan—which included the introduction of a new currency and tight control of the money supply—and by 1987 the country’s annual inflation rate was down to 16 percent.10

Another way of looking at the same phenomenon is that an in- crease in a country’s money supply, which increases the amount of currency available, changes the relative demand-and-supply condi- tions in the foreign exchange market. If the U.S. money supply is growing more rapidly than U.S. output, dollars will be relatively more plentiful than the currencies of countries where monetary growth is closer to output growth. As a result of this relative in- crease in the supply of dollars, the dollar will depreciate on the foreign exchange market against the currencies of countries with slower monetary growth.

Government policy determines whether the rate of growth in a country’s money supply is greater than the rate of growth in output. A government can increase the money supply simply by telling the country’s central bank to issue more money. Governments tend to do this to finance public expenditure (building roads, paying government workers, paying for defense, etc.). A government could finance public expenditure by raising taxes, but because nobody likes paying more taxes and because politicians do not like to be unpopular, they have a natural preference for expanding the money supply. Unfortunately, there is no magic money tree. The result of excessive growth in money supply is typically price inflation. How- ever, this has not stopped governments around the world from expanding the money supply, with predictable results. If an international business is attempting to predict future move- ments in the value of a country’s currency on the foreign exchange market, it should exam- ine that country’s policy toward monetary growth. If the government seems committed to controlling the rate of growth in money supply, the country’s future inflation rate may be low (even if the current rate is high) and its currency should not depreciate too much on the foreign exchange market. If the government seems to lack the political will to control the rate of growth in money supply, the future inflation rate may be high, which is likely to cause its currency to depreciate. Historically, many Latin American governments have fallen into this latter category, including Argentina, Bolivia, and Brazil. More recently, many of the newly democratic states of eastern Europe made the same mistake. In late 2010, when the U.S. Federal Reserve decided to promote growth by expanding the U.S. money supply using a technique known as quantitative easing, critics charged that this too would lead to infla- tion and a decline in the value of the U.S. dollar on foreign exchange markets, but are they right? For a discussion of this, see the accompanying Country Focus.

Empirical Tests of PPP Theory PPP theory predicts that exchange rates are deter- mined by relative prices and that changes in relative prices will result in a change in exchange rates. A country in which price inflation is running wild should expect to see its currency depreciate against that of countries with lower inflation rates. This is intuitively appealing, but is it true in practice? There are several good examples of the connection between a country’s price inflation and exchange rate position (such as Bolivia). However, extensive empirical testing of PPP theory has yielded mixed results.11 While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to be a strong predic- tor of short-run movements in exchange rates covering time spans of five years or less.12 In addition, the theory seems to best predict exchange rate changes for countries with high rates of inflation and underdeveloped capital markets. The theory is less useful for predict- ing short-term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates.

The failure to find a strong link between relative inflation rates and exchange rate move- ments has been referred to as the purchasing power parity puzzle. Several factors may

Women shop at an outdoor market in La Paz, Boliva. Bolivia’s inflation rate is much lower today than it was in 1985 but must be carefully monitored.

Chapter Ten The Foreign Exchange Market 297

explain the failure of PPP theory to predict exchange rates more accurately.13 PPP theory assumes away transportation costs and barriers to trade. In practice, these factors are sig- nificant, and they tend to create significant price differentials between countries. Transpor- tation costs are certainly not trivial for many goods. Moreover, as we saw in Chapter 7, governments routinely intervene in international trade, creating tariff and nontariff barri- ers to cross-border trade. Barriers to trade limit the ability of traders to use arbitrage to equalize prices for the same product in different countries, which is required for the law of one price to hold. Government intervention in cross-border trade, by violating the as- sumption of efficient markets, weakens the link between relative price changes and changes in exchange rates predicted by PPP theory.

PPP theory may not hold if many national markets are dominated by a handful of mul- tinational enterprises that have sufficient market power to be able to exercise some influ- ence over prices, control distribution channels, and differentiate their product offerings between nations.14 In fact, this situation seems to prevail in a number of industries. In such cases, dominant enterprises may be able to exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions. This is referred to as price discrimination. For price discrimination to work, arbitrage must be limited. According to this argument, enterprises with some market power may be able to control distribution channels and therefore limit the unauthorized resale (arbitrage) of products purchased in another national market. They may also be able to limit resale (arbitrage) by differentiating otherwise identical products among nations along some line, such as de- sign or packaging.

Quantitative Easing, Inflation, and the Value of the U.S. Dollar

In fall 2010, the U.S. Federal Reserve decided to expand the U.S. money supply by entering the open market and purchasing $600 billion in U.S. government bonds from bondholders, a technique known as quantitative easing. Where did the $600 billion come from? The Fed simply created new bank reserves and used this cash to pay for the bonds. It had, in effect, printed money. The Fed took this action in an attempt to stimulate the U.S. economy, which, in the aftermath of the 2008–2009 global financial crisis, was struggling with low economic growth and high unemployment rates. The Fed had already tried to stimulate the economy by lowering short-term interest rates, but these were already close to zero, so it decided to lower medium- to longer- term rates; its tool for doing this was to pump $600 billion into the economy, increasing the supply of money and lowering its price, the interest rate. The Fed pursued further rounds of quantitative easing in 2011 through to 2013, and announced that it would continue to pursue the policy at least through 2014, or until the U.S. unemployment rate fell below 6.5 percent.

Critics were quick to attack the Fed’s moves. Many claimed that the policy of expanding the money supply would fuel inflation and lead to a decline in the value of the U.S. dollar on the foreign ex- change market. Some even called the policy a deliberate attempt by the Fed to debase the value of the U.S. currency, thereby driving down its value and promoting U.S. exports, which if true would be a form of mercantilism.

However, these charges may be unfounded for two reasons. First, at the time, the core U.S. inflation rate was the lowest in 50 years. In fact, the Fed actually feared the risk of deflation (a persistent fall in prices), which is a very damaging phenomenon. When prices are falling, people hold off their purchases because they know that goods will be cheaper tomorrow than they are today. This can result in a collapse in aggregate demand and high unemployment. The Fed felt that a little inflation—say, 2 percent per year—might be a good thing. Second, U.S. economic growth had been weak, unemployment was high, and there was excess productive capacity in the economy. Consequently, if the injection of money into the economy did stimulate demand, this would not translate into price inflation, because the first response of businesses would be to expand output to utilize their excess capacity. Defenders of the Fed ar- gued that the important point, which the critics seemed to be missing, was that expanding the money supply only leads to higher price inflation when unemployment is relatively low and there is not much excess ca- pacity in the economy, a situation that did not exist in fall 2010. As for the currency market, its reaction was muted. At the beginning of No- vember 2010, just before the Fed announced its policy, the index value of the dollar against a basket of other major currencies stood at 72.0116. At the end of January 2013, it stood at 73.4087—little changed. In short, currency traders did not seem to be selling off the dollar or reflecting worries about high inflation rates.

Sources: P. Wallsten and S. Reddy, “Fed’s Bond Buying Plan Ignites Growing Criticism,” The Wall Street Journal, November 15, 2010; S. Chan, “Under Attack, the Fed Defends Policy of Buying Bonds,” International Herald Tribune, November 17, 2010; and “What QE Means for the World; Positive Sum Currency Wars,” The Economist, February 14, 2013.

country FOCUS

298 Part Four The Global Monetary System

For example, even though the version of Microsoft Office sold in China may be less expensive than the ver- sion sold in the United States, the use of arbitrage to equalize prices may be limited because few Americans would want a version that was based on Chinese charac- ters. The design differentiation between Microsoft Office for China and for the United States means that the law of one price would not work for Microsoft Office, even if transportation costs were trivial and tariff barriers be- tween the United States and China did not exist. If the inability to practice arbitrage were widespread enough, it would break the connection between changes in relative prices and exchange rates predicted by the PPP theorem and help explain the limited empirical support for this theory.

Another factor of some importance is that govern- ments also intervene in the foreign exchange market in attempting to influence the value of their currencies. We look at why and how they do this in Chapter 11. For now, the important thing to note is that governments regularly intervene in the foreign exchange market, and this further weakens the link between price changes and changes in exchange rates. One more factor explaining the failure of PPP theory to predict short-term movements in foreign exchange rates is the impact of investor psychology and

other factors on currency purchasing decisions and exchange rate movements. We discuss this issue in more detail later in this chapter.

INTEREST RATES AND EXCHANGE RATES Economic theory tells us that interest rates reflect expectations about likely future inflation rates. In countries where inflation is expected to be high, interest rates also will be high, because investors want compensation for the decline in the value of their money. This relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher effect. The Fisher effect states that a country’s “nominal” interest rate (i) is the sum of the required “real” rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). More formally,

i 5 r 1 I

For example, if the real rate of interest in a country is 5 percent and annual inflation is expected to be 10 percent, the nominal interest rate will be 15 percent. As predicted by the Fisher effect, a strong relationship seems to exist between inflation rates and interest rates.15

We can take this one step further and consider how it applies in a world of many coun- tries and unrestricted capital flows. When investors are free to transfer capital between countries, real interest rates will be the same in every country. If differences in real inter- est rates did emerge between countries, arbitrage would soon equalize them. For example, if the real interest rate in Japan was 10 percent and only 6 percent in the United States, it would pay investors to borrow money in the United States and invest it in Japan. The re- sulting increase in the demand for money in the United States would raise the real inter- est rate there, while the increase in the supply of foreign money in Japan would lower the real interest rate there. This would continue until the two sets of real interest rates were equalized.

It follows from the Fisher effect that if the real interest rate is the same worldwide, any difference in interest rates between countries reflects differing expectations about

Fisher Effect Nominal interest rates (i ) in each country equal the required real rate of interest (r ) and the expected rate of inflation over the period of time for which the funds are to be lent (l ). That is, i 5 r 1 I.

What About the Starbucks Index, a Good Idea? To test the Big Mac index, which applies the purchasing power parity (PPP) theory using the price of a Big Mac in various mar- kets to determine the equilibrium value of the foreign currency, The Economist established a Starbucks index in 2004. Like the Big Mac, a cup of Starbucks coffee can be found in many foreign markets and can be seen as a proxy for a basket of goods. The results of the Starbucks index followed the Big Mac index in most markets, except in Asia, where the former indicated that the dol- lar was at parity with the Chinese yuan. The Big Mac index sug- gested that the yuan was heavily undervalued. Neither of these consumer items is a good proxy for a basket of goods, but com- paring their relative prices with exchange rates is an interesting and playful approach to quickly grasping how under- or overvalued the foreign currency is against the dollar. This obviously does not take into account whether you think a McDonald’s Big Mac or a Starbucks cup of coffee is overpriced or relatively cheap where you live! What would be a good product, sold worldwide, that can replace the Big Mac and Starbucks indices?

Chapter Ten The Foreign Exchange Market 299

inflation rates. Thus, if the expected rate of inflation in the United States is greater than that in Japan, U.S. nominal interest rates will be greater than Japanese nominal interest rates.

Because we know from PPP theory that there is a link (in theory at least) between infla- tion and exchange rates, and because interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and exchange rates. This link is known as the international Fisher effect (IFE). The international Fisher effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries. Stated more formally, the change in the spot exchange rate between the United States and Japan, for example, can be modeled as follows:

S1 2 S2 S2

3 100 5 i$ 2 i¥

where i$ and i¥ are the respective nominal interest rates in the United States and Japan, S1 is the spot exchange rate at the beginning of the period, and S2 is the spot exchange rate at the end of the period. If the U.S. nominal interest rate is higher than Japan’s, reflecting greater expected inflation rates, the value of the dollar against the yen should fall by that interest rate differential in the future. So if the interest rate in the United States is 10 percent and in Japan it is 6 percent, we would expect the value of the dollar to depreciate by 4 percent against the Japanese yen.

Do interest rate differentials help predict future currency movements? The evidence is mixed; as in the case of PPP theory, in the long run, there seems to be a relationship be- tween interest rate differentials and subsequent changes in spot exchange rates. However, considerable short-run deviations occur. Like PPP, the international Fisher effect is not a good predictor of short-run changes in spot exchange rates.16

INVESTOR PSYCHOLOGY AND BANDWAGON EFFECTS Em- pirical evidence suggests that neither PPP theory nor the international Fisher effect is par- ticularly good at explaining short-term movements in exchange rates. One reason may be the impact of investor psychology on short-run exchange rate movements. Evidence reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates.17 In turn, expectations have a tendency to become self-fulfilling prophecies.

A famous example of this mechanism occurred in September 1992 when the interna- tional financier George Soros made a huge bet against the British pound. Soros bor- rowed billions of pounds, using the assets of his investment funds as collateral, and immediately sold those pounds for German deutsche marks (this was before the advent of the euro). This technique, known as short selling, can earn the speculator enormous profits if he can subsequently buy back the pounds he sold at a much better exchange rate and then use those pounds, purchased cheaply, to repay his loan. By selling pounds and buying deutsche marks, Soros helped to start pushing down the value of the pound on the foreign exchange markets. More importantly, when Soros started shorting the British pound, many foreign exchange traders, knowing Soros’s reputation, jumped on the band- wagon and did likewise. This triggered a classic bandwagon effect with traders moving as a herd in the same direction at the same time. As the bandwagon effect gained momen- tum, with more traders selling British pounds and purchasing deutsche marks in expecta- tion of a decline in the pound, their expectations became a self-fulfilling prophecy. Massive selling forced down the value of the pound against the deutsche mark. In other words, the pound declined in value not so much because of any major shift in macroeco- nomic fundamentals, but because investors followed a bet placed by a major speculator, George Soros.

According to a number of studies, investor psychology and bandwagon effects play an important role in determining short-run exchange rate movements.18 However, these

International Fisher Effect For any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between countries.

Bandwagon Effect Movement of traders like a herd, all in the same direction and at the same time, in response to each other’s perceived actions.

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effects can be hard to predict. Investor psychology can be influenced by political factors and by microeconomic events, such as the investment decisions of individual firms, many of which are only loosely linked to macroeconomic fundamentals, such as relative inflation rates. Also, bandwagon effects can be both triggered and exacerbated by the idiosyncratic behavior of politicians. Something like this seems to have occurred in Southeast Asia dur- ing 1997 when, one after another, the currencies of Thailand, Malaysia, South Korea, and Indonesia lost between 50 percent and 70 percent of their value against the U.S. dollar in a few months.

SUMMARY OF EXCHANGE RATE THEORIES Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates. They are poor predictors of short- run changes in exchange rates, however, perhaps because of the impact of psychological factors, investor expectations, and bandwagon effects on short-term currency movements. This information is useful for an international business. Insofar as the long-term profit- ability of foreign investments, export opportunities, and the price competitiveness of for- eign imports are all influenced by long-term movements in exchange rates, international businesses would be advised to pay attention to countries’ differing monetary growth, inflation, and interest rates. International businesses that engage in foreign exchange trans- actions on a day-to-day basis could benefit by knowing some predictors of short-term for- eign exchange rate movements. Unfortunately, short-term exchange rate movements are difficult to predict.

Exchange Rate Forecasting A company’s need to predict future exchange rate variations raises the issue of whether it is worthwhile for the company to invest in exchange rate forecasting services to aid deci- sion making. Two schools of thought address this issue. The efficient market school argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money. The other school of thought, the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates (as contained in the for- ward rate) by investing in forecasting services. In other words, this school of thought does not believe the forward exchange rates are the best possible predictors of future spot exchange rates.

THE EFFICIENT MARKET SCHOOL Forward exchange rates represent market participants’ collective predictions of likely spot exchange rates at specified future dates. If forward exchange rates are the best possible predictor of future spot rates, it would make no sense for companies to spend additional money trying to forecast short- run exchange rate movements. Many economists believe the foreign exchange market is efficient at setting forward rates.19 An efficient market is one in which prices reflect all available public information. (If forward rates reflect all available information about likely future changes in exchange rates, a company cannot beat the market by investing in fore- casting services.)

If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of future spot rates. This does not mean the predictions will be accurate in any specific situation. It means inaccuracies will not be consistently above or below future spot rates; they will be random. Many empirical tests have addressed the efficient market hypoth- esis. Although most of the early work seems to confirm the hypothesis (suggesting that companies should not waste their money on forecasting services) some studies have chal- lenged it.20 There is some evidence that forward rates are not unbiased predictors of future spot rates, and that more accurate predictions of future spot rates can be calculated from publicly available information.21

LO 10-5 Identify the merits of different approaches toward exchange rate forecasting.

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THE INEFFICIENT MARKET SCHOOL Citing evidence against the efficient market hypothesis, some economists believe the foreign exchange market is inefficient. An inefficient market is one in which prices do not reflect all available information. In an inef- ficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates.

If this is true, it may be worthwhile for international businesses to invest in forecasting services (as many do). The belief is that professional exchange rate forecasts might pro- vide better predictions of future spot rates than forward exchange rates do. However, the track record of professional forecasting services is not that good.22 For example, forecast- ing services did not predict the 1997 currency crisis that swept through Southeast Asia, nor did they predict the rise in the value of the dollar that occurred during late 2008, a period when the United States fell into a deep financial crisis that some thought would lead to a decline in the value of the dollar (it appears that the dollar rose because it was seen as a relatively safe currency in a time when many nations were experiencing economic trouble).

APPROACHES TO FORECASTING Assuming the inefficient market school is correct that the foreign exchange market’s estimate of future spot rates can be improved, on what basis should forecasts be prepared? Here again, there are two schools of thought. One adheres to fundamental analysis, while the other uses technical analysis.

Fundamental Analysis Fundamental analysis draws on economic theory to con- struct sophisticated econometric models for predicting exchange rate movements. The vari- ables contained in these models typically include those we have discussed, such as relative money supply growth rates, inflation rates, and interest rates. In addition, they may include variables related to balance-of-payments positions.

Running a deficit on a balance-of-payments current account (a country is importing more goods and services than it is exporting) creates pressures that may result in the depre- ciation of the country’s currency on the foreign exchange market.23 Consider what might happen if the United States was running a persistent current account balance-of-payments deficit (as it has been). Because the United States would be importing more than it was ex- porting, people in other countries would be increasing their holdings of U.S. dollars. If these people were willing to hold their dollars, the dollar’s exchange rate would not be influenced. However, if these people converted their dollars into other currencies, the supply of dollars in the foreign exchange market would increase (as would demand for the other currencies). This shift in demand and supply would create pressures that could lead to the depreciation of the dollar against other currencies.

This argument hinges on whether people in other countries are willing to hold dollars. This depends on such factors as U.S. interest rates, the return on holding other dollar- denominated assets such as stocks in U.S. companies, and, most important, inflation rates. So, in a sense, the balance-of-payments situation is not a fundamental predictor of future exchange rate movements. But what makes financial assets such as stocks and bonds attractive? The answer is prevailing interest rates and inflation rates, both of which affect underlying economic growth and the real return to holding U.S. financial assets. Given this, we are back to the argument that the fundamental determinants of exchange rates are monetary growth, inflation rates, and interest rates.

Technical Analysis Technical analysis uses price and volume data to determine past trends, which are expected to continue into the future. This approach does not rely on a consideration of economic fundamentals. Technical analysis is based on the premise that there are analyzable market trends and waves and that previous trends and waves can be used to predict future trends and waves. Since there is no theoretical rationale for this assumption of predictability, many economists compare technical analysis to fortune-telling. Despite this skepticism, technical analysis has gained favor in recent years.24

Inefficient Market One in which prices do not reflect all available information.

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302 Part Four The Global Monetary System

Currency Convertibility Until this point, we have assumed that the currencies of various countries are freely convert- ible into other currencies. Due to government restrictions, a significant number of curren- cies are not freely convertible into other currencies. A country’s currency is said to be freely convertible when the country’s government allows both residents and nonresidents to pur- chase unlimited amounts of a foreign currency with it. A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations. A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency.

Free convertibility is not universal. Many countries place some restrictions on their residents’ ability to convert the domestic currency into a foreign currency (a policy of external convertibility). Restrictions range from the relatively minor (such as restricting the amount of foreign currency they may take with them out of the country on trips) to the major (such as restricting domestic businesses’ ability to take foreign currency out of the country). External convertibility restrictions can limit domestic companies’ ability to invest abroad, but they present few problems for foreign companies wishing to do busi- ness in that country. For example, even if the Japanese government tightly controlled the ability of its residents to convert the yen into U.S. dollars, all U.S. businesses with depos- its in Japanese banks may at any time convert all their yen into dollars and take them out of the country. Thus, a U.S. company with a subsidiary in Japan is assured that it will be able to convert the profits from its Japanese operation into dollars and take them out of the country.

Serious problems arise, however, under a policy of nonconvertibility. This was the practice of the former Soviet Union, and it continued to be the practice in Russia for several years after the collapse of the Soviet Union. When strictly applied, nonconvert- ibility means that although a U.S. company doing business in a country such as Russia may be able to generate significant ruble profits, it may not convert those rubles into dollars and take them out of the country. Obviously this is not desirable for interna- tional business.

Governments limit convertibility to preserve their foreign exchange reserves. A coun- try needs an adequate supply of these reserves to service its international debt commit- ments and to purchase imports. Governments typically impose convertibility restrictions on their currency when they fear that free convertibility will lead to a run on their for- eign exchange reserves. This occurs when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency—a phenomenon generally referred to as capital flight. Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country’s economic prospects are shaky in other respects. Under such circumstances, both resi- dents and nonresidents tend to believe that their money is more likely to hold its value if it is converted into a foreign currency and invested abroad. Not only will a run on for- eign exchange reserves limit the country’s ability to service its international debt and pay for imports, but it will also lead to a precipitous depreciation in the exchange rate as residents and nonresidents unload their holdings of domestic currency on the foreign exchange markets (thereby increasing the market supply of the country’s currency). Governments fear that the rise in import prices resulting from currency depreciation will lead to further increases in inflation. This fear provides another rationale for limiting convertibility.

Companies can deal with the nonconvertibility problem by engaging in countertrade. Countertrade refers to a range of barter-like agreements by which goods and services can be traded for other goods and services. Countertrade can make sense when a country’s currency is nonconvertible. For example, consider the deal that General Electric struck with the Romanian government when that country’s currency was nonconvertible. When General Electric won a contract for a $150 million generator project in Romania, it agreed to take payment in the form of Romanian goods that could be sold for $150 million on international markets. In a similar case, the Venezuelan government negotiated a contract

Freely Convertible Currency A country’s currency is freely convertible when the government of that country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with the domestic currency.

Externally Convertible Currency Limitations on the ability of residents to convert domestic currency, though nonresidents can convert their holdings of domestic currency into foreign currency.

Nonconvertible Currency A currency is not convertible when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency.

Capital Flight Converting domestic currency into a foreign currency.

Countertrade The trade of goods and services for other goods and services.

FOCUS ON MANAGERIAL IMPLICATIONS

FOREIGN EXCHANGE RATE RISK This chapter contains a number of clear implications for business. First, it is critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Adverse changes in exchange rates can make apparently profit- able deals unprofitable. As noted, the risk introduced into international business transac- tions by changes in exchange rates is referred to as foreign exchange risk. Foreign exchange risk is usually divided into three main categories: transaction exposure, translation exposure, and economic exposure.

TRANSACTION EXPOSURE Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies. For example, suppose in 2004 an American air- line agreed to purchase 10 Airbus 330 aircraft for €120 million each for a total price of €1.20 billion, with delivery scheduled for 2008 and payment due then. When the contract was signed in 2004 the dollar/euro exchange rate stood at $1 5 €1.10, so the American airline anticipated paying $1.09 billion for the 10 aircraft when they were delivered (€1.2 billion/1.1 5 $1.09 billion). However, imagine that the value of the dollar depreci- ates against the euro over the intervening period, so that a dollar only buys €0.80 in 2008 when payment is due ($1 5 €0.80). Now the total cost in U.S. dollars is $1.5 billion (€1.2 billion/0.80 5 $1.5 billion), an increase of $0.41 billion! The transaction exposure here is $0.41 billion, which is the money lost due to an adverse movement in exchange rates between the time when the deal was signed and when the aircraft were paid for.

TRANSLATION EXPOSURE Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Translation exposure is concerned with the present mea- surement of past events. The resulting accounting gains or losses are said to be unrealized—they are “paper” gains and losses—but they are still important. Consider a U.S. firm with a subsidiary in Mexico. If the value of the Mexican peso depreciates significantly against the dollar, this would substantially reduce the dollar value of the Mexican subsid- iary’s equity. In turn, this would reduce the total dollar value of the firm’s equity reported in its consolidated balance sheet. This would raise the apparent leverage of the firm (its debt ratio), which could increase the firm’s cost of borrowing and potentially limit its access to the capital market. Similarly, if an American firm has a subsidiary in the European Union, and if the value of the euro depreciates rapidly against that of the dollar over a year, this will reduce the dollar value of the euro profit made by the European subsidiary, resulting in

LO 10-6 Compare and contrast the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.

Transaction Exposure The extent to which income from individual transactions is affected by fluctuations in foreign exchange values.

Translation Exposure The extent to which the reported consolidated results and balance sheets of a corporation are affected by fluctuations in foreign exchange values.

with Caterpillar under which Venezuela would trade 350,000 tons of iron ore for Cater- pillar heavy construction equipment. Caterpillar subsequently traded the iron ore to Romania in exchange for Romanian farm products, which it then sold on international markets for dollars.25

How important is countertrade? Twenty years ago, a large number of nonconvertible currencies existed in the world, and countertrade was quite significant. However, in recent years many governments have made their currencies freely convertible, and the percentage of world trade that involves countertrade is probably significantly below 10 percent.26

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negative translation exposure. In fact, many U.S. firms suffered from significant negative translation exposure in Europe during 2000, precisely because the euro did depreciate rap- idly against the dollar. In 2002–2007, the euro rose in value against the dollar. This positive translation exposure boosted the dollar profits of American multinationals with significant operations in Europe.

ECONOMIC EXPOSURE Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long- run effect of changes in exchange rates on future prices, sales, and costs. This is distinct from transaction exposure, which is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months. Consider the effect of wide swings in the value of the dollar on many U.S. firms’ international competitiveness. The rapid rise in the value of the dollar on the foreign exchange market in the 1990s hurt the price competitiveness of many U.S. producers in world markets. U.S. manufacturers that relied heavily on exports saw their export volume and world market share decline. The reverse phenomenon occurred in 2000–2009, when the dollar declined against most major currencies. The fall in the value of the dollar helped increase the price competitiveness of U.S. manufacturers in world markets.

REDUCING TRANSLATION AND TRANSACTION EXPOSURE A number of tactics can help firms minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. We have already discussed two of these tactics at length in the chapter, entering into forward exchange rate contracts and buying swaps. In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure through leading and lagging payables and receivables—that is, paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables (payments from customers) early when a foreign currency is expected to depreciate and paying foreign currency payables (to suppliers) before they are due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Leading and lagging involve accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries.

Lead and lag strategies can be difficult to implement, however. The firm must be in a position to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly when they are dealing with important customers who are in a position to dictate payment terms. Also, because lead and lag strategies can put pressure on a weak currency, many governments limit leads and lags. For example, some countries set 180 days as a limit for receiving payments for exports or making payments for imports.

REDUCING ECONOMIC EXPOSURE Reducing economic exposure requires strategic choices that go beyond the realm of finan- cial management. The key to reducing economic exposure is to distribute the firm’s produc- tive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates. This is a strategy that firms both large and small sometimes pursue. For example, fearing that the euro will continue to strengthen against the U.S. dollar, some European firms that do significant business in the United States have set up local production facilities in that market to ensure that a rising euro does not put them at a competitive disadvantage relative to their local rivals. Similarly, Toyota has production plants distributed around the world in part to make sure that a rising yen does

Economic Exposure The extent to which a firm’s future international earning power is affected by changes in exchange rates.

Lead Strategy Collecting foreign currency receivables early when a foreign currency is expected to depreciate, and paying foreign currency payables before they are due when a currency is expected to appreciate.

Lag Strategy Delaying the collection of foreign currency receivables if that currency is expected to appreciate, and delaying payables if that currency is expected to depreciate.

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not price Toyota cars out of local markets. Caterpillar has also pursued this strategy, setting up factories around the world that can act as a hedge against the possibility that a strong dollar will price Caterpillar’s exports out of foreign markets. In 2008 and 2009, this real hedge proved to be very useful.

OTHER STEPS FOR MANAGING FOREIGN EXCHANGE RISK A firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure. Although there is no universal agreement as to the components of this mechanism, a number of common themes stand out.27 First, central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers. Although such centers may not be able to execute all foreign exchange deals—particularly in large, complex multinationals where myriad transac- tions may be pursued simultaneously—they should at least set guidelines for the firm’s sub- sidiaries to follow.

Second, firms should distinguish between, on one hand, transaction and translation expo- sure and, on the other, economic exposure. Many companies seem to focus on reducing their transaction and translation exposure and pay scant attention to economic exposure, which may have more profound long-term implications.28 Firms need to develop strategies for dealing with economic exposure. For example, Stanley Black & Decker, the maker of power tools, has a strategy for actively managing its economic risk. The key to Stanley Black & Decker’s strategy is flexible sourcing. In response to foreign exchange movements, Stanley Black & Decker can move production from one location to another to offer the most com- petitive pricing. Stanley Black & Decker manufactures in more than a dozen locations around the world—in Europe, Australia, Brazil, Mexico, and Japan. More than 50 percent of the company’s productive assets are based outside North America. Although each of Stanley Black & Decker’s factories focuses on one or two products to achieve economies of scale, there is considerable overlap. On average, the company runs its factories at no more than 80 percent capacity, so most are able to switch rapidly from producing one product to pro- ducing another or to add a product. This allows a factory’s production to be changed in response to foreign exchange movements. For example, if the dollar depreciates against other currencies, the amount of imports into the United States from overseas subsidiaries can be reduced and the amount of exports from U.S. subsidiaries to other locations can be increased.29

Third, the need to forecast future exchange rate movements cannot be overstated, though, as we saw earlier in the chapter, this is a tricky business. No model comes close to perfectly predicting future movements in foreign exchange rates. The best that can be said is that in the short run, forward exchange rates provide the best predictors of exchange rate movements, and in the long run, fundamental economic factors—particularly relative infla- tion rates—should be watched because they influence exchange rate movements. Some firms attempt to forecast exchange rate movements in-house; others rely on outside fore- casters. However, all such forecasts are imperfect attempts to predict the future.

Fourth, firms need to establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm’s exposure positions. Such reporting systems should enable the firm to identify any exposed accounts, the exposed posi- tion by currency of each account, and the time periods covered.

Finally, on the basis of the information it receives from exchange rate forecasts and its own regular reporting systems, the firm should produce monthly foreign exchange exposure reports. These reports should identify how cash flows and balance sheet elements might be affected by forecasted changes in exchange rates. The reports can then be used by manage- ment as a basis for adopting tactics and strategies to hedge against undue foreign exchange risks.

Surprisingly, some of the largest and most sophisticated firms don’t take such precaution- ary steps, exposing themselves to very large foreign exchange risks. Thus, as we have seen in this chapter, Volkswagen suffered significant losses during the early 2000s due to a failure to adequately hedge its foreign exchange exposure.

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foreign exchange market, p. 286 exchange rate, p. 286 foreign exchange risk, p. 287 currency speculation, p. 288 carry trade, p. 288 spot exchange rate, p. 289 forward exchange, p. 290 forward exchange rate, p. 290 currency swap, p. 290

arbitrage, p. 292 law of one price, p. 293 efficient market, p. 293 Fisher effect, p. 298 international Fisher effect, p. 299 bandwagon effect, p. 299 inefficient market, p. 301 freely convertible currency, p. 302 externally convertible currency, p. 302

nonconvertible currency, p. 302 capital flight, p. 302 countertrade, p. 302 transaction exposure, p. 303 translation exposure, p. 303 economic exposure, p. 304 lead strategy, p. 304 lag strategy, p. 304

Key Terms

Summary

This chapter explained how the foreign exchange market works, examined the forces that determine exchange rates, and then discussed the implications of these factors for international business. Given that changes in exchange rates can dramatically alter the profitability of foreign trade and investment deals, this is an area of major inter- est to international business. The chapter made the fol- lowing points:

1. One function of the foreign exchange market is to convert the currency of one country into the currency of another. A second function of the foreign exchange market is to provide insurance against foreign exchange risk.

2. The spot exchange rate is the exchange rate at which a dealer converts one currency into another currency on a particular day.

3. Foreign exchange risk can be reduced by using forward exchange rates. A forward exchange rate is an exchange rate governing future transactions. Foreign exchange risk can also be reduced by engaging in currency swaps. A swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

4. The law of one price holds that in competitive markets that are free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in the same currency.

5. Purchasing power parity (PPP) theory states the price of a basket of particular goods should be roughly equivalent in each country. PPP theory predicts that the exchange rate will change if relative prices change.

6. The rate of change in countries’ relative prices depends on their relative inflation rates. A country’s

inflation rate seems to be a function of the growth in its money supply.

7. The PPP theory of exchange rate changes yields relatively accurate predictions of long-term trends in exchange rates, but not of short-term movements. The failure of PPP theory to predict exchange rate changes more accurately may be due to transportation costs, barriers to trade and investment, and the impact of psychological factors such as bandwagon effects on market movements and short-run exchange rates.

8. Interest rates reflect expectations about inflation. In countries where inflation is expected to be high, interest rates also will be high.

9. The international Fisher effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates.

10. The most common approach to exchange rate forecasting is fundamental analysis. This relies on variables such as money supply growth, inflation rates, nominal interest rates, and balance-of- payments positions to predict future changes in exchange rates.

11. In many countries, the ability of residents and nonresidents to convert local currency into a foreign currency is restricted by government policy. A government restricts the convertibility of its currency to protect the country’s foreign exchange reserves and to halt any capital flight.

12. Nonconvertibility of a currency makes it very difficult to engage in international trade and investment in the country. One way of coping with the nonconvertibility problem is to engage in countertrade—to trade goods and services for other goods and services.

Chapter Ten The Foreign Exchange Market 307

13. The three types of exposure to foreign exchange risk are transaction exposure, translation exposure, and economic exposure.

14. Tactics that insure against transaction and translation exposure include buying forward, using currency

swaps, and leading and lagging payables and receivables.

15. Reducing a firm’s economic exposure requires strategic choices about how the firm’s productive assets are distributed around the globe.

Critical Thinking and Discussion Questions

1. The interest rate on South Korean government securities with one-year maturity is 4 percent, and the expected inflation rate for the coming year is 2 percent. The interest rate on U.S. government securities with one-year maturity is 7 percent, and the expected rate of inflation is 5 percent. The current spot exchange rate for Korean won is $1 5 W1,200. Forecast the spot exchange rate one year from today. Explain the logic of your answer.

2. Two countries, Great Britain and the United States, produce just one good: beef. Suppose the price of beef in the United States is $2.80 per pound and in Britain it is £3.70 per pound. a. According to PPP theory, what should the dollar/

pound spot exchange rate be? b. Suppose the price of beef is expected to rise to $3.10 in

the United States and to £4.65 in Britain. What should the one-year forward dollar/pound exchange rate be?

c. Given your answers to parts a and b, and given that the current interest rate in the United States is 10 percent, what would you expect the current interest rate to be in Britain?

3. Reread the Management Focus on Volkswagen; then answer the following questions: a. Why do you think management at Volkswagen

decided to hedge only 30 percent of the automaker’s

foreign currency exposure in 2003? What would have happened if it had hedged 70 percent of exposure?

b. Why do you think the value of the U.S. dollar declined against that of the euro in 2003?

c. Apart from hedging through the foreign exchange market, what else can Volkswagen do to reduce its exposure to future declines in the value of the U.S. dollar against the euro?

4. You manufacture wine goblets. In mid-June, you receive an order for 10,000 goblets from Japan. Payment of ¥400,000 is due in mid-December. You expect the yen to rise from its present rate of $1 5 ¥130 to $1 5 ¥100 by December. You can borrow yen at 6 percent a year. What should you do?

5. You are the CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures component parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take?

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

1. One of your company’s essential suppliers is located in Japan. Your company needs to make a 1 million Japanese yen payment in six months. Considering that your company primarily operates in U.S. dollars, you are assigned the task of deciding on a strategy to minimize your transaction exposure. Identify the spot and forward exchange rates between the two currencies. What factors influence your decision to use each? Which one would you choose? How many dollars must you spend to acquire the amount of yen required?

2. Sometimes, analysts use the price of specific products in different locations to compare currency valuation and purchasing power. For example, the Big Mac Index compares the purchasing-power parity of many countries based on the price of a Big Mac. Locate the latest edition of this index that is accessible. Identify the five countries (and their currencies) with the lowest purchasing-power parity according to this classification. Which currencies, if any, are overvalued?

Research Task http://globalEDGE.msu.edu

During the first half of the 2000s, the Japanese yen was relatively weak against the U.S. dollar. This was a boon for Japan’s export-led economy. On January 1, 2008, it took 122 yen to buy one U.S. dollar. For the next four years, the yen strengthened relentlessly against the dollar, hitting an all-time record high of ¥75.31 to the dollar on October 31, 2011. The reasons for the rise of the yen were complex and had little to do with the strength of the Japanese economy because there has been very little of that in evidence.

The weakness of the yen during the early to mid-2000s was due to the so-called carry trade. This financial strategy involved borrowing in Japa- nese yen, where interest rates were close to zero, and investing the loans in higher yielding assets, typically U.S. Treasury bills, which carried interest rates 3 to 4 percentage points greater. Investors made profits from the in- terest rate differential. At its peak, financial institutions had more than a trillion dollars invested in the carry trade. Because the strategy involved selling borrowed yen to purchase dollar-denominated assets, it drove the value of the yen lower. The interest rate differential existed because the Japanese economy was weak, prices were falling, and the Bank of Japan had been lowering interest rates in an attempt to boost growth and get Japan out of a dangerous deflationary cycle.

When the global financial crisis hit in 2008 and 2009, the Federal Reserve in the United States responded by injecting liquidity into battered financial markets, effectively lowering U.S. interest rates on U.S. Treasury bonds. As these fell, the interest rate differential between Japanese and U.S. assets narrowed sharply, and the carry trade became unprofitable. Financial institutions unwound their positions, selling dollar-denominated assets and buying yen to pay back their original loans. The increased demand drove up the value of the yen.

For Japanese exporters, the 40 percent increase in the value of the yen against the dollar (and the euro) between early 2008 and 2012 was a pain- ful experience. A strong yen hurts the price competitiveness of Japanese exports and reduces the value of profits earned overseas when translated back into yen. Take Toyota as an example: In February 2012, the company stated that its profit for the year ending March 31, 2012, would be about ¥200 billion, 51 percent lower than in the prior year. Toyota makes nearly half of the cars it sells globally at its Japanese plants, so it has been par- ticularly hard hit by a rise in the value of the yen.

In late 2012, things started to change when the pro-business Liberal Democratic Party won national elections and Shinzo Abe was appointed prime minister. Abe had campaigned on a platform that included taking actions to weaken the value of the yen in order to help Japan’s exporters. Even before the election, Japan’s central bank had accelerated purchases of government securities, thereby expanding the money supply, and had agreed to a higher inflation target. Under Abe’s leadership, this policy had explicit government support. One consequence of the policy was to reduce the value of the yen against other currencies. Indeed, between October 2012 and December 2013, the yen lost more than 25 percent of its value against the U.S. dollar. The yen was trading at ¥104 to the U.S. dollar in late December 2013. While this helped Japan’s exporters, the policy was criticized by other major industrial nations as unilateral action that came dangerously close to precipitating a currency war.

Sources: C. Dawson and Y. Takahashi, “Toyota Shows Optimism Despite Gloom,” The Wall Street Journal, February 8, 2012; Y. Takahashi, “Nissan’s CEO Says Yen Still Not Weak Enough,” The Wall Street Journal, February 27, 2010; “The Yen’s 40 Year Win Streak May Be Ending,” The Wall Street Journal, January 27, 2012; and “U.S., Europe Seek to Cool Currency Jitters,” The Wall Street Journal, February 11, 2013.

CASE DISCUSSION QUESTIONS 1. Why did the yen carry trade work during the early 2000s? Why did it

stop working after 2008?

2. What drove an increase in the value of the yen between 2008 and 2011?

3. Why did the policy of the Abe government to purchase government securities help to drive down the value of the yen? What was the mechanism at work here?

4. Do you think the Japanese government is engaging in currency manipulation? If so, what should other nations do about this?

5. Who in Japan benefits from devaluation of the yen? Who does this hurt in Japan?

6. What does this case teach you about the way foreign exchange markets work?

ccccccllooooooossssiinnnnnnggggggggggg ccccccaaaaaassssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeThe Rise (and Fall) of the Japanese Yen

A foreign exchange trader watches an electronic board displaying the U.S. dollar rate against the Japenese yen in Tokyo.

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Chapter Ten The Foreign Exchange Market 309

Endnotes

1. For a good general introduction to the foreign exchange market, see R. Weisweiller, How the Foreign Exchange Market Works (New York: New York Institute of Finance, 1990). A detailed description of the economics of foreign exchange markets can be found in P. R. Krugman and M. Obstfeld, In- ternational Economics: Theory and Policy (New York: Harper- Collins, 1994).

2. “The Domino Effect,” The Economist, July 5, 2008, p. 85.

3. Bank for International Settlements, Tri-annual Central Bank Survey of Foreign Exchange and Derivatives Market Activity, April 2013 (Basle, Switzerland: BIS, September 2013).

4. Ibid.

5. Ibid.

6. M. Dickson, “Capital Gain: How London Is Thriving as It Takes on the Global Competition,” Financial Times, March 27, 2006, p. 11.

7. For a comprehensive review, see M. Taylor, “The Economics of Exchange Rates,” Journal of Economic Literature 33 (1995), pp. 13–47.

8. Krugman and Obstfeld, International Economics.

9. M. Friedman, Studies in the Quantity Theory of Money (Chicago: University of Chicago Press, 1956). For an acces- sible explanation, see M. Friedman and R. Friedman, Free to Choose (London: Penguin Books, 1979), chap. 9.

10. Juan-Antonio Morales, “Inflation Stabilization in Bolivia,” in Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge, MA: MIT Press, 1988); and The Economist, World Book of Vital Statistics (New York: Random House, 1990).

11. For reviews and various articles, see H. J. Edison, J. E. Gagnon, and W. R. Melick, “Understanding the Empirical Literature on Purchasing Power Parity,” Journal of Interna- tional Money and Finance 16 (February 1997), pp. 1–18; J. R. Edison, “Multi-country Evidence on the Behavior of Pur- chasing Power Parity under the Current Float,” Journal of International Money and Finance 16 (February 1997), pp. 19–36; K. Rogoff, “The Purchasing Power Parity Puzzle,” Journal of Economic Literature 34 (1996), pp. 647–68; D. R. Rapach and M. E. Wohar, “Testing the Monetary Model of Exchange Rate Determination: New Evidence from a Century of Data,” Journal of International Economics, December 2002, pp. 359–85; and M. P. Taylor, “Purchasing Power Parity,” Review of International Economics, August 2003, pp. 436–56.

12. M. Obstfeld and K. Rogoff, “The Six Major Puzzles in Inter- national Economics,” National Bureau of Economic Research Working Paper Series, paper no. 7777, July 2000.

13. Ibid.

14. See M. Devereux and C. Engel, “Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility,” National Bureau of Economic Research Working Paper Series, paper no. 7665, April 2000. See also P. Krugman, “Pricing to Market When the Exchange Rate Changes,” in Real Financial Economics, ed. S. Arndt and J. Richardson (Cambridge, MA: MIT Press, 1987).

15. For a summary of the evidence, see the survey by Taylor, “The Economics of Exchange Rates.”

16. R. E. Cumby and M. Obstfeld, “A Note on Exchange Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis,” Journal of Finance, June 1981, pp. 697–703; and L. Coppock and M. Poitras, “Evaluating the Fisher Effect in Long Term Cross Country Averages,” International Review of Economics and Finance 9 (2000), pp. 181–203.

17. Taylor, “The Economics of Exchange Rates.” See also R. K. Lyons, The Microstructure Approach to Exchange Rates (Cambridge, MA: MIT Press, 2002).

18. See H. L. Allen and M. P. Taylor, “Charts, Noise, and Funda- mentals in the Foreign Exchange Market,” Economic Journal 100 (1990), pp. 49–59; T. Ito, “Foreign Exchange Rate Expectations: Micro Survey Data,” American Economic Review 80 (1990), pp. 434–49; and T. F. Rotheli, “Bandwagon Effects and Run Patterns in Exchange Rates,” Journal of International Financial Markets, Money and Institutions 12, no. 2 (2002), pp. 157–66.

19. For example, see E. Fama, “Forward Rates as Predictors of Future Spot Rates,” Journal of Financial Economics, October 1976, pp. 361–77.

20. L. Kilian and M. P. Taylor, “Why Is It So Difficult to Beat the Random Walk Forecast of Exchange Rates?” Journal of Inter- national Economics 20 (May 2003), pp. 85–103; and R. M. Levich, “The Efficiency of Markets for Foreign Exchange,” in International Finance, ed. G. D. Gay and R. W. Kold (Richmond, VA: Robert F. Dane, Inc., 1983).

21. J. Williamson, The Exchange Rate System (Washington, DC: Institute for International Economics, 1983); and R. H. Clarida, L. Sarno, M. P. Taylor, and G. Valente, “The Out of Sample Success of Term Structure Models as Exchange Rate Predictors,” Journal of International Economics 60 (May 2003), pp. 61–84.

22. Kilian and Taylor, “Why Is It So Difficult to Beat the Ran- dom Walk Forecast of Exchange Rates?” Journal of Interna- tional Economics, Vol 60(1), pp. 85–107.

23. Rogoff, “The Purchasing Power Parity Puzzle.”

24. C. Engel and J. D. Hamilton, “Long Swings in the Dollar: Are They in the Data and Do Markets Know It?” American Economic Review, September 1990, pp. 689–713.

25. J. R. Carter and J. Gagne, “The Do’s and Don’ts of Interna- tional Countertrade,” Sloan Management Review, Spring 1988, pp. 31–37.

26. D. S. Levine, “Got a Spare Destroyer Lying Around?” World Trade 10 (June 1997), pp. 34–35; and Dan West, “Counter- trade,” Business Credit, April 2001, pp. 64–67.

27. For details on how various firms manage their foreign ex- change exposure, see the articles contained in the special for- eign exchange issue of Business International Money Report, December 18, 1989, pp. 401–12.

28. Ibid.

29. S. Arterian, “How Black & Decker Defines Exposure,” Busi- ness International Money Report, December 18, 1989, pp. 404, 405, 409.

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11-1 Describe the historical development of the modern global monetary system.

11-2 Explain the role played by the World Bank and the IMF in the international monetary system.

11-3 Compare and contrast the differences between a fixed and a floating exchange rate system.

11-4 Identify exchange rate regimes used in the world today and why countries adopt different exchange rate regimes.

11-5 Understand the debate surrounding the role of the IMF in the management of financial crises.

11-6 Explain the implications of the global monetary system for currency management and business strategy.

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opening case

W hen the global financial crisis hit in 2008, tiny Iceland suffered more than most. The country’s three biggest banks had been expanding at a breakneck pace since 2000 when the govern-ment privatized the banking sector. With a population of around 320,000, Iceland was too small for the banking sector’s ambitions, so the banks started to expand into other Scandinavian countries

and the UK. They entered local mortgage markets, purchased foreign financial institutions, and opened

foreign branches, attracting depositors by offering high interest rates. The expansion was financed by debt,

much of it structured as short-term loans that had to be regularly refinanced. By early 2008, the three

banks held debts that amounted to almost six times the value of the entire economy of Iceland! So long as

they could periodically refinance this debt, it was not a problem. However, in 2008, global financial mar-

kets imploded following the bankruptcy of Lehman Brothers and the collapse of the U.S. housing market. In

the aftermath financial markets froze. The Icelandic banks found that they could not refinance their debt,

and they faced bankruptcy.

The Icelandic government lacked the funds to bail out the banks, so it decided to let the big three fail.

In quick succession the local stock market plunged 90 percent and unemployment increased ninefold. The

krona, Iceland’s currency, plunged on foreign exchange markets, pushing up the price of imports, and

inflation soared to 18 percent. Iceland appeared to be in free fall. The economy shrank by almost 7 percent

in 2009 and another 4 percent in 2010.

To stem the decline, the government secured $10 billion in loans from the International Monetary Fund

(IMF) and other countries. The Icelandic government stepped in to help local depositors, seizing the

domestic assets of the Icelandic banks and using IMF and other loans to backstop deposit guarantees. Far

from implementing austerity measures to solve the crisis, the Icelandic government looked for ways to

shore up consumer spending. For example, the government provided means-tested subsidies to reduce the

mortgage interest expenses of borrowers. The idea was to stop domestic consumer spending from imploding

and further depressing the economy.

The IMF and Iceland’s Economic Recovery

The International Monetary System

–continued

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With the financial system stabilized, thanks to the IMF and other foreign loans,

what happened next is an object lesson in the value of having a floating currency.

The fall in the value of the krona helped boost Iceland’s exports, such as fish and

aluminum, while depressing demand for costly imports, such as automobiles. By

2009 the krona was worth half as much against the U.S. dollar and euro as it was in

2007 before the crisis. Iceland’s exports surged and imports slumped. While the high

cost of imports did stoke inflation, booming exports started to pump money back

into the Icelandic economy. In 2011 the economy grew again at a 3.1 percent annual

rate. This was followed by 2.7 percent growth in 2012 and 4 percent growth in 2013,

while unemployment fell from a high of nearly 10 percent to 4.4 percent at the end

of 2013. • Sources: Charles Forelle, “In European Crisis, Iceland Emerges as an Island of Recovery,” The Wall Street Journal, May 19, 2012, pp. A1, A10; “Coming in from the Cold,” The Economist, December 16, 2010; Charles Duxbury, “Europe Gets Cold Shoulder in Iceland,” The Wall Street Journal, April 26, 2012; and “Iceland,” The World Factbook 2013 (Washington, DC: Central Intelligence Agency, 2013).

Introduction What happened in Iceland goes to the heart of the subject matter covered in this chapter. Here, we look at the international monetary system, and its role in determining exchange rates. The international monetary system refers to the institutional arrangements that govern exchange rates. In Chapter 10, we assumed the foreign exchange market was the primary institution for determining exchange rates and the impersonal market forces of demand and supply determined the relative value of any two currencies (i.e., their exchange rate). Furthermore, we explained that the demand and supply of currencies is influenced by their respective countries’ relative inflation rates and interest rates. When the foreign ex- change market determines the relative value of a currency, we say that the country is adher- ing to a floating exchange rate regime. Four of the world’s major trading currencies—the U.S. dollar, the European Union’s euro, the Japanese yen, and the British pound—are all free to float against each other. Thus, their exchange rates are determined by market forces and fluctuate against each other day to day, if not minute to minute. As we saw in the open- ing case, the Icelandic currency, the krona, is also free to float against other currencies, a fact that some claim helped Iceland recover from the 2008 financial crisis in that country. How- ever, the exchange rates of many currencies are not determined by the free play of market forces; other institutional arrangements are adopted.

Many of the world’s developing nations peg their currencies, primarily to the dollar or the euro. A pegged exchange rate means the value of the currency is fixed relative to a reference currency, such as the U.S. dollar, and then the exchange rate between that cur- rency and other currencies is determined by the reference currency exchange rate.

Other countries, while not adopting a formal pegged rate, try to hold the value of their currency within some range against an important reference currency such as the U.S. dollar, or a “basket” of currencies. This is often referred to as a dirty float. It is a float because in theory, the value of the currency is determined by market forces, but it is a dirty float (as opposed to a clean float) because the central bank of a country will intervene in the foreign exchange market to try to maintain the value of its currency if it depreciates too rapidly against an important reference currency. This has been the policy adopted by the Chinese since July 2005. The value of the Chinese currency, the yuan, has been linked to a basket of other currencies—including the dollar, yen, and euro—and it is allowed to vary in value against individual currencies, but only within limits.

Still other countries have operated with a fixed exchange rate, in which the values of a set of currencies are fixed against each other at some mutually agreed-on exchange rate.

International Monetary System Institutional arrangements countries adopt to govern exchange rates.

Floating Exchange Rate A system under which the exchange rate for converting one currency into another is continuously adjusted depending on the laws of supply and demand.

Pegged Exchange Rate Currency value is fixed relative to a reference currency.

Dirty-Float System A system under which a country’s currency is nominally allowed to float freely against other currencies, but in which the government will intervene, buying and selling currency, if it believes that the currency has deviated too far from its fair value.

Fixed Exchange Rate A system under which the exchange rate for converting one currency into another is fixed.

Chapter Eleven The International Monetary System 313

Before the introduction of the euro in 1999, several member-states of the European Union operated with fixed exchange rates within the context of the European Monetary System (EMS). For a quarter of a century after World War II, the world’s major industrial nations participated in a fixed exchange rate system. Although this system collapsed in 1973, some still argue that the world should attempt to reestablish it.

This chapter explains how the international monetary system works and points out its implications for international business. To understand how the system works, we must re- view its evolution. We begin with a discussion of the gold standard and its breakup during the 1930s. Then we discuss the 1944 Bretton Woods conference. The Bretton Woods con- ference also created two major international institutions that play a role in the international monetary system—the International Monetary Fund (IMF) and the World Bank. The IMF was given the task of maintaining order in the international monetary system; the World Bank’s role was to promote development. Today, both these institutions continue to play major roles in the world economy and in the international monetary system. As we saw in the opening case, the IMF stepped in to help Iceland navigate its way through a financial crisis when its three biggest banks failed in 2008. The Bretton Woods system of fixed ex- change rates collapsed in 1973. Since then, the world has operated with a mixed system in which some currencies are allowed to float freely, but many are either managed by govern- ment intervention or pegged to another currency.

Finally, we discuss the implications of all this material for international business. We will see how the exchange rate policy adopted by a government can have an important impact on the outlook for business operations in a given country. We also look at how the policies ad- opted by the IMF can have an impact on the economic outlook for a country and, accord- ingly, on the costs and benefits of doing business in that country.

The Gold Standard The gold standard had its origin in the use of gold coins as a medium of exchange, unit of account, and store of value—a practice that dates to ancient times. When international trade was limited in volume, payment for goods purchased from another country was typically made in gold or silver. However, as the volume of international trade expanded in the wake of the Industrial Revolution, a more convenient means of financing international trade was needed. Shipping large quantities of gold and silver around the world to finance interna- tional trade seemed impractical. The solution adopted was to arrange for payment in paper currency and for governments to agree to convert the paper currency into gold on demand at a fixed rate.

MECHANICS OF THE GOLD STANDARD Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. By 1880, most of the world’s

European Monetary System (EMS) EU system designed to create a zone of monetary stability in Europe, control inflation, and coordinate exchange rate policies of EU countries.

LO 11-1 Describe the historical development of the modern global monetary system.

Gold Standard The practice of pegging currencies to gold and guaranteeing convertibility.

globalEDGE Blog

The international monetary system captures our attention because here we are talking about the institutional arrangements that govern exchange rates, and this is a tricky business where countries have leverage to influence their country’s currency value but do not neces- sarily always use it. The options for how the value, or “rate,” is set for a currency are many: floating exchange rate, pegged exchange rate, dirty float, and fixed exchange rate are the ones covered in Chapter 11. We start the chapter by some history related to the “gold standard,” a practice that takes us back to ancient times. Technically, no country uses the gold standard any longer but many, including the United

States, hold substantial gold reserves. The international monetary sys- tem depends on a lot of variables (see the globalEDGE Database of International Business Statistics which we covered in Chapter 10); today, these variables also include “behavioral” (perception) issues in addition to hard, concrete data. The globalEDGE Blog has been a favored “international business” vehicle to stay current on important topics, often related to monetary issues. Check out the globalEDGE Blog (http://globaledge.msu.edu/blog), see what is covered on mone- tary issues, and engage with people from around the world on issues that are of interest to you.

314 Part Four The Global Monetary System

major trading nations, including Great Britain, Germany, Japan, and the United States, had adopted the gold standard. Given a common gold standard, the value of any currency in units of any other currency (the exchange rate) was easy to determine.

For example, under the gold standard, one U.S. dollar was defined as equivalent to 23.22 grains of “fine” (pure) gold. Thus, one could, in theory, demand that the U.S. government convert that one dollar into 23.22 grains of gold. Because there are 480 grains in an ounce, one ounce of gold cost $20.67 (480y23.22). The amount of a currency needed to purchase one ounce of gold was referred to as the gold par value. The British pound was valued at 113 grains of fine gold. In other words, one ounce of gold cost £4.25 (480y113). From the gold par values of pounds and dollars, we can calculate what the exchange rate was for con- verting pounds into dollars; it was £1 5 $4.87 (i.e., $20.67y£4.25).

STRENGTH OF THE GOLD STANDARD The great strength claimed for the gold standard was that it contained a powerful mechanism for achieving balance-of- trade equilibrium by all countries.1 A country is said to be in balance-of-trade equilibrium when the income its residents earn from exports is equal to the money its residents pay to other countries for imports (the current account of its balance of payments is in balance). Suppose there are only two countries in the world, Japan and the United States. Imagine Japan’s trade balance is in surplus because it exports more to the United States than it im- ports from the United States. Japanese exporters are paid in U.S. dollars, which they ex- change for Japanese yen at a Japanese bank. The Japanese bank submits the dollars to the U.S. government and demands payment of gold in return. (This is a simplification of what would occur, but it will make our point.)

Under the gold standard, when Japan has a trade surplus, there is a net flow of gold from the United States to Japan. These gold flows automatically reduce the U.S. money supply and swell Japan’s money supply. As we saw in Chapter 10, there is a close connection be- tween money supply growth and price inflation. An increase in money supply will raise prices in Japan, while a decrease in the U.S. money supply will push U.S. prices downward. The rise in the price of Japanese goods will decrease demand for these goods, while the fall in the price of U.S. goods will increase demand for these goods. Thus, Japan will start to buy more from the United States, and the United States will buy less from Japan, until a balance- of-trade equilibrium is achieved.

This adjustment mechanism seems so simple and attractive that even today, 80 years after the final collapse of the gold standard, some people believe the world should return to a gold standard.

THE PERIOD BETWEEN THE WARS: 1918–1939 The gold standard worked reasonably well from the 1870s until the start of World War I in 1914, when it was abandoned. During the war, several governments financed part of their massive military expenditures by printing money. This resulted in inflation, and by the war’s end in 1918, price levels were higher everywhere. The United States returned to the gold standard in 1919, Great Britain in 1925, and France in 1928.

Great Britain returned to the gold standard by pegging the pound to gold at the prewar gold parity level of £4.25 per ounce, despite substantial inflation between 1914 and 1925. This priced British goods out of foreign markets, which pushed the country into a deep depression. When foreign holders of pounds lost confidence in Great Britain’s commitment to maintaining its currency’s value, they began converting their holdings of pounds into gold. The British government saw that it could not satisfy the demand for gold without seri- ously depleting its gold reserves, so it suspended convertibility in 1931.

The United States followed suit and left the gold standard in 1933 but returned to it in 1934, raising the dollar price of gold from $20.67 per ounce to $35 per ounce. Because more dollars were needed to buy an ounce of gold than before, the implication was that the dollar was worth less. This effectively amounted to a devaluation of the dollar relative to other currencies. Thus, before the devaluation, the pound/dollar exchange rate was £1 5 $4.87, but after the devaluation it was £1 5 $8.24. By reducing the price of U.S.

Gold Par Value The amount of currency needed to purchase one ounce of gold.

Balance-of-Trade Equilibrium Reached when the income a nation’s residents earn from exports equals money paid for imports.

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.

Chapter Eleven The International Monetary System 315

exports and increasing the price of imports, the govern- ment was trying to create employment in the United States by boosting output (the U.S. government was basically us- ing the exchange rate as an instrument of trade policy— something it now accuses China of doing). However, a number of other countries adopted a similar tactic, and in the cycle of competitive devaluations that soon emerged, no country could win.

The net result was the shattering of any remaining confi- dence in the system. With countries devaluing their curren- cies at will, one could no longer be certain how much gold a currency could buy. Instead of holding onto another coun- try’s currency, people often tried to change it into gold im- mediately, lest the country devalue its currency in the intervening period. This put pressure on the gold reserves of various countries, forcing them to suspend gold convertibil- ity. By the start of World War II in 1939, the gold standard was dead.

The Bretton Woods System In 1944, at the height of World War II, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system. With the collapse of the gold standard and the Great Depression of the 1930s fresh in their minds, these statesmen were determined to build an enduring economic order that would facilitate post- war economic growth. There was consensus that fixed exchange rates were desirable. In addition, the conference participants wanted to avoid the senseless competitive devaluations of the 1930s, and they recognized that the gold standard would not ensure this. The major problem with the gold standard as previously constituted was that no multinational institu- tion could stop countries from engaging in competitive devaluations.

The agreement reached at Bretton Woods established two multinational institutions— the International Monetary Fund (IMF) and the World Bank. The task of the IMF would be to maintain order in the international monetary system and that of the World Bank would be to promote general economic development. The Bretton Woods agreement also called for a system of fixed exchange rates that would be policed by the IMF. Under the agreement, all countries were to fix the value of their currency in terms of gold but were not required to exchange their currencies for gold. Only the dollar remained convertible into gold—at a price of $35 per ounce. Each country decided what it wanted its exchange rate to be vis-à-vis the dollar and then calculated the gold par value of the currency based on that selected dollar exchange rate. All participating countries agreed to try to maintain the value of their currencies within 1 percent of the par value by buying or selling currencies (or gold) as needed. For example, if foreign exchange dealers were selling more of a country’s currency than demanded, that country’s government would intervene in the foreign exchange mar- kets, buying its currency in an attempt to increase demand and maintain its gold par value.

Another aspect of the Bretton Woods agreement was a commitment not to use devalua- tion as a weapon of competitive trade policy. However, if a currency became too weak to defend, a devaluation of up to 10 percent would be allowed without any formal approval by the IMF. Larger devaluations required IMF approval.

THE ROLE OF THE IMF The IMF Articles of Agreement were heavily influ- enced by the worldwide financial collapse, competitive devaluations, trade wars, high unem- ployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars. The aim of the Bretton Woods agreement, of which the IMF was the main custodian, was to try to avoid a repetition of that chaos through a combination of discipline and flexibility.

LO 11-2 Explain the role played by the World Bank and the IMF in the international monetary system.

Does the World Bank Make Global Markets Less Competitive? The World Bank was created in 1944 as an international finan- cial institution of the United Nations that would provide loans to developing countries for capital investments in the country. Broadly, the World Bank’s official goal is the reduction of poverty in the global marketplace. According to its Articles of Agreement, all of the World Bank’s decisions must be guided by a commit- ment to the promotion of foreign investment and international trade and to the facilitation of capital investment. These goals are admirable by most people and countries, but what effect does lending to developing countries have on the rest of the world? Would it be better or worse if lending was only based on risk assessments and financial opportunities of countries in a free market system?

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Discipline A fixed exchange rate regime imposes discipline in two ways. First, the need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stabil- ity to the world trade environment. Second, a fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation. For example, consider what would happen under a fixed exchange rate regime if Great Britain rapidly increased its money sup- ply by printing pounds. As explained in Chapter 10, the increase in money supply would lead to price inflation. Given fixed exchange rates, inflation would make British goods un- competitive in world markets, while the prices of imports would become more attractive in Great Britain. The result would be a widening trade deficit in Great Britain, with the coun- try importing more than it exports. To correct this trade imbalance under a fixed exchange rate regime, Great Britain would be required to restrict the rate of growth in its money supply to bring price inflation back under control. Thus, fixed exchange rates are seen as a mechanism for controlling inflation and imposing economic discipline on countries.

Flexibility Although monetary discipline was a central objective of the Bretton Woods agreement, it was recognized that a rigid policy of fixed exchange rates would be too inflex- ible. It would probably break down just as the gold standard had. In some cases, a country’s attempts to reduce its money supply growth and correct a persistent balance-of-payments deficit could force the country into recession and create high unemployment. The architects of the Bretton Woods agreement wanted to avoid high unemployment, so they built limited flexibility into the system. Two major features of the IMF Articles of Agreement fostered this flexibility: IMF lending facilities and adjustable parities.

The IMF stood ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficits, when a rapid tightening of monetary or fiscal policy would hurt domestic employment. A pool of gold and currencies contributed by IMF members provided the resources for these lending operations. A persistent balance-of- payments deficit can lead to a depletion of a country’s reserves of foreign currency, forcing it to devalue its currency. By providing deficit-laden countries with short-term foreign cur- rency loans, IMF funds would buy time for countries to bring down their inflation rates and reduce their balance-of-payments deficits. The belief was that such loans would reduce pressures for devaluation and allow for a more orderly and less painful adjustment.

Countries were to be allowed to borrow a limited amount from the IMF without adher- ing to any specific agreements. However, extensive drawings from IMF funds would require a country to agree to increasingly stringent IMF supervision of its macroeconomic policies. Heavy borrowers from the IMF must agree to monetary and fiscal conditions set down by the IMF, which typically included IMF-mandated targets on domestic money supply growth, exchange rate policy, tax policy, government spending, and so on.

The system of adjustable parities allowed for the devaluation of a country’s currency by more than 10 percent if the IMF agreed that a country’s balance of payments was in “funda- mental disequilibrium.” The term fundamental disequilibrium was not defined in the IMF’s Articles of Agreement, but it was intended to apply to countries that had suffered permanent adverse shifts in the demand for their products. Without devaluation, such a country would experience high unemployment and a persistent trade deficit until the domestic price level had fallen far enough to restore a balance-of-payments equilibrium. The belief was that devaluation could help sidestep a painful adjustment process in such circumstances.

THE ROLE OF THE WORLD BANK The official name for the World Bank is the International Bank for Reconstruction and Development (IBRD). When the Bretton Woods participants established the World Bank, the need to reconstruct the war-torn economies of Europe was foremost in their minds. The bank’s initial mission was to help finance the building of Europe’s economy by providing low-interest loans. As it turned out, the World Bank was overshadowed in this role by the Marshall Plan, under which the United States lent money directly to European nations to help them rebuild. So the bank turned its attention to development and began lending money to third-world nations. In the 1950s, the bank concentrated on public-sector projects. Power stations, road building,

Chapter Eleven The International Monetary System 317

and other transportation investments were much in favor. During the 1960s, the bank also began to lend heavily in support of agriculture, education, population control, and urban development.

The bank lends money under two schemes. Under the IBRD scheme, money is raised through bond sales in the international capital market. Borrowers pay what the bank calls a market rate of interest—the bank’s cost of funds plus a margin for expenses. This “market” rate is lower than commercial banks’ market rate. Under the IBRD scheme, the bank offers low-interest loans to risky customers whose credit rating is often poor, such as the govern- ments of underdeveloped nations.

A second scheme is overseen by the International Development Association (IDA), an arm of the bank created in 1960. Resources to fund IDA loans are raised through subscrip- tions from wealthy members such as the United States, Japan, and Germany. IDA loans go only to the poorest countries. Borrowers have up to 50 years to repay at an interest rate of less than 1 percent a year. The world’s poorest nations receive grants and interest-free loans.

The Collapse of the Fixed Exchange Rate System The system of fixed exchange rates established at Bretton Woods worked well until the late 1960s, when it began to show signs of strain. The system finally collapsed in 1973, and since then we have had a managed-float system. To understand why the system collapsed, one must appreciate the special role of the U.S. dollar in the system. As the only currency that could be converted into gold, and as the currency that served as the reference point for all others, the dollar occupied a central place in the system. Any pressure on the dollar to de- value could wreak havoc with the system, and that is what occurred.

Most economists trace the breakup of the fixed exchange rate system to the U.S. macro- economic policy package of 1965–1968.2 To finance both the Vietnam conflict and his wel- fare programs, President Lyndon Johnson backed an increase in U.S. government spending that was not financed by an increase in taxes. Instead, it was financed by an increase in the money supply, which led to a rise in price inflation from less than 4 percent in 1966 to close to 9 percent by 1968. At the same time, the rise in government spending had stimulated the economy. With more money in their pockets, people spent more—particularly on imports— and the U.S. trade balance began to deteriorate.

The increase in inflation and the worsening of the U.S. foreign trade position gave rise to speculation in the foreign exchange market that the dollar would be devalued. Things came to a head in spring 1971 when U.S. trade figures showed that for the first time since 1945, the United States was importing more than it was exporting. This set off massive purchases of German deutsche marks in the foreign exchange market by speculators who guessed that the mark would be revalued against the dollar. On a single day, May 4, 1971, the Bundesbank (Germany’s central bank) had to buy $1 billion to hold the dollar/deutsche mark exchange rate at its fixed exchange rate given the great demand for deutsche marks. On the morning of May 5, the Bundesbank purchased another $1 billion during the first hour of foreign exchange trading! At that point, the Bundesbank faced the inevitable and allowed its currency to float.

In the weeks following the decision to float the deutsche mark, the foreign exchange market became increasingly convinced that the dollar would have to be devalued. How- ever, devaluation of the dollar was no easy matter. Under the Bretton Woods provisions, any other country could change its exchange rates against all currencies simply by fixing its dollar rate at a new level. But as the key currency in the system, the dollar could be devalued only if all countries agreed to simultaneously revalue against the dollar. Many countries did not want this, because it would make their products more expensive relative to U.S. products.

To force the issue, President Nixon announced in August 1971 that the dollar was no longer convertible into gold. He also announced that a new 10 percent tax on imports would remain in effect until U.S. trading partners agreed to revalue their currencies against the

LO 11-1 Describe the historical development of the modern global monetary system.

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.

318 Part Four The Global Monetary System

dollar. This brought the trading partners to the bargain- ing table, and in December 1971 an agreement was reached to devalue the dollar by about 8 percent against foreign currencies. The import tax was then removed. The problem was not solved, however. The U.S. balance- of-payments position continued to deteriorate through- out 1973, while the nation’s money supply continued to expand at an inflationary rate. Speculation continued to grow that the dollar was still overvalued and that a second devaluation would be necessary. In anticipation, foreign exchange dealers began converting dollars to deutsche marks and other currencies. After a massive wave of spec- ulation in February 1973, which culminated with Euro- pean central banks spending $3.6 billion on March 1 to try to prevent their currencies from appreciating against the dollar, the foreign exchange market was closed. When the foreign exchange market reopened March 19, the currencies of Japan and most European countries were floating against the dollar, although many developing countries continued to peg their currency to the dollar, and many do to this day. At that time, the switch to a floating system was viewed as a temporary response to unmanageable speculation in the foreign exchange mar- ket. But it is now more than 40 years since the Bretton Woods system of fixed exchange rates collapsed, and the temporary solution looks permanent.

The Bretton Woods system had an Achilles’ heel: The system could not work if its key currency, the U.S. dollar, was under speculative attack. The Bretton Woods system could work only as long as the U.S. inflation rate re-

mained low and the United States did not run a balance-of-payments deficit. Once these things occurred, the system soon became strained to the breaking point.

The Floating Exchange Rate Regime The floating exchange rate regime that followed the collapse of the fixed exchange rate sys- tem was formalized in January 1976 when IMF members met in Jamaica and agreed to the rules for the international monetary system that are in place today.

THE JAMAICA AGREEMENT The Jamaica meeting revised the IMF’s Articles of Agreement to reflect the new reality of floating exchange rates. The main elements of the Jamaica agreement include the following:

• Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange market to even out “unwarranted” speculative fluctuations.

• Gold was abandoned as a reserve asset. The IMF returned its gold reserves to members at the current market price, placing the proceeds in a trust fund to help poor nations. IMF members were permitted to sell their own gold reserves at the market price.

• Total annual IMF quotas—the amount member countries contribute to the IMF— were increased to $41 billion. (Since then, they have been increased to $767 billion, while the membership of the IMF has been expanded to include 188 countries. Non- oil-exporting, less developed countries were given greater access to IMF funds.)

EXCHANGE RATES SINCE 1973 Since March 1973, exchange rates have be- come much more volatile and less predictable than they were between 1945 and 1973.3 This

LO 11-1 Describe the historical development of the modern global monetary system.

Should We Go Back to the Gold Standard? Nixon’s decision to not link the dollar to gold is the “primary cause of the troubles we have [today],” says Porter Stansberry, founder of Stansberry & Associates Investment Research. “The purpose of gold is to make sure credit growth is restrained and limited to real growth and productivity.” Since 1971, the amount of debt in the United States has skyrocketed, while the value of the dollar has tumbled. Moving away from gold “allows people who have borrowed money to pay it back in currency that’s worth less,” Stansberry says. Unfortunately, “it’s hugely disrup- tive to our economy.” His idea is that the United States and other countries should go back to a gold (or silver) standard. On the other hand, “Why should we limit the amount of currency float- ing in circulation by a rock we have to dig out of the ground and store?” asks James Altucher of Formula Capital. “Gold is ulti- mately a limited resource.” Why should we arbitrarily pick this yellow rock and limit the world’s economy by it? Innovation hap- pens because we’ve been able to extend credit . . . beyond what gold would allow us. And it’s through debt and lending that com- panies grow.” Who do you agree with—Stansberry, who argues for the gold standard, or Altucher, who argues for today’s cur- rency system?

Source: Aaron Task, “40 Years Later: Should America Go Back to the Gold Standard?” Yahoo! Finance, August 19, 2011, http://fi nance.yahoo.com/blogs/ daily-ticker/40-years-later-america-back-gold-standard-114623756.html.

Chapter Eleven The International Monetary System 319

volatility has been partly due to a number of unexpected shocks to the world monetary sys- tem, including:

• The oil crisis in 1971, when the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of oil. The harmful effect of this on the U.S. inflation rate and trade position resulted in a further decline in the value of the dollar.

• The loss of confidence in the dollar that followed a sharp rise in the U.S. inflation rate in 1977–1978.

• The oil crisis of 1979, when OPEC once again increased the price of oil dramatically— this time it was doubled.

• The unexpected rise in the dollar between 1980 and 1985, despite a deteriorating balance-of-payments picture.

• The rapid fall of the U.S. dollar against the Japanese yen and German deutsche mark between 1985 and 1987, and against the yen between 1993 and 1995.

• The partial collapse of the European Monetary System in 1992. • The 1997 Asian currency crisis, when the Asian currencies of several countries—

including South Korea, Indonesia, Malaysia, and Thailand—lost between 50 and 80 percent of their value against the U.S. dollar in a few months.

• The global financial crisis of 2008–2010 and the sovereign debt crisis in the European Union during 2010–2011.

Figure 11.1 summarizes how the value of the U.S. dollar has fluctuated against an index of major trading currencies between January 1973 and December 2013. (The index, which was set equal to 100 in March 1973, is a weighted average of the foreign exchange values of the U.S. dollar against currencies that circulate widely outside the country of issue.) An interesting phenomenon in Figure 11.1 is the rapid rise in the value of the dollar between 1980 and 1985 and its subsequent fall between 1985 and 1988. A similar, though less pronounced, rise and fall in the value of the dollar occurred between 1995 and 2012. We briefly discuss the rise and fall of the dollar during these periods, because this tells us something about how the international monetary system has oper- ated in recent years.4

11.1 FIGURE Major Currencies Dollar Index, 1973–2013 Source: From data at www.federalreserve.gov/releases/H10/summary/indexn_m.htm.

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320 Part Four The Global Monetary System

The rise in the value of the dollar between 1980 and 1985 occurred when the United States was running a large and growing trade deficit, importing substantially more than it exported. Conventional wisdom would suggest that the increased supply of dollars in the foreign exchange market as a result of the trade deficit should lead to a reduction in the value of the dollar, but as shown in Figure 11.1, it increased in value. Why?

A number of favorable factors overcame the unfavorable effect of a trade deficit. Strong economic growth in the United States attracted heavy inflows of capital from foreign inves- tors seeking high returns on capital assets. High real interest rates attracted foreign inves- tors seeking high returns on financial assets. At the same time, political turmoil in other parts of the world, along with relatively slow economic growth in the developed countries of Europe, helped create the view that the United States was a good place to invest. These in- flows of capital increased the demand for dollars in the foreign exchange market, which pushed the value of the dollar upward against other currencies.

The fall in the value of the dollar between 1985 and 1988 was caused by a combination of government intervention and market forces. The rise in the dollar, which priced U.S. goods out of foreign markets and made imports relatively cheap, had contributed to a dismal trade picture. In 1985, the United States posted a then record-high trade deficit of more than $160 billion. This led to growth in demands for protectionism in the United States. In Sep- tember 1985, the finance ministers and central bank governors of the so-called Group of Five major industrial countries (Great Britain, France, Japan, Germany, and the United States) met at the Plaza Hotel in New York and reached what was later referred to as the Plaza Accord. They announced that it would be desirable for most major currencies to ap- preciate vis-à-vis the U.S. dollar and pledged to intervene in the foreign exchange markets, selling dollars, to encourage this objective. The dollar had already begun to weaken during summer 1985, and this announcement further accelerated the decline.

The dollar continued to decline until 1987. The governments of the Group of Five began to worry that the dollar might decline too far, so the finance ministers of the Group of Five met in Paris in February 1987 and reached a new agreement known as the Louvre Accord. They agreed that exchange rates had been realigned sufficiently and pledged to support the stability of exchange rates around their current levels by intervening in the foreign exchange markets when necessary to buy and sell currency. Although the dollar continued to decline for a few months after the Louvre Accord, the rate of decline slowed, and by early 1988 the decline had ended.

Except for a brief speculative flurry around the time of the Persian Gulf War in 1991, the dollar was relatively stable for the first half of the 1990s. However, in the late 1990s, the dollar again began to appreciate against most major currencies, including the euro after its introduc- tion, even though the United States was still running a significant balance-of-payments deficit. Once again, the driving force for the appreciation in the value of the dollar was that foreigners continued to invest in U.S. financial assets, primarily stocks and bonds, and the inflow of money drove up the value of the dollar on foreign exchange markets. The inward investment was due to a belief that U.S. financial assets offered a favorable rate of return.

By 2002, however, foreigners had started to lose their appetite for U.S. stocks and bonds, and the inflow of money into the United States slowed. Instead of reinvesting dollars earned from exports to the United States in U.S. financial assets, they exchanged those dollars for other currencies, particularly euros, to invest them in non-dollar-denominated assets. One reason for this was the continued growth in the U.S. trade deficit, which hit a record $791 billion in 2005 (by 2011 it had fallen to $540 billion). Although the U.S. trade deficits had been hitting records for decades, this deficit was the largest ever when measured as a percentage of the country’s GDP (6.3 percent of GDP in 2005).

The record deficit meant that even more dollars were flowing out of the United States into foreign hands, and those foreigners were less inclined to reinvest those dollars in the United States at a rate required to keep the dollar stable. This growing reluctance of foreigners to in- vest in the United States was in turn due to several factors. First, there was a slowdown in U.S. economic activity during 2001–2002. Second, the U.S. government’s budget deficit expanded rapidly after 2001. This led to fears that ultimately the budget deficit would be financed by an expansionary monetary policy that could lead to higher price inflation. Third, from 2003

Chapter Eleven The International Monetary System 321

onward, U.S. government officials began to “talk down” the value of the dollar, in part because the administration believed that a cheaper dollar would increase exports and reduce imports, thereby improving the U.S. balance of trade position.5 Foreigners saw this as a signal that the U.S. government would not intervene in the foreign exchange markets to prop up the value of the dollar, which increased their reluctance to reinvest dollars earned from export sales in U.S. financial assets. As a result of these factors, demand for dollars weakened, and the value of the dollar slid on the foreign exchange markets—hitting an index value of 69.069 in August 2011, the lowest value since the index began in 1973. Some believe that it could resume its fall in coming years, particularly if large holders of U.S. dollars, such as oil-producing states and China, decide to diversify their foreign exchange holdings (see the accompanying Country Focus for a discussion of this possibility with respect to oil-producing states).

Interestingly, from mid-2008 through early 2009, the dollar staged a moderate rally against major currencies, despite the fact that the American economy was suffering from a serious financial crisis. The reason seems to be that despite America’s problems, things were even worse in many other countries, and foreign investors saw the dollar as a safe haven and put their money in low-risk U.S. assets, particularly low-yielding U.S. government bonds. This rally faltered in mid-2009 as investors became worried about the level of U.S. indebtedness.

This review tells us that in recent history both market forces and government interven- tion have determined the value of the dollar. Under a floating exchange rate regime, market forces have produced a volatile dollar exchange rate. Governments have sometimes

The U.S. Dollar, Oil Prices, and Recycling Petrodollars

Between 2004 and 2008, global oil prices surged. They peaked at $147 a barrel in July 2008, up from about $20 in 2001, before falling sharply back to a $34 to $48 range by early 2009. Since then, they have in- creased again, rising to around $100 a barrel in early 2014. The rise in oil prices has been due to a combination of greater-than-expected de- mand for oil, particularly from rapidly developing giants such as China and India; tight supplies; and perceived geopolitical risks in the Middle East, the world’s largest oil-producing region.

The surge in oil prices was a windfall for oil-producing countries. Collectively, they earned around $700 billion in oil revenues in 2005, and well over $1 trillion in 2007 and 2008—some 64 percent of which went to members of OPEC. Saudi Arabia, the world’s largest oil pro- ducer, reaped a major share. Because oil is priced in U.S. dollars, the rise in oil prices has translated into a substantial increase in the dollar holdings of oil producers (the dollars earned from the sale of oil are often referred to as petrodollars). In essence, rising oil prices represent a net transfer of dollars from oil consumers in countries such as the United States to oil producers in Russia, Saudi Arabia, and Venezuela. What have they been doing with these dollars?

One option for producing countries was to spend their petrodollars on public-sector infrastructure, such as health services, education, roads, and telecommunications systems. Among other things, this could boost economic growth in those countries and pull in foreign imports, which would help counterbalance the trade surpluses enjoyed by oil producers and support global economic growth. Spending did indeed pick up in many oil-producing countries. However, according to the IMF, OPEC members spent only about 40 percent of their windfall profits from higher oil prices in 2002–2007 (an exception was Venezuela,

whose leader, Hugo Chávez, was on a spending spree until his death in early 2013). The last time oil prices increased sharply in 1979, oil pro- ducers significantly ramped up spending on infrastructure, only to find themselves saddled with excessive debt when oil prices collapsed a few years later. This time they were more cautious—an approach that seems wise given the rapid fall in oil prices during late 2008.

Another option was for oil producers to invest a good chunk of the dollars they earned from oil sales in dollar-denominated assets, such as U.S. bonds, stocks, and real estate. This did happen. OPEC members in particular funneled dollars back into U.S. assets, mostly low-risk gov- ernment bonds. The implication is that by recycling their petrodollars, oil producers helped finance the large and growing current account deficit of the United States, enabling it to pay its large oil import bill.

A third possibility for oil producers was to invest in non-dollar- denominated assets, including European and Japanese bonds and stocks. This, too, happened. Also, some OPEC investors had purchased not just small equity positions but entire companies. In 2005, for exam- ple, Dubai International Capital purchased the Tussauds Group, a British theme-park firm, and DP World of Dubai purchased P&O, Britain’s big- gest port and ferries group. Despite examples such as these, between 2005 and 2008 at least, the bulk of petrodollars appear to have been recycled into dollar-denominated assets. In part, this was because U.S. interest rates increased throughout 2004–2007 and in part because the US was viewed as a safe haven in economically troubled times. However, if the flow of petrodollars should dry up, with oil-rich coun- tries investing in other currencies, such as euro-denominated assets, the dollar could fall significantly.

Sources: “Recycling the Petrodollars; Oil Producers’ Surpluses,” The Economist, November 12, 2005, pp. 101–02; S. Johnson, “Dollar’s Rise Aided by OPEC Holdings,” Financial Times, December 5, 2005, p. 17; and “The Petrodollar Puzzle,” The Economist, June 9, 2007, p. 86.

country FOCUS

322 Part Four The Global Monetary System

responded by intervening in the market—buying and selling dollars—in an attempt to limit the market’s volatility and to correct what they see as overvaluation (in 1985) or potential undervaluation (in 1987) of the dollar. In addition to direct intervention, statements from government officials have frequently influenced the value of the dollar. The dollar may not have declined by as much as it did in 2004, for example, had not U.S. government officials publicly ruled out any action to stop the decline. Paradoxically, a signal not to intervene can affect the market. The frequency of government intervention in the foreign exchange mar- ket explains why the current system is sometimes thought of as a managed-float system or a dirty-float system.

Fixed versus Floating Exchange Rates The breakdown of the Bretton Woods system has not stopped the debate about the relative merits of fixed versus floating exchange rate regimes. Disappointment with the system of floating rates in recent years has led to renewed debate about the merits of fixed exchange rates. This section reviews the arguments for fixed and floating exchange rate regimes.6 We discuss the case for floating rates before studying why many critics are disappointed with the experience under floating exchange rates and yearn for a system of fixed rates.

THE CASE FOR FLOATING EXCHANGE RATES The case in support of floating exchange rates has three main elements: monetary policy autonomy, automatic trade balance adjustments, and economic recovery following a severe economic crisis.

Monetary Policy Autonomy It is argued that under a fixed system, a country’s ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity. Monetary expansion can lead to inflation, which puts downward pres- sure on a fixed exchange rate (as predicted by the PPP theory; see Chapter 10). Similarly, monetary contraction requires high interest rates (to reduce the demand for money). Higher interest rates lead to an inflow of money from abroad, which puts upward pressure on a fixed exchange rate. Thus, to maintain exchange rate parity under a fixed system, countries were limited in their ability to use monetary policy to expand or contract their economies.

Advocates of a floating exchange rate regime argue that removal of the obligation to main- tain exchange rate parity would restore monetary control to a government. If a government faced with unemployment wanted to increase its money supply to stimulate domestic de- mand and reduce unemployment, it could do so unencumbered by the need to maintain its exchange rate. While monetary expansion might lead to inflation, this would lead to a depre- ciation in the country’s currency. If PPP theory is correct, the resulting currency depreciation on the foreign exchange markets should offset the effects of inflation. Although under a float- ing exchange rate regime, domestic inflation would have an impact on the exchange rate, it should have no impact on businesses’ international cost competitiveness due to exchange rate depreciation. The rise in domestic costs should be exactly offset by the fall in the value of the country’s currency on the foreign exchange markets. Similarly, a government could use mon- etary policy to contract the economy without worrying about the need to maintain parity.

Trade Balance Adjustments Under the Bretton Woods system, if a country devel- oped a permanent deficit in its balance of trade (importing more than it exported) that could not be corrected by domestic policy, this would require the IMF to agree to currency devaluation. Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime. They argue that if a country is running a trade deficit, the imbalance between the supply and demand of that country’s currency in the foreign exchange markets (supply exceeding demand) will lead to depreciation in its exchange rate. In turn, by making its exports cheaper and its imports more expensive, exchange rate depreciation should correct the trade deficit.

Crisis Recovery Advocates of floating exchange rates also argue that exchange rate adjustments can help a country to deal with economic crises. When a country is hit by a

Managed-Float System System under which some currencies are allowed to float freely, but the majority are either managed by government intervention or pegged to another currency.

L0 11-3 Compare and contrast the differences between a fixed and a floating exchange rate system.

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Chapter Eleven The International Monetary System 323

severe economic crisis, such as the banking crisis that hit Iceland in 2008 (see the opening case), its currency typically declines on foreign exchange markets. The reason for this is that investors respond to the crisis by taking their money out of the country, selling the local currency, and driving down its value. At some point, however, the currency becomes so cheap that it starts to stimulate exports. This is what occurred in Iceland after the krona lost 50 percent of its value against the U.S. dollar and euro following the 2008 banking crisis. By 2009 exports of fish and aluminum from Iceland were booming, which helped pull the Icelandic economy out of a recession. A similar process occurred in South Korean after the 1997 Asian banking crisis. The value of the South Korean won plunged to 1,700 per dollar from around 800. In turn, the cheap won helped South Korea increase its exports and re- sulted in an export-led economic recovery. On the other hand, in both countries the declin- ing value of the currency did raise import prices and led to an increase in inflation, so there is a price that has to be paid for an export-led recovery due to falling currency values.

A contrast can be drawn with the recent situation in Greece, where the economy im- ploded following the 2008–2009 global financial crisis, and has struggled to recover. Part of the problem in Greece is that it gave up its own currency to adopt the euro in 2001, and the euro has remained quite strong—thus Greece cannot rely upon a falling local currency to boost exports and stimulate economic recovery.

THE CASE FOR FIXED EXCHANGE RATES The case for fixed exchange rates rests on arguments about monetary discipline, speculation, uncertainty, and the lack of connection between the trade balance and exchange rates.

Monetary Discipline We have already discussed the nature of monetary discipline inherent in a fixed exchange rate system when we discussed the Bretton Woods system. The need to maintain fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates. While advocates of floating rates argue that each coun- try should be allowed to choose its own inflation rate (the monetary autonomy argument), advocates of fixed rates argue that governments all too often give in to political pressures and expand the monetary supply far too rapidly, causing unacceptably high price inflation. A fixed exchange rate regime would ensure that this does not occur.

Speculation Critics of a floating exchange rate regime also argue that speculation can cause fluctuations in exchange rates. They point to the dollar’s rapid rise and fall during the 1980s, which they claim had nothing to do with comparative inflation rates and the U.S. trade deficit, but everything to do with speculation. They argue that when foreign exchange dealers see a currency depreciating, they tend to sell the currency in the expectation of future depreciation regardless of the currency’s longer-term prospects. As more traders jump on the bandwagon, the expectations of depreciation are realized. Such destabilizing speculation tends to accentuate the fluctuations around the exchange rate’s long-run value. It can damage a country’s economy by distorting export and import prices. Thus, advocates of a fixed ex- change rate regime argue that such a system will limit the destabilizing effects of speculation.

Uncertainty Speculation also adds to the uncertainty surrounding future currency movements that characterizes floating exchange rate regimes. The unpredictability of exchange rate movements in the post–Bretton Woods era has made business planning dif- ficult, and it adds risk to exporting, importing, and foreign investment activities. Given a volatile exchange rate, international businesses do not know how to react to the changes— and often they do not react. Why change plans for exporting, importing, or foreign invest- ment after a 6 percent fall in the dollar this month, when the dollar may rise 6 percent next month? This uncertainty, according to the critics, dampens the growth of international trade and investment. They argue that a fixed exchange rate, by eliminating such uncer- tainty, promotes the growth of international trade and investment. Advocates of a floating system reply that the forward exchange market ensures against the risks associated with exchange rate fluctuations (see Chapter 10), so the adverse impact of uncertainty on the growth of international trade and investment has been overstated.

324 Part Four The Global Monetary System

Trade Balance Adjustments and Economic Recovery Those in favor of floating exchange rates argue that floating rates help adjust trade imbalances and can assist with economic recovery after a crisis. Critics question the closeness of the link between the exchange rate, the trade balance and economic growth. They claim trade deficits are determined by the balance between sav- ings and investment in a country, not by the external value of its currency.7 They argue that depreciation in a currency will lead to inflation (due to the resulting increase in import prices). This inflation, they state, will wipe out any apparent gains in cost competitiveness that arise from cur- rency depreciation. In other words, a depreciating exchange rate will not boost exports and reduce imports, as advocates of floating rates claim; it will simply boost price inflation. In support of this argument, those who favor fixed rates point out that the 40 percent drop in the value

of the dollar between 1985 and 1988 did not correct the U.S. trade deficit. In reply, advocates of a floating exchange rate regime argue that between 1985 and 1992, the U.S. trade deficit fell from more than $160 billion to about $70 billion, and they attribute this in part to the decline in the value of the dollar. Moreover, the experience of countries like South Korea and Iceland seems to suggest that floating rates can help a country recover from a severe economic crisis.

WHO IS RIGHT? Which side is right in the vigorous debate between those who favor a fixed exchange rate and those who favor a floating exchange rate? Economists cannot agree. Business, as a major player on the international trade and investment scene, has a large stake in the resolution of the debate. Would international business be better off under a fixed regime, or are flexible rates better? The evidence is not clear.

However, a fixed exchange rate regime modeled along the lines of the Bretton Woods sys- tem probably will not work. Speculation ultimately broke the system, a phenomenon that advo- cates of fixed rate regimes claim is associated with floating exchange rates! Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the sta- bility that would facilitate more rapid growth in international trade and investment. In the next section, we look at potential models for such a system and the problems with such systems.

Exchange Rate Regimes in Practice Governments around the world pursue a number of different exchange rate policies. These range from a pure “free float” where the exchange rate is determined by market forces to a pegged system that has some aspects of the pre-1973 Bretton Woods system of fixed ex- change rates. Some 21 percent of the IMF’s members allow their currency to float freely. Another 23 percent intervene in only a limited way (the so-called managed float). A further 5 percent of IMF members now have no separate legal tender of their own (this figure ex- cludes the European Union countries that have adopted the euro). These are typically smaller states, mostly in Africa or the Caribbean, that have no domestic currency and have adopted a foreign currency as legal tender within their borders, typically the U.S. dollar or the euro. The remaining countries use more inflexible systems, including a fixed peg arrangement (43 percent) under which they peg their currencies to other currencies, such as the U.S. dollar or the euro, or to a basket of currencies. Other countries have adopted a system under which their exchange rate is allowed to fluctuate against other currencies within a target zone (an adjustable peg system). In this section, we look more closely at the mechanics and implica- tions of exchange rate regimes that rely on a currency peg or target zone.

PEGGED EXCHANGE RATES Under a pegged exchange rate regime, a country will peg the value of its currency to that of a major currency so that, for example, as the U.S.

LO 11-4 Identify exchange rate regimes used in the world today and why countries adopt different exchange rate regimes.

Floating or Fixed Exchange Rates? In Chapter 11, we have included a lot of material on the positives and negatives of floating and fixed exchange rates. The case for a floating exchange rate includes monetary policy autonomy, trade balance adjustments, and crisis recovery issues. The case for a fixed exchange rate includes monetary discipline, specula- tion issues, uncertainty, trade balance adjustments and eco- nomic recovery. We conclude these topics with a short section on “who is right” without actually addressing this very complex issue. But, what do you think? Who is right? Should we have a floating or fixed exchange rate system?

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Chapter Eleven The International Monetary System 325

dollar rises in value, its own currency rises too. Pegged exchange rates are popular among many of the world’s smaller nations. As with a full fixed exchange rate regime, the great virtue claimed for a pegged exchange rate is that it imposes monetary discipline on a country and leads to low inflation. For example, if Belize pegs the value of the Belizean dollar to that of the U.S. dollar so that US$1 5 B$1.97, then the Belizean government must make sure the infla- tion rate in Belize is similar to that in the United States. If the Belizean inflation rate is greater than the U.S. inflation rate, this will lead to pressure to devalue the Belizean dollar (i.e., to alter the peg). To maintain the peg, the Belizean government would be required to rein in in- flation. Of course, for a pegged exchange rate to impose monetary discipline on a country, the country whose currency is chosen for the peg must also pursue sound monetary policy.

Evidence shows that adopting a pegged exchange rate regime moderates inflationary pressures in a country. An IMF study concluded that countries with pegged exchange rates had an average annual inflation rate of 8 percent, compared with 14 percent for intermedi- ate regimes and 16 percent for floating regimes.8 However, many countries operate with only a nominal peg and in practice are willing to devalue their currency rather than pursue a tight monetary policy. It can be very difficult for a smaller country to maintain a peg against another currency if capital is flowing out of the country and foreign exchange trad- ers are speculating against the currency. Something like this occurred in 1997 when a com- bination of adverse capital flows and currency speculation forced several Asian countries, including Thailand and Malaysia, to abandon pegs against the U.S. dollar and let their cur- rencies float freely. Malaysia and Thailand would not have been in this position had they dealt with a number of problems that began to arise in their economies during the 1990s, including excessive private-sector debt and expanding current account trade deficits.

CURRENCY BOARDS Hong Kong’s experience during the 1997 Asian currency crisis added a new dimension to the debate over how to manage a pegged exchange rate. Dur- ing late 1997, when other Asian currencies were collapsing, Hong Kong maintained the value of its currency against the U.S. dollar at about $1 5 HK$7.80 despite several concerted specu- lative attacks. Hong Kong’s currency board has been given credit for this success. A country that introduces a currency board commits itself to converting its domestic currency on de- mand into another currency at a fixed exchange rate. To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100 percent of the domestic currency issued. The system used in Hong Kong means its cur- rency must be fully backed by the U.S. dollar at the specified exchange rate. This is still not a true fixed exchange rate regime, because the U.S. dollar, and by extension the Hong Kong dollar, floats against other currencies, but it has some features of a fixed exchange rate regime.

Under this arrangement, the currency board can issue additional domestic notes and coins only when there are foreign exchange reserves to back it. This limits the ability of the gov- ernment to print money and, thereby, create inflationary pressures. Under a strict currency board system, interest rates adjust automatically. If investors want to switch out of domestic currency into, for example, U.S. dollars, the supply of domestic currency will shrink. This will cause interest rates to rise until it eventually becomes attractive for investors to hold the local currency again. In the case of Hong Kong, the interest rate on three-month deposits climbed as high as 20 percent in late 1997, as investors switched out of Hong Kong dollars and into U.S. dollars. The dollar peg held, however, and interest rates declined again.

Since its establishment in 1983, the Hong Kong currency board has weathered several storms, including the latest. This success persuaded several other countries in the develop- ing world to consider a similar system. Argentina introduced a currency board in 1991 (but abandoned it in 2002), and Bulgaria, Estonia, and Lithuania have all gone down this road in recent years. Despite interest in the arrangement, however, critics are quick to point out that currency boards have their drawbacks.9 If local inflation rates remain higher than the infla- tion rate in the country to which the currency is pegged, the currencies of countries with currency boards can become uncompetitive and overvalued (this is what happened in the case of Argentina, which had a currency board). Also, under a currency board system, gov- ernment lacks the ability to set interest rates. Interest rates in Hong Kong, for example, are effectively set by the U.S. Federal Reserve. In addition, economic collapse in Argentina in

Currency Board Means of controlling a country’s currency.

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326 Part Four The Global Monetary System

2001 and the subsequent decision to abandon its currency board dampened much of the enthusiasm for this mechanism of managing exchange rates.

Crisis Management by the IMF Many observers initially believed that the collapse of the Bretton Woods system in 1973 would diminish the role of the IMF within the international monetary system. The IMF’s original function was to provide a pool of money from which members could borrow, short term, to adjust their balance-of-payments position and maintain their exchange rate. Some believed the demand for short-term loans would be considerably diminished under a float- ing exchange rate regime. A trade deficit would presumably lead to a decline in a country’s exchange rate, which would help reduce imports and boost exports. No temporary IMF adjustment loan would be needed. Consistent with this, after 1973, most industrialized countries tended to let the foreign exchange market determine exchange rates in response to demand and supply. Since the early 1970s, the rapid development of global capital markets has generally allowed developed countries such as Great Britain and the United States to finance their deficits by borrowing private money, as opposed to drawing on IMF funds.

Despite these developments, the activities of the IMF have expanded over the past 30 years. By 2014, the IMF had 188 members, 52 of which had some kind of IMF program in place. In 1997, the institution implemented its largest rescue packages until that date, committing more than $110 billion in short-term loans to three troubled Asian countries— South Korea, Indonesia, and Thailand. This was followed by additional IMF rescue pack- ages in Turkey, Russia, Argentina, and Brazil. IMF loans increased again in late 2008 as the global financial crisis took hold. Between 2008 and 2010, the IMF made more than $100 billion in loans to troubled economies such as Latvia, Greece, and Ireland. In April 2009, in response to the growing financial crisis, major IMF members agreed to triple the institution’s resources from $250 billion to $750 billion, thereby giving the IMF the finan- cial leverage to act aggressively in times of global financial crisis.

The IMF’s activities have expanded because periodic financial crises have continued to hit many economies in the post–Bretton Woods era. The IMF has repeatedly lent money to nations experiencing financial crises, requesting in return that the governments enact cer- tain macroeconomic policies. Critics of the IMF claim these policies have not always been as beneficial as the IMF might have hoped and, in some cases, may have made things worse. Following the IMF loans to several Asian economies, these criticisms reached new levels, and a vigorous debate was waged as to the appropriate role of the IMF. In this section, we discuss some of the main challenges the IMF has had to deal with over the past three de- cades and review the ongoing debate over the role of the IMF.

FINANCIAL CRISES IN THE POST–BRETTON WOODS ERA A number of broad types of financial crises have occurred over the past 30 years, many of which have required IMF involvement. A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency or forces authorities to expend large volumes of international currency reserves and sharply in- crease interest rates to defend the prevailing exchange rate. This happened in Brazil in 2002, and the IMF stepped in to help stabilize the value of the Brazilian currency on foreign ex- change markets by lending it foreign currency. A banking crisis refers to a loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits. This is what happened in Iceland in 2008 (see the opening case). A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private-sector or government debt. This happened to Greece, Ireland, and Portugal in 2010.

These crises tend to have common underlying macroeconomic causes: high relative price inflation rates, a widening current account deficit, excessive expansion of domestic borrow- ing, high government deficits, and asset price inflation (such as sharp increases in stock and property prices).10 At times, elements of currency, banking, and debt crises may be present simultaneously, as in the 1997 Asian crisis, the 2000–2002 Argentinean crisis, and the 2010 crisis in Ireland.

LO 11-5 Understand the debate surrounding the role of the IMF in the management of financial crises.

Currency Crisis Occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates to defend the prevailing exchange rate.

Banking Crisis A loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits.

Foreign Debt Crisis Situation in which a country cannot service its foreign debt obligations, whether private-sector or government debt.

Chapter Eleven The International Monetary System 327

To assess the frequency of financial crises, the IMF looked at the macroeconomic perfor- mance of a group of 53 countries from 1975 to 1997 (22 of these countries were developed nations, and 31 were developing countries).11 The IMF found there had been 158 currency crises, including 55 episodes in which a country’s currency declined by more than 25 percent. There were also 54 banking crises. The IMF’s data suggest that developing nations were more than twice as likely to experience currency and banking crises as developed nations. It is not surprising, therefore, that most of the IMF’s loan activities since the mid-1970s have been targeted toward developing nations. The above Country Focus gives a detailed look at the development of one currency crisis, that in Mexico during 1995.

In 1997, several Asian currencies started to fall sharply as international investors came to the realization that there was a speculative investment bubble in the region. They took their money out of local currencies, changing it into U.S. dollars, and those currencies started to fall precipi- tously. The currency declines started in Thailand and then, in a process of contagion, quickly spread to other countries in the region. Stabilizing those currencies required massive help from the IMF. In the case of South Korea, local enterprises had built up huge debt loads as they in- vested heavily in new industrial capacity. By 1997, they found they had too much industrial ca- pacity and could not generate the income required to service their debt. South Korean banks and companies had also made the mistake of borrowing in dollars, much of it in the form of short- term loans that would come due within a year. Thus, when the Korean won started to decline in fall 1997 in sympathy with the problems elsewhere in Asia, South Korean companies saw their debt obligations balloon. Several large companies were forced to file for bankruptcy. This trig- gered a decline in the South Korean currency and stock market that was difficult to halt.

The Mexican Currency Crisis of 1995

The Mexican peso had been pegged to the dollar since the early 1980s when the International Monetary Fund made it a condition for lending money to the Mexican government to help bail the country out of a 1982 financial crisis. Under the IMF-brokered arrangement, the peso had been allowed to trade within a tolerance band of plus or minus 3 percent against the dollar. The band was also permitted to “crawl” down daily, allowing for an annual peso depreciation of about 4 percent against the dollar. The IMF believed that the need to maintain the ex- change rate within a fairly narrow trading band would force the Mexican government to adopt stringent financial policies to limit the growth in the money supply and contain inflation.

Until the early 1990s, it looked as if the IMF policy had worked. How- ever, the strains were beginning to show by 1994. Since the mid-1980s, Mexican producer prices had risen 45 percent more than prices in the United States, and yet there had not been a corresponding adjustment in the exchange rate. By late 1994, Mexico was running a $17 billion trade deficit, which amounted to some 6 percent of the country’s gross do- mestic product, and there had been an uncomfortably rapid expansion in public- and private-sector debt. Despite these strains, Mexican gov- ernment officials had been stating publicly they would support the pe- so’s dollar peg at around $1 5 3.5 pesos by adopting appropriate monetary policies and by intervening in the currency markets if neces- sary. Encouraged by such statements, $64 billion of foreign investment money poured into Mexico between 1990 and 1994 as corporations and money managers sought to take advantage of the booming economy.

However, many currency traders concluded the peso would have to be devalued, and they began to dump pesos on the foreign exchange

market. The government tried to hold the line by buying pesos and sell- ing dollars, but it lacked the foreign currency reserves required to halt the speculative tide (Mexico’s foreign exchange reserves fell from $6 billion at the beginning of 1994 to less than $3.5 billion at the end of the year). In mid-December 1994, the Mexican government abruptly announced a devaluation. Immediately, much of the short-term invest- ment money that had flowed into Mexican stocks and bonds over the previous year reversed its course as foreign investors bailed out of peso-denominated financial assets. This exacerbated the sale of the peso and contributed to the rapid 40 percent drop in its value.

The IMF stepped in again, this time arm in arm with the U.S. gov- ernment and the Bank for International Settlements. Together, the three institutions pledged close to $50 billion to help Mexico stabilize the peso and to redeem $47 billion of public- and private-sector debt that was set to mature in 1995. Of this amount, $20 billion came from the U.S. government and another $18 billion came from the IMF (which made Mexico the largest recipient of IMF aid up to that point). Without the aid package, Mexico would probably have defaulted on its debt obligations, and the peso would have gone into free fall. As is normal in such cases, the IMF insisted on tight monetary policies and further cuts in public spending, both of which helped push the country into a deep recession. However, the recession was relatively short-lived, and by 1997 the country was once more on a growth path, had pared down its debt, and had paid back the $20 billion borrowed from the U.S. govern- ment ahead of schedule.

Sources: P. Carroll and C. Torres, “Mexico Unveils Program of Harsh Fiscal Medicine,” The Wall Street Journal, March 10, 1995, pp. A1, A6; and “Putting Mexico Together Again,” The Economist, February 4, 1995, p. 65.

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With its economy on the verge of collapse, the South Korean government requested $20 billion in standby loans from the IMF on November 21. As the negotiations progressed, it became apparent that South Korea was going to need far more than $20 billion. On Decem- ber 3, 1997, the IMF and South Korean government reached a deal to lend $55 billion to the country. The agreement with the IMF called for the South Koreans to open their economy and banking system to foreign investors. South Korea also pledged to restrain Korea’s largest

enterprises, the chaebol, by reducing their share of bank financing and requiring them to publish consolidated finan- cial statements and undergo annual independent external audits. On trade liberalization, the IMF said South Korea would comply with its commitments to the World Trade Organization to eliminate trade-related subsidies and re- strictive import licensing and would streamline its import certification procedures, all of which should open the South Korean economy to greater foreign competition.12

EVALUATING THE IMF’S POLICY PRE- SCRIPTIONS By 2013, the IMF was committing loans to some 52 countries that were struggling with eco- nomic and/or currency crises. All IMF loan packages come with conditions attached. Until very recently, the IMF has insisted on a combination of tight macroeconomic policies, including cuts in public spending, higher interest rates, and tight monetary policy. It has also often pushed for the de- regulation of sectors formerly protected from domestic and foreign competition, privatization of state-owned as- sets, and better financial reporting from the banking sector. These policies are designed to cool overheated economies by reining in inflation and reducing government spending and debt. This set of policy prescriptions has come in for tough criticisms from many observers, and the IMF itself has started to change its approach.13

Christine Lagarde heads the IMF.

Is the International Monetary Fund (IMF) Needed? The International Monetary Fund (IMF) is an organization of 188 countries working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce pov- erty around the world. It is a specialized agency of the United Nations, but has its own charter, governing structure, and finances. Its members are represented through a quota system broadly based on their relative size in the global economy. The Board of Governors, the highest decision-making body of the IMF, consists of one governor and one alternate governor for each member country. The governor is appointed by the member country and is usually the minister of finance or the governor of the central bank. Chapter 11 includes a lot of material on the IMF, the debate about its positive and negative effects on world markets, and its policy prescriptions. Based on this material, should the IMF’s one-size fits-all approach (see the section on Inappropriate Policies in Chapter 11) be evaluated? If yes, how would you change it? If no, why not?

Source: http://www.imf.org, accessed April 12, 2014.

Chapter Eleven The International Monetary System 329

Inappropriate Policies One criticism is that the IMF’s traditional policy prescrip- tions represent a “one-size-fits-all” approach to macroeconomic policy that is inappropriate for many countries. In the case of the 1997 Asian crisis, critics argue that the tight macroeco- nomic policies imposed by the IMF were not well suited to countries that are suffering not from excessive government spending and inflation, but from a private-sector debt crisis with deflationary undertones.14

In South Korea, for example, the government had been running a budget surplus for years (it was 4 percent of South Korea’s GDP in 1994–1996), and inflation was low at about 5 per- cent. South Korea had the second-strongest financial position of any country in the Organiza- tion for Economic Cooperation and Development. Despite this, critics say, the IMF insisted on applying the same policies that it applies to countries suffering from high inflation. The IMF required South Korea to maintain an inflation rate of 5 percent. However, given the col- lapse in the value of its currency and the subsequent rise in price for imports such as oil, critics claimed inflationary pressures would inevitably increase in South Korea. So to hit a 5 percent inflation rate, the South Koreans would be forced to apply an unnecessarily tight monetary policy. Short-term interest rates in South Korea did jump from 12.5 percent to 21 percent im- mediately after the country signed its initial deal with the IMF. Increasing interest rates made it even more difficult for companies to service their already excessive short-term debt obliga- tions, and critics used this as evidence to argue that the cure prescribed by the IMF may actu- ally increase the probability of widespread corporate defaults, not reduce them.

At the time the IMF rejected this criticism. According to the IMF, the central task was to rebuild confidence in the won. Once this was achieved, the won would recover from its oversold levels, reducing the size of South Korea’s dollar-denominated debt burden when expressed in won, making it easier for companies to service their debt. The IMF also argued that by requiring South Korea to remove restrictions on foreign direct investment, foreign capital would flow into the country to take advantage of cheap assets. This, too, would in- crease demand for the Korean currency and help improve the dollar/won exchange rate.

South Korea did recover fairly quickly from the crisis, supporting the position of the IMF. While the economy contracted by 7 percent in 1998, by 2000 it had rebounded and grew at a 9 percent rate (measured by growth in GDP). Inflation, which peaked at 8 percent in 1998, fell to 2 percent by 2000, and unemployment fell from 7 percent to 4 percent over the same period. The won hit a low of $1 5 W1,812 in early 1998, but by 2000 was back to an exchange rate of around $1 5 W1,200, at which it seems to have stabilized.

Moral Hazard A second criticism of the IMF is that its rescue efforts are exacerbating a problem known to economists as moral hazard. Moral hazard arises when people behave recklessly because they know they will be saved if things go wrong. Critics point out that many Japanese and Western banks were far too willing to lend large amounts of capital to overleveraged Asian companies during the boom years of the 1990s. These critics argue that the banks should now be forced to pay the price for their rash lending policies, even if that means some banks must close.15 Only by taking such drastic action, the argument goes, will banks learn the error of their ways and not engage in rash lending in the future. By provid- ing support to these countries, the IMF is reducing the probability of debt default and in effect bailing out the banks whose loans gave rise to this situation.

This argument ignores two critical points. First, if some Japanese or Western banks with heavy exposure to the troubled Asian economies were forced to write off their loans due to widespread debt default, the impact would have been difficult to contain. The fail- ure of large Japanese banks, for example, could have triggered a meltdown in the Japanese financial markets. That would almost inevitably lead to a serious decline in stock markets around the world, which was the very risk the IMF was trying to avoid by stepping in with financial support. Second, it is incorrect to imply that some banks have not had to pay the price for rash lending policies. The IMF insisted on the closure of banks in South Korea, Thailand, and Indonesia after the 1997 Asian financial crisis. Foreign banks with short- term loans outstanding to South Korean enterprises have been forced by circumstances to reschedule those loans at interest rates that do not compensate for the extension of the loan maturity.

Moral Hazard Arises when people behave recklessly because they know they will be saved if things go wrong.

Lack of Accountability The final criticism of the IMF is that it has become too power- ful for an institution that lacks any real mechanism for accountability.16 The IMF has deter- mined macroeconomic policies in those countries, yet according to critics such as noted economist Jeffrey Sachs, the IMF, with a staff of less than 1,000, lacks the expertise required to do a good job. Evidence of this, according to Sachs, can be found in the fact that the IMF was singing the praises of the Thai and South Korean governments only months before both coun- tries lurched into crisis. Then the IMF put together a draconian program for South Korea with- out having deep knowledge of the country. Sachs’s solution to this problem is to reform the IMF so it makes greater use of outside experts and its operations are open to greater outside scrutiny.

Observations As with many debates about international economics, it is not clear which side is correct about the appropriateness of IMF policies. There are cases where one can argue that IMF policies had been counterproductive or only had limited success. For example, one might question the success of the IMF’s involvement in Turkey given that the country has had to implement some 18 IMF programs since 1958! But the IMF can also point to some notable accomplishments, including its success in containing the Asian crisis, which could have rocked the global international monetary system to its core, and its actions in 2008–2010 to contain the global financial crisis, quickly stepping in to rescue Iceland, Ireland, Greece, and Latvia. Similarly, many observers give the IMF credit for its deft handling of politically difficult situa- tions, such as the Mexican peso crisis, and for successfully promoting a free market philosophy.

Several years after the IMF’s intervention, the Asian economy of Asia recovered. Cer- tainly they all averted the kind of catastrophic implosion that might have occurred had the IMF not stepped in, and although some countries still faced considerable problems, it is not clear that the IMF should take much blame for this. The IMF cannot force countries to adopt the policies required to correct economic mismanagement. While a government may commit to taking corrective action in return for an IMF loan, internal political problems may make it difficult for a government to act on that commitment. In such cases, the IMF is caught between a rock and a hard place, because if it decided to withhold money, it might trigger financial collapse and the kind of contagion that it seeks to avoid.

Finally, it is notable that in recent years the IMF has started to change its policies. In re- sponse to the global financial crisis of 2008–2009, the IMF began to urge countries to adopt policies that included fiscal stimulus and monetary easing—the direct opposite of what the fund traditionally advocated. Some economists in the fund are also now arguing that higher inflation rates might be a good thing, if the consequence is greater growth in aggregate de- mand, which would help pull nations out of recessionary conditions. The IMF, in other words, is starting to display the very flexibility in policy responses that its critics claim it lacks. While the traditional policy of tight controls on fiscal policy and tight monetary policy tar- gets might be appropriate for countries suffering from high inflation rates, the Asian eco- nomic crisis and the 2008–2009 global financial crisis were caused not by high inflation rates but by excessive debt, and the IMF’s “new approach” seems tailored to deal with this.17

FOCUS ON MANAGERIAL IMPLICATIONS

CURRENCY MANAGEMENT, BUSINESS STRATEGY, AND GOVERNMENT RELATIONS The implications for international businesses of the material discussed in this chapter fall into three main areas: currency management, business strategy, and corporate–government relations.

CURRENCY MANAGEMENT An obvious implication with regard to currency management is that companies must recog- nize that the foreign exchange market does not work quite as depicted in Chapter 10. The

LO 11-6 Explain the implications of the global monetary system for currency management and business strategy.

330 Part Four The Global Monetary System

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current system is a mixed system in which a combination of government intervention and speculative activity can drive the foreign exchange market. Companies engaged in signifi- cant foreign exchange activities need to be aware of this and to adjust their foreign exchange transactions accordingly. For example, the currency management unit of Caterpillar claims it made millions of dollars in the hours following the announcement of the Plaza Accord by selling dollars and buying currencies that it expected to appreciate on the foreign exchange market following government intervention.

Under the present system, speculative buying and selling of currencies can create very volatile movements in exchange rates (as exhibited by the rise and fall of the dollar during the 1980s and the Asian currency crisis of the late 1990s). Contrary to the predictions of the purchasing power parity theory (see Chapter 10), exchange rate movements during the 1980s and 1990s often did not seem to be strongly influenced by relative inflation rates. Insofar as volatile exchange rates increase foreign exchange risk, this is not good news for business. On the other hand, as we saw in Chapter 10, the foreign exchange market has de- veloped a number of instruments, such as the forward market and swaps, that can help en- sure against foreign exchange risk. Not surprisingly, use of these instruments has increased markedly since the breakdown of the Bretton Woods system in 1973.

BUSINESS STRATEGY The volatility of the current global exchange rate regime presents a conundrum for interna- tional businesses. Exchange rate movements are difficult to predict, and yet their movement can have a major impact on a business’s competitive position. For a detailed example, see the accompanying Management Focus on Airbus. Faced with uncertainty about the future value of currencies, firms can utilize the forward exchange market, which Airbus has done. How- ever, the forward exchange market is far from perfect as a predictor of future exchange rates (see Chapter 10). It is also difficult if not impossible to get adequate insurance coverage for exchange rate changes that might occur several years in the future. The forward market tends to offer coverage for exchange rate changes a few months—not years—ahead. Given this, it makes sense to pursue strategies that will increase the company’s strategic flexibility in the face of unpredictable exchange rate movements—that is, to pursue strategies that re- duce the economic exposure of the firm (which we first discussed in Chapter 10).

Maintaining strategic flexibility can take the form of dispersing production to different loca- tions around the globe as a real hedge against currency fluctuations (this seems to be what Air- bus has considered). Consider the case of Daimler-Benz, Germany’s export-oriented automobile and aerospace company. In June 1995, the company stunned the German business community when it announced it expected to post a severe loss in 1995 of about $720 million. The cause was Germany’s strong currency, which had appreciated by 4 percent against a basket of major currencies since the beginning of 1995 and had risen by more than 30 percent against the U.S. dollar since late 1994. By mid-1995, the exchange rate against the dollar stood at $1 5 DM1.38. Daimler’s management believed it could not make money with an exchange rate under $1 5 DM1.60. Daimler’s senior managers concluded the appreciation of the mark against the dollar was probably permanent, so they decided to move substantial production outside of Germany and increase purchasing of foreign components. The idea was to reduce the vulnera- bility of the company to future exchange rate movements. Even before the company’s acquisition of Chrysler Corporation in 1998, the Mercedes-Benz division planned to produce 10 percent of its cars outside Germany by 2000, mostly in the United States. Similarly, the move by Japanese automobile companies to expand their productive capacity in the United States and Europe can be seen in the context of the increase in the value of the yen between 1985 and 1995, which raised the price of Japanese exports. For the Japanese companies, building production capacity overseas was a hedge against continued appreciation of the yen (as well as against trade barriers).

Another way of building strategic flexibility and reducing economic exposure involves contracting out manufacturing. This allows a company to shift suppliers from country to country in response to changes in relative costs brought about by exchange rate movements. However, this kind of strategy may work only for low-value-added manufacturing (e.g., tex- tiles), in which the individual manufacturers have few if any firm-specific skills that contribute to the value of the product. It may be less appropriate for high-value-added manufacturing,

Chapter Eleven The International Monetary System 331

Airbus and the Euro

Airbus had reason to celebrate in 2003; for the first time in the compa- ny’s history, it delivered more commercial jet aircraft than long-time rival Boeing. Airbus delivered 305 planes in 2003, compared to Boeing’s 281. The celebration, however, was muted, because the strength of the euro against the U.S. dollar was casting a cloud over the company’s future. Airbus, which is based in Toulouse, France, prices planes in dol- lars, just as Boeing has always done. But more than half of Airbus’s costs are in euros. So as the dollar drops in value against the euro—and it dropped by more than 50 percent between 2002 and the end of 2009—Airbus’s costs rise in proportion to its revenue, squeezing profits in the process.

In the short run, the fall in the value of the dollar against the euro did not hurt Airbus. The company fully hedged its dollar exposure in 2005 and was mostly hedged for 2006. However, anticipating that the dollar would stay weak against the euro, Airbus started to take other steps to reduce its economic exposure to a strong European currency. Recognizing that raising prices is not an option given the strong com- petition from Boeing, Airbus decided to focus on reducing its costs. As a step toward doing this, Airbus is giving U.S. suppliers a greater share of work on new aircraft models, such as the A380 superjumbo and the A350. It is also shifting supply work on some of its older models from European to American-based suppliers. This will increase the propor- tion of its costs that are in dollars, making profits less vulnerable to a rise in the value of the euro and reducing the costs of building an air- craft when they are converted back into euros.

In addition, Airbus is pushing its European-based suppliers to start pricing in U.S. dollars. Because the costs of many suppliers are in euros, the suppliers are finding that to comply with Airbus’s wishes, they too have to move more work to the United States, or to countries whose

currency is pegged to the U.S. dollar. Thus, one large French-based supplier, Zodiac, has announced that it was considering acquisitions in the United States. Not only is Airbus pushing suppliers to price compo- nents for commercial jet aircraft in dollars, but the company is also re- quiring suppliers to its A400M program, a military aircraft that will be sold to European governments and priced in euros, to price components in U.S. dollars. Beyond these steps, the CEO of EADS, Airbus’s parent company, has publicly stated it might be prepared to assemble aircraft in the United States if that helps win important U.S. contracts.

Sources: D. Michaels, “Airbus Deliveries Top Boeing’s; but Several Obstacles Remain,” The Wall Street Journal, January 16, 2004, p. A9; J. L. Gerondeau, “Airbus Eyes U.S. Suppliers as Euro Gains,” Seattle Times, February 21, 2004, p. C4; “Euro’s Gains Create Worries in Europe,” Houston Chronicle.com, January 13, 2004, p. 3; and K. Done, “Soft Dollar and A380 Hitches Lead to EADS Losses,” Financial Times, November 9, 2006, p. 32.

management FOCUS

in which firm-specific technology and skills add significant value to the product (e.g., the heavy equipment industry) and in which switching costs are correspondingly high. For high- value-added manufacturing, switching suppliers will lead to a reduction in the value that is added, which may offset any cost gains arising from exchange rate fluctuations.

The roles of the IMF and the World Bank in the current international monetary system also have implications for business strategy. Increasingly, the IMF has been acting as the macroeconomic police of the world economy, insisting that countries seeking significant borrowings adopt IMF-mandated macroeconomic policies. These policies typically include anti-inflationary monetary policies and reductions in government spending. In the short run, such policies usually result in a sharp contraction of demand. International businesses selling or producing in such countries need to be aware of this and plan accordingly. In the long run, the kind of policies imposed by the IMF can promote economic growth and an expansion of demand, which create opportunities for international business.

CORPORATE–GOVERNMENT RELATIONS As major players in the international trade and investment environment, businesses can influ- ence government policy toward the international monetary system. For example, intense gov- ernment lobbying by U.S. exporters helped convince the U.S. government that intervention in the foreign exchange market was necessary. With this in mind, business can and should use its influence to promote an international monetary system that facilitates the growth of interna- tional trade and investment. Whether a fixed or floating regime is optimal is a subject for debate.

Wings are assembled at the Airbus SAS factory in Broughton, U.K. Completed wings are transported to Toulouse, France or Hamburg, Germany, for final assembly.

332 Part Four The Global Monetary System

Chapter Eleven The International Monetary System 333

However, exchange rate volatility such as the world experienced during the 1980s and 1990s creates an environment less conducive to international trade and investment than one with more stable exchange rates. Therefore, it would seem to be in the interests of international busi- ness to promote an international monetary system that minimizes volatile exchange rate move- ments, particularly when those movements are unrelated to long-run economic fundamentals.

international monetary system, p. 312 floating exchange rate, p. 312 pegged exchange rate, p. 312 dirty-float system, p. 312 fixed exchange rate, p. 312

European Monetary System (EMS), p. 313 gold standard, p. 313 gold par value, p. 314 balance-of-trade equilibrium, p. 314 managed-float system, p. 322

currency board, p. 325 currency crisis, p. 326 banking crisis, p. 326 foreign debt crisis, p. 326 moral hazard, p. 329

Key Terms

Summary

This chapter explained the workings of the international monetary system and pointed out its implications for inter- national business. The chapter made the following points:

1. The gold standard is a monetary standard that pegs currencies to gold and guarantees convertibility to gold. It was thought that the gold standard contained an automatic mechanism that contributed to the simultaneous achievement of a balance-of-payments equilibrium by all countries. The gold standard broke down during the 1930s as countries engaged in competitive devaluations.

2. The Bretton Woods system of fixed exchange rates was established in 1944. The U.S. dollar was the central currency of this system; the value of every other currency was pegged to its value. Significant exchange rate devaluations were allowed only with the permission of the IMF. The role of the IMF was to maintain order in the international monetary system (a) to avoid a repetition of the competitive devaluations of the 1930s and (b) to control price inflation by imposing monetary discipline on countries.

3. The fixed exchange rate system collapsed in 1973, primarily due to speculative pressure on the dollar following a rise in U.S. inflation and a growing U.S. balance-of-trade deficit.

4. Since 1973, the world has operated with a floating exchange rate regime, and exchange rates have become more volatile and far less predictable. Volatile exchange rate movements have helped reopen the debate over the merits of fixed and floating systems.

5. The case for a floating exchange rate regime claims (a) such a system gives countries autonomy regarding their monetary policy and (b) floating exchange rates facilitate smooth adjustment of trade imbalances.

6. The case for a fixed exchange rate regime claims (a) the need to maintain a fixed exchange rate imposes monetary discipline on a country; (b) floating exchange rate regimes are vulnerable to speculative pressure; (c) the uncertainty that accompanies floating exchange rates dampens the growth of international trade and investment; and (d) far from correcting trade imbalances, depreciating a currency on the foreign exchange market tends to cause price inflation.

7. In today’s international monetary system, some countries have adopted floating exchange rates; some have pegged their currency to another currency such as the U.S. dollar; and some have pegged their currency to a basket of other currencies, allowing their currency to fluctuate within a zone around the basket.

8. In the post–Bretton Woods era, the IMF has continued to play an important role in helping countries navigate their way through financial crises by lending significant capital to embattled governments and by requiring them to adopt certain macroeconomic policies.

9. An important debate is occurring over the appropriateness of IMF-mandated macroeconomic policies. Critics charge that the IMF often imposes inappropriate conditions on developing nations that are the recipients of its loans.

10. The current managed-float system of exchange rate determination has increased the importance of currency management in international businesses.

11. The volatility of exchange rates under the current managed-float system creates both opportunities and threats. One way of responding to this volatility is for companies to build strategic flexibility and limit their economic exposure by dispersing production to different locations around the globe by contracting out manufacturing (in the case of low-value-added manufacturing) and other means.

Critical Thinking and Discussion Questions

1. Why did the gold standard collapse? Is there a case for returning to some type of gold standard? What is it?

2. What opportunities might current IMF lending policies to developing nations create for international businesses? What threats might they create?

3. Do you think the standard IMF policy prescriptions of tight monetary policy and reduced government spending are always appropriate for developing nations experiencing a currency crisis? How might the IMF change its approach? What would the implications be for international businesses?

4. Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most important criteria in a choice between the systems? Which system is the more desirable for an international business?

5. Imagine that Canada, the United States, and Mexico decide to adopt a fixed exchange rate system. What would be the likely consequences of such a system for (a) international businesses and (b) the flow of trade and investment among the three countries?

6. Reread the Country Focus on the U.S. dollar, oil prices, and recycling petrodollars; then answer the following questions: a. What will happen to the value of the U.S. dollar

if oil producers decide to invest most of their earnings from oil sales in domestic infrastructure projects?

b. What factors determine the relative attractiveness of dollar-, euro-, and yen- denominated assets to oil producers flush with petrodollars? What might lead them to direct more funds toward non-dollar- denominated assets?

c. What will happen to the value of the U.S. dollar if OPEC members decide to invest more of their petrodollars toward non-dollar-denominated assets, such as euro-denominated stocks and bonds?

d. In addition to oil producers, China is also accumulating a large stock of dollars, currently estimated to total $1.4 trillion. What would happen to the value of the dollar if China and oil-producing nations all shifted out of dollar-denominated assets at the same time? What would be the consequence for the U.S. economy?

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

1. The Global Financial Stability Report is a semiannual report published by the International Capital Markets division of the International Monetary Fund (IMF). The report includes an assessment of the risks facing the global financial markets. Locate and download the latest report to get an overview of the most important issues currently under discussion. Also, download a report from five years ago. How do issues from five years ago compare with financial issues identified in the current report?

2. An important element to understanding the international monetary system is keeping updated on current growth trends worldwide. A German colleague told you yesterday that Deutsche Bank Research provides an effective way to stay informed on important topics in international finance from a European perspective. One area of focus for the site is emerging markets and economic and financial challenges faced by these markets. Find an emerging market research report for analysis. On which emerging market region did you choose to focus? What are the key takeaways from your chosen report?

Research Task http://globalEDGE.msu.edu

When the former World Bank economist Bingu wa Mutharika became president of the East African nation of Malawi in 2004, it seemed to be the beginning of a new age for one of the world’s poorest countries. In land- locked Malawi, most of the population subsists on less than a dollar a day. Mutharika was their champion. He introduced a subsidy program for fertilizer to help poor farmers and gave them seeds. Agricultural output expanded,

and the economy boomed, growing by 7 percent per year between 2005 and 2010. International donors loved him, and aid money started to pour in from the United Kingdom and the United States. By 2011, foreign aid was accounting for more than half of Malawi’s annual budget.

In 2009, to no one’s surprise, Mutharika was reelected president. Then things started to fall apart. Mutharika became increasingly dictatorial. He

ccccccllooooooosssssiinnnnnnggggggggggg ccccccaaaaasssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeCurrency Trouble in Malawi

334 Part Four The Global Monetary System

pushed aside the country’s central bankers and ministers to take full con- trol of economic policy. He called himself “Economist in Chief.” Critics at home were harassed and jailed. Independent newspapers were threat- ened. When a cable from the British ambassador describing Mutharika as “autocratic and intolerant of criticism” was leaked, he expelled the British ambassador. Britain responded by freezing aid worth $550 million over four years. When police in mid-2011 killed 20 antigovernment protestors, other aid donors withdrew their support, including most significantly the United States. Mutharika told the donors they could go to hell. To com- pound matters, tobacco sales, which usually accounted for 60 percent of foreign currency revenues, plunged on diminishing international demand and the decreasing quality of the local product, which had been hurt by a persistive drought.

By late 2011, Malawi was experiencing a full-blown foreign currency crisis. The International Monetary Fund urged Mutharika to devalue the kwacha, Malawi’s currency, to spur tobacco and tea exports. The kwacha was pegged to the U.S. dollar at 170 kwacha to the dollar. The IMF wanted Malawi to adopt an exchange rate of 280 kwacha to the dollar, which was closer to the black market exchange rate. Mutharika refused, arguing that this would cause price inflation and hurt Malawi’s poor. He also refused to meet with an IMF delegation, saying that the delegates were “too junior.” The IMF put a $79 million loan program it had with Malawi on hold, further exacerbating the foreign currency crisis. Malawi was in a tailspin.

In early April 2012, Mutharika had a massive heart attack. He was rushed to the hospital in the capital Lilongwe, but ironically, the medicines

that he needed were out of stock—the hospital lacked the foreign cur- rency to buy them! Mutharika died. Despite considerable opposition from Mutharika supporters who wanted his brother to succeed him, Joyce Banda, the vice president, was sworn in as president. Although no one has stated this publicly, it seems clear that intense diplomatic pressure from the United Kingdom and United States persuaded Mutharika’s supporters to relent. Once in power, Banda announced that Malawi would devalue the kwacha by 40 percent. For its part, the IMF unblocked its loan program, while foreign donors, including the UK and United States, stated that they would resume their programs.

Sources: P. McGroarty, “Currency Woes Curb Business in Malawi,” The Wall Street Journal, April 4, 2012; P. McGroarty, “Malawi Hopes New Leader Spurs Recovery,” The Wall Street Journal, April 8, 2012; J. Herskovitz, “Malawi Paid Price for Ego of Economist in Chief,” Reuters, April 16, 2012; and A. R. Martinez and F. Jomo, “Malawi to Devalue Kwacha 40% to Unlock Aid,” Bloomberg Businessweek, April 27, 2012.

CASE DISCUSSION QUESTIONS 1. What were the causes of Malawi’s currency troubles?

2. Why did Mutharika resist IMF calls for currency devaluation? If he had lived and remained in power, what do you think would have happened to the economy of Malawi assuming that he did not change his position?

3. Now that Malawi’s currency has been devalued, what do you think the economic consequences will be? Is this good for the economy?

Chapter Eleven The International Monetary System 335

Endnotes

1. The argument goes back to eighteenth-century philosopher David Hume. See D. Hume, “On the Balance of Trade,” re- printed in The Gold Standard in Theory and in History, ed. B. Eichengreen (London: Methuen, 1985).

2. R. Solomon, The International Monetary System, 1945–1981 (New York: Harper & Row, 1982).

3. International Monetary Fund, World Economic Outlook, 2005 (Washington, DC: IMF, May 2005).

4. For an extended discussion of the dollar exchange rate in the 1980s, see B. D. Pauls, “US Exchange Rate Policy: Bretton Woods to the Present,” Federal Reserve Bulletin, November 1990, pp. 891–908.

5. R. Miller, “Why the Dollar Is Giving Way,” BusinessWeek, December 6, 2004, pp. 36–37.

6. For a feel for the issues contained in this debate, see P. Krugman, Has the Adjustment Process Worked? (Washington, DC: Institute for International Economics, 1991); “Time to Tether Currencies,” The Economist, January 6, 1990, pp. 15–16; P. R. Krugman and M. Obstfeld, International Economics: The- ory and Policy (New York: HarperCollins, 1994); J. Shelton, Money Meltdown (New York: Free Press, 1994); and S. Edwards, “Exchange Rates and the Political Economy of Macroeconomic Discipline,” American Economic Review 86, no. 2 (May 1996), pp. 159–63.

7. The argument is made by several prominent economists, par- ticularly Stanford’s Robert McKinnon. See R. McKinnon,

“An International Standard for Monetary Stabilization,” Policy Analyses in International Economics 8 (1984). The details of this argument are beyond the scope of this book. For a relatively accessible exposition, see P. Krugman, The Age of Diminished Expectations (Cambridge, MA: MIT Press, 1990).

8. A. R. Ghosh and A. M. Gulde, “Does the Exchange Rate Regime Matter for Inflation and Growth?” Economic Issues, no. 2 (1997).

9. “The ABC of Currency Boards,” The Economist, November 1, 1997, p. 80.

10. International Monetary Fund, World Economic Outlook, 1998 (Washington, DC: IMF, 1998).

11. Ibid.

12. T. S. Shorrock, “Korea Starts Overhaul; IMF Aid Hits $55 Billion,” Journal of Commerce, December 8, 1997, p. 3A.

13. See J. Sachs, “Economic Transition and Exchange Rate Re- gime,” American Economic Review 86, no. 92 (May 1996), pp. 147–52; and J. Sachs, “Power unto Itself,” Financial Times, December 11, 1997, p. 11.

14. Sachs, “Power unto Itself.”

15. Martin Wolf, “Same Old IMF Medicine,” Financial Times, December 9, 1997, p. 12.

16. Sachs, “Power unto Itself.”

17. “New Fund, Old Fundamentals,” The Economist, May 2, 2009, p. 78.

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learning objectives

12-1 Explain the concept of strategy.

12-2 Recognize how firms can profit by expanding globally.

12-3 Understand how pressures for cost reductions and pressures for local responsiveness influence strategic choice.

12-4 Identify the different strategies for competing globally and their pros and cons.

12-5 Explain the pros and cons of using strategic alliances to support global strategies.

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opening case

W alk into an IKEA store anywhere in the world, and you would recognize it instantly. The warehouse-type stores all sell the same broad range of affordable home furnishings, kitchens, and accessories. Most of the products are instantly recognizable as IKEA merchandise, with their clean yet tasteful lines and functional design. The outside of the store will be wrapped in the blue and

yellow colors of the Swedish flag. The store itself will be laid out as a maze that requires customers to walk

through every department before they reach the checkout stations. Immediately before the checkout, there

is an in-store warehouse where customers can pick up the items they purchased. The furniture is all flat,

packed for ease of transportation, and requires assembly by the customer. If you look at the customers in

the store, you will see that many of them are in there 20s and 30s. IKEA sells to the same basic customer

set the world over: young upwardly mobile people who are looking for tasteful yet inexpensive “disposable”

furniture.

A global network of more than 1,050 suppliers based in 53 countries manufactures most of the 9,500 or

so products that IKEA sells. IKEA itself focuses on the design of products and works closely with suppliers to

bring down manufacturing costs. Developing a new product line can be a painstaking process that takes

years. IKEA’s designers will develop a prototype design—a small couch, for example—look at the price that

rivals charge for a similar piece, and then work with suppliers to figure out a way to cut prices by

40 percent without compromising on quality. IKEA also manufactures about 10 percent of what it sells in-

house and uses the knowledge gained to help its suppliers improve their productivity, thereby lowering

costs across the entire supply chain.

It’s a formula that has worked remarkably well. From its roots in Scandinavia, IKEA has grown to become

the largest furniture retailer in the world with almost 300 stores in 26 countries and revenues of more than

27 billion euros. IKEA is particularly strong in Europe, where it has 227 stores, but it also has around

50 stores in North America. Its strongest growth recently has been in China, where it had 17 stores in 2013,

and Russia, where it had 14 stores.

IKEA

The Strategy of International Business

–continued

338 Part Five The Strategy of International Business

Look a little closer, however, and you will see subtle differences between the IKEA

offerings in North America, Europe, and China. In North America, sizes are different to

reflect the American demand for bigger beds, furnishings, and kitchenware. This

adaptation to local tastes and preferences was the result of a painful learning experience

for IKEA. When the company first entered the United States in the late 1980s, it thought

that consumers would flock to their stores the same way that they had in western Europe.

At first they did, but they didn’t buy as much, and sales fell short of expectations. IKEA

discovered that its European-style sofas were not big enough, wardrobe drawers were

not deep enough, glasses were too small, and kitchens didn’t fit U.S. appliances. So the

company set about redesigning its offerings to better match American tastes and was

rewarded with accelerating sales growth.

Lesson learned, when IKEA entered China in the 2000s, it made adaptations to the

local market. The store layout reflects the layout of many Chinese apartments, where

most people live, and because many Chinese apartments have balconies, IKEA’s

Chinese stores include a balcony section. IKEA has also had to shift its locations in

China, where car ownership lags behind that in Europe and North America. In the

West, IKEA stores are located in suburban areas and have lots of parking space. In

China, stores are located near public transportation, and IKEA offers a delivery service

so that Chinese customers can get their purchases home. •

Sources: J. Leland, “How the Disposable Sofa Conquered America,” The New York Times Magazine, October 5, 2005, p. 45; “The Secret of IKEA’s Success,” The Economist, February 24, 2011; B. Torekull, Leading by Design: The IKEA Story (New York: Harper Collins, 1998); and P. M. Miller, “IKEA with Chinese Characteristics,” Chinese Business Review, July–August 2004, pp. 36–69.

Introduction The primary concern thus far in this book has been with aspects of the larger environment in which international businesses compete. As described in the preceding chapters, this environment has included the different political, economic, and cultural institutions found in nations; the international trade and investment framework; and the international mon- etary system. Now, our focus shifts from the environment to the firm itself and, in particu- lar, to the actions managers can take to compete more effectively as an international business. This chapter looks at how firms can increase their profitability by expanding their operations in foreign markets. We discuss the different strategies that firms pursue when competing internationally, consider the pros and cons of these strategies, and study the various factors that affect a firm’s choice of strategy. We also look at why firms often enter into strategic alliances with their global competitors, and we discuss the benefits, costs, and risks of strategic alliances.

The strategy of furniture retailer IKEA, which was discussed in the opening case, gives us a preview of some of the key issues discussed in this chapter. IKEA’s business-level strategy is to target young, upwardly mobile people and offer them affordable, tastefully designed, furniture and accessories. IKEA differentiates its offering by design. At the same time, the company does everything it can to lower the costs of the products it sells, thereby enabling it to underprice its rivals and still make good profits. IKEA developed its basic formula for competing in Scandinavia in the 1950s and 1960s. This formula, or business model, includes self-service warehouse-type stores, a maze-like store layout that funnels customers through every department and maximizes impulse purchases, the design of furniture so that it can be flat-packed, an in-store warehouse, and so on. IKEA initially expanded into other countries by using exactly the same segmentation strategy and retailing formula and selling the same set of products. We refer to such a standardized approach as a global strategy. One of its great

Chapter Twelve The Strategy of International Business 339

virtues is that it can help a company attain a low-cost position through the realization of economies of scale. However, as the opening case makes clear, while this worked in the west- ern European region, it did not work in North America where IKEA had to adapt its prod- uct design to the tastes and preferences of North American consumers. In other words, IKEA found that it needed to localize some of its offerings. As we shall see in this chapter, there is often a tension between the desire to standardize a product offering in order to attain low costs and the need to localize the offering to better match the tastes and prefer- ences of local consumers, which can make it more difficult to attain scale economies and raise costs.

Strategy and the Firm Before we discuss the strategies that managers in the multinational enterprise can pursue, we need to review some basic principles of strategy. A firm’s strategy can be defined as the actions that managers take to attain the goals of the firm. For most firms, the preeminent goal is to maximize the value of the firm for its owners, its shareholders (subject to the con- straint that this is done in a legal, ethical, and socially responsible manner—see Chapter 5 for details). To maximize the value of a firm, managers must pursue strategies that increase the profitability of the enterprise and its rate of profit growth over time (see Figure 12.1). Profitability can be measured in a number of ways, but for consistency, we shall define it as the rate of return that the firm makes on its invested capital (ROIC), which is calculated by dividing the net profits of the firm by total invested capital.1 Profit growth is measured by the percentage increase in net profits over time. In general, higher profitability and a higher rate of profit growth will increase the value of an enterprise and thus the returns garnered by its owners, the shareholders.2

Managers can increase the profitability of the firm by pursuing strategies that lower costs or by pursuing strategies that add value to the firm’s products, which enables the firm to raise prices. Managers can increase the rate at which the firm’s profits grow over time by pursuing strategies to sell more products in existing markets or by pursuing strategies to enter new markets. As we shall see, expanding internationally can help managers boost the firm’s profitability and increase the rate of profit growth over time.

VALUE CREATION The way to increase the profitability of a firm is to create more value. The amount of value a firm creates is measured by the difference between its

LO 12-1 Explain the concept of strategy.

Strategy Actions managers take to attain the firm’s goals.

Profitability A ratio or rate of return concept.

Profit Growth The percentage increase in net profits over time.

12.1 FIGURE Determinants of Enterprise Value

Sell more in existing markets

Add value and raise prices

Profitability

Profit growth

Enterprise valuation

Reduce costs

Enter new markets

340 Part Five The Strategy of International Business

costs of production and the value that consumers perceive in its products. In general, the more value customers place on a firm’s products, the higher the price the firm can charge for those products. However, the price a firm charges for a good or service is typically less than the value placed on that good or service by the customer. This is because the customer captures some of that value in the form of what economists call a consumer surplus.3 The customer is able to do this because the firm is competing with other firms for the cus- tomer’s business, so the firm must charge a lower price than it could were it a monopoly supplier. Also, it is normally impossible to segment the market to such a degree that the firm can charge each customer a price that reflects that individual’s assessment of the value of a product, which economists refer to as a customer’s reservation price. For these reasons, the price that gets charged tends to be less than the value placed on the product by many customers.

Figure 12.2 illustrates these concepts. The value of a product to an average consumer is V, the average price that the firm can charge a consumer for that product given competitive pressures and its ability to segment the market is P, and the average unit cost of producing that product is C (C comprises all relevant costs, including the firm’s cost of capital). The firm’s profit per unit sold (p) is equal to P 2 C, while the consumer surplus per unit is equal to V 2 P (another way of thinking of the consumer surplus is as “value for the money”; the greater the consumer surplus, the greater the value for the money the consumer gets). The firm makes a profit so long as P is greater than C, and its profit will be greater the lower C is relative to P. The difference between V and P is in part determined by the intensity of com- petitive pressure in the marketplace; the lower the intensity of competitive pressure, the higher the price charged relative to V.4 In general, the higher the firm’s profit per unit sold is, the greater its profitability will be, all else being equal.

The firm’s value creation is measured by the difference between V and C (V 2 C); a company creates value by converting inputs that cost C into a product on which consumers place a value of V. A company can create more value (V 2 C) either by lowering production costs, C, or by making the product more attractive through superior design, styling, func- tionality, features, reliability, after-sales service, and the like, so that consumers place a greater value on it (V increases) and, consequently, are willing to pay a higher price (P in- creases). This discussion suggests that a firm has high profits when it creates more value for its customers and does so at a lower cost. We refer to a strategy that focuses primarily on lowering production costs as a low-cost strategy. We refer to a strategy that focuses primarily on in- creasing the attractiveness of a product as a differentiation strategy.5 IKEA’s strategy is primar- ily about lowering costs, although you will note from the opening case that the company also tries to differentiate itself by design.

Michael Porter has argued that low cost and differentiation are two basic strategies for cre- ating value and attaining a competitive advantage in an industry.6 According to Porter, supe- rior profitability goes to those firms that can create superior value, and the way to create superior value is to drive down the cost structure of the business and/or differentiate the

Value Creation Performing activities that increase the value of goods or services to consumers.

12.2 FIGURE Value Creation

V P C

V – C

V – P

P – C

V = Value of product to an average customer P = Price per unit C = Cost of production per unit

V – P = Consumer surplus per unit P – C = Profit per unit sold V – C = Value created per unit

Chapter Twelve The Strategy of International Business 341

product in some way so that consumers value it more and are prepared to pay a premium price. Superior value creation relative to rivals does not necessarily require a firm to have the lowest cost structure in an industry, or to create the most valuable product in the eyes of consumers. However, it does require that the gap between value (V) and cost of production (C) be greater than the gap attained by competitors.

STRATEGIC POSITIONING Porter notes that it is important for a firm to be explicit about its choice of strategic emphasis with regard to value creation (differentiation) and low cost, and to configure its internal operations to support that strategic emphasis.7 Figure 12.3 illustrates his point. The convex curve in Figure 12.3 is what economists refer to as an efficiency frontier. The efficiency frontier shows all of the different positions that a firm can adopt with regard to adding value to the product (V) and low cost (C) assuming that its internal operations are configured efficiently to support a particular position (note that the horizontal axis in Figure 12.3 is reverse scaled—moving along the axis to the right im- plies lower costs). The efficiency frontier has a convex shape because of diminishing returns. Diminishing returns imply that when a firm already has significant value built into its prod- uct offering, increasing value by a relatively small amount requires significant additional costs. The converse also holds, when a firm already has a low-cost structure, it has to give up a lot of value in its product offering to get additional cost reductions.

Figure 12.3 plots three hotel firms with a global presence that cater to international travelers: Four Seasons, Marriott International, and Starwood (Starwood owns the Sheraton and Westin chains). Four Seasons positions itself as a luxury chain and emphasizes the value of its product offering, which drives up its costs of operations. Marriott and Starwood are positioned more in the middle of the market. Both emphasize sufficient value to attract international business travelers, but are not luxury chains like Four Seasons. In Figure 12.3, Four Seasons and Marriott are shown to be on the efficiency frontier, indicating that their internal operations are well configured to their strategy and run efficiently. Starwood is inside the frontier, indicating that its operations are not running as efficiently as they might be and that its costs are too high. This implies that Starwood is less profitable than Four Seasons and Marriott and that its managers must take steps to improve the company’s performance.

Porter emphasizes that it is very important for management to decide where the company wants to be positioned with regard to value (V) and cost (C), to configure operations accord- ingly, and to manage them efficiently to make sure the firm is operating on the efficiency

12.3 FIGURE Strategic Choice in the International Hotel Industry

Marriott

Strategic choices in this area not viable in international hotel industry

Low cost (C)High cost

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Efficiency frontier

Four Seasons

Starwood

342 Part Five The Strategy of International Business

frontier. However, not all positions on the efficiency frontier are viable. In the international hotel industry, for example, there might not be enough demand to support a chain that em- phasizes very low cost and strips all the value out of its product offering (see Figure 12.3). International travelers are relatively affluent and expect a degree of comfort (value) when they travel away from home.

A central tenet of the basic strategy paradigm is that to maximize its profitability, a firm must do three things: (1) pick a position on the efficiency frontier that is viable in the sense that there is enough demand to support that choice; (2) configure its internal operations, such as manufacturing, marketing, logistics, information systems, human resources, and so on, so that they support that position; and (3) make sure that the firm has the right organiza- tion structure in place to execute its strategy. The strategy, operations, and organization of the firm must all be consistent with each other if it is to attain a competitive advantage and garner supe- rior profitability. By operations we mean the different value creation activities a firm under- takes, which we shall review next.

OPERATIONS: THE FIRM AS A VALUE CHAIN The operations of a firm can be thought of as a value chain composed of a series of distinct value creation activi- ties, including production, marketing and sales, materials management, R&D, human re- sources, information systems, and the firm infrastructure. We can categorize these value creation activities, or operations, as primary activities and support activities (see Figure 12.4).8 As noted earlier, if a firm is to implement its strategy efficiently, and position itself on the efficiency frontier shown in Figure 12.3, it must manage these activities effectively and in a manner that is consistent with its strategy.

Primary Activities Primary activities have to do with the design, creation, and de- livery of the product; its marketing; and its support and after-sale service. Following nor- mal practice, in the value chain illustrated in Figure 12.4, the primary activities are divided into four functions: research and development, production, marketing and sales, and cus- tomer service.

Research and development (R&D) is concerned with the design of products and pro- duction processes. Although we think of R&D as being associated with the design of phys- ical products and production processes in manufacturing enterprises, many service companies also undertake R&D. For example, banks compete with each other by develop- ing new financial products and new ways of delivering those products to customers. Online banking and smart debit cards are two examples of product development in the banking industry. Earlier examples of innovation in the banking industry included automated teller machines, credit cards, and debit cards. Through superior product design, R&D can

Operations The various value creation activities a firm undertakes.

12.4 FIGURE The Value Chain

Primary activities

R&D

Company infrastructure

Support activities

Information systems Logistics Human resources

Production Marketing

and sales

Customer service

Chapter Twelve The Strategy of International Business 343

increase the functionality of products, which makes them more attractive to consumers (raising V). Alternatively, R&D may result in more efficient production processes, thereby cutting production costs (lowering C). Either way, the R&D function can create value.

Production is concerned with the creation of a good or service. For physical products, when we talk about production, we generally mean manufacturing. Thus, we can talk about the production of an automobile. For services such as banking or health care, “produc- tion” typically occurs when the service is delivered to the customer (e.g., when a bank originates a loan for a customer it is engaged in “production” of the loan). For a retailer such as Walmart, “produc- tion” is concerned with selecting the merchandise, stocking the store, and ringing up the sale at the cash register. For MTV, production is concerned with the creation, programming, and broadcasting of content, such as music videos and thematic shows. The production activity of a firm creates value by performing its activities efficiently so lower costs result (lower C) and/or by performing them in such a way that a higher- quality product is produced (which results in higher V).

The marketing and sales functions of a firm can help to create value in several ways. Through brand positioning and advertising, the marketing function can increase the value (V) that consumers perceive to be contained in a firm’s product. If these create a favorable impression of the firm’s product in the minds of consumers, they increase the price that can be charged for the firm’s product. For example, Ford produced a high-value version of its Ford Expedition SUV. Sold as the Lincoln Navigator and priced around $10,000 higher, the Navigator has the same body, engine, chassis, and design as the Expedition, but through skilled advertising and marketing, supported by some fairly minor features changes (e.g., more accessories and the addition of a Lincoln-style engine grille and nameplate), Ford has fostered the perception that the Navigator is a “luxury SUV.” This marketing strategy has increased the perceived value (V) of the Navigator relative to the Expedition and enables Ford to charge a higher price for the car (P).

Marketing and sales can also create value by discovering consumer needs and commu- nicating them back to the R&D function of the company, which can then design products that better match those needs. For example, the allocation of research budgets at Pfizer, the world’s largest pharmaceutical company, is determined by the marketing function’s assessment of the potential market size associated with solving unmet medical needs. Thus, Pfizer is currently directing significant monies to R&D efforts aimed at finding treatments for Alzheimer’s disease, principally because marketing has identified the treat- ment of Alzheimer’s as a major unmet medical need in nations around the world where the population is aging.

The role of the enterprise’s service activity is to provide after-sale service and support. This function can create a perception of superior value (V) in the minds of consumers by solving customer problems and supporting customers after they have purchased the prod- uct. Caterpillar, the U.S.-based manufacturer of heavy earthmoving equipment, can get spare parts to any point in the world within 24 hours, thereby minimizing the amount of downtime its customers have to suffer if their Caterpillar equipment malfunctions. This is an extremely valuable capability in an industry where downtime is very expensive. It has helped to increase the value that customers associate with Caterpillar products and thus the price that Caterpillar can charge.

Support Activities The support activities of the value chain provide inputs that allow the primary activities to occur (see Figure 12.4). In terms of attaining a competitive advan- tage, support activities can be as important as, if not more important than, the primary ac- tivities of the firm. Consider information systems; these systems refer to the electronic systems for managing inventory, tracking sales, pricing products, selling products, dealing with customer service inquiries, and so on. Information systems, when coupled with the communications features of the Internet, can alter the efficiency and effectiveness with

A Caterpillar motor factory in Germany helps to ensure product after-sales and service outside the U.S.

344 Part Five The Strategy of International Business

which a firm manages its other value creation activities. Dell, for example, has used its infor- mation systems to attain a competitive advantage over rivals. When customers place an or- der for a Dell product over the firm’s website, that information is immediately transmitted, via the Internet, to suppliers, who then configure their production schedules to produce and ship that product so that it arrives at the right assembly plant at the right time. These sys- tems have reduced the amount of inventory that Dell holds at assembly plants to under two days, which is a major source of cost savings.

The logistics function controls the transmission of physical materials through the value chain, from procurement through production and into distribution. The efficiency with which this is carried out can significantly reduce cost (lower C), thereby creating more value. The combination of logistics systems and information systems is a particularly potent source of cost savings in many enterprises, such as Dell, where information systems tell Dell on a real-time basis where in its global logistics network parts are, when they will arrive at an as- sembly plant, and thus how production should be scheduled.

The human resource function can help create more value in a number of ways. It ensures that the company has the right mix of skilled people to perform its value creation activities

effectively. The human resource function also ensures that people are adequately trained, motivated, and compen- sated to perform their value creation tasks. In a multina- tional enterprise, one of the things human resources can do to boost the competitive position of the firm is to take advantage of its transnational reach to identify, recruit, and develop a cadre of skilled managers, regardless of their nationality, who can be groomed to take on senior management positions. They can find the very best, wher- ever they are in the world. Indeed, the senior management ranks of many multinationals are becoming increasingly diverse, as managers from a variety of national back- grounds have ascended to senior leadership positions.

The final support activity is the company infrastruc- ture, or the context within which all the other value cre- ation activities occur. The infrastructure includes the organizational structure, control systems, and culture of the firm. Because top management can exert considerable influence in shaping these aspects of a firm, top manage- ment should also be viewed as part of the firm’s infrastruc- ture. Through strong leadership, top management can consciously shape the infrastructure of a firm and through that the performance of all its value creation activities.

globalEDGE Business Review

In Chapter 12, we are bringing you closer to running a globally oriented company based on the issues we have covered on country differences, global trade and investment environment, and the global money sys- tem. This is where many of you will “make your money” as strategic decision makers in corporations. This also means you need to know what is current, important, and strategic in the global marketplace; your company’s products or services; and your company’s uniqueness in satisfying the needs and wants of customers. The globalEDGE Business Review (gBR) is a leading source for cutting-edge global busi- ness knowledge with a main target audience of business executives

(globaledge.msu.edu/gbr). Note that gBR complements the overall glo- balEDGE site content by publishing cutting-edge articles dealing with a variety of international business issues facing managers in different world areas, industries, and management functions. With millions of visitors to the site and some 30,000 subscribers, gBR reaches farther and has more impact and visibility than any business journal in interna- tional business. One gBR article is titled “From Domestic to Interna- tional to Global Sourcing.” Based on this article, how much should a company engage in “international/global purchasing activities” versus “domestic purchasing only” to best operate a global strategy?

Is Education Creating Value for You? The concept of a value chain can be used to examine the role your education plays in your life plans, if you look closely at your personal development plans (education, internship, work, physi- cal and emotional fitness, and extracurricular activities) and think about them in terms of primary and support activities. If we use the logic that the amount of value you receive from your education is the difference between the costs (e.g., tuition, time, lost income) and what you receive in the form of education (e.g., knowledge, tools, networks), how does your choice of major area of focus in your education fit into your personal develop- ment strategy? How do your choices of how you spend your time fit into your value chain? Do you ever spend time doing things that do not support the strategic goals of your personal value chain? But, most importantly, what is the one thing you should do more of to drive the value higher for yourself today and in the future?

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Organization: The Implementation of Strategy The strategy of a firm is implemented through its organization. For a firm to have superior ROIC, its organization must support its strategy and operations. The term organization architecture can be used to refer to the totality of a firm’s organization, including formal organizational structure, control systems and incentives, organizational culture, processes, and people.9 Figure 12.5 illustrates these different elements. By organizational structure, we mean three things: first, the formal division of the organization into subunits such as product divisions, national operations, and functions (most organizational charts display this aspect of struc- ture); second, the location of decision-making responsibilities within that structure (e.g., centralized or decentralized); and third, the establishment of integrating mechanisms to coordinate the activities of subunits including cross functional teams and or pan-regional committees.

Controls are the metrics used to measure the performance of subunits and make judg- ments about how well managers are running those subunits. Incentives are the devices used to reward appropriate managerial behavior. Incentives are very closely tied to performance metrics. For example, the incentives of a manager in charge of a national operating subsid- iary might be linked to the performance of that company. Specifically, she might receive a bonus if her subsidiary exceeds its performance targets.

Processes are the manner in which decisions are made and work is performed within the organization. Examples are the processes for formulating strategy, for deciding how to allocate resources within a firm, or for evaluating the performance of managers and giving feedback. Processes are conceptually distinct from the location of decision-making responsibilities within an organization, although both involve decisions. While the CEO might have ultimate responsibility for deciding what the strategy of the firm should be (i.e., the decision-making responsibility is centralized), the process he or she uses to make that decision might include the solicitation of ideas and criticism from lower-level managers.

Organizational culture is the norms and value systems that are shared among the em- ployees of an organization. Just as societies have cultures (see Chapter 4 for details), so do organizations. Organizations are societies of individuals who come together to perform col- lective tasks. They have their own distinctive patterns of culture and subculture.10 As we shall see, organizational culture can have a profound impact on how a firm performs. Finally, by people we mean not just the employees of the organization, but also the strategy used to recruit, compensate, and retain those individuals and the type of people that they are in terms of their skills, values, and orientation (discussed in depth in Chapter 17).

As illustrated by the arrows in Figure 12.5, the various components of an organization’s architecture are not independent of each other: Each component shapes, and is shaped by,

Organization Architecture The totality of a firm’s organization, including formal organizational structure, control systems and incentives, organizational culture, processes, and people.

Organizational Structure The three-part structure of an organization, including its formal division into subunits such as product divisions, its location of decision-making responsibilities within that structure, and the establishment of integrating mechanisms to coordinate the activities of all subunits.

Controls The metrics used to measure the performance of subunits and make judgments about how well managers are running those subunits.

Incentives The devices used to reward appropriate managerial behavior.

Processes The manner in which decisions are made and work is performed within any organization.

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

People The employees of the organization, the strategy used to recruit, compensate, and retain those individuals and the type of people that they are in terms of their skills, values, and orientation.

12.5 FIGURE Organization Architecture

Processes Incentives and controls

Culture

People

Structure

346 Part Five The Strategy of International Business

other components of architecture. An obvious example is the strategy regarding people. This can be used proactively to hire individuals whose internal values are consistent with those that the firm wishes to emphasize in its organization culture. Thus, the people compo- nent of architecture can be used to reinforce (or not) the prevailing culture of the organiza- tion. If a firm is going to maximize its profitability, it must pay close attention to achieving internal consistency among the various components of its architecture, and the architecture must support the strategy and operations of the firm.

In Sum: Strategic Fit In sum, as we have repeatedly stressed, for a firm to attain superior performance and earn a high return on capital, its strategy (as captured by its de- sired strategic position on the efficiency frontier) must make sense given market conditions (there must be sufficient demand to support that strategic choice). The operations of the firm must be configured in a way that supports the strategy of the firm, and the organiza- tion architecture of the firm must match the operations and strategy of the firm. In other words, as illustrated in Figure 12.6, market conditions, strategy, operations, and organiza- tion must all be consistent with each other, or fit each other, for superior performance to be attained.

Of course, the issue is more complex than illustrated in Figure 12.6. For example, the firm can influence market conditions through its choice of strategy—it can create demand by leveraging core skills to create new market opportunities. In addition, shifts in market conditions caused by new technologies, government action such as deregulation, demo- graphics, or social trends can mean that the strategy of the firm no longer fits the market. In such circumstances, the firm must change its strategy, operations, and organization to fit the new reality—which can be an extraordinarily difficult challenge. And last but by no means least, international expansion adds another layer of complexity to the strategic challenges facing the firm. We shall now consider this.

Global Expansion, Profitability, and Profit Growth Expanding globally allows firms to increase their profitability and rate of profit growth in ways not available to purely domestic enterprises.11 Firms that operate internationally are able to:

1. Expand the market for their domestic product offerings by selling those products in international markets.

LO 12-2 Recognize how firms can profit by expanding globally.

12.6 FIGURE Strategic Fit

Strategy

Operations strategy

Organization architecture

Su pp

or ts

Supports

Fits Market conditions

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.

Chapter Twelve The Strategy of International Business 347

2. Realize location economies by dispersing individual value creation activities to those locations around the globe where they can be performed most efficiently and effectively.

3. Realize greater cost economies from experience effects by serving an expanded global market from a central location, thereby reducing the costs of value creation.

4. Earn a greater return by leveraging any valuable skills developed in foreign operations and transferring them to other entities within the firm’s global network of operations.

As we will see, however, a firm’s ability to increase its profitability and profit growth by pursuing these strategies is constrained by the need to customize its product offering, mar- keting strategy, and business strategy to differing national or regional conditions—that is, by the imperative of localization.

EXPANDING THE MARKET: LEVERAGING PRODUCTS AND COMPETENCIES A company can increase its growth rate by taking goods or ser- vices developed at home and selling them internationally. Almost all multinationals started out doing just this. For example, Procter & Gamble developed most of its best-selling prod- ucts (such as Pampers disposable diapers and Ivory soap) in the United States and subse- quently sold them around the world. Likewise, although Microsoft developed its software in the United States, from its earliest days the company has always focused on selling that software in international markets. Automobile companies such as Volkswagen and Toyota also grew by developing products at home and then selling them in international markets. The returns from such a strategy are likely to be greater if indigenous competitors in the nations that a company enters lack comparable products. Thus, Toyota increased its profits by entering the large automobile markets of North America and Europe, offering products that were different from those offered by local rivals (Ford and GM) by their superior qual- ity and reliability.

The success of many multinational companies that expand in this manner is based not just upon the goods or services that they sell in foreign nations, but also upon the core competencies that underlie the development, production, and marketing of those goods or services. The term core competence refers to skills within the firm that competitors cannot easily match or imitate.12 These skills may exist in any of the firm’s value creation activities—production, marketing, R&D, human resources, logistics, general manage- ment, and so on. Such skills are typically expressed in product offerings that other firms find difficult to match or imitate. Core competencies are the bedrock of a firm’s competi- tive advantage. They enable a firm to reduce the costs of value creation and/or to create perceived value in such a way that premium pricing is possible. For example, Toyota has a core competence in the production of cars. It is able to produce high-quality, well-designed cars at a lower delivered cost than any other firm in the world. The competencies that enable Toyota to do this seem to reside primarily in the firm’s production and logistics functions.13 Similarly, IKEA has a core competence in the design of stylish and affordable furniture that can be manufactured at a low cost and flat-packed, McDonald’s has a core competence in managing fast-food opera- tions (it seems to be one of the most skilled firms in the world in this industry), and Procter & Gamble has a core competence in de- veloping and marketing name-brand consumer products (it is one of the most skilled firms in the world in this business.

Because core competencies are, by definition, the source of a firm’s competitive advantage, the successful global expansion by manufacturing companies such as Toyota and P&G was based not just on leveraging products and selling them in foreign markets, but also on the transfer of core competencies to foreign markets where indigenous competitors lacked them. The same can be said of com- panies engaged in the service sectors of an economy, such as financial institutions, retailers like IKEA, restaurant chains, and hotels. Expanding the market for their services often means replicating their business model in foreign nations (albeit with some changes to

Core Competence Firm skills that competitors cannot easily match or imitate.

P&G’s core competency in marketing is evidenced in this photo of Olay men’s skin care products for sale in a Shanghai, China supermarket.

348 Part Five The Strategy of International Business

account for local differences, which we will discuss in more detail shortly). Firms like Star- bucks and IKEA, for example, expanded rapidly outside of their home markets the United States by taking the basic business model that they developed at home and using that as a blueprint for establishing international operations.

LOCATION ECONOMIES Earlier chapters revealed that countries differ along a range of dimensions—including the economic, political, legal, and cultural—and that these differences can either raise or lower the costs of doing business in a country. The theory of international trade also teaches that due to differences in factor costs, certain countries have a comparative advantage in the production of certain products. Japan might excel in the production of automobiles and consumer electronics; the United States in the production of computer software, pharmaceuticals, biotechnology products, and financial services; Swit- zerland in the production of precision instruments and pharmaceuticals; South Korea in the production of semiconductors; and Vietnam in the production of apparel.14

For a firm that is trying to survive in a competitive global market, this implies that trade barriers and transportation costs permitting, the firm will benefit by basing each value creation activity it performs at that location where economic, political, and cultural conditions— including relative factor costs—are most conducive to the performance of that activity. Thus, if the best designers for a product live in France, a firm should base its design opera- tions in France. If the most productive labor force for assembly operations is in Mexico, assembly operations should be based in Mexico. If the best marketers are in the United States, the marketing strategy should be formulated in the United States. And so on.

Firms that pursue such a strategy can realize what we refer to as location economies, which are the economies that arise from performing a value creation activity in the optimal location for that activity, wherever in the world that might be (transportation costs and trade barriers permitting). Locating a value creation activity in the optimal location for that activ- ity can have one of two effects. It can lower the costs of value creation and help the firm to achieve a low-cost position, and/or it can enable a firm to differentiate its product offering from those of competitors. In terms of Figure 12.2, it can lower C and/or increase V (which, in general, sup- ports higher pricing), both of which boost the profitability of the enterprise.

For an example of how this works in an international business, consider Clear Vision, a manufacturer and distributor of eyewear. Started by David Glassman, the firm now gener- ates annual gross revenues of more than $100 million. Not exactly small, but no corporate giant either, Clear Vision is a multinational firm with production facilities on three conti- nents and customers around the world. Clear Vision began its move toward becoming a multinational when its sales were still less than $20 million. At the time, the U.S. dollar was very strong, and this made U.S.-based manufacturing expensive. Low-priced imports were taking an ever-larger share of the U.S. eyewear market, and Clear Vision realized it could not survive unless it also began to import. Initially, the firm bought from independent over- seas manufacturers, primarily in Hong Kong. However, the firm became dissatisfied with these suppliers’ product quality and delivery. As Clear Vision’s volume of imports increased, Glassman decided the best way to guarantee quality and delivery was to set up Clear Vision’s own manufacturing operation overseas. Accordingly, Clear Vision found a Chinese partner, and together they opened a manufacturing facility in Hong Kong, with Clear Vision being the majority shareholder.

The choice of the Hong Kong location was influenced by its combination of low labor costs, a skilled workforce, and tax breaks given by the Hong Kong government. The firm’s objective at this point was to lower production costs by locating value creation activities at an appropriate location. After a few years, however, the increasing industrialization of Hong Kong and a growing labor shortage had pushed up wage rates to the extent that it was no longer a low-cost location. In response, Glassman and his Chinese partner moved part of their manufacturing to a plant in mainland China to take advantage of the lower wage rates there. Again, the goal was to lower production costs. The parts for eyewear frames manufac- tured at this plant are shipped to the Hong Kong factory for final assembly and then distrib- uted to markets in North and South America. The Hong Kong factory employs 80 people and the China plant between 300 and 400.

Location Economies Cost advantages from performing a value creation activity at the optimal location for that activity.

Chapter Twelve The Strategy of International Business 349

At the same time, Clear Vision was looking for opportunities to invest in foreign eyewear firms with reputations for fashionable design and high quality. Its objective was not to re- duce production costs but to launch a line of high-quality, differentiated, “designer” eye- wear. Clear Vision did not have the design capability in-house to support such a line, but Glassman knew that certain foreign manufacturers did. As a result, Clear Vision invested in factories in Japan, France, and Italy, holding a minority shareholding in each case. These factories now supply eyewear for Clear Vision’s Status Eye division, which markets high- priced designer eyewear.15

Thus, to deal with a threat from foreign competition, Clear Vision adopted a strategy intended to lower its cost structure (lower C): shifting its production from a high-cost loca- tion, the United States, to a low-cost location, first Hong Kong and later China. Then Clear Vision adopted a strategy intended to increase the perceived value of its product (increase V) so it could charge a premium price (P). Reasoning that premium pricing in eyewear depended on superior design, its strategy involved investing capital in French, Italian, and Japanese factories that had reputations for superior design. In sum, Clear Vi- sion’s strategies included some actions intended to reduce its costs of creating value and other actions intended to add perceived value to its product through differentiation. The overall goal was to increase the value created by Clear Vision and thus the profitability of the enterprise. To the extent that these strategies were successful, the firm should have at- tained a higher profit margin and greater profitability than if it had remained a U.S.-based manufacturer of eyewear.

Creating a Global Web Generalizing from the Clear Vision example, one result of this kind of thinking is the creation of a global web of value creation activities, with differ- ent stages of the value chain being dispersed to those locations around the globe where perceived value is maximized or where the costs of value creation are minimized.16 Consider Lenovo’s ThinkPad laptop computers (Lenovo is the Chinese computer company that pur- chased IBM’s personal computer operations in 2005).17 This product is designed in the United States by engineers because Lenovo believes that the United States is the best loca- tion in the world to do the basic design work. The case, keyboard, and hard drive are made in Thailand; the display screen and memory in South Korea; the built-in wireless card in Malaysia; and the microprocessor in the United States. In each case, these components are manufactured and sourced from the optimal location given current factor costs. These com- ponents are then shipped to an assembly operation in China, where the product is assembled before being shipped to the United States for final sale. Lenovo assembles the ThinkPad in Mexico because managers have calculated that due to low labor costs, the costs of assembly can be minimized there. The marketing and sales strategy for North America is developed by Lenovo personnel in the United States, primarily because managers believe that due to their knowledge of the local marketplace, U.S. personnel add more value to the product through their marketing efforts than personnel based elsewhere.

In theory, a firm that realizes location economies by dispersing each of its value creation activities to its optimal location should have a competitive advantage vis-à-vis a firm that bases all of its value creation activities at a single location. It should be able to better differ- entiate its product offering (thereby raising perceived value, V) and lower its cost structure (C) than its single-location competitor. In a world where competitive pressures are increas- ing, such a strategy may become an imperative for survival.

Some Caveats Introducing transportation costs and trade barriers complicates this picture. Due to favorable factor endowments, New Zealand may have a comparative advan- tage for automobile assembly operations, but high transportation costs would make it an uneconomical location from which to serve global markets. Another caveat concerns the importance of assessing political and economic risks when making location decisions. Even if a country looks very attractive as a production location when measured against all the standard criteria, if its government is unstable or totalitarian, the firm might be advised not to base production there. (Political risk is discussed in Chapter 3.) Similarly, if the govern- ment appears to be pursuing inappropriate economic policies that could lead to foreign

Global Web When different stages of value chain are dispersed to those locations around the globe where value added is maximized or where costs of value creation are minimized.

350 Part Five The Strategy of International Business

exchange risk, that might be another reason for not basing production in that location, even if other factors look favorable.

EXPERIENCE EFFECTS The experience curve refers to systematic reductions in production costs that have been observed to occur over the life of a product.18 A num- ber of studies have observed that a product’s production costs decline by some quantity about each time cumulative output doubles. The relationship was first observed in the aircraft industry, where each time cumulative output of airframes was doubled, unit costs typically declined to 80 percent of their previous level.19 Thus, production cost for the fourth airframe would be 80 percent of production cost for the second airframe, the eighth airframe’s production costs 80 percent of the fourth’s, the sixteenth’s 80 percent of the eighth’s, and so on. Figure 12.7 illustrates this experience curve relationship between unit production costs and cumulative output (the relationship is for cumulative output over time, and not output in any one period, such as a year). Two things explain this: learning effects and economies of scale.

Learning Effects Learning effects refer to cost savings that come from learning by doing. Labor, for example, learns by repetition how to carry out a task, such as assembling airframes, most efficiently. Labor productivity increases over time as individuals learn the most efficient ways to perform particular tasks. Equally important in new production facili- ties, management typically learns how to manage the new operation more efficiently over time. Hence, production costs decline due to increasing labor productivity and management efficiency, which increases the firm’s profitability.

Learning effects tend to be more significant when a technologically complex task is re- peated because there is more that can be learned about the task. Thus, learning effects will be more significant in an assembly process involving 1,000 complex steps than in one of only 100 simple steps. No matter how complex the task, however, learning effects typically disappear after a while. It has been suggested that they are important only during the start- up period of a new process and that they cease after two or three years.20 Any decline in the experience curve after such a point is due to economies of scale.

Economies of Scale Economies of scale refer to the reductions in unit cost achieved by producing a large volume of a product. Attaining economies of scale lowers a firm’s unit costs and increases its profitability. Economies of scale have a number of sources. One is the ability to spread fixed costs over a large volume.21 Fixed costs are the costs re- quired to set up a production facility, develop a new product, and the like. They can be substantial. For example, the fixed cost of establishing a new production line to manufacture

Experience Curve Systematic production cost reductions that occur over the life of a product.

Learning Effects Cost savings from learning by doing.

Economies of Scale Cost advantages associated with large- scale production.

12.7 FIGURE The Experience Curve

Cumulative output Un

it co

st s B

Chapter Twelve The Strategy of International Business 351

semiconductor chips now exceeds $1 billion. Similarly, according to one estimate, develop- ing a new drug and bringing it to market costs about $800 million and takes about 12 years.22 The only way to recoup such high fixed costs may be to sell the product worldwide, which reduces average unit costs by spreading fixed costs over a larger volume. The more rapidly that cumulative sales volume is built up, the more rapidly fixed costs can be amortized over a large production volume, and the more rapidly unit costs will fall.

Second, a firm may not be able to attain an efficient scale of production unless it serves global markets. In the automobile industry, for example, an efficiently scaled factory is one designed to produce about 200,000 units a year. Automobile firms would prefer to produce a single model from each factory because this eliminates the costs associated with switching production from one model to another. If domestic demand for a particular model is only 100,000 units a year, the inability to attain a 200,000-unit output will drive up average unit costs. By serving international markets as well, however, the firm may be able to push pro- duction volume up to 200,000 units a year, thereby reaping greater scale economies, lower- ing unit costs, and boosting profitability. By serving domestic and international markets from its production facilities, a firm may be able to utilize those facilities more intensively. For example, if Intel sold microprocessors only in the United States, it might be able to keep its factories open for only one shift, five days a week. By serving international markets from the same factories, Intel can utilize its productive assets more intensively, which translates into higher capital productivity and greater profitability.

Finally, as global sales increase the size of the enterprise, its bargaining power with sup- pliers increases as well, which may allow it to attain economies of scale in purchasing, bar- gaining down the cost of key inputs and boosting profitability that way. For example, Walmart has used its enormous sales volume as a lever to bargain down the price it pays suppliers for merchandise sold through its stores.

Strategic Significance The strategic significance of the experience curve is clear. Moving down the experience curve allows a firm to reduce its cost of creating value (to lower C in Figure 12.2) and increase its profitability. The firm that moves down the experi- ence curve most rapidly will have a cost advantage vis-à-vis its competitors. Firm A in Figure 12.7, because it is farther down the experience curve, has a clear cost advantage over firm B.

Many of the underlying sources of experience-based cost economies are plant based. This is true for most learning effects as well as for the economies of scale derived by spreading the fixed costs of building productive capacity over a large output, attaining an efficient scale of output, and utilizing a plant more intensively. Thus, one key to pro- gressing downward on the experience curve as rapidly as possible is to increase the vol- ume produced by a single plant as rapidly as possible. Because global markets are larger than domestic markets, a firm that serves a global market from a single location is likely to build accumulated volume more quickly than a firm that serves only its home market or that serves multiple markets from multiple production locations. Thus, serving a global market from a single location is consistent with moving down the experience curve and establishing a low-cost position. In addition, to get down the experience curve rapidly, a firm may need to price and market aggressively so demand will expand rapidly. It will also need to build sufficient production capacity for serving a global market. Also, the cost advantages of serving the world market from a single location will be even more significant if that location is the optimal one for performing the particular value creation activity.

Once a firm has established a low-cost position, it can act as a barrier to new competition. Specifically, an established firm that is well down the experience curve, such as firm A in Figure 12.7, can price so that it is still making a profit while new entrants, which are farther up the curve, are suffering losses. Intel is one of the masters of this kind of strategy. The costs of building a state-of-the-art facility to manufacture microprocessors are so large (now around $5 billion) that to make this investment pay Intel must pursue experience curve effects, serving world markets from a limited number of plants to maximize the cost econo- mies that derive from scale and learning effects.

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LEVERAGING SUBSIDIARY SKILLS Implicit in our earlier discussion of core competencies is the idea that valuable skills are developed first at home and then trans- ferred to foreign operations. However, for more mature multinationals that have already established a network of subsidiary operations in foreign markets, the development of valu- able skills can just as well occur in foreign subsidiaries.23 Skills can be created anywhere within a multinational’s global network of operations, wherever people have the opportunity and incentive to try new ways of doing things. The creation of skills that help to lower the costs of production, or to enhance perceived value and support higher product pricing, is not the monopoly of the corporate center.

Leveraging the skills created within subsidiaries and applying them to other operations within the firm’s global network may create value. McDonald’s is increasingly finding that its foreign franchisees are a source of valuable new ideas. Faced with slow growth in France, its local franchisees began to experiment not only with the menu, but also with the layout and theme of restaurants. Gone are the ubiquitous golden arches; gone too are many of the utilitarian chairs and tables and other plastic features of the fast-food giant. Many McDonald’s restaurants in France now have hardwood floors, exposed brick walls, and even armchairs. The menu, too, has been changed to include premier sandwiches, such as chicken on focaccia bread, priced some 30 percent higher than the average hamburger. In France at least, the strategy seems to be working. Following the change, increases in same-store sales rose from 1 percent annually to 3.4 percent, and France is now the second largest national market for McDonald’s. Impressed with the impact, McDonald’s executives are considering similar changes at other McDonald’s restaurants in markets where same-store sales growth is slug- gish, including the United States.24

For the managers of the multinational enterprise, this phenomenon creates important new challenges. First, they must have the humility to recognize that valuable skills that lead to competencies can arise anywhere within the firm’s global network, not just at the corpo- rate center. Second, they must establish an incentive system that encourages local employees to acquire new skills. This is not as easy as it sounds. Creating new skills involves a degree of risk. Not all new skills add value. For every valuable idea created by a McDonald’s subsidiary in a foreign country, there may be several failures. The management of the multinational must install incentives that encourage employees to take the necessary risks. The company must reward people for successes and not sanction them unnecessarily for taking risks that did not pan out. Third, managers must have a process for identifying when valuable new skills have been created in a subsidiary. And finally, they need to act as facilitators, helping to transfer valuable skills within the firm.

PROFITABILITY AND PROFIT GROWTH SUMMARY We have seen how firms that expand globally can increase their profitability and profit growth by enter- ing new markets where indigenous competitors lack similar competencies, by lowering costs and adding value to their product offering through the attainment of location econ- omies, by exploiting experience curve effects, and by transferring valuable skills among their global network of subsidiaries. For completeness, it should be noted that strategies that increase profitability may also expand a firm’s business and thus enable it to attain a higher rate of profit growth. For example, by simultaneously realizing location economies and experience effects, a firm may be able to produce a more highly valued product at a lower unit cost, thereby boosting profitability. The increase in the perceived value of the product may also attract more customers, thereby growing revenues and profits as well. Furthermore, rather than raising prices to reflect the higher perceived value of the prod- uct, the firm’s managers may elect to hold prices low in order to increase global market share and attain greater scale economies (in other words, they may elect to offer consum- ers better “value for money”). Such a strategy could increase the firm’s rate of profit growth even further, because consumers will be attracted by prices that are low relative to value. The strategy might also increase profitability if the scale economies that result from market share gains are substantial. In sum, managers need to keep in mind the complex relationship between profitability and profit growth when making strategic decisions about pricing.

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Cost Pressures and Pressures for Local Responsiveness Firms that compete in the global marketplace typically face two types of competitive pres- sure that affect their ability to realize location economies and experience effects, and to le- verage products and transfer competencies and skills within the enterprise. They face pressures for cost reductions and pressures to be locally responsive (see Figure 12.8).25 These com- petitive pressures place conflicting demands on a firm. Responding to pressures for cost reductions requires that a firm try to minimize its unit costs. But responding to pressures to be locally responsive requires that a firm differentiate its product offering and marketing strategy from country to country (or in some cases region to region) in an effort to accom- modate the diverse demands arising from national (or regional) differences in consumer tastes and preferences, business practices, distribution channels, competitive conditions, and government policies. Because differentiation across countries can involve significant dupli- cation and a lack of product standardization, it may raise costs.

While some enterprises, such as firm A in Figure 12.8, face high pressures for cost reduc- tions and low pressures for local responsiveness, and others, such as firm B, face low pres- sures for cost reductions and high pressures for local responsiveness, many companies are in the position of firm C. They face high pressures for both cost reductions and local respon- siveness. Dealing with these conflicting and contradictory pressures is a difficult strategic challenge, primarily because being locally responsive tends to raise costs.

Pressures for Cost Reductions In competitive global markets, international businesses often face pressures for cost reduc- tions. Responding to pressures for cost reduction requires a firm to try to lower the costs of value creation. A manufacturer, for example, might mass-produce a standardized product at the optimal locations in the world, wherever that might be, to realize economies of scale, learning effects, and location economies. Alternatively, a firm might outsource certain func- tions to low-cost foreign suppliers in an attempt to reduce costs. Thus, many computer companies have outsourced their telephone-based customer service functions to India, where qualified technicians who speak English can be hired for a lower wage rate than in the United States. In the same manner, a retailer such as Walmart might push its suppliers (manufacturers) to do the same. (The pressure that Walmart has placed on its suppliers to

LO 12-3 Understand how pressures for cost reductions and pressures for local responsiveness influence strategic choice.

12.8 FIGURE Pressures for Cost Reductions and Local Responsiveness

Firm B

Firm A

Low

Lo w

Pressures for local responsiveness

Pr es

su re

s fo

r c os

t r ed

uc tio

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Hi gh Firm C

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354 Part Five The Strategy of International Business

reduce prices has been cited as a major cause of the trend among North American manufac- turers to shift production to China.26) A service business such as a bank might respond to cost pressures by moving some back-office functions, such as information processing, to developing nations where wage rates are lower.

Pressures for cost reduction can be particularly intense in industries producing commodity- type products where meaningful differentiation on nonprice factors is difficult and price is the main competitive weapon. This tends to be the case for products that serve universal needs. Universal needs exist when the tastes and preferences of consumers in different na- tions or regions are similar if not identical. This is the case for conventional commodity products such as bulk chemicals, petroleum, steel, sugar, and the like. It also tends to be the case for many industrial and consumer products—for example, smartphones, semiconductor chips, personal computers, and liquid crystal display screens. Pressures for cost reductions are also intense in industries where major competitors are based in low-cost locations, where there is persistent excess capacity, and where consumers are powerful and face low switching costs. The liberalization of the world trade and investment environment in recent decades, by facilitating greater international competition, has generally increased cost pressures.27

PRESSURES FOR LOCAL RESPONSIVENESS Pressures for local respon- siveness arise from national or regional differences in consumer tastes and preferences, infra- structure, accepted business practices, and distribution channels and from host-government demands. Responding to pressures to be locally responsive requires a firm to differentiate its products and marketing strategy from country to country, or region to region, to accommo- date these factors—all of which tends to raise the firm’s cost structure.

Differences in Customer Tastes and Preferences Strong pressures for local responsiveness emerge when customer tastes and preferences differ significantly among countries, as they often do for deeply embedded historic or cultural reasons. In such cases, a multinational’s products and marketing message have to be customized to appeal to the tastes and preferences of local customers. This typically creates pressure to delegate produc- tion and marketing responsibilities and functions to a firm’s overseas subsidiaries.

For example, the automobile industry in the 1990s moved toward the creation of “world cars.” The idea was that global companies such as General Motors, Ford, and Toyota would be able to sell the same basic vehicle the world over, sourcing it from centralized production locations. If successful, the strategy would have enabled automobile companies to reap sig- nificant gains from global scale economies. However, this strategy frequently ran aground upon the hard rocks of consumer reality. Consumers in different automobile markets seem to have different tastes and preferences, and they demand different types of vehicles. North American consumers show a strong demand for pickup trucks. This is particularly true in the South and West of the United States, where many families have a pickup truck as a sec- ond or third car. But in European countries, pickup trucks are seen purely as utility vehicles and are purchased primarily by firms rather than individuals. As a consequence, the product mix and marketing message needs to be tailored to consider the different nature of demand in North America and Europe.

Some have argued that customer demands for local customization are on the decline world- wide.28 According to this argument, modern communications and transport technologies have created the conditions for a convergence of the tastes and preferences of consumers from dif- ferent nations. The result is the emergence of enormous global markets for standardized con- sumer products. The worldwide acceptance of McDonald’s hamburgers, Coca-Cola, Gap clothes, Apple iPhones, and Microsoft’s Xbox—all of which are sold globally as standardized products—are often cited as evidence of the increasing homogeneity of the global marketplace.

However, this argument may not hold in many consumer goods markets. Significant dif- ferences in consumer tastes and preferences still exist across nations, regions, and cultures. Managers in international businesses do not yet have the luxury of being able to ignore these differences, and they may not for a long time to come. For an example of a company that has discovered how important pressures for local responsiveness can still be, read the accompanying Management Focus on MTV Networks.

Universal Needs Needs that are the same all over the world, such as steel, bulk chemicals, and industrial electronics.

Chapter Twelve The Strategy of International Business 355

Differences in Infrastructure and Traditional Practices Pressures for local responsiveness arise from differences in infrastructure or traditional practices among coun- tries, creating a need to customize products accordingly. Fulfilling this need may require the delegation of manufacturing and production functions to foreign subsidiaries. For example, in North America, consumer electrical systems are based on 110 volts, whereas in some European countries, 240-volt systems are standard. Thus, domestic electrical appliances have to be customized for this difference in infrastructure. Traditional practices also often vary across nations. For example, in Britain, people drive on the left-hand side of the road, creat- ing a demand for right-hand-drive cars, whereas in France (and the rest of Europe), people drive on the right-hand side of the road and therefore want left-hand-drive cars. Obviously, automobiles have to be customized to accommodate this difference in traditional practice.

Although many national and regional differences in infrastructure are rooted in history, some are quite recent. For example, in the wireless telecommunications industry, different tech- nical standards exist in different parts of the world. A technical standard known as GSM is com- mon in Europe, and an alternative standard, CDMA, is more common in the United States and parts of Asia. Equipment designed for GSM will not work on a CDMA network, and vice versa. Thus, companies in this industry—such as Apple, Nokia, Motorola, Samsung, and Ericsson— that manufacture smartphones or infrastructure such as switches need to customize their prod- uct offering according to the technical standard prevailing in a given country or region.

Differences in Distribution Channels A firm’s marketing strategies may have to be responsive to differences in distribution channels among countries, which may necessi- tate the delegation of marketing functions to national subsidiaries. In the pharmaceutical industry, for example, the British and Japanese distribution systems are radically different from the U.S. system. British and Japanese doctors will not accept or respond favorably to a U.S.-style high-pressure sales force. Thus, pharmaceutical companies have to adopt different marketing practices in Britain and Japan compared with the United States—soft sell versus hard sell. Similarly, Poland, Brazil, and Russia all have similar per capita income on a pur- chasing power parity basis, but there are big differences in distribution systems across the three countries. In Brazil, supermarkets account for 36 percent of food retailing, in Poland

Local Responsiveness at MTV Networks

MTV Networks has become a symbol of globalization. Established in 1981, the U.S.-based TV network has been expanding outside of its North American base since 1987 when it opened MTV Europe. Today, MTV Networks figures that every second of every day more than 2 million people are watching MTV around the world, the majority outside the United States. Despite its international success, MTV’s global expansion got off to a weak start. In the 1980s, when the main programming fare was still music videos, it piped a single feed across Europe almost entirely composed of American programming with English-speaking veejays. Naively, the network’s U.S. managers thought Europeans would flock to the American programming. But while viewers in Europe shared a common interest in a handful of global superstars, their tastes turned out to be surprisingly local. After losing share to local competitors, who focused more on local tastes, MTV changed its strategy in the 1990s. It broke its service into “feeds” aimed at national or regional markets. While MTV Net- works exercises creative control over these different feeds, and while all the channels have the same familiar frenetic look and feel of MTV

in the United States, a significant share of the programming and con- tent is now local.

Today, an increasing share of programming is local in conception. Although a lot of programming ideas still originate in the United States, with staples such as The Real World having equivalents in different countries, an increasing share of programming is local in conception. In Italy, MTV Kitchen combines cooking with a music countdown. Erotica airs in Brazil and features a panel of youngsters discussing sex. The Indian channel produces 21 homegrown shows hosted by local veejays who speak “Hinglish,” a city-bred version of Hindi and English. Many feeds still feature music videos by locally popular performers. This lo- calization push reaped big benefits for MTV, allowing the network to capture viewers back from local imitators.

Sources: M. Gunther, “MTV’s Passage to India,” Fortune, August 9, 2004, pp. 117–22; B. Pulley and A. Tanzer, “Sumner’s Gemstone,” Forbes, February 21, 2000, pp. 107–11; K. Hoffman, “Youth TV’s Old Hand Prepares for the Digital Challenge,” Financial Times, February 18, 2000, p. 8; presentation by Sumner M. Redstone, chairman and CEO, Viacom Inc., delivered to Salomon Smith Barney 11th Annual Global Entertainment Media, Telecommunications Conference, Scottsdale, AZ, January 8, 2001, archived at www. viacom.com; and Viacom 10K Statement, 2005.

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356 Part Five The Strategy of International Business

for 18 percent, and in Russia for less than 1 percent.29 These differences in channels require that companies adapt their own distribution and sales strategies.

Host-Government Demands Economic and political demands imposed by host- country governments may require local responsiveness. For example, pharmaceutical com- panies are subject to local clinical testing, registration procedures, and pricing restrictions—all of which make it necessary that the manufacturing and marketing of a drug should meet local requirements. Because governments and government agencies control a significant proportion of the health care budget in most countries, they are in a powerful position to demand a high level of local responsiveness.

More generally, threats of protectionism, economic nationalism, and local content rules (which require that a certain percentage of a product should be manufactured locally) dictate that international businesses manufacture locally. For example, consider Bombardier, the Canadian-based manufacturer of railcars, aircraft, jet boats, and snowmobiles. Bombardier has 12 railcar factories across Europe. Critics of the company argue that the resulting dupli- cation of manufacturing facilities leads to high costs and helps explain why Bombardier makes lower profit margins on its railcar operations than on its other business lines. In reply, managers at Bombardier argue that in Europe, informal rules with regard to local content favor people who use local workers. To sell railcars in Germany, they claim, you must manu- facture in Germany. The same goes for Belgium, Austria, and France. To try to address its cost structure in Europe, Bombardier has centralized its engineering and purchasing func- tions, but it has no plans to centralize manufacturing.30

The Rise of Regionalism Traditionally, we have tended to think of pressures for local responsiveness as being derived from national differences in tastes and preferences, infra- structure, and the like. While this is still often the case, there is also a tendency toward the convergence of tastes, preferences, infrastructure, distribution channels, and host-government demands with a broader region that is composed of two or more nations.31 We tend to see this when there are strong pressures for convergence due to, for example, a shared history and culture or the establishment of a trading block where there are deliberate attempts to harmonize trade policies, infrastructure, regulations, and the like.

The most obvious example of a region is the European Union, and particularly the euro zone countries within that trade block, where there are institutional forces that are pushing towards convergence (see Chapter 9 for details). The creation of a single EU market—with a single currency, common business regulations, standard infrastructure, and so on—cannot help but result in the reduction of certain national differences among countries within the EU and the creation of one regional rather than several national markets. Indeed, at the economic level at least, that is the explicit intent of the EU.

Another example of regional convergence is North America, which includes the United States, Canada, and to some extent in some product markets, Mexico. Canada and the United States share history, language, and much of their culture, and both are members of NAFTA. Mexico is clearly different in many regards, but its proximity to the United States, along with its membership in NAFTA, implies that for some product markets (e.g., automo- biles), it might be reasonable to consider Mexico as part of a relatively homogenous regional market. We might also talk about the Latin America region, where shared Spanish history, cultural heritage, and language (with the exception of Brazil, which was colonized by the Portuguese) means that national differences are somewhat moderated. It can also be argued that Greater China, which includes the city-states of Honk Kong and Singapore along with Taiwan, is a coherent region, as is much of the Middle East, where a strong Arab culture and shared history may limit national differences. Similarly, Russia and some of the former states of the Soviet Union, such as Belarus and the Ukraine, might be considered part of a larger regional market, at least for some products.

Taking a regional perspective is important because it may suggest that localization at the regional rather than the national level is the appropriate strategic response. For example, rather than produce cars for each national market within the Europe or North America, it makes far more sense for car manufacturers to build cars for the European or North American

Chapter Twelve The Strategy of International Business 357

regions. The ability to standardize product offering within a region allows for the attainment of greater scale economies, and hence lower costs, than if each nation had to have its own of- fering. At the same time, this perspective should not be pushed too far. There are still deep and profound cultural differences among the United Kingdom, France, Germany, and Italy—all members of the EU—that may in turn require some degree of local customization at the national level. Managers must thus make a judgment call about the appropriate level of aggre- gation given (1) the product market they are looking at and (2) the nature of national differ- ences and trends for regional convergence. What might make sense for automobiles, for example, might not be appropriate for packaged food products.

Choosing a Strategy Pressures for local responsiveness imply that it may not be possible for a firm to realize the full benefits from economies of scale, learning effects, and location economies. It may not be pos- sible to serve the global marketplace from a single low-cost location, producing a globally standardized product, and marketing it worldwide to attain the cost reductions associated with experience effects. The need to customize the product offering to local conditions, whether national or regional, may work against the implementation of such a strategy. For example, as noted automobile firms have found that Japanese, American, and European consumers de- mand different kinds of cars, and this necessitates producing products that are customized for regional markets. In response, firms such as Honda, Ford, and Toyota are pursuing a strategy of establishing top-to-bottom design and production facilities in each of these regions so that they can better serve local demands. Although such customization brings benefits, it also limits the ability of a firm to realize significant scale economies and location economies.

In addition, pressures for local responsiveness imply that it may not be possible to lever- age skills and products associated with a firm’s core competencies wholesale from one nation or region to another. Concessions often have to be made to local conditions. Despite being depicted as “poster boy” for the proliferation of standard- ized global products, even McDonald’s has found that it has to customize its product offerings (i.e., its menu) to account for national differences in tastes and preferences.

How do differences in the strength of pressures for cost reductions versus those for local responsiveness affect a firm’s choice of strategy? Firms typically choose among four main strategic postures when competing internationally. These can be characterized as a global standardization strategy, a localization strategy, a transnational strategy, and an interna- tional strategy.32 The appropriateness of each strategy varies given the extent of pressures for cost reductions and local responsiveness. Figure 12.9 illustrates the conditions under which each of these strategies is most appropriate.

GLOBAL STANDARDIZATION STRATEGY Firms that pursue a global standardization strategy focus on increasing profitability and profit growth by reaping the cost reductions that come from economies of scale, learning effects, and location economies; that is, their strategic goal is to pursue a low-cost strategy on a global scale. The produc- tion, marketing, and R&D activities of firms pursuing a global standardization strategy are concentrated in a few fa- vorable locations. Firms pursuing a global standardization strategy try not to customize their product offering and marketing strategy to local conditions because customiza- tion involves shorter production runs and the duplication of functions, which tends to raise costs. Instead, they prefer to market a standardized product worldwide so that they can

LO 12-4 Identify the different strategies for competing globally and their pros and cons.

Global Standardization Strategy A firm focuses on increasing profitability and profit growth by reaping the cost reductions that come from economies of scale, learning effects, and location economies.

More Customized Products in the Global Marketplace? The Coca-Cola Company’s (TCCC) Minute Maid Pulpy became the cola giant’s 14th brand to reach US$1 billion in global retail sales (in 2011). As opposed to cola carbonates, which often rely on global brand recognition and cross-generational formulas for suc- cess, Minute Maid Pulpy has relied on product development and innovations inspired by local flavors and textures. Minute Maid released Minute Maid Pulpy toward the end of 2004, which con- tained less than 24 percent actual fruit juice, but TCCC was able to retail the product at a much lower price point. In China and throughout the Asia-Pacific region, consumer notions of freshness and health are connected much more to the consumption of actual fruit. Minute Maid Pulpy acknowledged this by including pieces of fruit in the drink, thereby creating a thicker texture that would not appeal to most North American consumers but has proven very popular in this region of the world. In customizing the product, Minute Maid Pulpy went from the 10th most popular fruit/ vegetable juice brand in China in 2004 to 1st by the time it had achieved $1 billion in total sales in 2011. But isn’t the world be- coming more globalized? Do we still need large multinational cor- porations customizing their products to local markets?

Source: http://blog.euromonitor.com/2012/05/fl avours-and-textures-how-local- consumer-taste-palates-aredefi ning-global-soft-drinks.html.

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358 Part Five The Strategy of International Business

reap the maximum benefits from economies of scale and learning effects. They also tend to use their cost advantage to support aggressive pricing in world markets.

This strategy makes most sense when there are strong pressures for cost reductions and demands for local responsiveness are minimal. Increasingly, these conditions prevail in many industrial goods industries, whose products often serve universal needs. In the semiconductor industry, for example, global standards have emerged, creating enormous demands for stan- dardized global products. Accordingly, companies such as Intel, Texas Instruments, and Motorola all pursue a global standardization strategy. However, these conditions are not al- ways found in many consumer goods markets, where demands for local responsiveness can re- main high. The strategy is inappropriate when demands for local responsiveness are high. The experience of Vodafone, which is discussed in the accompanying Management Focus, illustrates what can happen when a global standardization strategy does not match market realities.

12.9 FIGURE Four Basic Strategies

Low

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es su

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ed uc

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Global standardization

strategy

International strategy

Transnational strategy

Localization strategy

Vodafone in Japan

In 2002, Vodafone Group of the United Kingdom, the world’s largest provider of wireless telephone service, made a big splash by paying $14 billion to acquire J-Phone, the number-three player in Japan’s fast-growing market for wireless communications services. J-Phone was considered a hot property, having just launched Japan’s first cell phones that were embedded with digital cameras, winning over large numbers of young people who wanted to e-mail photos to their friends. Four years later, after losing market share to local competitors, Vodafone sold J-Phone and took an $8.6 billion charge against earn- ings related to the sale. What went wrong?

According to analysts, Vodafone’s mistake was to focus too much on building a global brand and not enough on local market conditions in Japan. In the early 2000s, Vodafone’s vision was to offer consumers in different countries the same technology so that they could take their phones with them when they traveled across international borders. The problem, however, was that Japan’s most active cell phone users— many of them young people who don’t regularly travel abroad—care

far less about this capability than about game playing and other fea- tures that are embedded in their cell phones.

Vodafone’s emphasis on global services meant that it delayed its launch in Japan of phones that use 3G technology, which allowed us- ers to do things such as watch video clips and teleconference on their cell phones. The company, in line with its global branding ambitions, had decided to launch 3G cell phones that worked both inside and outside Japan. The delay was costly. Its Japanese competitors launched 3G phones a year ahead of Vodafone. Although these phones only worked in Japan, they rapidly gained share as consumers adopted these leading-edge devices. When Vodafone did finally introduce a 3G phone, design problems associated with making a phone that worked globally meant that the supply of phones was limited, and the launch fizzled despite strong product reviews, simply because consumers could not get the phones.

Sources: C. Bryan-Low, “Vodafone’s Global Ambitions Got Hung Up in Japan,” The Wall Street Journal, March 18, 2006, p. A1; and G. Parket, “Going Global Can Hit Snags Vodafone Finds,” The Wall Street Journal, June 16, 2004, p. B1.

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LOCALIZATION STRATEGY A localization strategy focuses on increasing profitability by customizing the firm’s goods or services so that they provide a good match to tastes and preferences in different national or regional markets. Localization is most ap- propriate when there are substantial differences across nations or regions with regard to consumer tastes and preferences and where cost pressures are not too intense. By custom- izing the product offering to local demands, the firm increases the value of that product in the local market. On the downside, because it involves some duplication of functions and smaller production runs, customization limits the ability of the firm to capture the cost re- ductions associated with mass-producing a standardized product for global consumption. The strategy may make sense, however, if the added value associated with local customiza- tion supports higher pricing, which enables the firm to recoup its higher costs, or if it leads to substantially greater local demand, enabling the firm to reduce costs through the attain- ment of some scale economies in the local market.

At the same time, firms still have to keep an eye on costs. Firms pursuing a localization strategy still need to be efficient and, whenever possible, to capture some scale economies from their global reach. As noted earlier, many automobile companies have found that they have to customize some of their product offerings to local market demands—for example, producing large pickup trucks for North American consumers and small fuel-efficient cars for Europeans and Japanese. At the same time, these multinationals try to get some scale economies from their global volume by using common vehicle platforms and components across many different models and manufacturing those platforms and components at effi- ciently scaled factories that are optimally located. By designing their products in this way, these companies have been able to localize their product offering, yet simultaneously cap- ture some scale economies, learning effects, and location economies.

TRANSNATIONAL STRATEGY We have argued that a global standardization strategy makes most sense when cost pressures are intense and demands for local respon- siveness are limited. Conversely, a localization strategy makes most sense when demands for local responsiveness are high, but cost pressures are moderate or low. What happens, how- ever, when the firm simultaneously faces both strong cost pressures and strong pressures for local responsiveness? How can managers balance the competing and inconsistent demands such divergent pressures place on the firm? According to some researchers, the answer is to pursue what has been called a transnational strategy.

Two of these researchers, Christopher Bartlett and Sumantra Ghoshal, argue that in the modern global environment, competitive conditions are so intense that to survive, firms must do all they can to respond to pressures for cost reductions and local responsiveness.33 They must try to realize location economies and experience effects, to leverage products internationally, to transfer core competencies and skills within the company, and to simulta- neously pay attention to pressures for local responsiveness.34 Bartlett and Ghoshal note that in the modern multinational enterprise, core competencies and skills do not reside just in the home country but can develop in any of the firm’s worldwide operations. Thus, they maintain that the flow of skills and product offerings should not be all one way, from home country to foreign subsidiary. Rather, the flow should also be from foreign subsidiary to home country and from foreign subsidiary to foreign subsidiary. Transnational enterprises, in other words, must also focus on leveraging subsidiary skills.

In essence, firms that pursue a transnational strategy are trying to simultaneously achieve low costs through location economies, economies of scale, and learning effects; differentiate their product offering across geographic markets to account for local differences; and foster a multidirectional flow of skills between different subsidiaries in the firm’s global network of op- erations. As attractive as this may sound in theory, the strategy is not an easy one to pursue be- cause it places conflicting demands on the company. Differentiating the product to respond to local demands in different geographic markets raises costs, which runs counter to the goal of reducing costs. Companies such as 3M and ABB (one of the world’s largest engineering con- glomerates) have tried to embrace a transnational strategy and found it difficult to implement.

How best to implement a transnational strategy is one of the most complex questions that large multinationals are grappling with today. Few if any enterprises have perfected this

Localization Strategy Increasing profitability by customizing the firm’s goods and services so that they provide a good match to tastes and preferences in different national markets.

Transnational Strategy Attempt to simultaneously achieve low costs through location economies, economies of scale, and learning effects while also differentiating product offerings across geographic markets to account for local differences and fostering multidirectional flows of skills between different subsidiaries in the firm’s global network of operations.

360 Part Five The Strategy of International Business

strategic posture. But some clues as to the right approach can be derived from a number of companies. For an ex- ample, consider the case of Caterpillar. The need to com- pete with low-cost competitors such as Komatsu of Japan forced Caterpillar to look for greater cost economies. However, variations in construction practices and gov- ernment regulations across countries and regions mean that Caterpillar also has to be responsive to local de- mands. Therefore, Caterpillar confronted significant pressures for cost reductions and for local responsiveness.

To deal with cost pressures, Caterpillar redesigned its products to use many identical components and invested in a few large-scale component manufacturing facilities, sited at favorable locations, to fill global demand and realize scale economies. At the same time, the company augments the centralized manufacturing of components with assem- bly plants in each of its major global markets. At these plants, Caterpillar adds local product features, tailoring the finished product to local needs. Thus, Caterpillar is able to realize many of the benefits of global manufacturing while reacting to pressures for local responsiveness by differenti- ating its product among national markets.35 Caterpillar started to pursue this strategy in the 1980s; by the 2000s, it had succeeded in doubling output per employee, signifi- cantly reducing its overall cost structure in the process. Meanwhile, Komatsu and Hitachi, which are still wedded to a Japan-centric global strategy, have seen their cost ad- vantages evaporate and have been steadily losing market share to Caterpillar.

Changing a firm’s strategic posture to build an organi- zation capable of supporting a transnational strategy is a

complex and challenging task. Some would say it is too complex because the strategy imple- mentation problems of creating a viable organizational structure and control systems to manage this strategy are immense.

INTERNATIONAL STRATEGY Sometimes it is possible to identify multina- tional firms that find themselves in the fortunate position of being confronted with low cost pressures and low pressures for local responsiveness. Many of these enterprises have pursued an international strategy, taking products first produced for their domestic market and sell- ing them internationally with only minimal local customization. The distinguishing feature of many such firms is that they are selling a product that serves universal needs, but they do not face significant competitors; thus, unlike firms pursuing a global standardization strategy, they are not confronted with pressures to reduce their cost structure. Xerox found itself in this position in the 1960s after its invention and commercialization of the photocopier. The tech- nology underlying the photocopier was protected by strong patents, so for several years Xerox did not face competitors—it had a monopoly. The product serves universal needs, and it was highly valued in most developed nations. Thus, Xerox was able to sell the same basic product the world over, charging a relatively high price for that product. Because Xerox did not face direct competitors, it did not have to deal with strong pressures to minimize its cost structure.

Enterprises pursuing an international strategy have followed a similar developmental pattern as they expanded into foreign markets. They tend to centralize product develop- ment functions such as R&D at home. However, they also tend to establish manufacturing and marketing functions in each major country or geographic region in which they do busi- ness. The resulting duplication can raise costs, but this is less of an issue if the firm does not face strong pressures for cost reductions. Although they may undertake some local custom- ization of product offering and marketing strategy, this tends to be rather limited in scope.

International Strategy Trying to create value by transferring core competencies to foreign markets where indigenous competitors lack those competencies.

Is Citigroup Now the Best in Financials? Recent earnings reports of the financials showed a separation between the more internationally focused business models of Bank of America and Citigroup, from the more domestic focused growth strategies of JP Morgan and Wells Fargo. The banking sector in the United States is heavily saturated, and the financials who rely primarily on the domestic economy for growth continue to struggle. Today, when you look at Citi’s business model, the company looks like an international bank headquartered in the United States because the company gets nearly 70 percent of its revenue overseas. The company is strongly positioned in almost every major emerging market economy, with bold plans for con- tinued future growth. In Latin America, for instance, Eduardo Cruz, one of the most respected executives in the banking indus- try, continues to successfully build out Citi’s retail and investment banking presence. Also, in Asia, where Citi has its largest interna- tional footprint, the company continues to be similarly successful in building out its core banking business across the region, with a particularly strong retail franchise in India. Based on the material in Chapter 12, do you think Citigroup is using a global stan- dardization strategy, localization strategy, transnational strat- egy, or international strategy? And, perhaps more interestingly, is Citigroup now the best in financials?

Source: http://seekingalpha.com/article/307549-is-citigroup-now-the-best-in- fi nancials.

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Ultimately, in most firms that pursue an international strategy, the head office retains fairly tight control over marketing and product strategy.

Firms that have pursued this strategy include Procter & Gamble and Microsoft. Histori- cally, Procter & Gamble developed innovative new products in Cincinnati and then trans- ferred them wholesale to local markets (see the accompanying Management Focus). Similarly, the bulk of Microsoft’s product development work occurs in Redmond, Washington, where the company is headquartered. Although some localization work is undertaken elsewhere, this is limited to producing foreign-language versions of popular Microsoft programs.

THE EVOLUTION OF STRATEGY The Achilles’ heel of the international strategy is that over time, competitors inevitably emerge, and if managers do not take proac- tive steps to reduce their firm’s cost structure, it will be rapidly outflanked by efficient global competitors. This is what happened to Xerox. Japanese companies such as Canon ultimately invented their way around Xerox’s patents, produced their own photocopiers in very effi- cient manufacturing plants, priced them below Xerox’s products, and rapidly took global market share from Xerox. In the final analysis, Xerox’s demise was not due to the emergence of competitors—because, ultimately, that was bound to occur—but due to its failure to pro- actively reduce its cost structure in advance of the emergence of efficient global competi- tors. The message in this story is that an international strategy may not be viable in the long term, and to survive, firms need to shift toward a global standardization strategy or a trans- national strategy in advance of competitors (see Figure 12.10).

Evolution of Strategy at Procter & Gamble

Founded in 1837, Cincinnati-based Procter & Gamble has long been one of the world’s most international companies. Today, P&G is a global co- lossus in the consumer products business with annual sales in excess of $80 billion, some 54 percent of which are generated outside of the United States. P&G sells more than 300 brands—including Ivory soap, Tide, Pampers, IAMS pet food, Crisco, and Folgers—to consumers in 180 countries. Historically, the strategy at P&G was well established. The company developed new products in Cincinnati and then relied on semiautonomous foreign subsidiaries to manufacture, market, and dis- tribute those products in different nations. In many cases, foreign sub- sidiaries had their own production facilities and tailored the packaging, brand name, and marketing message to local tastes and preferences. For years, this strategy delivered a steady stream of new products and reliable growth in sales and profits. By the 1990s, however, profit growth at P&G was slowing.

The essence of the problem was simple; P&G’s costs were too high because of extensive duplication of manufacturing, marketing, and ad- ministrative facilities in different national subsidiaries. The duplication of assets made sense in the world of the 1960s, when national mar- kets were segmented from each other by barriers to cross-border trade. Products produced in Great Britain, for example, could not be sold economically in Germany due to high tariff duties levied on im- ports into Germany. By the 1980s, however, barriers to cross-border trade were falling rapidly worldwide and fragmented national markets were merging into larger regional or global markets. Also, the retailers through which P&G distributed its products were growing larger and more global, such as Walmart, Tesco from the United Kingdom, and Carrefour from France. These emerging global retailers were demand- ing price discounts from P&G.

In the 1990s, P&G embarked on a major reorganization in an attempt to control its cost structure and recognize the new reality of emerging global markets. The company shut down some 30 manufacturing plants around the globe, laid off 13,000 employees, and concentrated produc- tion in fewer plants that could better realize economies of scale and serve regional markets. It wasn’t enough! Profit growth remained slug- gish, so in 1999 P&G launched its second reorganization of the decade. Named “Organization 2005,” the goal was to transform P&G into a truly global company. The company tore up its old organization, which was based on countries and regions, and replaced it with one based on seven self-contained global business units, ranging from baby care to food products. Each business unit was given complete responsibility for gen- erating profits from its products and for manufacturing, marketing, and product development. Each business unit was told to rationalize produc- tion, concentrating it in fewer larger facilities; to try to build global brands wherever possible, thereby eliminating marketing differences among countries; and to accelerate the development and launch of new prod- ucts. P&G announced that as a result of this initiative, it would close an- other 10 factories and lay off 15,000 employees, mostly in Europe where there was still extensive duplication of assets. The annual cost savings were estimated to be about $800 million. P&G planned to use the savings to cut prices and increase marketing spending in an effort to gain market share, and thus further lower costs through the attainment of scale econ- omies. This time, the strategy seemed to be working. For most of the 2000s, P&G reported strong growth in both sales and profits. Signifi- cantly, P&G’s global competitors, such as Unilever, Kimberly-Clark, and Colgate-Palmolive, were struggling during the same time period.

Sources: J. Neff, “P&G Outpacing Unilever in Five-Year Battle,” Advertising Age, November 3, 2003, pp. 1–3; G. Strauss, “Firm Restructuring into Truly Global Company,” USA Today, September 10, 1999, p. B2; Procter & Gamble 10K Report, 2005; and M. Kolbasuk McGee, “P&G Jump-Starts Corporate Change,” Information Week, November 1, 1999, pp. 30–34.

management FOCUS

362 Part Five The Strategy of International Business

The same can be said about a localization strategy. Localization may give a firm a com- petitive edge, but if it is simultaneously facing aggressive competitors, the company will also have to reduce its cost structure, and the only way to do that may be to shift toward a trans- national strategy. This is what Procter & Gamble has been doing (see the accompanying Management Focus). Thus, as competition intensifies, international and localization strate- gies tend to become less viable, and managers need to orient their companies toward either a global standardization strategy or a transnational strategy.

Strategic Alliances Strategic alliances refer to cooperative agreements between potential or actual competitors. In this section, we are concerned specifically with strategic alliances between firms from dif- ferent countries. Strategic alliances run the range from formal joint ventures, in which two or more firms have equity stakes (e.g., Fuji Xerox), to short-term contractual agreements, in which two companies agree to cooperate on a particular task (such as developing a new

product). Collaboration between competitors is fashionable; recent decades have seen an explosion in the number of strategic alliances.

THE ADVANTAGES OF STRATEGIC ALLIANCES Firms ally themselves with actual or potential competitors for various strategic purposes.36 First, strategic alliances may facilitate entry into a foreign market. For example, many firms believe that if they are to successfully enter the Chinese market, they need a local partner who understands business conditions and who has good connections (or guanxi—see Chapter 4). Thus, Warner Brothers entered into a joint venture with two Chinese partners to produce and distribute films in China. As a foreign film company, Warner found that if it wanted to produce films on its own for the Chinese market, it had to go through a complex approval process for every film, and it had to farm out dis- tribution to a local company, which made doing business in China very difficult. Due to the participation of Chinese firms, however, the joint-venture films will go through a streamlined approval process,

LO 12-5 Explain the pros and cons of using strategic alliances to support global strategies.

12.10 FIGURE Changes in Strategy over Time

Low

Lo w

Pressures for local responsiveness Pr

es su

re s

fo r c

os t r

ed uc

tio ns

High

Hi gh

Global standardization

strategy

International strategy

Localization strategy

Transnational strategy

As competitors emerge, these strategies become

less viable

A moviegoer walks past a poster of the Warner Bros movie, Gravity, in Shanghai, China. The strategic alliance between Warner Bros and their Chinese partners has helped streamline the process for film distribution.

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Chapter Twelve The Strategy of International Business 363

and the venture will be able to distribute any films it pro- duces. Also, the joint venture will be able to produce films for Chinese TV, something that foreign firms are not allowed to do.37

Strategic alliances also allow firms to share the fixed costs (and associated risks) of developing new products or pro- cesses. An alliance between Boeing and a number of Japanese companies to build Boeing’s latest commercial jetliner, the 787, was motivated by Boeing’s desire to share the estimated $8 billion investment required to develop the aircraft.

Third, an alliance is a way to bring together complemen- tary skills and assets that neither company could easily de- velop on its own.38 In 2003, for example, Microsoft and Toshiba established an alliance aimed at developing embed- ded microprocessors (essentially tiny computers) that can perform a variety of entertainment functions in an automo- bile (e.g., run a backseat DVD player or a wireless Internet connection). The processors run a version of Microsoft’s Windows operating system. Microsoft brings its software engineering skills to the alliance and Toshiba its skills in de- veloping microprocessors.39

Fourth, it can make sense to form an alliance that will help the firm establish technological standards for the in- dustry that will benefit the firm. For example, in 2011 Nokia, one of the leading makers of smartphones, entered into an alliance with Microsoft under which Nokia agreed to license and use Microsoft’s Windows Mobile operating system in Nokia’s phones. The motivation for the alliance was in part to help establish Windows Mobile as the industry standard for smartphones as opposed to the rival operating systems such as Apple’s iPhone and Google’s Android. Unfortunately for Microsoft, the Nokia’s Windows phones failed to gain sufficient market share. In 2013, Microsoft decided to acquire Nokia’s mobile phone business and bring it in house so that it could ensure a continued aggressive push into the smartphone hardware business.

THE DISADVANTAGES OF STRATEGIC ALLIANCES The advan- tages we have discussed can be very significant. Despite this, some have criticized strategic alliances on the grounds that they give competitors a low-cost route to new technology and markets.40 For example, two decades ago, critics argued that many strategic alliances be- tween U.S. and Japanese firms were part of an implicit Japanese strategy to keep high-paying, high-value-added jobs in Japan while gaining the project engineering and production pro- cess skills that underlie the competitive success of many U.S. companies.41 They argued that Japanese success in the machine tool and semiconductor industries was built on U.S. tech- nology acquired through strategic alliances. And they argued that U.S. managers were aid- ing the Japanese by entering alliances that channel new inventions to Japan and provide a U.S. sales and distribution network for the resulting products. Although such deals may generate short-term profits, so the argument goes, in the long run the result is to “hollow out” U.S. firms, leaving them with no competitive advantage in the global marketplace. The same arguments are now made regarding alliances with Chinese firms.

These critics have a point; alliances have risks. Unless a firm is careful, it can give away more than it receives. But there are so many examples of apparently successful alliances be- tween firms—including alliances between U.S. and Japanese firms—that the critics’ position seems extreme. It is difficult to see how the Microsoft–Toshiba alliance, the Boeing– Mitsubishi alliance for the 787, and the Fuji–Xerox alliance fit the critics’ thesis. In these cases, both partners seem to have gained from the alliance. Why do some alliances benefit both firms while others benefit one firm and hurt the other? The next section provides an answer to this question.

Was Nokia a Risky Purchase for Microsoft? Microsoft Corporation’s acquisition of Nokia Corporation’s devices and services business was seen as a bold but risky gamble in the software giant’s bid for a larger footprint in the fast-growing mobile market. Initially, it relied heavily on a strategic alliance with Nokia, which in 2011 announced that it was embracing Microsoft’s Windows Phone as its main operating system. This partnership produced Lumia, a Windows-based Nokia phone. It has won up- beat reviews but remains an insignificant player in a market domi- nated by Apple’s iPhone and other devices based on Google’s Android operating system. Nokia got caught in a tough transition from its phones based on its Symbian operating system to Windows-based devices, and this transition has been more painful than Nokia anticipated. Despite the somewhat rocky start to their alliance, in September 2013, Microsoft and Nokia announced that the two companies “have decided to enter into a transaction whereby Microsoft will purchase substantially all of Nokia’s Devices and Services business, license Nokia’s patents, and license and use Nokia’s mapping services.” Experts, the markets, and customers are skeptical. Was Nokia a risky purchase for Microsoft?

Source: “Microsoft to Acquire Nokia’s Devices and Services Business, License Nokia’s Patents and Mapping Services,” Microsoft News Center, September 3, 2013.

364 Part Five The Strategy of International Business

MAKING ALLIANCES WORK The failure rate for international strategic alli- ances seems to be high. One study of 49 international strategic alliances found that two- thirds run into serious managerial and financial troubles within two years of their formation, and that although many of these problems are solved, 33 percent are ultimately rated as fail- ures by the parties involved.42 The success of an alliance seems to be a function of three main factors: partner selection, alliance structure, and the manner in which the alliance is managed.

Partner Selection One key to making a strategic alliance work is to select the right ally. A good ally, or partner, has three characteristics. First, a good partner helps the firm achieve its strategic goals, whether they are market access, sharing the costs and risks of product development, or gaining access to critical core competencies. The partner must have capabilities that the firm lacks and that it values. Second, a good partner shares the firm’s vision for the purpose of the alliance. If two firms approach an alliance with radically different agendas, the chances are great that the relationship will not be harmonious, will not flourish, and will end in divorce. Third, a good partner is unlikely to try to opportunisti- cally exploit the alliance for its own ends, that is, to expropriate the firm’s technological know-how while giving away little in return. In this respect, firms with reputations for “fair play” to maintain probably make the best allies. For example, companies such as General Electric are involved in so many strategic alliances that it would not pay the company to trample over individual alliance partners.43 This would tarnish GE’s reputation of being a good ally and would make it more difficult for GE to attract alliance partners. Because IBM attaches great importance to its alliances, it is unlikely to engage in the kind of opportunistic behavior that critics highlight. Similarly, their reputations make it less likely (but by no means impossible) that such Japanese firms as Sony, Toshiba, and Fuji, which have histories of alliances with non-Japanese firms, would opportunistically exploit an alliance partner.

To select a partner with these three characteristics, a firm needs to conduct comprehen- sive research on potential alliance candidates. To increase the probability of selecting a good partner, the firm should:

1. Collect as much pertinent, publicly available information on potential allies as possible. 2. Gather data from informed third parties. These include firms that have had alliances

with the potential partners, investment bankers that have had dealings with them, and former employees.

3. Get to know the potential partner as well as possible before committing to an alliance. This should include face-to-face meetings between senior managers (and perhaps middle-level managers) to ensure that the chemistry is right.

Alliance Structure A partner having been selected, the alliance should be structured so that the firm’s risks of giving too much away to the partner are reduced to an acceptable level. First, alliances can be designed to make it difficult (if not impossible) to transfer technology not meant to be transferred. The design, development, manufacture, and service of a product manufactured by an alliance can be structured so as to wall off sensitive technologies to pre- vent their leakage to the other participant. In a long-standing alliance between General Elec- tric and Snecma to build commercial aircraft engines for single-aisle commercial jet aircraft, for example, GE reduced the risk of excess transfer by walling off certain sections of the pro- duction process. The modularization effectively cut off the transfer of what GE regarded as key competitive technology, while permitting Snecma access to final assembly. Formed in 1974, the alliance has been remarkably successful, and today it dominates the market for jet engines used on the Boeing 737 and Airbus 320.44 Similarly, in the alliance between Boeing and the Japanese to build the 767, Boeing walled off research, design, and marketing functions considered central to its competitive position, while allowing the Japanese to share in produc- tion technology. Boeing also walled off new technologies not required for 767 production.45

Second, contractual safeguards can be written into an alliance agreement to guard against the risk of opportunism by a partner. (Opportunism includes the theft of technology and/or markets.) For example, TRW Inc. entered into three strategic alliances with large Japanese auto component suppliers to produce seat belts, engine valves, and steering gears for sale to

Chapter Twelve The Strategy of International Business 365

Japanese-owned auto assembly plants in the United States. TRW put clauses in each of its alliance contracts that barred the Japanese firms from competing with TRW to supply U.S.- owned auto companies with component parts. By doing this, TRW protected itself against the possibility that the Japanese companies were entering into the alliances merely to gain access to the North American market to compete with TRW in its home market.

Third, both parties to an alliance can agree in advance to swap skills and technologies that the other covets, thereby ensuring a chance for equitable gain. Cross-licensing agree- ments are one way to achieve this goal. Fourth, the risk of opportunism by an alliance part- ner can be reduced if the firm extracts a significant credible commitment from its partner in advance. The long-term alliance between Xerox and Fuji to build photocopiers for the Asian market perhaps best illustrates this. Rather than enter into an informal agreement or a licensing arrangement (which Fuji Photo initially wanted), Xerox insisted that Fuji invest in a 50/50 joint venture to serve Japan and East Asia. This venture constituted such a signifi- cant investment in people, equipment, and facilities that Fuji Photo was committed from the outset to making the alliance work in order to earn a return on its investment. By agreeing to the joint venture, Fuji essentially made a credible commitment to the alliance. Given this, Xerox felt secure in transferring its photocopier technology to Fuji.46

Managing the Alliance Once a partner has been selected and an appropriate alli- ance structure has been agreed on, the task facing the firm is to maximize its benefits from the alliance. As in all international business deals, an important factor is sensitivity to cul- tural differences (see Chapter 4). Many differences in management style are attributable to cultural differences, and managers need to make allowances for these in dealing with their partner. Beyond this, maximizing the benefits from an alliance seems to involve building trust between partners and learning from partners.47

Managing an alliance successfully requires building interpersonal relationships between the firms’ managers, or what is sometimes referred to as relational capital.48 This is one lesson that can be drawn from a successful strategic alliance between Ford and Mazda. Ford and Mazda set up a framework of meetings within which their managers not only discuss mat- ters pertaining to the alliance but also have time to get to know each other better. The belief is that the resulting friendships help build trust and facilitate harmonious relations between the two firms. Personal relationships also foster an informal management network between the firms. This network can then be used to help solve problems arising in more formal contexts (such as in joint committee meetings between personnel from the two firms).

Academics have argued that a major determinant of how much acquiring knowledge a company gains from an alliance is its ability to learn from its alliance partner.49 For example, in a five-year study of 15 strategic alliances between major multinationals, Gary Hamel, Yves Doz, and C. K. Prahalad focused on a number of alliances between Japanese companies and Western (European or American) partners.50 In every case in which a Japanese company emerged from an alliance stronger than its Western partner, the Japanese company had made a greater effort to learn. Few Western companies studied seemed to want to learn from their Japanese partners. They tended to regard the alliance purely as a cost-sharing or risk-sharing device, rather than as an opportunity to learn how a potential competitor does business.

Consider the alliance between General Motors and Toyota constituted in 1985 to build the Chevrolet Nova. This alliance was structured as a formal joint venture, called New United Motor Manufacturing Inc., and each party had a 50 percent equity stake. The venture owned an auto plant in Fremont, California. According to one Japanese manager, Toyota quickly achieved most of its objectives from the alliance: “We learned about U.S. supply and transportation. And we got the confidence to manage U.S. workers.”51 All that knowledge was then transferred to Georgetown, Kentucky, where Toyota opened its own plant in 1988. Possibly all GM got was a new product, the Chevrolet Nova. Some GM managers complained that the knowledge they gained through the alliance with Toyota has never been put to good use inside GM. They be- lieve they should have been kept together as a team to educate GM’s engineers and workers about the Japanese system. Instead, they were dispersed to various GM subsidiaries.

To maximize the learning benefits of an alliance, a firm must try to learn from its partner and then apply the knowledge within its own organization. It has been suggested that all

366 Part Five The Strategy of International Business

operating employees should be well briefed on the partner’s strengths and weaknesses and should understand how acquiring particular skills will bolster their firm’s competitive posi- tion. Hamel, Doz, and Prahalad note that this is already standard practice among Japanese companies. They made this observation:

We accompanied a Japanese development engineer on a tour through a partner’s factory. This engineer dutifully took notes on plant layout, the number of produc- tion stages, the rate at which the line was running, and the number of employees. He recorded all this despite the fact that he had no manufacturing responsibility in his own company, and that the alliance did not encompass joint manufacturing. Such dedication greatly enhances learning.52

strategy, p. 339 profitability, p. 339 profit growth, p. 339 value creation, p. 340 operations, p. 342 organization architecture, p. 345 organizational structure, p. 345 controls, p. 345

incentives, p. 345 processes, p. 345 organizational culture, p. 345 people, p. 345 core competence, p. 347 location economies, p. 348 global web, p. 349 experience curve, p. 350

learning effects, p. 350 economies of scale, p. 350 universal needs, p. 354 global standardization strategy, p. 357 localization strategy, p. 359 transnational strategy, p. 359 international strategy, p. 360

Key Terms

Summary

This chapter reviewed basic principles of strategy and the various ways in which firms can profit from global expan- sion, and it looked at the strategies that firms that compete globally can adopt. The chapter made the following points:

1. A strategy can be defined as the actions that managers take to attain the goals of the firm. For most firms, the preeminent goal is to maximize shareholder value. Maximizing shareholder value requires firms to focus on increasing their profitability and the growth rate of profits over time.

2. International expansion may enable a firm to earn greater returns by transferring the product offerings derived from its core competencies to markets where indigenous competitors lack those product offerings and competencies.

3. It may pay a firm to base each value creation activity it performs at that location where factor conditions are most conducive to the performance of that activity. We refer to this strategy as focusing on the attainment of location economies.

4. By rapidly building sales volume for a standardized product, international expansion can assist a firm in moving down the experience curve by realizing learning effects and economies of scale.

5. A multinational firm can create additional value by identifying valuable skills created within its foreign subsidiaries and leveraging those skills within its global network of operations.

6. The best strategy for a firm to pursue often depends on a consideration of the pressures for cost reductions and for local responsiveness.

7. Firms pursuing an international strategy transfer the products derived from core competencies to foreign markets, while undertaking some limited local customization.

8. Firms pursuing a localization strategy customize their product offering, marketing strategy, and business strategy to national conditions.

9. Firms pursuing a global standardization strategy focus on reaping the cost reductions that come from experience curve effects and location economies.

10. Many industries are now so competitive that firms must adopt a transnational strategy. This involves a simultaneous focus on reducing costs, transferring skills and products, and boosting local responsiveness. Implementing such a strategy may not be easy.

11. Strategic alliances are cooperative agreements between actual or potential competitors.

12. The advantages of alliances are that they facilitate entry into foreign markets, enable partners to share the fixed costs and risks associated with new products and processes, facilitate the transfer of complementary skills between companies, and help firms establish technical standards.

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Critical Thinking and Discussion Questions

1. In a world of zero transportation costs, no trade barriers, and nontrivial differences between nations with regard to factor conditions, firms must expand internationally if they are to survive. Discuss.

2. Plot the position of the following firms on Figure 12.8: Procter & Gamble, IBM, Apple, Coca-Cola, Dow Chemical, U.S. Steel, McDonald’s. In each case, justify your answer.

3. In what kind of industries does a localization strategy make sense? When does a global standardization strategy make most sense?

4. Reread the Management Focus on Procter & Gamble and then answer the following questions: a. What strategy was Procter & Gamble pursuing when

it first entered foreign markets in the period up until the 1980s?

b. Why do you think this strategy became less viable in the 1990s?

c. What strategy does P&G appear to be moving toward? What are the benefits of this strategy? What are the potential risks associated with it?

5. What do you see as the main organizational problems that are likely to be associated with implementation of a transnational strategy?

13. A disadvantage of a strategic alliance is that the firm risks giving away technological know-how and market access to its alliance partner in return for very little.

14. The disadvantages associated with alliances can be reduced if the firm selects partners carefully, paying close attention to the firm’s reputation and the

structure of the alliance so as to avoid unintended transfers of know-how.

15. Keys to making alliances work seem to be building trust and informal communications networks between partners and taking proactive steps to learn from alliance partners.

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

1. Several classifications and rankings of the world’s largest companies are prepared by a variety of sources. Find one such composite ranking system and identify the criteria that are used to rank the top global companies. Extract the list of the top 20 ranked companies, paying particular attention to their home countries.

2. The top management of your company, a manufacturer and marketer of smartphones, has decided to pursue international expansion opportunities in eastern Europe. To ensure success, management’s goal is to enter into countries with a high level of global connectedness. Identify the top three eastern European countries in which your company can market its current product line. Prepare an executive summary to support your recommendations.

Research Task http://globalEDGE.msu.edu

When Ford CEO Alan Mulally arrived at the company in 2006 after a long career at Boeing, he was shocked to learn that the company produced one Ford Focus for Europe and a totally different one for the United States. “Can you imagine having one Boeing 737 for Europe and one 737 for the United States?” he said at the time. Due to this product strategy, Ford was unable to buy common parts for the vehicles, could not share development costs, and couldn’t use its European Focus plants to make cars for the United States, or vice versa. In a business where economies of scale are impor- tant, the result was high costs. Nor were these problems limited to the Ford Focus. The strategy of designing and building different cars for different regions was the standard approach at Ford.

Ford’s long-standing strategy of regional models was based upon the assumption that consumers in different regions had different tastes and preferences, which required considerable local customization. Americans,

it was argued, loved their trucks and SUVs, while Europeans preferred smaller, fuel-efficient cars. Notwithstanding such differences, Mulally still could not understand why small car models like the Focus, or the Escape SUV, which were sold in different regions, were not built on the same plat- form and did not share common parts. In truth, the strategy probably had more to do with the autonomy of different regions within Ford’s organization—a fact that was deeply embedded in Ford’s history as one of the oldest multinational corporations.

When the global financial crisis rocked the world’s automobile industry in 2008–2009 and precipitated the steepest drop in sales since the Great De- pression, Mulally decided that Ford had to change its long-standing practices in order to get its costs under control. Moreover, he felt that there was no way that Ford would be able to compete effectively in the large developing markets of China and India unless Ford leveraged its global scale to produce

Ford’s Global Strategy ccccccloooooooossssiinnnngggggggggg ccccccaaaassssssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeee

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368 Part Five The Strategy of International Business

Endnotes

1. More formally, ROIC 5 Net profit after tax/Capital, where capital includes the sum of the firm’s equity and debt. This way of calculating profitability is highly correlated with return on assets.

2. T. Copeland, T. Koller, and J. Murrin, Valuation: Measuring and Managing the Value of Companies (New York: John Wiley & Sons, 2000).

3. The concept of consumer surplus is an important one in eco- nomics. For a more detailed exposition, see D. Besanko, D. Dranove, and M. Shanley, Economics of Strategy (New York: John Wiley & Sons, 1996).

4. However, P 5 V only in the special case where the company has a perfect monopoly, and where it can charge each customer a unique price that reflects the value of the product to that cus- tomer (i.e., where perfect price discrimination is possible). More generally, except in the limiting case of perfect price discrimina- tion, even a monopolist will see most consumers capture some of the value of a product in the form of a consumer surplus.

5. This point is central to the work of Michael Porter, Competi- tive Advantage (New York: Free Press, 1985). See also chap. 4 in P. Ghemawat, Commitment: The Dynamic of Strategy (New York: Free Press, 1991).

6. M. E. Porter, Competitive Strategy (New York: Free Press, 1980). 7. M. E. Porter, “What Is Strategy?” Harvard Business Review,

On-point Enhanced Edition article, February 1, 2000. 8. Porter, Competitive Advantage. 9. D. Naidler, M. Gerstein, and R. Shaw, Organization Architecture

(San Francisco: Jossey-Bass, 1992). 10. G. Morgan, Images of Organization (Beverly Hills, CA: Sage

Publications, 1986). 11. Empirical evidence does seem to indicate that, on average,

international expansion is linked to greater firm profitability. For some recent examples, see M. A. Hitt, R. E. Hoskisson,

and H. Kim, “International Diversification, Effects on Inno- vation and Firm Performance,” Academy of Management Jour- nal 40, no. 4 (1997), pp. 767–98; and S. Tallman and J. Li, “Effects of International Diversity and Product Diversity on the Performance of Multinational Firms,” Academy of Man- agement Journal 39, no. 1 (1996), pp. 179–96.

12. This concept has been popularized by G. Hamel and C. K. Prahalad, Competing for the Future (Boston: Harvard Business School Press, 1994). The concept is grounded in the resource-based view of the firm; for a summary, see J. B. Barney, “Firm Resources and Sustained Competitive Advan- tage,” Journal of Management 17 (1991), pp. 99–120; and K. R. Conner, “A Historical Comparison of Resource-Based The- ory and Five Schools of Thought within Industrial Organiza- tion Economics: Do We Have a New Theory of the Firm?” Journal of Management 17 (1991), pp. 121–54.

13. J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).

14. M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990).

15. Example is based on C. S. Trager, “Enter the Mini-Multina- tional,” Northeast International Business, March 1989, pp. 13–14.

16. See R. B. Reich, The Work of Nations (New York: Alfred A. Knopf, 1991); and P. J. Buckley and N. Hashai, “A Global System View of Firm Boundaries,” Journal of International Business Studies, January 2004, pp. 33–50.

17. D. Barboza, “An Unknown Giant Flexes Its Muscles,” The New York Times, December 4, 2004, pp. B1, B3.

18. G. Hall and S. Howell, “The Experience Curve from an Economist’s Perspective,” Strategic Management Journal 6 (1985), pp. 197–212.

19. A. A. Alchain, “Reliability of Progress Curves in Airframe Production,” Econometrica 31 (1963), pp. 697–98.

low-cost cars. The result was Mulally’s One Ford strategy, which aims to cre- ate a handful of car platforms that Ford can use everywhere in the world.

Under this strategy, new models—such as the 2013 Fiesta, Focus, and Escape—share a common design, are built on a common platform, use the same parts, and will be built in identical factories around the world. Ultimately, Ford hopes to have only five platforms to deliver sales of more than 6 million vehicles by 2016. In 2006, Ford had 15 platforms that accounted for sales of 6.6 million vehicles. By pursuing this strategy, Ford can share the costs of design and tooling, and it can attain much greater scale economies in the production of component parts. Ford has stated that it will take about one- third out of the $1 billion cost of developing a new car model and should sig- nificantly reduce its $50 billion annual budget for component parts. Moreover, because the different factories producing these cars are identical in all re- spects, useful knowledge acquired through experience in one factory can quickly be transferred to other factories, resulting in systemwide cost savings.

What Ford hopes is that this strategy will bring down costs sufficiently to enable Ford to make greater profit margins in developed markets and be able to achieve good profit margins at lower price points in hypercompetitive developing nations, such as China (now the world’s largest car market),

where Ford currently trails its global rivals such as General Motors and Volkswagen. Indeed, the strategy is central to Mulally’s goal for growing Ford’s sales from 5.5 million in 2010 to 8 million by mid-decade.

Sources: M. Ramsey, “For SUV Marks New World Car Strategy,” The Wall Street Journal, November 16, 2011; B. Vlasic, “Ford Strategy Will Call for Stepping Up Expansion, Especially in Asia,” The New York Times, June 7, 2011; and “Global Manufacturing Strategy Gives Ford Competitive Advantage,” Ford Motor Company website, http://media.ford.com/article_display.cfm?article_id513633.

CASE DISCUSSION QUESTIONS 1. How would you characterize the strategy for competing internationally

that Ford was pursuing prior to the arrival of Alan Mulally in 2006? What were the benefits of this strategy? What were the costs? Why was Ford pursuing this strategy?

2. What strategy is Mulally trying to get Ford to pursue with his One Ford initiative? What are the benefits of this strategy? Can you see any drawbacks?

3. Does the One Ford initiative imply that Ford will now ignore national and regional differences in demand?

Chapter Twelve The Strategy of International Business 369

20. Hall and Howell, “The Experience Curve from an Econo- mist’s Perspective.”

21. For a full discussion of the source of scale economies, see D. Besanko, D. Dranove, and M. Shanley, Economics of Strategy (New York: John Wiley & Sons, 1996).

22. This estimate was provided by the Pharmaceutical Manufac- turers Association.

23. See J. Birkinshaw and N. Hood, “Multinational Subsidiary Evolution: Capability and Charter Change in Foreign Owned Subsidiary Companies,” Academy of Management Review 23 (October 1998), pp. 773–95; A. K. Gupta and V. J. Govindarajan, “Knowledge Flows within Multinational Corporations,” Strategic Management Journal 21 (2000), pp. 473–96; V. J. Govindarajan and A. K. Gupta, The Quest for Global Dominance (San Francisco: Jossey Bass, 2001); T. S. Frost, J. M. Birkinshaw, and P. C. Ensign, “Centers of Excel- lence in Multinational Corporations,” Strategic Management Journal 23 (2002), pp. 997–1018; and U. Andersson, M. Forsgren, and U. Holm, “The Strategic Impact of External Networks,” Strategic Management Journal 23 (2002), pp. 979–96.

24. S. Leung, “Armchairs, TVs and Espresso: Is It McDonald’s?” The Wall Street Journal, August 30, 2002, pp. A1, A6; and E. Beardsley, “Why McDonald’s in France Doesn’t Feel Like Fast Food,” NPR, January 24, 2012.

25. C. K. Prahalad and Yves L. Doz, The Multinational Mission: Balancing Local Demands and Global Vision (New York: Free Press, 1987). Also see J. Birkinshaw, A. Morrison, and J. Hulland, “Structural and Competitive Determinants of a Global Integration Strategy,” Strategic Management Journal 16 (1995), pp. 637–55; and P. Ghemawat, Redefining Global Strategy (Boston: Harvard Business School Press, 2007).

26. J. E. Garten, “Wal-Mart Gives Globalization a Bad Name,” BusinessWeek, March 8, 2004, p. 24.

27. Prahalad and Doz, The Multinational Mission. Prahalad and Doz actually talk about local responsiveness rather than local customization.

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

29. W. W. Lewis, The Power of Productivity (Chicago: University of Chicago Press, 2004).

30. C. J. Chipello, “Local Presence Is Key to European Deals,” The Wall Street Journal, June 30, 1998, p. A15.

31. For an extended discussion see: G. S. Yip and G. Tomas M. Hult, Total Global Strategy (Boston: Pearson, 2012), and A. M. Rugman and A. Verbeke, “A Perspective on Regional and Global Strategies of Multinational Enterprises,” Journal of International Business Studies 35, no. 1 (2004)), pp. 3–18.

32. C. A. Bartlett and S. Ghoshal, Managing Across Borders: The Trans- national Solution (Boston: Harvard Business School Press, 1998).

33. C. A. Bartlett and S. Ghoshal, Managing Across Borders: The Transnational Solution (Boston: Harvard Business School Press, 1998).

34. Pankaj Ghemawat makes a similar argument, although he does not use the term transnational. See Ghemawat, Redefin- ing Global Strategy.

35. T. Hout, M. E. Porter, and E. Rudden, “How Global Companies Win Out,” Harvard Business Review, September–October 1982, pp. 98–108.

36. See K. Ohmae, “The Global Logic of Strategic Alliances,” Harvard Business Review, March–April 1989, pp. 143–54; G. Hamel, Y. L. Doz, and C. K. Prahalad, “Collaborate with Your Competitors and Win!” Harvard Business Review, January– February 1989, pp. 133–39; W. Burgers, C. W. L. Hill, and W. C. Kim, “Alliances in the Global Auto Industry,” Strategic Management Journal 14 (1993), pp. 419–32; and P. Kale, H. Singh, and H. Perlmutter, “Learning and Protection of Proprietary Assets in Strategic Alliances: Building Relational Capital,” Strategic Management Journal 21 (2000), pp. 217–37.

37. L. T. Chang, “China Eases Foreign Film Rules,” The Wall Street Journal, October 15, 2004, p. B2.

38. B. L. Simonin, “Transfer of Marketing Know-How in Inter- national Strategic Alliances,” Journal of International Business Studies, 1999, pp. 463–91; and J. W. Spencer, “Firms’ Knowl- edge Sharing Strategies in the Global Innovation System,” Strategic Management Journal 24 (2003), pp. 217–33.

39. C. Souza, “Microsoft Teams with MIPS, Toshiba,” EBN, February 10, 2003, p. 4.

40. Kale, Singh, and Perlmutter, “Learning and Protection of Proprietary Assets.”

41. R. B. Reich and E. D. Mankin, “Joint Ventures with Japan Give Away Our Future,” Harvard Business Review, March–April 1986, pp. 78–90.

42. J. Bleeke and D. Ernst, “The Way to Win in Cross-Border Alliances,” Harvard Business Review, November–December 1991, pp. 127–35.

43. C. H. Deutsch, “The Venturesome Giant,” The New York Times, October 5, 2007, pp. C1, C8.

44. “Odd Couple: Jet Engines,” The Economist, May 5, 2007, pp. 79–80.

45. W. Roehl and J. F. Truitt, “Stormy Open Marriages Are Better,” Columbia Journal of World Business, Summer 1987, pp. 87–95.

46. B. Gomes-Casseres and K. McQuade, “Xerox and Fuji Xerox,” Cambridge, MA: Harvard Business School Case, February 15, 1991.

47. See T. Khanna, R. Gulati, and N. Nohria, “The Dynamics of Learning Alliances: Competition, Cooperation, and Relative Scope,” Strategic Management Journal 19 (1998), pp. 193–210; and Kale, Singh, and Perlmutter, “Learning and Protection of Proprietary Assets in Strategic Alliances.”

48. Kale, Singh, Perlmutter, “Learning and Protection of Propri- etary Assets in Strategic Alliances.”

49. Hamel, Doz, and Prahalad, “Collaborate with Competitors”; Khanna, Gulati, and Nohria, “The Dynamics of Learning Alliances: Competition, Cooperation, and Relative Scope”; and E. W. K. Tang, “Acquiring Knowledge by Foreign Part- ners from International Joint Ventures in a Transition Econ- omy: Learning by Doing and Learning Myopia,” Strategic Management Journal 23 (2002), pp. 835–54.

50. Hamel, Doz, and Prahalad, “Collaborate with Competitors.” 51. B. Wysocki, “Cross-Border Alliances Become Favorite Way

to Crack New Markets,” The Wall Street Journal, March 4, 1990, p. A1.

52. Hamel, Doz, and Prahalad, “Collaborate with Competitors,” p. 138.

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learning objectives

13-1 Explain the three basic decisions that firms contemplating foreign expansion must make: which markets to enter, when to enter those markets, and on what scale.

13-2 Compare and contrast the different modes that firms use to enter foreign markets.

13-3 Identify the factors that influence a firm’s choice of entry mode.

13-4 Recognize the pros and cons of acquisitions versus greenfield ventures as an entry strategy.

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opening case

Forty years ago, Starbucks was a single store in Seattle’s Pike Place Market selling premium-roasted coffee. Today, it is a global roaster and retailer of coffee with almost 20,000 stores, 40 percent of which are in 62 countries outside of the United States. Starbucks set out on its current course in the 1980s when the company’s director of marketing, Howard Schultz, came back from a trip to Italy enchanted

with the Italian coffeehouse experience. Schultz, who later became CEO, persuaded the company’s owners

to experiment with the coffeehouse format—and the Starbucks experience was born. The strategy was to

sell the company’s own premium roasted coffee and freshly brewed espresso-style coffee beverages, along

with a variety of pastries, coffee accessories, teas, and other products, in a tastefully designed coffeehouse

setting. From the outset, the company focused on selling “a third place experience,” rather than just the

coffee. The formula led to spectacular success in the United States, where Starbucks went from obscurity

to one of the best-known brands in the country in a decade. Thanks to Starbucks, coffee stores became

places for relaxation, chatting with friends, reading the newspaper, holding business meetings, or (more

recently) browsing the web.

In 1995, with 700 stores across the United States, Starbucks began exploring foreign opportunities. The

first target market was Japan. The company established a joint venture with a local retailer, Sazaby Inc.

Each company held a 50 percent stake in the venture, Starbucks Coffee of Japan. Starbucks initially

invested $10 million in this venture, its first foreign direct investment. The Starbucks format was then

licensed to the venture, which was charged with taking over responsibility for growing Starbucks’ presence

in Japan.

To make sure the Japanese operations replicated the “Starbucks experience” in North America,

Starbucks transferred some employees to the Japanese operation. The licensing agreement required all

Japanese store managers and employees to attend training classes similar to those given to U.S. employees.

The agreement also required that stores adhere to the design parameters established in the United States.

In 2001, the company introduced a stock option plan for all Japanese employees, making it the first

Market Entry at Starbucks

Entering Foreign Markets

–continued

372 Part Five The Strategy of International Business

company in Japan to do so. Skeptics doubted that Starbucks would be able to replicate

its North American success overseas, but by the end of 2013 Starbucks’ had some 1,000

stores and a profitable business in Japan.

After Japan, the company embarked on an aggressive foreign investment program.

In 1998, it purchased Seattle Coffee, a British coffee chain with 60 retail stores, for

$84 million. An American couple, originally from Seattle, had started Seattle Coffee

with the intention of establishing a Starbucks-like chain in Britain. In the late 1990s,

Starbucks opened stores in Taiwan, Singapore, Thailand, New Zealand, South Korea,

Malaysia, and—most significantly—China. In Asia, Starbucks’ most common strategy

was to license its format to a local operator in return for initial licensing fees

and royalties on store revenues. As in Japan, Starbucks insisted on an intensive

employee-training program and strict specifications regarding the format and layout

of the store.

By 2002, Starbucks was pursuing an aggressive expansion in mainland Europe. As its

first entry point, Starbucks chose Switzerland. Drawing on its experience in Asia, the

company entered into a joint venture with a Swiss company, Bon Appetit Group,

Switzerland’s largest food service company. Bon Appetit was to hold a majority stake in

the venture, and Starbucks would license its format to the Swiss company using a similar

agreement to those it had used successfully in Asia. This was followed by a joint venture

in other countries.

By 2014, Starbucks was emphasizing the rapid growth of its operations in China,

where it now had 1,000 stores and plans to roll out another 500 in three years. The

success of Starbucks in China has been attributed to a smart partnering strategy. China

is not one homogeneous market; the culture of northern China is very different from

that of the east, consumer spending power inland is not on par with that of the big

coastal cities. To deal with this complexity, Starbucks entered into three different joint

ventures. In the north, with Beijong Mei Da coffee, in the east with Taiwan based Uni-

President, and in the south with Hong Kong based Maxim’s Caterers. Each partner

bought different strengths and local expertise that helped the company to gain insights

into the tastes and preferences of local Chinese customers, and to adapt accordingly.

Starbucks now believes that China will become its second largest market after the

United States by 2020. •

Sources: Starbucks 10K, various years; C. McLean, “Starbucks Set to Invade Coffee-Loving Continent,” Seattle Times, October 4, 2000, p. E1; J. Ordonez, “Starbucks to Start Major Expansion in Overseas Market,” The Wall Street Journal, October 27, 2000, p. B10; S. Homes and D. Bennett, “Planet Starbucks,” BusinessWeek, September 9, 2002, pp. 99–110; “Starbucks Outlines International Growth Strategy,” Business Wire, October 14, 2004; A. Yeh, “Starbucks Aims for New Tier in China,” Financial Times, February 14, 2006, p. 17; C. Matlack, “Will Global Growth Help Starbucks?” BusinessWeek, July 2, 2008; and H. H.Wang, “Five Things Starbucks Did to Get China Right,” Forbes, July 10, 2012.

Introduction This chapter is concerned with two closely related topics: (1) the decision of which foreign markets to enter, when to enter them, and on what scale and (2) the choice of entry mode. Any firm contemplating foreign expansion must first struggle with the issue of which for- eign markets to enter and the timing and scale of entry. The choice of which markets to enter should be driven by an assessment of relative long-run growth and profit potential. For example, enticed by its long-term growth potential, Starbucks entered China back in

Chapter Thirteen Entering Foreign Markets 373

1999. The company now believes that China will ultimately become its second largest mar- ket after the United States, and accordingly, it has been investing heavily in that nation.

The choice of mode for entering a foreign market is another major issue with which in- ternational businesses must wrestle. The various modes for serving foreign markets are ex- porting, licensing or franchising to host-country firms, establishing joint ventures with a host-country firm, setting up a new wholly owned subsidiary in a host country to serve its market, and acquiring an established enterprise in the host nation to serve that market. Each of these options has advantages and disadvantages. The magnitude of the advantages and disadvantages associated with each entry mode is determined by a number of factors, includ- ing transport costs, trade barriers, political risks, economic risks, business risks, costs, and firm strategy. The optimal entry mode varies by situation, depending on these factors. Thus, whereas some firms may best serve a given market by exporting, other firms may better serve the market by setting up a new wholly owned subsidiary or by acquiring an established enterprise. Starbucks, for example, seems to have had a preference for entering into joint ventures with local partners and then licensing its format to the joint venture. Starbucks has done this in order to benefit from its joint-venture partners’ local expertise, which has helped the company to better configure its store format and menu to the tastes and prefer- ences of local customers. In China, for example, its partners urged Starbucks to capitalize on the tea-drinking culture of the country by using popular local ingredients such as green tea. This helped to get consumers through the door, and once they frequented the stores, they quickly developed a taste for Starbucks coffee.

Basic Entry Decisions A firm contemplating foreign expansion must make three basic decisions: which markets to enter, when to enter those markets, and on what scale.1

WHICH FOREIGN MARKETS? The 196 nation-states in the world do not all hold the same profit potential for a firm contemplating foreign expansion. Ultimately, the choice must be based on an assessment of a nation’s long-run profit potential. This potential is a function of several factors, many of which we have studied in earlier chapters. Chapters 2 and 3 looked in detail at the economic and political factors that influence the potential attractiveness of a foreign market. The attractiveness of a country as a potential market for an international business depends on balancing the benefits, costs, and risks associated with doing business in that country.

Chapters 2 and 3 also noted that the long-run economic benefits of doing business in a country are a function of factors such as the size of the market (in terms of demographics), the present wealth (purchasing power) of consumers in that market, and the likely future wealth of consumers, which depends upon economic growth rates. While some markets are very large when measured by number of consumers (e.g., China, India, and Indonesia), liv- ing standards and economic growth must also be evaluated. On this basis, China and India, while relatively poor, are growing so rapidly that they are attractive targets for inward in- vestment. Alternatively, weak growth in Indonesia implies that this populous nation is a far less attractive target for inward investment. As we saw in Chapters 2 and 3, likely future economic growth rates appear to be a function of a free market system and a country’s ca- pacity for growth (which may be greater in less developed nations). Also, the costs and risks associated with doing business in a foreign country are typically lower in economically ad- vanced and politically stable democratic nations, and they are greater in less developed and politically unstable nations.

The discussion in Chapters 2 and 3 suggests that, other things being equal, the benefit– cost–risk trade-off is likely to be most favorable in politically stable developed and develop- ing nations that have free market systems and where there is not a dramatic upsurge in either inflation rates or private-sector debt. The trade-off is likely to be least favorable in politically unstable developing nations that operate with a mixed or command economy or in developing nations where speculative financial bubbles have led to excess borrowing.

LO 13-1 Explain the three basic decisions that firms contemplating foreign expansion must make: which markets to enter, when to enter those markets, and on what scale.

374 Part Five The Strategy of International Business

Another important factor is the value an international business can create in a foreign market. This depends on the suitability of its product offering to that market and the nature of indigenous competition.2 If the international business can offer a product that has not been widely available in that market and that satisfies an unmet need, the value of that product to consumers is likely to be much greater than if the international business simply offers the same type of product that indigenous competitors and other foreign entrants are already offering. Greater value translates into an ability to charge higher prices and/or to build sales volume more rapidly. By considering such factors, a firm can rank countries in terms of their attractiveness and long-run profit potential. Preference is then given to entering markets that rank highly. For example, Tesco, the large British grocery chain, has been aggressively expanding its foreign operations, primarily by focus- ing on emerging markets that lack strong indigenous competitors (see the accompanying Management Focus).

TIMING OF ENTRY Once attractive markets have been identified, it is important to consider the timing of entry. Entry is early when an international business enters a for- eign market before other foreign firms and late when it enters after other international busi- nesses have already established themselves. The advantages frequently associated with entering a market early are commonly known as first-mover advantages.3 One first-mover advantage is the ability to preempt rivals and capture demand by establishing a strong brand name. This desire has driven the rapid expansion by Tesco into developing nations (see the Management Focus). A second advantage is the ability to build sales volume in that country and ride down the experience curve ahead of rivals, giving the early entrant a cost advantage over later entrants. This cost advantage may enable the early entrant to cut prices below that of later entrants, thereby driving them out of the market. A third advantage is the ability of early entrants to create switching costs that tie customers into their products or services. Such switching costs make it difficult for later entrants to win business.

There can also be disadvantages associated with entering a foreign market before other international businesses. These are often referred to as first-mover disadvantages.4 These disadvantages may give rise to pioneering costs—that is, costs that an early entrant has to bear that a later entrant can avoid. Pioneering costs arise when the business system in a foreign country is so different from that in a firm’s home market that the enterprise has to devote considerable effort, time, and expense to learning the rules of the game. Pioneering costs include the costs of business failure if the firm, due to its ignorance of the foreign environment, makes major mistakes. A certain liability is associated with being a foreigner, and this liability is greater for foreign firms that enter a national mar- ket early.5 Research seems to confirm that the probability of survival increases if an inter- national business enters a national market after several other foreign firms have already done so.6 The late entrant may benefit by observing and learning from the mistakes made by early entrants.

Timing of Entry Entry is early when a firm enters a foreign market before other foreign firms and late when a firm enters after other international businesses have established themselves.

First-Mover Advantages Advantages accruing to the first to enter a market.

First-Mover Disadvantages Disadvantages associated with entering a foreign market before other international businesses.

Pioneering Costs Costs an early entrant bears that later entrants avoid, such as the time and effort in learning the rules, failure due to ignorance, and the liability of being a foreigner.

Interactive Rankings

Entering foreign markets is the focus of Chapter 13. The selection of country markets to choose from is getting larger for many product categories as more countries see their populations’ growing pur- chasing power. With more than 200 countries in the world, the data are overwhelming, and even the starting point for analysis is not always an easy decision. The Interactive Rankings on globalEDGE can serve as a great pictorial view of the world on some 50 important variables in categories covering the economy, energy, government,

health, infrastructure, labor, people, and trade and investment (globaledge.msu.edu/tools-and-data/interactive-rankings). Active data maps such as the Interactive Rankings maps are a good starting point for analysis to evaluate data for a specific country as well as the countries around in a region. This allows for a focus on entry into one market now and a strategy for expansion later on to nearby countries with similar characteristics. Which are the top three coun- tries for Internet users?

Chapter Thirteen Entering Foreign Markets 375

Pioneering costs also include the costs of promoting and establishing a product offering, including the costs of educating customers. These can be significant when the product being promoted is unfamiliar to local consumers. In contrast, later entrants may be able to ride on an early entrant’s investments in learning and customer education by watching how the early entrant proceeded in the market, by avoiding costly mistakes made by the early en- trant, and by exploiting the market potential created by the early entrant’s investments in customer education. For example, KFC introduced the Chinese to American-style fast food, but a later entrant, McDonald’s, has capitalized on the market in China.

Tesco’s International Growth Strategy

Tesco is the largest grocery retailer in the United Kingdom, with a 25 percent share of the local market. In its home market, the compa- ny’s strengths are reputed to come from strong competencies in mar- keting and store site selection, logistics and inventory management, and its own label product offerings. By the early 1990s, these compe- tencies had already given the company a leading position in the United Kingdom. The company was generating strong free cash flows, and senior management had to decide how to use that cash. One strategy they settled on was overseas expansion. As they looked at international markets, they soon concluded the best opportunities were not in estab- lished markets, such as those in North America and western Europe, where strong local competitors already existed, but in the emerging markets of eastern Europe and Asia, where there were few capable competitors but strong underlying growth trends.

Tesco’s first international foray was into Hungary in 1995, when it acquired an initial 51 percent stake in Global, a 43-store, state-owned grocery chain. By 2013, Tesco was the market leader in Hungary, with some 216 stores. In 1996, Tesco acquired 31 stores in Poland from Stavia; a year later it added 13 stores purchased from Kmart in the Czech Republic and Slovakia; and the following year it entered the Republic of Ireland.

Tesco’s Asian expansion began in 1998 in Thailand when it pur- chased 75 percent of Lotus, a local food retailer with 13 stores. Building on that base, Tesco had some 1,433 stores in Thailand by 2013. In 1999, the company entered South Korea when it partnered with Samsung to develop a chain of hypermarkets. This was followed by entry into Taiwan in 2000, Malaysia in 2002, and China in 2004. The move into China came after three years of careful research and discussions with potential part- ners. Like many other Western companies, Tesco was attracted to the Chinese market by its large size and rapid growth. In the end, Tesco set- tled on a 50/50 joint venture with Hymall, a hypermarket chain that is controlled by Ting Hsin, a Taiwanese group, that had been operating in China for six years. By 2013, Tesco had 131 stores in China. Ting Hsin is a well-capitalized enterprise in its own right, and it has matched Tesco’s investments, reducing the risks Tesco faces in China.

As a result of these moves, by 2013 Tesco generated sales of £20.8 billion outside of the United Kingdom (its UK annual revenues were £43.6 billion, excluding value-added taxes [VAT]). The addition of international stores has helped make Tesco the third-largest company in the global grocery market behind Walmart and Carrefour of France. Of the three, however, Tesco may be the most successful internation- ally. By 2013, all of its foreign ventures—except for a small U.S. opera- tion that it is in the process of divesting—were making money.

In explaining the company’s success, Tesco’s managers have de- tailed a number of important factors. First, the company devotes con- siderable attention to transferring its core capabilities in retailing to its new ventures. At the same time, it does not send in an army of expa- triate managers to run local operations, preferring to hire local man- agers and support them with a few operational experts from the United Kingdom. Second, the company believes that its partnering strategy in Asia has been a great asset. Tesco has teamed up with good companies that have a deep understanding of the markets in which they are participating but that lack Tesco’s financial strength and retailing capabilities. Consequently, both Tesco and its partners have brought useful assets to the venture, increasing the probability of success. As the venture becomes established, Tesco has typically in- creased its ownership stake in its partner. By 2010, Tesco owned 99 percent of Homeplus, its South Korean hypermarket chain. When the venture was established, Tesco owned 51 percent. Third, the com- pany has focused on markets with good growth potential but that lack strong indigenous competitors, which provides Tesco with ripe ground for expansion.

Sources: P. N. Child, “Taking Tesco Global,” The McKenzie Quarterly 3 (2002); H. Keers, “Global Tesco Sets Out Its Stall in China,” Daily Telegraph, July 15, 2004, p. 31; K. Burgess, “Tesco Spends Pounds 140m on Chinese Partnership,” Financial Times, July 15, 2004, p. 22; J. McTaggart, “Industry Awaits Tesco Invasion,” Progressive Grocer, March 1, 2006, pp. 8–10; Tesco’s annual reports, archived at www.tesco.com; “Tesco Set to Push Ahead in the United States,” The Wall Street Journal, October 6, 2010, p. 19; and P. Sonne, “Five Years and $1.6 Billion Later, Tesco Decides to Quit US,” The Wall Street Journal, December 6, 2012.

management FOCUS

Chinese customers enter a Tesco supermarket in Xiamen. Tesco’s expansion into China has proven to be very successful.

376 Part Five The Strategy of International Business

An early entrant may be put at a severe disadvantage, relative to a later entrant, if regulations change in a way that diminishes the value of an early entrant’s invest- ments. This is a serious risk in many developing nations where the rules that govern business practices are still evolving. Early entrants can find themselves at a disad- vantage if a subsequent change in regulations invalidates prior assumptions about the best business model for operating in that country.

SCALE OF ENTRY AND STRATEGIC COMMITMENTS Another issue that an interna- tional business needs to consider when contemplating market entry is the scale of entry. Entering a market on a large scale involves the commitment of significant re- sources. Entering a market on a large scale implies rapid entry. Consider the entry of the Dutch insurance com- pany ING into the U.S. insurance market in 1999. ING had to spend several billion dollars to acquire its U.S. op- erations. Not all firms have the resources necessary to enter on a large scale, and even some large firms prefer to enter foreign markets on a small scale and then build slowly as they become more familiar with the market.

The consequences of entering on a significant scale— entering rapidly—are associated with the value of the re- sulting strategic commitments.7 A strategic commitment

has a long-term impact and is difficult to reverse. Deciding to enter a foreign market on a significant scale is a major strategic commitment. Strategic commitments, such as rapid, large-scale market entry, can have an important influence on the nature of competition in a market. For example, by entering the U.S. financial services market on a significant scale, ING signaled its commitment to the market. This will have several effects. On the positive side, it will make it easier for the company to attract customers and distributors (such as in- surance agents). The scale of entry gives both customers and distributors reasons for believ- ing that ING will remain in the market for the long run. The scale of entry may also give other foreign institutions considering entry into the United States pause; now they will have to compete not only against indigenous institutions in the United States, but also against an aggressive and successful European institution. On the negative side, by committing itself heavily to one country, the United States, ING may have fewer resources available to sup- port expansion in other desirable markets, such as Japan. The commitment to the United States limits the company’s strategic flexibility.

As suggested by the ING example, significant strategic commitments are neither unam- biguously good nor bad. Rather, they tend to change the competitive playing field and un- leash a number of changes, some of which may be desirable and some of which will not be. It is important for a firm to think through the implications of large-scale entry into a market and act accordingly. Of particular relevance is trying to identify how actual and potential competitors might react to large-scale entry into a market. Also, the large-scale entrant is more likely than the small-scale entrant to be able to capture first-mover advantages associ- ated with demand preemption, scale economies, and switching costs.

The value of the commitments that flow from rapid large-scale entry into a foreign mar- ket must be balanced against the resulting risks and lack of flexibility associated with sig- nificant commitments. But strategic inflexibility can also have value. A famous example from military history illustrates the value of inflexibility. When Hernán Cortés landed in Mexico, he ordered his men to burn all but one of his ships. Cortés reasoned that by eliminating their only method of retreat, his men had no choice but to fight hard to win against the Aztecs—and ultimately they did.8

Is First-Mover Advantage Always a Good Thing? Timing of entry into a foreign market is one of the most critical aspects of going international. Popularized by Marvin Lieberman and David Montgomery in 1988, first-mover advantage was an idea that resonated with every company. But, 10 years later, in 1998, Lieberman and Montgomery actually backed off their own idea that taking advantage of being the first mover was always a good strategy. At this time, it was too late: Venture capitalists, companies, people, and many scholars had already latched on to the positive things about being first in a new foreign market and stressed this approach over any other timing of entry. Now we are some 15 years into the twenty-first century, and the realiza- tion is that first-mover advantages also come with pioneering costs. If you had a choice of being the first-mover into a new emerging foreign market (e.g., Turkey) and being the fifth com- pany entering that market with your product, what would you choose and why?

Sources: M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9, no. S1 (1988), pp. 41–58;and M. B. Lieberman and D. B. Montgomery, “First-Mover (Dis)Advantages: Retrospective and Link with the Resource-Based View,” Strategic Management Journal 19, no. 12 (1998), pp. 1111–25.

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Balanced against the value and risks of the commitments associated with large-scale entry are the benefits of a small-scale entry. Small-scale entry allows a firm to learn about a for- eign market while limiting the firm’s exposure to that market. Small-scale entry is a way to gather information about a foreign market before deciding whether to enter on a significant scale and how best to enter. By giving the firm time to collect information, small-scale entry reduces the risks associated with a subsequent large-scale entry. But the lack of commitment associated with small-scale entry may make it more difficult for the small-scale entrant to build market share and to capture first-mover or early-mover advantages. The risk-averse firm that enters a foreign market on a small scale may limit its potential losses, but it may also miss the chance to capture first-mover advantages.

MARKET ENTRY SUMMARY There are no “right” decisions here, just deci- sions that are associated with different levels of risk and reward. Entering a large devel- oping nation such as China or India before most other international businesses in the firm’s industry, and entering on a large scale, will be associated with high levels of risk. In such cases, the liability of being foreign is increased by the absence of prior foreign en- trants whose experience can be a useful guide. At the same time, the potential long-term rewards associated with such a strategy are great. The early large-scale entrant into a major developing nation may be able to capture significant first-mover advantages that will bolster its long-run position in that market.9 In contrast, entering developed nations such as Australia or Canada after other international businesses in the firm’s industry, and entering on a small scale to first learn more about those markets, will be associated with much lower levels of risk. However, the potential long-term rewards are also likely to be lower because the firm is essentially forgoing the opportunity to capture first-mover ad- vantages and because the lack of commitment signaled by small-scale entry may limit its future growth potential.

This section has been written largely from the perspective of a business based in a devel- oped country considering entry into foreign markets. Christopher Bartlett and Sumantra Ghoshal have pointed out the ability that businesses based in developing nations have to enter foreign markets and become global players.10 Although such firms tend to be late entrants into foreign markets, and although their resources may be limited, Bartlett and Ghoshal argue that such late movers can still succeed against well-established global com- petitors by pursuing appropriate strategies. In particular, Bartlett and Ghoshal argue that companies based in developing nations should use the entry of foreign multinationals as an opportunity to learn from these competitors by benchmarking their operations and perfor- mance against them. Furthermore, they suggest the local company may be able to find ways to differentiate itself from a foreign multinational, for example, by focusing on market niches that the multinational ignores or is unable to serve effectively if it has a standardized global product offering. Having improved its performance through learning and differenti- ated its product offering, the firm from a developing nation may then be able to pursue its own international expansion strategy. Even though the firm may be a late entrant into many countries, by benchmarking and then differentiating itself from early movers in global markets, the firm from the developing nation may still be able to build a strong in- ternational business presence. A good example of how this can work is given in the accom- panying Management Focus, which looks at how Jollibee, a Philippines-based fast-food chain, has started to build a global presence in a market dominated by U.S. multinationals such as McDonald’s and KFC.

Entry Modes Once a firm decides to enter a foreign market, the question arises as to the best mode of entry. Firms can use six different modes to enter foreign markets: exporting, turnkey proj- ects, licensing, franchising, establishing joint ventures with a host-country firm, or setting up a new wholly owned subsidiary in the host country. Each entry mode has advantages and disadvantages. Managers need to consider these carefully when deciding which to use.11

LO 13-2 Compare and contrast the different modes that firms use to enter foreign markets.

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.

378 Part Five The Strategy of International Business

EXPORTING Many manufacturing firms begin their global expansion as exporters and only later switch to another mode for serving a foreign market. We take a close look at the mechanics of exporting in Chapter 16. Here, we focus on the advantages and disadvan- tages of exporting as an entry mode.

Advantages Exporting has two distinct advantages. First, it avoids the often substan- tial costs of establishing manufacturing operations in the host country. Second, exporting may help a firm achieve experience curve and location economies (see Chapter 12).

Exporting Sale of products produced in one country to residents of another country.

The Jollibee Phenomenon—A Philippine Multinational

Jollibee is one of the Philippines’ phenomenal business success sto- ries. Jollibee, which stands for “Jolly Bee,” began operations in 1975 as a two-branch ice cream parlor. It later expanded its menu to in- clude hot sandwiches and other meals. Encouraged by early success, Jollibee Foods Corporation was incorporated in 1978, with a network that had grown to seven outlets. In 1981, when Jollibee had 11 stores, McDonald’s began to open stores in Manila. Many observers thought Jollibee would have difficulty competing against McDonald’s. How- ever, Jollibee saw this as an opportunity to learn from a very success- ful global competitor. Jollibee benchmarked its performance against that of McDonald’s and started to adopt operational systems similar to those used at McDonald’s to control its quality, cost, and service at the store level. This helped Jollibee to improve its performance.

As it came to better understand McDonald’s business model, Jollibee began to look for a weakness in McDonald’s global strategy. Jollibee executives concluded that McDonald’s fare was too standard- ized for many locals and that the local firm could gain share by tailoring its menu to local tastes. Jollibee’s hamburgers were set apart by a secret mix of spices blended into the ground beef to make the burgers sweeter than those produced by McDonald’s, appealing more to Philippine tastes. It also offered local fare, including various rice dishes, pineapple burgers, and banana langka and peach mango pies for desserts. By pur- suing this strategy, Jollibee maintained a leadership position over the global giant. By 2012, Jollibee had more than 740 stores in the Philippines, a mar- ket share of more than 60 per- cent, and revenues in excess of $600 million. McDonald’s, in contrast, had about 250 stores.

In the mid-1980s, Jollibee had gained enough confidence to expand internationally. Its initial ventures were into neighboring Asian countries such as Indonesia, where it pursued the

strategy of localizing the menu to better match local tastes, thereby dif- ferentiating itself from McDonald’s. In 1987, Jollibee entered the Middle East, where a large contingent of expatriate Filipino workers provided a ready-made market for the company. The strategy of focusing on expa- triates worked so well that in the late 1990s Jollibee decided to enter another foreign market where there was a large Filipino population— the United States. Between 1999 and 2012, Jollibee opened 25 stores in the United States, 20 of which are in California. Even though many believe the U.S. fast-food market is saturated, the stores have performed well. While the initial clientele was strongly biased toward the expatriate Filipino community, where Jollibee’s brand awareness is high, non-Filipinos in- creasingly are coming to the restaurant. In the San Francisco store, which has been open the longest, more than half the customers are now non- Filipino. Today, Jollibee has 75 international stores that operate under the Jollibee name and a potentially bright future as a niche player in a market that has historically been dominated by U.S. multinationals.

Sources: “Jollibee Battles Burger Giants in US Market,” Philippine Daily Inquirer, July 13, 2000; M. Ballon, “Jollibee Struggling to Expand in U.S.,” Los Angeles Times, September 16, 2002, p. C1; J. Hookway, “Burgers and Beer,” Far Eastern Economic Review, December 2003, pp. 72–74; S. E. Lockyer, “Coming to America,” Nation’s Restaurant News, February 14, 2005, pp. 33–35; Erik de la Cruz, “Jollibee to Open 120 New Stores This Year, Plans India,” Inquirer Money, July 5, 2006 (www.business.inquirer.net); and www.jollibee.com.ph.

management FOCUS

Jollibee may be heading your way! Unlike many fast-food chains that have their roots within the United States, the Jollibee chain originated in the Philippines using McDonald’s as a role model.

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By manufacturing the product in a centralized location and exporting it to other national markets, the firm may realize substantial scale economies from its global sales volume. This is how many Japanese automakers made inroads into the U.S. market.

Disadvantages Exporting has a number of drawbacks. First, exporting from the firm’s home base may not be appropriate if lower-cost locations for manufacturing the product can be found abroad (i.e., if the firm can realize location economies by moving production elsewhere). Thus, particularly for firms pursuing global or transnational strate- gies, it may be preferable to manufacture where the mix of factor conditions is most favor- able from a value creation perspective and to export to the rest of the world from that location. This is not so much an argument against exporting as an argument against ex- porting from the firm’s home country. Many U.S. electronics firms have moved some of their manufacturing to the Far East because of the availability of low-cost, highly skilled labor there. They then export from that location to the rest of the world, including the United States.

A second drawback to exporting is that high transport costs can make exporting uneco- nomical, particularly for bulk products. One way of getting around this is to manufacture bulk products regionally. This strategy enables the firm to realize some economies from large-scale production and at the same time to limit its transport costs. For example, many multinational chemical firms manufacture their products regionally, serving several coun- tries from one facility.

Another drawback is that tariff barriers can make exporting uneconomical. Similarly, the threat of tariff barriers by the host-country government can make it very risky. A fourth drawback to exporting arises when a firm delegates its marketing, sales, and service in each country where it does business to another company. This is a common approach for manu- facturing firms that are just beginning to expand internationally. The other company may be a local agent, or it may be another multinational with extensive international distribution operations. Local agents often carry the products of competing firms and so have divided loyalties. In such cases, the local agent may not do as good a job as the firm would if it man- aged its marketing itself. Similar problems can occur when another multinational takes on distribution.

The way around such problems is to set up wholly owned subsidiaries in foreign nations to handle local marketing, sales, and service. By doing this, the firm can exercise tight con- trol over marketing and sales in the country while reaping the cost advantages of manufac- turing the product in a single location, or a few choice locations.

TURNKEY PROJECTS Firms that specialize in the design, construction, and start-up of turnkey plants are common in some industries. In a turnkey project, the con- tractor agrees to handle every detail of the project for a foreign client, including the training of operating personnel. At completion of the contract, the foreign client is handed the “key” to a plant that is ready for full operation—hence, the term turnkey. This is a means of ex- porting process technology to other countries. Turnkey projects are most common in the chemical, pharmaceutical, petroleum-refining, and metal-refining industries, all of which use complex, expensive production technologies.

Advantages The know-how required to assemble and run a technologically complex process, such as refining petroleum or steel, is a valuable asset. Turnkey projects are a way of earning great economic returns from that asset. The strategy is particularly useful where FDI is limited by host-government regulations. For example, the governments of many oil- rich countries have set out to build their own petroleum-refining industries, so they restrict FDI in their oil-refining sectors. But because many of these countries lack petroleum- refining technology, they gain it by entering into turnkey projects with foreign firms that have the technology. Such deals are often attractive to the selling firm because, without them, they would have no way to earn a return on their valuable know-how in that country. A turnkey strategy can also be less risky than conventional FDI. In a country with unstable political and economic environments, a longer-term investment might expose the firm to

Turnkey Project A project in which a firm agrees to set up an operating plant for a foreign client and hand over the “key” when the plant is fully operational.

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unacceptable political and/or economic risks (e.g., the risk of nationalization or of economic collapse).

Disadvantages Three main drawbacks are associated with a turnkey strategy. First, the firm that enters into a turnkey deal will have no long-term interest in the foreign coun- try. This can be a disadvantage if that country subsequently proves to be a major market for the output of the process that has been exported. One way around this is to take a minority equity interest in the operation. Second, the firm that enters into a turnkey project with a foreign enterprise may inadvertently create a competitor. For example, many of the Western firms that sold oil-refining technology to firms in Saudi Arabia, Kuwait, and other Gulf states now find themselves competing with these firms in the world oil market. Third, if the firm’s process technology is a source of competitive advantage, then selling this technology through a turnkey project is also selling competitive advantage to potential and/or actual competitors.

LICENSING A licensing agreement is an arrangement whereby a licensor grants the rights to intangible property to another entity (the licensee) for a specified period, and in return, the licensor receives a royalty fee from the licensee.12 Intangible property includes patents, inventions, formulas, processes, designs, copyrights, and trademarks. For example, to enter the Japanese market, Xerox, inventor of the photocopier, established a joint venture with Fuji Photo that is known as Fuji Xerox. Xerox then licensed its xerographic know-how to Fuji Xerox. In return, Fuji Xerox paid Xerox a royalty fee equal to 5 percent of the net sales revenue that Fuji Xerox earned from the sales of photocopiers based on Xerox’s pat- ented know-how. In the Fuji Xerox case, the license was originally granted for 10 years, and it has been renegotiated and extended several times since. The licensing agreement between Xerox and Fuji Xerox also limited Fuji Xerox’s direct sales to the Asian Pacific region (although Fuji Xerox does supply Xerox with photocopiers that are sold in North America under the Xerox label).13

Advantages In the typical international licensing deal, the licensee puts up most of the capital necessary to get the overseas operation going. Thus, a primary advantage of licensing is that the firm does not have to bear the development costs and risks associated with open- ing a foreign market. Licensing is very attractive for firms lacking the capital to develop operations overseas. In addition, licensing can be attractive when a firm is unwilling to com- mit substantial financial resources to an unfamiliar or politically volatile foreign market. Licensing is also often used when a firm wishes to participate in a foreign market but is prohibited from doing so by barriers to investment. This was one of the original reasons for the formation of the Fuji Xerox joint venture. Xerox wanted to participate in the Japanese market but was prohibited from setting up a wholly owned subsidiary by the Japanese gov- ernment. So Xerox set up the joint venture with Fuji and then licensed its know-how to the joint venture.

Finally, licensing is frequently used when a firm possesses some intangible property that might have business applications, but it does not want to develop those applications itself. For example, Bell Laboratories at AT&T originally invented the transistor circuit in the 1950s, but AT&T decided it did not want to produce transistors, so it licensed the technol- ogy to a number of other companies, such as Texas Instruments. Similarly, Coca-Cola has licensed its famous trademark to clothing manufacturers, which have incorporated the de- sign into clothing.

Disadvantages Licensing has three serious drawbacks. First, it does not give a firm the tight control over manufacturing, marketing, and strategy that is required for realizing experience curve and location economies. Licensing typically involves each licensee setting up its own production operations. This severely limits the firm’s ability to realize experience curve and location economies by producing its product in a centralized location. When these economies are important, licensing may not be the best way to expand overseas.

Licensing Agreement Arrangement in which a licensor grants the rights to intangible property to the licensee for a specified period and receives a royalty fee in return.

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Second, competing in a global market may require a firm to coordinate strategic moves across countries by using profits earned in one country to support competitive attacks in another. By its very nature, licensing limits a firm’s ability to do this. A licensee is unlikely to allow a multinational firm to use its profits (beyond those due in the form of royalty pay- ments) to support a different licensee operating in another country.

A third problem with licensing is one that we encountered in Chapter 8 when we re- viewed the economic theory of FDI. This is the risk associated with licensing technological know-how to foreign companies. Technological know-how constitutes the basis of many multinational firms’ competitive advantage. Most firms wish to maintain control over how their know-how is used, and a firm can quickly lose control over its technology by licensing it. Many firms have made the mistake of thinking they could maintain control over their know-how within the framework of a licensing agree- ment. RCA Corporation, for example, once licensed its color TV technology to Japanese firms including Matsushita and Sony. The Japanese firms quickly assimilated the tech- nology, improved on it, and used it to enter the U.S. market, taking substantial market share away from RCA.

There are ways of reducing this risk. One way is by enter- ing into a cross-licensing agreement with a foreign firm. Under a cross-licensing agreement, a firm might license some valuable intangible property to a foreign partner, but in addition to a royalty payment, the firm might also request that the foreign partner license some of its valuable know- how to the firm. Such agreements are believed to reduce the risks associated with licensing technological know-how be- cause the licensee realizes that if it violates the licensing contract (by using the knowledge obtained to compete di- rectly with the licensor), the licensor can do the same to it. Cross-licensing agreements enable firms to hold each other hostage, which reduces the probability that they will behave

Exporting or Licensing? In Chapter 13, we discuss as series of advantages and disad- vantages of exporting and licensing (as well as turnkey projects, franchising, joint ventures, and wholly owned subsidiaries as other entry mode choices). Exporting refers to the sale of prod- ucts produced in one country to residents of another country. Licensing refers to an arrangement in which a licensor grants the rights to intangible property to the licensee for a specified period and receives a royalty fee in return. Both of these modes of entry into a foreign market have unique advantages and dis- advantages. Oftentimes, selecting exporting or licensing de- pends on myriad factors—one being the global mindset of the business owner. Assume you have a choice to enter three emerging markets—Bolivia, Chile, and Peru, neighboring coun- tries in South America. You have a great product, with lots of technological innovation and a lightweight packaging. Would you opt for exporting or licensing, and why?

Models walk the catwalk at Coca-Cola’s clothing show in Rio de Janeiro, Brazil. Coca-Cola has licensed its famous trademark to clothing manufacturers.

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opportunistically toward each other.14 Such cross-licensing agreements are increasingly common in high-technology industries.

Another way of reducing the risk associated with licensing is to follow the Fuji Xerox model and link an agreement to license know-how with the formation of a joint venture in which the licensor and licensee take important equity stakes. Such an approach aligns the interests of licensor and licensee because both have a stake in ensuring that the venture is successful. Thus, the risk that Fuji Photo might appropriate Xerox’s technological know- how, and then compete directly against Xerox in the global photocopier market, was re- duced by the establishment of a joint venture in which both Xerox and Fuji Photo had an important stake.

FRANCHISING Franchising is similar to licensing, although franchising tends to involve longer-term commitments than licensing. Franchising is basically a specialized form of licensing in which the franchiser not only sells intangible property (normally a trademark) to the franchisee, but also insists that the franchisee agree to abide by strict rules as to how it does business. The franchiser will also often assist the franchisee to run the busi- ness on an ongoing basis. As with licensing, the franchiser typically receives a royalty pay- ment, which amounts to some percentage of the franchisee’s revenues. Whereas licensing is pursued primarily by manufacturing firms, franchising is employed primarily by service firms.15 McDonald’s is a good example of a firm that has grown by using a franchising strat- egy. McDonald’s strict rules as to how franchisees should operate a restaurant extend to control over the menu, cooking methods, staffing policies, and design and location. McDonald’s also organizes the supply chain for its franchisees and provides management training and financial assistance.16

Advantages The advantages of franchising as an entry mode are very similar to those of licensing. The firm is relieved of many of the costs and risks of opening a foreign market on its own. Instead, the franchisee typically assumes those costs and risks. This creates a good incentive for the franchisee to build a profitable operation as quickly as possible. Thus, using a franchising strategy, a service firm can build a global presence quickly and at a rela- tively low cost and risk, as McDonald’s has.

Disadvantages The disadvantages of franchising are less pronounced than in the case of licensing. Because franchising is often used by service companies, there is no reason to consider the need for coordination of manufac- turing to achieve experience curve and location econo- mies. But franchising may inhibit the firm’s ability to take profits out of one country to support competitive attacks in another. A more significant disadvantage of franchising is quality control. The foundation of franchising arrange- ments is that the firm’s brand name conveys a message to consumers about the quality of the firm’s product. Thus, a business traveler checking in at a Four Seasons hotel in Hong Kong can reasonably expect the same quality of room, food, and service that she would receive in New York. The Four Seasons name is supposed to guarantee consistent product quality. This presents a problem in that foreign franchisees may not be as concerned about quality as they are supposed to be, and the result of poor quality can extend beyond lost sales in a particular foreign market to a decline in the firm’s worldwide reputation. For example, if the business traveler has a bad experience at the Four Seasons in Hong Kong, she may never go to another Four Seasons hotel and may urge her colleagues to do likewise. The geographical distance of the firm

Franchising A specialized form of licensing in which the franchiser sells intangible property to the franchisee and insists on rules to conduct the business.

So, You Think You Want to Own a Franchise? Franchising is a specialized form of licensing in which the fran- chiser not only sells intangible property to the franchisee, but also insists that the franchisee agree to abide by strict rules as to how it does business. Some of the advantages of franchising include branding, advertising, reputation, and headquarters/ company support for development of the infrastructure needed to operate the franchise business. Some of the disadvantages of franchising include restrictions on territory and pricing, not being completely independent, franchise fee and ongoing royalty pay- ments, and dependence on other franchise owners for nurturing the brand. Well-known worldwide franchise systems include Subway, 7-Eleven, Pizza Hut, and McDonald’s, for example. Assume you are interested in being an international entrepreneur. Would franchising be your choice of starting a business?

Source: T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Lev- eraging Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill Education, 2014).

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from its foreign franchisees can make poor quality difficult to detect. In addition, the sheer numbers of franchisees—in the case of McDonald’s, tens of thousands—can make quality control difficult. Due to these factors, quality problems may persist.

One way around this disadvantage is to set up a subsidiary in each country in which the firm expands. The subsidiary might be wholly owned by the company or a joint venture with a foreign company. The subsidiary assumes the rights and obligations to establish franchises throughout the particular country or region. McDonald’s, for example, establishes a master franchisee in many countries. Typically, this master franchisee is a joint venture between McDonald’s and a local firm. The proximity and the smaller number of franchises to oversee reduce the quality control challenge. In addition, because the subsidiary (or master franchisee) is at least partly owned by the firm, the firm can place its own managers in the subsidiary to help ensure that it is doing a good job of monitoring the franchises. This organizational arrangement has proven very satisfactory for McDonald’s, KFC, and others.

JOINT VENTURES A joint venture entails establishing a firm that is jointly owned by two or more otherwise independent firms. Fuji Xerox, for example, was set up as a joint venture between Xerox and Fuji Photo. Establishing a joint venture with a foreign firm has long been a popular mode for entering a new market. The most typical joint venture is a 50/50 venture, in which there are two parties, each of which holds a 50 percent ownership stake and contributes a team of managers to share operating control. This was the case with the Fuji–Xerox joint venture until 2001; it is now a 25/75 venture with Xerox holding 25 percent. GM’s successful joint venture in China with its Chinese partner, SAIC, was a 50/50 venture until 2010, which it became a 51/49 venture, with SAIC holding the 51 per- cent stake. Some firms, however, have sought joint ventures in which they have a majority share and thus tighter control.17

Advantages Joint ventures have a number of advantages. First, a firm benefits from a local partner’s knowledge of the host country’s competitive conditions, culture, language, political systems, and business. Thus, for many U.S. firms, joint ventures have involved the U.S. company providing technological know-how and products and the local partner pro- viding the marketing expertise and the local knowledge necessary for competing in that country. Second, when the development costs and/or risks of opening a foreign market are high, a firm might gain by sharing these costs and or risks with a local partner. Third, in many countries, political considerations make joint ventures the only feasible entry mode. Research suggests joint ventures with local partners face a low risk of being subject to na- tionalization or other forms of adverse government interference.18 This appears to be be- cause local equity partners, who may have some influence on host-government policy, have a vested interest in speaking out against nationalization or government interference.

Disadvantages Despite these advantages, there are major disadvantages with joint ventures. First, as with licensing, a firm that enters into a joint venture risks giving control of its technology to its partner. Thus, a proposed joint venture in 2002 between Boeing and Mitsubishi Heavy Industries to build a new wide-body jet (the 787) raised fears that Boeing might unwittingly give away its commercial airline technology to the Japanese. However, joint-venture agreements can be constructed to minimize this risk. One option is to hold majority ownership in the venture. This allows the dominant partner to exercise greater control over its technology. But it can be difficult to find a foreign partner who is willing to settle for minority ownership. Another option is to “wall off” from a partner technology that is central to the core competence of the firm, while sharing other technology.

A second disadvantage is that a joint venture does not give a firm the tight control over subsidiaries that it might need to realize experience curve or location economies. Nor does it give a firm the tight control over a foreign subsidiary that it might need for engaging in co- ordinated global attacks against its rivals. Consider the entry of Texas Instruments (TI) into the Japanese semiconductor market. When TI established semiconductor facilities in Japan, it did so for the dual purpose of checking Japanese manufacturers’ market share and limiting their cash available for invading TI’s global market. In other words, TI was engaging in global

Joint Venture Establishing a firm that is jointly owned by two or more otherwise independent firms.

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strategic coordination. To implement this strategy, TI’s subsidiary in Japan had to be pre- pared to take instructions from corporate headquarters regarding competitive strategy. The strategy also required the Japanese subsidiary to run at a loss if necessary. Few if any potential joint-venture partners would have been willing to accept such conditions because it would have necessitated a willingness to accept a negative return on investment. Indeed, many joint ventures establish a degree of autonomy that would make such direct control over strategic decisions all but impossible to establish.19 Thus, to implement this strategy, TI set up a wholly owned subsidiary in Japan.

A third disadvantage with joint ventures is that the shared ownership arrangement can lead to conflicts and battles for control between the investing firms if their goals and objec- tives change or if they take different views as to what the strategy should be. This was appar- ently not a problem with the Fuji Xerox joint venture. According to Yotaro Kobayashi, the former chairman of Fuji Xerox, a primary reason is that both Xerox and Fuji Photo adopted an arm’s-length relationship with Fuji Xerox, giving the venture’s management considerable freedom to determine its own strategy.20 However, much research indicates that conflicts of interest over strategy and goals often arise in joint ventures. These conflicts tend to be greater when the venture is between firms of different nationalities, and they often end in the dissolution of the venture.21 Such conflicts tend to be triggered by shifts in the relative bargaining power of venture partners. For example, in the case of ventures between a for- eign firm and a local firm, as a foreign partner’s knowledge about local market conditions increases, it depends less on the expertise of a local partner. This increases the bargaining power of the foreign partner and ultimately leads to conflicts over control of the venture’s strategy and goals.22 Some firms have sought to limit such problems by entering into joint ventures in which one partner has a controlling interest.

WHOLLY OWNED SUBSIDIARIES In a wholly owned subsidiary, the firm owns 100 percent of the stock. Establishing a wholly owned subsidiary in a foreign market can be done two ways. The firm either can set up a new operation in that country, often re- ferred to as a greenfield venture, or it can acquire an established firm in that host nation and use that firm to promote its products.23 For example, ING’s strategy for entering the U.S. insurance market was to acquire established U.S. enterprises, rather than try to build an operation from the ground floor.

Advantages There are several clear advantages of wholly owned subsidiaries. First, when a firm’s competitive advantage is based on technological competence, a wholly owned subsidiary will often be the preferred entry mode because it reduces the risk of los- ing control over that competence. (See Chapter 8 for more details.) Many high-tech firms prefer this entry mode for overseas expansion (e.g., firms in the semiconductor, electron- ics, and pharmaceutical industries). Second, a wholly owned subsidiary gives a firm tight control over operations in different countries. This is necessary for engaging in global strategic coordination (i.e., using profits from one country to support competitive attacks in another).

Third, a wholly owned subsidiary may be required if a firm is trying to realize location and experience curve economies (as firms pursuing global and transnational strategies try to do). As we saw in Chapter 12, when cost pressures are intense, it may pay a firm to con- figure its value chain in such a way that the value added at each stage is maximized. Thus, a national subsidiary may specialize in manufacturing only part of the product line or certain components of the end product, exchanging parts and products with other subsid- iaries in the firm’s global system. Establishing such a global production system requires a high degree of control over the operations of each affiliate. The various operations must be prepared to accept centrally determined decisions as to how they will produce, how much they will produce, and how their output will be priced for transfer to the next op- eration. Because licensees or joint-venture partners are unlikely to accept such a subservi- ent role, establishing wholly owned subsidiaries may be necessary. Finally, establishing a wholly owned subsidiary gives the firm a 100 percent share in the profits generated in a foreign market.

Wholly Owned Subsidiary A subsidiary in which the firm owns 100 percent of the stock.

Chapter Thirteen Entering Foreign Markets 385

Disadvantage Establishing a wholly owned subsidiary is generally the most costly method of serving a foreign market from a capital investment standpoint. Firms doing this must bear the full capital costs and risks of setting up overseas operations. The risks associ- ated with learning to do business in a new culture are less if the firm acquires an established host-country enterprise. However, acquisitions raise additional problems, including those associated with trying to marry divergent corporate cultures. These problems may more than offset any benefits derived by acquiring an established operation. Because the choice between greenfield ventures and acquisitions is such an important one, we shall discuss it in more detail later in the chapter.

Selecting an Entry Mode As the preceding discussion demonstrated, all the entry modes have advantages and disad- vantages, as summarized in Table 13.1. Thus, trade-offs are inevitable when selecting an entry mode. For example, when considering entry into an unfamiliar country with a track record for discriminating against foreign-owned enterprises when awarding government contracts, a firm might favor a joint venture with a local enterprise. Its rationale might be that the local partner will help it establish operations in an unfamiliar environment and will help the company win government contracts. However, if the firm’s core competence is based on proprietary technology, entering a joint venture might risk losing control of that technology to the joint-venture partner, in which case the strategy may seem unattractive.

LO 13-3 Identify the factors that influence a firm’s choice of entry mode.

13.1 TABLE Advantages and Disadvantages of Entry Modes

Entry Mode Advantages Disadvantages

Exporting Ability to realize location and experience curve economies

High transport costs

Trade barriers

Problems with local marketing agents

Turnkey contracts

Ability to earn returns from process technology skills in countries where FDI is restricted

Creating efficient competitors

Lack of long-term market presence

Licensing Low development costs and risks Lack of control over technology

Inability to realize location and experience curve economies

Inability to engage in global strategic coordination

Franchising Low development costs and risks Lack of control over quality

Inability to engage in global strategic coordination

Joint ventures

Access to local partner’s knowledge

Sharing development costs and risks

Politically acceptable

Lack of control over technology

Inability to engage in global strategic coordination

Inability to realize location and experience economies

Wholly owned subsidiaries

Protection of technology

Ability to engage in global strategic coordination

Ability to realize location and experience economies

High costs and risks

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386 Part Five The Strategy of International Business

Despite the existence of such trade-offs, it is possible to make some generalizations about the optimal choice of entry mode.24

CORE COMPETENCIES AND ENTRY MODE We saw in Chapter 12 that firms often expand internationally to earn greater returns from their core competencies, transferring the skills and products derived from their core competencies to foreign markets where indigenous competitors lack those skills. The optimal entry mode for these firms depends to some degree on the nature of their core competencies. A distinction can be drawn between firms whose core competency is in technological know-how and those whose core competency is in management know-how.

Technological Know-How As was observed in Chapter 8, if a firm’s competitive advantage (its core competence) is based on control over proprietary technological know- how, licensing and joint-venture arrangements should be avoided if possible to minimize the risk of losing control over that technology. Thus, if a high-tech firm sets up operations in a foreign country to profit from a core competency in technological know-how, it will prob- ably do so through a wholly owned subsidiary. This rule should not be viewed as hard and fast, however. Sometimes a licensing or joint-venture arrangement can be structured to re- duce the risk of licensees or joint-venture partners expropriating technological know-how. Another exception exists when a firm perceives its technological advantage to be only transi- tory, such as when it expects rapid imitation of its core technology by competitors. In such cases, the firm might want to license its technology as rapidly as possible to foreign firms to gain global acceptance for its technology before the imitation occurs.25 Such a strategy has some advantages. By licensing its technology to competitors, the firm may deter them from developing their own, possibly superior, technology. Further, by licensing its technology, the firm may establish its technology as the dominant design in the industry. This may ensure a steady stream of royalty payments. However, the attractions of licensing are frequently out- weighed by the risks of losing control over technology, and if this is a risk, licensing should be avoided.

Management Know-How The competitive advantage of many service firms is based on management know-how (e.g., McDonald’s, Starbucks). For such firms, the risk of losing control over the management skills to franchisees or joint-venture partners is not that great. These firms’ valuable asset is their brand name, and brand names are generally well protected by international laws pertaining to trademarks. Given this, many of the issues aris- ing in the case of technological know-how are of less concern here. As a result, many service firms favor a combination of franchising and subsidiaries to control the franchises within particular countries or regions. The subsidiaries may be wholly owned or joint ventures, but most service firms have found that joint ventures with local partners work best for the con- trolling subsidiaries. A joint venture is often politically more acceptable and brings a degree of local knowledge to the subsidiary.

PRESSURES FOR COST REDUCTIONS AND ENTRY MODE The greater the pressures for cost reductions are, the more likely a firm will want to pursue some combination of exporting and wholly owned subsidiaries. By manufacturing in those loca- tions where factor conditions are optimal and then exporting to the rest of the world, a firm may be able to realize substantial location and experience curve economies. The firm might then want to export the finished product to marketing subsidiaries based in various coun- tries. These subsidiaries will typically be wholly owned and have the responsibility for over- seeing distribution in their particular countries. Setting up wholly owned marketing subsidiaries is preferable to joint-venture arrangements and to using foreign marketing agents because it gives the firm tight control that might be required for coordinating a glob- ally dispersed value chain. It also gives the firm the ability to use the profits generated in one market to improve its competitive position in another market. In other words, firms pursu- ing global standardization or transnational strategies tend to prefer establishing wholly owned subsidiaries.

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Chapter Thirteen Entering Foreign Markets 387

Greenfield Venture or Acquisition? A firm can establish a wholly owned subsidiary in a country by building a subsidiary from the ground up, the so-called greenfield strategy, or by acquiring an enterprise in the target market.26 The volume of cross-border acquisitions has been growing at a rapid rate for two decades. Over most of the past two decades, between 40 and 80 percent of all FDI inflows have been in the form of mergers and acquisitions.27

PROS AND CONS OF ACQUISITIONS Acquisitions have three major points in their favor. First, they are quick to execute. By acquiring an established enterprise, a firm can rapidly build its presence in the target foreign market. When the German auto- mobile company Daimler-Benz decided it needed a bigger presence in the U.S. automobile market, it did not increase that presence by building new factories to serve the United States, a process that would have taken years. Instead, it acquired the no. 3 U.S. automobile company, Chrysler, and merged the two operations to form DaimlerChrysler (Daimler spun off Chrysler into a private equity firm in 2007). When the Spanish telecommunications service provider Telefónica wanted to build a service presence in Latin America, it did so through a series of acquisitions, purchasing telecommunications companies in Brazil and Argentina. In these cases, the firms made acquisitions because they knew that was the quick- est way to establish a sizable presence in the target market.

Second, in many cases firms make acquisitions to preempt their competitors. The need for preemption is particularly great in markets that are rapidly globalizing, such as tele- communications, where a combination of deregulation within nations and liberalization of regulations governing cross-border foreign direct investment has made it much easier for enterprises to enter foreign markets through acquisitions. Such markets may see con- centrated waves of acquisitions as firms race each other to attain global scale. In the tele- communications industry, for example, regulatory changes triggered what can be called a feeding frenzy, with firms entering each other’s markets via acquisitions to establish a global presence. These included the $56 billion acquisition of AirTouch Communications in the United States by the British company Vodafone, which was the largest acquisition ever; the $13 billion acquisition of One 2 One in Britain by the German company Deutsche Telekom; and the $6.4 billion acquisition of Excel Communications in the United States by Teleglobe of Canada, all of which occurred in 1998 and 1999.28 A similar wave of cross-border acquisitions occurred in the global automobile industry over the same time period, with Daimler acquiring Chrysler, Ford acquiring Volvo, and Renault acquiring Nissan.

Third, managers may believe acquisitions to be less risky than greenfield ventures. When a firm makes an acquisition, it buys a set of assets that are producing a known reve- nue and profit stream. In contrast, the revenue and profit stream that a greenfield venture might generate is uncertain because it does not yet exist. When a firm makes an acquisition in a foreign market, it not only acquires a set of tangible assets, such as factories, logistics systems, customer service systems, and so on, but it also acquires valuable intangible assets including a local brand name and managers’ knowledge of the business environment in that nation. Such knowledge can reduce the risk of mistakes caused by ignorance of the national culture.

Despite the arguments for making acquisitions, acquisitions often produce disappointing results.29 For example, a study by Mercer Management Consulting looked at 150 acquisi- tions worth more than $500 million each.30 The Mercer study concluded that 50 percent of these acquisitions eroded shareholder value, while another 33 percent created only marginal returns. Only 17 percent were judged to be successful. Similarly, a study by KPMG, an ac- counting and management consulting company, looked at 700 large acquisitions. The study found that while some 30 percent of these actually created value for the acquiring company, 31 percent destroyed value, and the remainder had little impact.31 A similar study by McKinsey & Company estimated that some 70 percent of mergers and acquisitions failed to achieve expected revenue synergies.32 In a seminal study of the post-acquisition performance of acquired companies, David Ravenscraft and Mike Scherer concluded that on average the

LO 13-4 Recognize the pros and cons of acquisitions versus greenfield ventures as an entry strategy.

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profits and market shares of acquired companies declined following acquisition.33 They also noted that a smaller but substantial subset of those companies experienced traumatic difficulties, which ultimately led to their being sold by the acquiring company. Ravenscraft and Scherer’s evidence suggests that many acquisitions destroy rather than create value. While most research has looked at domestic acquisitions, the findings probably also apply to cross-border acquisitions.34

Why Do Acquisitions Fail? Acquisitions fail for several reasons. First, the acquiring firms often overpay for the assets of the acquired firm. The price of the target firm can get bid up if more than one firm is interested in its purchase, as is often the case. In addition, the management of the acquiring firm is often too optimistic about the value that can be created via an acquisition and is thus willing to pay a significant premium over a target firm’s market capitalization. This is called the “hubris hypothesis” of why acquisitions fail. The hubris hypothesis postulates that top managers typically overestimate their ability to create value from an acquisition, primarily because rising to the top of a corporation has given them an exaggerated sense of their own capabilities.35 For example, Daimler acquired Chrysler in 1998 for $40 billion, a premium of 40 percent over the market value of Chrysler before the takeover bid. Daimler paid this much because it thought it could use Chrysler to help it grow market share in the United States. At the time, Daimler’s management issued bold an- nouncements about the “synergies” that would be created from combining the operations of the two companies. However, within a year of the acquisition, Daimler’s German manage- ment was faced with a crisis at Chrysler, which was suddenly losing money due to weak sales in the United States. In retrospect, Daimler’s management had been far too optimistic about the potential for future demand in the U.S. auto market and about the opportunities for creating value from “synergies.” Daimler acquired Chrysler at the end of a multiyear boom in U.S. auto sales and paid a large premium over Chrysler’s market value just before demand slumped (and in 2007, in an admission of failure, Daimler sold its Chrysler unit to a private equity firm).36

Second, many acquisitions fail because there is a clash between the cultures of the acquir- ing and acquired firms. After an acquisition, many acquired companies experience high management turnover, possibly because their employees do not like the acquiring company’s way of doing things.37 This happened at DaimlerChrysler; many senior managers left Chrysler in the first year after the merger. Apparently, Chrysler executives disliked the dom- inance in decision making by Daimler’s German managers, while the Germans resented that Chrysler’s American managers were paid two to three times as much as their German coun- terparts. These cultural differences created tensions, which ultimately exhibited themselves in high management turnover at Chrysler.38 The loss of management talent and expertise can materially harm the performance of the acquired unit.39 This may be particularly prob- lematic in an international business, where management of the acquired unit may have valu- able local knowledge that can be difficult to replace.

Third, many acquisitions fail because attempts to realize gains by integrating the opera- tions of the acquired and acquiring entities often run into roadblocks and take much longer than forecast. Differences in management philosophy and company culture can slow the integration of operations. Differences in national culture may exacerbate these problems. Bureaucratic haggling between managers also complicates the process. Again, this report- edly occurred at DaimlerChrysler, where grand plans to integrate the operations of the two companies were bogged down by endless committee meetings and by simple logistical con- siderations such as the six-hour time difference between Detroit and Germany. By the time an integration plan had been worked out, Chrysler was losing money, and Daimler’s German managers suddenly had a crisis on their hands.

Finally, many acquisitions fail due to inadequate pre-acquisition screening.40 Many firms decide to acquire other firms without thoroughly analyzing the potential benefits and costs. They often move with undue haste to execute the acquisition, perhaps because they fear another competitor may preempt them. After the acquisition, however, many acquiring firms discover that instead of buying a well-run business, they have purchased a troubled organization. This may be a particular problem in cross-border acquisitions because the

Chapter Thirteen Entering Foreign Markets 389

acquiring firm may not fully understand the target firm’s national culture and business sys- tem. For example, in 2011 Hewlett-Packard acquired the British information technology company Autonomy for $11 billion. A year later, the company admitted that Autonomy was both less profitable and smaller than it had realized and wrote down the value of Autonomy by $8.8 billion. HP subsequently claimed that senior managers at Autonomy were engaged in systematic accounting fraud and had overstated the revenues of their business in order to close a sale to HP. Be this as it may, HP’s failure to see problems prior to the acquisition raises serious questions about its diligence processes.41

Reducing the Risks of Failure These problems can all be overcome if the firm is careful about its acquisition strategy.42 Screening of the foreign enterprise to be acquired, including a detailed auditing of operations, financial position, and management culture, can help to make sure the firm (1) does not pay too much for the acquired unit, (2) does not uncover any nasty surprises after the acquisition, and (3) acquires a firm whose organization culture is not antagonistic to that of the acquiring enterprise. It is also important for the acquirer to allay any concerns that management in the acquired enterprise might have. The objective should be to reduce unwanted management attrition after the acquisition. Finally, managers must move rapidly after an acquisition to put an integration plan in place and to act on that plan. Some people in both the acquiring and acquired units will try to slow or stop any integration efforts, particularly when losses of employment or management power are involved, and managers should have a plan for dealing with such impediments before they arise.

PROS AND CONS OF GREENFIELD VENTURES The big advantage of establishing a greenfield venture in a foreign country is that it gives the firm a much greater ability to build the kind of subsidiary company that it wants. For example, it is much easier to build an organization culture from scratch than it is to change the culture of an acquired unit. Similarly, it is much easier to establish a set of operating routines in a new sub- sidiary than it is to convert the operating routines of an ac- quired unit. This is a very important advantage for many international businesses, where transferring products, com- petencies, skills, and know-how from the established opera- tions of the firm to the new subsidiary are principal ways of creating value. For example, when Lincoln Electric, the U.S. manufacturer of arc welding equipment, first ventured over- seas in the mid-1980s, it did so by acquisitions, purchasing arc welding equipment companies in Europe. However, Lincoln’s competitive advantage in the United States was based on a strong organizational culture and a unique set of incentives that encouraged its employees to do everything possible to increase productivity. Lincoln found through bit- ter experience that it was almost impossible to transfer its organizational culture and incentives to acquired firms, which had their own distinct organizational cultures and in- centives. As a result, the firm switched its entry strategy in the mid-1990s and began to enter foreign countries by es- tablishing greenfield ventures, building operations from the ground up. While this strategy takes more time to execute, Lincoln has found that it yields greater long-run returns than the acquisition strategy.

Set against this significant advantage are the disadvan- tages of establishing a greenfield venture. Greenfield ven- tures are slower to establish. They are also risky. As with any new venture, a degree of uncertainty is associated with fu- ture revenue and profit prospects. However, if the firm has

How Risky Would Indonesia Be for a New Greenfield Investment? Business is all about risk, the right risks. Choosing which risks to accept and which to avoid is at the heart of international busi- ness. These risks increase and become more interesting with entry into foreign markets. David Conklin discusses the idea of managing risk through planned uncertainty. By “planned uncer- tainty,” he means an awareness of contingencies, with possible what-if scenarios developed in advance. The key idea here is that through an ongoing monitoring of the various risk areas, decision makers can have much of the data they may need to address a number of possible outcomes. Of course, we have to know what uncertainty to plan for, and we don’t know what we don’t know. Planning for everything is impossible, but what Conklin suggests is that planned uncertainty is a way of think- ing. Given that we don’t know the future, this way of thinking may be helpful in career development and other parts of our lives. Who ever said business wasn’t like surfing? So, as just one country example, how big do you think the risk is by entering Indonesia with a new greenfield investment?

Source: D. Conklin, “Analyzing and Managing Country Risks,” Ivey Business Journal: Improving the Practice of Management, January/February, 1992. Also, see “Indices” for countries on globalEDGE.msu.edu (e.g., for Indonesia, globaledge.msu.edu/countries/indonesia/indices).

390 Part Five The Strategy of International Business

already been successful in other foreign markets and understands what it takes to do busi- ness in other countries, these risks may not be that great. For example, having already gained great knowledge about operating internationally, the risk to McDonald’s of entering yet another country is probably not that great. Also, greenfield ventures are less risky than ac- quisitions in the sense that there is less potential for unpleasant surprises. A final disadvan- tage is the possibility of being preempted by more aggressive global competitors who enter via acquisitions and build a big market presence that limits the market potential for the greenfield venture.

GREENFIELD VENTURE OR ACQUISITION? The choice between ac- quisitions and greenfield ventures is not an easy one. Both modes have their advantages and disadvantages. In general, the choice will depend on the circumstances confronting the firm. If the firm is seeking to enter a market where there are already well-established in- cumbent enterprises, and where global competitors are also interested in establishing a presence, it may pay the firm to enter via an acquisition. In such circumstances, a greenfield venture may be too slow to establish a sizable presence. However, if the firm is going to make an acquisition, its management should be cognizant of the risks associated with ac- quisitions that were discussed earlier and consider these when determining which firms to purchase. It may be better to enter by the slower route of a greenfield venture than to make a bad acquisition.

If the firm is considering entering a country where there are no incumbent competitors to be acquired, then a greenfield venture may be the only mode. Even when incumbents ex- ist, if the competitive advantage of the firm is based on the transfer of organizationally em- bedded competencies, skills, routines, and culture, it may still be preferable to enter via a greenfield venture. Things such as skills and organizational culture, which are based on significant knowledge that is difficult to articulate and codify, are much easier to embed in a new venture than they are in an acquired entity, where the firm may have to overcome the established routines and culture of the acquired firm. Thus, as our earlier examples suggest, firms such as McDonald’s and Lincoln Electric prefer to enter foreign markets by establish- ing greenfield ventures.

timing of entry, p. 374 first-mover advantages, p. 374 first-mover disadvantages, p. 374 pioneering costs, p. 374

exporting, p. 378 turnkey project, p. 379 licensing agreement, p. 380 franchising, p. 382

joint venture, p. 383 wholly owned subsidiary, p. 384

Key Terms

Summary

The chapter made the following points:

1. Basic entry decisions include identifying which markets to enter, when to enter those markets, and on what scale.

2. The most attractive foreign markets tend to be found in politically stable developed and developing nations that have free market systems and where there is no dramatic upsurge in either inflation rates or private- sector debt.

3. There are several advantages associated with entering a national market early, before other international

businesses have established themselves. These advantages must be balanced against the pioneering costs that early entrants often have to bear, including the greater risk of business failure.

4. Large-scale entry into a national market constitutes a major strategic commitment that is likely to change the nature of competition in that market and limit the entrant’s future strategic flexibility. Although making major strategic commitments can yield many benefits, there are also risks associated with such a strategy.

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Chapter Thirteen Entering Foreign Markets 391

5. There are six modes of entering a foreign market: exporting, creating turnkey projects, licensing, franchising, establishing joint ventures, and setting up a wholly owned subsidiary.

6. Exporting has the advantages of facilitating the realization of experience curve economies and of avoiding the costs of setting up manufacturing operations in another country. Disadvantages include high transport costs, trade barriers, and problems with local marketing agents.

7. Turnkey projects allow firms to export their process know-how to countries where FDI might be prohibited, thereby enabling the firm to earn a greater return from this asset. The disadvantage is that the firm may inadvertently create efficient global competitors in the process.

8. The main advantage of licensing is that the licensee bears the costs and risks of opening a foreign market. Disadvantages include the risk of losing technological know-how to the licensee and a lack of tight control over licensees.

9. The main advantage of franchising is that the franchisee bears the costs and risks of opening a foreign market. Disadvantages center on problems of quality control of distant franchisees.

10. Joint ventures have the advantages of sharing the costs and risks of opening a foreign market and of gaining local knowledge and political influence. Disadvantages include the risk of losing control over technology and a lack of tight control.

11. The advantages of wholly owned subsidiaries include tight control over technological know-how. The main

disadvantage is that the firm must bear all the costs and risks of opening a foreign market.

12. The optimal choice of entry mode depends on the firm’s strategy. When technological know-how constitutes a firm’s core competence, wholly owned subsidiaries are preferred because they best control technology. When management know-how constitutes a firm’s core competence, foreign franchises controlled by joint ventures seem to be optimal. When the firm is pursuing a global standardization or transnational strategy, the need for tight control over operations to realize location and experience curve economies suggests wholly owned subsidiaries are the best entry mode.

13. When establishing a wholly owned subsidiary in a country, a firm must decide whether to do so by a greenfield venture strategy or by acquiring an established enterprise in the target market.

14. Acquisitions are quick to execute, may enable a firm to preempt its global competitors, and involve buying a known revenue and profit stream. Acquisitions may fail when the acquiring firm overpays for the target, when the cultures of the acquiring and acquired firms clash, when there is a high level of management attrition after the acquisition, and when there is a failure to integrate the operations of the acquiring and acquired firm.

15. The advantage of a greenfield venture in a foreign country is that it gives the firm a much greater ability to build the kind of subsidiary company that it wants. For example, it is much easier to build an organization culture from scratch than it is to change the culture of an acquired unit.

Critical Thinking and Discussion Questions

1. Review the Management Focus on Tesco. Then answer the following questions: a. Why did Tesco’s initial international expansion

strategy focus on developing nations? b. How does Tesco create value in its international

operations? c. In Asia, Tesco has a history of entering into joint-

venture agreements with local partners. What are the benefits of doing this for Tesco? What are the risks? How are those risks mitigated?

d. In March 2006, Tesco announced it would enter the United States. This represented a departure from its historic strategy of focusing on developing nations. Why do you think Tesco made this decision? How is the U.S. market different from others Tesco has entered? What are the risks here?

2. Licensing proprietary technology to foreign competitors is the best way to give up a firm’s competitive advantage. Discuss.

3. Discuss how the need for control over foreign operations varies with firms’ strategies and core competencies. What are the implications for the choice of entry mode?

4. A small Canadian firm that has developed valuable new medical products using its unique biotechnology know- how is trying to decide how best to serve the European Union market. Its choices are given on the next page. The cost of investment in manufacturing facilities will be a major one for the Canadian firm, but it is not outside its reach. If these are the firm’s only options, which one would you advise it to choose? Why?

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

1. A vital element in a successful international market entry strategy is an appropriate fit of skills and capabilities between partners. As such, the Entrepreneur magazine annually publishes a ranking of the “Top Global Franchises.” Provide a list of the top 10 companies that pursue franchising as a mode of international expansion. Study one of these companies in detail, and provide a description of its business model, its international expansion pattern, desirable qualifications in possible franchisees, and the support

and training typically provided by the franchiser. Are there areas where improvement can be made for the company to maintain competitiveness? Provide sufficient justification for your position.

2. The U.S. Commercial Service prepares reports known as the “Country Commercial Guide” for countries of interest to U.S. investors. Utilize the Country Commercial Guide for Russia to gather information on this country’s energy and mining industry. Considering that your company has plans to enter Russia in the foreseeable future, select the most appropriate entry method. Be sure to support your decision with the information collected.

Research Task http://globalEDGE.msu.edu

JCB, the venerable British manufacturer of construction equipment, has long been a relatively small player in a global market that is dominated by the likes of Caterpillar and Komatsu, but there is one exception to this: India. While the company is present in 150 countries, of the 69,100 machines it sold globally in 2012, around a third were in India. For JCB, India is truly the jewel in the crown.

The story of JCB in India dates back to 1979 when the company en- tered into a joint venture with Escorts, an Indian engineering conglomerate, to manufacture backhoe loaders for sale in India. Escorts held a majority 60 percent stake in the venture, and JCB 40 percent. The joint venture was a first for JCB, which historically had exported as much as two-thirds of its production from Britain to a wide range of nations. However, high tariff barriers made direct exports to India difficult.

JCB would probably have preferred to go it alone in India, but govern- ment regulations at the time required foreign investors to create joint ven- tures with local companies. JCB believed the Indian construction market was ripe for growth and could become very large. The company’s manag- ers believed that it was better to get a foothold in the nation, thereby gain- ing an advantage over global competitors, rather than wait until the growth potential was realized.

By the end of the 1990s the joint venture was selling some 2,000 backhoes in India and had an 80 percent share of the Indian market. After years of deregulation, the Indian economy was booming. However, JCB felt that the joint venture limited its ability to expand. For one thing, much of

JCB’s global success was based upon the utilization of leading-edge man- ufacturing technologies and relentless product innovation, but the com- pany was very hesitant about transferring this know-how to a venture where it did not have a majority stake and therefore lacked control. The last thing JCB wanted was for these valuable technologies to leak out of the joint venture into Escorts, which was one of the largest manufacturers of tractors in India and might conceivably become a direct competitor in

ccccccllooooooossssiinnnnnggggggggggg ccccccaaaassssssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeJCB in India

Tradition meets the new as a camel-drawn cart moves past a backhoe awaiting transportation outside a JCB factory in Faridabad, India.

• Manufacture the products at home and let foreign sales agents handle marketing.

• Manufacture the products at home and set up a wholly owned subsidiary in Europe to handle marketing.

• Enter into an alliance with a large European pharmaceutical firm. The products would be manufactured in Europe by the 50/50 joint venture and marketed by the European firm.

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Chapter Thirteen Entering Foreign Markets 393

the future. Moreover, JCB was unwilling to make the investment in India required to take the joint venture to the next level unless it could capture more of the long-run returns.

In 1999, JCB took advantages of changes in government regulations to renegotiate the terms of the venture with Escorts, purchasing 20 percent of its partner’s equity to give JCB majority control. In 2003, JCB took this to its logical end when it responded to further relaxation of government regu- lations on foreign investment to purchase all of Escorts’ remaining equity, transforming the joint venture into a wholly owned subsidiary.

Having gained full control, in early 2005 JCB increased its investment in India, announcing it would build a second factory in Pune that it would use to serve the Indian market. In 2007, in what represented a bold bet on future demand in the Indian market in the face of a global economic slow- down, JCB embarked on a major overhaul and expansion of its original India factory in Ballabgarh. To sell the additional Indian output, JCB rapidly expanded its dealer network, doubling the number of outlets in six years to reach 400 by 2011. The company also localized production for more than 80 percent of the parts used in its best-selling backhoe loader. This was done both to keep costs low and to make sure dealers had immediate ac- cess to spare parts. The strategy worked; between 2001 and 2012 JCB’s Indian revenues increased tenfold, and the company is now the leading manufacturer of backhoes in the country.

Sources: P. Marsh, “Partnerships Feel the Indian Heat,” Financial Times, June 22, 2006, p. 11; P. Marsh, “JCB Targets Asia to Spread Production,” Financial Times, March 16, 2005, p. 26; D. Jones, “Profits Jump at JCB,” Daily Post, June 20, 2006, p. 21; R. Bentley, “Still Optimistic about Asia,” Asian Business Review, October 1, 1999, p. 1; “JCB Launches India-Specific Heavy Duty Crane,” The Hindu, October 18, 2008; P. M. Thomas, “JCB Hits Pay Dirt in India,” Forbes.com, December 6, 2011; and J. Moulds, “JCB Unearths Record Sales and Profits,” The Guardian, April 17, 2012.

CASE DISCUSSION QUESTIONS 1. Why do you think that India was an attractive market for JCB?

2. Historically, JCB entered foreign markets through exports. Why do you think JCB generally favored exports?

3. In India, JCB decided to enter via a joint venture. What was the articulated rational for this? In what other ways might the joint venture strategy have benefited JCB?

4. What were the risks associated with the joint venture strategy? How did JCB deal with these risks?

5. What are the benefits to JCB of localizing significant production in India? What are the disadvantages? Do the benefits outweigh the disadvantages?

Endnotes

1. For interesting empirical studies that deal with the issues of timing and resource commitments, see T. Isobe, S. Makino, and D. B. Montgomery, “Resource Commitment, Entry Timing, and Market Performance of Foreign Direct Invest- ments in Emerging Economies,” Academy of Management Journal 43, no. 3 (2000), pp. 468–84; and Y. Pan and P. S. K. Chi, “Financial Performance and Survival of Multinational Corporations in China,” Strategic Management Journal 20, no. 4 (1999), pp. 359–74. A complementary theoretical per- spective on this issue can be found in V. Govindarjan and A. K. Gupta, The Quest for Global Dominance (San Francisco: Jossey-Bass, 2001). Also see F. Vermeulen and H. Barkeme, “Pace, Rhythm and Scope: Process Dependence in Building a Profitable Multinational Corporation,” Strategic Management Journal 23 (2002), pp. 637–54.

2. This can be reconceptualized as the resource base of the en- trant, relative to indigenous competitors. For work that fo- cuses on this issue, see W. C. Bogner, H. Thomas, and J. McGee, “A Longitudinal Study of the Competitive Posi- tions and Entry Paths of European Firms in the U.S. Phar- maceutical Market,” Strategic Management Journal 17 (1996), pp. 85–107; D. Collis, “A Resource-Based Analysis of Global Competition,” Strategic Management Journal 12 (1991), pp. 49–68; and S. Tallman, “Strategic Management Models and Resource-Based Strategies among MNEs in a Host Market,” Strategic Management Journal 12 (1991), pp. 69–82.

3. For a discussion of first-mover advantages, see M. Lieberman and D. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 (Summer Special Issue, 1988), pp. 41–58.

4. J. M. Shaver, W. Mitchell, and B. Yeung, “The Effect of Own Firm and Other Firm Experience on Foreign Direct Invest- ment Survival in the United States, 1987–92,” Strategic Management Journal 18 (1997), pp. 811–24.

5. S. Zaheer and E. Mosakowski, “The Dynamics of the Liabil- ity of Foreignness: A Global Study of Survival in the Finan- cial Services Industry,” Strategic Management Journal 18 (1997), pp. 439–64.

6. Shaver, Mitchell, and Yeung, “The Effect of Own Firm and Other Firm Experience on Foreign Direct Investment Survival in the United States.”

7. P. Ghemawat, Commitment: The Dynamics of Strategy (New York: Free Press, 1991).

8. R. Luecke, Scuttle Your Ships before Advancing (Oxford: Oxford University Press, 1994).

9. Isobe, Makino, and Montgomery, “Resource Commitment, Entry Timing, and Market Performance”; Pan and Chi, “Financial Performance and Survival of Multinational Cor- porations in China”; and Govindarjan and Gupta, The Quest for Global Dominance.

10. Christopher Bartlett and Sumantra Ghoshal, “Going Global: Lessons from Late Movers,” Harvard Business Review, March– April 2000, pp. 132–45.

11. This section draws on numerous studies, including C. W. L. Hill, P. Hwang, and W. C. Kim, “An Eclectic Theory of the Choice of International Entry Mode,” Strategic Management Journal 11 (1990), pp. 117–28; C. W. L. Hill and W. C. Kim, “Searching for a Dynamic Theory of the Multinational

394 Part Five The Strategy of International Business

Enterprise: A Transaction Cost Model,” Strategic Management Journal 9 (Special Issue on Strategy Content, 1988), pp. 93–104; E. Anderson and H. Gatignon, “Modes of For- eign Entry: A Transaction Cost Analysis and Propositions,” Journal of International Business Studies 17 (1986), pp. 1–26; F. R. Root, Entry Strategies for International Markets (Lexington, MA: D. C. Heath, 1980); A. Madhok, “Cost, Value and For- eign Market Entry: The Transaction and the Firm,” Strategic Management Journal 18 (1997), pp. 39–61; K. D. Brouthers and L. B. Brouthers, “Acquisition or Greenfield Start-Up?” Strategic Management Journal 21, no. 1 (2000), pp. 89–97; X. Martin and R. Salmon, “Knowledge Transfer Capacity and Its Implications for the Theory of the Multinational Enter- prise,” Journal of International Business Studies, July 2003, p. 356; and A. Verbeke, “The Evolutionary View of the MNE and the Future of Internalization Theory,” Journal of Interna- tional Business Studies, November 2003, pp. 498–515.

12. For a general discussion of licensing, see F. J. Contractor, “The Role of Licensing in International Strategy,” Columbia Journal of World Business, Winter 1982, pp. 73–83.

13. See E. Terazono and C. Lorenz, “An Angry Young Warrior,” Financial Times, September 19, 1994, p. 11; and K. McQuade and B. Gomes-Casseres, “Xerox and Fuji-Xerox,” Harvard Business School Case No. 9-391-156. Harvard University Press in Cambridge, MA.

14. O. E. Williamson, The Economic Institutions of Capitalism (New York: Free Press, 1985).

15. J. H. Dunning and M. McQueen, “The Eclectic Theory of International Production: A Case Study of the International Hotel Industry,” Managerial and Decision Economics 2 (1981), pp. 197–210.

16. Andrew E. Serwer, “McDonald’s Conquers the World,” For- tune, October 17, 1994, pp. 103–16.

17. For an excellent review of the basic theoretical literature of joint ventures, see B. Kogut, “Joint Ventures: Theoretical and Empirical Perspectives,” Strategic Management Journal 9 (1988), pp. 319–32. More recent studies include T. Chi, “Op- tion to Acquire or Divest a Joint Venture,” Strategic Manage- ment Journal 21, no. 6 (2000), pp. 665–88; H. Merchant and D. Schendel, “How Do International Joint Ventures Create Shareholder Value?” Strategic Management Journal 21, no. 7 (2000), pp. 723–37; H. K. Steensma and M. A. Lyles, “Ex- plaining IJV Survival in a Transitional Economy though Social Exchange and Knowledge Based Perspectives,” Strate- gic Management Journal 21, no. 8 (2000), pp. 831–51; and J. F. Hennart and M. Zeng, “Cross Cultural Differences and Joint Venture Longevity,” Journal of International Business Studies, December 2002, pp. 699–717.

18. D. G. Bradley, “Managing against Expropriation,” Harvard Business Review, July–August 1977, pp. 78–90.

19. J. A. Robins, S. Tallman, and K. Fladmoe-Lindquist, “Autonomy and Dependence of International Cooperative Ventures,” Strategic Management Journal, October 2002, pp. 881–902.

20. Speech given by Tony Kobayashi at the University of Washington Business School, October 1992.

21. A. C. Inkpen and P. W. Beamish, “Knowledge, Bargaining Power, and the Instability of International Joint Ventures,” Academy of Management Review 22 (1997), pp. 177–202; and S. H. Park and G. R. Ungson, “The Effect of National Culture, Organizational Complementarity, and Economic Motivation on Joint Venture Dissolution,” Academy of Management Jour- nal 40 (1997), pp. 279–307.

22. Inkpen and Beamish, “Knowledge, Bargaining Power, and the Instability of International Joint Ventures.”

23. See Brouthers and Brouthers, “Acquisition or Greenfield Start-Up?”; and J. F. Hennart and Y. R. Park, “Greenfield versus Acquisition: The Strategy of Japanese Investors in the United States,” Management Science, 1993, pp. 1054–70.

24. This section draws on Hill, Hwang, and Kim, “An Eclectic Theory of the Choice of International Entry Mode.”

25. C. W. L. Hill, “Strategies for Exploiting Technological Inno- vations: When and When Not to License,” Organization Sci- ence 3 (1992), pp. 428–41.

26. See Brouthers and Brouthers, “Acquisition or Greenfield Start-Up?”; and J. Anand and A. Delios, “Absolute and Rela- tive Resources as Determinants of International Acquisi- tions,” Strategic Management Journal, February 2002, pp. 119–34.

27. United Nations, World Investment Report, 2010 (New York and Geneva: United Nations, 2010).

28. Ibid.

29. For evidence on acquisitions and performance, see R. E. Caves, “Mergers, Takeovers, and Economic Efficiency,” Inter- national Journal of Industrial Organization 7 (1989), pp. 151–74; M. C. Jensen and R. S. Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics 11 (1983), pp. 5–50; R. Roll, “Empirical Evidence on Takeover Activity and Shareholder Wealth,” in Knights, Raiders and Targets, ed. J. C. Coffee, L. Lowenstein, and S. Rose (Oxford: Oxford University Press, 1989); A. Schleifer and R. W. Vishny, “Takeovers in the 60s and 80s: Evidence and Implications,” Strategic Management Journal 12 (Winter 1991 Special Issue), pp. 51–60; T. H. Brush, “Pre- dicted Changes in Operational Synergy and Post-Acquisition Performance of Acquired Businesses,” Strategic Management Journal 17 (1996), pp. 1–24; and A. Seth, K. P. Song, and R. R. Pettit, “Value Creation and Destruction in Cross-Border Acquisitions,” Strategic Management Journal 23 (October 2002), pp. 921–40.

30. J. Warner, J. Templeman, and R. Horn, “The Case against Mergers,” BusinessWeek, October 30, 1995, pp. 122–34.

31. “Few Takeovers Pay Off for Big Buyers,” Investor’s Business Daily, May 25, 2001, p. 1.

32. S. A. Christofferson, R. S. McNish, and D. L. Sias, “Where Mergers Go Wrong,” The McKinsey Quarterly 2 (2004), pp. 92–110.

33. D. J. Ravenscraft and F. M. Scherer, Mergers, Selloffs, and Economic Efficiency (Washington, DC: Brookings Institu- tion, 1987).

Chapter Thirteen Entering Foreign Markets 395

34. See P. Ghemawat and F. Ghadar, “The Dubious Logic of Global Mega-Mergers,” Harvard Business Review, July–August 2000, pp. 65–72.

35. R. Roll, “The Hubris Hypothesis of Corporate Takeovers,” Journal of Business 59 (1986), pp. 197–216.

36. “Marital Problems,” The Economist, October 14, 2000.

37. See J. P. Walsh, “Top Management Turnover Following Mergers and Acquisitions,” Strategic Management Journal 9 (1988), pp. 173–83.

38. B. Vlasic and B. A. Stertz, Taken for a Ride: How Daimler-Benz Drove Off with Chrysler (New York: HarperCollins, 2000).

39. See A. A. Cannella and D. C. Hambrick, “Executive Depar- ture and Acquisition Performance,” Strategic Management Journal 14 (1993), pp. 137–52.

40. P. Haspeslagh and D. Jemison, Managing Acquisitions (New York: Free Press, 1991).

41. V. Aggarwal, “HP Was Aware of Autonomy’s Loss Making Hardware Sales,” Reuters, February 18, 2014.

42. P. Haspeslagh and D. Jemison, Managing Acquisitions (New York: Free Press, 1991).

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14-1 Explain the promises and risks associated with exporting.

14-2 Identify the steps managers can take to improve their firm’s export performance.

14-3 Identify information sources and government programs that exist to help exporters.

14-4 Recognize the basic steps involved in export financing.

14-5 Describe how countertrade can be used to facilitate exporting.

learning objectives

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a pt

opening case

It is a little know fact that small firms comprise the majority of U.S. exporters. Business with fewer than 500 employees made up 97 percent of all U.S. exporters in 2012 according the U.S. Census Bureau. These small businesses generated $460 billion in foreign sales in 2012, an increase of $10 billion over 2011. In total, companies with less than 500 employees accounted for 34 percent of all U.S. exports by value in

2012. Despite this, there is still significant room for growth. Only about 5 percent of small businesses actu-

ally export.

One company that has illustrated the power of exporting for a small business is Sono-Tek Corp, a developer

of ultrasonic spray coating technology in Milton, New York. Sono-Tek’s primary overseas customers include

contract manufacturers for electronic and medical equipment firms. Some $6 million of Sono-Tek’s annual

revenues now come from exports to customers in Europe, Southeast Asia, and Latin America. Sono-Tek’s CEO,

Chris Coccio, believes that without exporting the company would be one-third of its current size.

Another New York company, Vision Quest Lighting, has had a similar experience. Vision Quest Lighting,

which has around 30 employees, makes decorative lighting for retail chains, including Limited Brands, Ann

Taylor, and Abercrombie and Fitch. As these brands expanded their international presence, Vision Quest

Lighting grew with them. According to the company’s management, its international exposure helped the

company to survive in the recessionary years of 2008–2009 when demand in the United States was very

soft. Looking forward, Vision Quest Lighting sees great growth opportunities in China, where it has recently

established a factory to produce products for the local market.

Both of these companies have found exporting to be challenging. Sono-Tek’s Chris Coccio notes that his

biggest worries include recruiting foreign staff that understand the local market, the costs of business

travel, problems associated with communicating with far-flung clients, and getting paid. He is not alone in

this last worry. According to the Small Business Exporters Association, getting paid can be a major

headache. In a recent survey conducted by the Association, 41 percent of respondents indicated that they

worried about getting paid. The association urges small exporters to work with banks and to make sure

Growing Through Exports

Exporting, Importing, and Countertrade

–continued

398 Part Six International Business Functions

that they get letters of credit from foreign importers before shipping goods or performing

services.

At Vision Quest Lighting, management notes that being successfully requires a

bilingual agent or foreign employee who understands the business system, lives in

country, and can help the foreign company to navigate its way through a culturally

challenging environment. There is no substitute, according to the company, for someone

with his or her feet on the ground who understands the local business culture. In Vision

Quests’ case, for example, their business in China did not start to take off until they hired

a local Chinese employee. • Sources: R. Colvin, “The Cost of Expanding Overseas,” The Wall Street Journal, February 26, 2014; John Grossman, “New Path for Trade: Selling in China,” The New York Times, January 23, 2013; and N. Levy, “LI Lighting Firm Learns the Ropes in China,” Newsday, October 20, 2013.

Introduction The previous chapter reviewed exporting from a strategic perspective. We considered exporting as just one of a range of strategic options for profiting from international expansion. This chapter is more concerned with the nuts and bolts of exporting (and importing). It looks at how to export. As the opening case makes clear, exporting is not just for large enter- prises; many small firms such as Sono-Tek and Vision Quest Lighting have benefited sig- nificantly from the moneymaking opportunities of exporting.

The volume of export activity in the world economy has increased as exporting has be- come easier. The gradual decline in trade barriers under the umbrella of GATT and now the WTO (see Chapter 7) along with regional economic agreements such as the European Union and the North American Free Trade Agreement (see Chapter 9) have significantly increased export opportunities. At the same time, modern communication and transporta- tion technologies have alleviated the logistical problems associated with exporting. Over the last two decades firms have increasingly used the Internet, toll-free phone numbers, and international air express services to reduce the costs of exporting. Consequently, it is not unusual to find thriving exporters among small companies.

Nevertheless, exporting remains a challenge for many firms. Smaller enterprises can find the process intimidating. The firm wishing to export must identify foreign market opportu- nities, avoid a host of unanticipated problems that are often associated with doing business in a foreign market, familiarize itself with the mechanics of export and import financing, learn where it can get financing and export credit insurance, and learn how it should deal with foreign exchange risk. The process can be made more problematic by currencies that are not freely convertible. Arranging payment for exports to countries with weak currencies can be a problem. Countertrade allows payment for exports to be made through goods and services rather than money. This chapter discusses all these issues with the exception of for- eign exchange risk, which was covered in Chapter 10. The chapter opens by considering the promise and pitfalls of exporting.

The Promise and Pitfalls of Exporting The great promise of exporting is that large revenue and profit opportunities are to be found in foreign markets for most firms in most industries. This was true for both Sono-Tek Corp. and Vision Quest Lighting in the opening case. The international market is normally so much larger than the firm’s domestic market that exporting is nearly always a way to increase the revenue and profit base of a company. By expanding the size of the market, exporting can enable a firm to achieve economies of scale, thereby lowering its unit costs.

LO 14-1 Explain the promises and risks associated with exporting.

Chapter Fourteen Exporting, Importing, and Countertrade 399

Firms that do not export often lose out on significant opportunities for growth and cost reduction.1

Consider the case of Marlin Steel Wire Products, a Baltimore manufacturer of wire bas- kets and fabricated metal items with revenues of about $5 million. Among its products are baskets to hold dedicated parts for aircraft engines and automobiles. Its engineers design custom wire baskets for the assembly lines of companies such as Boeing and Toyota. It has a reputation for producing high-quality products for these niche markets. Like many small businesses, Marlin did not have a history of exporting. However, in the mid-2000s, Marlin dipped its toe in the export market, shipping small numbers of products to Mexico and Canada. Marlin CEO Drew Greenblatt soon realized that export sales could be the key to growth. In 2008, when the global financial crisis hit and America slid into a serious recession, Marlin was exporting only 5 percent of its orders to foreign markets. Greenblatt’s strategy for dealing with weak demand from the United States was to aggressively expand international sales. By 2010, exports accounted for 17 percent of sales, and the company had set a goal of exporting half its output.2

Despite examples such as SteelMaster and Marlin, studies have shown that while many large firms tend to be proactive about seeking opportunities for profitable exporting— systematically scanning foreign markets to see where the opportunities lie for leveraging their technology, products, and marketing skills in foreign countries—many medium- size and small firms are very reactive.3 Typically, such reac- tive firms do not even consider exporting until their domestic market is saturated and the emergence of excess productive capacity at home forces them to look for growth opportunities in foreign markets. Also, many small and me- dium-size firms tend to wait for the world to come to them, rather than going out into the world to seek opportunities. Even when the world does come to them, they may not re- spond. An example is MMO Music Group, which makes sing-along tapes for karaoke machines. Foreign sales accounted for about 15 percent of MMO’s revenues of $8 million, but the firm’s CEO admits this figure would probably have been much higher had he paid attention to building international sales. Unanswered e-mails and phone messages from Asia and Europe often piled up while he was trying to manage the burgeoning domestic side of the busi- ness. By the time MMO did turn its attention to foreign markets, competitors had stepped into the breach, and MMO found it tough going to build export volume.4

Export Tutorials

Exporting, importing, and countertrade are the focus areas of Chapter 14. The exporting entry mode choice, also discussed in Chapter 13, is the most often used way to conduct cross-border trade for compa- nies. The vast majority of small and medium-sized enterprises, for example, use exporting as their way to expand to international mar- kets. But that begs the question of whether the company is ready to export and whether the product the company plans to export is ready to be exported. The “Export Tutorials” section of globalEDGE (http:// globaledge.msu.edu/reference-desk/export-tutorials) includes CORE

as a diagnostic tool to assess “company readiness to export.” The Export Tutorial section also has a lengthy set of questions and answers to the most common exporting-related questions in the cat- egories of government regulations, financial considerations, sales and marketing, and logistics. For example, one question deals with whether a company needs a license to export. Assume you are based in the United States. How can you identify the relevant commodity jurisdiction for a product?

For Which Product Is Autarky a Good Choice for Countries? The word autarky refers to the quality and belief that a country should be self-sufficient and avoid trade and/or external assis- tance with other nations. Many economists regard autarky as an idealistic, but impractical, goal of countries. Basically, it sounds like a nice idea to be self-sufficient and practice autarky. In real- ity, throughout history countries have tried to achieve autarky but soon discovered they could not produce the wide range of products and services customers in their population want and need. These countries also found out that manufacturing prod- ucts at competitive prices over the long term became a daunting task. In fact, those countries found themselves worse off eco- nomically than nations that engaged in international trade. So, a word to the wise; unless your country can efficiently produce everything it needs, the country needs to engage in international trade. A more logical and achievable possibility is to perhaps fo- cus on being self-sufficient in certain areas, for certain products or services. Which product or service do you think a country should strive to be self-sufficient in?

Source: J. Heathcote, “Financial Autarky and International Business Cycles,” Journal of Monetary Economics 49, no. 3 (2002), pp. 601-627.

400 Part Six International Business Functions

MMO’s experience is common, and it suggests a need for firms to become more proac- tive about seeking export opportunities. One reason more firms are not proactive is that they are unfamiliar with foreign market opportunities; they simply do not know how big the opportunities actually are or where they might lie. Simple ignorance of the potential opportunities is a huge barrier to exporting.5 Also, many would-be exporters, particularly smaller firms, are often intimidated by the complexities and mechanics of exporting to countries where business practices, language, culture, legal systems, and currency are very different from the home market.6 This combination of unfamiliarity and intimidation probably explains why exporters still account for only a tiny percentage of U.S. firms, less than 5 percent of firms with fewer than 500 employees, according to the Small Business Administration.7

To make matters worse, many neophyte exporters run into significant problems when first trying to do business abroad, and this sours them on future exporting ventures. Com- mon pitfalls include poor market analysis, a poor understanding of competitive conditions in the foreign market, a failure to customize the product offering to the needs of foreign customers, a lack of an effective distribution program, a poorly executed promotional cam- paign, and problems securing financing.8 Novice exporters tend to underestimate the time and expertise needed to cultivate business in foreign countries.9 Few realize the amount of management resources that have to be dedicated to this activity. Many foreign customers require face-to-face negotiations on their home turf. An exporter may have to spend months learning about a country’s trade regulations, business practices, and more before a deal can be closed. The accompanying Management Focus, which documents the experience of FCX

FCX Systems

Founded with the help of a $20,000 loan from the Small Business Ad- ministration, FCX Systems is an exporting success story. FCX makes power converters for the aerospace industry. These devices convert common electric utility frequencies into the higher frequencies used in aircraft systems and are primarily used to provide power to aircraft while they are on the ground. Today, the West Virginia enterprise gener- ates more than half its annual sales from exports to more than 75 countries. FCX’s prowess in opening foreign markets has earned the company several awards for export excellence, including a presidential award for achieving extraordinary growth in export sales.

FCX initially got into exporting because it found that foreigners were often more receptive to the company’s products than potential American customers. According to Don Gallion, president of FCX, “In the overseas market, they were looking for a good technical product, preferably made in the U.S., but they weren’t asking questions about ‘How long have you been in business? Are you still going to be here tomorrow?’ They were just anxious to get the product.”

In 1989, shortly after it had been founded, FCX signed on with an international distribution company to help with exporting, but Gallion became disillusioned with that company, and in 1994 FCX started to handle the exporting process on its own. At the time, exports repre- sented 12 percent of sales, but by 1997 they had jumped to more than 50 percent of the total, where they have stayed since.

In explaining the company’s export success, Gallion cites a number of factors. One was the extensive assistance that FCX has received over the years from a number of federal and state agencies, including

the U.S. Department of Commerce and the Development Office of West Virginia. These agencies demystified the process of exporting and pro- vided good contacts for FCX. Finding a good local representative to help work through local regulations and customs is another critical fac- tor, according to Gallion, who says, “A good rep will keep you out of trouble when it comes to customs and what you should and shouldn’t do.” Persistence is also very important, says Gallion, particularly when trying to break into markets where personal relationships are crucial, such as China.

China has been an interesting story for FCX. The company has been booking $2 million to $3 million in sales to China, but it took years to get to this point. China had been on Gallion’s radar screen since the early 1990s, primarily because of the country’s rapid modernization and its plans to build or remodel almost 200 airports. This constituted a poten- tially large market opportunity for FCX, particularly compared with the United States, where perhaps only three new airports would be built during the same period. Despite the scale of the opportunity, progress was very slow. The company had to identify airports and airline projects, government agencies, customers, and decision makers, as well as work through different languages—and make friends. According to Gallion, “Only after they consider you a friend will they buy a product. They be- lieve a friend would never cheat you.” To make friends in China, Gallion estimates he had to make more than 100 trips to China, but now that the network has been established, it is starting to pay dividends.

Sources: J. Sparshott, “Businesses Must Export to Compete,” The Washington Times, September 1, 2004, p. C8; “Entrepreneur of the Year 2001: Donald Gallion, FCX Systems,” The State Journal, June 18, 2001, p. S10; and T. Pierro, “Exporting Powers Growth of FCX Systems,” The State Journal, April 6, 1998, p. 1.

management FOCUS

Chapter Fourteen Exporting, Importing, and Countertrade 401

Systems in China, suggests that it may take years before foreigners are comfortable enough to purchase in significant quantities.

Exporters often face voluminous paperwork, complex formalities, and many potential delays and errors. According to a UN report on trade and development, a typical interna- tional trade transaction may involve 30 parties, 60 original documents, and 360 document copies, all of which have to be checked, transmitted, reentered into various information systems, processed, and filed. The United Nations has calculated that the time involved in preparing documentation, along with the costs of common errors in paperwork, often amounts to 10 percent of the final value of goods exported.10

Improving Export Performance Inexperienced exporters have a number of ways to gain information about foreign market opportunities and avoid common pitfalls that tend to discourage and frustrate novice ex- porters.11 In this section, we look at information sources for exporters to increase their knowledge of foreign market opportunities, we consider the pros and cons of using export management companies (EMCs) to assist in the export process, and we review various ex- porting strategies that can increase the probability of successful exporting. We begin, how- ever, with a look at how several nations try to help domestic firms export.

AN INTERNATIONAL COMPARISON One big impediment to exporting is the simple lack of knowledge of the opportunities available. Often, there are many markets for a firm’s product, but because they are in countries separated from the firm’s home base by culture, language, distance, and time, the firm does not know of them. Identifying export opportunities is made even more complex because more than 200 countries with widely dif- fering cultures compose the world of potential opportunities. Faced with such complexity and diversity, firms sometimes hesitate to seek export opportunities.

The way to overcome ignorance is to collect information. In Germany—one of the world’s most successful exporting nations—trade associations, government agencies, and commercial banks gather information, helping small firms identify export opportunities. A similar function is provided by the Japanese Ministry of International Trade and Industry (MITI), which is always on the lookout for export opportunities. In addition, many Japanese firms are affiliated in some way with the sogo shosha, Japan’s great trading houses. The sogo shosha have offices all over the world, and they proactively, continuously seek export oppor- tunities for their affiliated companies large and small.12

German and Japanese firms can draw on the large reservoirs of experience, skills, infor- mation, and other resources of their respective export-oriented institutions. Unlike their German and Japanese competitors, many U.S. firms are relatively blind when they seek export opportunities; they are information-disadvantaged. In part, this reflects historical dif- ferences. Both Germany and Japan have long made their living as trading nations, whereas until recently the United States has been a relatively self-contained continental economy in which international trade played a minor role. This is changing; both imports and exports now play a greater role in the U.S. economy than they did 20 years ago. However, the United States has not yet evolved an institutional structure for promoting exports similar to that of either Germany or Japan.

INFORMATION SOURCES Despite institutional disadvantages, U.S. firms can increase their awareness of export opportunities. The most comprehensive source of infor- mation is the U.S. Department of Commerce and its district offices all over the country. Within that department are two organizations dedicated to providing businesses with intel- ligence and assistance for attacking foreign markets: the International Trade Administration and the U.S. Commercial Service.

Those agencies provide the potential exporter with a “best prospects” list, which gives the names and addresses of potential distributors in foreign markets along with businesses they are in, the products they handle, and their contact person. In addition, the Department of

LO 14-2 Identify the steps managers can take to improve their firm’s export performance.

LO 14-3 Identify information sources and government programs that exist to help exporters.

MITI Japan’s Ministry of International Trade and Industry.

Sogo Shosha Japanese trading companies; a key part of the keiretsu, the large Japanese industrial groups.

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402 Part Six International Business Functions

Commerce has assembled a “comparison shopping ser- vice” for 14 countries that are major markets for U.S. ex- ports. For a small fee, a firm can receive a customized market research survey on a product of its choice. This survey provides information on marketability, the compe- tition, comparative prices, distribution channels, and names of potential sales representatives. Each study is conducted on-site by an officer of the Department of Commerce.

The Department of Commerce also organizes trade events that help potential exporters make foreign contacts and explore export opportunities. The department orga- nizes exhibitions at international trade fairs, which are held regularly in major cities worldwide. The department also has a matchmaker program, in which department rep- resentatives accompany groups of U.S. businesspeople abroad to meet with qualified agents, distributors, and customers.

Another government organization, the Small Business Administration (SBA), can help potential exporters (see the accompanying Management Focus for examples of the SBA’s work). The SBA employs 76 district interna- tional trade officers and 10 regional international trade officers throughout the United States as well as a 10-person international trade staff in Washington, D.C. Through its Service Corps of Retired Executives (SCORE) pro-

gram, the SBA also oversees some 11,500 volunteers with international trade experience to provide one-on-one counseling to active and new-to-export businesses. The SBA also co- ordinates the Export Legal Assistance Network (ELAN), a nationwide group of interna- tional trade attorneys who provide free initial consultations to small businesses on export-related matters.

In addition to the Department of Commerce and SBA, nearly every state and many large cities maintain active trade commissions whose purpose is to promote exports. Most of these provide business counseling, information gathering, technical assistance, and financing. Un- fortunately, many have fallen victim to budget cuts or to turf battles for political and finan- cial support with other export agencies.

A number of private organizations are also beginning to provide more assistance to would-be exporters. Commercial banks and major accounting firms are more willing to as- sist small firms in starting export operations than they were a decade ago. In addition, large multinationals that have been successful in the global arena are typically willing to discuss opportunities overseas with the owners or managers of small firms.13

UTILIZING EXPORT MANAGEMENT COMPANIES One way for first-time exporters to identify the opportunities associated with exporting and to avoid many of the associated pitfalls is to hire an export management company (EMC). EMCs are export specialists that act as the export marketing department or international department for their client firms. EMCs normally accept two types of export assignments. They start exporting operations for a firm with the understanding that the firm will take over operations after they are well established. In another type, start-up services are per- formed with the understanding that the EMC will have continuing responsibility for sell- ing the firm’s products. Many EMCs specialize in serving firms in particular industries and in particular areas of the world. Thus, one EMC may specialize in selling agricultural products in the Asian market, while another may focus on exporting electronics products to eastern Europe.

In theory, the advantage of EMCs is that they are experienced specialists that can help the neophyte exporter identify opportunities and avoid common pitfalls. A good EMC

LO 14-2 Identify the steps managers can take to improve their firm’s export performance.

Export Management Company (EMC) Export specialists who act as an export marketing department for client firms.

Is Chinese Exporting the Next Edge for the Country? With hundreds of television sets stacked high, Changhong Elec- tronics’ warehouse in Shunde resembles many other storage depots in southern China, but their destinations reveal an impor- tant shift in global trade patterns. While Changhong’s smaller sets are headed for Europe, its 50-inch plasma screens, which domi- nate the warehouse, will be shipped to South Africa. Fast growth in developing countries and sluggish Western economies are prompting these companies to abandon their obsession with the United States and Europe and to try and capitalize on rapidly growing markets in Asia, Africa, and Latin America. The so-called China price—a vastly lower price because of low labor costs and the low cost of capital for large government-owned companies— now applies to industrial goods, not just consumer goods. Experts believe that cheap Chinese exports could provide a boost to in- vestment in the developing world, just as they once did to con- sumption in the developed world. Can China boost investment in the developing world and also boost its own economy?

Source: R. Jacob, “Chinese Exporters Seek New Markets,” Financial Times, June 12, 2012.

Chapter Fourteen Exporting, Importing, and Countertrade 403

Exporting with a Little Government Help

Exporting can seem like a daunting prospect, but the reality is that in the United States, as in many other countries, many small enterprises have built profitable export businesses. For example, Landmark Sys- tems of Virginia had virtually no domestic sales before it entered the European market. Landmark had developed a software program for IBM mainframe computers and located an independent distributor in Europe to represent its product. In the first year, 80 percent of sales were attributed to exporting. In the second year, sales jumped from $100,000 to $1.4 million—with 70 percent attributable to exports. Landmark is not alone; government data suggest that in the United States, more than 97 percent of the 240,000 firms that export are small or medium-size businesses that employ fewer than 500 people. Their share of total U.S. exports has grown steadily and is around 30 percent today.

To help jump-start the exporting process, many small companies have drawn on the expertise of government agencies, financial institu- tions, and export management companies. Consider the case of Novi Inc., a California-based business. Company President Michael Stoff tells how he utilized the services of the U.S. Small Business Adminis- tration (SBA) Office of International Trade to start exporting:

“When I began my business venture, Novi Inc., I knew that my Tune- Tote (a stereo system for bicycles) had the potential to be successful in international markets. Although I had no prior experience in this area, I began researching and collecting information on international markets. I was willing to learn, and by targeting key sources for information and guidance, I was able to penetrate international markets in a short period of time. One vital source I used from the beginning was the SBA. Through SBA I was directed to a program that dealt specifically with

business development—the Service Corps of Retired Executives (SCORE). I was assigned an adviser who had run his own import/export business for 30 years. The services of SCORE are provided on a contin- ual basis and are free.”

“As I began to pursue exporting, my first step was a thorough mar- keting evaluation. I targeted trade shows with a good presence of in- ternational buyers. I also went to DOC [Department of Commerce] for counseling and information about the rules and regulations of export- ing. I advertised my product in Commercial News USA, distributed through United States embassies to buyers worldwide. I utilized DOC’s World Traders Data Reports to get background information on poten- tial foreign buyers. As a result, I received 60–70 inquiries about Tune- Tote from around the world. Once I completed my research and evaluation of potential buyers, I decided which ones would be most suitable to market my product internationally. Then I decided to grant exclusive distributorship. In order to effectively communicate with my international customers, I invested in a fax. I chose a U.S. bank to handle international transactions. The bank also provided guidance on methods of payment and how best to receive and transmit money. This is essential know-how for anyone wanting to be successful in foreign markets.”

In just one year of exporting, export sales at Novi topped $1 million and increased 40 percent in the second year of operations. Today, Novi Inc. is a large distributor of wireless intercom systems that exports to more than 10 countries.

Sources: Small Business Administration Office of International Trade, “Guide to Exporting,” www.sba.gov/oit/info/Guide-ToExporting/index.html; U.S. Department of Commerce, “A Profile of U.S. Exporting Companies, 2000–2001,” February 2003, report available at www.census.gov/foreign-trade/aip/index.html#profile; and The 2007 National Exporting Strategy (Washington, DC: U.S. International Trade Commission, 2007).

management FOCUS

will have a network of contacts in potential markets, have multilingual employees, have a good knowledge of different business mores, and be fully conversant with the ins and outs of the exporting process and with local business regulations. However, the quality of EMCs varies.14 While some perform their functions very well, others appear to add little value to the exporting company. Therefore, an exporter should review carefully a number of EMCs and check references. One drawback of relying on EMCs is that the company can fail to develop its own exporting capabilities.

EXPORT STRATEGY In addition to using EMCs, a firm can reduce the risks as- sociated with exporting if it is careful about its choice of export strategy.15 A few guidelines can help firms improve their odds of success. For example, one of the most successful ex- porting firms in the world, 3M (originally, Minnesota Mining & Manufacturing Company), has built its export success on three main principles—enter on a small scale to reduce risks, add additional product lines once the exporting operations start to become successful, and hire locals to promote the firm’s products (3M’s export strategy is profiled in the accompa- nying Management Focus). Another successful exporter, Red Spot Paint & Varnish Com- pany, emphasizes the importance of cultivating personal relationships when trying to build an export business.

The probability of exporting successfully can be increased dramatically by taking a hand- ful of simple strategic steps. First, particularly for the novice exporter, it helps to hire an

LO 14-2 Identify the steps managers can take to improve their firm’s export performance.

404 Part Six International Business Functions

Export Strategy at 3M

3M, which makes more than 40,000 products including tape, sand- paper, medical products, and the ever-present Post-it notes, is one of the world’s great multinational operations. Today, more than 60 percent of the firm’s revenues are generated outside the United States. Although the bulk of these revenues came from foreign- based operations, 3M remains a major exporter with more than $2 billion in exports. The company often uses its exports to establish an initial presence in a foreign market, only building foreign production facilities once sales volume rises to a level that justifies local pro- duction.

The export strategy is built around simple principles. One is known as “FIDO,” which stands for first in (to a new market) defeats others. The essence of FIDO is to gain an advantage over other exporters by getting into a market first and learning about that country and how to sell there before others do. A second principle is “make a little, sell a little,” which is the idea of entering on a small scale with a very modest investment and pushing one basic product, such as reflective sheeting for traffic signs in Russia or scouring pads in Hungary. Once 3M believes it has learned enough about the market to reduce the risk of failure to reasonable levels, it adds additional products.

A third principle at 3M is to hire local employees to sell the firm’s products. The company normally sets up a local sales subsid- iary to handle its export activities in a country. It then staffs this

subsidiary with local hires because it believes they are likely to have a much better idea than American expatriates of how to sell in their own country. Because of the implementation of this principle, fewer than 200 of 3M’s 40,000-plus foreign employees are U.S. expatriates.

Another common practice at 3M is to formulate global strategic plans for the export and eventual overseas production of its prod- ucts. Within the context of these plans, 3M gives local managers considerable autonomy to find the best way to sell the product within their country. Thus, when 3M first exported its Post-it notes, it planned to “sample the daylights” out of the product, but it also told local managers to find the best way of doing this. Local managers hired office cleaning crews to pass out samples in Great Britain and Germany; in Italy, office products distributors were used to pass out free samples; while in Malaysia, local managers employed young women to go from office to office handing out samples of the prod- uct. In typical 3M fashion, when the volume of Post-it notes was sufficient to justify it, exports from the United States were replaced by local production. Thus, after several years, 3M found it worth- while to set up production facilities in France to produce Post-it notes for the European market.

Sources: R. L. Rose, “Success Abroad,” The Wall Street Journal, March 29, 1991, p. A1; T. Eiben, “US Exporters Keep On Rolling,” Fortune, June 14, 1994, pp. 128–31; 3M Company, A Century on Innovation, 3M, 2002; and 2005 10K form archived at 3M’s website at www.3m.com.

management FOCUS

EMC or at least an experienced export consultant to identify opportunities and navigate the paperwork and regulations so often involved in exporting. Second, it often makes sense to initially focus on one market or a handful of markets. Learn what is required to succeed in those markets before moving to other markets. The firm that enters many markets at once runs the risk of spreading its limited management resources too thin. The result of such a shotgun approach to exporting may be a failure to become established in any one market. Third, as with 3M, it often makes sense to enter a foreign market on a small scale to reduce the costs of any subsequent failure. Most important, entering on a small scale provides the time and opportunity to learn about the foreign country before making significant capital commitments to that market. Fourth, the exporter needs to recognize the time and managerial commitment involved in building export sales and should hire additional personnel to over- see this activity. Fifth, in many countries, it is important to devote a lot of attention to build- ing strong and enduring relationships with local distributors and/or customers. Sixth, as 3M often does, it is important to hire local personnel to help the firm establish itself in a foreign market. Local people are likely to have a much greater sense of how to do business in a given country than a manager from an exporting firm who has previously never set foot in that country. Seventh, several studies have suggested the firm needs to be proactive about seek- ing export opportunities.16 Armchair exporting does not work! The world will not normally beat a pathway to your door. Finally, it is important for the exporter to retain the option of local production. Once exports reach a sufficient volume to justify cost-efficient local pro- duction, the exporting firm should consider establishing production facilities in the foreign market. Such localization helps foster good relations with the foreign country and can lead to greater market acceptance. Exporting is often not an end in itself, but merely a step on the road toward establishment of foreign production (again, 3M provides an example of this philosophy).

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Chapter Fourteen Exporting, Importing, and Countertrade 405

Export and Import Financing Mechanisms for financing exports and imports have evolved over the centuries in response to a problem that can be particularly acute in international trade: the lack of trust that exists when one must put faith in a stranger. In this section, we examine the financial devices that have evolved to cope with this problem in the context of international trade: the letter of credit, the draft (or bill of exchange), and the bill of lading. Then we trace the 14 steps of a typical export-import transaction.17

LACK OF TRUST Firms engaged in international trade have to trust someone they may have never seen, who lives in a different country, who speaks a different language, who abides by (or does not abide by) a different legal system, and who could be very difficult to track down if he or she defaults on an obligation. Consider a U.S. firm exporting to a dis- tributor in France. The U.S. businessman might be concerned that if he ships the products to France before he receives payment from the French businesswoman, she might take delivery of the products and not pay him. Conversely, the French importer might worry that if she pays for the products before they are shipped, the U.S. firm might keep the money and never ship the products or might ship defective products. Neither party to the exchange completely trusts the other. This lack of trust is exacerbated by the distance be- tween the two parties—in space, language, and culture—and by the problems of using an underdeveloped international legal system to enforce contractual obligations.

Due to the (quite reasonable) lack of trust between the two parties, each has his or her own preferences as to how the transaction should be configured. To make sure he is paid, the manager of the U.S. firm would prefer the French distributor to pay for the products before he ships them (see Figure 14.1). Alternatively, to ensure she receives the prod- ucts, the French distributor would prefer not to pay for them until they arrive (see Figure 14.2). Thus, each party has a different set of preferences. Unless there is some way of establishing trust between the parties, the transaction might never occur.

The problem is solved by using a third party trusted by both—normally a reputable bank—to act as an intermediary. What happens can be summarized as follows (see Fig- ure 14.3). First, the French importer obtains the bank’s promise to pay on her behalf, knowing the U.S. exporter will trust the bank. This promise is known as a letter of credit. Having seen the letter of credit, the U.S. exporter now ships the products to France. Title to the products is given to the bank in the form of a document called a bill of lading. In return, the U.S. exporter tells the bank to pay for the prod- ucts, which the bank does. The document for requesting this

LO 14-4 Recognize the basic steps involved in export financing.

How Trusting Can You Be? In Chapter 14, we discuss the fact that firms that are engaged in international trade have to trust someone they may have never seen, who lives in a different country, who speaks a different lan- guage, who abides by (or does not abide by) a different legal sys- tem, and who could be very difficult to track down if he or she defaults on an obligation. Basically, there is a lot of potential for unknown issues to arise and for complications to happen given the lack of established trust between trading partners. With more than 200 countries in the world, lots of cultural values and be- liefs, and many potential avenues to run into complications, how much trust would you place on a relationship that (1) involved an organization from a country like yours (e.g., Swedish people doing business with Danish people) or (2) involved an organiza- tion from a country very different from yours (e.g., a Canadian doing business with someone from Turkey)?

14.1 FIGURE Preference of the U.S. Exporter

French Importer American Exporter

2 Exporter Ships the Goods after Being Paid

1 Importer Pays for the Goods

406 Part Six International Business Functions

payment is referred to as a draft. The bank, having paid for the products, now passes the title on to the French importer, whom the bank trusts. At that time or later, depending on their agreement, the importer reimburses the bank. In the remainder of this section, we examine how this system works in more detail.

LETTER OF CREDIT A letter of credit, abbreviated as L/C, stands at the center of international commercial transactions. Issued by a bank at the request of an importer, the letter of credit states that the bank will pay a specified sum of money to a beneficiary, nor- mally the exporter, on presentation of particular, specified documents.

Consider again the example of the U.S. exporter and the French importer. The French importer applies to her local bank, say, the Bank of Paris, for the issuance of a letter of credit. The Bank of Paris then undertakes a credit check of the importer. If the Bank of Paris is satisfied with her creditworthiness, it will issue a letter of credit. However, the Bank of Paris might require a cash deposit or some other form of collateral from her first. In addition, the Bank of Paris will charge the importer a fee for this service. Typically this amounts to between 0.5 and 2 percent of the value of the letter of credit, depending on the importer’s creditworthiness and the size of the transaction. (As a rule, the larger the trans- action, the lower the percentage.)

Assume the Bank of Paris is satisfied with the French importer’s creditworthiness and agrees to issue a letter of credit. The letter states that the Bank of Paris will pay the U.S. exporter for the merchandise as long as it is shipped in accordance with specified instructions and conditions. At this point, the letter of credit becomes a financial con- tract between the Bank of Paris and the U.S. exporter. The Bank of Paris then sends the letter of credit to the U.S. exporter’s bank, say, the Bank of New York. The Bank of New York tells the exporter that it has received a letter of credit and that he can ship the merchandise. After the exporter has shipped the merchandise, he draws a draft against

Letter of Credit Issued by a bank, indicating that the bank will make payments under specific circumstances.

14.2 FIGURE Preference of the French Importer

French Importer American Exporter

2 Importer Pays after the Goods Are Received

1 Exporter Ships the Goods

14.3 FIGURE The Use of a Third Party

French Importer American Exporter

3 Exporter Ships “to the Bank,” Trusting Bank's Promise to Pay

1 Importer Obtains Bank's Promise to Pay on Importer's Behalf

Bank

2 Bank Promises Exporter to Pay on Behalf of Importer

5 Bank Gives Merchandise to Importer

4 Bank Pays Exporter

6 Importer Pays Bank

Chapter Fourteen Exporting, Importing, and Countertrade 407

the Bank of Paris in accordance with the terms of the letter of credit, attaches the re- quired documents, and presents the draft to his own bank, the Bank of New York, for payment. The Bank of New York then forwards the letter of credit and associated docu- ments to the Bank of Paris. If all the terms and conditions contained in the letter of credit have been complied with, the Bank of Paris will honor the draft and will send payment to the Bank of New York. When the Bank of New York receives the funds, it will pay the U.S. exporter.

As for the Bank of Paris, once it has transferred the funds to the Bank of New York, it will collect payment from the French importer. Alternatively, the Bank of Paris may allow the importer some time to resell the merchandise before requiring payment. This is not unusual, particularly when the importer is a distributor and not the final consumer of the merchandise, since it helps the importer’s cash flow. The Bank of Paris will treat such an extension of the payment period as a loan to the importer and will charge an appropriate rate of interest.

The great advantage of this system is that both the French importer and the U.S. ex- porter are likely to trust reputable banks, even if they do not trust each other. Once the U.S. exporter has seen a letter of credit, he knows that he is guaranteed payment and will ship the merchandise. Also, an exporter may find that having a letter of credit will facili- tate obtaining pre-export financing. For example, having seen the letter of credit, the Bank of New York might be willing to lend the exporter funds to process and prepare the merchandise for shipping to France. This loan may not have to be repaid until the ex- porter has received his payment for the merchandise. As for the French importer, she does not have to pay for the merchandise until the documents have arrived and unless all con- ditions stated in the letter of credit have been satisfied. The drawback for the importer is the fee she must pay the Bank of Paris for the letter of credit. In addition, because the letter of credit is a financial liability against her, it may reduce her ability to borrow funds for other purposes.

DRAFT A draft, sometimes referred to as a bill of exchange, is the instrument nor- mally used in international commerce to effect payment. A draft is simply an order written by an exporter instructing an importer, or an importer’s agent, to pay a specified amount of money at a specified time. In the example of the U.S. exporter and the French importer, the exporter writes a draft that instructs the Bank of Paris, the French importer’s agent, to pay for the merchandise shipped to France. The person or business initiating the draft is known as the maker (in this case, the U.S. exporter). The party to whom the draft is presented is known as the drawee (in this case, the Bank of Paris).

International practice is to use drafts to settle trade transactions. This differs from do- mestic practice in which a seller usually ships merchandise on an open account, followed by a commercial invoice that specifies the amount due and the terms of payment. In domestic transactions, the buyer can often obtain possession of the merchandise without signing a formal document acknowledging his or her obligation to pay. In contrast, due to the lack of trust in international transactions, payment or a formal promise to pay is required before the buyer can obtain the merchandise.

Drafts fall into two categories, sight drafts and time drafts. A sight draft is payable on presentation to the drawee. A time draft allows for a delay in payment—normally 30, 60, 90, or 120 days. It is presented to the drawee, who signifies acceptance of it by writing or stamping a notice of acceptance on its face. Once accepted, the time draft becomes a prom- ise to pay by the accepting party. When a time draft is drawn on and accepted by a bank, it is called a banker’s acceptance. When it is drawn on and accepted by a business firm, it is called a trade acceptance.

Time drafts are negotiable instruments; that is, once the draft is stamped with an accep- tance, the maker can sell the draft to an investor at a discount from its face value. Imagine the agreement between the U.S. exporter and the French importer calls for the exporter to pres- ent the Bank of Paris (through the Bank of New York) with a time draft requiring payment

Bill of Exchange An order written by an exporter instructing an importer, or an importer’s agent, to pay a specified amount of money at a specified time.

Draft An order written by an exporter telling an importer what and when to pay.

Sight Draft A draft payable on presentation to the drawee.

Time Draft A promise to pay by the accepting party at some future date.

408 Part Six International Business Functions

120 days after presentation. The Bank of Paris stamps the time draft with an acceptance. Imagine further that the draft is for $100,000.

The exporter can either hold onto the accepted time draft and receive $100,000 in 120 days or sell it to an investor, say, the Bank of New York, for a discount from the face value. If the prevailing discount rate is 7 percent, the exporter could receive $97,700 by selling it immediately (7 percent per year discount rate for 120 days for $100,000 equals $2,300, and $100,000 2 $2,300 5 $97,700). The Bank of New York would then collect the full $100,000 from the Bank of Paris in 120 days. The exporter might sell the accepted time draft immediately if he needed the funds to finance merchandise in transit and/or to cover cash flow shortfalls.

BILL OF LANDING The third key document for financing international trade is the bill of lading. The bill of lading is issued to the exporter by the common carrier trans- porting the merchandise. It serves three purposes: it is a receipt, a contract, and a document of title. As a receipt, the bill of lading indicates that the carrier has received the merchandise described on the face of the document. As a contract, it specifies that the carrier is obligated to provide a transportation service in return for a certain charge. As a document of title, it can be used to obtain payment or a written promise of payment before the merchandise is released to the importer. The bill of lading can also function as collateral against which funds may be advanced to the exporter by its local bank before or during shipment and be- fore final payment by the importer.

A TYPICAL INTERNATIONAL TRADE TRANSACTION Now that we have reviewed the elements of an international trade transaction, let us see how the pro- cess works in a typical case, sticking with the example of the U.S. exporter and the French importer. The typical transaction involves 14 steps (see Figure 14.4).

1. The French importer places an order with the U.S. exporter and asks the American if he would be willing to ship under a letter of credit.

Bill of Lading A document issued to an exporter by a common carrier transporting merchandise. It serves as a receipt, a contract, and a document of title.

14.4 FIGURE A Typical International Trade Transaction

American Exporter French Importer

2 Exporter Agrees to Fill Order

12 Bank Tells Importer Documents Arrive

Bank of New York Bank of Paris

6 Goods Shipped to France

1 Importer Orders Goods

14 Bank of New York Presents Matured Draft and Gets Payment

8 Bank of New York Presents Draft to Bank of Paris

9 Bank of Paris Returns Accepted Draft

4 Bank of Paris Sends Letter of Credit to Bank of New York

13 Importer Pays Bank

3 Importer Arranges for Letter of Credit

5 Bank of New York Informs Exporter of Letter of Credit

10 and 11 Exporter Sells Draft to Bank

7 Exporter Presents Draft to Bank

Chapter Fourteen Exporting, Importing, and Countertrade 409

2. The U.S. exporter agrees to ship under a letter of credit and specifies relevant information such as prices and delivery terms.

3. The French importer applies to the Bank of Paris for a letter of credit to be issued in favor of the U.S. exporter for the merchandise the importer wishes to buy.

4. The Bank of Paris issues a letter of credit in the French importer’s favor and sends it to the U.S. exporter’s bank, the Bank of New York.

5. The Bank of New York advises the exporter of the opening of a letter of credit in his favor.

6. The U.S. exporter ships the goods to the French importer on a common carrier. An official of the carrier gives the exporter a bill of lading.

7. The U.S. exporter presents a 90-day time draft drawn on the Bank of Paris in accordance with its letter of credit and the bill of lading to the Bank of New York. The exporter endorses the bill of lading so title to the goods is transferred to the Bank of New York.

8. The Bank of New York sends the draft and bill of lading to the Bank of Paris. The Bank of Paris accepts the draft, taking possession of the documents and promising to pay the now-accepted draft in 90 days.

9. The Bank of Paris returns the accepted draft to the Bank of New York. 10. The Bank of New York tells the U.S. exporter that it has received the accepted bank

draft, which is payable in 90 days. 11. The exporter sells the draft to the Bank of New York at a discount from its face value

and receives the discounted cash value of the draft in return. 12. The Bank of Paris notifies the French importer of the arrival of the documents. She

agrees to pay the Bank of Paris in 90 days. The Bank of Paris releases the documents so the importer can take possession of the shipment.

13. In 90 days, the Bank of Paris receives the importer’s payment, so it has funds to pay the maturing draft.

14. In 90 days, the holder of the matured acceptance (in this case, the Bank of New York) presents it to the Bank of Paris for payment. The Bank of Paris pays.

Export Assistance Prospective U.S. exporters can draw on two forms of government-backed assistance to help finance their export programs. They can get financing aid from the Export-Import Bank and export credit insurance from the Foreign Credit Insurance Association (similar pro- grams are available in most countries).

EXPORT-IMPORT BANK Export-Import Bank (Ex-Im Bank) is an inde- pendent agency of the U.S. government. Its mission is to provide financing aid that will facilitate exports, imports, and the exchange of commodities between the United States and other countries. In 2010, its financing activities were expanded from $4 billion to $6 billion following a push by the Obama administration to try to create some 2 million new jobs through exports. The Ex-Im Bank pursues its mission with various loan and loan-guarantee programs. The agency guarantees repayment of medium- and long-term loans U.S. commercial banks make to foreign borrowers for purchasing U.S. exports. The Ex-Im Bank guarantee makes the commercial banks more willing to lend cash to foreign enterprises.

Ex-Im Bank also has a direct lending operation under which it lends dollars to foreign borrowers for use in purchasing U.S. exports. In some cases, it grants loans that commercial banks would not if it sees a potential benefit to the United States in doing so. The foreign borrowers use the loans to pay U.S. suppliers and repay the loan to Ex- Im Bank with interest.

LO 14-3 Identify information sources and government programs that exist to help exporters.

Export–Import Bank (Ex-Im Bank) Agency of the U.S. government whose mission is to provide aid in financing and facilitate exports and imports.

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410 Part Six International Business Functions

EXPORT CREDIT INSURANCE For reasons outlined earlier, exporters clearly prefer to get letters of credit from importers. However, sometimes an exporter who insists on a letter of credit will lose an order to one who does not require a letter of credit. Thus, when the importer is in a strong bargaining position and able to play competing suppliers against each other, an exporter may have to forgo a letter of credit.18 The lack of a letter of credit exposes the exporter to the risk that the foreign importer will default on payment. The exporter can insure against this possibility by buying export credit insurance. If the customer defaults, the insurance firm will cover a major portion of the loss.

In the United States, export credit insurance is provided by the Foreign Credit Insur- ance Association (FCIA), an association of private commercial institutions operating un- der the guidance of the Export-Import Bank. The FCIA provides coverage against commercial risks and political risks. Losses due to commercial risk result from the buyer’s insolvency or payment default. Political losses arise from actions of governments that are beyond the control of either buyer or seller. Marlin, the small Baltimore manufacturer of wire baskets discussed earlier, credits export credit insurance with giving the company the confidence to push ahead with export sales. For a premium of roughly half a percent of the price of a sale, Marlin has been able to insure itself against the possibility of nonpay- ment by a foreign buyer.19

Countertrade Countertrade is an alternative means of structuring an international sale when conventional means of payment are difficult, costly, or nonexistent. We first encountered countertrade in Chapter 10’s discussion of currency convertibility. A government may restrict the convert- ibility of its currency to preserve its foreign exchange reserves so they can be used to service international debt commitments and purchase crucial imports.20 This is problematic for exporters. Nonconvertibility implies that the exporter may not be paid in his or her home currency, and few exporters would desire payment in a currency that is not convertible. Countertrade is a common solution.21 Countertrade denotes a range of barterlike agree-

LO 14-5 Describe how countertrade can be used to facilitate exporting.

Countertrade The trade of goods and services for other goods and services.

Fred Hochber, chairman and president of the U.S. Export-Import Bank, speaks during their annual conference.

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Chapter Fourteen Exporting, Importing, and Countertrade 411

ments; its principle is to trade goods and services for other goods and services when they cannot be traded for money. Some examples of countertrade are:

• An Italian company that manufactures power-generating equipment, ABB SAE Sadelmi SpA, was awarded a 720 million baht ($17.7 million) contract by the Electricity Generating Authority of Thailand. The contract specified that the company had to accept 218 million baht ($5.4 million) of Thai farm products as part of the payment.

• Saudi Arabia agreed to buy ten 747 jets from Boeing with payment in crude oil, discounted at 10 percent below posted world oil prices.

• General Electric won a contract for a $150 million electric generator project in Romania by agreeing to market $150 million of Romanian products in markets to which Romania did not have access.

• The Venezuelan government negotiated a contract with Caterpillar under which Venezuela would trade 350,000 tons of iron ore for Caterpillar earthmoving equipment.

• Albania offered such items as spring water, tomato juice, and chrome ore in exchange for a $60 million fertilizer and methanol complex.

• Philip Morris ships cigarettes to Russia, for which it receives chemicals that can be used to make fertilizer. Philip Morris ships the chemicals to China, and in return, China ships glassware to North America for retail sale by Philip Morris.22

THE POPULARITY OF COUNTERTRADE In the modern era, countertrade arose in the 1960s as a way for the Soviet Union and the communist states of eastern Europe, whose currencies were generally nonconvertible, to purchase imports. During the 1980s, the technique grew in popularity among many developing nations that lacked the foreign exchange reserves re- quired to purchase necessary imports. Today, reflecting their own shortages of foreign ex- change reserves, some successor states to the former Soviet Union and the eastern European communist nations periodically engage in countertrade to purchase their imports. Estimates of the percentage of world trade covered by some sort of countertrade agreement range from highs of 8 and 10 percent by value to lows of around 2 percent.23 The precise figure is unknown, but it is probably at the low end of these estimates, given the increasing liquidity of international financial markets and wider currency convertibility. However, a short-term spike in the volume of countertrade can follow periodic financial crises. For example, coun- tertrade activity increased notably after the Asian financial crisis of 1997. That crisis left many Asian nations with little hard currency to finance international trade. In the tight monetary regime that followed the crisis in 1997, many Asian firms found it very difficult to get access to export credit to finance their own international trade. Thus, they turned to the only option available to them—countertrade.

Given that countertrade is a means of financing international trade, albeit a relatively minor one, prospective exporters may have to engage in this technique from time to time to gain access to certain international markets. The governments of developing nations some- times insist on a certain amount of countertrade.24

TYPES OF COUNTERTRADE With its roots in the simple trading of goods and services for other goods and services, countertrade has evolved into a diverse set of

Is Countertrade an Appropriate Way of Trading Today? Countertrades can take many forms, and there are several examples of how it works internationally. For instance, the Malaysian government recently bought 20 diesel electric lo- comotives from General Electric. Officials of the government said that GE will be paid with palm oil supplied by a planta- tion company. The company will supply about 200,000 metric tons of palm oil over a period of 30 months. No money changed hands, and no third parties were involved. As an- other example, in order to save foreign exchange reserves, the Philippine government offered some creditors tinned tuna to repay part of a state $4 billion debt. In other examples, General Motors Corporation sold $12 million worth of loco- motive and diesel engines to Yugoslavia and took cash and $4 million in Yugoslavian cutting tools as payment. Plus, McDonnell Douglas agreed to a compensation deal with Thai- land for eight top-of-the-line F/A–18 strike aircraft. Thailand agreed to pay $578 million of the total cost in cash, and McDonnell Douglas agreed to accept $93 million in a mixed bag of goods, including Thai rubber, ceramics, furniture, fro- zen chicken, and canned fruit. To some, these types of trad- ing contracts are strange and to some they are normal, especially if we go back in time. But what about today? Should the global marketplace engage in these types of non- monetary trades?

Source: S. Rama, “Types of Counter Trade,” 2011, www.citeman.com/13236- types-of-counter-trade.html.

412 Part Six International Business Functions

activities that can be categorized as five distinct types of trading arrangements: barter, coun- terpurchase, offset, switch trading, and compensation or buyback.25 Many countertrade deals involve not just one arrangement, but elements of two or more.

Barter Barter is the direct exchange of goods and/or services between two parties with- out a cash transaction. Although barter is the simplest arrangement, it is not common. Its problems are twofold. First, if goods are not exchanged simultaneously, one party ends up financing the other for a period. Second, firms engaged in barter run the risk of having to accept goods they do not want, cannot use, or have difficulty reselling at a reasonable price. For these reasons, barter is viewed as the most restrictive countertrade arrangement. It is primarily used for one-time-only deals in transactions with trading partners who are not creditworthy or trustworthy.

Counterpurchase Counterpurchase is a reciprocal buying agreement. It occurs when a firm agrees to purchase a certain amount of materials back from a country to which a sale is made. Suppose a U.S. firm sells some products to China. China pays the U.S. firm in dollars, but in exchange, the U.S. firm agrees to spend some of its proceeds from the sale on textiles produced by China. Thus, although China must draw on its for- eign exchange reserves to pay the U.S. firm, it knows it will receive some of those dollars back because of the counterpurchase agreement. In one counterpurchase agreement, Rolls-Royce sold jet parts to Finland. As part of the deal, Rolls-Royce agreed to use some of the proceeds from the sale to purchase Finnish-manufactured TV sets that it would then sell in Great Britain.

Offset An offset is similar to a counterpurchase insofar as one party agrees to purchase goods and services with a specified percentage of the proceeds from the original sale. The difference is that this party can fulfill the obligation with any firm in the country to which the sale is being made. From an exporter’s perspective, this is more attractive than a straight counterpurchase agreement because it gives the exporter greater flexibility to choose the goods that it wishes to purchase.

Switch Trading The term switch trading refers to the use of a specialized third- party trading house in a countertrade arrangement. When a firm enters a counterpur- chase or offset agreement with a country, it often ends up with what are called counterpurchase credits, which can be used to purchase goods from that country. Switch trading occurs when a third-party trading house buys the firm’s counterpurchase credits and sells them to another firm that can better use them. For example, a U.S. firm concludes a counterpurchase agreement with Poland for which it receives some number of counterpurchase credits for purchasing Polish goods. The U.S. firm cannot use and does not want any Polish goods, however, so it sells the credits to a third-party trading house at a discount. The trading house finds a firm that can use the credits and sells them at a profit.

In one example of switch trading, Poland and Greece had a counterpurchase agreement that called for Poland to buy the same U.S.-dollar value of goods from Greece that it sold to Greece. However, Poland could not find enough Greek goods that it required, so it ended up with a dollar-denominated counterpurchase balance in Greece that it was unwilling to use. A switch trader bought the right to 250,000 counterpurchase dollars from Poland for $225,000 and sold them to a European sultana (grape) merchant for $235,000, who used them to purchase sultanas from Greece.

Compensation or Buybacks A buyback occurs when a firm builds a plant in a country—or supplies technology, equipment, training, or other services to the country—and agrees to take a certain percentage of the plant’s output as partial payment for the contract. For example, Occidental Petroleum negotiated a deal with Russia under which Occidental

Barter The direct exchange of goods or services between two parties without a cash transaction.

Counterpurchase A reciprocal buying agreement.

Offset Agreement to purchase goods and services with a specified percentage of proceeds from an original sale in that country from any firm in the country.

Switch Trading Use of a specialized third-party trading house in a countertrade arrangement.

Buyback Agreement to accept a percentage of a plant’s output as payment for contract to build a plant.

Chapter Fourteen Exporting, Importing, and Countertrade 413

would build several ammonia plants in Russia and as partial payment receive ammonia over a 20-year period.

PROS AND CONS OF COUNTERTRADE Counter- trade’s main attraction is that it can give a firm a way to finance an export deal when other means are not available. Given the problems that many developing nations have in raising the foreign exchange necessary to pay for imports, countertrade may be the only option available when doing business in these countries. Even when coun- tertrade is not the only option for structuring an export transaction, many countries prefer countertrade to cash deals. Thus, if a firm is unwilling to enter a countertrade agreement, it may lose an export opportunity to a competitor that is willing to make a countertrade agreement.

In addition, a countertrade agreement may be required by the government of a country to which a firm is exporting goods or ser- vices. Boeing often has to accept to counterpurchase agreements to capture orders for its commercial jet aircraft. For example, in exchange for gaining an order from Air India, Boeing may be required to purchase certain component parts, such as air- craft doors, from an Indian company. Taking this one step further, Boeing can use its will- ingness to enter into a counterpurchase agreement as a way of winning orders in the face of intense competition from its global rival, Airbus. Thus, countertrade can become a strategic marketing weapon.

However, the drawbacks of countertrade agreements are substantial. Other things being equal, firms would normally prefer to be paid in hard currency. Countertrade contracts may involve the exchange of unusable or poor-quality goods that the firm cannot dispose of profit- ably. For example, a few years ago, one U.S. firm got burned when 50 percent of the television sets it received in a countertrade agreement with Hungary were defective and could not be sold. In addition, even if the goods it receives are of high quality, the firm still needs to dispose of them profitably. To do this, countertrade requires the firm to invest in an in-house trading de- partment dedicated to arranging and managing countertrade deals. This can be expensive and time-consuming.

Given these drawbacks, countertrade is most attractive to large, diverse multinational enterprises that can use their worldwide network of contacts to dispose of goods acquired in countertrading. The masters of countertrade are Japan’s giant trading firms, the sogo shosha, which use their vast networks of affiliated companies to profitably dispose of goods acquired through countertrade agreements. The trading firm of Mitsui & Company, for example, has about 120 affiliated companies in almost every sector of the manufacturing and service in- dustries. If one of Mitsui’s affiliates receives goods in a countertrade agreement that it can- not consume, Mitsui & Company will normally be able to find another affiliate that can profitably use them. Firms affiliated with one of Japan’s sogo shosha often have a competitive advantage in countries where countertrade agreements are preferred.

Western firms that are large, diverse, and have a global reach (e.g., General Electric, Philip Morris, and 3M) have similar profit advantages from countertrade agreements. Indeed, 3M has established its own trading company—3M Global Trading Inc.—to de- velop and manage the company’s international countertrade programs. Unless there is no alternative, small and medium-size exporters should probably try to avoid countertrade deals because they lack the worldwide network of operations that may be required to profitably utilize or dispose of goods acquired through them.26

A subsea oil and gas tree is lowered into a testing pool at a GE plant in Montrose, UK. Large, diverse, global companies like GE can benefit from countertrade agreements.

MITI, p. 401 sogo shosha, p. 401

export management company (EMC), p. 402

letter of credit, p. 406 bill of exchange, p. 407

Key Terms

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414 Part Six International Business Functions

Critical Thinking and Discussion Questions

1. A firm based in Washington State wants to export a shipload of finished lumber to the Philippines. The would-be importer cannot get sufficient credit from domestic sources to pay for the shipment but insists that the finished lumber can quickly be resold in the Philippines for a profit. Outline the steps the exporter should take to effect this export to the Philippines.

2. You are the assistant to the CEO of a small textile firm that manufactures quality, premium-priced, stylish clothing. The CEO has decided to see what the opportunities are for exporting and has asked you for advice as to the steps the company should take. What advice would you give the CEO?

Summary

This chapter examined the steps that firms must take to establish themselves as exporters. The chapter made the following points:

1. One big impediment to exporting is ignorance of foreign market opportunities.

2. Neophyte exporters often become discouraged or frustrated with the exporting process because they encounter many problems, delays, and pitfalls.

3. The way to overcome ignorance is to gather information. In the United States, a number of institutions, the most important of which is the Department of Commerce, can help firms gather information in the matchmaking process. Export management companies can also help identify export opportunities.

4. Many of the pitfalls associated with exporting can be avoided if a company hires an experienced export management company, or export consultant, and if it adopts the appropriate export strategy.

5. Firms engaged in international trade must do business with people they cannot trust and people who may be difficult to track down if they default on an obligation. Due to the lack of trust, each party to an international transaction has a different set of preferences regarding the configuration of the transaction.

6. The problems arising from lack of trust between exporters and importers can be solved by using a third party that is trusted by both, normally a reputable bank.

7. A letter of credit is issued by a bank at the request of an importer. It states that the bank promises to pay a

beneficiary, normally the exporter, on presentation of documents specified in the letter.

8. A draft is the instrument normally used in international commerce to effect payment. It is an order written by an exporter instructing an importer, or an importer’s agent, to pay a specified amount of money at a specified time.

9. Drafts are either sight drafts or time drafts. Time drafts are negotiable instruments.

10. A bill of lading is issued to the exporter by the common carrier transporting the merchandise. It serves as a receipt, a contract, and a document of title.

11. U.S. exporters can draw on two types of government- backed assistance to help finance their exports: loans from the Export-Import Bank and export credit insurance from the FCIA.

12. Countertrade includes a range of barterlike agreements. It is primarily used when a firm exports to a country whose currency is not freely convertible and may lack the foreign exchange reserves required to purchase the imports.

13. The main attraction of countertrade is that it gives a firm a way to finance an export deal when other means are not available. A firm that insists on being paid in hard currency may be at a competitive disadvantage vis-à-vis one that is willing to engage in countertrade.

14. The main disadvantage of countertrade is that the firm may receive unusable or poor-quality goods that cannot be disposed of profitably.

draft, p. 407 sight draft, p. 407 time draft, p. 407 bill of lading, p. 408

Export–Import Bank (Ex-Im Bank), p. 409 countertrade, p. 410 barter, p. 412

counterpurchase, p. 412 offset, p. 412 switch trading, p. 412 buyback, p. 412

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

1. One way that exporters analyze conditions in emerging markets is through the use of macroeconomic indicators. The Market Potential Index (MPI) is a yearly study conducted by the Michigan State University Center for International Business Education and Research (MSU-CIBER) to compare the market potential of emerging markets for U.S. exporters. Provide a description of the dimensions used in the index. Which of the dimensions would have greater importance for a company that markets wireless devices? What about a company that sells clothing?

2. You work in the sales department of a company that manufactures and sells medical implants. A Brazilian company contacted your department and expressed interest in purchasing a large quantity of your products. The Brazilian company requested an FOB price quote. One of your colleagues mentioned to you that FOB is part of a collection of international shipping terms called “Incoterms,” but that was all he knew. Find the Export Tutorials on the globalEDGE site, and find a more detailed explanation of Incoterms. For an FOB quote, what line items will you need to include in your price quote, in addition to the price your company will charge for the products?

Research Task http://globalEDGE.msu.edu

3. An alternative to using a letter of credit is export credit insurance. What are the advantages and disadvantages of using export credit insurance rather than a letter of credit for exporting (a) a luxury yacht from California to Canada and (b) machine tools from New York to Ukraine?

4. How do you explain the use of countertrade? Under what scenarios might its use increase further

by 2020? Under what scenarios might its use decline?

5. How might a company make strategic use of countertrade schemes as a marketing weapon to generate export revenues? What are the risks associated with pursuing such a strategy?

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Al Merritt founded MD International in 1987. A former salesman for a med- ical equipment company, Merritt saw an opportunity to act as an export intermediary for medical equipment manufacturers in the United States. He chose to focus on Latin America and the Caribbean, a region that he already had experience in. Also, trade barriers were starting to fall through- out the region as Latin American governments embraced a more liberal economic ideology, creating an opening for entrepreneurs such as Merritt. Local governments were also expanding their spending on health care, creating an opportunity that Merritt was poised to exploit.

Merritt located his company in south Florida to be close to his mar- ket. Since then, the company has grown to become the largest interme- diary exporting medical devices to the region. Today, the company sells the products of more than 30 medical manufacturers to some 600 re- gional distributors. While many medical equipment manufacturers don’t sell directly to the region because of the sizable marketing costs, MD can afford to because it goes into those markets with a broad portfolio of products.

The company’s success is in part due to its deep-rooted knowledge and understanding of the Latin American market. MD works very closely with teams of doctors, biomedical engineers, microbiologists, and market-

ing managers across Latin America to understand their needs and what the company can do for them. The sale of products to customers is typi- cally only the beginning of a relationship. MD International also provides training to medical personnel in the use of devices and offers extensive after-sale service and support.

Along the way to becoming a successful exporter, MD International has leaned heavily upon export assistance programs established by the U.S. government. For example, a shipment to Venezuela was held up by the Venezuelan customs seeking proof that the medical devices were not in- tended for military use. Within two days, staff at the U.S. Export Assistance Center in Miami arranged for the U.S. embassy in Venezuela to have a let- ter written and delivered to the customs officials, assuring them that the products had no military applications, and the shipment was released. Merritt has also worked extensively with the Export–Import Bank to gain financing for its exports (the company needs to finance the inventory that it exports).

Despite these advantages, it has not all been easy going for MD Inter- national. Latin American economies have often been highly cyclical, and MD International has ridden those cycles with them. In the early 2000s, for example, after several years of solid growth, an economic crisis in both

MD International

Chapter Fourteen Exporting, Importing, and Countertrade 415

416 Part Six International Business Functions

Endnotes

1. R. A. Pope, “Why Small Firms Export: Another Look,” Journal of Small Business Management 40 (2002), pp. 17–26.

2. M. C. White, “Marlin Steel Wire Products,” Slate Magazine, November 10, 2010.

3. S. T. Cavusgil, “Global Dimensions of Marketing,” in Marketing, ed. P. E. Murphy and B. M. Enis (Glenview, IL: Scott, Foresman, 1985), pp. 577–99.

4. S. M. Mehta, “Enterprise: Small Companies Look to Culti- vate Foreign Business,” The Wall Street Journal, July 7, 1994, p. B2.

5. P. A. Julien and C. Ramagelahy, “Competitive Strategy and Performance of Exporting SMEs,” Entrepreneurship Theory and Practice, 2003, pp. 227–94.

6. W. J. Burpitt and D. A. Rondinelli, “Small Firms’ Motiva- tions for Exporting: To Earn and Learn?” Journal of Small Business Management, October 2000, pp. 1–14; and J. D. Mittelstaedt, G. N. Harben, and W. A. Ward, “How Small Is Too Small?” Journal of Small Business Management 41 (2003), pp. 68–85.

7. Small Business Administration, “The State of Small Business 1999–2000: Report to the President,” 2001; and D. Ransom, “Obama’s Math: More Exports Equals More Jobs,” The Wall Street Journal, February 6, 2010.

8. A. O. Ogbuehi and T. A. Longfellow, “Perceptions of U.S. Manufacturing Companies Concerning Exporting,” Journal of Small Business Management, October 1994, pp. 37–59; and U.S. Small Business Administration, “Guide to Export- ing,” www.sba.gov/oit/info/Guide-to-Exporting/index. html.

9. R. W. Haigh, “Thinking of Exporting?” Columbia Journal of World Business 29 (December 1994), pp. 66–86.

10. F. Williams, “The Quest for More Efficient Commerce,” Fi- nancial Times, October 13, 1994, p. 7.

11. See Burpitt and Rondinelli, “Small Firms’ Motivations for Exporting”; and C. S. Katsikeas, L. C. Leonidou, and N. A.

Morgan, “Firm Level Export Performance Assessment,” Academy of Marketing Science 28 (2000), pp. 493–511.

12. M. Y. Yoshino and T. B. Lifson, The Invisible Link (Cambridge, MA: MIT Press, 1986).

13. L. W. Tuller, Going Global (Homewood, IL: Business One– Irwin, 1991).

14. Haigh, “Thinking of Exporting?”

15. M. A. Raymond, J. Kim, and A. T. Shao. “Export Strategy and Performance,” Journal of Global Marketing 15 (2001), pp. 5–29; and P. S. Aulakh, M. Kotabe, and H. Teegen, “Export Strategies and Performance of Firms from Emerg- ing Economies,” Academy of Management Journal 43 (2000), pp. 342–61.

16. J. Francis and C. Collins-Dodd, “The Impact of Firms’ Export Orientation on the Export Performance of High- Tech Small and Medium Sized Enterprises,” Journal of Inter- national Marketing 8, no. 3 (2000), pp. 84–103.

17. J. Koch, “Integration of U.S. Small Businesses into the Export Trade Sector Using Available Financial Tools and Resources,” Business Credit 109, no. 10 (2007), pp. 64–68.

18. For a review of the conditions under which a buyer has power over a supplier, see M. E. Porter, Competitive Strategy (New York: Free Press, 1980).

19. White, “Marlin Steel Wire Products.”

20. Exchange Agreements and Exchange Restrictions (Washington, DC: International Monetary Fund, 1989).

21. It’s also sometimes argued that countertrade is a way of re- ducing the risks inherent in a traditional money-for-goods transaction, particularly with entities from emerging econo- mies. See C. J. Choi, S. H. Lee, and J. B. Kim, “A Note of Countertrade: Contractual Uncertainty and Transactional Governance in Emerging Economies,” Journal of Interna- tional Business Studies 30, no. 1 (1999), pp. 189–202.

22. J. R. Carter and J. Gagne, “The Do’s and Don’ts of Interna- tional Countertrade,” Sloan Management Review, Spring 1988,

Argentina and Brazil, coupled with a slowdown in Mexico, resulted in losses for the year and forced Merritt to lay off one-third of his staff and cut the pay of others, which included a 50 percent pay cut for himself. Things started to improve by the mid-2000s, and a weak dollar at the time also helped to boost export sales. However, the global financial crisis of 2008–2009 ushered in another tough period. MD International not only survived the downturn, but came out stronger as weaker competitors fall by the wayside.

CASE DISCUSSION QUESTIONS 1. How does an intermediary such as MD International create value for

the manufacturers that use it to sell medical equipment in foreign markets? Why do they want to use MD International rather than export directly themselves?

2. Why did MD International focus on Latin America? What are the benefits of this regional approach? What are the potential drawbacks?

3. What would it take for MD International to start exporting to other regions, such as Asia or Europe? Given this, would you advise Al Merritt to continue his regional focus going forward or to add other regions?

4. How important has government assistance been to MD International? Do you think helping firms such as MD International represents a good use of taxpayer money?

Sources: J. Bussey, “Where Have All the Exporters Gone?” Miami Herald, September 30, 2005, p. C1; M. Chandler, “Dade Firm Seeks to Remake Health Care,” Miami Herald, June 15, 2000; and C. Cultice, “Exports with a Heart,” U.S. Department of Commerce, export success stories, at www.export.gov.

Chapter Fourteen Exporting, Importing, and Countertrade 417

pp. 31–37; and W. Maneerungsee, “Countertrade: Farm Goods Swapped for Italian Electricity,” Bangkok Post, July 23, 1998.

23. Estimate from the American Countertrade Association at www.countertrade.org/index.htm. See also D. West, “Coun- tertrade,” Business Credit 104, no. 4 (2001), pp. 64–67; and B. Meyer, “The Original Meaning of Trade Meets the Future of Barter,” World Trade 13 (January 2000), pp. 46–50.

24. Carter and Gagne, “The Do’s and Don’ts of International Countertrade.”

25. For details, see Carter and Gagne, “Do’s and Don’ts of Inter- national Countertrade”; J. F. Hennart, “Some Empirical Di- mensions of Countertrade,” Journal of International Business Studies, 1990, pp. 240–60; and West, “Countertrade.”

26. D. J. Lecraw, “The Management of Counter-Trade: Factors Influencing Success,” Journal of International Business Studies, Spring 1989, pp. 41–59.

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learning objectives

15-1 Explain why global production and supply chain management decisions are of central importance to many global companies.

15-2 Explain how country differences, production technology, and production factors all affect the choice of where to locate production activities.

15-3 Recognize how the role of foreign subsidiaries in production can be enhanced over time as they accumulate knowledge.

15-4 Identify the factors that influence a firm’s decision of whether to source supplies from within the company or from foreign suppliers.

15-5 Understand the functions of logistics and purchasing (sourcing) within global supply chains.

15-6 Describe what is required to efficiently manage a global supply chain.

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a pt

Global Production and Supply Chain Management

Apple: The Best Supply Chains in the World?

opening case

For six straight years, Apple has been recognized as having the best worldwide supply chains in the “Gartner Global Supply Chain Top 25” ranking. Numerous accolades have also been made about Apple’s supply chain strategy, operations, and results. For example, Apple’s supply chains “best demonstrate leadership in applying demand-driven principles to drive business results.” “Apple dominates

because it consistently brings both operational and innovation excellence to bear in some of the most

competitive markets in the world.” Basically, Apple gets a lot of credit in the supply chain profession for

being able to ramp up volumes both in hardware and software while also innovatively helping to redefine

the consumer electronics market (e.g., iPhone, iPod, iPad, Mac).

Apple is the world’s second largest information technology company by revenue after Samsung and the

third largest mobile phone producer after Samsung and Nokia. In Interbrand’s “Best Global Brands” report,

Apple is now also the most valuable brand in the world. It overtook Coca-Cola for the number one position

after Coca-Cola’s 13-year run at the top. Apple has an estimated brand value of more than $98 billion. “Few

brands have enabled so many people to do so much so easily, which is why Apple has legions of adoring fans.”

These “fans” or customers have downloaded apps for Apple’s electronic gadgets more than 50 billion times.

The company’s general supply chain model follows the path of most large multinational corporation’s

supply chains. They do research and development to cultivate new technologies and/or to acquire

intellectual property needed for future products. They test the product concepts via marketing research,

product testing, and total cost analysis. After that, Apple typically does a pre-launch of new products,

where global production, sourcing commitments, inventory management, and so on are evaluated. The

product launch involves doing demand forecasts, resolving potential backlogs, and ensuring that the

products are in the hands of its customers in as fast cycle time as possible. After the launch, monitoring

starts with periodic reviews of inventory, demand, life cycle status, and component cost forecasts.

A number of factors make Apple’s global supply chains world leading. First, early on, Apple took steps

to manage the total value created in its global supply chains by managing its suppliers and all other

providers within the chains. Predetermined expectations of suppliers, exclusivity in supplier arrangements,

–continued

420 Part Six International Business Functions

and volume guarantees ensured a supply chain infrastructure that could support Apple’s

aggressive market leadership. Apple’s relationship building with its network partners is

also a strength that has helped with increased scaling of production and resulted in

improved quality in the manufacturing processes. Plus, and not to be underestimated,

Apple has amassed lots of cash! The available cash funds have partially been used to

place high volume orders, which strengthen supplier relationships, and in other ways

maintain global supply chain leadership.

Using its supply chain infrastructure, Apple has managed to solve most of the

challenges it has faced. For example, while the global economic downturn in 2008

presented problems for virtually all companies, Apple came through it in great shape. At

the time, Steve Jobs said, “We’re armed with the strongest product line in our history,

the most talented employees and the best customers in our industry . . . Apple just

reported one of the best quarters in its history.” Other challenges that Apple is facing

include obtaining enough quality components for its consumer electronics, potential for

supply chain disruptions (natural and people created), dependence on third-party

logistics providers, and inventory management issues. In each case, so far, Apple has

strategically solved major issues to the satisfaction of the marketplace (the company

consistently ranks at the top in “customer satisfaction” in the American Customer

Satisfaction Index).

However, everything is not all rosy or positive about Apple. The company’s reputation

has taken a few hits recently. For example, Apple was found guilty by a U.S. court of

conspiring with publishers to set the price of e-books that were bought using iTunes.

The ongoing feud with Samsung regarding various patents keeps lingering year-by-

year, and worldwide customers are almost fanatically taking sides for or against Apple.

There have also been allegations about the treatment of employees at Foxconn in

China (one of the Apple suppliers). Plus, there was a U.S. Senate hearing that

investigated Apple’s “highly questionable” tax minimization strategies. Now, on the

more positive side, Apple has a portfolio of potential blockbuster products, welcomed

upgrades, and innovative services in the making that are sure to remind its fans why

they favor Apple products.

The challenges attached to these new offerings are sure to test Apple’s leadership in both

brand value and best global supply chains. To some degree, the future challenges are clear.

To stay at the top of its industry, Apple has to succeed in slowing Samsung’s momentum and

capturing the booming Chinese mobile phone market. As always with Apple, as set in our

expectations over the years by Steve Jobs’ “one more thing” announcements, Tim Cook and

the new Apple leadership team must keep communicating to the market that their vision,

innovations, and leadership can drive the idea that Apple’s best days are ahead. As one way

to do this, Apple is on a hiring binge in Asia, adding hundreds of engineers and supply chain

managers to its staff in Shangai and Taipei as it seeks to increase the speed at which it

introduces new products. Plus, with Tim Cook as the CEO, Apple has a global production and

supply chain management expert at the helm who constantly scrutinizes Apple’s supply

chains, production operations, and fair labor practices. • Sources: D. Hofman, “The Gartner Supply Chain Top 25,” 2013, www.gartner.com/technology/supply-chain/top25.jsp, accessed April 13, 2014; “Interbrand’s Best Global Brands 2013,” www.interbrand.com/en/best-global-brands/2013/ Best-Global-Brands-2013.aspx, accessed April 13, 2014; “Apple Is the World’s Most Valuable Brand at $98 Billion,” The Huffington Post, September 30, 2013; “Apple Reports Fourth Quarter Results,” Apple Press Info, October 21, 2008; E. Doe, “Apple Goes on Hiring Binge in Asia to Speed Product Releases,” The Wall Street Journal, March 3, 2014; American Customer Satisfaction Index, http://theacsi.org; and “Fixing Apple’s Supply Chains,” The New York Times, April 2, 2012.

Chapter Fifteen Global Production and Supply Chain Management 421

Introduction As trade barriers fall and global markets develop, many firms increasingly confront a set of interrelated issues. First, where in the world should production activities be located? Should they be concentrated in a single country, or should they be dispersed around the globe, matching the type of activity with country differences in factor costs, tariff barri- ers, political risks, and the like to minimize costs and maxi- mize value added? Second, what should be the long-term strategic role of foreign production sites? Should the firm abandon a foreign site if factor costs change, moving pro- duction to another more favorable location, or is there value to maintaining an operation at a given location even if underlying economic conditions change? Third, should the firm own foreign production activities, or is it better to out- source those activities to independent vendors? Fourth, how should a globally dispersed supply chain be managed, and what is the role of Internet-based information technol- ogy in the management of global logistics and sourcing? Fifth, should the firm manage global supply chains itself, or should it outsource the management to enterprises that specialize in this activity?

The example of Apple’s global supply chains discussed in the opening case touches on some of these issues. Like many modern products, different components for Apple’s consumer electronics are manufactured in different locations to produce a low-cost product. In choosing which company should make which components, Apple was guided by the need to keep the cost of the component parts low so that it could price aggressively and gain market share from its global rivals, Samsung and Nokia. How- ever, as the case demonstrates, Apple may have miscalculated in some areas and the compa- ny’s reputation has taken a few recent hits. As the Apple example illustrates, companies also need to be very careful when deciding to outsource production to foreign suppliers, and they need to think about the total costs of their supply chains, not just basic differentials in production cost.

Strategy, Production, and Supply Chain Management Chapter 12 introduced the concept of the value chain and discussed a number of value creation activities, including production, marketing, logistics, R&D, human resources, and information systems. This chapter focuses on two of these activities—production and supply chain management—and attempts to clarify how they might be performed interna- tionally to (1) lower the costs of value creation and (2) add value by better serving customer needs. We also discuss the contributions of information technology to these activities, which has become particularly important in a globally integrated world. The remaining chapters in this text look at other value creation activities in the international context (marketing, R&D, and human resource management).

In Chapter 12, we defined production as “the activities involved in creating a product.” We used the term production to denote both service and manufacturing activities, because either a service or a physical product can be produced. Although in this chapter we focus more on the production of physical goods, we should not forget that the term can also be applied to services. This has become more evident in recent years, with the continued pattern among U.S. firms to outsource the “production” of certain service activities to developing nations where labor costs are lower (e.g., the trend among many U.S. companies to outsource cus- tomer care services to places such as India, where English is widely spoken and labor costs

LO 15-1 Explain why global production and supply chain management decisions are of central importance to many global companies.

Production Activities involved in creating a product.

Supply Chain Management The integration and coordination of logistics, purchasing, operations, and market channels activities from raw material to the end-customer.

Which Career Would You Choose in Global Supply Chain Management? With increased outsourcing and overseas production sites and customers, supply chain management is a growing field. The Council of Supply Chain Management Professionals (CSCMP), a professional association with more than 8,500 members world- wide, says the industry offers a promising outlook. What’s more, potential employers are everywhere—manufacturers and dis- tributors; government agencies; consulting firms; the transport industry; universities and colleges; service firms such as banks, hospitals, and hotels; and third-party logistics providers. The basic career options in global supply chains include its main functions of logistics, purchasing (sourcing), production and operations management, and marketing channels. Which func- tional area would you choose if you decided to get a job in supply chain management and why? For more information about the organization and careers in this field, visit the CSCMP website at www.cscmp.org and its careers site, www.careers- insupplychain.org.

422 Part Six International Business Functions

are much lower). Supply chain management is the integration and coordination of logistics, purchasing, operations, and market channel activities from raw material to the end- customer. Production and supply chain management are closely linked because a firm’s ability to perform its production activities efficiently depends on a timely supply of high- quality material and information inputs, for which purchasing and logistics are critical functions. Purchasing represents the part of the supply chain that involves worldwide buying of raw material, component parts, and products used in manufacturing of the company’s products and services. Logistics is the part of the supply chain that plans, implements, and controls the effective flows and inventory of raw material, component parts, and products used in manufacturing.

The production and supply chain management functions (purchasing, logistics) of an international firm have a number of important strategic objectives.1 One is to ensure that the total cost of moving from raw materials to finished goods is as low as possible for the value provided to the end-customer. Dispersing production activities to various locations around the globe where each activity can be performed most efficiently can lower the total costs. Costs can also be cut by managing the global supply chain effi- ciently so as to better match supply and demand. This involves both coordination and integration of the supply chain functions inside a global company (e.g., purchasing, logis- tics, production and operations management) and across the independent organizations (e.g., suppliers) involved in the chain. For example, efficient logistics practices reduce the amount of inventory in the system, increases inventory turnover, and facilitates the appropriate transportation modes being used. Maximizing purchasing operations enhance the order fulfillment and delivery, outsourcing initiatives, and supplier selec- tions. Efficient operations ensure that the right location of production is made, establishes which production priorities should be stressed, and facilitates a high-quality outcome of the supply chain.

Another strategic objective shared by production and supply chain management is to increase product (or service) quality by establishing process-based quality standards, and eliminating defective raw material, component parts, and products from the manufactur- ing process and the supply chain.2 In this context, quality means reliability, implying that ultimately the finished product has no defects and performs well. These quality assur- ances should be embedded in both the upstream and downstream portions of the global supply chain. The upstream supply chain includes all of the organizations (e.g., suppliers) and resources that are involved in the portion of the supply chain from raw materials to the production facility (this is sometimes also called the inbound supply chain). The downstream supply chain includes all of the organizations (e.g., wholesaler, retailer) that are involved in the portion of the supply chain from the production facility to the end- customer (this is also sometimes called the outbound supply chain). Through the up- stream and downstream chains, the objectives of reducing costs and increasing quality are not independent of each other. As illustrated in Figure 15.1, the firm that improves

Purchasing The part of the supply chain that includes the worldwide buying of raw material, component parts, and products used in manufacturing of the company’s products and services.

Logistics The part of the supply chain that plans, implements, and controls the effective flows and inventory of raw material, component parts, and products used in manufacturing.

Upstream Supply Chain The portion of the supply chain from raw materials to the production facility.

Downstream Supply Chain The portion of the supply chain from the production facility to the end-customer.

Outsourcing

The Global Production and Supply Chain Management chapter tackles a number of issues related to production, make-or-buy decisions, sourcing, and logistics. Outsourcing is one of the most commonly dis- cussed topics in news media and on the Internet related to production and supply chains. In effect, the word outsourcing sometimes even creates “us against them” mentality (i.e., should the company out- source production or other activities to entities outside its country bor- ders, or should it use only domestic operations?). Often, the answer is

more of a political issue than a strategic resource issue. To stay com- petitive, companies typically opt for the best value to infuse in their supply chains. The “Outsourcing” section on globalEDGE ensures that you have an updated set of data and knowledge on outsourcing (http:// globaledge.msu.edu/global-resources/outsourcing). For example, did you know that there is an International Association of Outsourcing Pro- fessionals? Do you know what it does, its goals, and how many mem- bers it has worldwide?

Chapter Fifteen Global Production and Supply Chain Management 423

its quality control will also reduce its costs of value creation. Improved quality control reduces costs by:

• Increasing productivity because time is not wasted producing poor-quality products that cannot be sold, leading to a direct reduction in unit costs.

• Lowering rework and scrap costs associated with defective products. • Reducing the warranty costs and time associated with fixing defective products.

The effect is to lower the total costs of value creation by reducing both production and after-sales service costs. This creates an increased overall reliability in global production and supply chain management.

The principal tool that most managers now use to increase the reliability of their prod- uct offering is the Six Sigma quality improvement methodology. Six Sigma is a direct descendant of the total quality management (TQM) philosophy that was widely adopted, first by Japanese companies and then American companies, during the 1980s and early 1990s.3 The TQM philosophy was developed by a number of American consultants such as W. Edward Deming, Joseph Juran, and A. V. Feigenbaum.4 Deming identified a number of steps that should be part of any TQM program. He argued that management should embrace the philosophy that mistakes, defects, and poor-quality materials are not acceptable and should be eliminated. He suggested that the quality of supervision should be improved by allowing more time for supervisors to work with employees and by providing them with the tools they need to do the job. Deming recommended that man- agement should create an environment in which employees will not fear reporting prob- lems or recommending improvements. He believed that work standards should not only be defined as numbers or quotas, but also include some notion of quality to promote the production of defect-free output. He argued that management has the responsibility to train employees in new skills to keep pace with changes in the workplace. In addition, he believed that achieving better quality requires the commitment of everyone in the company.

Six Sigma, the modern successor to TQM, is a statistically based philosophy that aims to reduce defects, boost productivity, eliminate waste, and cut costs throughout a company. Six Sigma programs have been adopted by several major corporations, such as Motorola, General Electric, and Honeywell. Sigma comes from the Greek letter that statisticians use to represent a standard deviation from a mean; the higher the number of “sigmas,” the smaller the number of errors. At six sigmas, a production process would be 99.99966 per- cent accurate, creating just 3.4 defects per million units. While it is almost impossible for a company to achieve such perfection, Six Sigma quality is a goal to strive toward. Increas- ingly, companies are adopting Six Sigma programs to try to boost their product quality and productivity.5

Total Quality Management (TQM) Management philosophy that takes as its central focus the need to improve the quality of a company’s products and services.

Six Sigma Statistically based methodology for improving product quality.

15.1 FIGURE The Relationship between Quality and Costs Source: From “What Does Product Quality Really Mean?” by David A. Gandin, MIT Sloan Management Review, Fall 1984. Copyright ©1984 by Massachusetts Institute of Technology. All rights reserved. Distributed by Tribune Media Services. Reprinted with permission.

Improves Performance Reliability

Lowers Rework and Scrap Costs

Lowers Manufacturing Costs

Increases Profits

Increases Productivity

Lowers Warranty Costs

Lowers Service Costs

424 Part Six International Business Functions

The growth of international standards has also focused greater attention on the impor- tance of product quality. In Europe, for example, the European Union requires that the quality of a firm’s manufacturing processes and products be certified under a quality stan- dard known as ISO 9000 before the firm is allowed access to the EU marketplace. Although the ISO 9000 certification process has proved to be somewhat bureaucratic and costly for many firms, it does focus management attention on the need to improve the quality of prod- ucts and processes.6

In addition to lowering costs and improving quality, two other objectives have particular importance in international businesses. First, production and supply chain functions must be able to accommodate demands for local responsiveness. As we saw in Chapter 12, de- mands for local responsiveness arise from national differences in consumer tastes and pref- erences, infrastructure, distribution channels, and host-government demands. Demands for local responsiveness create pressures to decentralize production activities to the major na- tional or regional markets in which the firm does business or to implement flexible manu- facturing processes that enable the firm to customize the product coming out of a factory according to the market in which it is to be sold.

Second, production and supply chain management must be able to respond quickly to shifts in customer demand. In recent years, time-based competition has grown more impor- tant.7 When consumer demand is prone to large and unpredictable shifts, the firm that can adapt most quickly to these shifts will gain an advantage.8 As we shall see, both production and supply chain management play critical roles here.

Where to Produce An essential decision facing an international firm is where to locate its production activi- ties to best minimize costs and improve product quality. For the firm contemplating inter- national production, a number of factors must be considered. These factors can be grouped under three broad headings: country factors, technological factors, and produc- tion factors.9

COUNTRY FACTORS We reviewed country-specific factors in some detail earlier in the book. Political and economic systems, culture, and relative factor costs differ from country to country. In Chapter 6, we saw that due to differences in factor costs, some coun- tries have a comparative advantage for producing certain products. In Chapters 2, 3, and 4 we saw how differences in political and economic systems—and national culture—influence the benefits, costs, and risks of doing business in a country. Other things being equal, a firm should locate its various manufacturing activities where the economic, political, and cultural conditions—including relative factor costs—are conducive to the performance of those ac- tivities (for an example, see the accompanying Management Focus, which looks at the Philips investment in China). In Chapter 12, we referred to the benefits derived from such a strat- egy as location economies. We argued that one result of the strategy is the creation of a global web of value creation activities.

Also important in some industries is the presence of global concentrations of activities at certain locations. In Chapter 8, we discussed the role of location externalities in influ- encing foreign direct investment decisions. Externalities include the presence of an appro- priately skilled labor pool and supporting industries.10 Such externalities can play an important role in deciding where to locate production activities. For example, because of a cluster of semiconductor manufacturing plants in Taiwan, a pool of labor with experience in the semiconductor business has developed. In addition, the plants have attracted a num- ber of supporting industries, such as the manufacturers of semiconductor capital equip- ment and silicon, which have established facilities in Taiwan to be near their customers. This implies that there are real benefits to locating in Taiwan, as opposed to another loca- tion that lacks such externalities. Other things being equal, the externalities make Taiwan an attractive location for semiconductor manufacturing facilities. The same process is now under way in two Indian cities, Hyderabad and Bangalore, where both Western and Indian information technology companies have established operations. For example, locals refer

ISO 9000 Certification process that requires certain quality standards must be met.

LO 15-2 Explain how country differences, production technology, and production factors all affect the choice of where to locate production activities.

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.

Chapter Fifteen Global Production and Supply Chain Management 425

to a section of Hyderabad as “Cyberabad,” where Microsoft, IBM, Infosys, and Qualcomm (among others) have major facilities.

Of course, other things are not equal. Differences in relative factor costs, political econ- omy, culture, and location externalities are important, but other factors also loom large. Formal and informal trade barriers obviously influence location decisions (see Chapter 7), as do transportation costs and rules and regulations regarding foreign direct investment (see Chapter 8). For example, although relative factor costs may make a country look attractive as a location for performing a manufacturing activity, regulations prohibiting foreign direct investment may eliminate this option. Similarly, a consideration of factor costs might sug- gest that a firm should source production of a certain component from a particular country, but trade barriers could make this uneconomical.

Another important country factor is expected future movements in its exchange rate (see Chapters 10 and 11). Adverse changes in exchange rates can quickly alter a country’s attrac- tiveness as a manufacturing base. Currency appreciation can transform a low-cost location into a high-cost location. Many Japanese corporations had to grapple with this problem during the 1990s and early 2000s. The relatively low value of the yen on foreign exchange markets between 1950 and 1980 helped strengthen Japan’s position as a low-cost location for manufacturing. More recently, however, the yen’s steady appreciation against the dollar increased the dollar cost of products exported from Japan, making Japan less attractive as a manufacturing location. In response, many Japanese firms moved their manufacturing off- shore to lower-cost locations in East Asia.

Philips in China

The Dutch consumer electronics, lighting, semiconductor, and medical equipment conglomerate Philips Electronics NV has been operating factories in China since 1985, when the country first opened its mar- kets to foreign investors. When Philips initially entered China, it had dreams of Chinese consumers snapping up its products by the millions. However, the company soon found out that the reason it liked China— low wage rates—also meant that few Chinese workers could afford to buy its products. So Philips hit on a new strategy: Keep the factories in China, but export most of the goods to developed nations.

The initial attractions of China to Philips included low wage rates, an educated workforce, a robust Chinese economy, a stable exchange rate that is linked to the U.S. dollar through a managed float, a rapidly expanding industrial base that includes many other Western and Chinese companies that Philips uses as suppliers, and easier access to world markets given China’s entry into the WTO in 2001. By the early 2000s, Philips employed some 30,000 people in China either directly or indirectly at joint ventures. Philips exported nearly two-thirds of the $7 billion in products that its Chinese factories were producing. At this point, 25 percent of everything that Philips made worldwide came from China.

As time passed, Philips started to give its Chinese factories a greater role in product development. In the TV business, for example, basic de- velopment used to occur in Holland but was moved to Singapore in the early 1990s. In the early 2000s, Philips transferred TV development work to a new R&D center in Suzhou near Shanghai. Similarly, basic product development work on LCD screens for cell phones was shifted to Shanghai. In 2011, in a testament to just how important China had become to Philips, the company moved the global headquarters of its domestic appliances business from Amsterdam to Shanghai. By this

point, China was far more than just an export base. Demand in China had accelerated rapidly, and the country was now the second- largest market for Philips.

Some worry that Philips and companies pursuing a similar strategy might be overdoing it. Too much dependence on China could be dangerous if political, eco- nomic, or other problems disrupt production and the company’s ability to supply global markets. Some observers believe that it might be better if the manufactur- ing facilities of companies were more geographically diverse as a hedge against problems in China. These fears have taken on added importance recently as labor costs have accelerated in China due to labor shortages. According to estimates, labor costs have been growing by 20 percent per year since the 2000s. On the other hand, there is a silver lining to this cloud: Chinese consumption of many of the products that Philips makes there is now rising rapidly.

Sources: B. Einhorn, “Philips’ Expanding Asia Connections,” BusinessWeek Online, November 27, 2003; K. Leggett and P. Wonacott, “The World’s Factory: A Surge in Exports from China Jolts the Global Industry,” The Wall Street Journal, October 10, 2002, p.A1; J. Blau, “Philips Tears Down Eindhoven R&D Fence,” Research Technology Management 50, no. 6 (2007), pp. 9–11; L.Baijia, “Philips Elevates China’s Market Status,” China Daily, May 26, 2011; and information on Philips NV website, www.philips.com/shared/assets/ Downloadablefile/Investor/2011_05_26_Frans_van_Houten_Morgan_Stanley.pdf.

management FOCUS

Employees work at a Philips stand during a trade show in Shanghai, China.

426 Part Six International Business Functions

TECHNOLOGICAL FACTORS The type of technology a firm uses to perform specific manufacturing activities can be pivotal in location decisions. For example, because of technological constraints, in some cases it is necessary to perform certain manufacturing activities in only one location and serve the world market from there. In other cases, the technology may make it feasible to perform an activity in multiple locations. Three charac- teristics of a manufacturing technology are of interest here: the level of fixed costs, the minimum efficient scale, and the flexibility of the technology.

Fixed Costs As noted in Chapter 12, in some cases the fixed costs of setting up a production plant are so high that a firm must serve the world market from a single loca- tion or from very few locations. For example, it now costs up to $5 billion to set up a state-of-the-art plant to manufacture semiconductor chips. Given this, other things being equal, serving the world market from a single plant sited at a single (optimal) location can make sense.

Conversely, a relatively low level of fixed costs can make it economical to perform a par- ticular activity in several locations at once. This allows the firm to better accommodate de- mands for local responsiveness. Manufacturing in multiple locations may also help the firm avoid becoming too dependent on one location. Being too dependent on one location is particularly risky in a world of floating exchange rates. Many firms disperse their manufac- turing plants to different locations as a “real hedge” against potentially adverse moves in currencies.

Minimum Efficient Scale The concept of economies of scale tells us that as plant output expands, unit costs decrease. The reasons include the greater utilization of capital equipment and the productivity gains that come with specialization of employees within the plant.11 However, beyond a certain level of output, few additional scale economies are available. Thus, the “unit cost curve” declines with output until a certain output level is reached, at which point further increases in output realize little reduction in unit costs. The level of output at which most plant-level scale economies are exhausted is referred to as the minimum efficient scale of output. This is the scale of output a plant must operate to realize all major plant-level scale economies (see Figure 15.2).

The implications of this concept are as follows: The larger the minimum efficient scale of a plant relative to total global demand, the greater the argument for centralizing production in a single location or a limited number of locations. Alternatively, when the minimum effi- cient scale of production is low relative to global demand, it may be economical to manufac- ture a product at several locations. For example, the minimum efficient scale for a plant to manufacture personal computers is about 250,000 units a year, while the total global demand

Minimum Efficient Scale The level of output at which most plant- level scale economies are exhausted.

15.2 FIGURE Typical Unit Cost Curve

Volume

U ni

t C os

Minimum Efficient Scale

Chapter Fifteen Global Production and Supply Chain Management 427

exceeds 35 million units a year. The low level of minimum efficient scale in relation to total global demand makes it economically feasible for companies such as Dell and Lenovo to assemble PCs in multiple locations.

As in the case of low fixed costs, the advantages of a low minimum efficient scale include allowing the firm to accommodate demands for local responsiveness or to hedge against currency risk by manufacturing the same product in several locations.

Flexible Manufacturing and Mass Customization Central to the concept of economies of scale is the idea that the best way to achieve high efficiency, and hence low unit costs, is through the mass production of a standardized output. The trade-off implicit in this idea is between unit costs and product variety. Producing greater product variety from a factory implies shorter production runs, which in turn implies an inability to realize economies of scale. That is, wide product variety makes it difficult for a company to increase its production efficiency and thus reduce its unit costs. According to this logic, the way to increase efficiency and drive down unit costs is to limit product variety and produce a stan- dardized product in large volumes.

This view of production efficiency has been challenged by the rise of flexible manufactur- ing technologies. The term flexible manufacturing technology—or lean production, as it is often called—covers a range of manufacturing technologies designed to (1) reduce setup times for complex equipment, (2) increase the utilization of individual machines through better scheduling, and (3) improve quality control at all stages of the manufacturing pro- cess.12 Flexible manufacturing technologies allow the company to produce a wider variety of end products at a unit cost that at one time could be achieved only through the mass pro- duction of a standardized output. Research suggests the adoption of flexible manufacturing technologies may actually increase efficiency and lower unit costs relative to what can be achieved by the mass production of a standardized output while enabling the company to customize its product offering to a much greater extent than was once thought possible. The term mass customization has been coined to describe the ability of companies to use flexible manufacturing technology to reconcile two goals that were once thought to be incompatible—low cost and product customization.13 Flexible manufacturing technologies vary in their sophistication and complexity.

One of the most famous examples of a flexible manufacturing technology, Toyota’s pro- duction system, has been credited with making Toyota the most efficient auto company in the world. (Despite Toyota’s recent problems with sudden uncontrolled acceleration, the company continues to be an efficient producer of high-quality automobiles, according to J.D. Power, which produces an annual quality survey. Toyota’s Lexus models continue to top J.D. Power’s quality rankings.14) Toyota’s flexible manufacturing system was developed by one of the company’s engineers, Taiichi Ohno. After working at Toyota for five years and visiting Ford’s U.S. plants, Ohno became convinced that the mass production philosophy for making cars was flawed. He saw numerous problems with mass production.

First, long production runs created massive inventories that had to be stored in large warehouses. This was expensive, both because of the cost of warehousing and because inven- tories tied up capital in unproductive uses. Second, if the initial machine settings were wrong, long production runs resulted in the production of a large number of defects (i.e., waste). Third, the mass production system was unable to accommodate consumer prefer- ences for product diversity.

In response, Ohno looked for ways to make shorter production runs economical. He developed a number of techniques designed to reduce setup times for production equipment (a major source of fixed costs). By using a system of levers and pulleys, he reduced the time required to change dies on stamping equipment from a full day in 1950 to three minutes by 1971. This made small production runs economical, which allowed Toyota to respond better to consumer demands for product diversity. Small production runs also eliminated the need to hold large inventories, thereby reducing warehousing costs. Plus, small product runs and the lack of inventory meant that defective parts were produced only in small numbers and entered the assembly process immediately. This reduced waste and helped trace defects back to their source to fix the problem. In sum, these innovations enabled Toyota to produce a

Flexible Manufacturing Technology Manufacturing technology designed to improve job scheduling, reduce setup time, and improve quality control.

Lean Production See flexible manufacturing technology.

Mass Customization The production of a variety of end products at a unit cost that could once be achieved only through mass production of a standardized output.

428 Part Six International Business Functions

more diverse product range at a lower unit cost than was possible with conventional mass production.15

Flexible machine cells are another common flexible manufacturing technology. A flexi- ble machine cell is a grouping of various types of machinery, a common materials handler, and a centralized cell controller (computer). Each cell normally contains four to six machines capable of performing a variety of operations. The typical cell is dedicated to the production of a family of parts or products. The settings on machines are computer controlled, which allows each cell to switch quickly between the production of different parts or products.

Improved capacity utilization and reductions in work in progress (i.e., stockpiles of partly finished products) and in waste are major efficiency benefits of flexible machine cells. Improved capacity utilization arises from the reduction in setup times and from the computer- controlled coordination of production flow between machines, which eliminates bottle- necks. The tight coordination between machines also reduces work-in-progress inventory. Reductions in waste are due to the ability of computer-controlled machinery to identify ways to transform inputs into outputs while producing a minimum of unusable waste mate- rial. While freestanding machines might be in use 50 percent of the time, the same machines when grouped into a cell can be used more than 80 percent of the time and produce the same end product with half the waste. This increases efficiency and results in lower costs.

The effects of installing flexible manufacturing technology on a company’s cost structure can be dramatic. The Ford Motor Company has been introducing flexible manufacturing technologies into its automotive plants around the world. These new technologies should allow Ford to produce multiple models from the same line and to switch production from one model to another much more quickly than in the past, allowing Ford to take $2 billion out of its cost structure.16

Besides improving efficiency and lowering costs, flexible manufacturing technologies en- able companies to customize products to the demands of small consumer groups—at a cost that at one time could be achieved only by mass-producing a standardized output. Thus, the technologies help a company achieve mass customization, which increases its customer re- sponsiveness. Most important for international business, flexible manufacturing technologies can help a firm customize products for different national markets. The importance of this ad- vantage cannot be overstated. When flexible manufacturing technologies are available, a firm can manufacture products customized to various national markets at a single factory sited at the optimal location. And it can do this without absorbing a significant cost penalty. Thus,

firms no longer need to establish manufacturing facilities in each major national market to provide products that sat- isfy specific consumer tastes and preferences, part of the rationale for a localization strategy (Chapter 12).

PRODUCTION FACTORS Several production factors feature prominently into the reasons why produc- tion facilities are located and used in a certain way world- wide. They include (1) product features, (2) locating production facilities, and (3) strategic roles for produc- tion facilities.

Product Features Two product features affect location decisions. The first is the product’s value-to- weight ratio because of its influence on transportation costs. Many electronic components and pharmaceuticals have high value-to-weight ratios; they are expensive and they do not weigh very much. Thus, even if they are shipped halfway around the world, their transportation costs account for a very small percentage of total costs. Given this, other things being equal, there is great pres- sure to produce these products in the optimal location and to serve the world market from there. The opposite

Flexible Machine Cells Flexible manufacturing technology in which a grouping of various machine types, a common materials handler, and a centralized cell controller produce a family of products.

Should Nestlé Continue to Invest Heavily in Turkey? According to Nestlé Turkey’s CEO, Hans Ulrich Mayer, Turkey has been a great place to invest. “Turkey has been the recipient of several Nestlé investments many times greater than we invest in other markets,” reported Mayer. Nestlé has invested about 500 million U.S. dollars in Turkey over the last four years, and following its successful breakfast cereal investment in 2011, the company intends to go on investing because of the strong Turkish economy compared to other European economies. Nestlé prod- ucts sold in Turkey, ranging from pet food to chocolates, are manufactured in Turkey and also exported to North Africa and the Middle East. Given the political situation in Turkey, should Nestlé continue to establish increased production (i.e., expand its production facility) in delivering to North Africa and the Middle East, or should it establish production elsewhere?

Source: Invest in Turkey, www.spotblue.co.uk/turkey-property-news/11577/ nestle-goes-on-investing-in-turkey/.

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holds for products with low value-to-weight ratios. Refined sugar, certain bulk chemicals, paint, and petroleum products all have low value-to-weight ratios; they are relatively inex- pensive products that weigh a lot. Accordingly, when they are shipped long distances, trans- portation costs account for a large percentage of total costs. Thus, other things being equal, there is great pressure to make these products in multiple locations close to major markets to reduce transportation costs.

The other product feature that can influence location decisions is whether the product serves universal needs, needs that are the same all over the world. Examples include many industrial products (e.g., industrial electronics, steel, bulk chemicals) and modern con- sumer products (e.g., Apple’s iPhone or iPad, Amazon’s Kindle, Lenovo’s ThinkPad, Sony’s Cyber-shot camera, Microsoft’s Xbox). Because there are few national differences in consumer taste and preference for such products, the need for local responsiveness is reduced. This increases the attractiveness of concentrating production at an optimal location.

Locating Production Facilities There are two basic strategies for locating pro- duction facilities: (1) concentrating them in a centralized location and serving the world market from there or (2) decentralizing them in various regional or national locations that are close to major markets. The appropriate strategic choice is determined by the various country-specific, technological, and product factors discussed in this section and summa- rized in Table 15.1.

As can be seen, concentration of production makes most sense when:

• Differences among countries in factor costs, political economy, and culture have a substantial impact on the costs of manufacturing in various countries.

• Trade barriers are low. • Externalities arising from the concentration of like enterprises favor certain locations. • Important exchange rates are expected to remain relatively stable. • The production technology has high fixed costs and high minimum efficient scale

relative to global demand or flexible manufacturing technology exists. • The product’s value-to-weight ratio is high. • The product serves universal needs.

LO 15-3 Recognize how the role of foreign subsidiaries in production can be enhanced over time as they accumulate knowledge.

15.1 TABLE Location Strategy and Production

Concentrated Production Favored

Decentralized Production Favored

Country Factors

Differences in political economy Substantial Few

Differences in culture Substantial Few

Differences in factor costs Substantial Few

Trade barriers Few Substantial

Location externalities Important in industry Not important in industry

Exchange rates Stable Volatile

Technological Factors

Fixed costs High Low

Minimum efficient scale High Low

Flexible manufacturing technology Available Not available

Product Factors

Value-to-weight ratio High Low

Serves universal needs Yes No

430 Part Six International Business Functions

Alternatively, decentralization of production is appropriate when:

• Differences among countries in factor costs, political economy, and culture do not have a substantial impact on the costs of manufacturing in various countries.

• Trade barriers are high. • Location externalities are not important. • Volatility in important exchange rates is expected. • The production technology has low fixed costs and low minimum efficient scale, and

flexible manufacturing technology is not available. • The product’s value-to-weight ratio is low. • The product does not serve universal needs (i.e., significant differences in consumer

tastes and preferences exist among nations).

In practice, location decisions are seldom clear-cut. For example, it is not unusual for dif- ferences in factor costs, technological factors, and product factors to point toward concen- trated production, while a combination of trade barriers and volatile exchange rates points toward decentralized production. This seems to be the case in the world automobile indus- try. Although the availability of flexible manufacturing and cars’ relatively high value-to- weight ratios suggest concentrated manufacturing, the combination of formal and informal trade barriers and the uncertainties of the world’s current floating exchange rate regime (see Chapter 10) have inhibited firms’ ability to pursue this strategy. For these reasons, several automobile companies have established “top-to-bottom” manufacturing operations in three major regional markets: Asia, North America, and western Europe.

Strategic Roles for Production Facilities The growth of global production among multinational companies has been tremendous over the past two decades, outdoing the growth of home country production by more than tenfold.17 In essence, since the early 1990s, multinationals have opted to set up production facilities outside their home country 10 times for every 1 time they have opted to create such facilities at home. There is a clear strategic rational for this; multinationals are trying to capture the gains associated with a dispersed global production system. This trend is expected to continue going forward. Thus, managers need to be ready to make the decision to open up a new production facility out- side of their home base and decide where to locate the facility.

When making these decisions, managers need to think about the strategic role assigned to a foreign factory. A major consideration here is the importance of global learning—the idea that valuable knowledge does not reside just in a firm’s domestic operations; it may also be found in its foreign subsidiaries. Foreign factories that upgrade their capabilities over time are creating valuable knowledge that might benefit the whole corporation. Foreign factories can have one of a number of strategic roles or designations, including (1) offshore factory, (2) source factory, (3) server factory, (4) contributor factory, (5) outpost factory, and (6) lead factory.18

An offshore factory is one that is developed and set up mainly for producing component parts or finished goods at a lower cost than producing them at home or in any other market. At an offshore factory, investments in technology and managerial resources should ideally be kept to a minimum to achieve greater cost efficiencies. Basically, the best offshore factory should involve minimal everything—from engineering to development to engaging with suppliers to negotiating prices to any form of strategic decisions being made at that facility. In reality, we expect at least some strategic decisions to include input from the offshore fac- tory personnel.

The primary purpose of a source factory is also to drive down costs in the global supply chain. The main difference between a source factory and an offshore factory is the strategic role of the factory, which is more significant for a source factory than for an offshore factory. Managers of a source factory have more of a say in certain decisions, such as purchasing raw materials and component parts used in the production at the source factory. They also have strategic input into production planning, process changes, logistics issues, product custom- ization, and implementation of newer designs when needed. Centrally, a source factory is at the top of the standards in the global supply chain, and these factories are used and treated

Global Learning The flow of skills and product offerings from foreign subsidiary to home country and from foreign subsidiary to foreign subsidiary.

Offshore Factory A factory that is developed and set up mainly for producing component parts or finished goods at a lower cost than producing them at home or in any other market.

Source Factory A factory whose primary purpose is also to drive down costs in the global supply chain.

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just like any factory in the global firm’s home country. This also means that source factories should be located where production costs are low, where infrastructure is well developed, and where it is relatively easy to find a knowledgeable and skilled workforce to make the products.

A server factory is linked into the global supply chain for a global firm to supply specific country or regional markets around the globe. This type of factory—often with the same standards as the top factories in the global firm’s system—is set up to overcome intangible and tangible barriers in the global marketplace. For example, a server factory may be in- tended to overcome tariff barriers, reduce taxes, and reinvest money made in the region. Another obvious reason for a server factory is to reduce or eliminate costly global supply chain operations that would be needed if the factory were located much farther away from the end customers. Managers at a server factory typically have more authority to make mi- nor customizations to please their customers, but they still do not have much more input than managers in an offshore factory relative to the home country factories of the same global firm.

A contributor factory also serves a specific country or world region. The main differ- ence between a contributor factory and a server factory is that a contributor factory has re- sponsibilities for product and process engineering and development. This type of factory also has much more of a choice in terms of which suppliers to use for raw materials and component parts. In fact, a contributor factory often competes with the global firm’s home factories for testing new ideas and products. A contributor factory has its own infrastructure when it comes to development, engineering, and production. This means that a contributor factory is very much stand-alone in terms of what it can do and how it contributes to the global firm’s supply chain efforts.

An outpost factory can be viewed as an intelligence-gathering unit. This means that an outpost factory is often placed near a competitor’s headquarters or main operations, near the most demanding customers, or near key suppliers of unique and critically important parts. An outpost factory also has a function to fill in production; it often operates as a server and/ or offshore factory as well. The outpost factory can be very much connected to the idea of selecting countries for operations based on the countries’ strategic importance rather than on the production logic of a location. Maintaining and potentially even enhancing the posi- tion of the global firm in strategic countries is sometimes viewed as a practical factor. For example, the fact that Nokia has its headquarters in Finland may result in another mobile phone manufacturer locating some operations in Finland, even though the country market is rather small (about 5.5 million people).

A lead factory is intended to create new processes, products, and technologies that can be used throughout the global firm in all parts of the world. This is where cutting- edge production should take place, or at least be tested for implementation in other parts of the firm’s production network. Given the lead factory’s prominent role in setting a high bar for how the global firm wants to provide products to customers, we also expect that it will be located in an area where highly skilled employees can be found (or where they want to locate). A lead factory scenario also implies that managers and employees at the site have a direct connection to and say in which suppliers to use, what designs to implement, and other issues that are of critical importance to the core competencies of the global firm.

THE HIDDEN COSTS OF FOREIGN LOCATIONS There may be some “hidden costs” to basing production in a foreign location. Numerous anecdotes suggest that high employee turnover, shoddy workmanship, poor product quality, and low productivity are significant issues in some outsourcing locations.19

Microsoft, for example, established a major facility in Hyderabad, India, for four very good reasons: (1) The wage rate of software programmers in India is one-third of that in the United States. (2) India has an excellent higher education system that graduates a lot of computer science majors every year. (3) There was already a high concentration of in- formation technology companies and workers in Hyderabad. (4) Many of Microsoft’s highly skilled Indian employees, after spending years in the United States, wanted to

Server Factory A factory linked into the global supply chain for a global firm to supply specific country or regional markets around the globe.

Contributor Factory A factory that serves a specific country or world region.

Outpost Factory A factory that can be viewed as an intelligence-gathering unit.

Lead Factory A factory that is intended to create new processes, products, and technologies that can be used throughout the global firm in all parts of the world.

432 Part Six International Business Functions

return home, and Microsoft saw the Hyderabad facility as a way of holding on to this valuable human capital.

However, the company found that the turnover rate among its Indian employees is higher than in the United States. Demand for software programmers in India is high, and many employees are prone to switch jobs to get better pay. Although Microsoft has tried to limit turnover by offering good benefits and long-term incentive pay, such as stock grants to high performers who stay with the company, many of the Indians who were hired locally appar- ently place little value on long-term incentives and prefer higher current pay. High em- ployee turnover, of course, has a negative impact on productivity. One Microsoft manager in India noted that 40 percent of his core team had left within the past 12 months, making it very difficult to stay on track with development projects.20

Microsoft is not alone in experiencing this problem. The manager of an electronics company that outsourced the manufacture of wireless headsets to China noted that after four years of frustrations with late deliveries and poor quality, his company decided to move production back to the United States. In his words: “On the face of it, labor costs seemed so much lower in China that the decision to move production there was a very easy one. In retrospect, I wish we had looked much closer at productivity and workman- ship. We have actually lost market share because of this decision.”21 Another example of this phenomenon is given in the next Management Focus, which looks at the deci- sion by General Electric to move some production from China back to the United States. The lesson here is that it is important to look beyond pay rates and make judg- ments about employee productivity before deciding whether to outsource activities to foreign locations.

GE Moves Manufacturing from China to the United States

For decades, General Electric has been at the forefront of the move to shift production offshore from high-cost locations inside the United States to cheaper locations, such as China. But there are now some signs that the relentless flow of production offshore may be slowing down and, in some cases, starting to reverse. There are several rea- sons for this. Wage rates in China and some other developing nations have been rising fast, closing the differential between costs in the United States and overseas. In dollar terms, wage rates in China were some five times higher in 2012 than they were in 2000, and they are still rising fast. Labor productivity has also increased sig- nificantly in the United States, further closing the gap in labor costs. Meanwhile, high oil prices have raised the cost of shipping products across oceans, while the abundance of cheap natural gas in the United States is helping to lower production costs. If this were not enough, there are signs that there are benefits to having product design and manufacturing co-located, and in some cases, this is driving a shift in production back to the United States.

A case in point is GE’s GeoSpring water heater. This was originally designed in the United States and manufactured in China. The finished product was then shipped back across the ocean for sale in the United States. In 2010, given the macro trends in labor productivity and en- ergy prices, GE decided to see what would happen if it brought some of its appliance products back to the United States. The GeoSpring was one of its first attempts at this. GE established a team of engineers and

production workers at its appliance plant in Louisville, Kentucky, to see what they could do with the GeoSpring. The team quickly concluded that the GeoSpring was not easy to manufacture due to poor design. They redesigned the product for ease of assembly, eliminating one out of every five parts and cutting material costs by 25 percent. As a result, GE cut the time required to assemble the product from 10 hours in China to 2 hours in Louisville.

The end result: Material costs went down, labor requirement went down, and product quality went up. Indeed, the cost savings were so big that GE was able to reduce the price of the GeoSpring 20 percent below that of the Chinese-manufactured product and still maintain a decent profit margin. Time to market also improved greatly. It used to take five weeks to get a GeoSpring from China into a U.S. retail store— now GE can do that in a matter of days, which improves inventory management.

Having learned from experiences like this, GE is now planning to ramp up production of other appliance products at Louisville. It has recently doubled the workforce there to 3,700, and has also hired 500 new designers and engineers to redesign many of its products for ease of manufacture. A few years ago, less than half of the reve- nues of the appliance business came from products made in the United States. By mid-decade, GE plans to have 75 percent of the revenue of the appliance business to come from American-made products.

Sources: Charles Fishman, “The Insourcing Boom,” The Atlantic, December 2012; and J. R. Immelt, “Sparking an American Manufacturing Renewal,” Harvard Business Review, March 2012.

management FOCUS

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Chapter Fifteen Global Production and Supply Chain Management 433

Make-or-Buy Decisions The make-or-buy decision for a global firm is the strategic decision concerning whether to produce an item in-house (“make”) or purchase it from an outside supplier (“buy”). Make-or-buy decisions are made at both the strategic and operational levels, with the stra- tegic level being focused on the long term and the operational level being more focused on the short term. In some ways, the make-or-buy decision is also the starting point for opera- tions’ influence on global supply chains. That is, someone in the chain—within one firm— has to take the lead in deciding whether the global firm should make the product in-house or buy it from an external supplier. If the decision is to make it in-house, there are certain implications for that firm’s global supply chains (e.g., where to purchase raw materials and component parts). If the decision is to buy the product, that decision also has certain impli- cations (e.g., quality control and competitive priorities management).

A number of things are involved in determining which decision is the correct one for a particular global firm in a particular situation. At a broad level, issues of product success, specialized knowledge, and strategic fit can lead to the make (produce) decision. For exam- ple, if the item or part is critical to the success of the product, including perceptions among primary stakeholders, such a scenario skews the decision in favor of make. Another reason for a make decision is that the item or part requires specialized design or production skills and/or that equipment and reliable alternatives are very scarce. Strategic fit is also impor- tant. If the item or part strategically fits within the firm’s current and/or planned core com- petencies, then it should be a make decision for the global firm.

However, these are strategic decisions at a general level. In reality, the make-or-buy deci- sion is often based largely on two critical factors: cost and production capacity. Cost issues include such things as acquiring raw materials, component parts, and any other inputs into the process, along with the costs of finishing the product. The production capacity is really presented as an opportunity cost. That is, does the firm have the capacity to produce the product at a cost that is at least no higher than the cost of buying it from an external sup- plier? And, if the product is made in-house, what opportu- nity cost would be incurred as a result (e.g., what product or item was the firm unable to produce because of limited pro- duction capacity)? Unfortunately, many, and perhaps most, global companies think that cost and production capacity are the only factors playing into the make-or-buy decision. This is simply not true!

Cost and production capacity are just the two main driv- ers behind make-or-buy choices made by global companies when they engage in global supply chains. The decision of whether to buy or make a product is a much more complex and research-intensive process than the typical global firm may expect, though. For example, how many times have we heard, “Let’s move our production to China because we can get the same quality for a dime-on-the-dollar cost, and that will free up production capacity that we can use to focus on other products”? Of course, dime-on-the-dollar cost is not relevant because we have to take into account the costs of quality control measures that have to be instituted, raw ma- terials that have to be purchased far away from home, for- eign entry requirements, multiple-party contracts, management responsibilities for the outsourced production operations, and so on. Ultimately, we are unlikely to end up with a dime-on-the-dollar cost, but where do we end up and how do we get there? In other words, what are the core ele- ments that we should be evaluating when we are determin- ing whether the correct decision is to make or to buy?

LO 15-4 Identify the factors that influence a firm’s decision of whether to source supplies from within the company or from foreign suppliers.

Make-or-Buy Decision The strategic decision concerning whether to produce an item in-house (“make”) or purchase it from an outside supplier (“buy”).

Do You Expect a Trend in Bringing Jobs Back from Overseas? The United States may be on the verge of bringing back manu- facturing jobs from China. Outsourcing manufacturing to China is not as cheap as it used to be. Many companies, especially in the auto and furniture industries, moved plants overseas once China opened its doors to free trade and foreign investment in the last few decades. Labor was cheaper for American compa- nies—less than $1 per hour by some estimates at the time. Today, labor costs in China have risen dramatically, and shipping and fuel costs have skyrocketed. As China’s economy has expanded and as China has built new factories all across the country, the demand for workers has risen. As a result, wages are up as new companies compete to hire the best workers. Experts note the fears that U.S. manufacturing is in decline are overstated and that the United States is still a manufacturing giant. However, both China and the United States each account for about 20 percent global manufacturing value added. The U.S. share of about 20 percent of global manufacturing value added “has declined only slightly over the past three decades,” accord- ing to the Boston Consulting Group. With these estimates in mind, do you expect more and more outsourced jobs to be “insourced” in the future?

Source: http://rockcenter.msnbc.msn.com/_news/2012.

434 Part Six International Business Functions

To facilitate the make-or-buy decision, we have captured the dynamics of this choice in two figures that center on either operationally favoring a make decision or operationally favoring a buy decision (Figures 15.3 and 15.4). As shown, the core elements in both cases are cost and production capacity. However, the other elements differ for each of the deci- sions and influence the choice differently. This means that we need to evaluate each deci- sion separately, not jointly. In fact, through this process, we may end up thinking that both a make decision and a buy decision would be acceptable and strategically logical for our firm. Keep in mind that this simply means that we have a choice; if both choices seem positive for your firm, choose the one that is the best strategic fit with the least opportunity cost structure.

The elements that favor a make decision—beyond the core elements of cost and produc- tion capacity—include quality control, proprietary technology, having control, excess capac- ity, limited suppliers, assurance of continual supply, and industry drivers (see Figure 15.3). So, the starting point is lower (or at least no greater) cost than what we can expect when we outsource the production to an external party in another country (or another external party in general). The limitation is that we must have excess production capacity or capacity that is best used by our firm for making the product in-house.

After the cost and production capacity decisions have been explored and made (really, after the cost and production hurdles have been overcome), the next set of decisions follows logically from the path in Figure 15.3. For example, if quality control is important to the global firm, cannot be relied on fully if the part is outsourced, and is at the center of the strategic core that customers expect from the firm, then the quality control issue favors a make decision. If there is proprietary technology involved in making the product that can- not or should not be shared with outsourcing parties, then the decision has to be make.

The idea that limited suppliers may influence the make-or-buy choice in the direction of the make selection is important as well. Specifically, it could be that some suppliers do not want to work with certain companies in certain parts of the world. It could also be that a supplier cannot, because of various restrictions on production or location or because of in- ternational barriers, follow the production of your firm’s products to wherever you see fit to locate your production lines.

15.3 FIGURE Operationally Favoring a Make Decision

Cost HavingControl

Quality Control

Proprietary Technology

Excess Capacity

Limited Suppliers

Industry Drivers

Assurance of

Continual Supply

Production Capacity

Chapter Fifteen Global Production and Supply Chain Management 435

Naturally, if the firm has excess capacity that otherwise would not be productively used, the decision should favor a make choice to allow that excess capacity to be used for the ben- efit of the firm in the global marketplace. Some companies also simply want to have control over certain elements of their production processes. This affects the make-or-buy decision in favor of the make choice.

A make decision is also favored if there is any chance that supply cannot be guaranteed if the firm moves its production overseas. And, finally, the industry globalization drivers may dictate that a make decision should be the choice for various trust and commitment reasons involving your industry and the marketplace that you engage with in order to find success.

Now, some of these elements that favor make can probably influence a buy decision as well. Naturally, if one of the make elements is not in favor of the make decision (e.g., if there is no excess capacity), this would suggest that the global firm should think more seriously about a buy decision. However, again, the buy decision also involves a number of other ele- ments that are not necessarily factors in the make decision (see Figure 15.4). As with the make decision, after the cost and production capacity decisions have been considered and made, the next set of decisions for the buy choice follow logically from the path in Figure 15.4. For example, if the global firm has minimal restrictions on which firms or companies it can source raw materials and component parts from, then a buy decision is more likely because outsourcing production also increases the likelihood that other and/or more suppli- ers in those parts of the world will be used.

Another good reason to choose a buy scenario is if the firm lacks the needed expertise to make a product or component part and the supplier or outsourced production choice has that expertise. Supplier competencies can affect the decision in favor of a buy choice as well, especially if those competencies reside closer to the production facility that you buy from than the ones that will be available if you make the product. Small volumes would also be a reason favoring a buy decision; cost efficiencies can seldom be achieved when only small volumes are produced.

Inventory planning is also of critical importance. Even if your firm can make the product equally well in terms of quality and expectations set, perhaps a better choice is to buy simply

15.4 FIGURE Operationally Favoring a Buy Decision

Cost InventoryPlanning

Multisource Policy

Lack of Expertise

Small Volumes

Supplier Compe- tencies

Nonessential Item

Brand Preference

Production Capacity

436 Part Six International Business Functions

in order to strategically manage inventory (which is a cost center in the global supply chain). In certain cases, even brand preference is a reason to go with a buy decision; for example, many computer users favor Intel microchips in their computers, so many of the large com- puter manufacturers opt to buy chips from Intel instead of making them in-house for that reason (this was more true in the 1990s and 2000s than it is now, but it is still a factor). And, of course, if the item to be made is a so-called nonessential item that has little effect on the firm’s core competencies and what the customers expect in terms of uniqueness, this is a fac- tor in favor of a buy decision.

Global Supply Chain Functions To this point in the chapter, we have emphasized global production, a component of the operations management of a supply chain. Issues such as where to produce, the strategic role of a foreign production site, and the make-or-buy decisions are the core aspects of global production. In addition to global production, three additional supply chain func- tions need to be developed in concert with global production. They are logistics, purchas- ing (sourcing), and the company’s distribution strategy (i.e., marketing channels). The latter—distribution strategy—is addressed in Chapter 16, where we discuss marketing and R&D. Here we address logistics and purchasing. From earlier in this chapter, we know that production and supply chain management are closely linked because a firm’s ability to perform its production activities depends on information inputs and a timely supply of high-quality material (raw material, component parts, and even finished products that are used in the manufacturing of new products). Logistics and purchasing are critical func- tions in ensuring that materials are ordered and delivered and that an appropriate level of inventory is managed.

GLOBAL LOGISTICS From earlier in this chapter we know that logistics is the part of the supply chain that plans, implements, and controls the effective flows and inven- tory of raw material, component parts, and products used in manufacturing. The core ac- tivities performed in logistics are (1) global distribution center management, (2) inventory management, (3) packaging and materials handling, (4) transportation, and (5) reverse

logistics. Each of these core logistics is described in the next paragraphs.

A global distribution center (or warehouse) is a facil- ity that positions and allows customization of products for delivery to worldwide wholesalers or retailers or directly to consumers anywhere in the world. Distribution centers (DCs) are used by manufacturers, importers, exporters, wholesalers, retailers, transportation companies, and cus- toms agencies to store products and provide a location where customization can be facilitated. When warehous- ing shifted from passive storage of products to strategic assortments and processing, the term distribution center be- came more widely used to capture this strategic and dy- namic aspect of not only storing, but ofadding value to products that are being warehoused or staged. A DC is at the center of the global supply chain, specifically the order- processing part of the order-fulfillment process. DCs are the foundation of a global supply network because they allow either a single location or satellite warehouses to store quantities and assortments of products and allow for value-added customization. They should be located strate- gically in the global marketplace, considering the aggre- gate total labor and transportation cost of moving products from plants or suppliers through the distribution center and then delivering them to customers.

LO 15-5 Understand the functions of logistics and purchasing (sourcing) within global supply chains.

Global Distribution Center A facility that positions and allows customization of products for delivery to worldwide wholesalers or retailers, or directly to consumers anywhere in the world; also called a global distribution warehouse.

How Much Relationship Building Do You Really Want to Do? Like manufacturers, professional service firms have also been learning how to better manage their delivery on a global basis. For example, some global services firms are dealing with other global firms in a new way, using one supplier for all their ser- vice-related needs around the world. The traditional approach involved the development of market-specific relationships, so the same multinational client would have a number of individual service relationships, one in each major market for each com- pany division. Under a global account management approach, one relationship has a global span—and one contract. Such supply chain practices allow for more effective relationship management, a better sense of what the client needs, more product extension opportunities, and better pricing and econo- mies. But global account management also takes time, energy, and resources. How many “global accounts” do you think would be ideal for a global company? What is the minimum and maxi- mum number of global account relationships a large multina- tional corporation should have (e.g., Microsoft)?

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Chapter Fifteen Global Production and Supply Chain Management 437

Global inventory management can be viewed as the decision-making process regarding the raw materials, work-in-process (component parts), and finished goods inventory for a multinational corporation. The decisions include how much inventory to hold, in what form to hold it, and where to locate it in the supply chain. Examining the largest 20,910 global companies with headquarters in 105 countries, we find that these companies, on average across all industries, carry 14.41 percent of their total assets in some form of inventory.22 These companies have 32.30 percent of their inventory in raw materials, 17.94 percent of their inventory in work-in-process, and 49.76 percent of their inventory in finished goods.23 At the company level, Toyota (www.toyota.com) from Japan, one of the largest automobile firms in the world, has 8.71 percent of its total assets in inventory, with a mix of 25.87, 13.62, and 60.50 percent in raw materials, work-in-process, and finished vehicles, respectively. An- other example is Sinopec (www.sinopec.com), a petroleum firm and the largest firm in China. Sinopec has 21.46 percent of its total assets in inventory, with a mix of 36.58, 42.50, and 20.92 percent in raw materials and component parts, work-in-process, and finished goods, respectively. Note that Sinopec maintains a much higher percentage of its invento- ries in work-in-process and a much lower percentage in finished goods than Toyota does. This suggests that petroleum firms want more flexibility in deciding exactly how to formu- late the finished product. The company’s global inventory strategy must effectively trade off the service and economic benefits of making products in large quantities and positioning them near customers against the risk of having too much stock or the wrong items.

Packaging comes in all shapes, sizes, forms, and uses. It can be divided into three differ- ent types: primary, secondary, and transit. Primary packaging holds the product itself. These are the packages brought home from the store, usually a retailer, by the end-consumer. Sec- ondary packaging (sometimes called case-lot packaging) is designed to contain several pri- mary packages. Bulk buying or warehouse store customers may take secondary packages home (e.g., from Sam’s Club), but this is not the typical mode for retailers. Retailers can also use secondary packaging as an aid when stocking shelves in the store. Transit packaging comes into use when a number of primary and secondary packages are assembled on a pallet or unit load for transportation. Unit-load packaging—through palletizing, shrink-wrapping, or containerization—is the outer packaging envelope that allows for easier handling or product transfer among international suppliers, manufacturers, distribution centers, retail- ers, and any other intermediaries in the global supply chain.

Regardless of where the product is in the global supply chain, packaging is intended to achieve a set of multilayered functions. These can be grouped into (1) perform, (2) protect, and (3) inform.24 Perform refers to (1) the ability of the product in the package to handle be- ing transported between nodes in the global supply chain, (2) the ability of the product to be stored for typical lengths of time for a particular product category, and (3) the package pro- viding the convenience expected by both the supply chain partners and the end-customers. Protect refers to the package’s ability to (1) contain the products properly, (2) preserve the products to maintain their freshness or newness, and (3) provide the necessary security and safety to ensure that the products reach their end destination in their intended shape. Inform refers to the package’s inclusion of (1) logical and sufficient instructions for the use of the products inside the package, including specific requirements to satisfy local regulations, (2) a statement of a compelling product guarantee, and (3) information about service for the product if and when it is needed.

Transportation refers to the movement of raw material, component parts, and finished goods throughout the global supply chain. It typically represents the largest percentage of any logistics budget and an even greater percentage for global companies because of the distances involved. Global supply chains are directly or indirectly responsible for transport- ing raw materials from their suppliers to the production facilities, work-in-process and fin- ished goods inventories between plants and distribution centers, and finished goods from distribution centers to customers. The primary drivers of transportation rates and the re- sulting aggregate cost are distance, transport mode (ocean, air, or land), size of load, load characteristics, and oil prices. As would be expected, longer distances require more fuel and more time from vehicle operators, so transport rates increase with distance. Transport mode influences rates because of the different technologies involved. Ocean is the least expensive

Global Inventory Management The decision-making process regarding the raw materials, work-in-process (component parts), and finished goods inventory for a multinational corporation.

Packaging The container that holds the product itself. It can be divided into primary, secondary, and transit packaging.

Transportation the movement of inventory through the supply chain.

438 Part Six International Business Functions

because of the size of the vehicles used and the low friction of water. Land is the next least expensive, with rail being less expensive than motor carriers. Air is the most expensive be- cause there is a substantial charge for defying gravity. Transportation rates are heavily in- fluenced by economies of scale, so larger shipments are typically relatively less expensive than smaller shipments. The characteristics of the shipment also influence transportation rates through such factors as product density, value, perishability, potential for damage, and other such factors. Finally, oil prices have a major impact on transportation rates because anywhere from 10 to 40 percent of most carrier costs, depending on the mode, are related to fuel.

Reverse logistics is the process of planning, implementing, and controlling the efficient, cost-effective flow of raw materials, in-process inventory, finished goods, and related infor- mation from the point of consumption to the point of origin for the purpose of recapturing value or proper disposal. The ultimate goal is to optimize the after-market activity or make it more efficient, thus saving money and environmental resources. Reverse logistics is criti- cally important in global supply chains. For example, product returns cost manufacturers and retailers more than $100 billion per year in the United States, or an average of 3.8 per- cent in lost profits.25 Overall, manufacturers spend about 9 to 14 percent of their sales rev- enue on returns. Even more staggering, each year, consumers in America return more than the GDP of two-thirds of the nations in the world. Just these sample numbers suggest that reverse logistics is an incredibly important part of the global supply chain.

GLOBAL PURCHASING As defined in the introduction to this chapter, purchas- ing represents the part of the supply chain that involves worldwide buying of raw material, component parts, and products used in manufacturing of the company’s products and ser- vices. The core activities performed in purchasing include development of an appropriate strategy for global purchasing and selecting the type of purchasing strategy best suited for the company.

There are five strategic levels—from domestic to international to global—that can be undertaken by a global company.26 Level I is simply companies engaging in domestic pur- chasing activities only. Often, these companies stay close to their home base in their do- mestic market when purchasing raw materials, component parts, and the like for their operations (e.g., a Michigan firm purchasing raw materials, such as cherries, from another Michigan firm). Levels II and III are both considered “international purchasing,” but of various degrees and forms. Companies that are at level II engage in international purchas- ing activities only as needed. This means that their approach to international purchasing is often reactive and uncoordinated among the buying locations within the firm and/or across the various units that make up the firm, such as strategic business units and functional units. Companies at level III engage in international purchasing activities as part of the firm’s overall supply chain management strategy. As such, at the level III stage, companies begin to recognize that a well-formulated and well-executed worldwide international pur- chasing strategy can be very effective in elevating the firm’s competitive edge in the mar- ketplace. Levels IV and V both involve “global purchasing” to various degrees. Level IV refers to global purchasing activities that are integrated across worldwide locations. This involves integration and coordination of purchasing strategies across the firm’s buying lo- cations worldwide. With level IV, we are now dealing with a sophisticated form of world- wide purchasing. Level V involves engaging in global purchasing activities that are integrated across worldwide locations and functional groups. Broadly, this means that the firm integrates and coordinates the purchasing of common items, purchasing processes, and supplier selection efforts globally, for example.

Beyond the domestic, international, and global purchasing strategies in levels I through V, purchasing includes a number of basic choices that companies make in deciding how to engage with markets.27 The starting point is a choice of internal purchasing versus external purchasing—in other words, “how to purchase.” We find that roughly 35 percent of the pur- chasing in global companies today is internal (i.e., from sources within their own company), with 65 percent being classified as external (i.e., from sources outside of their company). The next decision, in both internal and external purchasing, is to figure out “where to purchase”

Reverse Logistics The process of moving inventory from the point of consumption to the point of origin in supply chains for the purpose of recapturing value or proper disposal.

Chapter Fifteen Global Production and Supply Chain Management 439

(domestically or globally). This takes us ultimately to the “types of purchasing” (where and how) and the four choices for purchasing strategy: domestic internal purchasing, global in- ternal purchasing, domestic external purchasing, and global external purchasing.

The types of purchasing activities and strategies just discussed come with a set of generic options for the “international arena.” But we all know that outsourcing and offshoring, along with many by-products and other similar yet quite different options, exist in the purchasing world today. At this stage of the text, we feel it is important to go over the outsourcing- related terms and options that companies have, especially the following terms that are often confusing to understand, develop strategy around, and implement: outsourcing, insourcing, offshoring, offshore outsourcing, nearshoring, and co-sourcing (see Table 15.2).

Managing a Global Supply Chain The potential for reducing costs through more efficient supply chain management is enor- mous. For the typical manufacturing enterprise, material costs account for between 50 and 70 percent of revenues, depending on the industry. Even a small reduction in these costs can have a substantial impact on profitability. According to one estimate, for a firm with reve- nues of $1 million, a return on investment rate of 5 percent, and materials costs that are 50 percent of sales revenues, a $15,000 increase in total profits could be achieved either by increasing sales revenues 30 percent or by reducing materials costs by 3 percent.28 In a satu- rated market, it would be much easier to reduce materials costs by 3 percent than to increase sales revenues by 30 percent. As such, managing global supply chains is one of the strategi- cally most important areas for a global company. Four main areas are of concern in manag- ing a global supply chain, including the role of just-in-time inventory, the role of information technology, coordination in global supply chains, and interorganizational relationships in global supply chains.

LO 15-6 Describe what is required to efficiently manage a global supply chain.

15.2 TABLE Outsourcing Terms and Options

Outsourcing A multinational corporation buys products or services from one of its suppliers that produces them somewhere else, whether domestically or globally. In that sense, it also refers to external purchasing in relation to purchasing strategy.

Insourcing A multinational corporation decides to stop outsourcing products or services and instead starts to produce them internally; insourcing is the opposite of outsourcing. Thus it refers to internal purchasing in the context of purchasing strategy.

Offshoring A multinational corporation buys products or services from one of its suppliers that produces them somewhere globally (outside the MNCs home country). Offshoring is thus a form of global external purchasing in terms of purchasing strategy.

Offshore outsourcing A multinational corporation buying products or services from one of its suppliers in a country other than the one in which the product is manufactured or the service is developed. This again is a form of global external purchasing in terms of purchasing strategy.

Nearshoring A multinational corporation transfers business or information technology processes to suppliers in a nearby country, often one that shares a border with the firm’s own country. While nearshoring is not a purchasing activity per se, it involves facilitating global external purchasing.

Co-sourcing A multinational corporation uses both its own employees from inside the firm and an external supplier to perform certain tasks, often in concert with each other. This applies to all four forms of purchasing strategy. It implies that the relationship between the firm and its supplier is rather strategic in nature— often, this involves the top suppliers in a particular product or component category.

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440 Part Six International Business Functions

ROLE OF JUST-IN-TIME INVENTORY Pioneered by Japanese firms dur- ing that country’s remarkable economic transformation during the 1960s and 1970s, just-in- time inventory systems now play a major role in most manufacturing firms. The basic philosophy behind just-in-time (JIT) inventory systems is to economize on inventory holding costs by having materials arrive at a manufacturing plant just in time to enter the production process and not before. The major cost savings comes from speeding up inven- tory turnover. This reduces inventory holding costs, such as warehousing and storage costs. It means the company can reduce the amount of working capital it needs to finance inven- tory, freeing capital for other uses and/or lowering the total capital requirements of the en- terprise. Other things being equal, this will boost the company’s profitability as measured by return on capital invested. It also means the company is less likely to have excess unsold in- ventory that it has to write off against earnings or price low to sell.

In addition to the cost benefits, JIT systems can also help firms improve product quality. Under a JIT system, parts enter the manufacturing process immediately; they are not ware- housed. This allows defective inputs to be spotted right away. The problem can then be traced to the supply source and fixed before more defective parts are produced. Under a more traditional system, warehousing parts for weeks before they are used allows many de- fective parts to be produced before a problem is recognized.

The drawback of a JIT system is that it leaves a firm without a buffer stock of inven- tory. Although buffer stocks are expensive to store, they can help a firm respond quickly to increases in demand and tide a firm over shortages brought about by disruption among suppliers. Such a disruption occurred after the September 11, 2001, attacks on the World Trade Center and Pentagon, when the subsequent shutdown of international air travel and shipping left many firms that relied upon globally dispersed suppliers and tightly managed “just-in-time” supply chains without a buffer stock of inventory. A less pro- nounced but similar situation occurred again in April 2003, when the outbreak of the pneumonia-like SARS (severe acute respiratory syndrome) virus in China resulted in the temporary shutdown of several plants operated by foreign companies and disrupted their global supply chains. Similarly, in late 2004, record imports into the United States left several major West Coast shipping ports clogged with too many ships from Asia that could not be unloaded fast enough, which disrupted the finely tuned supply chains of several major U.S. enterprises.29

There are ways of reducing the risks associated with a global supply chain that operates on just-in-time principles. To reduce the risks associated with depending on one supplier for an important input, some firms source these inputs from several suppliers located in differ- ent countries. While this does not help in the case of an event with global ramifications, such as September 11, 2001, it does help manage country-specific supply disruptions, which are more common. Strategically, all global companies need to build in some degree of re- dundancy in supply chains by having multiple options for suppliers.

ROLE OF INFORMATION TECHNOLOGY Web and cloud-based infor- mation systems play a crucial role in modern materials management. By tracking compo- nent parts as they make their way across the globe toward an assembly plant, information systems enable a firm to optimize its production scheduling according to when compo- nents are expected to arrive. By locating component parts in the supply chain precisely, good information systems allow the firm to accelerate production when needed by pulling key components out of the regular supply chain and having them flown to the manufac- turing plant.

Firms now typically use some form of supply chain information system to coordinate the flow of materials into manufacturing, through manufacturing, and out to customers. There are a variety of options for global supply chains. Electronic data interchange (EDI) refers to the electronic interchange of data between two or more companies. Enterprise resource planning (ERP) is a wide-ranging business planning and control system that includes supply chain-related subsystems (e.g., materials requirements planning, or MRP). Collabora- tive planning, forecasting, and replenishment (CPFR) was developed to fill the interorgani- zational connections that ERP cannot fill. Vendor management of inventory (VMI) allows

Just in Time (JIT) Inventory logistics system designed to deliver parts to a production process as they are needed, not before.

Chapter Fifteen Global Production and Supply Chain Management 441

for a holistic overview of the supply chain with a single point of control for all inventory management. A warehouse management system (WMS) often operates in concert with ERP systems; for example, an ERP system defines material requirements, and these are transmit- ted to a distribution center for a WMS.

Before the emergence of the Internet as a major communication medium, firms and their suppliers normally had to purchase expensive proprietary software solutions to implement EDI systems. The ubiquity of the Internet and the availability of web and cloud-based ap- plications have made most of these proprietary solutions obsolete. Less expensive systems that are much easier to install and manage now dominate the market for global supply chain management software. These systems have transformed the management of globally dis- persed supply chains, allowing even small firms to achieve a much better balance between supply and demand, thereby reducing the inventory in their systems and reaping the associ- ated economic benefits. Importantly, with most firms now using these systems, those that do not will find themselves at a competitive disadvantage. This has implications for small and medium-sized companies that may not always have the resources to implement the most sophisticated supply chain information systems.

COORDINATION IN GLOBAL SUPPLY CHAINS Consider how to turn an aircraft, and think in terms of coordination and leverage points. That is, aircraft are typi- cally steered using an integrated system of ailerons on the wings and the rudder at the tail of the aircraft. In comparison to the aircraft, the ailerons and the rudder seem very small. However, leverage allows the coordinated effort of the ailerons and the rudder to turn the aircraft. In other words, putting the right combination of a little leverage on the right places together with a coordinated effort leads to incredible maneuvering ability for the plane. Global supply chains are the same. Integration and coordination are critically important. Global supply chain coordination refers to shared decision-making opportunities and op- erational collaboration of key global supply chain activities.

Shared decision making—such as joint consideration of replenishment, inventory hold- ing costs, collaborative planning, costs of different processes, frequency of orders, batch size, and product development—creates a more integrated, coherent, efficient, and effec- tive global supply chain. This includes shared decision making by supply chain members both inside an organization (e.g., logistics, purchasing, operations, and marketing channels employees) and across organizations (e.g., raw materials producers, transportation compa- nies, manufacturers, wholesalers, retailers). Shared decision making is not joint decision making; it is decision making involving joint considerations. Shared decision making helps in resolving potential conflicts among global supply chain members and fosters a culture of coordination and integration. In most supply chains, certain parties are more influential, and shared decision making, at a minimum, should include the critically important chain members.

To achieve operational integration and collaboration within a global supply chain, six operational objectives should be addressed: responsiveness, variance reduction, inventory reduction, shipment consolidation, quality, and life-cycle support.30 Responsiveness refers to a global firm’s ability to satisfy customers’ requirements across global supply chain functions in a timely manner. Variance reduction refers to integrating a control system across global supply chain functions to eliminate global supply chain disruptions. Inventory reduction refers to integrating an inventory system, controlling asset commitment, and turning velocity across global supply chain functions. Shipment consolidation refers to using various programs to combine small shipments and provide timely, consolidated movement. This includes mul- tiunit coordination across global supply chain functions. Quality refers to integrating a sys- tem so that it achieves zero defects throughout global supply chains. Finally, life-cycle support refers to integrating the activities of reverse logistics, recycling, after-market service, prod- uct recall, and product disposal across global supply chain functions.

INTERORGANIZATIONAL RELATIONSHIPS Interorganizational rela- tionships have been studied and talked about in various contexts for decades. The two keys are trust and commitment. If we always had 100 percent trust within relationships and

Global Supply Chain Coordination The shared decision-making opportunities and operational collaboration of key global supply chain activities.

442 Part Six International Business Functions

100 percent commitment to them, most global supply chains would ultimately be efficient and effective. But we don’t! However, by looking at the building blocks for global supply chains, we would also assume that not all relationships are equally valuable and that they should not be treated as if they were. Two examples centered on upstream/inbound and downstream/outbound supply chain activities can effectively be used to illustrate this point. Figure 15.5 focuses on the upstream (or inbound) supply chain relationships, and Figure 15.6 focuses on the downstream (or outbound) supply chain relationships.

For the upstream/inbound portion of the global supply chain, the three logical scenarios of interacting organizations are labeled as vendors, suppliers, and partners. Each scenario is based on the degree of coordination, integration, and transactional versus relationship em- phasis that the firm should adopt in partnering with other entities in the global supply chain. For instance, a firm uses vendors to obtain raw materials and component parts through a transactional relationship that can change easily. A given firm may use suppliers to obtain raw materials and parts and maintain a relationship with those suppliers based on experience and performance. Another firm may engage with partners to obtain raw materials and parts, maintaining a relationship based on trust and commitment.

For the downstream/outbound portion of the global supply chain, the three logical sce- narios of interacting organizations are labeled as buyers, customers, and clients. As with the upstream/inbound examples, each downstream/outbound scenario is based on the degree of coordination, integration, and transactional versus relationship focus that the firm should adopt in partnering with other entities in the global supply chain. One firm may sell prod- ucts and parts to buyers through a transactional relationship that can change easily. Another firm may sell products and parts to customers and maintain a relationship that is based on experience and performance. Yet another firm may sell products and parts to clients and maintain a relationship that is based on trust and commitment.

Having reviewed the three scenarios for the upstream/inbound and downstream/out- bound portions of the global supply chain, let’s look at the emphasis a global company should place on the relationships with each entity: the benefits to be expected, favorable points of distinction, and resonating focus in the relationship.31 First, however, some basics on value are appropriate. Value between nodes and actors in global supply chains is a function of the cost (money and nonmoney resources) given up in return for the quality

15.5 FIGURE Upstream/Inbound Relationships Vendor

Low Coordination Low Integration Transactional Focus

High Coordination High Integration

Relationship Focus

Supplier Partner

15.6 FIGURE Downstream/Outbound Relationships Buyer

Low Coordination Low Integration Transactional Focus

High Coordination High Integration

Relationship Focus

Customer Client

Chapter Fifteen Global Production and Supply Chain Management 443

(products, services, information, trust, and commitment) received. Basically, greater value is achieved if the quality is greater while the cost remains the same or is reduced, or when the cost is reduced and the quality remains constant.

A global company should allocate 20 percent of its efforts to the vendor category, 30 per- cent to the supplier category, and 50 percent to the partner category in the upstream/ inbound portion of the global supply chain. Likewise, a global company should allocate 20 percent of its efforts to the buyer category, 30 percent to the customer category, and 50 percent to the client category in the downstream/outbound portion of the chain. In the vendor (upstream) and buyer (downstream) portions of the supply chain, the benefits that can be expected include those typical of a transactional exchange (costs equal to quality for the goods bought, but not necessarily the best goods in the marketplace). In the supplier (upstream) and customer (downstream) stages, the expectation is that the firm will receive all the favorable points that the raw materials, component parts, and/or products have rela- tive to the next best alternative in the global marketplace. This takes into account the ideas that the costs are equal to quality for the goods bought and that the goods are among the best goods in the marketplace. Finally, in the partner (upstream) and client (downstream) portions of the supply chain, the benefits that the firm can expect to receive include the one or two points of difference for the raw materials, component parts, and/or products whose improvements will deliver the greatest value to the customer for the foreseeable future (quality greater than cost).

production, p. 421 supply chain management, p. 421 purchasing, p. 422 logistics, p. 422 upstream supply chain, p. 422 downstream supply chain, p. 422 total quality management (TQM), p. 423 Six Sigma, p. 423 ISO 9000, p. 424 minimum efficient scale, p. 426

flexible manufacturing technology, p. 427 lean production, p. 427 mass customization, p. 427 flexible machine cells, p. 428 global learning, p. 430 offshore factory, p. 430 source factory, p. 430 server factory, p. 431 contributor factory, p. 431 outpost factory, p. 431

lead factory, p. 431 make-or-buy decision, p. 433 global distribution center, p. 436 global inventory management, p. 437 packaging, p. 437 transportation, p. 437 reverse logistics, p. 438 just in time (JIT), p. 440 global supply chain coordination, p. 441

Key Terms

Summary

This chapter explained how global production and supply chain management can improve the competitive position of an international business by lowering the total costs of value creation and by performing value creation activities in such ways that customer service is enhanced and value added is maximized. We looked closely at five issues cen- tral to global production and supply chain management: where to produce, the strategic role of foreign production sites, what to make and what to buy, global supply chain functions, and managing a global supply chain. The chap- ter made the following points:

1. The choice of an optimal production location must consider country factors, technological factors, and production factors.

2. Country factors include the influence of factor costs, political economy, and national culture on production costs, along with the presence of location externalities.

3. Technological factors include the fixed costs of setting up production facilities, the minimum efficient scale of production, and the availability of flexible manufacturing technologies that allow for mass customization.

4. Production factors include product features, locating production facilities, and strategic roles for production facilities.

5. Location strategies either concentrate or decentralize manufacturing. The choice should be made in light of

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444 Part Six International Business Functions

country, technological, and production factors. All location decisions involve trade-offs.

6. Foreign factories can improve their capabilities over time, and this can be of immense strategic benefit to the firm. Managers need to view foreign factories as potential centers of excellence and encourage and foster attempts by local managers to upgrade factory capabilities.

7. An essential issue in many international businesses is determining which component parts should be manufactured in-house and which should be outsourced to independent suppliers. Both making and buying component parts are primarily based on cost considerations and production capacity constraints, but each decision (make or buy) is also influenced by several different factors.

8. The core global supply chain functions are logistics, purchasing (sourcing), production (and operations management), and marketing channels.

9. Logistics is the part of the supply chain that plans, implements, and controls the effective flows and inventory of raw material, component parts, and products used in manufacturing. The core activities performed in logistics are to manage global distribution centers, inventory management, packaging and materials handling, transportation, and reverse logistics.

10. Purchasing represents the part of the supply chain that involves worldwide buying of raw material, component parts, and products used in manufacturing of the company’s products and services. The core activities performed in purchasing include

development of an appropriate strategy for global purchasing and selecting the type of purchasing strategy best suited for the company.

11. Managing a supply chain involves orchestrating effective just-in-time inventory systems, using information technology, coordination among functions and entities in the chain, and developing interorganizational relationships.

12. Just-in-time systems generate major cost savings by reducing warehousing and inventory holding costs and by reducing the need to write off excess inventory. In addition, JIT systems help the firm spot defective parts and remove them from the manufacturing process quickly, thereby improving product quality.

13. Information technology, particularly Internet-based electronic data interchange, plays a major role in materials management. EDI facilitates the tracking of inputs, allows the firm to optimize its production schedule, lets the firm and its suppliers communicate in real time, and eliminates the flow of paperwork between a firm and its suppliers.

14. Global supply chain coordination refers to shared decision-making opportunities and operational collaboration of key global supply chain activities.

15. The depth and involvement in interorganizational relationships in global supply chains should be based on the degree of coordination, integration, and transactional versus relationship emphasis that the firm should adopt in partnering with other entities in the global supply chain.

Critical Thinking and Discussion Questions

1. An electronics firm is considering how best to supply the world market for microprocessors used in consumer and industrial electronic products. A manufacturing plant costs about $500 million to construct and requires a highly skilled workforce. The total value of the world market for this product over the next 10 years is estimated to be between $10 billion and $15 billion. The tariffs prevailing in this industry are currently low. What kind of location(s) should the firm favor for its plant(s)?

2. A chemical firm is considering how best to supply the world market for sulfuric acid. A manufacturing plant costs about $20 million to construct and requires a moderately skilled workforce. The total value of the world market for this product over the next 10 years is estimated to be between $20 billion and $30 billion. The tariffs prevailing in this industry are moderate. What kind of location(s) should the firm seek for its plant(s)?

3. A firm must decide whether to make a component part in-house or to contract it out to an independent supplier. Manufacturing the part requires a nonrecoverable investment in specialized assets. The most efficient suppliers are located in countries with currencies that many foreign exchange analysts expect to appreciate substantially over the next decade. What are the pros and cons of (a) manufacturing the component in-house and (b) outsourcing manufacturing to an independent supplier? Which option would you recommend? Why?

4. Reread the Management Focus on Philips in China and then answer the following questions: a. What are the benefits to Philips of shifting so much

of its global production to China? b. What are the risks associated with a heavy

concentration of manufacturing assets in China? c. What strategies might Philips adopt to maximize

the benefits and mitigate the risks associated with moving so much product?

5. Explain how the global supply chain functions of (a) logistics and (b) purchasing can be used to strategically leverage the global supply chains for a manufacturing company producing mobile phones.

6. What type of interorganizational relationship should a global company consider in the (a) inbound portion of

its supply chains if the goal is to buy commodity- oriented component parts for its own production and (b) outbound portion of its supply chains if the goal is to establish a strong partnership in reaching end-customers?

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

1. The globalization of production makes many people aware of the differences in manufacturing costs worldwide. The U.S. Department of Labor’s Bureau of International Labor Affairs publishes the Chartbook of International Labor Comparisons. Locate the latest edition of this report, and identify the hourly compensation costs for manufacturing workers in China, Brazil, Mexico, Turkey, Germany, and the United States.

2. The World Bank’s Logistics Performance Index (LPI) assesses the trade logistics environment and performance of countries. Locate the most recent LPI ranking. What components for each country are examined to construct the index? Identify the top 10 logistics performers. Prepare an executive summary highlighting the key findings from the LPI. How are these findings helpful for companies trying to build a competitive supply chain network?

Research Task http://globalEDGE.msu.edu

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David Beckham, Freja Beha, Beyoncé, Gisele Bündchen, Georgia May Jag- ger, Miranda Kerr, Madonna, Vanessa Paradis, Katy Perry, Lana Del Rey, Rihanna, Anja Rubik, and so many more. Yes, it sounds like a list of celebri- ties and they are! These celebrities represent just a partial list of really well-known people around the world who have worked with H&M (do you recognize all of them?). But, let’s move on from the “name dropping” to Hennes & Mauritz, or H&M as it is more commonly known. H&M is a Swed- ish multinational retail-clothing giant known for its fashion clothing for women, men, teenagers, and children. H&M has effectively used superstar celebrities like David Beckham, Beyoncé, and Gisele Bündchen for years to carry their advertising message worldwide. Behind the scenes, H&M’s global supply chains are equally well orchestrated and are as high pow- ered as its advertising campaigns.

H&M Hennes & Mauritz AB is now the full name of the company (it started simply as “Hennes” in 1947 in a small Swedish town called Västerås). The idea for the company emerged when, in 1946, Erling Pers- son, the company’s founder, came up with the idea of offering fashionable clothing at relatively low prices while he was on a business trip to the United States. At that time, Erling Persson decided to focus on women’s clothing only, and “Hennes,” which means “her” or “hers” in Swedish, was started. A couple of decades later, in 1968, Hennes acquired the building and inventory of hunting equipment retailer Mauritz Widforss. A supply of men’s clothing was also a part of the inventory. This resulted in menswear being included in the company’s collection—and gave birth to Hennes & Maurits (H&M). H&M now has some 3,200 stores in 54 countries and ap- proximately 116,000 employees. It is the second largest clothing retailer in

the world after Spain-based Inditex (parent company of ZARA) and ahead of U.S.-based GAP Inc.

H&M Hennes & Mauritz AB comprises six different brands, although the H&M brand is the most recognizable worldwide. The other brands are COS, Monki, Weekday, Cheap Monday, and & Other Stories. H&M designs sus- tainable fashion for all people at relatively modest prices and sells its prod- ucts in 54 countries and online in an additional 10 markets. COS explores the concept of style over fashion and sells its products in stores and online in 38 countries. Monki is promoted as a fashion experience and is offered

H&M: The Retail-Clothing Giant

Chapter Fifteen Global Production and Supply Chain Management 445

Pedestrians walk past a H&M store in Singapore.

446 Part Six International Business Functions

in 30 markets in stores and online. Weekday is a jeans-focused fashion destination with sales in 25 markets. Cheap Monday combines “influences from street fashion and subculture with a catwalk vibe” and is offered in some 20 markets. The last brand, called “& Other Stories,” was launched in 2013 and focuses on personal expression and styling, with availability in 17 markets. The collection of these brands, driven by the H&M collection and its footprint in 64 countries, presents a unique global supply chain challenge for the company.

The collections of clothing are created by a team of 160 in-house de- signers and 100 pattern makers. The design and pattern team is large and diverse, representing different age groups and nationalities. H&M Hennes & Mauritz AB’s (H&M from now on) design process is about “striking the right balance between fashion, quality and the best price . . . and it always involves sustainability awareness.” H&M does not own its own factories but instead works with around 900 independent suppliers to implement the team’s designs into reality. These independent suppliers are mostly located in Europe and Asia. They manufacture all of H&M’s products, and they also generally source fabrics and other components needed to create the fashion statements we have come to know from the H&M brands. Some 80 people in the H&M organization are dedicated to constantly audit the working conditions at the factories of suppliers, including safety and quality testing and ensuring that chemicals requirements are met.

Within the global supply chain infrastructure, one key aspect of H&M is the ordering of each product. Specifically, ordering each product at the optimal moment is an important part of H&M achieving the right balance among price, cycle time, and quality. To realize the effectiveness needed to ultimately sell fashion-oriented clothing at affordable prices, H&M works closely with long-term partners and invests significant resources into the sustainability of the work needed in its supply chains. In these areas, H&M strives to promote lasting improvements in working conditions and envi- ronmental impact throughout the footprint that it makes worldwide.

Through its 900 suppliers, the company is connected to some 1,900 facto- ries and about 1.6 million workers.

Sources: H&M website, http://hm.com, accessed April 12, 2014; L. Siegle, “Is H&M The New Home of Ethical Fashion?” The Observer, April 7, 2012; G. Petro, “The Future of Fashion Retailing—The H&M Approach,” Forbes, November 5, 2012; K. Stock, “H&M’s New Store Blitz Moves Faster Than Its Digital Expansion,” Bloomberg Businessweek, March 17, 2014; and M. Kerppola, R. Moody, L. Zheng, and A. Liu, “H&M’s Global Supply Chain Management Sustainability: Factories and Fast Fashion,” GlobaLens, a division of the William Davidson Institute at the University of Michigan, February 8, 2014.

CASE DISCUSSION QUESTIONS 1. Does it surprise you that the second largest clothing retailer is only

selling in stores in 54 countries plus an additional 10 countries online? Why do you think it is not covering more of the world’s countries?

2. H&M does not own any of the factories that produce its clothes. Instead, it relies on some 1,900 factories and 900 suppliers to create what its team designed. These factories and suppliers are mostly in Europe and Asia. How can H&M ensure that its customers receive the quality expected in the clothing?

3. H&M stresses sustainability in its promotional campaigns. How can it ensure that the working conditions are appropriate for the 1.6 million people that serve in its supplier network? Is it even H&M’s role to ensure that the working conditions and environmental impact are great in every market it engages in?

4. If you worked for H&M, what would you suggest that it focus on to become even larger than it is now? Should it have its own factories? Should it expand to more than the 64 countries (54 with stores and 10 online) that it is in now? Should it control more of the global supply chains?

Endnotes

Note: Elements of the sections on Strategic Roles for Production Facili- ties; Make-or-Buy Decisions; Global Supply Chain Functions; Coordi- nation in Global Supply Chains; and Interorganizational Relationships are drawn from Tomas Hult, David Closs, and David Frayer (2014), Global Supply Chain Management, New York: McGraw Hill.

1. T. Hult, D. Closs, and D. Frayer, Global Supply Chain Manage- ment: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill Professional, 2014).

2. D. A. Garvin, “What Does Product Quality Really Mean,” Sloan Management Review 26 (Fall 1984), pp. 25–44.

3. See the articles published in the special issue of the Academy of Management Review on Total Quality Management 19, no. 3 (1994). The following article provides a good overview of many of the issues involved from an academic perspective: J. W. Dean and D. E. Bowen, “Management Theory and Total Quality,” Academy of Management Review 19 (1994), pp. 392–418. Also see T. C. Powell, “Total Quality Manage- ment as Competitive Advantage,” Strategic Management Jour- nal 16 (1995), pp. 15–37; and S. B. Han et al., “The Impact of

ISO 9000 on TQM and Business Performance,” Journal of Business and Economic Studies 13, no. 2 (2007), pp. 1–25.

4. For general background information, see “How to Build Quality,” The Economist, September 23, 1989, pp. 91–92; A. Gabor, The Man Who Discovered Quality (New York: Penguin, 1990); P. B. Crosby, Quality Is Free (New York: Mentor, 1980); and M. Elliot et al., “A Quality World, a Quality Life,” Indus- trial Engineer, January 2003, pp. 26–33.

5. G. T. Lucier and S. Seshadri, “GE Takes Six Sigma beyond the Bottom Line,” Strategic Finance, May 2001, pp. 40–46; and U. D. Kumar et al., “On the Optimal Selection of Process Alternatives in a Six Sigma Implementation,” Inter- national Journal of Production Economics 111, no. 2 (2008), pp. 456–70.

6. M. Saunders, “U.S. Firms Doing Business in Europe Have Options in Registering for ISO 9000 Quality Standards,” Business America, June 14, 1993, p. 7; and Han et al., “The Impact of ISO 9000.”

7. G. Stalk and T. M. Hout, Competing against Time (New York: Free Press, 1990).

Chapter Fifteen Global Production and Supply Chain Management 447

8. N. Tokatli, “Global Sourcing: Insights from the Global Cloth- ing Industry—The Case of Zara, a Fast Fashion Retailer,” Journal of Economic Geography 8, no. 1 (2008), pp. 21–39.

9. Diana Farrell, “Beyond Offshoring,” Harvard Business Review, December 2004, pp. 1–8; and M. A. Cohen and H. L. Lee, “Resource Deployment Analysis of Global Manufacturing and Distribution Networks,” Journal of Manufacturing and Operations Management 2 (1989), pp. 81–104.

10. P. Krugman, “Increasing Returns and Economic Geography,” Journal of Political Economy 99, no. 3 (1991), pp. 483–99; J. M. Shaver and F. Flyer, “Agglomeration Economies, Firm Het- erogeneity, and Foreign Direct Investment in the United States,” Strategic Management Journal 21 (2000), pp. 1175–93; and R. E. Baldwin and T. Okubo, “Heterogeneous Firms, Agglomeration Economies, and Economic Geography,” Jour- nal of Economic Geography 6, no. 3 (2006), pp. 323–50.

11. For a review of the technical arguments, see D. A. Hay and D. J. Morris, Industrial Economics: Theory and Evidence (Oxford, UK: Oxford University Press, 1979). See also C. W. L. Hill and G. R. Jones, Strategic Management: An Integrated Approach (Boston: Houghton Mifflin, 2004).

12. See P. Nemetz and L. Fry, “Flexible Manufacturing Organi- zations: Implications for Strategy Formulation,” Academy of Management Review 13 (1988), pp. 627–38; N. Greenwood, Implementing Flexible Manufacturing Systems (New York: Halstead Press, 1986); J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Raw- son Associates, 1990); and R. Parthasarthy and S. P. Seith, “The Impact of Flexible Automation on Business Strategy and Organizational Structure,” Academy of Management Review 17 (1992), pp. 86–111.

13. B. J. Pine, Mass Customization: The New Frontier in Business Competition (Boston: Harvard Business School Press, 1993); S. Kotha, “Mass Customization: Implementing the Emerging Paradigm for Competitive Advantage,” Strategic Management Journal 16 (1995), pp. 21–42; J. H. Gilmore and B. J. Pine II, “The Four Faces of Mass Customization,” Harvard Business Review, January–February 1997, pp. 91–101; and M. Zerenler and D. Ozilhan, “Mass Customization Manufacturing: The Drivers and Concepts,” Journal of American Academy of Busi- ness 12, no. 1 (2007), pp. 230–62.

14. “Toyota Motor Corporation Captures Ten Segment Awards,” J. D. Power press release, March 19, 2009, http://business- center.jdpower.com/news/pressrelease.aspx?ID52009043.

15. M. A. Cusumano, The Japanese Automobile Industry (Cambridge, MA: Harvard University Press, 1989); T. Ohno,

Toyota Production System (Cambridge, MA: Productivity Press, 1990); and Womack, Jones, and Roos, The Machine That Changed the World.

16. P. Waurzyniak, “Ford’s Flexible Push,” Manufacturing Engi- neering, September 2003, pp. 47–50.

17. Hult, Closs, and Frayer, Global Supply Chain Management.

18. F. Kasra, “Making the Most of Foreign Factories,” in World View, ed. J. E. Garten (Boston: Harvard Business School Press, 2000).

19. “The Boomerang Effect,” The Economist, April 21, 2012; and Charles Fishman, “The Insourcing Boom,” The Atlantic, December 2012.

20. This anecdote was told to the author by a Microsoft manager while the author was visiting Microsoft facilities in Hyderabad, India.

21. Interview by author. The manager was a former executive MBA student of the author.

22. Hult, Closs, and Frayer, Global Supply Chain Management.

23. Ibid.

24. D. A. Beeton, Technology Roadmapping in the Packaging Sector (Cambridge, UK: Institute for Manufacturing, University of Cambridge, 2004).

25. J. A. Peterson and V. Kumar, “Can Product Returns Make You Money?” MIT Sloan Management Review 51, no. 3 (2013), pp. 85–89.

26. Hult, Closs, and Frayer, Global Supply Chain Management; R. J. Trent and R. M. Monczka, “Achieving Excellence in Global Sourcing,” MIT Sloan Management Review 47, no. 1 (2005), pp. 24–32.

27. M. Kotabe and K. Helsen, Global Marketing Management (Hoboken, NJ: John Wiley & Sons, 2010).

28. H. F. Busch, “Integrated Materials Management,” IJPD & MM 18 (1990), pp. 28–39.

29. T. Aeppel, “Manufacturers Cope with the Costs of Strained Global Supply Lines,” The Wall Street Journal, December 8, 2004, p. A1.

30. D. J. Bowersox, D. J. Closs, M. B. Cooper, and J. C. Bowersox, Supply Chain Logistics Management (New York: McGraw-Hill Companies, 2012).

31. J. C. Anderson, J. A. Narus, and W. van Rossum (2006), “Cus- tomer Value Propositions in Business Markets,” Harvard Business Review, March, pp. 1–10.

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learning objectives

16-1 Explain why it might make sense to vary the attributes of a product from country to country.

16-2 Recognize why and how a firm’s distribution strategy might vary among countries.

16-3 Identify why and how advertising and promotional strategies might vary among countries.

16-4 Explain why and how a firm’s pricing strategy might vary among countries.

16-5 Understand how to configure the marketing mix globally.

16-6 Understand the importance of international market research.

16-7 Describe how globalization is affecting product development.

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Global Marketing and Research and Development

Global Branding of Avengers and Iron Man

opening case

In a global brand move, the post-credits to the original Iron Man movie had S.H.I.E.L.D. Director Nick Fury visit Tony Stark’s home. Fury told Stark that Iron Man is not “the only superhero in the world,” and says that he wants to discuss the “Avenger’s Initiative.” The Avengers and Iron Man movie franchises have made billions of dollars for Marvel Studios, a

television and motion picture studio that is part of the Walt Disney Company. They have also contributed

heavily to making Robert Downey Jr. one of the highest paid actors in Hollywood. Robert Downey Jr. was

born in 1965 in the United States. He made his movie debut at the age of 5 when he appeared in his

father’s movie titled Pound. The “up-and-down-and-up” career of Robert Downey Jr. is also a fascinating

global brand story. He is riding high with three incredible multi-sequel franchises—Iron Man, The Avengers,

and Sherlock Holmes. But the focus here is on The Avengers and Iron Man.

Iron Man premiered April 30, 2008, in international markets and a few days later in the United States.

Amazingly, the movie had been in development since 1990 at Universal Pictures, 20th Century Fox, and

New Line Cinema. Marvel Studios reacquired the rights to the movie in 2006. The basic plot has playboy,

philanthropist, and genius Tony Stark (played by Robert Downey Jr.) as the “superhero.” Iron Man is a

fictional character that first appeared in the Marvel Comics, Tales of Suspense, in 1963. The character itself

was created by Stan Lee. Iron Man 2 was released in 2010 and Iron Man 3 was released in 2013, with

plans for additional sequels after more Avengers movies.

The Avengers premiered on April 11, 2012, at the El Capitan Theatre in Hollywood. The film’s development

began in 2005, is based on the Marvel Comics superhero team with the same name, and was written and

directed by Joss Whedon. The Avengers is a superhero team with familiar heroes such as Iron Man, Captain

America, Hulk, Thor, Black Widow, Hawkeye, and so on. No one really plays the superhero, although

Scarlett Johansson’s role as Black Widow was important to the movie franchise; they set the release date

back from 2011 to 2012 to accommodate her inclusion. The second installment of the Avengers franchise is

set for 2015 (Avengers: Age of Ultron).

–continued

450 Part Six International Business Functions

While the movie character Iron Man is heavily connected to Robert Downey Jr., he

also plays an integral part of Tony Stark in The Avengers. In doing so, Robert Downey

Jr. has been part of Marvel Studios productions that have brought in more than

$1.5 billion (The Avengers) and $1.2 billion (Iron Man 3). Iron Man 1 and Iron Man 2,

respectively, made more than $600 million each as well. In total, Robert Downey Jr. has

starred in six films that have made more than $500 million each at the box office

worldwide.

Clearly, the connection between Tony Stark as Iron Man in the Iron Man franchise

and in the Avengers franchise is perhaps not needed for the movie plot in The Avengers

or its sequel. Marvel Comics has drawn from more than 100 characters for its Avengers

superheroes since 1963, but Iron Man was one of the original ones (along with Ant-Man,

the Wasp, Thor, and the Hulk). The global branding success of Tony Stark as played by

Robert Downey Jr. across these two brands is also very advantageous for Marvel Studios’

global branding.

Marvel Studios was originally known as Marvel Films from 1963 to 1996. It is an

American TV and motion picture studio that is a part of Marvel Entertainment, a wholly

owned subsidiary of The Walt Disney Company. Given that Marvel Studios is a part of

the Walt Disney Empire, it operates jointly with Walt Disney Studios on distribution and

marketing of Iron Man and Avengers movies. Other high-profile projects of Marvel

Studios have included the X-Men, Spider-Man, and Captain America franchises, with

more to come. Anything embedded in the global branding of The Walt Disney Company

has tremendous potential, reach, and longevity.

Walter Elias “Walt” Disney was an American business mogul as well as animator,

cartoonist, director, philanthropist, producer, screenwriter, and voice actor who lived

from 1901 to 1966. An international icon, he started Disney Brothers Cartoon Studio with

his brother, Roy O. Disney in 1923. The current name of The Walt Disney Company has

been around since 1986. Disney has one of the largest and most well-known studios in

the world. It also operates numerous related businesses, such as the ABC broadcast TV

network, cable TV networks (e.g., Disney Channel, ESPN), publishing, merchandising,

theatre divisions, theme parks (e.g., Disney World, Disneyland), and much more. Mickey

Mouse is the primary symbol of The Walt Disney Company, and one of the most globally

recognized brands ever! • Sources: K. Buchanan and J. Wolk, “How Vulture Ranked Its 2013 Most Valuable Stars List,” www.vulture.com, October 22, 2013; T. Culpan, “HTC Said to Hire Robert Downey Jr. for $12 Million Ad Campaign,” Bloomberg Businessweek, June 20, 2013; C. Isidore, “Avengers Set to Rescue Disney and Hollywood,” CNNMoney, May 7, 2012; “Iron Man 3: Clank Clank Bang Bang,” The Wall Street Journal, May 2, 2013; http://marvel.com/universe/Iron_Man; and http://marvel.com/ universe/Avengers.

Introduction The previous chapter looked at the roles of global production and supply chain manage- ment in an international business. This chapter continues our focus on specific business functions by examining the roles of marketing and research and development (R&D) in an international business. We focus on how marketing and R&D can be performed so they will reduce the costs of value creation and add value by better serving customer needs. This in- cludes distribution strategy (sometimes also called marketing channels) that is part of global supply chains that we discussed in Chapter 15.

Chapter Sixteen Global Marketing and Research and Development 451

In Chapter 13, we spoke of the tension existing in most international businesses between the need to reduce costs and, at the same time, respond to local conditions, which tends to raise costs. This tension continues to be a persistent theme in this chapter. A global market- ing strategy that views the world’s consumers as similar in their tastes and preferences is consistent with the mass production of a standardized output. By mass-producing a stan- dardized output—whether it be soap, semiconductor chips, or high-end apparel—the firm can realize substantial unit cost reductions from experience curve effects and other econo- mies of scale. However, ignoring country differences in consumer tastes and preferences can lead to failure. Thus, an international business’s marketing function needs to determine when product standardization is appropriate, how standardized it can be, and when it is not in the business’ best interest to standardize a product too much. Even if product standard- ization is appropriate, the way in which a product is positioned in a market and the promo- tions and messages used to sell that product may still have to be customized so that they resonate with local consumers.

In some way, the movie industry is becoming more and more standardized around the world, and the influence of the United States, via its strong film-making industry, on world culture is, in fact, making the globe more homogenous in customers’ needs and wants (see the opening case). Such homogenization, especially of younger populations across devel- oped and emerging nations, helps marketing professionals sell products and services glob- ally. These days, it is commonplace to see a movie launched worldwide on the same day, whereas in the past movies were typically screened first in the United States and then pro- moted region by region in the world in the weeks that followed. Interestingly, Iron Man premiered a few days earlier internationally than it did in the United States—such a launch pattern would seldom be seen with large-scale movies in the past. Globalization has in- creased the pressure on marketing to deliver on product quality and availability in a far- spanning way worldwide, with effective distribution strategies, appropriate communication strategies, and competitive pricing strategies.

We consider marketing and R&D within the same chapter because of their close rela- tionship. A critical aspect of the marketing function is identifying gaps in the market so that the firm can develop new products to fill those gaps. Developing new products requires R&D—thus the linkage between marketing and R&D. A firm should develop new products with market needs in mind, and marketing is best suited to define those needs for R&D personnel given, among many things, its closeness to the market via front-line customer service personnel. Also, marketing personnel are well suited to communicate to R&D per- sonnel whether to produce globally standardized or locally customized products. The rea- son marketing is so well positioned to communicate with R&D about (1) customer needs and wants and (2) degree of product standardization or customization needed is that the marketing function is responsible for the international marketing research that is conducted by the global company. Overall, our thinking here is in line with long-standing research that

Get Insights by Industry

When conducting research and development (R&D) and creating inter- national marketing campaigns, the vast majority of global companies focuses on the customers’ needs in a particular industry. Industries worldwide are classified according to the Harmonized Commodity De- scription and Coding System, or simply HS Codes, which are maintained by the World Customs Organization. The HS Codes are divided into about 20 sections for its roughly 5,000 commodity groups. The “Get Insights by Industry” section on globalEDGE is a great source for international business–related resources, statistics, risk assessments, regulatory

agencies, corporations, and events for these 20 industry sectors. An interesting aspect of each industry section on globalEDGE is the rating provided of the industry’s level of fragmentation. Highly concentrated industries are dominated by many large firms that are capable of shap- ing the industry’s direction and price levels. Highly fragmented indus- tries have many companies involved, with none of them really large enough to be able to influence the industry’s direction or price levels. Which do you think is more fragmented: consumer products or technol- ogy? Check out the industry section on globalEDGE for an answer.

452 Part Six International Business Functions

maintains that a major contributor to the success of new-product introductions is a close relationship between marketing and R&D.1

In this chapter, we begin by reviewing the debate on the globalization of markets. Then we discuss the issue of market segmentation. Next, we look at four elements that constitute a firm’s marketing mix: product attributes, distribution strategy, communication strategy, and pricing strategy (these are sometimes called the 4 P’s for product, place, promotion, and price in many basic marketing textbooks). The marketing mix is the set of choices the firm offers to its targeted markets. Many firms vary their marketing mix from country to country, depending on differences in national culture, economic development, product standards, distribution channels, and so on. The best way to think about the marketing mix is that it represents the tactical activities implemented by a global company based on its international marketing strategy to offer the best possible “mix” of product, distribution, communication, and price to a specific target market in a country or region.

Given the importance of the marketing mix and having the right products, we include three sections on those topics in this chapter after we provide a detailed discussion of the marketing mix elements. First, we have a section on configuring an appropriate marketing mix for each unique international market segment. This includes a set of sample questions to ask for each of the marketing mix elements (product, distribution, communication, and price) to gauge how standardized or customized a marketing mix should be for a certain international market segment. Next, we discuss international market research as a way to better understand how to configure the marketing mix for international market segments. Third, we focus a discussion on product development issues, with a particular emphasis on new-product development. Here we integrate R&D, marketing, and production issues along with management issues such as cross-functional teams.

Globalization of Markets and Brands In a now-classic Harvard Business Review article, the late Theodore Levitt wrote lyrically about the globalization of world markets. Levitt’s arguments have become something of a lightning rod in the debate about the extent of globalization. According to Levitt,

A powerful force drives the world toward a converging commonalty, and that force is technology. It has proletarianized communication, transport, and travel. The result is a new commercial reality—the emergence of global markets for standardized consumer products on a previously unimagined scale of magnitude.

Gone are accustomed differences in national or regional preferences. The globalization of markets is at hand. With that, the multinational commercial world nears its end, and so does the multinational corporation. The multinational corporation operates in a number of countries and adjusts its products and practices to each—at high relative costs. The global corporation operates with resolute consistency—at low relative cost—as if the entire world were a single entity; it sells the same thing in the same way everywhere.

Commercially, nothing confirms this as much as the success of McDonald’s from the Champs Élysées to the Ginza, of Coca-Cola in Bahrain and Pepsi-Cola in Moscow, and of rock music, Greek salad, Hollywood movies, Revlon cosmetics, Sony television, and Levi’s jeans everywhere.

Ancient differences in national tastes or modes of doing business disappear. The commonalty of preference leads inescapably to the standardization of products, manufacturing, and the institutions of trade and commerce.2

This is eloquent and evocative writing, but is Levitt correct? The rise of the global media phenomenon from CNN to MTV, and the ability of such media to help shape a global cul- ture, would seem to lend weight to Levitt’s argument. If Levitt is correct, his argument has major implications for the marketing strategies pursued by international businesses. How- ever, many academics feel that Levitt overstates his case.3 Although Levitt may have a point when it comes to many basic industrial products, such as steel, bulk chemicals, and semicon- ductor chips, globalization in the sense used by Levitt seems to be the exception rather than

Marketing Mix Choices about product attributes, distribution strategy, communication strategy, and pricing strategy that a firm offers its targeted markets.

Chapter Sixteen Global Marketing and Research and Development 453

the rule in many consumer goods markets and industrial markets. Even a firm such as McDonald’s, which Levitt holds up as the archetypal example of a consumer products firm that sells a standardized product worldwide, modifies its menu from country to country in light of local consumer preferences. In the Middle East, for example, McDonald’s sells the McArabia, a chicken sandwich on Arabian-style bread, and in France, the Croque McDo, a hot ham and cheese sandwich.4

On the other hand, Levitt is probably correct to assert that modern transportation and communications technolo- gies are facilitating a convergence of certain tastes and pref- erences among consumers in the more advanced countries of the world, and this has become even more prevalent since he wrote his article. Our movie example in the opening case of this chapter highlights such a convergence in tastes. By extension, in the long run, technological and other forces may lead to the evolution of a global culture. At present, however, the continuing persistence of some unique cultural and economic differences between nations acts as a brake on many trends toward the standardization of consumer tastes and preferences across nations. While we see more homog- enization and standardization of needs and wants among younger people, typically 40 years and younger, there are still wide gaps in tastes among older people. What will be interesting to find out is if this increased homogenization among younger people will remain when they become older. Some indications exist that standardization of needs and wants stay with people when they become older but, at least anecdotally, we also see people adopt more culturally specific needs as they grow older.

So, we may never see a world where globalization is fully spread across the more than 200 countries that exist. Some writers have argued that the rise of global culture does not mean that consumers share the same tastes and preferences.5 Rather, people in different nations, often with conflicting viewpoints, are increasingly participating in a shared “global” conver- sation, drawing upon shared symbols that include global brands from Nike and Dove to Coca-Cola and Sony. But the way in which these brands are perceived, promoted, and used still varies from country to country, depending on local differences in tastes and preferences. Another reason it appears that globalization is spreading is that certain products simply exist everywhere—but that does not mean consumers everywhere prefer those products over more local options if such product alternatives existed. Better technology, production pro- cesses, and innovation may lead to better local product alternatives in the future that can compete with global products. If so, international marketing is going to be even more criti- cal than it already is for global and local companies. Furthermore, trade barriers and differ- ences in product and technical standards also constrain a firm’s ability to sell a standardized product to a global market using a standardized marketing strategy. We discuss the sources of these differences in subsequent sections when we look at how products must be altered from country to country. In short, Levitt’s fully standardized international marketplace is some way off in many industries.

Market Segmentation Market segmentation refers to identifying distinct groups of consumers whose needs, wants, and purchasing behavior differ from others in important ways. Markets can be seg- mented in numerous ways: by geography, demography (e.g., gender, age, income, race, edu- cation level), sociocultural factors (e.g., social class, values, religion, lifestyle choices), and psychological factors (e.g., personality). Because different segments exhibit different needs, wants, and patterns of purchasing behavior, firms often adjust their marketing mix from

Market Segmentation Identifying groups of consumers whose purchasing behavior differs from others in important ways.

Will Toyota Stay Number 1? Yundong, or Cloud Action, is Toyota China’s first-ever strategic plan for its business in China. China is the “most important” market in the world, but the Japanese carmaker has less than 10 percent of the auto market, far behind global rivals such as General Motors and Volkswagen. The auto giant aims to become a company “that is beyond consumers’ expectations and creates happiness and fortune for consumers and the regions where it operates,” emphasizing local responsiveness to Chinese cus- tomers but still maintaining a global strategy. The Yundong plan combines the company’s global strategy and local marketing operation, which will bring advanced technologies to the local market, improve the local management and marketing system, and build “exciting” products “that touch the hearts of Chinese consumers and are beyond their expectations” according to company officials. China is clearly an important market if Toyota is to maintain the overall worldwide leadership in auto sales. Do you think Toyota will capture a significant share of the Chinese auto market? And, do you think Toyota can maintain its number 1 position in the worldwide auto market?

Sources: www.chinadaily.com.cn/bizchina/2012-03/05/content_14757469.htm; and J. Korceniewski, “Toyota Is World’s Top-Selling Automaker for Second Year in a Row,” Autoblog, January 26, 2014.

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.

454 Part Six International Business Functions

segment to segment. Thus, the precise design of a product, the pricing strategy, the distri- bution channels used, and the choice of communication strategy may all be varied from segment to segment. The goal is to optimize the fit between the purchasing behavior of consumers in a given segment and the marketing mix, thereby maximizing sales to that seg- ment. Automobile companies, for example, use a different marketing mix to sell cars to different socioeconomic segments. Thus, Toyota uses its Lexus division to sell high-priced luxury cars to high-income consumers while selling its entry-level models, such as the Toyota Corolla, to lower-income consumers. Similarly, computer manufacturers will offer different computer models, embodying different combinations of product attributes and price points, to appeal to consumers from different market segments (e.g., business users and home users).

When managers in an international business consider market segmentation in foreign countries, they need to be cognizant of two main issues: the differences between countries in the structure of market segments and the existence of segments that transcend national borders. For example, some companies opt to target a country with a number of different product options based on the multiple unique market segments in a country. Other compa- nies opt to target one unique market segment in a country that also has parallels in other countries. A segment that spans multiple countries, transcending national boarders, is often called an intermarket segment. Strategically, marketing managers have marketing mix op- tions with these two choices. Targeting one country and its multiple potential market seg- ments with multiple marketing mixes allows a company to focus on the cultural characteristics of one country (or the characteristics of a manageable set of countries). Tar- geting many countries and the intermarket segment that has characteristics that are largely the same across countries allows a company to focus on the cultural characteristics that are universal for certain customers across countries.

These are important choices because the structure of the many potential market seg- ments may differ significantly from country to country and also within countries. In fact, an important market segment in a foreign country may have no parallel in the firm’s home country, and vice versa. In such a case, the focus cannot be on an intermarket segment, at least not one involving the home-country market. The firm may have to develop a unique marketing mix to appeal to the needs, wants, and purchasing behavior of a certain segment in a given country. An example of such a market segment is given in the accompanying Man- agement Focus, which looks at the African Brazilian market segment in Brazil that, as you will see, is very different from the African American segment in the United States. In an- other example, a research project identified a segment of consumers in China in the 45-to- 55 age range that has few parallels in other countries.6 This group came of age during China’s Cultural Revolution in the late 1960s and early 1970s. This group’s values have been shaped by their experiences during the Cultural Revolution. They tend to be highly sensi- tive to price and respond negatively to new products and most forms of marketing. Thus, firms doing business in China may need to customize their marketing mix to address the unique values and purchasing behavior of the group. The existence of such a segment con- strains the ability of firms to standardize their global marketing strategy.

In contrast, the existence of market segments that transcend national borders clearly en- hances the ability of an international business to view the global marketplace as a single entity and pursue a global strategy—selling a standardized product worldwide and using the same basic marketing mix to help position and sell that product in a variety of national mar- kets. For a segment to transcend national borders, consumers in that segment must have some compelling similarities along important dimensions—such as age, values, lifestyle choices—and those similarities must translate into similar needs, wants, and purchasing be- havior. If this is true, the company can globalize its marketing mix efforts by adopting the so-called intermarket segment to target customers’ needs, wants, and purchasing behavior. Although such segments clearly exist in certain industrial markets, they have historically been rarer in consumer markets.

The forecast, however, is that these intermarket segments will become more and more common with the increased globalization among younger consumers (40 years and younger) in the developed- and emerging-country markets. For example, one emerging

Intermarket Segment A segment of customers that spans multiple countries, transcending national borders.

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global segment that is attracting the attention of international marketers of consumer goods is the global teenage segment. Global media are paving the way for a global youth segment. Evidence that such a segment exists comes from a study of the cultural attitudes and purchasing behavior of more than 6,500 teenagers in 26 countries.7 The findings sug- gest that teens and young adults around the world are increasingly living parallel lives that share many common values. It follows that they are likely to purchase the same kind of consumer goods and for the same reasons.

Product Attributes A product can be viewed as a bundle of attributes.8 For example, the attributes that make up a car include power, design, quality, performance, fuel consumption, and comfort; the attributes of a hamburger include taste, texture, and size; a hotel’s attributes include atmo- sphere, quality, comfort, and service. Products sell well when their attributes match con- sumer needs (and when their prices are appropriate). BMW cars sell well to people who have high needs for luxury, quality, and performance precisely because BMW builds those attributes into its cars. If consumer needs were the same the world over, a firm could sim- ply sell the same product worldwide. However, consumer needs vary from country to country, depending on culture and the level of economic development. A firm’s ability to sell the same product worldwide is further constrained by countries’ differing product standards. This section reviews each of these issues and discusses how they influence product attributes.

CULTURAL DIFFERENCES We discussed countries’ cultural differences in Chapter 4. Countries differ along a whole range of dimensions, including social structure,

LO 16-1 Explain why it might make sense to vary the attributes of a product from country to country.

Marketing to Black Brazil

Brazil is home to the largest black population outside of Nigeria. Nearly half of the 195 million people in Brazil are of African or mixed race ori- gin. Despite this, until recently businesses have made little effort to target this numerically large segment of the population. Part of the rea- son is rooted in economics. Black Brazilians have historically been poorer than Brazilians of European origin and thus have not received the same attention as whites. But after a decade of relatively strong economic performance in Brazil, an emerging black middle class is beginning to command the attention of consumer product companies. To take advantage of this, companies such as Unilever have introduced a range of skin care products and cosmetics aimed at black Brazilians, and Brazil’s largest toy company introduced a black Barbie-like doll, Susi Olodum, sales of which quickly caught up with sales of a similar white doll.

But there is more to the issue than simple economics. Unlike the United States, where a protracted history of racial discrimination gave birth to the civil rights movement, fostered black awareness, and pro- duced an identifiable subculture in U.S. society, the history of blacks in Brazil has been very different. Although Brazil did not abolish slavery until 1888, racism in Brazil has historically been much subtler than in the United States. Brazil has never excluded blacks from voting nor had a tradition of segregating the races. Historically, too, the government encouraged intermarriage between whites and blacks. Partly due to

this more benign history, Brazil has not had a black rights movement similar to that in the United States, and racial self-identification is much weaker. Surveys routinely find that African Brazilian consumers decline to categorize themselves as either black or white; instead, they choose one of dozens of skin tones and see themselves as being part of a culture that transcends race. Indeed, only 7.4 percent of Brazil’s population classify themselves as “Afro-Brazilian,” while 42.6 percent classify themselves as “pardo” or brown Brazilians of mixed race an- cestry including white, African, and Amerindian descent.

This subtler racial dynamic has important implications for market segmentation and tailoring the marketing mix in Brazil. Unilever had to face this issue when launching a Vaseline Intensive Care lotion for black consumers in Brazil. The company learned in focus groups that for the product to resonate with nonwhite women, its promotions had to feature women of different skin tones, excluding neither whites nor blacks. The campaign Unilever devised features three women with different skin shades at a fitness center. The bottle says the lotion is for “tan and black skin,” a description that could include many white women considering that much of the population lives near the beach. Unilever learned that the segment exists, but it is more difficult to define and requires more subtle marketing messages than the African American segment in the United States or middle-class segments in Africa.

Source: M. Jordan, “Marketers Discover Black Brazil,” The Wall Street Journal, November 24, 2000, pp. A11, A14. Copyright 2000 by Dow Jones & Co. Inc. Reproduced with permission from Dow Jones & Co. Inc. in the format textbook by the Copyright Clearance Center.

management FOCUS

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456 Part Six International Business Functions

language, religion, and education. These differences have important implications for marketing strategy. For example, “hamburgers” do not sell well in Islamic countries, where the consumption of ham is forbidden by Islamic law (the name is changed). The most impor- tant aspect of cultural differences is probably the impact of tradi- tion. Tradition is particularly important in foodstuffs and beverages. For example, reflecting differences in traditional eating habits, the Findus frozen food division of Nestlé, the Swiss food giant, markets fish cakes and fish fingers in Great Britain, but beef bourguignon and coq au vin in France and vitéllo con funghi and braviola in Italy. In addition to its normal range of products, Coca-Cola in Japan markets Georgia, a cold coffee in a can, and Aquarius, a tonic drink, both of which appeal to traditional Japanese tastes.

For historical and idiosyncratic reasons, a range of other cultural differences exist among countries. For example, scent preferences

differ from one country to another. SC Johnson, a manufacturer of waxes and polishes, encountered resistance to its lemon-scented Pledge furniture polish among older con- sumers in Japan. Careful market research revealed the polish smelled similar to a latrine disinfectant used widely in Japan. Sales rose sharply after the scent was adjusted.9

There is some evidence of the trends Levitt talked about. Tastes and preferences are becoming more cosmopolitan. Coffee is gaining ground against tea in Japan and Great Britain, while American-style frozen dinners have become popular in Europe (with some fine-tuning to local tastes). Taking advantage of these trends, Nestlé has found that it can market its instant coffee, spaghetti bolognese, and Lean Cuisine frozen din- ners in essentially the same manner in both North America and western Europe. How- ever, there is no market for Lean Cuisine dinners in most of the rest of the world, and there may not be for years or decades. Although some cultural convergence has oc- curred, particularly among the advanced industrial nations of North America and west- ern Europe, Levitt’s global culture characterized by standardized tastes and preferences is still a long way off.

ECONOMIC DEVELOPMENT Just as important as differences in culture are differences in the level of economic development. We discussed the extent of country differ- ences in economic development in Chapter 3. Consumer behavior is influenced by the level of economic development of a country. Firms based in highly developed countries such as the United States tend to build a lot of extra performance attributes into their products. These extra attributes are not usually demanded by consumers in less developed nations, where the preference is for more basic products. Thus, cars sold in less developed nations typically lack many of the features found in developed nations, such as air-conditioning, power steering, power windows, radios, and CD players. For most consumer durables, prod- uct reliability may be a more important attribute in less developed nations, where such a purchase may account for a major proportion of a consumer’s income, than it is in advanced nations.

Contrary to Levitt’s suggestions, consumers in the most developed countries are often not willing to sacrifice their preferred attributes for lower prices. Consumers in the most advanced countries often shun globally standardized products that have been developed with the lowest common denominator in mind. They are willing to pay more for products that have additional features and attributes customized to their tastes and preferences. For example, demand for top-of-the-line four-wheel-drive sport utility vehicles—such as Chrysler’s Jeep, Ford’s Explorer, and Toyota’s Land Cruiser—has been largely restricted to the United States. This is due to a combination of factors, including the high income level of U.S. consumers, the country’s vast distances, the relatively low cost of gasoline, and the culturally grounded “outdoor” theme of American life.

PRODUCT AND TECHNICAL STANDARDS Even with the forces that are creating some convergence of consumer tastes and preferences among advanced, industrialized

Coca-Cola responded to Japan’s traditional tastes with the beverage, Georgia, a cold coffee in a can.

Chapter Sixteen Global Marketing and Research and Development 457

nations, Levitt’s vision of global markets may still be a long way off because of national differences in product and tech- nological standards. However, if anything, the increased de- velopment and implementation of regional trade agreements, often taking into account technical standards setting, may influence certain regional markets to become more globalized, as Levitt suggested.

For now, differing government-mandated product stan- dards can often result in companies ruling out mass pro- duction and marketing of a fully global and standardized product. Differences in technical standards also constrain the globalization of markets. Some of these differences re- sult from idiosyncratic decisions made long ago, rather than from government actions, but their long-term effects are profound. For example, DVD equipment manufac- tured for sale in the United States will not play DVDs re- corded on equipment manufactured for sale in Great Britain, Germany, and France (and vice versa). Different technical standards for television signal frequency emerged in the 1950s that require television and video equipment to be customized to prevailing standards. RCA stumbled in the 1970s when it failed to account for this in its marketing of TVs in Asia. Although several Asian coun- tries adopted the U.S. standard, Singapore, Hong Kong, and Malaysia adopted the British standard. People who bought RCA TVs in those countries could receive a pic- ture but no sound!10

Distribution Strategy A critical element of a firm’s marketing mix is its distribution strategy: the means it chooses for delivering the product to the consumer. The way the product is delivered is determined by the firm’s entry strategy, discussed in Chapter 15. This section examines a typical distri- bution system, discusses how its structure varies between countries, and looks at how ap- propriate distribution strategies vary from country to country.

Figure 16.1 illustrates a typical distribution system consisting of a channel that includes a wholesale distributor and a retailer. If the firm manufactures its product in the particular country, it can sell directly to the consumer, to the retailer, or to the wholesaler. The same options are available to a firm that manufactures outside the country. Plus, this firm may decide to sell to an import agent, which then deals with the wholesale distributor, the re- tailer, or the consumer. Later in the chapter, we consider the factors that determine the firm’s choice of channel.

DIFFERENCES BETWEEN COUNTRIES The four main differences be- tween distribution systems worldwide are retail concentration, channel length, channel ex- clusivity, and channel quality.

Retail Concentration In some countries, the retail system is very concentrated, but it is fragmented in others. In a concentrated retail system, a few retailers supply most of the market. A fragmented retail system is one in which there are many retailers, none of which has a major share of the market. Many of the differences in concentration are rooted in history and tradition. In the United States, the importance of the automobile and the relative youth of many urban areas have resulted in a retail system centered on large stores or shopping malls to which people can drive. This has facilitated system concentration. Japan, with a much greater population density and a large number of urban centers that grew up before the automobile, has a more fragmented retail system, with many small stores

LO 16-2 Recognize why and how a firm’s distribution strategy might vary among countries.

Concentrated Retail System A retail system in which a few retailers supply most of the market.

Fragmented Retail System A retail system in which there are many retailers, no one of which has a major share of the market.

Can Spotify and Coca-Cola Leverage Their Partnership for Sales? Swedish music-streaming service Spotify has gained access to Coca-Cola’s global marketing engine, and Coca-Cola can use Spotify tunes in its online marketing. Spotify is hoping that Coke will teach the world to click its play button. The Swedish digital music service has a broad-ranging marketing deal with Coca-Cola Co. that could help turbocharge the number of people who are exposed to, and ultimately sign up for, Spotify. For Spotify, getting access to Coca-Cola’s formidable global marketing engine will come in handy as it expands its international footprint. In return, Coca-Cola can now use Spotify’s service to instantly add music to its online marketing repertoire. For instance, the drink giant can add songs to its Face- book page via Spotify without having to negotiate licenses for each tune (Spotify already has financial agreements with major record labels to pay royalties for every song that is played on its digital service). These co-branding deals sometimes motivate customers to buy more from each company—if you are a fan of Spotify, you may buy more from Coca-Cola and vice versa. If your favorite com- pany co-branded with a company you have never bought from, would you try that company’s products?

Sources: A. Pham, “Spotify and Coca-Cola Form Marketing Partnership,” Los Angeles Times, April 18, 2012; “Spotify and Coca-Cola Partner to Share Music with the World,” Spotify Press Release, http://press.spotify.com/no/2012/04/18/ spotify-and-coca-cola-partner, April 18, 2012.

458 Part Six International Business Functions

serving local neighborhoods and to which people frequently walk. In addition, the Japanese legal system protects small retailers. Small retailers can try to block the establishment of a large retail outlet by petitioning their local government.

There is a tendency for greater retail concentration in developed countries. Three fac- tors that contribute to this are the increases in car ownership, the number of households with refrigerators and freezers, and the number of two-income households. All these fac- tors have changed shopping habits and facilitated the growth of large retail establish- ments sited away from traditional shopping areas. The last decade has seen consolidation in the global retail industry, with companies such as Walmart and Carrefour attempting to become global retailers by acquiring retailers in different countries. This has increased retail concentration.

In contrast, retail systems are very fragmented in many developing countries, which can make for interesting distribution challenges. In rural China, large areas of the coun- try can be reached only by traveling rutted dirt roads. In India, Unilever has to sell to retailers in 600,000 rural villages, many of which cannot be accessed via paved roads, which means products can reach their destination only by bullock, bicycle, or cart. In neighboring Nepal, the terrain is so rugged that even bicycles and carts are not practical, and businesses rely on yak trains and the human back to deliver products to thousands of small retailers.

Channel Length Channel length refers to the number of intermediaries between the producer (or manufacturer) and the consumer. If the producer sells directly to the consumer, the channel is very short. If the producer sells through an import agent, a wholesaler, and a retailer, a long channel exists. The choice of a short or long channel is, in part, a strategic decision for the producing firm. However, some countries have longer distribution channels than others. The most important determinant of channel length is the degree to which the retail system is fragmented. Fragmented retail systems tend to promote the growth of wholesalers to serve retailers, which lengthens channels.

The more fragmented the retail system, the more expensive it is for a firm to make con- tact with each individual retailer. Imagine a firm that sells toothpaste in a country where there are more than a million small retailers, as in rural India. To sell directly to the retailers, the firm would have to build a huge sales force. This would be very expensive, particularly because each sales call would yield a very small order. But suppose a few hundred wholesalers

Channel Length The number of intermediaries that a product has to go through before it reaches the final consumer.

16.1 FIGURE A Typical Distribution System

Manufacturer Inside the Country

Wholesale Distributor

Manufacturer Outside the Country

Retail Distributor

Final Customer

Import Agent

Chapter Sixteen Global Marketing and Research and Development 459

in the country supply retailers not only with toothpaste but also with all other personal care and household products. Because these wholesalers carry a wide range of products, they get bigger orders with each sales call, making it worthwhile for them to deal directly with the retailers. Accordingly, it makes economic sense for the firm to sell to the wholesalers and the wholesalers to deal with the retailers.

Because of such factors, countries with fragmented retail systems also tend to have long channels of distribution, sometimes with multiple layers. The classic example is Japan, where there are often two or three layers of wholesalers between the firm and retail outlets. In countries such as Great Britain, Germany, and the United States, where the retail systems are far more concentrated, channels are much shorter. When the retail sector is very con- centrated, it makes sense for the firm to deal directly with retailers, cutting out wholesalers. A relatively small sales force is required to deal with a concentrated retail sector, and the orders generated from each sales call can be large. Such circumstances tend to prevail in the United States, where large food companies may sell directly to supermarkets rather than going through wholesale distributors.

Another factor that is shortening channel length in some countries is the entry of large discount superstores, such as Carrefour, Walmart, and Tesco. The business model of these retailers is, in part, based on the idea that in an attempt to lower prices, they cut out whole- salers and instead deal directly with manufacturers. Thus, when Walmart entered Mexico, its policy of dealing directly with manufacturers, instead of buying merchandise through wholesalers, helped shorten distribution channels in that nation. Similarly, Japan’s histori- cally long distribution channels are now being shortened by the rise of large retailers, some of them foreign-owned, such as Toys “R” Us and Walmart, and some of them indigenous enterprises that are imitating the American model, all of which are progressively cutting out wholesalers and dealing directly with manufacturers.

Channel Exclusivity An exclusive distribution channel is one that is difficult for outsiders to access. For example, it is often difficult for a new firm to get access to shelf space in supermarkets. This occurs because retailers tend to prefer to carry the products of established manufacturers of foodstuffs with national reputations rather than gamble on the products of unknown firms. The exclusivity of a distribution system varies among countries. Japan’s system is often held up as an example of a very exclusive system. In Japan, relation- ships among manufacturers, wholesalers, and retailers often go back decades. Many of these relationships are based on the understanding that distributors will not carry the products of competing firms. In return, the distributors are guaranteed an attractive markup by the manufacturer. As many U.S. and European manufacturers have learned, the close ties that result from this arrangement can make access to the Japanese market difficult. However, it is possible to break into the Japanese market with a new consumer product. Procter & Gamble did during the 1990s with its Joy brand of dish soap. P&G was able to overcome a tradition of exclusivity for two reasons. First, after two decades of lackluster economic per- formance, Japan is changing. In their search for profits, retailers are far more willing than they have been historically to violate the old norms of exclusivity. Second, P&G has been in Japan long enough and has a broad enough portfolio of consumer products to give it consid- erable leverage with distributors, enabling it to push new products out through the distribu- tion channel.

Channel Quality Channel quality refers to the expertise, competencies, and skills of established retailers in a nation and their ability to sell and support the products of interna- tional businesses. Although the quality of retailers is good in most developed nations, in emerging markets and less developed nations from Russia to Indonesia, channel quality is variable at best. The lack of a high-quality channel may impede market entry, particularly in the case of new or sophisticated products that require significant point-of-sale assistance and after-sales services and support. When channel quality is poor, an international busi- ness may have to devote considerable attention to upgrading the channel, for example, by providing extensive education and support to existing retailers and, in extreme cases, by establishing its own channel. Thus, after pioneering its Apple retail store concept in the

Exclusive Distribution Channel A distribution channel that outsiders find difficult to access.

Channel Quality The expertise, competencies, and skills of established retailers in a nation and their ability to sell and support the products of international businesses.

460 Part Six International Business Functions

United States, Apple opened retail stores in several nations—including the United Kingdom, France, Germany, Japan, and China—to provide point-of-sales education, service, and support for its popular iPod, iPad, iPhone, and iMac products. Apple believes that this strategy will help it gain market share in these nations.

CHOOSING A DISTRIBUTION STRATEGY A choice of distribution strategy determines which chan- nel the firm will use to reach potential consumers. Should the firm try to sell directly to the consumer? Or should it go through retailers, go through a wholesaler, use an import agent, or invest in establishing its own channel? The optimal strategy is determined by the rela- tive costs and benefits of each alternative, which vary from country to country, depending on the four factors we have just discussed: retail concentration, channel length, channel exclusivity, and channel quality.

Because each intermediary in a channel adds its own markup to the products, there is generally a critical link among channel length, the final selling price, and the firm’s profit margin. The longer a channel, the greater the aggregate markup, and the higher the price that con- sumers are charged for the final product. To ensure that prices do not get too high as a result of markups by mul- tiple intermediaries, a firm might be forced to operate with lower profit margins. Thus, if price is an important competitive weapon, and if the firm does not want to see its profit margins squeezed, other things being equal, the

firm would prefer to use a shorter channel. However, the benefits of using a longer channel may outweigh these drawbacks. As we

have seen, one benefit of a longer channel is that it cuts selling costs when the retail sector is very fragmented. Thus, it makes sense for an international business to use longer channels in countries where the retail sector is fragmented and shorter channels in countries where the retail sector is concentrated. Another benefit of using a longer channel is market access—the ability to enter an exclusive channel. Import agents may have long-term rela- tionships with wholesalers, retailers, or important consumers and thus be better able to win orders and get access to a distribution system. Similarly, wholesalers may have long-standing relationships with retailers and be better able to persuade them to carry the firm’s product than the firm itself would.

Import agents are not limited to independent trading houses; any firm with a strong local reputation could serve as well. For example, to break down channel exclusivity and gain greater access to the Japanese market, when Apple Computer originally entered Japan, it signed distribution agreements with five large Japanese firms, including busi- ness equipment giant Brother Industries, stationery leader Kokuyo, Mitsubishi, Sharp, and Minolta. These firms use their own long-established distribution relationships with consumers, retailers, and wholesalers to push Apple computers through the Japanese distribution system. Today, Apple has supplemented this strategy with its own stores in the country.

If such an arrangement is not possible, the firm might want to consider other, less tradi- tional alternatives to gaining market access. Frustrated by channel exclusivity in Japan, some foreign manufacturers of consumer goods have attempted to sell directly to Japanese con- sumers using direct mail and catalogs. Finally, if channel quality is poor, a firm should con- sider what steps it could take to upgrade the quality of the channel, including establishing its own distribution channel.

Is the Google Advertising Model Viable in the Long Term? Google’s share of the Internet ads is at about 33 percent of the $117 billion market, making it the undisputed Goliath of online advertising. Google also continues to grow, thanks to acquisi- tions like DoubleClick, YouTube, and even drone company Titan Aerospace. Facebook is solidly in the number 2 spot in Internet ads but is gaining market share (it has about 5 percent of the online ad market). Google is also a heavyweight in mobile ads with about 56 percent of the $16 billion market (Facebook has about 13 percent of this market). Research experts predict that new ad dollars will come from emerging markets such as China, Russia, and Indonesia. Over the next three years, about half of all global ad growth will come from 10 developing markets—with Brazil, Russia, India, and China combined accounting for 33 per- cent. Currently, there are four markets in which Internet ads ac- count for more than 30 percent of total spending: Canada, Norway, Sweden, and the United Kingdom. Basically, the world is shifting its ad spending to the Internet and similar options. With that in mind, where can global companies reach you via adver- tisements if they wanted to target you? And, do you think the Google advertisement business model is viable as a way to reach customers for the long term?

Source: A. Efrati, “In Online Ads, There’s Google—and Then Everybody Else,” The Wall Street Journal, June 13, 2013.

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Communication Strategy Another critical element in the marketing mix is communicating the attributes of the prod- uct to prospective customers. A number of communication channels are available to a firm, including direct selling, sales promotion, direct marketing, and advertising. A firm’s com- munication strategy is partly defined by its choice of channel. Some firms rely primarily on direct selling, others on point-of-sale promotions or direct marketing, and others on mass advertising; still others use several channels simultaneously to communicate their message to prospective customers. This section looks first at the barriers to international communi- cation. Then, we survey the various factors that determine which communication strategy is most appropriate in a particular country. After that, we discuss global advertising.

BARRIERS TO INTERNATIONAL COMMUNICATION International communication occurs whenever a firm uses a marketing message to sell its products in an- other country. The effectiveness of a firm’s international communication can be jeopardized by three potentially critical variables: cultural barriers, source effects, and noise levels.

Cultural Barriers Cultural barriers can make it difficult to communicate messages across cultures. We discussed some sources and consequences of cultural differences be- tween nations in Chapter 4 and in the previous section of this chapter. Because of cultural differences, a message that means one thing in one country may mean something quite dif- ferent in another. Benetton, the Italian clothing manufacturer and retailer, ran into cultural problems with its advertising. The company launched a worldwide advertising campaign with the theme “United Colors of Benetton” that had won awards in France. One of its ads featured a black woman breast-feeding a white baby, and another one showed a black man and a white man handcuffed together. Benetton was surprised when the ads were attacked by U.S. civil rights groups for promoting white racial domination. Benetton withdrew its ads and fired its advertising agency, Eldorado of France.

The best way for a firm to overcome cultural barriers is to develop cross-cultural literacy (see Chapter 4). In addition, it should use local input, such as a local advertising agency, in developing its marketing message. If the firm uses direct selling rather than advertising to communicate its message, it should develop a local sales force whenever possible. Cultural differences limit a firm’s ability to use the same marketing message and selling approach worldwide. What works well in one country may be offensive in another.

Source and Country of Origin Effects Source effects occur when the receiver of the message (the potential consumer in this case) evaluates the message on the basis of status or image of the sender. Source effects can be damaging for an international business when potential consumers in a target country have a bias against foreign firms. For example, a wave of “Japan bashing” swept the United States in the early 1990s. Worried that U.S. consumers might view its products negatively, Honda responded by creating ads that em- phasized the U.S. content of its cars to show how “American” the company had become.

Many international businesses try to counter negative source effects by deemphasizing their foreign origins. When the French antiglobalization protester José Bové was hailed as a hero by some in France for razing a partly built McDonald’s in 1999, the French franchisees of McDonald’s responded with an ad depicting a fat, ignorant American who could not un- derstand why McDonald’s France used locally produced food that wasn’t genetically modi- fied. The edgy ad worked, and McDonald’s French operations are now among the most robust in the company’s global network.11

A subset of source effects is referred to as country of origin effects, or the extent to which the place of manufacturing influences product evaluations. Research suggests that the consumer may use country of origin as a cue when evaluating a product, particularly if he or she lacks more detailed knowledge of the product. For example, one study found that Japanese consumers tended to rate Japanese products more favorably than U.S. products across multiple dimensions, even when independent analysis showed that they were actually inferior.12 When a negative country of origin effect exists, an international business may

LO 16-3 Identify why and how advertising and promotional strategies might vary among countries.

Source Effects Effects that occur when the receiver of the message (i.e. a potential consumer) evaluates the message on the basis of status or image of the sender.

Country of Origin Effects A subset of source effects, or the extent to which the place of manufacturing influences product evaluations.

462 Part Six International Business Functions

have to work hard to counteract this effect by, for example, using promotional messages that stress the positive performance attributes of its product.

Source effects and country of origin effects are not always negative. French wine, Italian clothes, and German luxury cars benefit from nearly universal positive source effects. In such cases, it may pay a firm to emphasize its foreign origins.

Noise Levels Noise tends to reduce the probability of effective communication. Noise refers to the amount of other messages competing for a potential consumer’s attention, and this too varies across countries. In highly developed countries such as the United States, noise is extremely high. Fewer firms vie for the attention of prospective customers in devel- oping countries; thus the noise level is lower.

PUSH VERSUS PULL STRATEGIES The main decision with regard to com- munications strategy is the choice between a push strategy and a pull strategy. A push strategy emphasizes personal selling rather than mass media advertising in the promotional mix. Although effective as a promotional tool, personal selling requires intensive use of a sales force and is relatively costly. A pull strategy depends more on mass media advertising to communicate the marketing message to potential consumers.

Although some firms employ only a pull strategy and others only a push strategy, still other firms combine direct selling with mass advertising to maximize communication ef- fectiveness. Factors that determine the relative attractiveness of push and pull strategies in- clude product type relative to consumer sophistication, channel length, and media availability.

Product Type and Consumer Sophistication Firms in consumer goods in- dustries that are trying to sell to a large segment of the market generally favor a pull strat- egy. Mass communication has cost advantages for such firms; thus they rarely use direct selling. Exceptions can be found in poorer nations with low literacy levels, where direct selling may be the only way to reach consumers (see the Management Focus on Unilever). Firms that sell industrial products or other complex products favor a push strategy. Direct selling allows the firm to educate potential consumers about the features of the product. This may not be necessary in advanced nations where a complex product has been in use for some time, where the product’s attributes are well understood, where consumers are sophisticated, and where high-quality channels exist that can provide point-of-sale assis- tance. However, customer education may be important when consumers have less sophisti- cation toward the product, which can be the case in developing nations or in advanced nations when a new complex product is being introduced, or where high-quality channels are absent or scarce.

Channel Length The longer the distribution channel, the more intermediaries there are that must be persuaded to carry the product for it to reach the consumer. This can lead to inertia in the channel, which can make entry difficult. Using direct selling to push a prod- uct through many layers of a distribution channel can be expensive. In such circumstances, a firm may try to pull its product through the channels by using mass advertising to create consumer demand—once demand is created, intermediaries will feel obliged to carry the product.

In Japan, products often pass through two, three, or even four wholesalers before they reach the final retail outlet. This can make it difficult for foreign firms to break into the Japanese market. Not only must the foreign firm persuade a Japanese retailer to carry its product, but it may also have to persuade every intermediary in the chain to carry the prod- uct. Mass advertising may be one way to break down channel resistance in such circum- stances. However, in countries such as India, which has a very long distribution channel to serve its massive rural population, mass advertising may not work because of low literacy levels, in which case the firm may need to fall back on direct selling or rely on the goodwill of distributors (see the Management Focus on Unilever).

Noise The amount of other messages competing for a potential consumer’s attention.

Push Strategy A marketing strategy emphasizing personal selling rather than mass media advertising.

Pull Strategy A marketing strategy emphasizing mass media advertising as opposed to personal selling.

Chapter Sixteen Global Marketing and Research and Development 463

Unilever—Selling to India’s Poor

One of the world’s largest and oldest consumer products companies, Unilever has long had a substantial presence in many of the world’s poorer nations, such as India. Outside major urban areas, low income, unsophisticated consumers, illiteracy, fragmented retail distribution systems, and the lack of paved roads have made for difficult marketing challenges. Despite this, Unilever has built a significant presence among impoverished rural populations by adopting innovative selling strategies.

India’s large rural population is dispersed among some 600,000 villages, more than 500,000 of which cannot be reached by a motor vehicle. Some 91 percent of the rural population lives in villages of fewer than 2,000 people, and of necessity, rural retail stores are very small and carry limited stock. The population is desperately poor, making perhaps a dollar a day, and two-thirds of that income is spent on food, leaving about 30 cents a day for other items. Literacy levels are low, and TVs are rare, making traditional media ineffective. Despite these drawbacks, Hindustan Lever, Unilever’s Indian subsidiary, has made a concerted effort to reach the rural poor. Although the revenues generated from rural sales are small, Unilever hopes that as the country develops and income levels rise, the population will continue to purchase the Unilever brands that they are familiar with, giving the company a long-term competitive advantage.

To contact rural consumers, Hindustan Lever tries to establish a physical presence wherever people frequently gather in numbers. This means ensuring that advertisements are seen in places where people

congregate and make purchases, such as at village wells and weekly rural markets, and where they consume products, such as at river- banks where people gather to wash their clothes using (the company hopes) Unilever soap. It is not uncommon to see the village well plas- tered with advertisements for Unilever products. The company also takes part in weekly rural events, such as market day, at which farm produce is sold and family provisions purchased. Hindustan Lever salespeople will visit these gatherings, display their products, explain how they work, give away some free samples, make a few sales, and seed the market for future demand.

The backbone of Hindustan Lever’s selling effort, however, is a rural distribution network that encompasses 100 factories, 7,500 dis- tributors, and an estimated 3 million retail stores, many of which are little more than a hole in a wall or a stall at a market. The total stock of Unilever products in these stores may be no more than a few sa- chets of shampoo and half a dozen bars of soap. A depot in each of India’s states feeds products to major wholesalers, which then sell directly to retailers in thousands of small towns and villages that can be reached by motor vehicles. If access via motor vehicles is not pos- sible, the major wholesalers sell to smaller second-tier wholesalers, which then handle distribution to India’s 500,000 inaccessible rural villages, reaching them by bicycle, bullock cart, or baskets carried on a human back.

Sources: K. Merchant, “Striving for Success—One Sachet at a Time,” Financial Times, December 11, 2000, p. 14; M. Turner, “Bicycle Brigade Takes Unilever to the People,” Financial Times, August 17, 2000, p. 8; “Brands Thinking Positively,” Brand Strategy, December 2003, pp. 28–29; and “The Legacy That Got Left on the Shelf,” The Economist, February 2, 2008, pp. 77–79.

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An ad for Lux soap sits in front of a vegetable seller in Mumbai, India.

464 Part Six International Business Functions

Media Availability A pull strategy relies on access to advertising media. In the United States, a large num- ber of media are available, including print media (news- papers and magazines), broadcasting media (television and radio), and the Internet. The rise of cable television in the United States has facilitated extremely focused ad- vertising (e.g., MTV for teens and young adults, Life- time for women, ESPN for sports enthusiasts). The same is true of the Internet, with different websites attracting different kinds of users, and companies such as Google transforming the ability of companies to do targeted ad- vertising. While this level of media sophistication is now found in many other developed countries, it is still not universal. Even many advanced nations have far fewer electronic media available for advertising than the United States. In Scandinavia, for example, no commer- cial television or radio stations existed until recently; all electronic media were state owned and carried no com- mercials, although this has now changed with the advent of satellite television deregulation. In many developing nations, the situation is even more restrictive because mass media of all types are typically more limited. A firm’s ability to use a pull strategy is limited in some countries by media availability. In such circumstances, a push strategy is more attractive. For example, Unilever

uses a push strategy to sell consumer products in rural India, where few mass media are available (see the Management Focus).

Media availability is limited by law in some cases. Few countries allow advertisements for tobacco and alcohol products on television and radio, though they are usually permit- ted in print media. When the leading Japanese whiskey distiller, Suntory, entered the U.S. market, it had to do so without television, its preferred medium. The firm spends about $50 million annually on television advertising in Japan. Similarly, while advertising phar- maceutical products directly to consumers is allowed in the United States, it is prohibited in many other advanced nations. In such cases, pharmaceutical firms must rely heavily on advertising and direct-sales efforts focused explicitly at doctors to get their products pre- scribed.

The Push–Pull Mix The optimal mix between push and pull strategies depends on product type and consumer sophistication, channel length, and media sophistication. Push strategies tend to be emphasized:

• For industrial products or complex new products. • When distribution channels are short. • When few print or electronic media are available. Pull strategies tend to be emphasized: • For consumer goods. • When distribution channels are long. • When sufficient print and electronic media are available to carry the marketing

message.

GLOBAL ADVERTISING In recent years, largely inspired by the work of visionaries such as Theodore Levitt, there has been much discussion about the pros and cons of standardizing advertising worldwide.13 One of the most successful standardized campaigns in history was Philip Morris’s promotion of Marlboro cigarettes. The cam- paign was instituted in the 1950s, when the brand was repositioned, to assure smokers that the flavor would be unchanged by the addition of a filter. The campaign theme of “Come

Is iPhone the Next BlackBerry? BlackBerry accounted for less than half a percentage point of sales in the United States in the last quarter of 2013, down from its dominating position as the market leader just a few years ago. The rise of Apple and Samsung in the mobile phone market has made BlackBerry nearly irrelevant. At the same time, Apple is in a fierce battle against Android and Windows-based phones. Apple’s smartphone market share has steadily declined in the global marketplace. Apple has also traditionally maintained higher prices for the iPhone by leveraging its brand value and gaining maximum profits during the process. Analysts believe that Apple could gain by showing some price flexibility on the iPhone, especially for weaker economies. Another initiative that Apple could take is to come up with a cheaper iPhone with lower specifications than the current iPhones. Where will Apple’s iPhone be by the year 2020? Will it still be a strong force in the mobile phone market, or will it be the next BlackBerry?

Sources: S. Rodriguez, “BlackBerry Accounts for Less Than 0.5% of Smartphone Sales,” Los Angeles Times, January 31, 2014; J. Pepitone, “New BlackBerry CEO Optimistic Despite Loss,” CNNMoney, December 30, 2013; and L. Whitney, “iPhone Market Share Shrinks as Android, Windows Phone Grow,” CNET, January 6, 2014.

Chapter Sixteen Global Marketing and Research and Development 465

to where the flavor is: Come to Marlboro country” was a worldwide success. Marlboro built on this when it introduced “the Marlboro man,” a rugged cowboy smoking his Marlboro while riding his horse through the great outdoors. This ad proved successful in almost every major market around the world, and it helped propel Marlboro to the top of the world market.

For Standardized Advertising The support for global advertising is threefold. First, it has significant economic advantages. Standardized advertising lowers the costs of value creation by spreading the fixed costs of developing the advertisements over many countries. For example, Coca-Cola’s advertising agency, McCann Erickson, claims to have saved Coca-Cola more than $100 million over 20 years by using certain elements of its cam- paigns globally.

Second, there is the concern that creative talent is scarce, so one large effort to de- velop a campaign will produce better results than 40 or 50 smaller efforts. A third justifi- cation for a standardized approach is that many brand names are global. With the substantial amount of international travel today and the considerable overlap in media across national borders, many international firms want to project a single brand image to avoid confusion caused by local campaigns. This is particularly important in regions such as western Europe, where travel across borders is almost as common as travel across state lines in the United States.

Against Standardized Advertising There are two main arguments against globally standardized advertising. First, as we have seen repeatedly in this chapter and in Chapter 4, cultural differences among nations are such that a message that works in one nation can fail miserably in another. Cultural diversity makes it extremely difficult to develop a single advertising theme that is effective worldwide. Messages directed at the culture of a given country may be more effective than global messages.

Second, advertising regulations may block implementation of standardized advertising. For example, Kellogg could not use a television commercial it produced in Great Britain to promote its cornflakes in many other European countries. A reference to the iron and vita- min content of its cornflakes was not permissible in the Netherlands, where claims relating to health and medical benefits are outlawed. A child wearing a Kellogg T-shirt had to be edited out of the commercial before it could be used in France because French law forbids the use of children in product endorsements. The key line “Kellogg’s makes their cornflakes the best they have ever been” was disallowed in Germany because of a prohibition against competitive claims.14

Dealing with Country Differences Some firms are experimenting with captur- ing some benefits of global standardization while recognizing differences in countries’ cultural and legal environments. A firm may select some features to include in all its ad- vertising campaigns and localize other features. By doing so, it may be able to save on some costs and build international brand recognition and yet customize its advertisements to different cultures.

Nokia, the Finnish cell phone manufacturer, has tried to do this. Historically, Nokia had used a different advertising campaign in different markets. In 2004, however, the company launched a global advertising campaign that used the slogan “1001 reasons to have a Nokia imaging phone.” Nokia did this to reduce advertising costs, capture some economies of scale, and establish a consistent global brand image. At the same time, Nokia tweaked the advertisements for different cultures. The campaign used actors from the region where the ad ran to reflect the local population, though they said the same lines. Local settings were also modified when showcasing the phones by, for example, using a marketplace when ad- vertising in Italy or a bazaar when advertising in the Middle East.15 Another example of this process is given in the accompanying Management Focus, which looks at how Unile- ver built a global brand for its Dove products while still tweaking the message to consider local sensibilities.

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466 Part Six International Business Functions

Pricing Strategy International pricing strategy is an important component of the overall international mar- keting mix.16 This section looks at three aspects of international pricing strategy. First, we examine the case for pursuing price discrimination, charging different prices for the same product in different countries. Second, we look at what might be called strategic pricing. Third, we review regulatory factors, such as government-mandated price controls and antidumping regulations that limit a firm’s ability to charge the prices it would prefer in a country.

PRICE DISCRIMINATION Price discrimination exists whenever consumers in different countries are charged different prices for the same product, or for slightly different variations of the product.17 Price discrimination involves charging whatever the market will bear; in a competitive market, prices may have to be lower than in a market where the firm has a monopoly. Price discrimination can help a company maximize its profits. It makes economic sense to charge different prices in different countries.

LO 16-4 Explain why and how a firm’s pricing strategy might vary among countries.

Dove’s Global “Real Beauty” Campaign

In 2003, Dove was not a beauty brand; it was a bar of soap that was positioned and sold differently in different markets. Unilever, the company that marketed Dove, was a storied consumer product mul- tinational with global reach, had a strong position in fast-growing developing nations, and had a reputation for customizing products to conditions prevailing in local markets. In India, for example, women often oil their hair before washing it, so Western shampoos that do not remove the oil have not sold well. Unilever reformulated its sham- poo for India and was rewarded with market leadership. But some- times Unilever went too far. It used different formulations for shampoo in Hong Kong and mainland China, for example, even though hair and washing habits were very similar in both markets. Unilever would also often vary the packaging and marketing message in similar products, even for its most commoditized products. The company tended to exaggerate complexity, and by 2003 its financial perfor- mance was suffering.

A decade later, Unilever’s financial performance has improved, in no small part because it has shifted toward a more global emphasis, and the Dove brand has led the way. The Dove story dates to 2003 when the global brand director, Silvia Lagnado, who was based in New York, decided to move the positioning of Dove from one based on the product to one of an entire beauty brand. The basic message: The brand should stand for the real beauty of all women. Dove’s mission was to make women feel more beautiful every day by widening the stereotypical definition of beauty and inspiring them to take care of themselves.

But how was this mission to be executed? Following a series of workshops held around the globe that asked brand managers and ad- vertising agency partners to find ways to communicate an inclusive definition of beauty, the Canadian brand manager asked 67 female photographers to submit work that best reflects real beauty. The photo- graphs are stunning portraits not of models, but of women from all walks of life that come in all shapes, sizes, and ages. It led to a coffee table book and traveling exhibition, called the Dove Photo Tour, which

garnered a lot of positive press in Canada. Silvia Lagnado realized that the Canadians were on to something. Around the same time, the German office of Unilever’s advertising agency, Ogilvy and Mather Worldwide, came up with a concept for communicating “real beauty” based on photographs showing, instead of skinny models, ordinary women in their underwear. The original German advertisements quickly made their way to the United Kingdom, where a London newspaper article stated the campaign was not advertising; it was politics. Lagnado was not surprised by this. She had commissioned research that revealed only 2 percent of women worldwide considered them- selves beautiful and that half thought their weight was too high.

In 2004, the “Dove Campaign for Real Beauty” was launched glob- ally. This was a radical shift for Unilever and the Dove brand, which until then had left marketing in the hands of local brand managers. The Real Beauty campaign was tweaked to take local sensibilities into ac- count. For example, it was deemed better not to show women touching each other in America, while in Latin America tactile women do not shock anybody, so touching was seen as OK.

In 2005, the campaign was followed by the launch of the Dove “self-esteem fund,” a worldwide campaign to persuade girls and young women to embrace a more positive image of themselves. Unilever also made an online video, loaded onto YouTube, called Onslaught, which was critical of the beauty industry and ended with the slogan, “Talk to your daughter before the beauty industry does.” Another video, Evolu- tion, showed how the face of a girl can be changed, partly through computer graphics, to create an image of beauty. The video ended with the tag line, “No wonder our perception of beauty is distorted.” Made for very little money, the YouTube videos created a viral buzz around the campaign that helped transform Dove into one of Unilever’s leading brands. By its use of such techniques, the campaign has become a model for how to revitalize and build a new global brand.

Sources: “The Legacy That Got Left on the Shelf,” The Economist, February 2, 2008, pp. 77–79; R. Rothenberg, “Dove Effort Gives Package-Goods Marketers Lessons for the Future,” Advertising Age, March 5, 2007, p. 18; J. Neff, “A Real Beauty: Dove’s Viral Makes Big Splash for No Cash,” Advertising Age, 2006, pp. 1–2; and K. Mazurkewich, “Dove Story: You Know the Name, and Some of the Story,” Strategy, January 2007, pp. 37–39.

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Chapter Sixteen Global Marketing and Research and Development 467

Two conditions are necessary for profitable price discrimination. First, the firm must be able to keep its national markets separate. If it cannot do this, individuals or businesses may undercut its attempt at price discrimination by engaging in arbitrage. Arbitrage occurs when an individual or business capitalizes on a price differential for a firm’s product between two countries by purchasing the product in the country where prices are lower and reselling it in the country where prices are higher. For example, many automobile firms have long prac- ticed price discrimination in Europe. A Ford Escort once cost $2,000 more in Germany than it did in Belgium. This policy broke down when car dealers bought Escorts in Belgium and drove them to Germany, where they sold them at a profit for slightly less than Ford was selling Escorts in Germany. To protect the market share of its German auto dealers, Ford had to bring its German prices into line with those being charged in Belgium. Ford could not keep these markets separate, unlike in Britain where the need for right-hand-drive cars keep the market separate from the rest of Europe.

The second necessary condition for profitable price discrimination is different price elas- ticities of demand in different countries. The price elasticity of demand is a measure of the responsiveness of demand for a product to change in price. Demand is said to be elastic when a small change in price produces a large change in demand; it is said to be inelastic when a large change in price produces only a small change in demand. Figure 16.2 illus- trates elastic and inelastic demand curves. Generally, a firm can charge a higher price in a country where demand is inelastic.

The elasticity of demand for a product in a given country is determined by a number of factors, of which income level and competitive conditions are the two most important. Price elasticity tends to be greater in countries with low income levels. Consumers with limited incomes tend to be very price conscious; they have less to spend, so they look much more closely at price. Thus, price elasticity for products such as personal computers is greater in countries such as India, where a PC is still a luxury item, than in the United States, where it is now considered a necessity. The same is true of the software that resides on those PCs; thus, to sell more software in India, Microsoft has had to introduce low-priced versions of its products into that market, such as Windows Starter Edition.

In general, the more competitors there are, the greater consumers’ bargaining power will be and the more likely consumers will be to buy from the firm that charges the lowest price. Thus, many competitors cause high elasticity of demand. In such circumstances, if a firm raises its prices above those of its competitors, consumers will switch to the competitors’ products. The opposite is true when a firm faces few competitors. When competitors are limited, consumers’ bargaining power is weaker, and price is less important as a competitive weapon. Thus, a firm may charge a higher price for its product in a country where competi- tion is limited than in one where competition is intense.

Price Elasticity of Demand A measure of how responsive demand for a product is to changes in price.

Elastic A small change in price produces a large change in demand.

Inelastic When a large change in price produces only a small change in demand.

16.2 FIGURE Elastic and Inelastic Demand Curves

Inelastic Demand Curve

Elastic Demand Curve

Output

468 Part Six International Business Functions

STRATEGIC PRICING The concept of strategic pricing has three aspects, which we refer to as predatory pricing, multipoint pricing, and experience curve pricing. Both predatory pricing and experience curve pricing may violate antidumping regulations. After we review predatory and experience curve pricing, we will look at antidumping rules and other regulatory policies.

Predatory Pricing Predatory pricing is the use of price as a competitive weapon to drive weaker competitors out of a national market. Once the competitors have left the market, the firm can raise prices and enjoy high profits. For such a pricing strategy to work, the firm must normally have a profitable position in another national market, which it can use to subsi- dize aggressive pricing in the market it is trying to monopolize. Historically, many Japanese firms were accused of pursuing such a policy. The argument ran like this: Because the Japanese market was protected from foreign competition by high informal trade barriers, Japanese firms could charge high prices and earn high profits at home. They then used these profits to subsi- dize aggressive pricing overseas, with the goal of driving competitors out of those markets. Once this had occurred, so it is claimed, the Japanese firms then raised prices. Matsushita was accused of using this strategy to enter the U.S. TV market. As one of the major TV producers in Japan, Matsushita earned high profits at home. It then used these profits to subsidize the losses it made in the United States during its early years there, when it priced low to increase its market penetration. Ultimately, Matsushita became the world’s largest manufacturer of TVs.18

Multipoint Pricing Strategy Multipoint pricing becomes an issue when two or more international businesses compete against each other in two or more national mar- kets. Multipoint pricing was an issue for Kodak and Fujifilm because the companies long competed against each other around the world in the market for silver halide film.19 Multipoint pricing refers to the fact that a firm’s pricing strategy in one market may have an impact on its rivals’ pricing strategy in another market. Aggressive pricing in one market may elicit a competitive response from a rival in another market. For example, Fuji launched an aggressive competitive attack against Kodak in the U.S. company’s home market in January 1997, cutting prices on multiple-roll packs of 35mm film by as much as 50 percent.20 This price cutting resulted in a 28 percent increase in shipments of Fuji color film during the first six months of 1997, while Kodak’s shipments dropped by 11 percent. This attack created a dilemma for Kodak; the company did not want to start price discounting in its largest and most profitable market. Kodak’s response was to aggressively cut prices in Fuji’s largest market, Japan. This strategic response recognized the interdependence between Kodak and Fuji and the fact that they compete against each other in many different nations. Fuji responded to Kodak’s counterattack by pulling back from its aggressive stance in the United States.

The Kodak story illustrates an important aspect of multipoint pricing: Aggressive pricing in one market may elicit a response from rivals in another market. The firm needs to con- sider how its global rivals will respond to changes in its pricing strategy before making those changes. A second aspect of multipoint pricing arises when two or more global companies focus on particular national markets and launch vigorous price wars in those markets in an attempt to gain market dominance. In Brazil’s market for disposable diapers, two U.S. com- panies, Kimberly-Clark and Procter & Gamble, entered a price war as each struggled to establish dominance in the market.21 As a result, over three years the cost of disposable dia- pers fell from $1 per diaper to 33 cents per diaper, while several other competitors, includ- ing indigenous Brazilian firms, were driven out of the market. Kimberly-Clark and Procter & Gamble are engaged in a global struggle for market share and dominance, and Brazil is one of their battlegrounds. Both companies can afford to engage in this behavior, even though it reduces their profits in Brazil, because they have profitable operations else- where in the world that can subsidize these losses.

Pricing decisions around the world need to be centrally monitored. It is tempting to del- egate full responsibility for pricing decisions to the managers of various national subsidiaries, thereby reaping the benefits of decentralization. However, because pricing strategy in one

Strategic Pricing The concept containing the three aspects: predatory pricing, multipoint pricing, and experience curve pricing.

Predatory Pricing Reducing prices below fair market value as a competitive weapon to drive weaker competitors out of the market (“fair” being cost plus some reasonable profit margin).

Multipoint Pricing Occurs when a pricing strategy in one market may have an impact on a rival’s pricing strategy in another market.

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part of the world can elicit a competitive response in another, central management needs to at least monitor and approve pricing decisions in a given national market, and local managers need to recognize that their actions can affect competitive conditions in other countries.

Experience Curve Pricing We first encountered the experience curve in Chapter 13. As a firm builds its accumulated production volume over time, unit costs fall due to experi- ence effects. Learning effects and economies of scale underlie the experience curve. Price comes into the picture because aggressive pricing (along with aggressive promotion and advertising) can build accumulated sales volume rapidly and thus move production down the experience curve. Firms farther down the experience curve have a cost advantage vis-à-vis those farther up the curve.

Many firms pursuing an experience curve pricing strategy on an international scale will price low worldwide in attempting to build global sales volume as rapidly as possible, even if this means taking large losses initially. Such a firm believes that in several years, when it has moved down the experience curve, it will be making substantial profits and have a cost ad- vantage over its less aggressive competitors.

REGULATORY INFLUENCES ON PRICES The ability to engage in either price discrimination or strategic pricing may be limited by national or international regula- tions. Most important, a firm’s freedom to set its own prices is constrained by antidumping regulations and competition policy.

Antidumping Regulations Both predatory pricing and experience curve pricing can run afoul of antidumping regulations. Dumping occurs whenever a firm sells a product for a price that is less than the cost of producing it. Most regulations, however, define dumping more vaguely. For example, a country is allowed to bring antidumping actions against an importer under Article 6 of GATT as long as two criteria are met: sales at “less than fair value” and “material injury to a domestic industry.” The problem with this terminology is that it does not indicate what a fair value is. The ambiguity has led some to argue that selling abroad at prices below those in the country of origin, as opposed to below cost, is dumping.

Such logic led the Bush administration to place a 20 percent duty on imports of foreign steel in 2001. Foreign manufacturers protested that they were not selling below cost. Admit- ting that their prices were lower in the United States than some other countries, they ar- gued that this simply reflected the intensely competitive nature of the U.S. market (i.e., different price elasticities).

Antidumping rules set a floor under export prices and limit firms’ ability to pursue strategic pricing. The rather vague terminology used in most antidumping actions suggests that a firm’s ability to engage in price discrimination also may be challenged under antidumping legislation.

Competition Policy Most developed nations have regulations designed to promote competition and to restrict monopoly practices. These regulations can be used to limit the prices a firm can charge in a given country. For example, at one time the Swiss pharmaceuti- cal manufacturer Hoffmann–La Roche had a monopoly on the supply of Valium and Librium tranquilizers. The company was investigated by the British Monopolies and Mergers Commission, which is responsible for promoting fair competition in Great Britain. The commission found that Hoffmann–La Roche was overcharging for its tranquilizers and ordered the company to reduce its prices 50 to 60 percent and repay excess profit of $30 million. Hoffmann–La Roche maintained unsuccessfully that it was merely engaging in price discrimination. Similar actions were later brought against Hoffmann–La Roche by the German cartel office and by the Dutch and Danish governments.22

Configuring the Marketing Mix A firm might vary aspects of its marketing mix from country to country to take into account local differences in culture, economic conditions, competitive conditions, product and tech- nical standards, distribution systems, government regulations, and the like. Such differences

Experience Curve Pricing Aggressive pricing designed to increase volume and help the firm realize experience curve economies.

LO 16-5 Understand how to configure the marketing mix globally.

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470 Part Six International Business Functions

may require variation in product attributes, distribution strategy, communication strategy, and pricing strategy. The cumulative effect of these factors makes it rare for a firm to adopt the same marketing mix worldwide. A detailed example is given in the accompanying Management Focus, which looks at how Levi Strauss now varies its marketing mix from country to country. This is a particularly interesting example because Theodore Levitt held up Levi Strauss as an example of global standardization, but as the Management Focus makes clear, the opposite now seems to be the case.

The financial services industry is often thought of as one in which global standardization of the marketing mix is the norm. However, while a financial services company such as American Express may sell the same basic charge card service worldwide, utilize the same basic fee structure for that product, and adopt the same basic global advertising message (“don’t leave home without it”), differences in national regulations still mean that it has to vary aspects of its communication strategy from country to country. Similarly, while McDonald’s is often thought of as the quintessential example of a firm that sells the same basic standardized product worldwide, in reality it varies one important aspect of its market- ing mix—its menu—from country to country. McDonald’s also varies its distribution strat- egy. In Canada and the United States, most McDonald’s are located in areas that are easily accessible by car, whereas in more densely populated and less automobile-reliant societies of the world, such as Japan and Great Britain, location decisions are driven by the accessibility

Levi Strauss Goes Local

It’s been tough going for Levi Strauss, the iconic manufacturer of blue jeans. The company—whose 501 jeans became the global symbol of the baby boom generation and were sold in more than 100 countries— saw its sales drop from a peak of $7.1 billion in 1996 to under $4.0 billion in 2004. Fashion trends had moved on, its critics charged, and Levi Strauss, hamstrung by high costs and a stagnant product line, was looking more faded than a well-worn pair of 501s. Perhaps so, but the second half of the 2000s decade brought signs that a turnaround was in progress. Sales increased after several years of decline, and after a string of losses, the company started to register profits again. At the end of 2013, annual sales had reached $4.6 billion, placing Levi Strauss among the top 100 largest private companies in the United States.

There were three parts to this turnaround. First, there were cost reductions at home. Levi Strauss closed its last remaining American factories and moved production offshore where jeans could be pro- duced more cheaply. Second, the company broadened its product line, introducing the Levi’s Signature brand that could be sold through lower-priced outlets in markets that were more competitive, including the core American market where Walmart had driven down prices. Third, there was a decision in the late 1990s to give more responsibility to national managers, allowing them to better tailor the product offer- ing and marketing mix to local conditions. Before this, Levi Strauss had basically sold the same product worldwide, often using the same ad- vertising message. The old strategy was designed to enable the com- pany to realize economies of scale in production and advertising, but it wasn’t working.

Under the new strategy, variations between national markets have become more pronounced. Jeans have been tailored to different body types. In Asia, shorter leg lengths are common, whereas in South Africa, more room is needed for the backside of women’s jeans, so Levi

Strauss has customized the product offering to account for these phys- ical differences. Then there are sociocultural differences: In Japan, tight-fitting black jeans are popular; in Islamic countries, women are discouraged from wearing tight-fitting jeans, so Levi Strauss offerings in countries such as Turkey are roomier. Climate also has an effect on product design. In northern Europe, standard-weight jeans are sold, whereas in hotter countries lighter denim is used, along with brighter colors that are not washed out by the tropical sun.

Levi’s ads, which used to be global, have also been tailored to re- gional differences. In Europe, the ads now talk about the cool fit. In Asia, they talk about the rebirth of an original. In the United States, the ads show real people who are themselves originals: ranchers, surfers, great musicians. There are also differences in distribution channels and pricing strategy. In the fiercely competitive American market, prices are as low as $25, and Levi’s are sold through mass-market discount re- tailers, such as Walmart. In India, strong sales growth is being driven by Levi’s low-priced Signature brand. In Spain, jeans are seen as higher fashion items and are being sold for $50 in higher-quality out- lets. In the United Kingdom, prices for 501s are much higher than in the United States, reflecting a more benign competitive environment.

This variation in marketing mix seems to be reaping dividends; although demand in the United States and Europe remains sluggish, growth in many other countries is strong. Turkey, South Korea, and South Africa all recorded growth rates in excess of 20 percent a year following the introduction of this strategy in 2005. Looking forward, Levi Strauss expects 60 percent of its growth to come from emerging markets.

Sources: “How Levi Strauss Rekindled the Allure of Brand America,” World Trade, March 2005, p. 28; “Levi Strauss Walks with a Swagger into New Markets,” Africa News, March 17, 2005; “Levi’s Adaptable Standards,” Strategic Direction, June 2005, pp. 14–16; A. Benady, “Levi’s Looks to the Bottom Line,” Financial Times, February 15, 2005, p. 14; and R. A. Smith, “At Levi Strauss Dockers Are In,” The Wall Street Journal, February 14, 2007, p. A14.

management FOCUS

Chapter Sixteen Global Marketing and Research and Development 471

of a restaurant to pedestrian traffic. Because countries typically still differ along one or more of the dimensions discussed earlier, some customization of the marketing mix is normal.

However, there are often significant opportunities for standardization along one or more elements of the marketing mix.23 Firms may find that it is possible and desirable to standardize their global advertising message or core product attributes to realize sub- stantial cost economies. They may find it desirable to customize their distribution and pricing strategy to take advantage of local differences. In reality, the “customization versus standardization” debate is not an all-or-nothing issue; it frequently makes sense to stan- dardize some aspects of the marketing mix and customize others, depending on condi- tions in various national marketplaces. Table 16.1 illustrates issues that should be evaluated to assess how standardized or customized the marketing mix needs to be for various international market segments.

16.1 TABLE Questions to Address to Configure the Marketing Mix

Mix Element Sample Questions to Address

Product Strategy

Product core Do the customers have similar product needs across international market segments?

Product adoption How is the product bought by customers in the international market segments targeted?

Product management How are established products versus new products managed for customers in the international market segments?

Product branding What is the perception of the product brand by customers in the international market segments?

Distribution Strategy

Distribution channels Where is the product typically bought by customers in the international market segments?

Wholesale distribution What is the role of wholesalers for the international market segments targeted?

Retail distribution What is the availability of different types of retail stores in the international markets for the customer segments targeted?

Communication Strategy

Advertising How is product awareness created for a product to reach customers in the international market segments targeted?

Publicity What role does publicity (e.g., public relations) play among customers in the international market segments targeted?

Mass media What role do various media (e.g., TV, radio, newspapers, magazines, billboards) have in reaching customers in the international market segments targeted?

Social media What role do various social media (e.g., Facebook, Twitter, blogs, virtual communities), mainly focused on user- generated content, have in communicating with customers in the international market segments targeted?

Sales promotion Are rebates, coupons, and other sale offers a widespread activity to motivate customers in the international market segments targeted to buy a company’s products?

Pricing Strategy

Value Is the price of a product critical to the customer’s understanding (or perception) of the value of the product itself among customers in the international market segments?

Demand Is the demand for the product among customers in the international market segments targeted similar to domestic demands?

Costs Are the fixed and variable costs of the product the same when targeting customers in the international market segments (e.g., are there variable costs that change significantly when going international)?

Retail price Are there trade tariffs, nontariff barriers, and/or other regulatory influences on price that will influence the pricing equation used to determine the retail price to customers in the international market segments?

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472 Part Six International Business Functions

International Market Research To effectively configure the marketing mix and answer questions such as those in Table 16.1, global companies conduct international marketing research. International market research is defined as the systematic collection, recording, analysis, and interpretation of data to provide knowledge that is useful for decision making in a global company. Com- pared with market research that is domestic only, international market research involves additional issues such as (1) translation of questionnaires and reports into appropriate for- eign languages and (2) accounting for cultural and environmental differences in data col- lection. In this section, some of the more prominent international market research companies are highlighted; the basic steps and issues in conducting international market research are then discussed.

International market research is one of the most critical aspects of understanding the global marketplace. Given this importance, global companies often have their own in- house marketing research department to continually assess customers’ needs, wants, and purchasing behavior. In addition, global companies also typically undertake ongoing data collection to assess customers’ satisfaction with products and services offered. J.D. Power (www.jdpower.com) and the CFI Group (www.cfigroup.com) are two of the most promi- nent customer-satisfaction measurement companies. In addition, for large-scale projects such as better understanding a new country market, global companies often work with outside marketing research firms for input. A sample of prominent international market research firms includes Nielsen, Kantar, Ipsos, and the NPD Group.

• Nielsen (www.nielsen.com) is an international market research company with headquarters in New York in the United States and Diemen in the Netherlands. The company was founded in 1923, is active in more than 100 countries, employs about 40,000 people, and has revenue of about $6 billion annually. Nielsen says on its website that “Whether you’re eyeing markets in the next town or across continents, we understand the importance of knowing what consumers watch and buy.”

• Kantar (www.kantar.com) is an international market research company based in London. The company was founded in 1993 as the market research, insight, and consultancy division of WPP (an advertising and public relations firm). It operates in more than 100 countries, employs some 28,000 people, and has revenues of about $4 billion annually. As a conglomerate of research companies, Kantar works with more than half of the Fortune 500 companies (a “kantar” is a measure for cotton that is still being used in the ports of Egypt today).

• Ipsos (www.ipsos.com) is an international market research company based in Paris, France. The company was founded in 1975, has offices in some 90 countries, employs about 15,000 people, and has revenue of about $2 billion annually. Ipsos is now the only major international market research firm that is controlled and operated by market researchers; it focuses on a mantra of BQC (“better, quicker, cheaper”) as a way to be competitive in the global marketplace.

• NPD Group (www.npd.com), formerly known as National Purchase Diary, is an international market research firm based in Port Washington, New York. The company was founded in 1967, has 25 worldwide offices, employs about 5,000 people, and is a privately held company (estimated to have revenues of about $500 million annually). NPD Group is known for its retail tracking services and market size and trends analysis. Today, it tracks businesses that represent more than $1 trillion in sales worldwide.

Nielsen, Kantar, Ipsos, and the NPD Group, along with many other market research firms, follow a similar process when conducting international market research. The basic data that companies want collected in international market research include: (1) data on the country and potential market segments (geography, demography, sociocultural factors, and psycho- logical factors); (2) data to forecast customer demands within specific country or world re- gion (social, economic, consumer, and industry trends); and (3) data to make marketing mix decisions (product, distribution, communication, and price). The data collection needed to

LO 16-6 Understand the importance of international market research.

International Market Research The systematic collection, recording, analysis, and interpretation of data to provide knowledge that is useful for decision making in a global company.

Chapter Sixteen Global Marketing and Research and Development 473

address these three areas always entails give-and-take in terms of time, cost, and available data collection techniques. The process, however, is somewhat universal across both domes- tic and international settings and includes (1) defining the research objectives, (2) determin- ing the data sources, (3) assessing the costs and benefits of the research, (4) collecting the data, (5) analyzing and interpreting the research, and (6) reporting the research findings.24 Each step is discussed in more detail in the following paragraphs.

Defining the research objectives includes both (1) defining the research problem and (2) set- ting objectives for the international market research. At the outset of any international mar- ket research project, one of the problem areas is to have a baseline understanding of a country market or target segment that is sufficient enough to properly capture what should be done and what can be accomplished with the research. Oftentimes, the research starts with a relatively vague idea of the research problem and the objectives, subsequently refined when a better understanding of country markets, potential customer segments, and more data have been collected.25 One of the most critical aspects of the early stages of interna- tional market research is to be willing to refine the research problem and objectives through- out the process; not doing so may lead to unwanted conclusions. For example, not understanding the scope of the research problem (i.e., children turning to more electronic devices and video games) and accompanying objectives led Mattel Inc., the world’s largest toy maker by sales, to suffer dismal holiday season sales in 2013. While the NPD Group reported that U.S. toy sales dropped just 1 percent in the last quarter of 2013, Mattel’s CEO, Bryan G. Stockton, concluded that “our product innovations and our marketing programs were not strong enough.”26

Determining the data sources that will address specific research problems and ultimately achieve the objectives is often not an easy task, especially if the international market re- search spans more than one country market. In market research, we talk about two forms of data that can be used: primary and secondary data.27 Primary data refers to data collected by the global company and/or its recruited international market research agency for the pur- pose of addressing the research problem and objectives defined by the company. Given the costs of collecting international data, most companies try to avoid duplicating similar data that have been collected previously. However, for more than half of the world’s countries, so-called secondary data that can be helpful can be tough to come by; are often unreliable; and typically do not address what global companies require to better understand the needs, wants, and purchasing behaviors of targeted customers. Secondary data refers to data that have been collected previously by organizations, people, or agencies for purposes other than specifically addressing the research problem and objectives at hand. Overall, the data used in international market research should be evaluated based on (1) availability, (2) comparability across countries and potential market segments, (3) reliability (whether the research pro- duces consistent results), and (4) validity (whether the research measures what it set out to measure). globalEDGE.msu.edu is a great starting point for secondary data on countries and industries, among many data categories, and the research firms mentioned earlier (i.e., Nielsen, Kantar, Ipsos, and the NPD Group) are great organizations used by many global companies for primary data collection worldwide.

Assessing the costs and benefits of the research often relates to the cost of collecting primary data that can address the research problem and objectives directly versus using available secondary data. If secondary data are available, such data are typically available as a less

16.3 FIGURE International Market Research Steps

Defining the Research Objectives

Determining the Data Sources

Assessing the Costs and

Benefists of the Research

Collecting the Data

Analyzing and Interpreting

the Data

Reporting the Research Findings

474 Part Six International Business Functions

costly alternative to collecting primary data. The costs that drive up the spending in primary data collections broadly include survey development and sampling frame issues. For the survey, the questions have to be developed so that they clearly communicate the attitudes, attributes, or characteristics about a product or customer issue in such a way that the re- spondent recognizes the value. This also means overcoming any barriers or differences in language, answer choices, and cultural values and beliefs. For example, the most common way of converting a survey question into another language is to have the question translated into the foreign language (e.g., from English to Spanish) and then back-translated into English again by another person. The two English versions are then compared to ensure similarity in the back-translated version with the original. For the sampling frame, one of the core issues internationally is to make sure that comparable samples can be drawn in the countries in which international market research is conducted. This includes identifying reliable lists or groups of potential people to survey and cultivating potential people to respond to the survey.28

Collecting the data simply refers to gathering data via primary or secondary methods that address the research problem and objectives that the global company has established. The two mechanisms to collect data are quantitative and qualitative data collection. Quantitative methods include experiments, clinical trials, observing and recording events, and adminis- tering surveys with closed-end questions. The goal of quantitative methods is to systemati- cally gain an understanding of customers’ needs, wants, and purchase behavior via numerical data and computational techniques. A popular way of collecting quantitative data today is to use online surveys and consumer mail panels. Most large international market research firms have access to global customer mail panels and potential sampling frames that target both business-to-business customers and end-customers. Qualitative methods include in- depth interviews, observation methods, and document reviews. Here, the focus is broad- based questions aimed at gaining a depth understanding of customers’ needs, wants, and purchase behaviors.

Analyzing and interpreting the research begins when the data have been collected. Assum- ing the survey is reliable and valid, whether the data come from primary or secondary data collection methods, analyzing and interpreting the data is an important step in the interna- tional market research process. It takes a fairly high degree of knowledge—both statistically and culturally—to analyze and interpret international market research. First, statistically the goal should be to use the technique that best addresses the research problem—often stated in the form of research questions or hypothesis (a specified relationship between study vari- ables). There is a plethora of quantitative and qualitative methods of analyzing data, often taught in sophisticated marketing research programs around the world.29 In these programs, software such as SAS, SPSS, LISREL, and Smart-PLS are used for quantitative analysis and ATLAS.ti and MAXQDA are used for qualitative methods. Second, the researcher inter- preting the findings must be in tune culturally with the values, beliefs, norms, and artifacts that affect a respondent’s answers in a certain world region, country, and/or subculture. If possible, it is always advisable to include at least one native of the country being researched to add to the understanding of the research findings, social customs, semantics, attitudes, and business customs. For example, some societies have a tendency to not provide extreme answers (e.g., strongly agree or strongly disagree) to questions but instead answer by using middle-of-the-scale choices (e.g., Japan), while other countries use more of the extreme answer choices (e.g., the U.S.).

Reporting the research findings is a way to communicate the overall results of the interna- tional market research project. Such reports often include information about customers, competitors, countries, the industry, and the environment that affect how the global com- pany develops an appropriate marketing mix for the targeted international market segment. Ultimately, the focus will be on how best to reach customers by addressing their needs, wants, and purchasing behavior in a way that is competitive vis-à-vis existing competitors and potential new entrants into the market. Ideally, top executives who receive the report should have been part of the formulation of the research problem and objectives earlier on in the international market research process. Preferably, they should also take part in some of the fieldwork to collect the data to better understand the voices of customers. If critical

Chapter Sixteen Global Marketing and Research and Development 475

employee levels of the global company—from front-line service employees to market re- searchers to top executives—are insiders of the culture in which the customers are targeted, a lot of misunderstanding and faulty market research can be prevented. The worst-case scenario would be if customers misunderstand the questions and managers misunderstand the answers! One such example was the case of the Toyota accelerator debacle in 2010; Toyota had issues with accelerator pedals that could get stuck, causing vehicles to speed unintentionally.30 Toyota was slow to correct the problems with the accelerator due to a disconnect between identifying the problem (i.e., they did not know why the accelerator pedals got stuck), analyzing the damage, and reporting it to senior management for rectifi- cation. Culturally, Japan prides itself on quality products, which means that disclosing poor quality, assuming responsibility, communicating with senior management, and fixing the problem are very difficult tasks within a Japanese firm.

Product Development So far in this chapter, we have discussed several issues related to globalization of markets and brands, characteristics of the marketing mix (product attributes, distribution strategy, communication strategy, and pricing strategy), configuring the marketing mix, and interna- tional market research. These issues represent the core of this chapter’s discussion of inter- national marketing and R&D. However, firms that successfully develop and market new products can earn enormous returns, and this final section of the chapter addresses the in- terplay among international marketing, R&D, and manufacturing. Examples of firms that have been very successful at mastering the interplay among international marketing, R&D, and manufacturing include DuPont, which has produced a steady stream of successful in- novations such as cellophane, nylon, Freon, and Teflon (nonstick pans); Sony, whose suc- cesses include the Walkman, the compact disc, the PlayStation, and the Blu-ray high-definition DVD player; Pfizer, the drug company that during the 1990s produced sev- eral major new drugs, including Viagra; 3M, which has applied its core competency in tapes and adhesives to developing a wide range of new products; Intel, which has consistently managed to lead in the development of innovative microprocessors to run personal comput- ers; and Apple, with its string of hits, including the iPod, iPhone, and iPad. These and other success stories warrant a specific focus. As such, we draw on the material up to this point in the chapter and combine it with the global production material in Chapter 15 to illustrate this interplay of marketing, R&D, and manufacturing.

In today’s world, competition is as much about technological innovation as anything else. The pace of technological change has accelerated since the Industrial Revolution in the eighteenth century, and it continues to do so today. The result has been a dramatic shorten- ing of product life cycles. Technological innovation is both creative and destructive.31 An innovation can make established products obsolete overnight. But an innovation can also make a host of new products possible. Witness changes in the electronics industry. For 40 years before the early 1950s, vacuum tubes were a major component in radios and then in record players and early computers. The advent of transistors destroyed the market for vac- uum tubes, but at the same time it created new opportunities connected with transistors. Transistors took up far less space than vacuum tubes, creating a trend toward miniaturiza- tion that continues today. The transistor held its position as the major component in the electronics industry for just a decade. Microprocessors were developed in the 1970s, and the market for transistors declined rapidly. The microprocessor created yet another set of new- product opportunities: handheld calculators (which destroyed the market for slide rules), compact disc players (which destroyed the market for analog record players), personal com- puters (which destroyed the market for typewriters), and mobile phones (which are making landline phones obsolete).

This “creative destruction” unleashed by technological change makes it critical that a firm stay on the leading edge of technology, lest it lose out to a competitor’s innovations. As explained next, this not only creates a need for the firm to invest in R&D, but also requires the firm to establish R&D activities at those locations where expertise is concentrated. As we shall see, leading-edge technology on its own is not enough to guarantee a firm’s survival.

LO 16-7 Describe how globalization is affecting product development.

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476 Part Six International Business Functions

The firm must also apply that technology to developing products that satisfy consumer needs, and it must design the product so that it can be manufactured in a cost-effective man- ner. To do that, the firm needs to build close links among R&D, marketing, and manufactur- ing. This is difficult enough for the domestic firm, but it is even more problematic for the international business competing in an industry where consumer tastes and preferences dif- fer from country to country.32 With all of this in mind, we move on to examine locating R&D activities and building links among R&D, marketing, and manufacturing.

THE LOCATION OF R&D Ideas for new products are stimulated by the interac- tions of scientific research, demand conditions, and competitive conditions. Other things being equal, the rate of new-product development seems to be greater in countries where:

• More money is spent on basic and applied research and development. • Underlying demand is strong. • Consumers are affluent. • Competition is intense.33

Basic and applied research and development discovers new technologies and then com- mercializes them. Strong demand and affluent consumers create a potential market for new products. Intense competition among firms stimulates innovation as the firms try to beat their competitors and reap potentially enormous first-mover advantages that result from successful innovation.

For most of the post–World War II period, the country that ranked highest on these criteria was the United States. The United States devoted a greater proportion of its gross domestic product to R&D than any other country did. Its scientific establishment was the largest and most active in the world. U.S. consumers were the most affluent, the market was large, and competition among U.S. firms was brisk. Due to these factors, the United States was the market where most new products were developed and introduced. Accordingly, it was the best location for R&D activities; it was where the action was.

Over the past 25 years, things have been changing quickly. The U.S. monopoly on new- product development has weakened considerably. Although U.S. firms are still at the leading edge of many new technologies, Asian and European firms are also strong players. Compa- nies such as Sony, Sharp, Samsung, Ericsson, Nokia, and Philips have often driven product innovation in their respective industries. In addition, Japan, the European Union and in- creasingly parts of China and other developing nations are large, affluent markets, and the wealth gap between them and the United States is closing.

As a result, it is often no longer appropriate to consider the United States as the lead market. In video games, for example, Japan is often the lead market, with companies such as Sony and Nintendo introducing their latest video-game players in Japan some six months before they introduce them in the United States. However, it often is question- able whether any developed nation can be considered the lead market. To succeed in to- day’s high-technology industries, it is often necessary to simultaneously introduce new products in all major industrialized markets. When Intel introduces a new microproces- sor, for example, it does not first introduce it in the United States and then roll it out in Europe a year later. It introduces it simultaneously around the world. The same is true of Microsoft with new versions of its Windows operating systems or Samsung with a new smartphone.

Because leading-edge research is now carried out in many locations around the world, the argument for centralizing R&D activity in the United States is not as strong as it was three decades ago. (It used to be argued that centralized R&D eliminated duplication.) Much leading-edge research is now occurring in Asia and Europe. Dispersing R&D activi- ties to those locations allows a firm to stay close to the center of leading-edge activity to gather scientific and competitive information and to draw on local scientific resources.34 This may result in some duplication of R&D activities, but the cost disadvantages of dupli- cation are outweighed by the advantages of dispersion.

For example, to expose themselves to the research and new-product development work being done in Japan, many U.S. firms have set up satellite R&D centers in Japan. U.S. firms

Chapter Sixteen Global Marketing and Research and Development 477

that have established R&D facilities in Japan include Corning, Texas Instruments, IBM, Procter & Gamble, Pfizer, DuPont, Monsanto, and Microsoft.35 The National Science Foundation (NSF) has documented a sharp increase in the proportion of total R&D spend- ing by U.S. firms that is now done abroad.36 For example, Bristol-Myers Squibb has 12 facilities in five countries. At the same time, to internationalize their own research and gain access to U.S. talent, many European and Asian firms are investing in U.S.-based re- search facilities, according to the NSF.

INTEGRATING R&D, MARKETING, AND PRODUCTION Although a firm that is successful at developing new products may earn enormous returns, new- product development has a high failure rate. One study of product development in 16 companies in the chemical, drug, petroleum, and electronics industries suggested that only about 20 percent of R&D projects result in commercially successful products or pro- cesses.37 Another in-depth case study of product development in three companies (one in chemicals and two in drugs) reported that about 60 percent of R&D projects reached technical completion, 30 percent were commercialized, and only 12 percent earned an economic profit that exceeded the company’s cost of capital.38 Along the same lines, an- other study concluded that one in nine major R&D projects, or about 11 percent, pro- duced commercially successful products.39 In sum, the evidence suggests that only 10 to 20 percent of major R&D projects give rise to commercially successful products. Well- publicized product failures include Apple Computer’s Newton personal digital assistant, Sony’s Betamax format in the video player and recorder market, and Sega’s Dreamcast video-game console.

The reasons for such high failure rates are various and include development of a technol- ogy for which demand is limited, failure to adequately commercialize promising technology, and inability to manufacture a new product cost effectively. Firms can reduce the probability of making such mistakes by insisting on tight cross-functional coordination and integration among three core functions involved in the development of new products: R&D, marketing, and production.40 Tight cross-functional integration among R&D, production, and market- ing can help a company ensure that:

1. Product development projects are driven by customer needs. 2. New products are designed for ease of manufacture. 3. Development costs are kept in check. 4. Time to market is minimized.

Close integration between R&D and marketing is required to ensure that product devel- opment projects are driven by the needs of customers. A company’s customers can be a pri- mary source of new-product ideas. Identification of customer needs, particularly unmet needs, can set the context within which successful product innovation occurs. As the point of contact with customers, the marketing function of a company can provide valuable informa- tion in this regard. Integration of R&D and marketing is crucial if a new product is to be properly commercialized. Without integration of R&D and marketing, a company runs the risk of developing products for which there is little or no demand.

Integration between R&D and production can help a company design products with manufacturing requirements in mind. Designing for manufacturing can lower costs and increase product quality. Integrating R&D and production can also help lower develop- ment costs and speed products to market. If a new product is not designed with manufac- turing capabilities in mind, it may prove too difficult to build. Then the product will have to be redesigned, and both overall development costs and the time it takes to bring the product to market may increase significantly. Making design changes during product planning could increase overall development costs by 50 percent and add 25 percent to the time it takes to bring the product to market.41 Many quantum product innovations require new processes to manufacture them, which makes it all the more important to achieve close integration between R&D and production. Minimizing time to market and development costs may require the simultaneous development of new products and new processes.42

478 Part Six International Business Functions

CROSS-FUNCTIONAL TEAMS One way to achieve cross-functional integra- tion is to establish cross-functional product development teams composed of representatives from R&D, marketing, and production. Because these functions may be located in different countries, the team will sometimes have a multinational membership. The objective of a team should be to take a product development project from the initial concept development to market introduction. A number of attributes seem to be important for a product develop- ment team to function effectively and meet all its development milestones.43

First, the team should be led by a “heavyweight” project manager who has high status within the organization and who has the power and authority required to get the finan- cial and human resources the team needs to succeed. The leader should be dedicated primarily, if not entirely, to the project. He or she should be someone who believes in the project (a champion) and who is skilled at integrating the perspectives of different func- tions and at helping personnel from different functions and countries work together for a common goal. The leader should also be able to act as an advocate of the team to senior management.

Second, the team should be composed of at least one member from each key func- tion. The team members should have a number of attributes, including an ability to contribute functional expertise, high standing within their function, a willingness to share responsibility for team results, and an ability to put functional and national advo- cacy aside. It is generally preferable if core team members are 100 percent dedicated to the project for its duration. This ensures their focus on the project, not on the ongoing work of their function.

Third, the team members should physically be in one location if possible to create a sense of camaraderie and to facilitate communication. This presents problems if the team mem- bers are drawn from facilities in different nations. One solution is to transfer key individuals to one location for the duration of a product development project. Fourth, the team should have a clear plan and clear goals, particularly with regard to critical development milestones and development budgets. The team should have incentives to attain those goals, such as receiving pay bonuses when major development milestones are hit. Fifth, each team needs to develop its own processes for communication and conflict resolution. For example, one product development team at Quantum Corporation, a California-based manufacturer of hard drives for personal computers, instituted a rule that all major decisions would be made and conflicts resolved at meetings that were held every Monday afternoon. This simple rule helped the team meet its development goals. In this case, it was also common for team members to fly in from Japan, where the product was to be manufactured, to the U.S. devel- opment center for the Monday morning meetings.44

BUILDING GLOBAL R&D CAPABILITIES The need to integrate R&D and marketing to adequately commercialize new technologies poses special problems in the international business because commercialization may require different versions of a new product to be produced for various countries.45 To do this, the firm must build close links between its R&D centers and its various country operations. A similar argument applies to the need to integrate R&D and production, particularly in those international businesses that have dispersed production activities to different locations around the globe in consider- ation of relative factor costs and the like.

Integrating R&D, marketing, and production in an international business may require R&D centers in North America, Asia, and Europe that are linked by formal and informal integrating mechanisms with marketing operations in each country in their regions and with the various manufacturing facilities. In addition, the international business may have to establish cross-functional teams whose members are dispersed around the globe. This com- plex endeavor requires the company to utilize formal and informal integrating mechanisms to knit its far-flung operations together so they can produce new products in an effective and timely manner.

While there is no one best model for allocating product development responsibilities to various centers, one solution adopted by many international businesses involves establishing

Chapter Sixteen Global Marketing and Research and Development 479

a global network of R&D centers. Within this model, fundamental research is undertaken at basic research centers around the globe. These centers are normally located in regions or cities where valuable scientific knowledge is being created and where there is a pool of skilled research talent (e.g., Silicon Valley in the United States, Cambridge in England, Kobe in Japan, Singapore). These centers are the innovation engines of the firm. Their job is to develop the basic technologies that become new products.

These technologies are picked up by R&D units attached to global product divisions and are used to generate new products to serve the global marketplace. At this level, commer- cialization of the technology and design for manufacturing are emphasized. If further cus- tomization is needed so the product appeals to the tastes and preferences of consumers in individual markets, such redesign work will be done by an R&D group based in a subsidiary in that country or at a regional center that customizes products for several countries in the region.

Hewlett-Packard has seven basic research centers located in Palo Alto, California; Bristol, England; Haifa, Israel; Beijing, China; Singapore; Bangalore, India; and St. Petersburg, Russia.46 These labs are the seedbed for technologies that ultimately become new products and businesses. They are the company’s innovation engines. The Palo Alto center, for ex- ample, pioneered HP’s thermal ink-jet technology. The products are developed by R&D centers associated with HP’s global product divisions. Thus, HP’s Consumer Products Group, which has its worldwide headquarters in San Diego, California, designs, develops, and manufactures a range of imaging products using HP-pioneered thermal ink-jet technol- ogy. Subsidiaries might then customize the product so that it best matches the needs of im- portant national markets. HP’s subsidiary in Singapore, for example, is responsible for the design and production of thermal ink-jet printers for Japan and other Asian markets. This subsidiary takes products originally developed in San Diego and redesigns them for the Asian market. In addition, the Singapore subsidiary has taken the lead from San Diego in the design and development of certain portable thermal ink-jet printers. HP delegated this responsibility to Singapore because this subsidiary has acquired important competencies in the design and production of thermal ink-jet products, so it has become the best place in the world to undertake this activity.

John Maltabes, research engineer at Hewlett-Packard, takes out a thin flexible electronic display which has etched resistors, and uses self-aligned imprint lithography technology for testing at Hewlett-Packard Laboratories.

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.

480 Part Six International Business Functions

marketing mix, p. 452 market segmentation, p. 453 intermarket segment, p. 454 concentrated retail system, p. 457 fragmented retail system, p. 457 channel length, p. 458 exclusive distribution channel, p. 459

channel quality, p. 459 source effects, p. 461 country of origin effects, p. 461 noise, p. 462 push strategy, p. 462 pull strategy, p. 462 price elasticity of demand, p. 467

elastic, p. 467 inelastic, p. 467 strategic pricing, p. 468 predatory pricing, p. 468 multipoint pricing, p. 468 experience curve pricing, p. 469 international market research, p. 472

Key Terms

Summary

This chapter discussed the marketing and R&D functions in international business. A persistent theme of the chapter is the tension that exists between the need to reduce costs and the need to be responsive to local condi- tions, which raises costs. The chapter made the following points:

1. Theodore Levitt argued that due to the advent of modern communications and transport technologies, consumer tastes and preferences are becoming global, which is creating global markets for standardized consumer products. However, this position is regarded as extreme by many experts, who argue that substantial differences still exist between customers from different countries and cultures.

2. Market segmentation refers to the process of identifying distinct groups of consumers whose needs, wants, and purchasing behavior differs from each other in important ways. Managers in an international business need to be aware of two main issues relating to segmentation: the extent to which there are differences between countries in the structure of market segments and the existence of segments that transcend national borders (i.e., intermarket segments).

3. A product can be viewed as a bundle of attributes. Product attributes often need to be varied from country to country to satisfy different consumer tastes and preferences.

4. Country differences in consumer tastes and preferences are due to differences in culture and economic development. In addition, differences in product and technical standards may require the firm to customize product attributes from country to country.

5. A distribution strategy decision is an attempt to define the optimal channel for delivering a product to the consumer. In the global supply chain, the

marketing channel is a part of the downstream (also called outbound) portion of the supply chain (refer to Chapter 15).

6. Significant country differences exist in distribution systems. In some countries, the retail system is concentrated; in others, it is fragmented. In some countries, channel length is short; in others, it is long. Access to distribution channels is difficult to achieve in some countries, and the quality of the channel may be poor, especially in less developed nations.

7. A critical element in the marketing mix is communication strategy, which defines the process the firm will use in communicating the attributes of its product to prospective customers.

8. Barriers to international communication include cultural differences, source effects, and noise levels.

9. A communication strategy is either a push strategy or a pull strategy. A push strategy emphasizes personal selling, and a pull strategy emphasizes mass media advertising. Whether a push strategy or a pull strategy is optimal depends on the type of product, consumer sophistication, channel length, and media availability.

10. A globally standardized advertising campaign, which uses the same marketing message all over the world, has economic advantages, but it fails to account for differences in culture and advertising regulations.

11. Price discrimination exists when consumers in different countries are charged different prices for the same product. Price discrimination can help a firm maximize its profits. For price discrimination to be effective, the national markets must be separate and their price elasticities of demand must differ.

12. Predatory pricing is the use of profit gained in one market to support aggressive pricing in another market to drive competitors out of that market.

Chapter Sixteen Global Marketing and Research and Development 481

13. Multipoint pricing refers to the fact that a firm’s pricing strategy in one market may affect rivals’ pricing strategies in another market. Aggressive pricing in one market may elicit a competitive response from a rival in another market that is important to the firm.

14. Experience curve pricing is the use of aggressive pricing to build accumulated volume as rapidly as possible to quickly move the firm down the experience curve.

15. International market research involves (a) defining the research objectives, (b) determining the data sources, (c) assessing the costs and benefits of the

research, (d ) collecting the data, (e) analyzing and interpreting the research, and ( f ) reporting the research findings.

16. New-product development is a high-risk, potentially high-return activity. To build a competency in new- product development, an international business must do two things: disperse R&D activities to those countries where new products are being pioneered, and integrate R&D with marketing and manufacturing.

17. Achieving tight integration among R&D, marketing, and manufacturing requires the use of cross- functional teams.

Critical Thinking and Discussion Questions

1. Imagine that you are the marketing manager for a U.S. manufacturer of disposable diapers. Your firm is considering entering the Brazilian market. Your CEO believes the advertising message that has been effective in the United States will suffice in Brazil. Outline some possible objections to this. Your CEO also believes that the pricing decisions in Brazil can be delegated to local managers. Why might she be wrong?

2. Within 20 years, we will have seen the emergence of enormous global markets for standardized consumer products. Do you agree with this statement? Justify your answer.

3. You are the marketing manager of a food products company that is considering entering the Indian market. The retail system in India tends to be very fragmented. Also, retailers and wholesalers tend to have long-term ties with Indian food companies; these ties make access to distribution channels difficult. What distribution strategy would you advise the company to pursue? Why?

4. Price discrimination is indistinguishable from dumping. Discuss the accuracy of this statement.

5. You work for a company that designs and manufactures personal computers. Your company’s R&D center is in Michigan. The computers are manufactured under contract in Taiwan. Marketing strategy is delegated to the heads of three regional

groups: a North American group (based in Chicago), a European group (based in Paris), and an Asian group (based in Singapore). Each regional group develops the marketing approach within its region. In order of importance, the largest markets for your products are North America, Germany, Great Britain, China, and Australia. Your company is experiencing problems in its product development and commercialization process. Products are late to market, the manufacturing quality is poor, costs are higher than projected, and market acceptance of new products is less than hoped for. What might be the source of these problems? How would you fix them?

6. Reread the Management Focus on Levi Strauss, and then answer the following questions: a. What marketing strategy was Levi Strauss using

until the early 2000s? Why did this strategy appear to work for decades? Why was it not working by 2004?

b. How would you characterize Levi Strauss’s current strategy? What elements of the marketing mix are now changed from nation to nation?

c. What are the benefits of the company’s new marketing strategy? Is there a downside?

d. What does the Levi Strauss story tell you about the “globalization of markets”?

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

1. The consumer purchase of specific brands is an indication of the relationship that develops over time

between a company and its customers. Locate and retrieve the most current ranking of best global brands. Identify the criteria used. Which countries appear to dominate the top 100 global brands list? Why do you think this is the case? Now look at which sectors

Research Task http://globalEDGE.msu.edu

Domino’s made its name by pioneering home delivery service of pizza in the United States. The company was founded in 1960 in Ypsilanti, Michigan, by Tom Monaghan and his brother, Jim. Domino’s Pizza was sold to Bain Capital in 1998 and went public in 2004. On May 12, 1983, Domino’s opened its first store internationally—in Winnipeg, Canada. And, in 2012, Domino’s Pizza removed the word “Pizza” from the logo to emphasize its non-pizza products. Its current menu features a variety of Italian American entrees, side dishes, and desserts.

In recent years, the growth for Domino’s has been overseas. With the U.S. fast-food market saturated and consumer demand weak, Domino’s has been looking to international markets for growth opportunities. Today, almost all new store openings are outside the United States. As of 2013, Domino’s has 10,566 stores with 4,900 in the United States, 750 in the United Kingdom, 650 in India, and the remaining spread out in 70 coun- tries. Its plans call for 4 to 6 percent growth in stores per year for the next few years (some 500 new stores annually, with the majority in foreign mar- kets). Given this expansion and clear international growth strategy, per- haps even more amazing is the 76 straight quarters of same-store sales growth in Domino’s international stores.

As Domino’s expands its international businesses, there are some things that the company has kept the same as in the United States, and there are some things that are very different. What is the same is the basic business model of home delivery. This sets it apart from many of its rivals, which changed their basic offering when they entered foreign markets. For example, when Yum Brands Inc. introduced Pizza Hut into China, it radically altered the format, establishing Pizza Hut Casual Dining, a chain that offers a vast selection of American fare—including ribs, spaghetti, and steak—in a full-service setting. Pizza Hut adopted this format because table service was what the locals were used to, but Domino’s isn’t interested. “We go in there with a tried-and-true business model of delivery and carry-out pizza that we deploy around the world,” states Richard Allison, Domino’s Executive Vice President–International. “In emerging markets, we’ve got more tables than you would find in the U.S., but we have no plans to lean toward a casual dining model where the server comes out and takes an order.”

This general strategy is backed up by the CEO of Domino’s, J. Patrick Doyle, who said that, “The joy of pizza is that bread, sauce, and cheese works fundamentally everywhere, except maybe China, where dairy wasn’t a big part of their diet until lately.” He continued, “it’s easy to just change toppings market to market . . . in Asia, it’s seafood and fish . . . it’s curry in India . . . but half the toppings are standard offerings around the world.”

Only eight restaurant chains worldwide have more than 10,000 outlets and Domino’s is one of them (Domino’s opened its 10,000th store as a franchise-owned outlet in Istanbul, Turkey, in 2012). “Local knowledge and ownership are critical to our success overseas,” Doyle said.

Bottom line, Domino’s is the overall pizza-sales leader in the global marketplace and has established operations with some 5,700 store units worldwide. At this time, Domino’s is also making a run for the top pizza spot in the United States, which now is held by Pizza Hut (with Papa John’s at #3). This entrepreneurial leadership is best captured by Ronnie Asmar, director of new store development for STA Management in Southfield, Michigan, which owns 33 Domino’s outlets; he says, “We come from an entrepreneurial family in the hospitality industry, and Domino’s has been an awesome partner.”

And, Domino’s appear to lead the market in other ways as well. Domino’s appear to have captured, integrated, and found an edge in the social media world we live in now better than its competition. For ex- ample, Mitch Speiser, a securities analyst for Buckingham Research, in New York said, “Domino’s mobile app for ordering pizza is better than its rivals.” Information technology also helps drive sales for Domino’s vis-à-vis local pizza entrepreneurs. At this time, about 58 percent of Domino’s orders are digital in the United Kingdom and about 40 percent in the United States.

On the other hand, some things vary from country to country. In the United States, pizza is viewed as casual food, frequently mentioned in the same breath as beer and football. In Japan, it’s viewed as more upscale fare. This is reflected in the offering. Japanese pizzas come with toppings that the average American couldn’t fathom. Domino’s has sold a $50 pizza in Japan featuring foie gras. Other premium toppings include snow crab, Mangalitsa pork with Bordeaux sauce, and beef stew with fresh mozza- rella. Japanese consumers value aesthetics and really care about the look of food, so presentation is the key. Patrons expect every slice to have pre- cisely the same amount of toppings, which must be uniformly spaced. Shrimp, for example, are angled with the tails pointing the same way. Domino’s developed their business in South Korea in much the same manner as Japan.

Now, even with these unique toppings in Japan, pizza consumption is relatively low in Japan—the average Japanese pizza customer only con- sumes the product four times a year. To boost this, Domino’s has been working to create more occasions to enjoy it. For example, on Valentine’s Day, its Japanese stores deliver heart-shaped pizzas in pink boxes. Heart-shaped pizzas also appear on Mother’s Day. This culture of superb

ccccccllooooooossssiinnnnnnggggggggggg ccccccaaaaaassssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeDomino’s Pizza Worldwide

482 Part Six International Business Functions

appear to dominate the list, and try to identify the reasons. Prepare a short report identifying the countries that possess global brands and the potential reasons for success.

2. Part of developing a long-term R&D strategy is to locate facilities in countries that are widely known to be competitive. Your company seeks to develop R&D

facilities in Asia to counter recent competitor responses. A publication that evaluates economies based on their competitiveness is the Global Competitiveness Report. Locate this report, and develop a presentation for the top management team that presents the benefits and drawbacks for the top five Asian economies listed.

Chapter Sixteen Global Marketing and Research and Development 483

pizzas with high-quality toppings was actually an initiative that was ini- tially demanded by their U.S customer base; over an 18-month period during 2009 to 2011, Domino’s remade itself and its pizzas—at the same time, it stayed short of adding more than 10 percent in cost to the pizza ingredients.

But back to Japan! To promote the offering in Japan, rather than spending money on commercials, Domino’s tried to create news, like top- ics that people talk about. If the topic is fun and hot, Domino’s believes that people will talk about it, which ultimately translates into better sales. One promotion in particular received heavy coverage. The chain offered 2.5 million yen (about $31,000) for one hour’s work at a Domino’s store. In all, about 12,000 people applied for the “job.” The lucky winner was a rural housewife who had never eaten pizza. She flew to a small island to deliver pizza to schoolchildren, who were also new to pizza. The event received heavy news coverage—free advertising, in other words! As its interna- tional focus is now larger and advertisement funds are being allocated accordingly, Domino’s is moving much more toward TV commercials in its promotional efforts to complement other promotional efforts. This includes Japan, India, and a variety of countries.

In India, where Domino’s has some 650 stores and has plans for some 1,000 more, 50 percent of the menu is vegetarian in order to match the preferences of the large Hindu population. For delivery, Domino’s has a fleet of mopeds, which makes sense in large cities like Mumbai where traffic congestion is awful. Because Indians like things spicy, instead of including Parmesan cheese packets, Domino’s includes an “Oregano SpiceMix.” In general, the toppings have far more spice than in the United States. Although Indians are used to full service in restaurants, Domino’s doesn’t use servers or busboys in its stores, even though each store typi- cally has a few tables in for those who want to eat on premises. Instead, it is educating customers to clean up after themselves, with in-store trash- cans that say “Use Me” in big bold letters.

Domino’s today has focused on branding itself with high-quality in- gredients, efficiency but at a speed that fosters quality, and a devotion

to maintaining a cultural fabric that allows for a strong entrepreneurial mindset among employees and franchisees. The company captures the global marketplace effectively, either as a first-mover or as a strong follower. “For Domino’s the development and eventual channelization of industries is important strategically,” said Michael Lawton, chief finan- cial officer (CFO) of Domino’s. He continued: “It led the company to de- cide in some foreign markets that the best alternative was to let someone else introduce the pizza category with a sit down concept and then Domino’s moved in and captured their part of the industry as deliv- ery and carry-out developed.” In other cases, Domino’s led the market entry into foreign countries. These decision choices make for great global strategy. Domino’s has certainly captured the “taste” of the global marketplace!

Sources: A. Gasparro, “Domino’s Sticks to Its Ways Abroad,” The Wall Street Journal, April 17, 2012, p. B10; A. C. Beattie, “In Japan, Pizza Is Recast as a Meal for Special Occasions,” Advertising Age, April 2, 2012, p. 16; A. Gasparro, “Domino’s Sees Bigger Slice Overseas,” The Wall Street Journal, February 29, 2012, p.B7; R. Shah, “How Domino’s Pizza Is Taking a Bite Out of India,” Getting More Awesome, www.gettingmoreawesome.com/2012/02/08/how-dominos-is- taking-a-bite-out-of-india; and D. Buss, “Domino’s Global Growth Feeds Pizza Chain’s Rising Success,” Forbes, March 9, 2013.

CASE DISCUSSION QUESTIONS 1. Do you think it is wise for Domino’s to stick to its traditional “home

delivery” business model, even when that is not the norm in a country and when its international rivals have changed their format?

2. What do you think Domino’s does from an organizational perspective to make sure that it accommodates local differences in consumer tastes and preferences?

3. How does the marketing mix for Domino’s in Japan differ from that in the United States? How does the marketing mix in India differ?

4. What lessons can we draw from the Domino’s case study that might be useful for other international businesses selling consumer goods?

Endnotes

1. See R. W. Ruekert and O. C. Walker, “Interactions between Marketing and R&D Departments in Implementing Differ- ent Business-Level Strategies,” Strategic Management Journal 8 (1987), pp. 233–48; and K. B. Clark and S. C. Wheelwright, Managing New Product and Process Development (New York: Free Press, 1993).

2. T. Levitt, “The Globalization of Markets,” Harvard Business Review, May–June 1983, pp. 92–102. Reprinted by permis- sion of Harvard Business Review, an excerpt from “The Glo- balization of Markets,” by Theodore Levitt, May–June 1983. Copyright © 1983 by the President and Fellows of Harvard College. All rights reserved.

3. For example, see S. P. Douglas and Y. Wind, “The Myth of Globalization,” Columbia Journal of World Business, Winter 1987, pp. 19–29; C. A. Bartlett and S. Ghoshal, Managing across Borders: The Transnational Solution (Boston: Harvard Business School Press, 1989); V. J. Govindarajan and A. K. Gupta, The Quest for Global Dominance (San Francisco: Jossey

Bass, 2001); J. Quelch, “The Return of the Global Brand,” Harvard Business Review, August 2003, pp. 1–3; and P. J. Ghemawat, Redefining Global Strategy (Boston: Harvard Busi- ness School Press, 2007).

4. J. Tagliabue, “U.S. Brands Are Feeling Global Tension,” The New York Times, March 15, 2003, p. C3.

5. D. B. Holt, J. A. Quelch, and E. L. Taylor, “How Global Brands Compete,” Harvard Business Review, September 2004.

6. J. T. Landry, “Emerging Markets: Are Chinese Consumers Coming of Age?” Harvard Business Review, May–June 1998, pp.17–20.

7. C. Miller, “Teens Seen as the First Truly Global Consumers,” Marketing News, March 27, 1995, p. 9.

8. This approach was originally developed in K. Lancaster, “A New Approach to Demand Theory,” Journal of Political Econ- omy 74 (1965), pp. 132–57.

484 Part Six International Business Functions

9. V. R. Alden, “Who Says You Can’t Crack Japanese Markets?” Harvard Business Review, January–February 1987, pp. 52–56.

10. “RCA’s New Vista: The Bottom Line,” BusinessWeek, July 4, 1987, p. 44.

11. C. Matlack and P. Gogoi, “What’s This? The French Love McDonald’s?” BusinessWeek, January 13, 2003, pp. 50–51.

12. Z. Gurhan-Cvanli and D. Maheswaran, “Cultural Variation in Country of Origin Effects,” Journal of Marketing Research, August 2000, pp. 309–17.

13. See M. Laroche, V. H. Kirpalani, F. Pons, and L. Zhou, “A Model of Advertising Standardization in Multinational Corporations,” Journal of International Business Studies 32 (2001), pp. 249–66; and D. A. Aaker and E. Joachimsthaler, “The Lure of Global Branding,” Harvard Business Review, November–December 1999, pp. 137–44.

14. “Advertising in a Single Market,” The Economist, March 24, 1990, p. 64.

15. R. G. Matthews and D. Pringle, “Nokia Bets One Global Message Will Ring True in Many Markets,” The Wall Street Journal, September 27, 2004, p. B6.

16. R. J. Dolan and H. Simon, Power Pricing (New York: Free Press, 1999).

17. B. Stottinger, “Strategic Export Pricing: A Long Winding Road,” Journal of International Marketing 9 (2001), pp. 40–63; S. Gil-Pareja “Export Process Discrimination in Europe and Exchange Rates,” Review of International Economics, May 2002, pp. 299–312; and G. Corsetti and L. Dedola, “A Macro Eco- nomic Model of International Price Discrimination,” Journal of International Economics, September 2005, pp. 129–40.

18. These allegations were made on a PBS Frontline documen- tary telecast in the United States in May 1992.

19. Y. Tsurumi and H. Tsurumi, “Fujifilm-Kodak Duopolistic Competition in Japan and the United States,” Journal of In- ternational Business Studies 30 (1999), pp. 813–30.

20. G. Smith and B. Wolverton, “A Dark Moment for Kodak,” BusinessWeek, August 4, 1997, pp. 30–31.

21. R. Narisette and J. Friedland, “Disposable Income: Diaper Wars of P&G and Kimberly-Clark Now Heat Up in Brazil,” The Wall Street Journal, June 4, 1997, p. A1.

22. J. F. Pickering, Industrial Structure and Market Conduct (London: Martin Robertson, 1974).

23. S. P. Douglas, C. Samuel Craig, and E. J. Nijissen, “Integrat- ing Branding Strategy across Markets,” Journal of Interna- tional Marketing 9, no. 2 (2001), pp. 97–114.

24. We summarized the basic steps in the international market research process. Detailed discussions of similar processes can be found in P. Cateora, M. Gilly, and J. Graham, Interna- tional Marketing (New York: McGraw-Hill, 2013); V. Kumar, International Marketing Research (Upper Saddle River, NJ: Pearson Prentice Hall, 2000); and C. S. Craig and S. P. Douglas, International Marketing Research (West Sussex, UK: Wiley, 2005).

25. B. Pedersen, T. Pedersen, and M. Lyles, “Closing the Knowl- edge Gaps in Foreign Markets,” Journal of International Busi- ness Studies 39 (2008), pp. 1097–13.

26. P. Ziobro, “Mattel Takes a Hit as Barbie Sales Slump,” The Wall Street Journal, January 31, 2014.

27. Kumar, International Marketing Research; Craig and Douglas, International Marketing Research.

28. A-W. Harzing, “Response Rates in International Mail Sur- veys: Results of a 22-Country Study,” International Business Review 6 (1997), pp. 641–65.

29. Kumar, International Marketing Research; Craig and Douglas, International Marketing Research; J. Hair, W. Black, B. Babin, and R. Anderson, Multivariate Data Analysis (Upper Saddle River, NJ: Pearson Prentice Hall, 2010); and J. Hair, T. Hult, C. Ringle, and M. Sarstedt, A Primer on Partial Least Squares Structural Equation Modeling (PLS-SEM) (Los Angeles, CA: Sage, 2014).

30. N. Bunkley, “Toyota Issues a 2nd Recall,” The New York Times, January 21, 2010.

31. The phrase was first used by economist Joseph Schumpeter in Capitalism, Socialism, and Democracy (New York: Harper Brothers, 1942).

32. S. Kotabe, S. Srinivasan, and P. S. Aulakh. “Multinationality and Firm Performance: The Moderating Role of R&D and Marketing,” Journal of International Business Studies 33 (2002), pp. 79–97.

33. See D. C. Mowery and N. Rosenberg, Technology and the Pursuit of Economic Growth (Cambridge, UK: Cambridge University Press, 1989); and M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990).

34. W. Kuemmerle, “Building Effective R&D Capabilities Abroad,” Harvard Business Review, March–April 1997, pp. 61–70; and C. Le Bas and C. Sierra, “Location versus Home Country Advantages in R&D Activities,” Research Policy 31 (2002), pp. 589–609.

35. “When the Corporate Lab Goes to Japan,” The New York Times, April 28, 1991, sec. 3, p. 1.

36. D. Shapley, “Globalization Prompts Exodus,” Financial Times, March 17, 1994, p. 10.

37. E. Mansfield, “How Economists See R&D,” Harvard Business Review, November–December 1981, pp. 98–106.

38. Ibid.

39. G. A. Stevens and J. Burley, “Piloting the Rocket of Radical Innovation,” Research Technology Management 46 (2003), pp. 16–26.

40. K. B. Clark and S. C. Wheelwright, Managing New Product and Process Development (New York: Free Press, 1993); and M. A. Shilling and C. W. L. Hill, “Managing the New Product Development Process,” Academy of Management Executive 12, no. 3 (1998), pp. 67–81.

41. O. Port, “Moving Past the Assembly Line,” BusinessWeek Special Issue: Reinventing America, 1992, pp. 177–80.

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42. K. B. Clark and T. Fujimoto, “The Power of Product Integ- rity,” Harvard Business Review, November–December 1990, pp. 107–18; Clark and Wheelwright, Managing New Product and Process Development; S. L. Brown and K. M. Eisenhardt, “Product Development: Past Research, Present Findings, and Future Directions,” Academy of Management Review 20 (1995), pp. 348–78; and G. Stalk and T. M. Hout, Competing against Time (New York: Free Press, 1990).

43. Shilling and Hill, “Managing the New Product Development Process.”

44. C. Christensen, “Quantum Corporation—Business and Prod- uct Teams,” Harvard Business School case no. 9-692-023.

45. R. Nobel and J. Birkinshaw, “Innovation in Multinational Corporations: Control and Communication Patterns in In- ternational R&D Operations,” Strategic Management Journal 19 (1998), pp. 479–96.

46. Information comes from the company’s website; also see K. Ferdows, “Making the Most of Foreign Factories,” Harvard Business Review, March–April 1997, pp. 73–88.

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learning objectives

17-1 Summarize the strategic role of human resource management in the international business.

17-2 Identify the pros and cons of different approaches to staffing policy in the international business.

17-3 Explain why managers may fail to thrive in foreign postings.

17-4 Recognize how management development and training programs can increase the value of human capital in the international business firm.

17-5 Explain how and why performance appraisal systems might vary across nations.

17-6 Understand how and why compensation systems might vary across nations.

17-7 Understand how organized labor can influence strategic choices in international business firms.

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Global Human Resource Management

The Strategic Role of Human Resources at IBM

opening case

Back in the early 2000s IBM’s CEO, Sam Palmisano, set out to recreate IBM as a globally integrated enterprise that would provide its customers IBM products and services—software, hardware, busi-ness processing, consulting and more—wherever and whenever they needed it. Underpinning Palmisano’s vision was a realization that globalization was proceeding rapidly, and that many of IBM’s

customers were themselves increasingly global enterprises. Global customers wanted to deal with one

IBM, not many different national units. Palmisano also understood that for IBM to build a sustained com-

petitive advantage in this new world, it would have to have world-class human capital. People and their

acquired skills, he realized, were the foundation of competitive advantage. Companies that rely on tech-

nological or manufacturing innovations alone cannot be expected to dominate their markets indefinitely.

Competitors can and do catch up. In Palmisano’s view, the quality and strategic deployment of human

capital is what separates winners from also-rans. This was particularly true for a company like IBM,

which increasingly relied on its people to build and deliver world-class services.

To execute his strategy, Palmisano created global product divisions, but that alone was not enough. He

realized that IBM’s existing human resource systems were not aligned with the new strategy. Much of the

hiring, training, and staffing functions of HR were still based in national units. The company lacked a global

approach to managing and deploying its human capital, and executing Palmisano’s vision required this.

That insight was the genesis for what became known as the Workforce Management Initiative (WMI)

at IBM. Established by the global human resource group, the purpose of this initiative was to create for the

first time a single, integrated approach to hiring, managing, and deploying IBM’s global workforce. The

ultimate goal was to enable the company to find and deploy the best people within the company to help

solve client problems or respond to their requests. For this to work, HR had to become intimately involved

in understanding the business strategy of different IBM units and the implications that business strategy

holds for human resource deployment. Unless HR had a seat at the strategy table, it could not properly

identify and provide the right people to execute a unit’s strategy.

–continued

488 Part Six International Business Functions

As it progressed, the WMI involved investing more than $100 million to create a

companywide database to document the skills of more than 400,000 employees at IBM,

measure the supply and demand for different skills and capabilities, and seek to match

human capital with specific projects. The goal was to get the right person, with the right

skills, at the right time, place, and cost. For example, when a health care client needed

a consultant with a clinical background, a search using the WMI database immediately

targeted a former registered nurse who was now an IBM consultant. By improving the

efficiency of its internal labor market and leveraging its global workforce, IBM estimates

that the WMI database saved the company as much as $1.4 billion in its first four years

in operation.

The WMI database has a number of other benefits. It helps employees make career

decisions, as by accessing it they can see which skills are in demand. Moreover, by

identifying potential mismatches between the supply and demand of skills, it drives

decisions about internal management development and training programs, enabling

IBM to identify with precision which skills its employees need to acquire for the company

to maintain its competitive edge going forward. • Sources: G. Jones, “IBM: Pinpointing Inside Up and Comers,” BusinessWeek, October 9, 2005; J. Smerd, “IBM Optimas Award Winner for Financial Impact,” Workforce Management, October 24, 2008; and R. J. Grossman, “IBM’s HR Takes a Risk,” HR Magazine, April 1, 2007.

Introduction This chapter continues our survey of specific functions within an international business by looking at international human resource management. Human resource management (HRM) refers to the activities an organization carries out to use its human resources effec- tively.1 These activities include determining the firm’s human resource strategy, staffing, performance evaluation, management development, compensation, and labor relations. None of these activities is performed in a vacuum; all are related to the strategy of the firm. As we will see, HRM has an important strategic component.2 Through its influence on the character, development, quality, and productivity of the firm’s human resources, the HRM function can help the firm achieve its primary strategic goals of reducing the costs of value creation and adding value by better serving customers. A good example of this is given in the opening case, which looks at how IBM uses human resources in a highly strategic way to build and sustain a competitive advantage over rivals.

Irrespective of the desire of managers in multinationals such as IBM to build a truly global enterprise with a global workforce, the reality is that HRM practices still have to be modified to national context. The strategic role of HRM is complex enough in a purely domestic firm, but it is more complex in an international business, where staffing, manage- ment development, performance evaluation, and compensation activities are complicated by profound differences between countries in labor markets, culture, legal systems, economic systems, and the like (see Chapters 2, 3, and 4). For example,

• Compensation practices may vary from country to country, depending on prevailing management customs.

• Labor laws may prohibit union organization in one country and mandate it in another. • Equal employment legislation may be strongly pursued in one country and not in another.

If it is to build a cadre of managers capable of managing a multinational enterprise, the HRM function must deal with a host of issues. It must decide how to staff key management posts in the company, how to develop managers so that they are familiar with the nuances of doing business in different countries, how to compensate people in different nations, and

Human Resource Management (HRM) Activities an organization conducts to use its human resources effectively.

Chapter Seventeen Global Human Resource Management 489

how to evaluate the performance of managers based in different countries. HRM must also deal with a host of issues related to expatriate managers. (An expatriate manager is a citizen of one country who is working abroad in one of the firm’s subsidiaries.) It must decide when to use expatriates, determine whom to send on expatriate postings, be clear about the rea- sons why, compensate expatriates appropriately, and make sure that they are adequately de- briefed and reoriented once they return home.

This chapter looks closely at the role of HRM in an international business. It begins by briefly discussing the strategic role of HRM. Then we turn our attention to four major tasks of the HRM function: staffing policy, management training and development, performance appraisal, and compensation policy. We point out the strategic implications of each task. The chapter closes with a look at international labor relations and the relationship between the firm’s management of labor relations and its overall strategy.

The Strategic Role of International HRM A large and expanding body of academic research suggests that a strong fit between human resource practices and strategy is required for high profitability.3 You will recall from Chap- ter 12 that superior performance requires not only the right strategy, but the strategy must also be supported by the right organizational architecture. Strategy is implemented through organization. As shown in Figure 17.1, people are the linchpin of a firm’s organizational ar- chitecture. For a firm to outperform its rivals in the global marketplace, it must have the right people in the right postings (see the opening case on IBM for an example). Those people must be trained appropriately so that they have the skill sets required to perform their jobs effectively and so that they behave in a manner that is congruent with the desired culture of the firm. Their compensation packages must create incentives for them to take actions that are consistent with the strategy of the firm, and the performance appraisal sys- tem the firm uses must measure the behavior that the firm wants to encourage.

As indicated in Figure 17.1, the HRM function, through its staffing, training, compensa- tion, and performance appraisal activities, has a critical impact on the people, culture, incen- tive, and control system elements of the firm’s organizational architecture (performance appraisal systems are part of the control systems in an enterprise). Thus, HRM professionals have a critically important strategic role. It is incumbent on them to shape these elements of a firm’s organizational architecture in a manner that is consistent with the strategy of the enterprise, so that the firm can effectively implement its strategy.

In short, superior human resource management can be a sustained source of high pro- ductivity and competitive advantage in the global economy. At the same time, research suggests that many international businesses have room for improving the effectiveness of their HRM function. In one study of competitiveness among 326 large multinationals, the authors found that human resource management was one of the weakest capabilities in

Expatriate Manager A national of one country appointed to a management position in another country.

LO 17-1 Summarize the strategic role of human resource management in the international business.

International Internship Directory

People are what make value chains “valuable,” and global human resource management, which is the focus of Chapter 17, is a critical part of operating worldwide. So, we are ending the text on a good and important note with a focus on global HR issues. The obvious HR issue to us as authors is YOU—the student and reader of this text! Our goal is to provide information and data and infuse our knowledge to each student using the text. globalEDGE can help take this knowl- edge to another level with its International Internship Directory

(http://globaledge.msu.edu/international-internships). The Directory is a reference guide for students and others (e.g., faculty, staff, and administrators) to help match students with international internship opportunities offered by universities, governmental agencies, non- profit groups, private organizations, and corporations. To search for an internship, you can select a type of organization, country, or sub- ject of study (e.g., international business). Check it out. What oppor- tunities can you base on your interests?

490 Part Six International Business Functions

most firms, suggesting that improving the effectiveness of international HRM practices might have substantial performance benefits.4

In Chapter 12, we examined four strategies pursued by international businesses: localiza- tion strategy, international strategy, global standardization strategy, and transnational strat- egy. In this chapter, we will see that success also requires HRM policies to be congruent with the firm’s strategy. For example, a transnational strategy imposes different require- ments for staffing, management development, and compensation practices from a localiza- tion strategy. Firms pursuing a transnational strategy need to build a strong corporate culture and an informal management network for transmitting information and knowledge within the organization. Through its employee selection, management development, per- formance appraisal, and compensation policies, the HRM function can help develop these things. Thus, as we have noted, HRM has a critical role to play in implementing strategy. In each section that follows, we review the strategic role of HRM in some detail.

Staffing Policy Staffing policy is concerned with the selection of employees for particular jobs. At one level, this involves selecting individuals who have the skills required to do particular jobs. At another level, staffing policy can be a tool for developing and promoting the desired corporate culture of the firm.5 By corporate culture, we mean the organization’s norms and value systems. A strong corporate culture can help a firm implement its strategy. General Electric, for example, is not just concerned with hiring people who have the skills required for performing particular jobs; it wants to hire individuals whose behavioral styles, beliefs, and value systems are consis- tent with those of GE. This is true whether an American is being hired, an Italian, a German, or an Australian and whether the hiring is for a U.S. operation or a foreign operation. The belief is that if employees are predisposed toward the organization’s norms and value systems by their personality type, the firm will be able to attain higher performance.

TYPES OF STAFFING POLICY Research has identified three types of staffing policies in international businesses: the ethnocentric approach, the polycentric approach, and the geocentric approach.6 We review each policy and link it to the strategy pursued by the firm. The most attractive staffing policy is probably the geocentric approach, although there are several impediments to adopting it.

The Ethnocentric Approach An ethnocentric staffing policy is one in which all key management positions are filled by parent-country nationals. This practice was

LO 17-2 Identify the pros and cons of different approaches to staffing policy in the international business.

Staffing Policy Strategy concerned with selecting employees for particular jobs.

Corporate Culture The organization’s norms and value systems.

Ethnocentric Staffing Policy A staffing approach within the MNE in which all key management positions are filled by parent-country nationals.

17.1 FIGURE The Role of Human Resources in Shaping Organizational Architecture

Human Resources is responsible for these

aspects of organizational architecture

Structure

People Incentives &ControlsProcesses

Culture

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.

Chapter Seventeen Global Human Resource Management 491

widespread at one time. Firms such as Procter & Gamble, Philips, and Matsushita (now called Panasonic) originally followed it. In the Dutch firm Philips, for example, all im- portant positions in most foreign subsidiaries were at one time held by Dutch nationals, who were referred to by their non-Dutch colleagues as the Dutch Mafia. Historically in many Japanese and South Korean firms, such as Toyota, Matsushita, and Samsung, key positions in international operations have often been held by home-country nationals. For example, according to the Japanese Overseas Enterprise Association, only 29 percent of foreign subsidiaries of Japanese companies had presidents who were not Japanese. In contrast, 66 percent of the Japanese subsidiaries of for- eign companies had Japanese presidents.7 Today, there is evidence that as Chinese enterprises are expanding interna- tionally, they too are using an ethnocentric staffing policy in their foreign operations.8

Firms pursue an ethnocentric staffing policy for three reasons. First, the firm may believe the host country lacks qualified individuals to fill senior management positions. This argument is heard most often when the firm has opera- tions in less developed countries. Second, the firm may see an ethnocentric staffing policy as the best way to maintain a unified corporate culture. Many Japanese firms, for example, have traditionally preferred their foreign operations to be headed by expatriate Japanese managers because these man- agers will have been socialized into the firm’s culture while employed in Japan.9 Procter & Gamble until fairly recently preferred to staff important management positions in its foreign subsidiaries with U.S. nationals who had been socialized into P&G’s corporate culture by years of employment in its U.S. operations. Such reasoning tends to predominate when a firm places a high value on its corporate culture.

Third, if the firm is trying to create value by transferring core competencies to a foreign operation, as firms pursuing an international strategy are, it may believe that the best way to do this is to transfer parent-country nationals who have knowledge of that competency to the foreign operation. Imagine what might occur if a firm tried to transfer a core compe- tency in marketing to a foreign subsidiary without a corresponding transfer of home-coun- try marketing management personnel. The transfer would probably fail to produce the anticipated benefits because the knowledge underlying a core competency cannot easily be articulated and written down. Such knowledge often has a significant tacit dimension; it is acquired through experience. Just like the great tennis player who cannot instruct others how to become great tennis players simply by writing a handbook, the firm that has a core competency in marketing, or anything else, cannot just write a handbook that tells a foreign subsidiary how to build the firm’s core competency anew in a foreign setting. It must also transfer management personnel to the foreign operation to show foreign managers how to become good marketers, for example. The need to transfer managers overseas arises because the knowledge that underlies the firm’s core competency resides in the heads of its domestic managers and was acquired through years of experience, not by reading a handbook. Thus, if a firm is to transfer a core competency to a foreign subsidiary, it must also transfer the ap- propriate managers.

Despite this rationale for pursuing an ethnocentric staffing policy, the policy is now on the wane in most international businesses for two reasons. First, an ethnocentric staffing policy limits advancement opportunities for host-country nationals. This can lead to resent- ment, lower productivity, and increased turnover among that group. Resentment can be greater still if, as often occurs, expatriate managers are paid significantly more than home- country nationals.

Will We See an Influx of Chinese Workers Worldwide? Asia is among the fastest-growing areas of the world for inter- national students. For example, foreign enrollment of students at universities in Indonesia and South Korea has more than dou- bled since 2005. In particular, China has become the most popu- lar destination in Asia, and the country ranks third among all countries in hosting international students. Education in China is still a state-run system of public education, where the Ministry of Education is in charge. By some estimates, China has been growing investment in education by some 20 percent annually for more than a decade, and the quality of education has been improved along with this increased spending. This has resulted in Chinese people becoming more knowledgeable about today’s global marketplace; adding to the pool of talent are the Chinese who are educated abroad and decide to return home after their education. Collectively, these highly educated Chinese are more likely to want to work for a foreign company than a Chinese company. Companies already recruit Chinese in China for their foreign operations, but how significant do you think the potential influx of Chinese-educated people around the world will become in the next five years?

Source: K. Sheehy, “Explore the World’s Top Universities,” U.S. News & World Report, October 8, 2013.

492 Part Six International Business Functions

Second, an ethnocentric policy can lead to cultural myopia, the firm’s failure to understand host-country cultural differences that require different approaches to marketing and man- agement. The adaptation of expatriate managers can take a long time, during which they may make major mistakes. For example, expatriate managers may fail to appreciate how product attributes, distribution strategy, communications strategy, and pricing strategy should be adapted to host-country conditions. The result may be costly blunders. They may also make decisions that are ethically suspect simply because they do not understand the culture in which they are managing.10 In one highly publicized case in the United States, Mitsubishi Motors was sued by the federal Equal Employment Opportunity Commission for tolerating extensive and systematic sexual harassment in a plant in Illinois. The plant’s top management, all Japanese expatriates, denied the charges. The Japanese managers may have failed to realize that behavior that would be viewed as acceptable in Japan was not ac- ceptable in the United States.11

The Polycentric Approach A polycentric staffing policy requires host-country nationals to be recruited to manage subsidiaries, while parent-country nationals occupy key positions at corporate headquarters. In many respects, a polycentric approach is a response to the shortcomings of an ethnocentric approach. One advantage of adopting a polycentric approach is that the firm is less likely to suffer from cultural myopia. Host-country manag- ers are unlikely to make the mistakes arising from cultural misunderstandings to which ex- patriate managers are vulnerable. A second advantage is that a polycentric approach may be less expensive to implement, reducing the costs of value creation. Expatriate managers can be expensive to maintain.

A polycentric approach has its drawbacks. Host-country nationals have limited opportu- nities to gain experience outside their own country and thus cannot progress beyond senior positions in their own subsidiary. As in the case of an ethnocentric policy, this may cause resentment. Perhaps the major drawback with a polycentric approach, however, is the gap that can form between host-country managers and parent-country managers. Language bar- riers, national loyalties, and a range of cultural differences may isolate the corporate head- quarters staff from the various foreign subsidiaries. The lack of management transfers from home to host countries, and vice versa, can exacerbate this isolation and lead to a lack of integration between corporate headquarters and foreign subsidiaries. The result can be a “federation” of largely independent national units with only nominal links to the corporate headquarters. Within such a federation, the coordination required to transfer core compe- tencies or to pursue experience curve and location economies may be difficult to achieve. Thus, although a polycentric approach may be effective for firms pursuing a localization strategy, it is inappropriate for other strategies.

The federation that may result from a polycentric approach can also be a force for inertia within the firm. After decades of pursuing a polycentric staffing policy, food and detergents giant Unilever found that shifting from a strategic posture that emphasized localization to a transnational posture was very difficult. Unilever’s foreign subsidiaries had evolved into quasi-autonomous operations, each with its own strong national identity. These “little king- doms” objected strenuously to corporate headquarters’ attempts to limit their autonomy and to rationalize global manufacturing.12

The Geocentric Approach A geocentric staffing policy seeks the best people for key jobs throughout the organization, regardless of nationality. This policy has a num- ber of advantages. First, it enables the firm to make the best use of its human resources. Second, and perhaps more important, a geocentric policy enables the firm to build a cadre of international executives who feel at home working in a number of cultures. Creation of such a cadre may be a critical first step toward building a strong unifying corporate cul- ture and an informal management network, both of which are required for global stan- dardization and transnational strategies.13 Firms pursuing a geocentric staffing policy may be better able to create value from the pursuit of experience curve and location economies and from the multidirectional transfer of core competencies than firms pursuing other staffing policies. In addition, the multinational composition of the management team that

Polycentric Staffing Policy A staffing policy in an MNE in which host- country nationals are recruited to manage subsidiaries in their own country, while parent-country nationals occupy key positions at corporate headquarters.

Geocentric Staffing Policy A staffing policy where the best people are sought for key jobs throughout an MNE, regardless of nationality.

Chapter Seventeen Global Human Resource Management 493

results from geocentric staffing tends to reduce cultural myopia and to enhance local responsiveness.

In sum, other things being equal, a geocentric staffing policy seems the most attractive. Indeed, in recent years there has been a sharp shift toward adoption of a geocentric staffing policy by many multinationals. For example, India’s Tata Group, now a $100 billion global conglomerate, runs several of its companies with American and British executives. Japan’s Sony Corporation broke 60 years of tradition in 2005 when it installed its first non-Japanese chairman and CEO, Howard Stringer, a former CBS president and a U.S. citizen who was born and raised in Wales. American companies increasingly draw their managerial talent from overseas. In 2014, for example, Microsoft appointed Satya Nadella, a native of India, to its CEO position. One study found that by the mid-2000s, 24 percent of the managers among the top 100 to 250 people in U.S. companies were from outside the United States. For European companies, the average was 40 percent.14

However, a number of problems limit the firm’s ability to pursue a geocentric policy. Many countries want foreign subsidiaries to employ their citizens. To achieve this goal, they use immigration laws to require the employment of host-country nationals if they are avail- able in adequate numbers and have the necessary skills. Most countries, including the United States, require firms to provide extensive documentation if they wish to hire a for- eign national instead of a local national. This documentation can be time-consuming, ex- pensive, and at times futile. A geocentric staffing policy also can be expensive to implement. Training and relocation costs increase when transferring managers from country to country. The company may also need a compensation structure with a standardized international base pay level higher than national levels in many countries. In addition, the higher pay enjoyed by managers placed on an international fast track may be a source of resentment within a firm.

Summary The advantages and disadvantages of the three approaches to staffing policy are summarized in Table 17.1. Broadly speaking, an ethnocentric approach is compatible with an international strategy, a polycentric approach is compatible with a localization strat- egy, and a geocentric approach is compatible with both global standardization and transna- tional strategies. (See Chapter 12 for details of the strategies.)

While the staffing policies described here are well known and widely used among both practitioners and scholars of international businesses, some critics have claimed that the typology is too simplistic and that it obscures the internal differentiation of management practices within international businesses. The critics claim that within some international

17.1 TABLE Comparison of Staffing Approaches

Staffing Approach

Strategic Appropriateness Advantages Disadvantages

Ethnocentric International Overcomes lack of qualified managers in host nation

Unified culture

Helps transfer core competencies

Produces resentment in host country

Can lead to cultural myopia

Polycentric Localization Alleviates cultural myopia

Inexpensive to implement

Limits career mobility

Isolates headquarters from foreign subsidiaries

Geocentric Global standardization and transnational

Uses human resources efficiently

Helps build strong culture and informal management networks

National immigration policies may limit implementation

Expensive

494 Part Six International Business Functions

businesses, staffing policies vary significantly from na- tional subsidiary to national subsidiary; while some are managed on an ethnocentric basis, others are managed in a polycentric or geocentric manner.15 Other critics note that the staffing policy adopted by a firm is primarily driven by its geographic scope, as opposed to its strategic orientation. Firms that have a broad geographic scope are the most likely to have a geocentric mindset.16

EXPATRIATE MANAGERS Two of the three staffing policies we have discussed—the ethnocentric and the geocentric—rely on extensive use of expatriate man- agers. As defined earlier, expatriates are citizens of one country who are working in another country. Sometimes the term inpatriates is used to identify a subset of expatri- ates who are citizens of a foreign country working in the home country of their multinational employer.17 Thus, a citizen of Japan who moves to the United States to work at Microsoft would be classified as an inpatriate (Micro- soft has large numbers of inpatriates working at its main U.S. location near Seattle). With an ethnocentric policy, the expatriates are all home-country nationals who are transferred abroad. With a geocentric approach, the expa- triates need not be home-country nationals; the firm does

not base transfer decisions on nationality. A prominent issue in the international staffing literature is expatriate failure—the premature return of an expatriate manager to his or her home country.18 Here, we briefly review the evidence on expatriate failure before discussing a number of ways to minimize the failure rate.

Expatriate Failure Rates Expatriate failure represents a failure of the firm’s selec- tion policies to identify individuals who will not thrive abroad.19 The consequences include premature return from a foreign posting and high resignation rates, with expatriates leaving their company at about twice the rate of domestic managers.20 The costs of expatriate failure are high. One estimate is that the average cost per failure to the parent firm can be as high as three times the expatriate’s annual domestic salary plus the cost of relocation (which is affected by currency exchange rates and location of assignment). Estimates of the costs of each failure run between $40,000 and $1 million.21 In addition, approximately 30 to 50 per- cent of American expatriates, whose average annual compensation package runs to $250,000, stay at their international assignments but are considered ineffective or marginally effective by their firms.22 In a seminal study, undertaken in the 1980s R. L. Tung surveyed a number of U.S., European, and Japanese multinationals.23 Her results, summarized in Table 17.2, show that 76 percent of U.S. multinationals experienced expatriate failure rates of 10 per- cent or more, and 7 percent experienced a failure rate of more than 20 percent. Tung’s work also suggests that U.S.-based multinationals experience a much higher expatriate failure rate than either European or Japanese multinationals. However, more recent work suggests that Tung’s widely quoted estimates may no longer hold. For example, a study of 136 large mul- tinationals from four different countries undertaken in the late 2000s found that the rate of premature return of expatriate managers had dropped to 6.3 percent and that there was lit- tle difference between multinationals from different nations. The authors of this study sug- gest that multinationals have gotten much better at the selection and training of expatriates since Tung’s study.24

Tung asked her sample of multinational managers to indicate reasons for expatriate fail- ure. For U.S. multinationals, the reasons, in order of importance, were:

1. Inability of spouse to adjust. 2. Manager’s inability to adjust.

LO 17-3 Explain why managers may fail to thrive in foreign postings.

Expatriate Failure The premature return of an expatriate manager to the home country.

Would You Send a Woman on an International Assignment? Would you send a woman expatriate to Saudi Arabia, Japan, Korea, or Kuwait? How are Western women expatriates doing in foreign cultures that have traditionally limited women’s public roles? In many cases, women sent to these countries have met with sub- stantial success. Their key challenge is often simply to get the assignments! Once in place, women expatriates are usually suc- cessful. This is in part because once in the culture, women expa- triates are seen first as expatriates who fall outside the local role for women. In addition, “expat” women also have salience in their new environment—they are noticed—and this can be a distinct business advantage. Locals often take pride in developing busi- ness relationships with women expatriates because by doing so they can suggest that the foreign stereotype of their culture is superficial and incomplete. But cultural barriers still remain, with some cultures having restrictions on what women are allowed to do and not do in business settings and social life. With these lin- gering potential problems in some countries in the world, would you send a woman on an international assignment?

Chapter Seventeen Global Human Resource Management 495

3. Other family problems. 4. Manager’s personal or emotional maturity. 5. Inability to cope with larger overseas responsibilities.

Managers of European firms gave only one reason consistently to explain expatriate fail- ure: the inability of the manager’s spouse to adjust to a new environment. For the Japanese firms, the reasons for failure were:

1. Inability to cope with larger overseas responsibilities. 2. Difficulties with new environment. 3. Personal or emotional problems. 4. Lack of technical competence. 5. Inability of spouse to adjust.

The most striking difference between these lists is that “inability of spouse to adjust” was the top reason for expatri- ate failure among U.S. and European multinationals but only the fifth reason among Japanese multinationals. Tung comments that this difference was not surprising, given the role and status to which Japanese society traditionally rele- gates the wife and the fact that most of the Japanese expatri- ate managers in the study were men.

Since Tung’s study, a number of other studies have con- sistently confirmed that the inability of a spouse to adjust, the inability of the manager to adjust, or other family prob- lems remain major reasons for continuing high levels of ex- patriate failure.25 One study by International Orientation Resources, an HRM consulting firm, found that 60 percent of expatriate failures occur due to these three reasons.26 An- other study found that the most common reason for assign- ment failure is lack of partner (spouse) satisfaction, which was listed by 27 percent of respondents.27 The inability of expatriate managers to adjust to foreign postings seems to be caused by a lack of cultural skills on the part of the man- ager being transferred. According to one HRM consulting firm, this is because the expatriate selection process at many firms is fundamentally flawed: “Expatriate assignments

17.2 TABLE Expatriate Failure Rates Source: Data from R. L. Tung, “Selection and Training Procedures of U.S., European, and Japanese Multinationals,” California Management Review, Vol. 25, No. 1 (1982), pp. 51–71.

Recall Rate Percent Percent of Companies

U.S. multinationals

20–40

10–20

,10

European multinationals

11–15

6–10

Japanese multinationals

11–19

6–10

Which Country Do You Want To Go To? The HSBC Expat Explorer Survey is an interesting way to better understand the friendliness of a country. The Expat Explorer Survey provides an overall ranking based on economics, experience, and raising children in the country (because expatriates are often younger professionals establishing their family lives while abroad). China, Germany, Singapore, Cayman Island, and Australia are at the top in 2013. Interestingly, of the 24 countries ranked, at the bottom of the ranking are Ireland, Italy, United Kingdom, Kuwait, and Spain. Many rankings exist on how countries see foreign visitors, and visiting instead of staying to work in the country also has implica- tions. According to the World Economic Forum’s “friendliest coun- tries” ranking, the attitude of the local population toward foreign visitors is the best in Iceland, New Zealand, Morocco, Macedonia, and Austria. The bottom five countries, from the ranking of 140 countries, are Bolivia, Venezuela, Russia, Kuwait, and Latvia. Kuwait is at the bottom both for expats to work and visitors in general for tourism. If you can pick one country in the world to work in and also to visit as a visitor—not at the same time, naturally—which country would it be?

Sources: C. Davis, “The World’s Friendliest Countries to Foreigners, According to the World Economic Forum,” The Huffi ngton Post, April 9, 2013; J. Blanke and T. Chiesa, The Travel and Tourism Competitiveness Report 2013, World Economic Forum; and HSBC Expat Explorer Survey, http://www.expatexplorer.hsbc.com/, accessed April 12, 2014.

496 Part Six International Business Functions

rarely fail because the person cannot accommodate to the technical demands of the job. Typically, the expatriate selections are made by line managers based on technical compe- tence. They fail because of family and personal issues and lack of cultural skills that haven’t been part of the selection process.”28

The failure of spouses to adjust to a foreign posting seems to be related to a number of factors. Often, spouses find themselves in a foreign country without the familiar network of family and friends. Language differences make it difficult for them to make new friends. While this may not be a problem for the manager, who can make friends at work, it can be difficult for the spouse, who might feel trapped at home. The problem is often exacerbated by immigration regulations prohibiting the spouse from taking employment. With the re- cent rise of two-career families in many developed nations, this issue has become much more important. One survey found that 69 percent of expatriates are married, with spouses accompanying them 77 percent of the time. Of those spouses, 49 percent were employed before an assignment and only 11 percent were employed during an assignment.29 Research suggests that a main reason managers now turn down international assignments is concern over the impact such an assignment might have on their spouse’s career.30 The accompany- ing Management Focus examines how one large multinational company, Royal Dutch Shell, has tried to come to grips with this issue.

Expatriate Selection One way to reduce expatriate failure rates is by improving selection procedures to screen out inappropriate candidates. In a review of the research on

Managing Expatriates at Royal Dutch Shell

Royal Dutch Shell is a global petroleum company with joint headquar- ters in both London and The Hague in the Netherlands. The company employs more than 80,000 people, approximately 5,500 of whom are at any one time living and working as expatriates. The expatriates at Shell are a diverse group, made up of more than 70 nationalities and located in more than 100 countries. Shell, as a global corporation, has long recognized that the international mobility of its workforce is es- sential to its success. By the 1990s, however, Shell was finding it harder to recruit key personnel for foreign postings. To discover why, the company interviewed more than 200 expatriate employees and their spouses to determine their biggest concerns. The data were then used to construct a survey that was sent to 17,000 current and former expatriate employees, expatriates’ spouses, and employees who had declined international assignments.

The survey registered a phenomenal 70 percent response rate, clearly indicating that many employees thought this was an impor- tant issue. According to the survey, five issues had the greatest im- pact on the willingness of an employee to accept an international assignment. In order of importance, these were (1) separation from children during their secondary education (the children of British and Dutch expatriates were often sent to boarding schools in their home countries while their parents worked abroad), (2) harm done to a spouse’s career and employment, (3) failure to recognize and involve a spouse in the relocation decision, (4) failure to provide adequate information and assistance regarding relocation, and (5) health is- sues. The underlying message was that the family is the basic unit of expatriation, not the individual, and Shell needed to do more to rec- ognize this.

To deal with these issues, Shell implemented a number of pro- grams designed to address some of these problems. To help with the education of children, Shell built elementary schools for Shell employ- ees where there was a heavy concentration of expatriates. As for sec- ondary school education, it worked with local schools, often providing grants, to help them upgrade their educational offerings. It also offered an education supplement to help expatriates send their children to pri- vate schools in the host country.

Helping spouses with their careers is a more vexing problem. According to the survey data, half the spouses accompanying Shell staff on assignment were employed until the transfer. When expatri- ated, only 12 percent were able to secure employment, while a further 33 percent wished to be employed. Shell set up a spouse employment center to address the problem. The center provides career counseling and assistance in locating employment opportunities both during and immediately after an international assignment. The company also agreed to reimburse up to 80 percent of the costs of vocational train- ing, further education, or reaccreditation, up to $4,400 per assignment.

Shell also set up a global information and advice network known as “The Outpost” to provide support for families contemplating a foreign posting. The Outpost has its headquarters in The Hague and now runs 45 to 55 local offices around the world (depending on the business). The center recommends schools and medical facilities and provides housing advice and up-to-date information on employment, study, self- employment, and volunteer work.

Sources: E. Smockum, “Don’t Forget the Trailing Spouse,” Financial Times, May 6, 1998, p. 22; V. Frazee, “Tearing Down Roadblocks,” Workforce 77, no. 2 (1998), pp. 50–54; C. Sievers, “Expatriate Management,” HR Focus 75, no. 3 (1998), pp. 75–76; J. Barbian, “Return to Sender,” Training, January 2002, pp. 40–43; and J. Mainwaring, “Shell Schools: Supporting Expat Families,” Rigzone, June 21, 2012.

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this issue, Mendenhall and Oddou state that a major problem in many firms is that HRM managers tend to equate domestic performance with overseas performance potential.31 Domestic performance and overseas performance potential are not the same thing. An ex- ecutive who performs well in a domestic setting may not be able to adapt to managing in a different cultural setting. From their review of the research, Mendenhall and Oddou identi- fied four dimensions that seem to predict success in a foreign posting: self-orientation, others-orientation, perceptual ability, and cultural toughness.

1. Self-orientation. The attributes of this dimension strengthen the expatriate’s self-esteem, self-confidence, and mental well-being. Expatriates with high self-esteem, self- confidence, and mental well-being were more likely to succeed in foreign postings. Mendenhall and Oddou concluded that such individuals were able to adapt their interests in food, sport, and music; had interests outside of work that could be pursued (e.g., hobbies); and were technically competent.

2. Others-orientation. The attributes of this dimension enhance the expatriate’s ability to interact effectively with host-country nationals. The more effectively the expatriate interacts with host-country nationals, the more likely he or she is to succeed. Two factors seem to be particularly important here: relationship development and willingness to communicate. Relationship development refers to the ability to develop long-lasting friendships with host-country nationals. Willingness to communicate refers to the expatriate’s willingness to use the host-country language. Although language fluency helps, an expatriate need not be fluent to show willingness to communicate. Making the effort to use the language is what is important. Such gestures tend to be rewarded with greater cooperation by host-country nationals.

3. Perceptual ability. This is the ability to understand why people of other countries behave the way they do, that is, the ability to empathize. This dimension seems critical for managing host-country nationals. Expatriate managers who lack this ability tend to treat foreign nationals as if they were home-country nationals. As a result, they may experience significant management problems and considerable frustration. As one expatriate executive from Hewlett-Packard observed, “It took me six months to accept the fact that my staff meetings would start 30 minutes late, and that it would bother no one but me.” According to Mendenhall and Oddou, well-adjusted expatriates tend to be nonjudgmental and nonevaluative in interpreting the behavior of host-country nationals and willing to be flexible in their management style, adjusting it as cultural conditions warrant.

4. Cultural toughness. This dimension refers to the relationship between the country of assignment and how well an expatriate adjusts to a particular posting. Some countries are much tougher postings than others because their cultures are more unfamiliar and uncomfortable. For example, many Americans regard Great Britain as a relatively easy foreign posting, and for good reason—the two cultures have much in common. But many Americans find postings in non-Western cultures, such as India, Southeast Asia, and the Middle East, to be much tougher.32 The reasons are many, including poor health care and housing standards, inhospitable climate, lack of Western entertainment, and language difficulties. Also, many cultures are extremely male-dominated and may be particularly difficult postings for female Western managers.

THE GLOBAL MINDSET Some researchers suggest that a global mindset, one characterized by cognitive complexity and a cosmopolitan outlook, is the fundamental at- tribute of a global manager. Such managers can deal with high levels of complexity and ambiguity and are open to the world. How do you develop these attributes? Often they are gained in early life, from a family that is bicultural, lives in foreign countries, or learns for- eign languages as a regular part of family life.

Mendenhall and Oddou note that standard psychological tests can be used to assess the first three of these dimensions, whereas a comparison of cultures can give managers a feel- ing for the fourth dimension. They contend that these four dimensions, in addition to do- mestic performance, should be considered when selecting a manager for foreign posting.

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However, practice does not often conform to Mendenhall and Oddou’s recommendations. Tung’s research, for example, showed that only 5 percent of the firms in her sample used formal procedures and psychological tests to assess the personality traits and relational abilities of potential expatriates.33 Research by International Orientation Resources sug- gests that when selecting employees for foreign assignments, only 10 percent of the 50 Fortune 500 firms surveyed tested for important psychological traits such as cultural sensitivity, interpersonal skills, adaptability, and flexibility. Instead, 90 percent of the time employees were selected on the basis of their technical expertise, not their cross-cultural fluency.34

Mendenhall and Oddou do not address the problem of expatriate failure due to a spouse’s inability to adjust. According to a number of other researchers, a review of the family situa- tion should be part of the expatriate selection process (see the Management Focus on Royal Dutch Shell for an example).35 A survey by Windam International, another international HRM consulting firm, found that spouses were included in preselection interviews for for- eign postings only 21 percent of the time and that only half of them received any cross- cultural training. The rise of dual-career families has added an additional and difficult dimension to this long-standing problem.36 Increasingly, spouses wonder why they should have to sacrifice their own career to further that of their partner.37

Training and Management Development Selection is just the first step in matching a manager with a job. The next step is training the manager to do the specific job. For example, an intensive training program might be used to give expatriate managers the skills required for success in a foreign posting. How- ever, management development is a much broader concept. It is intended to develop the manager’s skills over his or her career with the firm. Thus, as part of a management devel- opment program, a manager might be sent on several foreign postings over a number of years to build his or her cross-cultural sensitivity and experience. At the same time, along with other managers in the firm, the person might attend management education programs at regular intervals. The thinking behind job transfers is that broad international experi- ence will enhance the management and leadership skills of executives. Research suggests this may be the case.38

Historically, most international businesses have been more concerned with training than with management development. Plus, they tended to focus their training efforts on preparing home-country nationals for foreign postings. Recently, however, the shift to- ward greater global competition and the rise of transnational firms have changed this. It is increasingly common for firms to provide general management development programs in addition to training for particular posts. In many international businesses, the explicit purpose of these management development programs is strategic. Management develop- ment is seen as a tool to help the firm achieve its strategic goals, not only by giving man- agers the required skill set but also by helping reinforce the desired culture of the firm and by facilitating the creation of an informal network for sharing knowledge within the multinational enterprise.

With this distinction between training and management development in mind, we first examine the types of training managers receive for foreign postings. Then we discuss the connection between management development and strategy in the international business.

TRAINING FOR EXPATRIATE MANAGERS Earlier in the chapter, we saw that the two most common reasons for expatriate failure were the inability of a manag- er’s spouse to adjust to a foreign environment and the manager’s own inability to adjust to a foreign environment. Training can help the manager and spouse cope with both these prob- lems. Cultural training, language training, and practical training all seem to reduce expatri- ate failure. We discuss each of these kinds of training here.39 Despite the usefulness of the training, evidence suggests that many managers receive no training before they are sent on foreign postings. One study found that only about 30 percent of managers sent on one- to five-year expatriate assignments received training before their departure.40

LO 17-4 Recognize how management development and training programs can increase the value of human capital in the international business firm.

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Cultural Training Cultural training seeks to foster an appreciation for the host country’s culture. The belief is that understanding a host country’s culture will help the manager empathize with the culture, which will enhance his or her effectiveness in dealing with host-country nationals. It has been suggested that expatriates should receive training in the host country’s culture, history, politics, economy, reli- gion, and social and business practices.41 If possible, it is also advisable to arrange for a familiarization trip to the host country before the formal transfer, because this seems to ease culture shock. Given the problems related to spouse ad- aptation, it is important that the spouse, and perhaps the whole family, be included in cultural training programs.

Language Training English is the language of world business; it is quite possible to conduct business all over the world using only English. Notwithstanding the prevalence of English, however, an exclusive reliance on English diminishes an expatriate manager’s ability to interact with host-country nationals. As noted earlier, a willingness to communi- cate in the language of the host country, even if the expatriate is far from fluent, can help build rapport with local employees and improve the manager’s effectiveness. Despite this, one study of 74 executives of U.S. multinationals found that only 23 believed knowledge of foreign languages was necessary for conducting business abroad.42 Those firms that did of- fer foreign language training for expatriates believed it improved their employees’ effective- ness and enabled them to relate more easily to a foreign culture, which fostered a better image of the firm in the host country.

Practical Training Practical training is aimed at helping the expatriate manager and family ease themselves into day-to-day life in the host country. The sooner a routine is es- tablished, the better are the prospects that the expatriate and his or her family will adapt successfully. One critical need is for a support network of friends for the expatriate. Where an expatriate community exists, firms often devote considerable effort to ensuring the new expatriate family is quickly integrated into that group. The expatriate community can be a useful source of support and information and can be invaluable in helping the family adapt to a foreign culture.

REPATRIATION OF EXPATRIATES A largely overlooked but critically im- portant issue in the training and development of expatriate managers is to prepare them for reentry into their home-country organization.43 Repatriation should be seen as the final link in an integrated, circular process that connects good selection and cross-cultural training of expatriate managers with completion of their term abroad and reintegration into their na- tional organization. However, instead of having employees come home to share their knowl- edge and encourage other high-performing managers to take the same international career track, expatriates too often face a different scenario.44

Often when they return home after a stint abroad—where they have typically been au- tonomous, well-compensated, and celebrated as a big fish in a little pond—they face an or- ganization that doesn’t know what they have done for the past few years, doesn’t know how to use their new knowledge, and doesn’t particularly care. In the worst cases, reentering employees have to scrounge for jobs, or firms will create standby positions that don’t use the expatriate’s skills and capabilities and fail to make the most of the business investment the firm has made in that individual.

Research illustrates the extent of this problem. According to one study of repatriated employees, 60 to 70 percent didn’t know what their position would be when they returned home. Also, 60 percent said their organizations were vague about repatriation, about their new roles, and about their future career progression within the company; 77 percent of

Lenovo decided that English was to be the official language of the company, even though it is a Chinese enterprise.

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those surveyed took jobs at a lower level in their home organization than in their interna- tional assignments.45 Not surprisingly, 15 percent of returning expatriates leave their firms within a year of arriving home, and 40 percent leave within three years.46

The key to solving this problem is good human resource planning. Just as the HRM function needs to develop good selection and training programs for its expatriates, it also needs to develop good programs for reintegrating expatriates back into work life within their home-country organization, for preparing them for changes in their physical and pro- fessional landscape, and for utilizing the knowledge they acquired while abroad. For an ex- ample of the kind of program that might be used, see the accompanying Management Focus that looks at the repatriation program developed by Monsanto.

MANAGEMENT DEVELOPMENT AND STRATEGY Management de- velopment programs are designed to increase the overall skill levels of managers through a mix of ongoing management education and rotations of managers through a number of jobs within the firm to give them varied experiences. They are attempts to improve the overall productivity and quality of the firm’s management resources.

International businesses are increasingly using management development as a strategic tool. This is particularly true in firms pursuing a transnational strategy, as increasing num- bers are. Such firms need a strong unifying corporate culture and informal management networks to assist in coordination and control. In addition, transnational firm managers need to be able to detect pressures for local responsiveness—and that requires them to un- derstand the culture of a host country.

Management development programs help build a unifying corporate culture by socializ- ing new managers into the norms and value systems of the firm. In-house company training

Monsanto’s Repatriation Program

Monsanto is a global provider of agricultural products with 20,000 em- ployees. At any one time, the company will have 100 mid- and higher- level managers on extended postings abroad. Two-thirds of these are Americans posted overseas; the remainder are foreign nationals em- ployed in the United States. At Monsanto, managing expatriates and their repatriation begins with a rigorous selection process and inten- sive cross-cultural training, both for the managers and for their fami- lies. As at many other global companies, the idea is to build an internationally minded cadre of highly capable managers who will lead the organization in the future.

One of the strongest features of this program is that employees and their sending and receiving managers, or sponsors, develop an agree- ment about how this assignment will fit into the firm’s business objec- tives. The focus is on why employees are going abroad to do the job and what their contribution to Monsanto will be when they return. Sponsoring managers are expected to be explicit about the kind of job opportunities the expatriates will have once they return home.

Once they arrive back in their home country, expatriate managers meet with cross-cultural trainers during debriefing sessions. They are also given the opportunity to showcase their experiences to their peers, subordinates, and superiors in special information exchanges.

However, Monsanto’s repatriation program focuses on more than just business; it also attends to the family’s reentry. Monsanto has

found that difficulties with repatriation often have more to do with personal and family-related issues than with work-related issues. But the personal matters obviously affect an employee’s on-the-job per- formance, so it is important for the company to pay attention to such issues.

This is why Monsanto offers returning employees an opportunity to work through personal difficulties. About three months after they return home, expatriates meet for three hours at work with several colleagues of their choice. The debriefing session is a conversation aided by a trained facilitator who has an outline to help the expatriate cover all the important aspects of the repatriation. The debriefing allows the em- ployee to share important experiences and to enlighten managers, col- leagues, and friends about his or her expertise so others within the organization can use some of the global knowledge. According to one participant, “It sounds silly, but it’s such a hectic time in the family’s life, you don’t have time to sit down and take stock of what’s happen- ing. You’re going through the move, transitioning to a new job, a new house, and the children may be going to a new school. This is a kind of oasis; a time to talk and put your feelings on the table.” Apparently it works; since the program was introduced, the attrition rate among re- turning expatriates has dropped sharply.

Sources: C. M. Solomon, “Repatriation: Up, Down, or Out?” Personnel Journal, January 1995, pp. 28–34; and J. Schaefer, E. Hannibal, and J. O’Neill, “How Strategy, Culture and Improved Service Delivery Reshape Monsanto’s International Assignment Program,” Journal of Organizational Excellence 22, no. 3 (2003), pp. 35–40.

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programs and intense interaction during off-site training can foster esprit de corps—shared experiences, informal networks, perhaps a company language or jargon—as well as develop technical competencies. These training events often include songs, picnics, and sporting events that promote feelings of togetherness. These rites of integration may include “initia- tion rites” wherein personal culture is stripped, company uniforms are donned (e.g., T-shirts bearing the company logo), and humiliation is inflicted (e.g., a pie in the face). All these ac- tivities aim to strengthen a manager’s identification with the company.47

Bringing managers together in one location for extended periods and rotating them through different jobs in several countries help the firm build an informal management network. Such a network can then be used as a conduit for exchanging valuable perfor- mance-enhancing knowledge within the organization.48 Consider the Swedish telecommu- nications company Ericsson. Interunit cooperation is extremely important at Ericsson, particularly for transferring know-how and core competencies from the parent to foreign subsidiaries, from foreign subsidiaries to the parent, and between foreign subsidiaries. To facilitate cooperation, Ericsson transfers large numbers of people back and forth between headquarters and subsidiaries. Ericsson sends a team of 50 to 100 engineers and managers from one unit to another for a year or two. This establishes a network of interpersonal con- tacts. This policy is effective for both solidifying a common culture in the company and coordinating the company’s globally dispersed operations.49

Performance Appraisal Performance appraisal systems are used to evaluate the performance of managers against some criteria that the firm judges to be important for the implementation of strategy and the attainment of a competitive advantage. A firm’s performance appraisal systems are an important element of its control systems, and control systems are a central component of organizational architecture. A particularly thorny issue in many international businesses is how best to evaluate the performance of expatriate managers.50 This section looks at this issue and considers guidelines for appraising expatriate performance.

PERFORMANCE APPRAISAL PROBLEMS Unintentional bias makes it difficult to evaluate the performance of expatriate managers objectively. In many cases, two groups evaluate the performance of expatriate managers—host-nation managers and home-office managers—and both are subject to bias. The host-nation managers may be biased by their own cultural frame of reference and expectations. For example, Oddou and Mendenhall report the case of a U.S. manager who introduced participative decision mak- ing while working in an Indian subsidiary.51 The manager subsequently received a negative evaluation from host-country managers because in India, the strong social stratification means managers are seen as experts who should not have to ask subordinates for help. The local employees apparently viewed the U.S. manager’s attempt at participatory manage- ment as an indication that he was incompetent and did not know his job.

Home-country managers’ appraisals may be biased by distance and by their own lack of experience working abroad. Home-office managers are often not aware of what is going on in a foreign operation. Accordingly, they tend to rely on hard data in evaluating an expatriate’s performance, such as the subunit’s productivity, profitability, or market share. Such criteria may reflect factors outside the expatriate manager’s control (e.g., adverse changes in exchange rates, economic downturns). Also, hard data do not take into account many less visible soft variables that are also important, such as an expatriate’s ability to develop cross-cultural awareness and to work productively with local managers. Due to such biases, many expatriate managers believe that headquarters management evaluates them unfairly and does not fully appreciate the value of their skills and experience. This could be one reason many expatriates believe a foreign posting does not benefit their careers. In one study of personnel managers in U.S. multinationals, 56 percent of the managers surveyed stated that a foreign assignment is either detrimental or immaterial to one’s career.52

LO 17-5 Explain how and why performance appraisal systems might vary across nations.

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GUIDELINES FOR PERFORMANCE APPRAISAL Several things can reduce bias in the performance appraisal process.53 First, most expatriates appear to believe more weight should be given to an on-site manager’s appraisal than to an off-site manager’s appraisal. Due to proximity, an on-site manager is more likely to evaluate the soft variables that are important aspects of an expatriate’s performance. The evaluation may be especially valid when the on-site manager is of the same nationality as the expatriate because cultural bias should be alleviated. In practice, home-office managers often write performance evalu- ations after receiving input from on-site managers. When this is the case, most experts rec- ommend that a former expatriate who served in the same location should be involved in the appraisal to help reduce bias. Finally, when the policy is for foreign on-site managers to write performance evaluations, home-office managers should be consulted before an on-site manager completes a formal termination evaluation. This gives the home-office manager the opportunity to balance what could be a very hostile evaluation based on a cultural mis- understanding.

Compensation Two issues are raised in every discussion of compensation practices in an international busi- ness. One is how compensation should be adjusted to reflect national differences in eco- nomic circumstances and compensation practices. The other issue is how expatriate managers should be paid. From a strategic perspective, the important point is that whatever compensation system is used, it should reward managers for taking actions that are consis- tent with the strategy of the enterprise.

NATIONAL DIFFERENCES IN COMPENSATION Differences exist in the compensation of executives at the same level in various countries. The results of a survey undertaken by Towers Watson, for example, suggest that U.S. CEOs earn, on average, roughly double the pay of non-U.S. CEOs.54

National differences in compensation raise a perplexing question for an international business: Should the firm pay executives in different countries according to the prevailing standards in each country, or should it equalize pay on a global basis? The problem does not arise in firms pursuing ethnocentric or polycentric staffing policies. In ethnocentric firms, the issue can be reduced to that of how much home-country expatriates should be paid (which we consider later). As for polycentric firms, the lack of managers’ mobility among national operations implies that pay can and should be kept country-specific. There would seem to be no point in paying executives in Great Britain the same as U.S. executives if they never work side by side.

However, this problem is very real in firms with geocentric staffing policies. A geocen- tric staffing policy is consistent with a transnational strategy. One aspect of this policy is the need for a cadre of international managers that may include many different nation- alities. Should all members of such a cadre be paid the same salary and the same incentive pay? For a U.S.-based firm, this would mean raising the compensation of foreign nation- als to U.S. levels, which could be expensive. If the firm does not equalize pay, it could cause considerable resentment among foreign nationals who are members of the interna- tional cadre and work with U.S. nationals. If a firm is serious about building an interna- tional cadre, it may have to pay its international executives the same basic salary irrespective of their country of origin or assignment. Currently, however, this practice is not widespread.

Over the past decade many firms have moved toward a compensation structure that is based on consistent global standards, with employees being evaluated by the same grading system and having access to the same bonus pay and benefits structure irrespective of where they work. Some 85 percent of the companies in a survey by Mercer Management Consulting stated they now have a global compensation strategy in place.55 McDonald’s, which is featured in the accompanying Management Focus, is one such enterprise. Another survey found that two-thirds of multinationals now exercise central control over

LO 17-6 Understand how and why compensation systems might vary across nations.

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the benefit plans offered in different nations.56 However, except for a relative small cadre of internationally mobile executives, base pay in most firms is set with regard to local mar- ket conditions.

EXPATRIATE PAY The most common approach to expatriate pay is the balance sheet approach. According to Organizational Resources Consulting, some 80 percent of the 781 companies it surveyed used this approach.57 This approach equalizes purchasing power across countries so employees can enjoy the same living standard in their foreign posting that they enjoyed at home. In addition, the approach provides financial incentives to offset qualitative differences between assignment locations.58 Figure 17.2 shows a typical balance sheet. Note that home-country outlays for the employee are designated as income

Global Compensation Practices at McDonald’s

With more than 400,000 managers and senior staff employees in 119 countries around the world, by the early 2000s McDonald’s realized it had to develop a consistent global compensation and performance ap- praisal strategy. After months of consultation with managers all over the world, the company began to roll out its new global compensation program in 2004.

One important element of this program calls for the corporate head office to provide local country managers with a menu of business prin- ciples to focus on in the coming year. These principles include areas such as customer service, marketing, and restaurant re-imaging. Each country manager then picks three to five areas to focus on for success in the local market. For example, if France is introducing a new menu item, it might create business targets around that for the year. Human resource managers then submit their business cases and targets to senior executives at headquarters for approval. At the end of the year,

the country’s annual incentive pool is based on how the region met its targets, as well as on the business unit’s operating income. A portion of an individual employee’s annual bonus is based on that mix.

The other portion of an employee’s annual incentive is based on individual performance. McDonald’s has always had a performance rating system, but in 2004 the company introduced global guidelines that suggest 20 percent of employees receive the highest rating, 70 percent the middle, and 10 percent the bottom. By giving guide- lines rather than forced ranking, McDonald’s hopes to encourage dif- ferentiation of performance while allowing for some local flexibility nuances. By providing principles and guidance, and yet allowing local managers to customize their compensation programs to meet local market demands, McDonald’s also claims it has seen a reduction in turnover. The company’s own internal surveys suggest more employ- ees now believe that their compensation is fair and reflects local mar- ket conditions.

Sources: J. Marquez, “McDonald’s Rewards Program Leaves Some Room for Local Flavor,” Workforce Management, April 10, 2006, p. 26.

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17.2 FIGURE The Balance Sheet Approach to Expatriate Pay

The Balance Sheet

Additional Costs Paid by Company

Income Taxes Housing

Reserve

Goods & Services

Home-Country Salary

Home- & Assignment-

Location Income Taxes

Housing

Reserve

Goods & Services

Assignment- Location Costs

Income Taxes

Housing

Reserve

Goods & Services

Assignment- Location Costs

Paid by Company and from Salary

Income Taxes Housing

Reserve

Goods & Services

Home-Country Equivalent

Purchasing Power

Premiums & Incentives

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taxes, housing expenses, expenditures for goods and services (food, clothing, entertainment, etc.), and reserves (savings, pension contributions, etc.). The balance sheet approach at- tempts to provide expatriates with the same standard of living in their host countries as they enjoy at home plus a financial inducement (i.e., premium, incentive) for accepting an overseas assignment.

The components of the typical expatriate compensation package are a base salary, a for- eign service premium, allowances of various types, tax differentials, and benefits. We briefly review each of these components.59 An expatriate’s total compensation package may amount to three times what he or she would cost the firm in a home-country posting. Because of the high cost of expatriates, many firms have reduced their use of them in recent years. How- ever, a firm’s ability to reduce its use of expatriates may be limited, particularly if it is pursu- ing an ethnocentric or geocentric staffing policy.

Base Salary An expatriate’s base salary is normally in the same range as the base salary for a similar position in the home country. The base salary is normally paid in either the home-country currency or in the local currency.

Foreign Service Premium A foreign service premium is extra pay the expatriate receives for working outside his or her country of origin. It is offered as an inducement to accept foreign postings. It compensates the expatriate for having to live in an unfamiliar country isolated from family and friends, having to deal with a new culture and language, and having to adapt to new work habits and practices. Many firms pay foreign service pre- miums as a percentage of base salary, ranging from 10 to 30 percent after tax, with 16 per- cent being the average premium.60

Allowances Four types of allowances are often included in an expatriate’s compensation package: hardship, housing, cost of living, and education. A hardship allowance is paid when the expatriate is being sent to a difficult location, usually defined as one where such basic amenities as health care, schools, and retail stores are grossly deficient by the standards of the

expatriate’s home country. A housing allowance is nor- mally given to ensure that the expatriate can afford the same quality of housing in the foreign country as at home. In locations where housing is expensive (e.g., London, Tokyo), this allowance can be substantial—as much as 10 to 30 percent of the expatriate’s total compensation pack- age. A cost-of-living allowance ensures that the expatriate will enjoy the same standard of living in the foreign post- ing as at home. An education allowance ensures that an expatriate’s children receive adequate schooling (by home- country standards). Host-country public schools are sometimes not suitable for an expatriate’s children, in which case they must attend a private school.

Taxation Unless a host country has a reciprocal tax treaty with the expatriate’s home country, the expatriate may have to pay income tax to both the home- and host- country governments. When a reciprocal tax treaty is not in force, the firm typically pays the expatriate’s income tax in the host country. In addition, firms normally make up the difference when a higher income tax rate in a host country reduces an expatriate’s take-home pay.

Benefits Many firms also ensure that their expatri- ates receive the same level of medical and pension bene- fits abroad that they received at home. This can be costly

Where Would You Go To Find Expat Resources? Not so many years ago, business professionals whose compa- nies sent them overseas to work had few outside resources to help them become acclimated to their new status as expatri- ates. Today, however, a wealth of information is available. For example, a simple keyword search online for “expatriate” yields an almost endless supply of links: newspapers and magazines published exclusively for expats; websites catering to expatri- ates in specific regions or countries; general information sites offering insiders’ guides to different countries and their finance, culture, and health care systems; not to mention blogs and chat rooms, forums and groups. The expatriate boom has even fu- eled an industry offering a broad array of services for expats, from mail forwarding to tax preparation to health and life insur- ance. One example is globalEDGE’s section on “Travel/Living Abroad” (http://globaledge.msu.edu/global-resources/travel- living-abroad). While often good, the examples in this short write-up are all online, removed from the country itself. How much would you trust online information and data as the only source for “getting to know” the new country you have just signed on to spend three years in as an expat?

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for the firm, because many benefits that are tax-deductible for the firm in the home country (e.g., medical and pension benefits) may not be deductible out of the country.

International Labor Relations The HRM function of an international business is typically responsible for international labor relations. From a strategic perspective, the key issue in international labor relations is the degree to which organized labor can limit the choices of an international business. A firm’s ability to integrate and consolidate its global operations to realize experience curve and location economies can be limited by organized labor, constraining the pursuit of a transnational or global standardization strategy. Prahalad and Doz cite the example of Gen- eral Motors, which gained peace with labor unions in Germany by agreeing not to integrate and consolidate operations in the most efficient manner.61 General Motors made substantial investments in Germany—matching its new investments in Austria and Spain—at the de- mand of the German metalworkers’ unions.

One task of the HRM function is to foster harmony and minimize conflict between the firm and organized labor. With this in mind, this section is divided into three parts. First, we review organized labor’s concerns about multinational enterprises. Second, we look at how organized labor has tried to deal with these concerns. And third, we look at how interna- tional businesses manage their labor relations to minimize labor disputes.

THE CONCERNS OF ORGANIZED LABOR Labor unions generally try to get better pay, greater job security, and better working conditions for their members through collective bargaining with management. Unions’ bargaining power is derived largely from their ability to threaten to disrupt production, either by a strike or some other form of work protest (e.g., refusing to work overtime). This threat is credible, however, only insofar as management has no alternative but to employ union labor.

A principal concern of domestic unions about multinational firms is that the company can counter its bargaining power with the power to move production to another country. Ford, for example, clearly threatened British unions with a plan to move manufacturing to continental Europe unless British workers abandoned work rules that limited productivity, showed restraint in negotiating for wage increases, and curtailed strikes and other work disruptions.62

Another concern of organized labor is that an international business will keep highly skilled tasks in its home country and farm out only low-skilled tasks to foreign plants. Such a practice makes it relatively easy for an international business to switch production from one location to another as economic conditions warrant. Consequently, the bargaining power of organized labor is once more reduced.

A final union concern arises when an international business attempts to import employ- ment practices and contractual agreements from its home country. When these practices are alien to the host country, organized labor fears the change will reduce its influence and power. This concern has surfaced in response to Japanese multinationals that have been trying to export their style of labor relations to other countries. For example, much to the annoy- ance of the United Auto Workers (UAW), many Japanese auto plants in the United States are not unionized. As a result, union influence in the auto industry is declining.

THE STRATEGY OF ORGANIZED LABOR Orga- nized labor has responded to the increased bargaining power of mul- tinational corporations by taking three actions: (1) trying to establish international labor organizations, (2) lobbying for national legisla- tion to restrict multinationals, and (3) trying to achieve international regulations on multinationals through such organizations as the United Nations. These efforts have not been very successful.

LO 17-7 Understand how organized labor can influence strategic choices in international business firms.

Employees work on the chassis of an Adam Opel AG car, at a GM factory in Eisenach, Germany.

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506 Part Six International Business Functions

In the 1960s, organized labor began to establish international trade secretariats (ITSs) to provide worldwide links for national unions in particular industries. The long-term goal was to be able to bargain transnationally with multinational firms. Organized labor believed that by coordinating union action across countries through an ITS, it could counter the power of a multinational corporation by threatening to disrupt production on an international scale. For example, Ford’s threat to move production from Great Britain to other European locations would not have been credible if the unions in various European countries had united to oppose it.

However, the ITSs have had virtually no real success. Although national unions may want to cooperate, they also compete with each other to attract investment from international businesses, and hence jobs for their members. For example, in attempting to gain new jobs for their members, national unions in the auto industry often court auto firms that are seek- ing locations for new plants. One reason Nissan chose to build its European production fa- cilities in Great Britain rather than Spain was that the British unions agreed to greater concessions than the Spanish unions did. As a result of such competition between national unions, cooperation is difficult to establish.

A further impediment to cooperation has been the wide variation in union structure. Trade unions developed independently in each country. As a result, the structure and ideol- ogy of unions tend to vary significantly from country to country, as does the nature of col- lective bargaining. For example, in Great Britain, France, and Italy, many unions are controlled by left-wing socialists, who view collective bargaining through the lens of “class conflict.” In contrast, most union leaders in Germany, the Netherlands, Scandinavia, and Switzerland are far more moderate politically. The ideological gap between union leaders in different countries has made cooperation difficult. Divergent ideologies are reflected in radically different views about the role of a union in society and the stance unions should take toward multinationals.

Organized labor has also met with only limited success in its efforts to get national and international bodies to regulate multinationals. Such international organizations as the In- ternational Labor Organization (ILO) and the Organization for Economic Cooperation and Development (OECD) have adopted codes of conduct for multinational firms to follow in labor relations. However, these guidelines are not as far-reaching as many unions would like. They also do not provide any enforcement mechanisms. Many researchers report that such guidelines are of only limited effectiveness.63

APPROACHES TO LABOR RELATIONS International businesses differ markedly in their approaches to international labor relations. The main difference is the degree to which labor relations activities are centralized or decentralized. Historically, most international businesses have decentralized international labor relations activities to their foreign subsidiaries because labor laws, union power, and the nature of collective bargaining varied so much from country to country. It made sense to decentralize the labor relations function to local managers. The belief was that there was no way central management could effectively handle the complexity of simultaneously managing labor relations in a number of different environments.

Although this logic still holds, the trend is toward greater centralized control. This trend reflects international firms’ attempts to rationalize their global operations. The general rise in competitive pressure in industry after industry has made it more important for firms to control their costs. Because labor costs account for such a large percentage of total costs, some firms are now using the threat to move production to another country in their nego- tiations with unions to change work rules and limit wage increases (as Ford did in Europe). Because such a move would involve major new investments and plant closures, this bargain- ing tactic requires the input of headquarters management. Thus, the level of centralized input into labor relations is increasing.

In addition, the realization is growing that the way work is organized within a plant can be a major source of competitive advantage. Much of the competitive advantage of Japanese automakers, for example, has been attributed to the use of self-managing teams, job rotation, cross-training, and the like in their Japanese plants.64 To replicate their

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domestic performance in foreign plants, the Japanese firms have tried to replicate their work practices there. This often brings them into direct conflict with traditional work practices in those countries, as sanctioned by the local labor unions, so the Japanese firms have often made their foreign investments contingent on the local union accepting a radical change in work practices. To achieve this, the headquarters of many Japanese firms bargains directly with local unions to get union agreement to changes in work rules before committing to an investment. For example, before Nissan decided to invest in northern England, it got a commitment from British unions to agree to a change in tra- ditional work practices. By its very nature, pursuing such a strategy requires centralized control over the labor relations function.

human resource management (HRM), p. 488 expatriate manager, p. 489

staffing policy, p. 490 corporate culture, p. 490 ethnocentric staffing policy, p. 490

polycentric staffing policy, p. 492 geocentric staffing policy, p. 492 expatriate failure, p. 494

Key Terms

Summary

This chapter focused on human resource management in international businesses. HRM activities include human resource strategy, staffing, performance evaluation, man- agement development, compensation, and labor relations. None of these activities is performed in a vacuum; all must be appropriate to the firm’s strategy. The chapter made the following points:

1. Firm success requires HRM policies to be congruent with the firm’s strategy and with its formal and informal structure and controls.

2. Staffing policy is concerned with selecting employees who have the skills required to perform particular jobs. Staffing policy can be a tool for developing and promoting a corporate culture.

3. An ethnocentric approach to staffing policy fills all key management positions in an international business with parent-country nationals. The policy is congruent with an international strategy. A drawback is that ethnocentric staffing can result in cultural myopia.

4. A polycentric staffing policy uses host-country nationals to manage foreign subsidiaries and parent- country nationals for the key positions at corporate headquarters. This approach can minimize the dangers of cultural myopia, but it can create a gap between home- and host-country operations. The policy is best suited to a localization strategy.

5. A geocentric staffing policy seeks the best people for key jobs throughout the organization, regardless of their nationality. This approach is consistent with building a strong unifying culture and informal management network and is well suited to both global standardization and transnational strategies.

Immigration policies of national governments may limit a firm’s ability to pursue this policy.

6. A prominent issue in the international staffing literature is expatriate failure, defined as the premature return of an expatriate manager to his or her home country. The costs of expatriate failure can be substantial.

7. Expatriate failure can be reduced by selection procedures that screen out inappropriate candidates. The most successful expatriates seem to be those who have high self-esteem and self-confidence, can get along well with others, are willing to attempt to communicate in a foreign language, and can empathize with people of other cultures.

8. Training can lower the probability of expatriate failure. It should include cultural training, language training, and practical training, and it should be provided to both the expatriate manager and the spouse.

9. Management development programs attempt to increase the overall skill levels of managers through a mix of ongoing management education and rotation of managers through different jobs within the firm to give them varied experiences. Management development is often used as a strategic tool to build a strong unifying culture and informal management network, both of which support transnational and global standardization strategies.

10. It can be difficult to evaluate the performance of expatriate managers objectively because of unintentional bias. A firm can take a number of steps to reduce this bias.

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11. Country differences in compensation practices raise a difficult question for an international business: Should the firm pay executives in different countries according to the standards in each country or equalize pay on a global basis?

12. The most common approach to expatriate pay is the balance sheet approach. This approach aims to equalize purchasing power so employees can enjoy the same living standard in their foreign posting that they had at home.

13. A key issue in international labor relations is the degree to which organized labor can limit the choices

available to an international business. A firm’s ability to pursue a transnational or global standardization strategy can be significantly constrained by the actions of labor unions.

14. A principal concern of organized labor is that the multinational can counter union bargaining power with threats to move production to another country.

15. Organized labor has tried to counter the bargaining power of multinationals by forming international labor organizations. In general, these efforts have not been effective.

Critical Thinking and Discussion Questions

1. What are the main advantages and disadvantages of the ethnocentric, polycentric, and geocentric approaches to staffing policy? When is each approach appropriate?

2. Research suggests that many expatriate employees encounter problems that limit both their effectiveness in a foreign posting and their contribution to the company when they return home. What are the main causes and consequences of these problems, and how might a firm reduce the occurrence of such problems?

3. What is the link between an international business’s strategy and its human resource management policies,

particularly with regard to the use of expatriate employees and their pay scale?

4. In what ways can organized labor constrain the strategic choices of an international business? How can an international business limit these constraints?

5. Reread the Management Focus on McDonald’s global compensation practices. How does the McDonald’s approach help the company take local differences into account when reviewing the performance of different country managers and awarding bonus pay?

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

1. The impact of strikes and lockouts on business activities can be substantial. Because your manufacturing company is planning to expand its operations in the Asian markets, you have to identify the countries where strikes and lockouts could introduce interruptions to your operations. Using labor statistics from the International Labour Organization (ILO) to develop your report, identify the three Asian countries with the highest number of strikes and lockouts, as well as the total number of lost worker days. What types of

precautions can your company take to prevent interruptions from occurring in these markets?

2. You work in the human resource department at the headquarters of a multinational corporation. Your company is about to send a number of managers overseas as expatriates (or expats) to France and New Zealand. You need to create an executive summary evaluating, comparing, and contrasting the possible issues expats may encounter in these two countries. Your manager tells you that a tool called Expat Explorer created by HSBC can assist you in your task.

Research Task http://globalEDGE.msu.edu

It had been a very bad morning for John Ross, the general manager of MMC’s Chinese joint venture. He had just gotten off the phone with his boss in St Louis, Phil Smith, who was demanding to know why the joint venture’s return on investment was still in the low single digits four years

after Ross had taken over the top post in the operation. “We had expected much better performance by now,” Smith said, “particularly given your re- cord of achievement; you need to fix this John! Our patience is not infinite. You know the corporate goal is for a 20 percent return on investment for

ccccccllooooooosssiinnnnnggggggggggg ccccccaaaassssssssssssssssssssssssssseeeeeeeeeeeeeeeeeeeeeeeeeeeMMC China

508 Part Six International Business Functions

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operating units, and your unit is not even close to that.” John Ross had a very bad feeling that Smith had just fired a warning shot across his bow. There was an implicit threat underlying Smith’s demands for improved performance. For the first time in his 20-year career at MMC, Ross felt that his job was on the line.

MMC was a U.S.-based multinational electronics enterprise with sales of $2 billion and operations in more than 10 countries. MMC China spe- cialized in the mass production of printed circuit boards for companies in the cell phone and computer industries. MMC was a joint venture with Shanghai Electronic Corporation, a former state-owned enterprise that held 49 percent of the joint-venture equity (MMC held the rest). While MMC held a majority of the equity, the company had to consult with its partner before making major investments or changing employment levels.

John Ross had been running MMC China for the past four years. He had arrived at MMC China after a very successful career at MMC, which included extended postings in Mexico and Hungary. When he took the China position, Ross thought that if he succeeded, he would probably be in line for one of the top jobs at corporate headquarters within a few years. Ross had known that he was taking on a challenge with MMC China, but nothing prepared him for what he found there. The joint ven- ture was a mess. Operations were horribly inefficient. Despite low wages, productivity was being killed by poor product quality, lax inventory con- trols, and high employee turnover. The venture probably employed too many people, but MMC’s Chinese partner seemed to view the venture as a job-creation program and repeatedly objected to any plans for cutting the workforce. To make matters worse, MMC China had failed to keep up with the latest developments in manufacturing technology, and it was fall- ing behind competitors. Ross was determined to change this, but it had not been easy.

To improve operations, Ross had put in a request to corporate HR for two specialists from the United States to work with the Chinese production employees. It had been a disaster. One had lasted three months before requesting a transfer home for personal reasons. Apparently, his spouse hated China. The other had stayed for a year, but he had interacted so poorly with the local Chinese employees that he had to be sent back to the United States. Ross wished that MMC’s corporate HR department had done a better job of selecting and then training these employees for a difficult foreign posting, but in retrospect he had to admit that he wasn’t surprised at the lack of training; he had never been given any.

After this failure, Ross had taken a different tack. He had picked four of his best Chinese production employees and sent them to MMC’s U.S. operations, along with a translator, for a two-month training program fo- cusing on the latest production techniques. This had worked out much better. The Chinese had visited efficient MMC factories in the United States, Mexico, and Brazil and had seen what was possible. They had returned home fired up to improve operations at MMC China. Within a year they had introduced a Six Sigma quality control program and improved the flow of inventory through MMC’s factory. Ross could now walk through the factory without being appalled by the sight of large quantities of inventory stacked on the floor or bins full of discarded circuit boards that had failed postas- sembly quality tests. Productivity had improved as a result, and after three tough years, MMC China had finally turned a profit.

Apparently this was not good enough for corporate headquarters. Ross knew that improving performance further would be tough. The market in China was very competitive. MMC was vying with many other enterprises to produce printed circuit boards for large multinational customers that had assembly operations in China. The customers were constantly demanding lower prices, and it seemed to Ross that prices were falling almost as fast as MMC’s costs. Also, Ross was limited in his ability to cut the workforce by the demands of his Chinese joint-venture partner. Ross had tried to explain all this to Phil Smith, but Smith didn’t seem to get it. “The man is just a number cruncher,” thought Ross. “He has no sense of the market in China. He has no idea how hard it is to do business here. I have worked damn hard to turn this operation around, and I am getting no credit for it, none at all.”

Sources: This is a disguised case history based on interviews undertaken by the author.

CASE DISCUSSION QUESTIONS 1. Is it right for MMC to hold Ross to the same performance goals as

managers of units in other countries? What other approach might it adopt?

2. Why had bringing in specialists from the United States not worked at MMC? Why did Ross’s strategy of sending Chinese employees over to the United States for training produce better results? What are the lessons here?

3. What changes could the HR department at MMC make to improve its utilization of human capital and facilitate knowledge transfers within the company?

Endnotes

1. P. J. Dowling and R. S. Schuler, International Dimensions of Human Resource Management (Boston: PSW-Kent, 1990).

2. J. Millman, M. A. von Glinow, and M. Nathan, “Organiza- tional Life Cycles and Strategic International Human Re- source Management in Multinational Companies,” Academy of Management Review 16 (1991), pp. 318–39; A. Bird and S. Beechler, “Links between Business Strategy and Human Re- source Management,” Journal of International Business Studies 26 (1995), pp. 23–47; B. A. Colbert, “The Complex Resource Based View: Implications for Theory and Practice of Strate- gic Human Resource Management,” Academy of Management

Review 29 (2004), pp. 341–60; and C. J. Collins and K. D. Clark, “Strategic Human Resource Practices, Top Manage- ment Team Social Networks, and Firm Performance,” Acad- emy of Management Journal 46 (2003), pp. 740–60.

3. See Peter Bamberger and Ilan Meshoulam, Human Resource Strategy: Formulation, Implementation, and Impact (Thousand Oaks, CA: Sage, 2000); P. M. Wright and S. Snell, “Towards a Unifying Framework for Exploring Fit and Flexibility in Human Resource Management,” Academy of Management Re- view 23 (October 1998), pp. 756–72; Colbert, “The Complex Resource-Based View”; and R. S. Schuler and S. E. Jackson,

510 Part Six International Business Functions

“A Quarter Century Review of Human Resource Manage- ment in the US: The Growth in Importance of the Interna- tional Perspective,” Management Review 16 (2005), pp. 1–25.

4. R. Colman, “HR Management Lags behind at World Class Firms,” CMA Management, July–August 2002, p. 9.

5. E. H. Schein, Organizational Culture and Leadership (San Francisco: Jossey-Bass, 1985).

6. H. V. Perlmutter, “The Tortuous Evolution of the Multina- tional Corporation,” Columbia Journal of World Business 4 (1969), pp. 9–18; D. A. Heenan and H. V. Perlmutter, Multi- national Organizational Development (Reading, MA: Addison- Wesley, 1979); D. A. Ondrack, “International Human Resources Management in European and North American Firms,” International Studies of Management and Organization 15 (1985), pp. 6–32; and T. Jackson, “The Management of People across Cultures: Valuing People Differently,” Human Resource Management 41 (2002), pp. 455–75.

7. V. Reitman and M. Schuman, “Men’s Club: Japanese and Korean Companies Rarely Look Outside for People to Run Their Overseas Operations,” The Wall Street Journal, Septem- ber 26, 1996, p. 17.

8. E. Wong, “China’s Export of Labor Faces Growing Scorn,” The New York Times, December 21, 2009, p. A1.

9. S. Beechler and J. Z. Yang, “The Transfer of Japanese Style Management to American Subsidiaries,” Journal of Interna- tional Business Studies 25 (1994), pp. 467–91. See also R. Konopaske, S. Warner, and K. E. Neupert, “Entry Mode Strategy and Performance: The Role of FDI Staffing,” Jour- nal of Business Research, September 2002, pp. 759–70.

10. M. Banai and L. M. Sama, “Ethical Dilemma in MNCs’ In- ternational Staffing Policies,” Journal of Business Ethics, June 2000, pp. 221–35.

11. V. Reitman and M. Schuman, “Men’s Club: Japanese and Korean Companies Rarely Look Outside for People to Run Their Overseas Operations,” The Wall Street Journal, Sep- tember 26, 1996, p. 17.

12. C. A. Bartlett and S. Ghoshal, Managing across Borders: The Transnational Solution (Boston: Harvard Business School Press, 1989).

13. S. J. Kobrin, “Geocentric Mindset and Multinational Strategy,” Journal of International Business Studies 25 (1994), pp. 493–511.

14. F. Hansen, “International Business Machine,” Workforce Man- agement, July 2005, pp. 36–44.

15. P. M. Rosenzweig and N. Nohria, “Influences on Human Re- source Management Practices in Multinational Corpora- tions,” Journal of International Business Studies 25 (1994), pp. 229–51.

16. Kobrin, “Geocentric Mindset and Multinational Strategy.”

17. M. Harvey and H. Fung, “Inpatriate Managers: The Need for Realistic Relocation Reviews,” International Journal of Man- agement 17 (2000), pp. 151–59.

18. S. Black, M. Mendenhall, and G. Oddou, “Toward a Compre- hensive Model of International Adjustment,” Academy of Management Review 16 (1991), pp. 291–317; J. Shay and T. J. Bruce, “Expatriate Managers,” Cornell Hotel & Restaurant

Administration Quarterly, February 1997, p. 30–40; and Y. Baruch and Y. Altman, “Expatriation and Repatriation in MNCs—A Taxonomy,” Human Resource Management 41 (2002), pp. 239–59.

19. M. G. Harvey, “The Multinational Corporation’s Expatriate Problem: An Application of Murphy’s Law,” Business Horizons 26 (1983), pp. 71–78.

20. J. Barbian, “Return to Sender,” Training, January 2002, pp. 40–43.

21. Barbian, “Return to Sender”; and K. Yeaton and N. Hall, “Expatriates: Reducing Failure Rates,” Journal of Corporate Accounting and Finance, March–April 2008, pp. 75–78.

22. Black, Mendenhall, and Oddou, “Toward a Comprehensive Model of International Adjustment.”

23. R. L. Tung, “Selection and Training Procedures of U.S., European, and Japanese Multinationals,” California Manage- ment Review 25 (1982), pp. 57–71.

24. T. Zsuzzanna and M. Pieperl, “Expatriate Practices in German, Japanese, U.K., and U.S. Multinational Companies: A Comparative Survey of Changes,” Human Resource Manage- ment, January–February 2009, pp. 153–71.

25. H. W. Lee, “Factors That Influence Expatriate Failure,” In- ternational Journal of Management 24 (2007), pp. 403–15.

26. C. M. Solomon, “Success Abroad Depends upon More Than Job Skills,” Personnel Journal, April 1994, pp. 51–58.

27. C. M. Solomon, “Unhappy Trails,” Workforce, August 2000, pp. 36–41.

28. Solomon, “Success Abroad.”

29. Solomon, “Unhappy Trails.”

30. M. Harvey, “Addressing the Dual-Career Expatriation Dilemma,” Human Resource Planning 19, no. 4 (1996), pp. 18–32.

31. M. Mendenhall and G. Oddou, “The Dimensions of Expatri- ate Acculturation: A Review,” Academy of Management Review 10 (1985), pp. 39–47.

32. I. Torbiorin, Living Abroad: Personal Adjustment and Personnel Policy in the Overseas Setting (New York: John Wiley & Sons, 1982).

33. R. L. Tung, “Selection and Training of Personnel for Over- seas Assignments,” Columbia Journal of World Business 16 (1981), pp. 68–78.

34. Solomon, “Success Abroad.”

35. S. Ronen, “Training and International Assignee,” in Training and Career Development, ed. I. Goldstein (San Francisco: Jossey-Bass, 1985); and Tung, “Selection and Training of Per- sonnel for Overseas Assignments.”

36. Solomon, “Success Abroad.”

37. Harvey, “Addressing the Dual-Career Expatriation Dilemma”; and J. W. Hunt, “The Perils of Foreign Postings for Two,” Financial Times, May 6, 1998, p. 22.

38. C. M. Daily, S. T. Certo, and D. R. Dalton, “International Experience in the Executive Suite: A Path to Prosperity?” Strategic Management Journal 21 (2000), pp. 515–23.

Chapter Seventeen Global Human Resource Management 511

39. Dowling and Schuler, International Dimensions.

40. Ibid.

41. G. Baliga and J. C. Baker, “Multinational Corporate Policies for Expatriate Managers: Selection, Training, and Evaluation,” Advanced Management Journal, Autumn 1985, pp. 31–38.

42. J. C. Baker, “Foreign Language and Departure Training in U.S. Multinational Firms,” Personnel Administrator, July 1984, pp. 68–70.

43. A 1997 study by the Conference Board looked at this in depth. For a summary, see L. Grant, “That Overseas Job Could Derail Your Career,” Fortune, April 14, 1997, p. 166. Also see J. S. Black and H. Gregersen, “The Right Way to Manage Expatriates,” Harvard Business Review, March–April 1999, pp. 52–63.

44. J. S. Black and M. E. Mendenhall, Global Assignments: Success- fully Expatriating and Repatriating International Managers (San Francisco: Jossey-Bass, 1992); and K. Vermond, “Expatriates Come Home,” CMA Management, October 2001, pp. 30–33.

45. Ibid.

46. Figures from the Conference Board study. For a summary, see Grant, “That Overseas Job Could Derail Your Career.”

47. S. C. Schneider, “National vs. Corporate Culture: Implica- tions for Human Resource Management,” Human Resource Management 27 (Summer 1988), pp. 231–46.

48. I. M. Manve and W. B. Stevenson, “Nationality, Cultural Dis- tance and Expatriate Status,” Journal of International Business Studies 32 (2001), pp. 285–303; and D. Minbaeva et al., “MNC Knowledge Transfer, Subsidiary Absorptive Capacity, and HRM,” Journal of International Business Studies 34, no. 6 (2003), pp. 586–604.

49. Bartlett and Ghoshal, Managing across Borders.

50. See G. Oddou and M. Mendenhall, “Expatriate Performance Appraisal: Problems and Solutions,” in International Human Resource Management, ed. M. Mendenhall and G. Oddou (Boston: PWS-Kent, 1991); Dowling and Schuler, Interna- tional Dimensions; R. S. Schuler and G.W. Florkowski, “Inter- national Human Resource Management,” in Handbook for International Management Research, ed. B. J. Punnett and

O. Shenkar (Oxford: Blackwell, 1996); and K. Roth and S. O’Donnell, “Foreign Subsidiary Compensation Strategy: An Agency Theory Perspective,” Academy of Management Journal 39, no. 3 (1996), pp. 678–703.

51. Oddou and Mendenhall, “Expatriate Performance Appraisal.”

52. “Expatriates Often See Little Benefit to Careers in Foreign Stints, Indifference at Home,” The Wall Street Journal, December 11, 1989, p. B1.

53. Oddou and Mendenhall, “Expatriate Performance Appraisal”; and Schuler and Florkowski, “International Human Resource Management.”

54. Towers Perrin, Towers Perrin Worldwide Total Remuneration Study, 2005–2006, www.towerswatson.com. Note all researchers agree with this conclusion; see for example N. Fernandes et al., “Are US CEOs Paid More? New Interna- tional Evidence,” The Review of Financial Studies, in press, 2013.

55. J. Cummings and L. Brannen, “The New World of Compen- sation,” Business Finance, June 2005, p. 8.

56. “Multinationals Tighten Control of Benefit Plans,” Workforce Management, May 2005, p. 5.

57. Organizational Resource Counselors, 2002 Survey of Interna- tional Assignment Policies and Practices, March 2003.

58. C. Reynolds, “Compensation of Overseas Personnel,” in Handbook of Human Resource Administration, ed. J. J. Famularo (New York: McGraw-Hill, 1986).

59. M. Helms, “International Executive Compensation Prac- tices,” in International Human Resource Management, ed. M. Mendenhall and G. Oddou (Boston: PWS-Kent, 1991).

60. G. W. Latta, “Expatriate Incentives,” HR Focus 75, no. 3 (March 1998), p. S3.

61. C. K. Prahalad and Y. L. Doz, The Multinational Mission (New York: Free Press, 1987).

62. Ibid.

63. Schuler and Florkowski, “International Human Resource Management.”

64. See J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).

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

capital flight Converting domestic currency into a foreign currency.

Caribbean Single Market and Economy (CSME) The six CARICOM members that agreed to lower trade barriers and harmonize macroeconomic and monetary policies.

CARICOM An association of English-speaking Caribbean states that are attempting to establish a customs union.

carry trade A kind of speculation that involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high.

caste system A system of social stratification in which social position is determined by the family into which a person is born, and change in that position is usually not possible during an individual’s lifetime.

Central America Free Trade Agreement (CAFTA) The agreement of the member-states of the Central American Common Market joined by the Dominican Republic to trade freely with the United States.

Central American Common Market A trade pact among Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua, which began in the early 1960s but collapsed in 1969 due to war.

channel length The number of intermediaries that a product has to go through before it reaches the final consumer.

channel quality The expertise, competencies, and skills of established retailers in a nation and their ability to sell and support the products of international businesses.

civil law system A system of law based on a very detailed set of written laws and codes.

class consciousness A tendency for individuals to perceive themselves in terms of their class background.

class system A system of social stratification in which social status is determined by the family into which a person is born and by subsequent socioeconomic achievements; mobility between classes is possible.

code of ethics A business’s formal statement of ethical priorities.

collectivism A political system that emphasizes collective goals as opposed to individual goals.

command economy An economic system where the allocation of resources, including determination of what goods and services should be produced, and in what quantity, is planned by the government.

common law A system of law based on tradition, precedent, and custom; when law courts interpret common law, they do so with regard to these characteristics.

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

ad valorem tariff A tariff levied as a proportion of the value of an imported good.

administrative trade policies Administrative policies, typically adopted by government bureaucracies, that can be used to restrict imports or boost exports.

Andean Community A 1969 agreement among Bolivia, Chile, Ecuador, Colombia, and Peru to establish a customs union.

antidumping policies Designed to punish foreign firms that engage in dumping and thus protect domestic producers from unfair foreign competition.

arbitrage The purchase of securities in one market for immediate resale in another to profit from a price discrepancy.

B balance-of-payments accounts National accounts that track both payments to and receipts from foreigners.

balance-of-trade equilibrium Reached when the income a nation’s residents earn from exports equals money paid for imports.

bandwagon effect Movement of traders like a herd, all in the same direction and at the same time, in response to each other’s perceived actions.

banking crisis A loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits.

barter The direct exchange of goods or services between two parties without a cash transaction.

bill of exchange An order written by an exporter instructing an importer, or an importer’s agent, to pay a specified amount of money at a specified time.

bill of lading A document issued to an exporter by a common carrier transporting merchandise. It serves as a receipt, a contract, and a document of title.

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

buyback Agreement to accept a percentage of a plant’s output as payment for contract to build a plant.

glossary

Glossary 513

common market A group of countries committed to (1) removing all barriers to the free flow of goods, services, and factors of production between each other and (2) the pursuit of a common external trade policy.

Communist totalitarianism A version of collectivism advocating that socialism can be achieved only through a totalitarian dictatorship.

Communists Those who believe socialism can be achieved only through revolution and totalitarian dictatorship.

concentrated retail system A retail system in which a few retailers supply most of the market.

constant returns to specialization 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.

contract A document that specifies the conditions under which an exchange is to occur and details the rights and obligations of the parties involved.

contract law The body of law that governs contract enforcement.

contributor factory A factory that serves a specific country or world region.

controls The metrics used to measure the performance of subunits and make judgments about how well managers are running those subunits.

copyrights The exclusive legal rights of authors, composers, playwrights, artists, and publishers to publish and disperse their work as they see fit.

core competence Firm skills that competitors cannot easily match or imitate.

corporate culture The organization’s norms and value systems.

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

counterpurchase A reciprocal buying agreement.

countertrade The trade of goods and services for other goods and services.

countervailing duties Antidumping duties.

country of origin effects A subset of source effects, or the extent to which the place of manufacturing influences product evaluations.

Court of Justice Supreme appeals court for EU law.

cross-cultural literacy Understanding how the culture of a country affects the way business is practiced.

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

culture A system of values and norms that are shared among a group of people and that when taken together constitute a design for living.

currency board Means of controlling a country’s currency.

currency crisis Occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates to defend the prevailing exchange rate.

currency speculation Involves short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates.

currency swap Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

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

current account deficit 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.

customs union A group of countries committed to (1) removing all barriers to the free flow of goods and services between each other and (2) the pursuit of a common external trade policy.

D democracy Political system in which government is by the people, exercised either directly or through elected representatives.

deregulation Removal of government restrictions concerning the conduct of a business.

dirty-float system A system under which a country’s currency is nominally allowed to float freely against other currencies, but in which the government will intervene, buying and selling currency, if it believes that the currency has deviated too far from its fair value.

downstream supply chain The portion of the supply chain from the production facility to the end-customer.

draft An order written by an exporter telling an importer what and when to pay.

dumping Selling goods in a foreign market for less than their cost of production or below their “fair” market value.

E eclectic paradigm Argument that combining location specific assets or resource endowments and the firm’s own unique assets often requires FDI; it requires the firm to establish production facilities where those foreign assets or resource endowments are located.

economic exposure The extent to which a firm’s future international earning power is affected by changes in exchange rates.

economic risk The likelihood that events, including economic mismanagement, will cause drastic changes in a country’s business environment that adversely affect the profit and other goals of a particular business enterprise.

economic union A group of countries committed to (1) removing all barriers to the free flow of goods, services, and factors of production between each other; (2) the adoption of a common currency; (3) the harmonization of tax rates; and (4) the pursuit of a common external trade policy.

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economies of scale Cost advantages associated with large-scale production.

efficient market A market where prices reflect all available information.

elastic A small change in price produces a large change in demand.

entrepreneurs Those who first commercialize innovations.

ethical dilemma A situation in which there is no ethically acceptable solution.

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

ethical systems A coherent collection of beliefs about the right way to behave in a society.

ethnocentric staffing policy A staffing approach within the MNE in which all key management positions are filled by parent-country nationals.

ethnocentrism Behavior that is based on the belief in the superiority of one’s own ethnic group or culture; often shows disregard or contempt for the culture of other countries.

European Commission Responsible for proposing EU legislation, implementing it, and monitoring compliance.

European Council The heads of state of EU members and the president of the European Commission.

European Free Trade Association (EFTA) A free trade association including Norway, Iceland, and Switzerland.

European Monetary System (EMS) EU system designed to create a zone of monetary stability in Europe, control inflation, and coordinate exchange rate policies of EU countries.

European Parliament Elected EU body that provides consultation on issues proposed by European Commission.

European Union An economic and political union of 28 countries (2014) that are located in Europe.

exchange rate The rate at which one currency is converted into another.

exclusive distribution channel A distribution channel that outsiders find difficult to access.

expatriate failure The premature return of an expatriate manager to the home country.

expatriate manager A national of one country appointed to a management position in another country.

experience curve Systematic production cost reductions that occur over the life of a product.

experience curve pricing Aggressive pricing designed to increase volume and help the firm realize experience curve economies.

export management company (EMC) Export specialists who act as an export marketing department for client firms.

Export–Import Bank (Ex-Im Bank) Agency of the U.S. government whose mission is to provide aid in financing and facilitate exports and imports.

exporting Sale of products produced in one country to residents of another country.

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

externalities Knowledge spillovers.

externally convertible currency Limitations on the ability of residents to convert domestic currency, though nonresidents can convert their holdings of domestic currency into foreign currency.

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

factors of production Inputs into the productive process of a firm, including labor, management, land, capital, and technological know-how.

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

first-mover advantages Advantages accruing to the first to enter a market.

first-mover disadvantages Disadvantages associated with entering a foreign market before other international businesses.

Fisher effect Nominal interest rates (i ) in each country equal the required real rate of interest (r) and the expected rate of inflation over the period of time for which the funds are to be lent (l ). That is, i 5 r 1 I.

fixed exchange rate A system under which the exchange rate for converting one currency into another is fixed.

flexible machine cells Flexible manufacturing technology in which a grouping of various machine types, a common materials handler, and a centralized cell controller produce a family of products.

flexible manufacturing technology Manufacturing technology designed to improve job scheduling, reduce setup time, and improve quality control.

floating exchange rate A system under which the exchange rate for converting one currency into another is continuously adjusted depending on the laws of supply and demand.

flow of FDI The amount of foreign direct investment undertaken over a given time period (normally one year).

folkways Routine conventions of everyday life.

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

foreign debt crisis Situation in which a country cannot service its foreign debt obligations, whether private-sector or government debt.

Foreign Direct Investment (FDI) Direct investment in business operations in a foreign country.

foreign exchange market A market for converting the currency of one country into that of another country.

foreign exchange risk The risk that changes in exchange rates will hurt the profitability of a business deal.

forward exchange When two parties agree to exchange currency and execute a deal at some specific date in the future.

forward exchange rate The exchange rates governing forward exchange transactions.

fragmented retail system A retail system in which there are many retailers, no one of which has a major share of the market.

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franchising A specialized form of licensing in which the franchiser sells intangible property to the franchisee and insists on rules to conduct the business.

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

free trade area A group of countries committed to removing all barriers to the free flow of goods and services between each other, but pursuing independent external trade policies.

freely convertible currency A country’s currency is freely convertible when the government of that country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with the domestic currency.

G General Agreement on Tariffs and Trade (GATT) International treaty that committed signatories to lowering barriers to the free flow of goods across national borders and led to the WTO.

geocentric staffing policy A staffing policy where the best people are sought for key jobs throughout an MNE, regardless of nationality.

global distribution center A facility that positions and allows customization of products for delivery to worldwide wholesalers or retailers, or directly to consumers anywhere in the world; also called a global distribution warehouse.

global inventory management The decision-making process regarding the raw materials, work-in-process (component parts), and finished goods inventory for a multinational corporation.

global learning The flow of skills and product offerings from foreign subsidiary to home country and from foreign subsidiary to foreign subsidiary.

global standardization strategy A firm focuses on increasing profitability and profit growth by reaping the cost reductions that come from economies of scale, learning effects, and location economies.

global supply chain coordination The shared decision-making opportunities and operational collaboration of key global supply chain activities.

global web When different stages of value chain are dispersed to those locations around the globe where value added is maximized or where costs of value creation are minimized.

globalization of markets Moving away from an economic system in which national markets are distinct entities, isolated by trade barriers and barriers of distance, time, and culture, and toward a system in which national markets are merging into one global market.

globalization of production Trend by individual firms to disperse parts of their productive processes to different locations around the globe to take advantage of differences in cost and quality of factors of production.

globalization Trend away from distinct national economic units and toward one huge global market.

gold par value The amount of currency needed to purchase one ounce of gold.

gold standard The practice of pegging currencies to gold and guaranteeing convertibility.

greenfield investment The establishment of a new operation in a foreign country.

Gross National Income (GNI) The yardstick for measuring economic activity of a country, this measures the total annual income of a nation’s residents.

group An association of two or more individuals who have a shared sense of identity and who interact with each other in structured ways on the basis of a common set of expectations about each other’s behavior.

H Human Development Index (HDI) An attempt by the UN to assess the impact of a number of factors on the quality of human life in a country.

human resource management (HRM) Activities an organization conducts to use its human resources effectively.

I import quota A direct restriction on the quantity of a good that can be imported into a country.

incentives The devices used to reward appropriate managerial behavior.

individualism An emphasis on the importance of guaranteeing individual freedom and self-expression.

individualism versus collectivism Theory focusing on the relationship between the individual and his or her fellows; in individualistic societies, the ties between individuals are loose and individual achievement is highly valued; in societies where collectivism is emphasized, ties between individuals are tight, people are born into collectives, such as extended families, and everyone is supposed to look after the interests of his or her collective.

inefficient market One in which prices do not reflect all available information.

inelastic When a large change in price produces only a small change in demand.

infant industry argument New industries in developing countries must be temporarily protected from international competition to help them reach a position where they can compete on world markets with the firms of developed nations.

inflows of FDI Flow of foreign direct investment into a country.

innovation Development of new products, processes, organizations, management practices, and strategies.

intellectual property Products of the mind, ideas (e.g., books, music, computer software, designs, technological know-how); intellectual property can be protected by patents, copyrights, and trademarks.

intermarket segment A segment of customers that spans multiple countries, transcending national borders.

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

516 Glossary

internalization theory Marketing imperfection approach to foreign direct investment.

international business Any firm that engages in international trade or investment.

international Fisher effect For any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between countries.

international market research The systematic collection, recording, analysis, and interpretation of data to provide knowledge that is useful for decision making in a global company.

International Monetary Fund (IMF) International institution set up to maintain order in the international monetary system.

international monetary system Institutional arrangements countries adopt to govern exchange rates.

international strategy Trying to create value by transferring core competencies to foreign markets where indigenous competitors lack those competencies.

international trade Occurs when a firm exports goods or services to consumers in another country.

ISO 9000 Certification process that requires certain quality standards must be met.

J joint venture Establishing a firm that is jointly owned by two or more otherwise independent firms.

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

just in time (JIT) Inventory logistics system designed to deliver parts to a production process as they are needed, not before.

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

L lag strategy Delaying the collection of foreign currency receivables if that currency is expected to appreciate, and delaying payables if that currency is expected to depreciate.

late-mover disadvantages Handicaps experienced by being a late entrant in a market.

law of one price In competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in the same currency.

lead factory A factory that is intended to create new processes, products, and technologies that can be used throughout the global firm in all parts of the world.

lead strategy Collecting foreign currency receivables early when a foreign currency is expected to depreciate, and paying foreign currency payables before they are due when a currency is expected to appreciate.

lean production See flexible manufacturing technology.

learning effects Cost savings from learning by doing.

legal risk The likelihood that a trading partner will opportunistically break a contract or expropriate intellectual property rights.

legal system System of rules that regulate behavior and the processes by which the laws of a country are enforced and through which redress of grievances is obtained.

letter of credit Issued by a bank, indicating that the bank will make payments under specific circumstances.

licensing agreement Arrangement in which a licensor grants the rights to intangible property to the licensee for a specified period and receives a royalty fee in return.

licensing Occurs when a firm (the licensor) licenses the right to produce its product, use its production processes, or use its brand name or trademark to another firm (the licensee). In return for giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells.

local content requirement A requirement that some specific fraction of a good be produced domestically.

localization strategy Increasing profitability by customizing the firm’s goods and services so that they provide a good match to tastes and preferences in different national markets.

location economies Cost advantages from performing a value creation activity at the optimal location for that activity.

location-specific advantages Advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm’s technological, marketing, or management know-how).

logistics The part of the supply chain that plans, implements, and controls the effective flows and inventory of raw material, component parts, and products used in manufacturing.

long-term versus short-term orientation The theory of the extent to which a culture programs its citizens to accept delayed gratification of their material, social, and emotional needs. It captures attitudes toward time, persistence, ordering by status, protection of face, respect for tradition, and reciprocation of gifts and favors.

M Maastricht Treaty Treaty agreed to in 1992, but not ratified until January 1, 1994, that committed the 12 member-states of the European Community to a closer economic and political union.

make-or-buy decision The strategic decision concerning whether to produce an item in-house (“make”) or purchase it from an outside supplier (“buy”).

managed-float system System under which some currencies are allowed to float freely, but the majority are either managed by government intervention or pegged to another currency.

market economy An economic system in which the interaction of supply and demand determines the quantity in which goods and services are produced.

market imperfections Imperfections in the operation of the market mechanism.

market segmentation Identifying groups of consumers whose purchasing behavior differs from others in important ways.

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marketing mix Choices about product attributes, distribution strategy, communication strategy, and pricing strategy that a firm offers its targeted markets.

masculinity versus femininity Theory of the relationship between gender and work roles. In masculine cultures, sex roles are sharply differentiated and traditional “masculine values” such as achievement and the effective exercise of power determine cultural ideals; in feminine cultures, sex roles are less sharply distinguished, and little differentiation is made between men and women in the same job.

mass customization The production of a variety of end products at a unit cost that could once be achieved only through mass production of a standardized output.

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

Mercosur Pact among Argentina, Brazil, Paraguay, and Uruguay to establish a free trade area.

minimum efficient scale The level of output at which most plant- level scale economies are exhausted.

MITI Japan’s Ministry of International Trade and Industry.

Moore’s Law The power of microprocessor technology doubles and its costs of production fall in half every 18 months.

moral hazard Arises when people behave recklessly because they know they will be saved if things go wrong.

mores Norms seen as central to the functioning of a society and to its social life.

multinational enterprise (MNE) A firm that owns business operations in more than one country.

multipoint competition Arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.

multipoint pricing Occurs when a pricing strategy in one market may have an impact on a rival’s pricing strategy in another market.

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

new trade theory 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.

noise The amount of other messages competing for a potential consumer’s attention.

nonconvertible currency A currency is not convertible when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency.

norms Social rules and guidelines that prescribe appropriate behavior in particular situations.

North American Free Trade Agreement (NAFTA) Free trade area among Canada, Mexico, and the United States.

O offset Agreement to purchase goods and services with a specified percentage of proceeds from an original sale in that country from any firm in the country.

offshore factory A factory that is developed and set up mainly for producing component parts or finished goods at a lower cost than producing them at home or in any other market.

offshore production FDI undertaken to serve the home market.

oligopoly An industry composed of a limited number of large firms.

operations The various value creation activities a firm undertakes.

optimal currency area Region in which similarities in economic activity make a single currency and exchange rate feasible instruments of macroeconomic policy.

organization architecture The totality of a firm’s organization, including formal organizational structure, control systems and incentives, organizational culture, processes, and people.

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

organizational structure The three-part structure of an organization, including its formal division into subunits such as product divisions, its location of decision-making responsibilities within that structure, and the establishment of integrating mechanisms to coordinate the activities of all subunits.

outflows of FDI Flow of foreign direct investment out of a country.

outpost factory A factory that can be viewed as an intelligence- gathering unit.

P packaging The container that holds the product itself. It can be divided into primary, secondary, and transit packaging.

Paris Convention for the Protection of Industrial Property International agreement to protect intellectual property.

patent Grants the inventor of a new product or process exclusive rights to the manufacture, use, or sale of that invention.

pegged exchange rate Currency value is fixed relative to a reference currency.

people The employees of the organization, the strategy used to recruit, compensate, and retain those individuals and the type of people that they are in terms of their skills, values, and orientation.

pioneering costs Costs an early entrant bears that later entrants avoid, such as the time and effort in learning the rules, failure due to ignorance, and the liability of being a foreigner.

political economy The political, economic, and legal systems of a country.

political risk The likelihood that political forces will cause drastic changes in a country’s business environment that will adversely affect the profit and other goals of a particular business enterprise.

political system System of government in a nation.

political union A central political apparatus coordinates economic, social, and foreign policy.

polycentric staffing policy A staffing policy in an MNE in which host-country nationals are recruited to manage subsidiaries in their own country, while parent-country nationals occupy key positions at corporate headquarters.

power distance Theory of how a society deals with the fact that people are unequal in physical and intellectual capabilities. High power distance cultures are found in countries that let inequalities

518 Glossary

grow over time into inequalities of power and wealth; low power distance cultures are found in societies that try to play down such inequalities as much as possible.

predatory pricing Reducing prices below fair market value as a competitive weapon to drive weaker competitors out of the market (“fair” being cost plus some reasonable profit margin).

price elasticity of demand A measure of how responsive demand for a product is to changes in price.

private action The theft, piracy, blackmail, and the like by private individuals or groups.

privatization The sale of state-owned enterprises to private investors.

processes The manner in which decisions are made and work is performed within any organization.

product liability Involves holding a firm and its officers responsible when a product causes injury, death, or damage.

product safety laws Set certain safety standards to which a product must adhere.

production Activities involved in creating a product.

profit growth The percentage increase in net profits over time.

profitability A ratio or rate of return concept.

property rights Bundle of legal rights over the use to which a resource is put and over the use made of any income that may be derived from that resource.

public action The extortion of income or resources of property holders by public officials, such as politicians and government bureaucrats.

pull strategy A marketing strategy emphasizing mass media advertising as opposed to personal selling.

purchasing The part of the supply chain that includes the worldwide buying of raw material, component parts, and products used in manufacturing of the company’s products and services.

purchasing power parity (PPP) An adjustment in gross domestic product per capita to reflect differences in the cost of living.

push strategy A marketing strategy emphasizing personal selling rather than mass media advertising.

Q quota rent Extra profit producers make when supply is artificially limited by an import quota.

R regional economic integration Agreements among countries in a geographic region to reduce and ultimately remove tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other.

religion A system of shared beliefs and rituals concerned with the realm of the sacred.

representative democracy A political system in which citizens periodically elect individuals to represent them in government.

reverse logistics The process of moving inventory from the point of consumption to the point of origin in supply chains for the purpose of recapturing value or proper disposal.

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

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

right-wing totalitarianism A political system in which political power is monopolized by a party, group, or individual that generally permits individual economic freedom but restricts individual political freedom, including free speech, often on the grounds that it would lead to the rise of communism.

S server factory A factory linked into the global supply chain for a global firm to supply specific country or regional markets around the globe.

sight draft A draft payable on presentation to the drawee.

Six Sigma Statistically based methodology for improving product quality.

Smoot-Hawley Act Enacted in 1930 by the U.S. Congress, this act erected a wall of tariff barriers against imports into the United States.

Social Democrats Those committed to achieving socialism by democratic means.

social mobility The extent to which individuals can move out of the social strata into which they are born.

social strata Hierarchical social categories often based on family background, occupation, and income.

social structure The basic social organization of a society.

Socialist Someone who believes in public ownership of the means of production for the common good of society.

society Group of people who share a common set of values and norms.

sogo shosha Japanese trading companies; a key part of the keiretsu, the large Japanese industrial groups.

source effects Effects that occur when the receiver of the message (i.e. a potential consumer) evaluates the message on the basis of status or image of the sender.

source factory A factory whose primary purpose is also to drive down costs in the global supply chain.

specific tariff Tariff levied as a fixed charge for each unit of good imported.

spot exchange rate The exchange rate at which a foreign exchange dealer will convert one currency into another that particular day.

staffing policy Strategy concerned with selecting employees for particular jobs.

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

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

strategic pricing The concept containing the three aspects: predatory pricing, multipoint pricing, and experience curve pricing.

strategic trade policy Government policy aimed at improving the competitive position of a domestic industry and/or domestic firm in the world market.

strategy Actions managers take to attain the firm’s goals.

subsidy Government financial assistance to a domestic producer.

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supply chain management The integration and coordination of logistics, purchasing, operations, and market channels activities from raw material to the end-customer.

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

switch trading Use of a specialized third-party trading house in a countertrade arrangement.

T tariff A tax levied on imports.

tariff rate quota Lower tariff rates applied to imports within the quota than those over the quota.

theocratic law system A system of law based on religious teachings.

theocratic totalitarianism A political system in which political power is monopolized by a party, group, or individual that governs according to religious principles.

time draft A promise to pay by the accepting party at some future date.

timing of entry Entry is early when a firm enters a foreign market before other foreign firms and late when a firm enters after other international businesses have established themselves.

total quality management (TQM) Management philosophy that takes as its central focus the need to improve the quality of a company’s products and services.

totalitarianism Form of government in which one person or political party exercises absolute control over all spheres of human life and opposing political parties are prohibited.

trade creation Trade created due to regional economic integration; occurs when high-cost domestic producers are replaced by low-cost foreign producers within a free trade area.

trade diversion Trade diverted due to regional economic integration; occurs when low-cost foreign suppliers outside a free trade area are replaced by higher-cost suppliers within a free trade area.

trademarks The designs and names, often officially registered, by which merchants or manufacturers designate and differentiate their products.

transaction exposure The extent to which income from individual transactions is affected by fluctuations in foreign exchange values.

translation exposure The extent to which the reported consolidated results and balance sheets of a corporation are affected by fluctuations in foreign exchange values.

transnational strategy Attempt to simultaneously achieve low costs through location economies, economies of scale, and learning effects while also differentiating product offerings across geographic markets to account for local differences and fostering multidirectional flows of skills between different subsidiaries in the firm’s global network of operations.

transportation the movement of inventory through the supply chain.

Treaty of Lisbon A European Union–sanctioned treaty that will allow the European Parliament to become the co-equal legislator for almost all European laws.

Treaty of Rome The 1957 treaty that established the European Community.

tribal totalitarianism A political system in which a party, group, or individual that represents the interests of a particular tribe (ethnic group) monopolizes political power.

turnkey project A project in which a firm agrees to set up an operating plant for a foreign client and hand over the “key” when the plant is fully operational.

U uncertainty avoidance Extent to which cultures socialize members to accept ambiguous situations and to tolerate uncertainty.

United Nations An international organization made up of 193 countries headquartered in New York City, formed in 1945 to promote peace, security, and cooperation.

Universal Declaration of Human Rights A United Nations document that lays down the basic principles of human rights that should be adhered to.

universal needs Needs that are the same all over the world, such as steel, bulk chemicals, and industrial electronics.

upstream supply chain The portion of the supply chain from raw materials to the production facility.

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

V value creation Performing activities that increase the value of goods or services to consumers.

values Abstract ideas about what a society believes to be good, right, and desirable.

voluntary export restraint (VER) A quota on trade imposed from the exporting country’s side, instead of the importer’s; usually imposed at the request of the importing country’s government.

W wholly owned subsidiary A subsidiary in which the firm owns 100 percent of the stock.

World Bank International institution set up to promote general economic development in the world’s poorer nations.

World Intellectual Property Organization An international organization whose members sign treaties to agree to protect intellectual property.

World Trade Organization (WTO) The organization that succeeded the General Agreement on Tariffs and Trade (GATT) as a result of the successful completion of the Uruguay Round of GATT negotiations.

Z zero- sum game A situation in which an economic gain by one country results in an economic loss by another.

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Chapter 9 Opener: Joe Raedle/Getty Images; p. 267: Martin Leissl/ Bloomberg/Getty Images; p. 269: Frederick Florina/AFP/ Getty Images; p. 282: Janine Wiedel Photolibrary/Alamy.

Chapter 10 Opener: Andre Penner/AP Images; p. 288: © Ed Brown/Alamy; p. 296: Noah Friedman-Rudovsky/Bloomberg/Getty Images; p. 308: © Yuya Shino/Reuters/Corbis.

Chapter 11 Opener: Bloomberg/Getty Images; p. 328: Stephen Jaffe/IMF/ Getty Images; p. 332: Christopher Furlong/Getty Images.

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Chapter 14 Opener: Hans Neleman/Stone/Getty Images; p. 403: Andrew Harrer/Bloomberg/Getty Images; p. 413: Simon Dawson/ Bloomberg/Getty Images.

Chapter 15 Opener: Rita Qian/AFP/Getty Images; p. 425: Imaginechina/AP Images; p. 445: Bloomberg/Getty Images.

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Chapter 17 Opener: Nigel Treblin/Getty Images; p. 499: Vincent Yu/AP Images; p. 505: Martin Leissl/Bloomberg/Getty Images.

About the Authors Page iv: Courtesy of Anke Weekes, Charles W. L. Hill, and G. Tomas M. Hult.

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Chapter 4 Opener: FlickrVision/Getty Images; p. 105: Ali Al-Saadi/AFP/ Getty Images; p. 116: AP Images/Michel Euler.

Chapter 5 Opener: Philippe Huguen/AFP/Getty Image; p. 132: PhotoDisc/ Getty Images; p. 137: Flickr Vision/Getty Images.

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photo credits

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name index A Abacha, Sani, 51 Abe, Shinzo, 308 Ahern, Kevin, 253–254 Allison, Richard, 482 Altucher, James, 318 Ambelang, Bryant, 254 Aristotle, 41 Arslan, Saffet, 105 Asmar, Ronnie, 482

B Banda, Joyce, 334–335 Barra, Mary T., 115 Barro, R. J., 101–102 Bartlett, Christopher, 377 Bartlett, D.L., 23 Bentham, Jeremy, 142 Bond, Michael Harris, 112 Bové, José, 24, 461 Buchanan, James, 41 Bush, George W., 203

C Calderon, Felipe, 273 Castro, Fidel, 82 Chandler, Alfred, 180 Chávez, Hugo, 42, 44, 55, 73, 82, 321 Cheuk-san, Ada Kong, 127 Coccio, Chris, 397 Conklin, David, 389 Cook, Tim, 420 Cortés, Hernán, 376

D Dalai Lama, 29 De Soto, Hernando, 69 DeFife, Scott, 254 Delors, Jacques, 263 Deming, W. Edward, 423 Diaz, Manuel, 24 Disney, Roy O., 450 Disney, Walter Elias, 450 Dobbs, Lou, 23 Downey, Robert, 449–450 Doyle, J. Patrick, 482 Doz, Yves, 365, 505 Dunning, John, 232–233

F Feigenbaum, A.V., 423 Frankel, Jeffrey, 173 Friedman, Milton, 41, 140–141 Friedman, Nancy, 107 Friedman, Thomas, 6 Fukuyama, Francis, 74–75

G Gaddafi, Muammar, 73 Gallion, Don, 400

Gandhi, Mahatmas, 107 Ghoshal, Sumantra, 377 Glassman, David, 348–349 Greenblast, Drew, 399

H Hall, Edward T., 118 Hamel, Gary, 365 Hamilton, Alexander, 205 Hamilton, Andrew, 205 Hardin, Garrett, 133 Heckscher, Eli, 161–162, 165, 174 Hewlett, Bill, 139 Hochber, Fred, 403 Hofstede, Geert, 92, 112–115, 139 Hume, David, 41, 142, 163 Huntington, Samuel, 74–75

J Jobs, Steve, 32–33, 131, 420 Johansson, Scarlett, 449 Johnson, Lyndon B., 317 Juran, Joseph, 423

K Kant, Immanuel, 143 Kluckhohn, Florence, 92 Knickerbocker, F.T., 232 Kotchian, Carl, 134 Krugman, Paul, 162, 207–208 K’ung-Fu-tzu, 108

L Lagnado, Silvia, 466 Lawton, Michael, 483 Lee, Stan, 449 Leontief, Wassily, 174 Levitt, Theodore, 452–453,

456–457, 480 Lieberman, Marvin, 376 Lula da Silva, Luís Inácio, 274

M Maduro, Nicholas, 44 Mao Zedong, 109 Marcos, Ferdinand, 49 Marx, Karl, 40 Mayer, Hans Ulrich, 428 McClearly, Rachel, 102 Mendenhall, M., 497–498, 501 Merritt, Al, 415–416 Mill, John Stuart, 41, 142 Minkov, Michael, 113 Mintz, Dan, 109 Mittal, Lakshmi, 236 Monaghan,Jim, 482 Monaghan,Tom, 482 Mondavi, Robert, 24 Montgomery, David, 376

Morales, Evo, 236 Morrow, Doug, 152 Morsi, Mohamed, 74, 86 Mubarak, Hosni, 86 Muhammad, Prophet, 48, 103, 105 Mulally, Alan, 367 Mun, Thomas, 163 Murphy, Karen, 282 Mutharika, Bingu wa, 334–335

N Nadella, Satya, 493 Nader, Ralph, 28 Nakamoto, Satoshi, 154 Nakane, C., 97 Namenwirth, Zvi, 92 Nixon, Richard M., 317 North, Douglass, 69

O Obama, Barack, 159 Obasanjo, Olusegun, 51 Oddou, G., 497–498, 501 Ohlin, Bertil, 161–162, 165, 174

P Packard, David, 139 Palmisano, Sam, 487 Perot, Ross, 271 Persson, Erling, 445 Plato, 40–41 Ponzi, Charles, 155 Porter, Michael, 111, 162,

180–185, 340–341 Powell, Colin, 75 Prahalad, C. K., 365, 505 Putin, Vladimir, 38–39, 44

Q Quiggin, John, 155

R Ravenscraft, David, 387–388 Rawlings, Jerry, 57 Rawls, John, 144–145,

147–148, 153 Reich, Robert, 8, 240 Rein, Shaun, 90 Ribadu, Nuhu, 51 Ricardo, David, 160–163, 165–167,

173–174, 185, 196, 207, 209, 234

Rokeach, Milton, 92 Romer, David, 173 Rometty, Virginia, 115 Romney, Mitt, 198 Ross, John, 508–509

S Sachs, Jeffrey, 29, 71, 173, 330 Samuelson, Paul, 169, 171–172 Scherer, Mike, 387–388 Schwartz, Shalom, 92 Scott, Lee, Jr., 52 Sein, Thein, 61 Sen, Amartya, 66–67, 71 Smith, Adam, 42, 71, 160–166,

185, 196, 207, 209, 234 Smith, Phil, 508–509 Son, Hasayoshi, 119 Soros, George, 299 Speiser, Mitch, 482 Spielberg, Steven, 109 Stansberry, Porter, 318 Steele, J.B., 23 Stockton, Bryan G., 473 Stott, Michael, 403 Stringer, Howard, 493 Strodtbeck, Fred, 92 Stross, Charlie, 155 Sullivan, Leon, 131 Sumner, William Graham, 93 Suu Kyi, Aung San, 61

T Taiichi Ohno, 427 Thatcher, Margaret, 77 Tung, R. L., 494–495 Tylor, Edward, 92

V Vernon, Raymond, 162,

175–176 Von Hayek, Friedrich, 41

W Wacziarg, R., 173 Wang You, 131 Warner, Andrew, 173 Weber, Max, 102, 106, 120 Weber, Robert, 92 Welch, Jack, 147 Welch, K. H., 173 Weng Bao, 131 Whedon, Joss, 449 Wolfson, Scott, 128

Y Yafi, Wissam, 71 Yeats, Alexander, 274 Yew, Lee Kuan, 70

Z Zhou Houjian, 21 Zyuganove, Gennadiy, 38

522

subject index A ABB SAE Sadelmi SpA, 411 Absolute advantage, 163–166 Absolution advantage theory, 185 A-CAPPP program, 203 Accent, lower case, 99 Acer, 262 Acquisition pros and cons,

387–392 acquisition failures, 388–389 failure risk reduction, 389

Acquisition strategy, 389 Acquisitions, 240, 387

versus greenfield investments, 228

Ad valorem tariff, 197, 199 Adams & Brooks, 195 Adjustable peg system, 324 Administrative barriers, 6 Administrative trade policies, 201 Advance factors, 181 Africa. see also Eastern Africa;

Northern Africa; South Africa; sub-Saharan Africa; Western Africa; specific countries

Christianity, 102 cultures, 93–94 currency management, 324 democracy, 73 economic development, 73 economy of, 57 fuel source, 5 gains in, 75 gateway, 122 inward investment, 226 Islam, 103 market-based economies, 75 markets, 79 politics, 40 population, 66 rare earth metals from, 32 regional investment, 275 socialist countries, 234, 236 totalitarian, 70–71 toxic waste disposal, 144 trade blocs, 278 tribal totalitarianism, 44

AFTA (ASEAN Free Trade Area), 276–278

Aggressive pricing, 469 Agriculture protectionism, 213 AIG, 46 Air India, 413 Air Touch Communications, 367 Airbus, 4–5, 7–8, 162, 179–180,

207–208, 221, 303, 331–332

Aircraft, 3–5, 7–8, 14, 161–162, 175, 179–180, 285–286, 290, 303, 332, 350, 356, 363–364, 399–400, 411, 413, 441

AirTouch Communications, 387 Al Jazeera, 15 Albania, 411 Alcoa, 202 Alcohol, 94 Alenia Aeronautica, 3 Alepia of Italy, 4 Algeria, 21, 103–104, 150 Alliances

managing, 365–366 partner selection, 364 structure, 364–365

Amarta Sen on development, 66–67 Amazon.com, 68 AMD, 262 American Customer Satisfaction

Index, 420 American Express, 470 American Idol, 117 American products, percentage

of, 201 American-based suppliers, 332 Americans, cultures in, 94 Americas, 102, 270, 274–275, 280 Amgen, 25 Anatolian Tiger, 105 Andean Community, 257,

270, 273 Andean Pact, 273 Angola, 40, 75 Annual incentives, 503 Antibribery provisions, 52 Antidumping

actions, 215 polices, 184, 201–202, 216

Antiglobalization in France, 24 Anti-trust laws, 45 Apartheid laws, 130, 243 Apartheid system, 130 APEC, 275–278, 281 Apple, 8, 13, 32–33, 90, 129–131,

172, 184, 233, 290–291, 354, 419–421, 459–460, 464, 475, 477

Apple Computer, 131, 184, 233, 290, 460

Apple iPads, 5 Apple iPhones, 5–7, 32, 354, 363,

429, 464 Appraisal systems, 501 Approaches to forecasting

fundamental analysis, 301 technical analysis, 301

Arbitrage, 292–293, 297–298, 467 Arbitration, 49 Arcelor, 236 Argentina, 10, 85, 208, 211, 255,

274–275, 296, 325–326, 387 Argentinian crisis (2000-2002), 326 Ascetic principles, of Hinduism, 120 ASEAN Free Trade Area (AFTA),

275–278 Asia, 9, 14–15, 20, 32, 53, 70, 73,

76, 79, 94, 100, 122, 128, 151, 173, 216, 225, 270, 275, 298, 327, 330, 355, 357, 360, 372, 375, 399, 402, 420, 430, 440, 446, 457, 470, 476, 478, 482, 491. see also specific countries

Asian banking crisis, 323 Asian currency crisis, 331 Asian financial crisis (1997), 319,

326, 330, 411 Asia-Pacific Economic

Cooperation (APEC), 275–278, 357

Association of Southeast Asian Nations (ASEAN), 275–276

Association to Advance Collegiate Schools of Business (AACSB), 74

AT&T, 380 Atag Holdings NV, 279 Attrition rate, of expatriates, 500 Audi, 109 Australia, 41, 63, 202, 204, 211,

214, 219, 253, 260, 277, 305, 356, 377, 415, 490, 495

Austria, 256, 260, 356, 485 Autarky, 399 Authoritarianism, 74 Auto companies, 230 Auto exports, 198, 200 Autonomy, 389 The Avenger, 450 Avengers (franchise), 449–450

B B&S Aircraft Alloys, 7 Balance sheet approach,

503–504 Balance-of-payments

accounting, 191 Balance-of-payments accounts,

189–192, 238 Balance-of-payments deficit, 318 Balance-of-payments position, 240

Balance-of-trade equilibrium, 314 Balance-of-trade surplus, 163 Ballot fraud, spread of, 73 Baltic countries, 269 Bandwagon effects, 298–299 Bangladesh, 161–162, 234 Bank for International

Settlements, 327 Bank of America, 172, 360 Banker’s acceptance, 408 Banking crisis, 326 Banks and moral hazards, 329 Bargaining power, 246 Barriers. see also trade barriers

administrative, 179 to cross-border trade, 13 cultural, 461, 494 to entry, 179 informal, 242 internal, 263 international communication,

461–462, 464–465 to international trade, 12 non-tariff, 159–160, 259 regulatory, 6 tariff and nontariff, 160

Barter, 412 Base pay, 503 Basic entry decisions

entry timing, 374–376 market entry summary, 377 scale of entry and strategic

commitments, 376–377 which foreign markets,

373–374 Basic factors, 181 Basic research, education in, 185 Basket of currencies, 312 BBC, 15 Behavior, symbolic, 93 Beijong Mei Da coffee, 372 BEL 20 index, 152 Belgium, 78, 110, 152, 260, 262,

356, 467 Bell Laboratories, 380 Benchmarking, 377 Benefit cost-risk trade-off, 373 Benefits, 80–81 Benefits and costs of foreign

direct investment (FDI) home-country benefits, 241 home-country costs, 241 host-country benefits, 237–239 host-county costs, 239–240 international trade theory and

FDI, 241 Benetton, 461

Subject Index 523

Best Buy, 90–91 “Best Global Brands,” 419 Beverages, 456 Bharti, 249 Biases

performance appraisal problems, 501

reduction of, 502 Big Mac Index, 294, 298, 317 Bill of exchange, 404–405, 407 Bill of lading, 404–405 Bills of lading, 405, 408 Black Brazil, 455 Black economy, 64, 223 Blackberry, 464 BMW, 455 BMW cars, 455 Boeing, 3–5, 7–8, 12, 25, 134, 162,

179–180, 199, 207–208, 221, 332, 363–364, 367, 383, 399, 411, 413

Boeing 737 (aircraft), 364, 367 Boeing 747 (aircraft), 8 Bolivia, 21, 43, 236, 257, 273,

295–296, 361, 495 Bolivian money supply, 295–296 Bombardier, 356 Bon Appetite Group, 372 Bono (rock-star), 29 Boston Consulting Group, 433 Bottlenecks, 428 Bound tariff rates, 213

Japan, 214 Bovine somatotropin (BST)

hormone, 204 BP (British Petroleum), 136,

142, 150 Brahmin (high caste level), 98 Brand loyalty, 80 Brand preference, 436 Brand value, 419–420 Brazil

African Brazilian market segment, 454–455

annual inflation rate, 285 auto industry, 206 BRIC country, 65 business regulations, 57 coffee export, 162 cultures of, 112 disposable diaper price

competition, 468 economy growth, 21 emerging economy, 16 FDI share, 18 Ford mistake in, 110 freest economy ranking, 77 globalization risk, 22 IMF rescue loss, 355–356 inflation rate speculation, 296 inward FDI, 226 inward FDI exclusion, 243 market growth developing, 460 marketing differences, 29 Mercosur, 255, 274–275 MMC China, 509 MTV Networks, 387

opportunities, 6–7 privatization of telephone

monopoly, 79 Real devaluation, 274–275 Real values, 285 renminbi reserve currency, 294 sociodemocracy, 41 Stanley Black & Decker, 305 state owned businesses, 46 sugar producing company, 195 Telefónica, 415 trade barriers, 208 transportation equipment

tariff, 215 VERs, 200 world output share, 15

Brazilian Real, 274–275, 285 Bretton Woods

agreements, 315–316 conference, 313 location, 10 provisions, 317 role of the IMF, 315–316 role of the World Bank,

316–317 Bretton Woods system, 313, 315,

318, 322–324, 326, 331, 333 Bribe Payers Index, 154 Bribery, 139 Bribes, 52, 81, 134, 136 Bristol-Myers Squibb, 477 British class system, 99 British Monopolies and Mergers

Commission, 469 British pound, 287–289, 292–293,

299, 312, 314 British Sky Broadcasting

Group, 282 British Telecom (BT), 77 Brookings Institution, 294 Brother Industries, 460 Buddhism, 107–108 Budweiser, 109 Build America Act, 201 Bulgaria, 220, 260 Bundesbank, 266, 316–317 Burma, 61, 132. see also Myanmar Bush administration, 275, 469 Business ethics, 129, 140–141 Business Software Alliance, 53 Businesses, state-owned, 76 Buy decision, 435 Buyback, 412–413 Buyer (downstream) function, 443

C Cabotage, 263 Calvinism, 105 Cambridge, 99 Canada, cultures in, 94 Canon, 176, 361 Capacity utilization, 428 Capital, in R&D, 237 Capital account, 187, 190–191 Capital equipment, 274 Capital flight, 302

Capital market, 265–266 Capitalism, 234 Capitalist mode, 91 Caribbean, 275, 324, 415 Caribbean Single Market and

Economy (CSME), 275 CARICOM, 275 Carrefour, 239, 248, 361, 375,

458–459 Carry trade, 288–289 Cases

Best Buy and eBay in China, 89–91

FDI in Nigeria, 223–224 global branding of Avengers

and Iron Man, 449–450 growing through exports,

397–398 IMF and Iceland’s recovery,

311–314 strategic of human resources at

IBM, 487 sugar subsidies, 195–196 tomato wars, 252–253 world’s largest trading zone,

159–160 Cash decks, 135 Cash funds, 420 Caste system, 98–99, 107 Cast-lot packaging, 437 Caterpillar, 7, 303, 305, 331, 343,

360, 392, 411 Catholic Church, 102 Cayman Island, 495 Celebrities, 445 Cemex, 228–230, 240, 248 Censorship, 77 Central America, 255, 324, 415 Central American Common

Market, 274–275, 280 Central American Free Trade

Agreement (CAFTA), 274–275

Central Asia, 20 Cerberus Capital Management,

135 CFI Group, 472 Chaebol, 328 Chain of causation, 95 Changhong Electronics, 402 Channel length, 458 Channel quality, 459 Channelization, of industries, 483 Child labor, 141 Chile, 2, 43, 73, 77, 272–273,

275, 381 China. see also Hong Kong

about, 6 African countries’

investment, 227 annual FDI, 21 Apple in, 460 ASEAN membership, 277 assembly labor, 33 Best Buy, 90 Buddhism, 107–108 carbon dioxide emissions, 27

Cemex, 229 China price, 402 Chinese Nation Offshore Oil

Company, 236 class divisions in, 100 Clear Vision, 349 communism, 40–41 communist totalitarianism, 43 Confucianism, 108 copyright infringement, 204 corruption, 55 corruption index, 50 country factors, 424–425 cultural differences, 89–91 culture, 119 dumping, 202 eBay, 90–91 economic growth, 79 economy size, 67 employment treatment, 420 exchange rates usage, 315 exports, 239 FCX Systems, 400–401 FDA approval, 188 FDI, 234–236 FDI and world trade, 13 FDI flow, 219–220, 226 FDI holdings, 321 FDI inflow, 227 FDI share, 18 financial status of, 80 Ford Motor Company,

367–368 free market economics, 31 free market reforms, 20 GE moves manufacturing

from, 432 General Motors, 383 global ad growth, 460 global labor pool, 23 GNI per capita, 63–64 gross domestic product

(GDP), 90 guanxi (relationships)

networks, 109 guanxiwang, 108–109 H&M (retail-clothing

giant), 445 Heckscher-Ohlin theory, 174 Hewlett-Packard (HP), 479 Hisense Co. Ltd., 19, 21 Hong Kong treatment by, 77 human rights record, 132 Huntington thesis on, 75 Hutchison Whampoa, 19 IKEA, 337–338 import substitution policy

in, 164 intellectual property rights, 53 inward investment FDI, 80 Islam, 103 joint venture films, 362 KFC, 377 labor abuses, 131 labor force size, 5 lead in products, 129 living standards, 80

524 Subject Index

market-based changes, 77–81 marketing mix, 453–454 McDonalds, 375 McDonald’s hamburger, 117 McDonalds in, 347 Microsoft moves from, 432 Minute Maid Pulsy, 357 MMC China situation,

508–509 neo-mercantilist policies,

163–164 oil demand, 321 P&G in, 347 PepsiCo slogan, 111 personal relationships, 400 Philip Morris, 411, 424–425 Pizza Hut, 482 production shift to, 354 property rights, 49 purchasing power, 80, 90–91 purchasing power parity

(PPP), 64 rare earth metals, 219–220 Renminbi, 294 reserve currency, 294 Ricardo theory, 174 safety regulation compliance

issue, 128 Samuelson critique, 171–174 SARS Virus, 440 Sinopec assets, 437 software piracy, 53 Starbucks Corporation, 54,

372–373 state owned companies, 78 TaoBao, 90 Tesco, 375 textile industry, 25 textile industry subsides, 198 totalitarian dictatorship, 43–44 tourism, 495 Toyota China, 453–454 trade surplus, 164 trading rules issue, 212 Unilever in, 466 U.S. current account

deficit, 191 U.S. Magnesium case, 202 Vision Quest Lighting, 397–398 wages, 26 wealth gap, 476 workers, 491 world output share, 15–16 WTO membership, 221, 227 Yum Brands Inc., 482 Zhou Houjian, 19

China Business News, 131 China currency, 164 China Mobile, 109 China National Offshore Oil

Company, 236 China price, 402 China renminbi, 294 Chinese banks, 80, 294 Chinese competition, TaoBao,

90–91

Chinese market, piracy in, 90 Chinese mobile phone

market, 420 Chinese Value Survey (CVS), 112 Chinese yuan, 298 Christian ethics, 100 Christianity, 100, 102–103 Christianity churches, 102 Chrysler Corporation, 135, 331,

387–388, 456 Cisco Systems, 68 Citigroup Inc., 6–7, 24, 46,

105, 360 Civil law, 52 Civil law system, 47 Civil strife, 82 Class conflict, 506 Class consciousness, 100 Class divisions, 91–92, 100 Class systems, 99 Class-based conflict, 118 Clear Vision, 348–349 Client (downstream)

function, 443 Clinton administration, 8 Closed economies, 173 Closing cases, general

ethics, corporate responsibility, and sustainability, 154–155

exporting, importing and countertrade, 415–416

focus on managerial implications, 334–335

foreign direct investment, 248–249

foreign exchange market, 308 foreign market entrances,

392–393 global human resource

management, 508–509 global marketing and research

and development, 482–483

global production and supply chain management, 443–444

government policy, 248–249 government policy and

international trade, 219–220

regional economic integration, 282

strategy of international business, 367–368

Closing cases, specific Bitcoin as ethical dilemma,

154–155 China limits of rare earth

minerals, 219–220 currency trouble in Malawi,

334–335 Domino’s Pizza worldwide,

482–483 Ford global strategy, 367–368 foreign retailers in India,

248–249

Greek TV, 282 H&M (retail-clothing giant),

443–444 India’s drug industry, 187–188 Japanese Yen movement, 308 JCB in India, 392–393 MD International, 415–416 MMC China, 508–509

CNN, 15, 452 Coca-Cola, 5–7, 74, 81, 83, 354,

357, 380, 419, 452–453, 456–457, 465

Code of conduct, 130 Code of ethics, 146–148 Coffee, 456 Cognizant Technology

Solution, 98 Cold War, 42 Colgate-Palmolive, 361 Collaborative planning,

forecasting and replenishment (CPER), 440

Collectivism, 40, 42 and individualism, 41–43 versus individualism, 79 and socialism, 40–41

Colombia, 75, 142, 211, 257, 273 Command economy, 46 Commercial News USA, 403 Commercial risks, 410 Commitment, 376 Common Agricultural Policy

(CAP), 203, 208 Common currency, 257, 259, 265 Common law, 47–48 Common market, 257 Common tariff, 257 Common union, 257 Communication, and information

technologies, 73 Communication strategy

global advertising, 464–465 international communication

barriers, 461–462 push versus pull strategies,

462–464 Communism, 41–42, 46, 74, 234 Communist countries, 234 Communist totalitarianism, 43–44 Communists, 40, 44 Comparative advantage, 235, 242,

248–249, 254, 271, 349 extensions of Ricardian Model,

169–174 gains from trade, 167–168 Hamilton on, 205 versus Heckscher-Ohlin

theory, 174 infant industry argument, 206 qualifications and assumptions,

168–169 Ricardian Model extensions,

169–173 Comparative advantage

model, 169 Comparative advantage theory,

148, 166, 184–186

Compensation, 412, 488 expatriate pay, 503–505 national differences, 502–503 national differences in

compensation, 502–503 practices, 488

Compensation packages, 489 Compensation structure, 493, 502 Competency strengths

experience, 491 Competition, 7, 117 Competitive advantage, 119, 162,

172, 216, 380, 506 Competitive disadvantage, 184 Computer and software firms, 233 Computer software, 53 Configuring the marketing mix,

469–471 Confucian ethics, 100 Confucianism, 108–110 Constant returns to

specialization, 169 Consumer mail panels, 474 Consumer preferences, 279 Consumers

incomes of, 22 products for, 89

Consumption taxes, 224 Contract, 48 Contract dispute, 108 Contract law, 48 Contract law differences, 48–49

property rights and corruption, 49–54

Contributor factory, 431 Controls, 345 Convention on Combating

Bribery of Foreign Public Officials in International Business Transactions, 51, 135

Convergence hypothesis, 117 Convex PPF, 169 Con-way, 136 Cooperation, 97, 109 Cooperative advantage theory, 167 Copyrights, 52 Core competencies, 347, 491 Core competencies and entry

mode management know-how, 386 technological know-how, 386

Corn Laws, 209 Corning, 5, 33 Corporate and social

responsibility, 151 Corporate culture, 385, 490, 500 Corporate social responsibility

(CSR), 129, 149 Corporate tax rate, 78 Corruption, 49–50, 55, 61, 81,

135, 140, 223 and FDI, 50

Cost advantages, 184 Cost and production capacity, 433 Cost of living, 63–64 Cost pressures, 176, 384

China (continued )

Subject Index 525

Cost processes and pressures for local responsiveness, 353

Cost reduction, 177 Costa Rica, 151, 172, 211,

259, 274 Costco, 9, 239 Costs, 81–82. see also benefits and

costs of FDI; transportation costs

apparent, of foreign direct investment (FDI), 241

control of, 506 labor, 506 pressures for reductions of,

353–357, 386 and production capacity, 434 relative factor, 425 relocation, 493 of research, 473 shipping, 14 total, 421 training, 493 of value creation, 450

Costs of doing business, 81 Council of Supply Chain

Management Professionals (CSCMP), 421

Council of the European Union, 260

Counterpurchase, 412 Counterpurchase agreements, 413 Countertrade, 302, 398, 410–413

popularity of, 411 pros and cons of, 413 types of, 411–413

Countertrade agreement, 411 Countervailing duties, 201 Countries, post-communist, 74 Country choices, 495 Country factors, 162, 424–425 Country focus, 205 Country focus, by country

America gains in trade, 215 China emerging property

rights, 70 China FDI, 227 China neo-mercantilism

question, 164–166 China subsidies, 198 Greek sovereign debt crisis, 268 India, 17 India’s caste system, 98 India’s caste system and ITs, 98 India’s economic

transformation, 78 Mexican currency crisis of

1995, 326–328 Nigeria corruption, 52 Turkey, Islamic capitalism

in, 105 U.S. white collar jobs offshore

moving, 172 Venezuela under Chávez, 42

Country focus, by issue hormone-treated beef, 204 oil process and recycling

petrodollars, 321

quantitative easing, inflation and U.S. dollar, 297

single market in financial securities, 264

trade policy instruments, 198 U.S. Dollar, oil process and

recycling petrodollars, 321 Country of origin, 461 Country Reports on Human

Rights, 154 Country-specific pay, 502 The Courier, 140 Court of Justice, 260, 263–264 Creative destruction, 475 Creditworthiness, 407 Criminal liability laws, 54 Crisis management by the IMF

financial crises in post-Bretton Woods era, 326–328

IMF policy prescriptions, 328–330

Mexican currency crisis of 1995, 326–328

Crisis membership, 100 Crisis recovery, 322–323 Crisis system, 100 Croque McDo, 453 Cross-border acquisitions, 388 Cross-border investments, 230 Cross-border mergers and

acquisitions, 228, 264 Cross-border trade, 275, 297 Cross-border trade and

investment, 29 Cross-border transactions, 29 Cross-cultural awareness, 501 Cross-cultural differences, 92 Cross-cultural literacy, 91,

117–118 Cross-cultural training, 498, 500 Cross-functional integration, and

fundamental integration, 477 Cross-licensing agreements, 381 Cross-training, 506 Cuba, 28, 40–43, 77, 82, 205, 234 Cultural and national

competition, 117 Cultural barriers, 461, 494 Cultural change, 116

cross-cultural literacy and competitive advantage, 117–118

cultural and comparative advantage, 118–120

focus on managerial implications, 117–118

Cultural convergence, 456 Cultural differences

breaking India’s caste system, 98

in China, 89–91 cultural and competitive

advantages, 118–120 cultural change, 115–120 culture (concept), 92–95 culture and business, 112–115 DMG-Shanghai, 109

education, 111–112 focus on managerial

implications, 118–120 India’s caste system, 98 individuals and groups, 95–97 introduction, 91–92 Islamic capitalism in

Turkey, 105 language, 109–111 opening case, 89–91, 120–121 religious and ethnic systems,

100–109 significance, 100 social mobility, 98 social stratification, 98, 100 social structure, 95–100 World Expo in Dubai,

UAE, 122 Cultural diversity, 465 Cultural factors, 119–120 Cultural issues, 91 Cultural myopia, 492 Cultural norms, 142 Cultural relativism, 141 Cultural Revolution (China), 454 Cultural sensitivity, lack of, 142 Cultural shock, 499 Cultural skills, 495 Cultural toughness, 497 Cultural values, 115, 404–405 Culture (concept), 429

cultural, society, and nation state, 94

culture, society and nation- state, 94

of customers, 475 definition, 92 determinants of, 95 and language, 110 values and norms, 92–94

Culture evolution, 92 Culture impact, 475 Culture(s)

African, 93 American, 29, 74, 94, 111, 143 Arabic, 93 Canadian, 94 Confucian, 108, 114 European, 93, 257 Islamist, 94 Latin, 93, 113 Latin American

immigration, 111 Middle East, 497 Nordic, 113 Rwandan, 94 Saudi, 94 South East Asia, 497

Cultures and Organization, 113 Currencies, 288, 312

convertibility, 398 Currency appreciation, 285 Currency board, 325 Currency convertibility,

approaches to forecasting, 302–303

Currency crises, 326–327

Currency depreciation, 296 Currency devaluation, 322 Currency management, business

strategy, and government relations

business strategy, 331–332 corporate-government

relations, 332–333 currency management,

330–331 focus on managerial

implications, 330–332 Currency speculation, 288 Currency swaps, 290 Currency war, 286 Current account, 189, 238 Current account balance-of-

payments deficit, 301 Current account deficits, 189, 192 Current account surplus, 189 Custom unions, 258, 278 Customer (downstream)

function, 443 Customer base, 378 Customer defaults, 410 Customer satisfaction, 420 Customer service, 14 Customers, market of, 90 Customization, 479

versus standardization, 471 Customs union, 256–257, 273, 275 Cyberadad (Hyderabad), 425 Cyprus, 110, 260, 269 Czech Republic, 73, 77, 269, 375 Czechoslovakia, 20, 40

D Daimler, 129, 135, 139, 387–388 Daimler-Benz, 331, 387 DaimlerChrysler, 387–388 Dalit (low caste level), 98 Damage control, 52 Dangerous products, 203 Data, primary and secondary, 473 Data supply collection, 474 Deadlines, 118 Debriefing, 500 Decision making, cultural and

ethics in, 117 Decision reasons, 228–232

limitations of exporting, 230 limitations of licensing,

230–231 Declaration of Independence, 41 Decree ruling, 42 Defining research objectives, 472 Definition, 6–9 DeHavilland, 180 Dell Computer, 14, 24–25, 68,

131, 235, 262, 288, 344, 427 Delors Commission, 263 Demand conditions, 181 Democracy, 43

spread of, 72–73 and totalitarianism, 43–44

Democratic reforms, 73

526 Subject Index

Demographics changing foreign direct

investment, 16–18 changing nature of

multinational enterprise, 19–20

world output and world trade picture, 15–16

Denmark, 77, 92, 113, 256, 260, 262, 265–266

Deregulating, markets, 6 Deregulation, 77 Determining the data sources, 472 Deutsche Telekom, 387 Developing, markets, 15 Developing countries, 16 Developing nations, 377, 464 Dharma, 106 Diamond, 181, 183 Dictators, 70 Dictatorship, militarian, 62 Diehl Luftahrt Elektronik, 3 Difference principle, 145 Differences in economic

development, 63–65 Differentiating, 377 Diminishing returns, 170, 173 Direct selling, 462 Direction of FDI, 244 Dirty float, 312–313 Dirty-float system, 312 Discount stores, 239 Discount superstores, 459 Disney, 5, 116, 449–450 Dispute resolution, 211 Distribution centers (DC), 436 Distribution strategy (differences

between countries) channel exclusivity, 459 channel length, 458–459 channel quality, 459–460 retail concentration, 457–458

Distributors, 462 Divestiture, 131–132 DMG-Shanghai, 108–109 Doha Round, 213, 255 Doha talks, 11–12 “Dollar crisis,” 192 Dollar-denominated assets,

267, 321 Dollar/yen carry trade, 289 Domestic markets, 239 Domestic producers, 213 Domestic purchasing, 438 Domino’s Pizza, 482–483 DoubleClick, 460 “Dove Campaign to Real

Beauty,” 466 Dove products, 465–466 Dow Corning, 136, 477 Downstream supply chain, 422 DP World, 236, 321 Drafts, 404–405, 407–408 DRAMs (chips), 7, 201–202 Drivers

declining trade and investment barriers, 11–13

the Internet, 13–14 microprocessors and

telecommunication, 13 technological role of change,

13–15 transportation, 14

Drug cartels, 273 Drug companies, 187 Du Pont, 475, 477 Dubai, 94, 122, 236–237, 321 Dubai International Capital, 321 Dum Dums (candy), 195 Dumping, 201

pesos, 327 Dun & Bradstreet (USA), 98 Dunning’s theory, 233 DuPont, 475 “Dutch Mafia,” 491 Dynamic random access memory

(DRAM), 201

E Early entrants, 376. see also first-

mover advantages Early large-scale entrance, 377 Earnings, outflow of, 240 Earth Summit (Rio de

Janeiro,1992), 27 East African Community

(EAC), 278 East Asia, 22, 365, 426 East Germany, 260 Eastern Africa, 63, 276 Eastern Africa Community

(EAC), 278 EBay, competition in, 90 e-books, 420 Eclectic paradigm, 228, 232–233 Economic arguments for

government intervention infant industry argument,

205–206 strategic trade policy, 206–207

Economic deregulation, 225 Economic environments, 55 Economic exposure, 304–305 Economic freedom, 68–69, 76–77 Economic growth, 84, 173 Economic growth rates, 64,

227, 373 Economic hardship, 205 Economic implications

of Buddhism, 107–108 of Confucianism, 108–110 of Hinduism, 106–107 of Islam, 104–106

Economic independence, 240 Economic integration, 258 Economic integration levels,

256–257 Economic market growth, 225 Economic policies, 226 Economic ransom, 240 Economic reform, 61, 78 Economic risks, 82. see also risks Economic stagnation, 68

Economic systems, 39–40, 62, 81 about, 44–45 command economy, 46 market economy, 45–46 mixed economy, 46

Economic theories of exchange rate determination

interest rates and exchange rates, 298–299

investor psychology and badwagon effects, 299–300

prices and exchange rates, 293–298

summary of exchange rate theories, 300

Economies of scale benefits of, 358 described, 177 in European Council, 263 European Ford, 367 examples, 178–179, 353 experience, 350 experience curve, 350, 366,

451, 469 exporting, importing and

countertrade, 398 flexible manufacturing, 427 IKEA, 339 impact of, 180 in India, 248 Levi Strauss, 470 versus local responsiveness, 357 minimum efficient scale, 426 new trade theory, 176, 180 Nokia, 465 Stanley Black & Decker, 305 subsidies, 199 and transnational strategy, 359 transportation rates, 438 Walmart, 351 in world market, 207

The Economist, 219, 294, 298 Economy, growth rate, 89 Ecuador, 21, 257, 273 Eddie Bauer, 133 Education, 116, 182–183

in basic research, 185 formal, 111 in infrastructure, 185 in investment, 185

Efficient market, 293 Efficient market school, 300 Efforts, allocation to, 443 Egypt, 5, 11, 24, 28, 61, 64, 79,

105, 121, 128, 160, 179–180, 187, 476

El Salvador, 274 ELAN. see Export Legal

Assistance Network (ELAN), 402

Elastic, 467 Elasticity of demand, 467 Electricity Generating Authority

of Thailand, 411 Electronic data interchange

(EDI), 440

Embraer, 286, 290 Embraer and Brazilian real,

285–287 EMCs, 404 EMI, 261 Emission limits, 134 Empire of the Sun

(Spielberg, S.), 109 Employment decline, 173 Employment effects, of foreign

direct investment (FDI), 243 Employment quota system, 98 Endowments, 174 Energy sector, 223, 257 Engineering degrees, 173 Engineers, 111–112, 182 Enron, 146 Enterprise resource planning

(ERP), 440 Entrepreneurial behavior, 107 Entrepreneurs, 68 Entrepreneurship, 174 Entry model selection

about, 385 core competencies and entry

mode, 386 pressures for cost reduction and

entry mode, 386 Entry modes

advantages and disadvantages, 377

exporting, 378–379 exporting as, 378–379 of foreign market, 373 franchising, 382–383 joint ventures, 383–384 licensing, 380–382 Starbucks Corporation, 372 turnkey projects, 379–380 wholly owned subsidiaries,

384–385 Environmental degradation, 143 Equal employment

legislation, 488 Ericsson Telecom AB, 355,

476, 501 Escorts, 392–393 ESPN, 282 Ethical algorithm, 137 Ethical behavior, 148 Ethical code, personal, 137 Ethical considerations, 138 Ethical custom, 140 Ethical decisions

internationally, 145 corporate social responsibility,

149–150 decision-making processes,

147–148 ethics officers, 148–149 hiring and promotion, 146 moral courage, 149 organization culture and

leaderships, 146–147 sustainability, 150–152

Ethical dilemmas, 136–137 Ethical issues, 55, 129

Subject Index 527

Ethical issues in international business, 129

corruption, 134–136 employment practices, 130 environmental pollution,

132–134 human rights, 130–132

Ethical problems, 147 Ethical strategy, 129 Ethical systems, 100 Ethics, 129, 153 Ethics, corporate responsibility,

and sustainability about, 126–129 Apple’s IPod, 131 closing case, 154–155 corruption at Daimler, 135 ethical dilemmas, 136–137 ethical issues in international

business, 129–136 focus on managerial

implications, 145–151 justice theories, 144–152 management focus, 133 management focus on

corporate responsibility at Stora Enso, 151–152

rights theories, 143–144 straw men, 140–142 unethical behavior roots,

137–140 Utilitarian and Kantian ethics,

142–143 summary, 153

Ethiopia, 24, 28, 75, 198, 203–205, 208, 211–213, 225, 254–255, 257, 260, 262–266, 269, 282, 291, 303, 312–313, 319, 324, 326, 398, 424, 476

Ethnocentric approach, 490 international strategy and, 493 policy impact, 491–492 staffing, 502 staffing policy, 491, 504

Ethnocentric behavior, 118 Ethnocentric staffing policy, 490 Ethnocentrism, 118 Etiquette, 93 Eton, 99 EU membership, 269 Euro, versus U.S. dollar, 285 Euro establishment

benefits of the euro, 265–266 costs of the euro, 266 euro experience, 267–269

Euro zone, 265, 269 Euro-consumer, 279 Euronext Brussels, 152 European capital market, 264 European Central Bank (ECB),

11, 266 European Coal and Steel

Community, 260 European Commission, 260–262 European Community (EC), 258 European Council, 262 European firms, managers of, 495

European Free Trade Association (EFTA), 256, 260, 280

European Monetary System (EMS), 313

European Parliament, 257, 260, 262

European Stability Initiative, 105 European Stability

Mechanism, 268 European treasury, 266 European Union (EU), 6

aircraft dominance, 179–180 bureaucracy, 264 CPSC, 128 economic sanctions, 61 free trade deal with, 159 and Group of Twenty, 11 hormone-treated beef, 24 implementation of, 255 labor forces, 5 markets, 476 name change, 264 pharmaceutical industry, 187 political structure of, 260–263 population, 79 proposed free trade deal, 160 regional economic agreements

with, 398 shadow economy, 64 subsidies, 198 on Turkey, 105, 121

European Union (EU) euro, 312 Euros, 265

survival of, 266 Excel Communications, 387 Excessive growth, 296 Exchange rate flexibility, 294 Exchange rate forecasting,

300–302 approaches to forecasting, 301 efficient market school, 300 inefficient market school, 301

Exchange rate functions, 323 Exchange rate parity, 322 Exchange rate regimes in practice

currency boards, 325–326 pegged exchange rate,

324–325 Exchange rates, 284, 298, 429. see

also floating exchange rates adjustable, 265 described, 296 dollars and, 269 dollars-euro, 269 euro lock, 265 fixed, 62 fundamental determinants

of, 301 locked in, 265 macroeconomic policy, 266 political structure, 260–263 real/dollars, 285–286 regional economic agreements

with, 266 speculation, 290–294 volatile changes, 287 volatility, 30, 168, 287, 333

Exchange rates movement, 30, 286, 291, 293–296, 298–301, 304–305, 323, 331, 333, 425

Exchange-control regulation, 242 Exclusive distribution

channel, 459 Execution, 136 Expansion strategy, 229 Expatriate, compensation

packages, 504 Expatriate community, 499 Expatriate failure, 494, 498 Expatriate failure rates, 494–496 Expatriate managers, 137–138,

375, 489, 494–497 Expatriate pay, 503–505 Expatriate resources, 504 Expatriates

attrition rate of, 500 high-cost, 504 reintegrating, 500 well-adjusted, 497

Experience curve, 350, 380, 505 Experience curve pricing, 469 Experience efforts

economies of scale, 350–351 learning efforts, 350 strategic significance, 351

Export and import financing, 410 bills of lading, 408 drafts, 407 letter of credit, 407 trust, 405–407 typical transactions, 408–409

Export assistance, 410 Export Legal Assistance Network

(ELAN), 402 Export management companies

(EMC), 401–402 Export markets, 15 Export opportunities, 401 Export performance improving

export management companies, 402–404

export strategy, 404–405 information sources, 401–402 international comparison, 401

Export principles, 404–405 Export subsides, 207 Export tariffs, 198 Exporters, 400, 408 Export-Import Bank (Ex-Im

Bank), 410 Exporting, 229, 378–379 Exporting, importing and

countertrade, 396, 400 countertrade, 410–413 export and import financing,

405–409 export assistance, 410 export performance improving,

401–405 export strategy at 3M, 404 exporting with little

government help, 403 introduction, 398 MD International, 415–416

opening case: growing through exports, 397–398

promise and pitfall of exporting, 398–401

Export-led economic growth, 239 Export-led recovery, 323 Export-oriented industries, 163 Exposure positions, 305 Exprit de corps, 501 External stakeholders, 147 Externalities, 233, 424, 430 Externally freely convertible

currency, 302 Exxon, 20, 131

F Facebook, 5, 68, 73, 86, 96,

457, 460 Facilitation payments, 136 Factor costs, 421, 425, 429 Factor endowments, 162, 174,

181, 183–184, 186, 349 Factors of production, 7, 185 Failure rate of product

development, 477 Fair market value, 201 Family issues, 496 Farm Bill 2008, 195 Farmers, 248 Fast food industry, 482 FCX Systems, 241, 400 FDI (foreign direct investment).

see foreign direct investment; foreign direct investment (FDI)

Federal Reserve, 83, 155, 266, 295–297, 308, 325

Federal Shariat Court, 48 Federal structure, 257 Federal Trade Commission, 200 Femininity, versus masculinity,

112–113, 121 Fiat, 135 “Fidelista,” 82 Financial account, 189, 191 Financial account balance, 191 Financial crisis, 268 Financial devices, 404–405 Financial incentives, 503 Financial institutions, 264 Financial returns, short-term, 182 Financial services, 264 Findus, 456 Finished goods, 437 Finland, 151, 197, 243, 256, 260,

266, 412, 431 Firm strategy, structure, and

rivalry, 181 First movers, 178 First-mover advantages, 81, 84–85,

162, 179–180, 183–185, 207, 218, 374, 376–377, 476

First-mover disadvantages, 374 Fiscal stimulus, 330 Fisher effect, 298 Fixed costs, 178, 426

528 Subject Index

Fixed exchange rate case, 323 Fixed exchange rate system

collapse, 317–318 Fixed exchange rates, 312, 316,

322, 324 Fixed versus floating exchange

rates fixed exchange rate case,

323–325 floating exchange rates case,

322–323 successful system, 324

Flat-panels, 9 Flexible machine cells, 428 Flexible manufacturing system, 427 Flexible sourcing, 305 Floating exchange rate regime,

326, 430 Floating exchange rates,

312–313, 323 Floating exchange rates case

crisis recovery, 322–323 monetary policy autonomy, 322 trade balance adjustments, 322

Floating exchange regime, 318–322

Floating rates, versus fixed exchange rates, 324

Floating system, 318 Flow of FDI, 224 Fluor Corp., 172 Fokker, 180 Folkways, 93 Forbe’s list, 93 Ford Motor Company, 5, 7, 13,

20, 110, 117, 343, 347, 354, 357, 365, 367–368, 387, 428, 462, 505–506

Foreign, markets, 13 Foreign Corrupt Practices Act

(FCAP), 50–51, 134–135, 141 Foreign Credit Insurance

Association (FCIA), 410 Foreign debt crisis, 326 Foreign direct investment (FDI)

apparent costs of, 241 benefits and costs of, 237–242 by Cemex, 229 China FDI, 227 economic theory of, 381 in Egypt, 86 employment effects of, 243 encouraging outward, 242 examples, 233 focus on managerial

implications: FDI and government policy, 244–246

foreign direct investment in world economy, 224–226

foreign retailers in India, 248–249

and government policy, 244–246

government policy, 246 government policy instruments

and, 242–243

and growth promotion, 237 inflows of, 224 international institutions and

liberalization of, 245 and international trade, 258 international trade theory

and, 74 introduction, 224 liberalization of, 244 versus licensing, 244 management focus, 229 in Myanmar, 62 in Nigeria, 223–224 occurrence of, 11 pattern of, 228 and petroleum refining

industries, 379–380 political ideology and, 234–237 regulations prohibiting, 425 resource-transfer effects of, 243 restricting outward, 242–243 role of, 13 in telecommunications, 79 theory of, 228–232, 244–246

Foreign direct investment (FDI), in world economy

acquisition versus greenfield, 228

direction of, 225–226 form of, 228 source of, 226, 228

Foreign direct investment theory benefits and costs of FDI,

237–242 decision reasons, 228–231 eclectic paradigm, 232–233 management focus of DP world

and the US, 236 patterns of FDI, 232 summary, 247

Foreign enterprises, 249 Foreign exchange centers, 305 Foreign exchange market,

285–308, 316 currency convertibility,

302–303 economic exposure, 304 economic exposure reduction,

304–305 economic theories of exchange

rate determination, 292–300

Embraer and Brazilian real, 285–286

exchange rate forecasting, 300–302

focus on managerial implications, 303–305

foreign exchange rate risk, 303 introduction, 286–287 Japanese yen movement, 308 nature of, 291–292 other steps for managing,

304–305 quantitative easing, inflation

and U.S. dollar, 297 transaction exposure, 303

translation and transaction exposure reduction, 304

translation exposure, 303–304 Volkswagen hedging

strategy, 291 summary, 306–307

Foreign exchange market, functions of

currency conversion, 286–289 insurance against foreign

exchange risk, 289–291 Foreign exchange risk, 286,

290, 398 Foreign firms, 228

jurisdiction of, 134 Foreign license, 231 Foreign managers, 238 Foreign market entrances

basic entry decisions, 373–377 entry model selection, 385–386 entry modes, 377–380 greenfield ventures vs.

acquisitions, 387–392 introduction, 372–373 JCB in India, 392–393 Jollibee phenomenon, 378 market entry at Starbucks,

371–372 Tesco’s international growth

strategy, 375 summary, 390–391

Foreign Monetary System, 319 Foreign multinational enterprise

(MNE), 235, 238, 240 Foreign multinationals, 377 Foreign nationals, 130 Foreign ownership, 243 Foreign production activities, 421 Formal education, 111 Formula Capital, 318 Fortune 500, 498 48 Hours program, 130 Forward contracts, 291 Forward exchange, 290 Forward exchange market, 331 Forward exchange rates, 290, 300 The Founding of a Republic

(movie), 109 Four Seasons, 341, 382 Four Seasons Starwood, 341 Foxcong, 131 France

3M Company, 404 absolute advantage through

wine, 164 Airbus, 332 Airbus consortium, 207 Apple rental stores, 460 black economy, 64 Carrefour, 361, 375 Clear Vision, 349 Croque McDo, 453 cultural differences, 357 currency conversion, 287 European Coal and Steel

Community, 260 European Parliament, 262

FDI encouragement, 243 FDI impacts, 238 FDI source country, 226 FDI stock, 17 financial crisis, 268 freeist rating, 77 gold standard, 314 government planning, 46 Group of 5, 320 Group of 20, 11 host government demands, 356 Hume on French economy,

163–164 industrialization history, 15–17 inward investment, 225 on inward investment

limitation, 16 Ipsos, 472 Law and Kelloggs, 465 location advantage

example, 184 location economies, 348 Maastricht Treaty, 265 McDonald’s, 503 McDonald’s foreign

franchise, 352 McDonald’s restaurant

protests, 23 new product starts in, 175 single market, 264 social democracy, 41 strategic behaviors, 232 trade unions, 506 tradition habits, 456–457 traditional auto design, 355 United Colors of Benetton, 461 Universal Declaration of

Human Rights (UDHR), 141

Franchising, 231, 377, 382–383 Franchising contract, 246 Free countries, 72 Free market economics, 225 Free market system, 71 Free trade, 26–27, 160–161, 167,

170, 172–173, 196, 209, 216 Free trade agreements, 208, 275 Free trade areas, 256, 258, 278 Free trade deal, with European

Union (EU), 159 Free trade, revised case, 207–208 Freedom, impediments to, 66–67 Freedom House, 38, 42, 57,

72–73, 77, 87 Freedom in the World (Freedom

House), 52 Freedoms, 144 Freely convertible currency, 302 Freeport McMoRan, 241 Freer trade, 254 Friendliest country ranking, 495 Friendships, 400, 497. see also

relationships Fuji, 468 Fuji Photo Film Co., 365, 380,

382–384 Fujifilm, 468

Subject Index 529

Fuji-Xerox, 176, 362–363, 380, 382–384, 394

Fundamental analysis, 301 Fundamental determinants, of

exchange rates, 301 Fundamental disequilibrium, 316 Fundamental integration, 477 Fundamental rights, 148 Fundamentalists, 103

G Gaijin (Westerner), 116 Galápagos Declaration, 273 The Gap, 117 GATT. see General Agreement on

Tariffs and Trade (GATT) GDP per capita, 61 GE moves manufacturing from

China to U.S., 432 Genentech, 204 General Administration of Quality

Supervision, 128 General Agreement on Tariffs and

Trade (GATT), 9–11, 28, 53, 197, 206, 209–211, 213–215, 218, 254, 259, 398, 469

General Electric, 223, 302, 432, 490

General Motors, 13, 20, 46, 81, 110, 115, 130–131, 354–355, 368, 383, 411, 453, 505

Geocentric approach, 490, 504 Geocentric staffing policy,

492, 502 GeoSpring water heater, 432 German Bundesbank, 266 Germany, 5, 7, 15, 29, 32

and 3M, 404 chemical industries, 180 civil system, 47 class conflict, 92 cultural differences, 357 cultural tendency, 118 culture, 93 Daimler, 135 Daimler-Benz, 331 DaimlerChrysler, 388 distribution channels, 459–460 economic freedom, 69 economics of, 265 EU forerunner, 226 euro zone, 268–269, 287, 291 expatriates, 495 export share, 16 fascist regimes, 44 foreign direct investment (FDI)

from, 17, 225 GDP growth, 90 global product non-technical

standards differences, 457 gold standard, 314–315 government subsidy, 207 Group of Five, 320 high tariff duties, 361 hyperinflation, 315 IDA loans, 317

on inflation, 266 information gathering

process, 401 and Intel, 261–262 and Kellogg, 465 new products, 175 political parties, 41, 44 price discrimination, 467 productivity, 180 Protestantism, 102 railcars, 356–357 Siemans penalty, 134 small firms from, 20 strategic trade party, 207 versus Switzerland, 181 trading nature, 205

Gestures, 111 Ghana, 55, 57–58, 120, 162,

164–168 Gift-giving, 136 Global (grocery chain), 375 Global 100 Index, 152 Global advertising, 464

dealing with country differences, 465

standard advertising against, 465

standard advertising for, 465 Global brands, 453 Global compensation practices, by

McDonalds, 503 Global customers, 487 Global distribution center, 436 Global economy, changing

demographics, 15–21 Global economy of 21st

century, 22 Global enterprise, 488 Global exchange rate,

volatility, 331 Global expansion, 378 Global expansion, profitability

and profit growth experience efforts, 350–351 leveraging subsidiary skills, 352 location economies, 348–350 market expansion, leveraging

products and competencies, 347–348

profitability and profit growth summary, 352

Global financial contagion, 22 Global financial crisis (2008-

2009), 211, 285, 311, 319, 330, 416

Global GDP, 13 Global human resource

management compensation, 502–505 international labor relations,

505–507 introduction, 488–489 managing expatriates at Royal

Dutch Shell, 496 MMC China, 508–509 performance appraisal, 501–502 staffing policy, 490–494

strategic role of human resources at IBM, 487

strategic role of international HRM, 489–490

training and management development, 498–500

summary, 507–508 Global institutions emergence,

9–11 Global inventory

management, 437 Global learning, 430 Global market, 7, 178 Global marketing and research

and development, 449–484 closing case: Domino’s Pizza

worldwide, 482–483 communication strategy,

461–465 configuring the marketing mix,

469–471 distribution strategy, 457–460 global branding of Avengers

and Iron Man, 449–450 globalization and brands,

452–453 international communication

barriers, 461–462, 464–465

international market research, 472–475

introduction, 450–452 Levi Strauss goes local, 470 market segmentation, 453–454 pricing strategy, 466–469 product attributes, 455–457 product development, 475–479 summary, 480–481

Global marketplace management, 29–30

Global media, 455 Global mindset, 497–498 Global oil prices, 321 Global oligopoly, 232 Global positioning systems

(GPS), 229 Global product divisions, 487 Global production and supply

chain management global supply chain

coordination, 441 global supply chain functions,

436–439 global supply management,

439–443 H&M (retail-clothing giant),

443–444 information technology role,

440–441 interorganizational

relationships, 441–443 introduction, 419–421 just-in-time role, 440 make-or-buy decisions,

433–436 Philips in China, 425 production factors, 428–431

strategy production and supply chain management, 421–424

where to produce, 424–432 summary, 443–444

Global production system, 384 Global purchasing, 438 Global standardization

strategy, 357 Global supply chain

coordination, 441 management, 439–443 management choice, 421

Global supply chain functions global logistics, 436–437 global purchasing, 438–439

Global terrorism, 75 Global tragedy of the

commons, 133 Global warming, 134 Global web, 349 Globalization, 451, 453, 487

of Boeing production, 3–6 country focus on India, 17 definition of, 6–9 drivers of, 11–15 global economy of 21st

century, 22 global institutions emergence,

9–11 global marketplace

management, 29–30 globalization debate, 22–29 Hisense, 21 management focus, 9, 24 of markets, 6–8, 10, 12–15, 29,

31, 452, 457, 475 of production, 7–8, 14 and risk, 22 technological role of change,

13–15 summary, 31

Globalization and brands, 452–453 Globalization debate

antiglobalization protests, 22–29

globalization, jobs, and income, 23–26

globalization, labor policies, and the environment, 26–27

national sovereignty, 27–28 world’s poor, 28–29

Globalization of markets, 6–7 Globalization of production, 7 GNI per capita, 63–64, 66–67 Gold standard

mechanics of, 313–314 period between World Wars,

314–315 strength of, 314

Goods, 189 Google, 68, 116, 233, 363, 460, 464 Government, 181 Government bonds, 267 Government debt, 267 Government interventions, 180,

202–207

530 Subject Index

Government investment politics, 185

Government planning, 46 Government policy, 183, 246 Government policy and

international trade, 215, 219–220

introduction, 196–197 economic arguments for

government intervention, 205–207

free trade, revised case, 207–208 government intervention,

202–207 management focus, 202 managerial implications,

216–217 opening case, 195–196 policy implications, 217 political arguments for

government intervention, 203–205

trade barriers, policy issues, and firm strategy, 216–217

trade on hormone-treated beef, 204

trade policy instruments, 197–202

world trading system development, 208–211

summary, 218 Government policy instruments

and FDI home-country policies,

242–243 host-country policies, 244–245 international institutions and

liberalization of FDI, 245 Government standards, 457 Government subsides, 196 Governments, undemocratic, 70 Grease payments, 52, 134 Great Britain. see also United

Kingdom Airbus Industry support, 207 British aircraft, 180–181 Cemex and RMC, 229 class consciousness, 100 class divisions, 92 class mobility, 100 common law, 47 counterpurchase example, 412 cross-border trade, 361 cultural differences, 456–457 currency conversion, 287 deficit finance method, 326 distribution channels, 459 DVD technology, 459 Euro currency, 265 European Free Trade

Association (EFTA), 256 European Union, 260 European Union Central Bank

issue, 259 foreign exchange, 288 free trade, 209 gold standard, 314

Group Five, 320 individualism and power

distance, 113 inward investment, 225 management process and

culture, 112 money supply, 316 national sovereignty, 266 new product demand, 175–176 privatization, 46, 77 social democracy, 41 standardization and advertising

example, 465 state monopoly, 68 trade liberalization, 209 world output share, 16

Great Depression, 195, 209 Greece, 64, 102, 111, 260, 263,

266–269, 282, 323, 326, 330, 412

Green revolution, 171 Greenfield investments, 224, 240 Greenfield ventures, 239, 390

or acquisitions, 390 pros and cons of, 389–390

Greenfield ventures vs. acquisitions, 389

acquisition pros and cons, 387–389

greenfield venture or acquisition, 390

pros and cons of greenfield ventures, 389–390

Greenpeace, 127–128 Gross domestic product

(GDP), 476 China, 90 Germany growth, 90 global, 13 growth of, 65, 90 per capita, 5, 61 United States, 215 world, 15

Gross national income (GNI), 63 Gross national income (GNI) per

capita, 51 Gross national product (GNP) per

person, 71 Group, as social organization, 97 Group affiliation, and loyalty, 119 Group identification, 97 Group of Five, 319–322 Group of Twenty (G20), 11 Groups, 95 Guanxi, 108–109, 227, 362 Guanxiwang (relationship

network), 108–109 Guatemala, 274 G.W. Barth, 20

H Haiti, property rights obstacles, 69 Hamilton, Andrew, 205 Harmonized Commodity

Description and Coding System (HS Codes), 451

Harvard Business Review, 452 Harwood Industries, 24 HBO, 15 Heavy metals, 127–128 Heckscher-Ohlin theory, 161–162,

174–175, 180–181, 183, 185–186, 196

Hedging, 289, 305 Hennes & Mauritz (H&M),

445–446 Heritage Foundation, 76–77 Hewlett-Packard (HP), 139, 233,

262, 389, 479, 497 Hidden costs of foreign locators,

431–432 High value-to-weight ratio, 430 Highly indebted poorer countries

(HIPCs), 29 High-value-added

manufacturing, 331 Hinduism

ascetic principles of, 120 economic implications of,

106–107 Hindus, 106–107 Hindustan Lever Ltd., 240, 463 Hisense Co. Ltd., 19, 21 Hitachi, 116, 360 HIV virus, 143 Hoffman-LaRoche, 469 Home, markets, 15 Home delivery, 482 Home demand, 182 Home-country benefits, 241 Home-country consumers, 242 Home-country costs, 241 Home-country employment, 241 Home-country manages, 501 Home-country marketing, 491 Home-country nationals, 498 Home-country policies, 242–243 Home-market protection, 207 Homeplus, 375 Homogenization, 453 Honda, 232, 235, 357, 461 Honduras, 23, 274 Honesty, 108 Hong Kong, 18–19, 69, 76–77,

219, 226–227, 234, 293, 325, 348–349, 375, 382, 457, 466

Hong Kong currency board, 325 Hormone-treated beef, 204 Host country, 243 Host-country

conditions of, 492 managers, 492

Host-country benefits balance of payments effects,

238–239 effect of competition and

economic growth, 239 employment benefits, 237–238 resource-transfer benefits,

237–238 Host-county costs

adverse effects on balance of payments, 240

adverse effects on competition, 239–240

national sovereignty and autonomy, 240

Host-country nationals, opportunities for, 491

Host-country policies encouraging inward FDI, 244 restricting inward FDI,

244–245 Household registration, 100 Housing bubble, 83 HSBC, 105 HSBC Expat Explorer Survey, 495 Hubris hypothesis, 388 Human capital, deployment

of, 487 Human Development Index

(HDI), 51, 70 Human resource management

(HRM), 488, 505 Human resource needs, 490 Human rights, 205, 269–270 Human suffering, 169 Hungary, 21, 40, 375, 404,

412–413, 509 Huntington thesis, 75 Hutchison Whampoa, 19 Hutus, 94 Hyderabad, India, 431–432 Hymall, 375 Hyperinflation, 295, 315 Hyundai, 201–202

I IBM, 8, 17, 24, 62, 83, 112,

114–116, 131, 184, 235, 349, 364, 367, 403, 425, 477, 487–489

Iceland, 161, 311 IKEA, 337–338 Illegal drug trade, 75 Illiteracy, 462 IMF policy prescriptions

inappropriate policies, 329 lack of accountability, 330 moral hazard issue, 329 observations, 330

Immigration laws, 493 Immigration regulations, 496 Impediments, 8 Import agents, and retailers, 460 Import licenses, 211 Import quotas, 195, 199

on VERs, 200 Import substitution policy, in

China, 164 Import tariffs, 78, 197, 224,

227, 230 Imports, voluntary

restrictions, 184 Incentive package, 243 Incentives, 345 Income per capita, 28 Income receipts and

payments, 189

Subject Index 531

Income tax rate, 78 Independent performance, 96 India

accountants, 6 ad growth, 460 antidumping charges, 212 Asian expatriates, 122 Buddhism, 107 caste system, 98–99, 107 channel length, 458 Citigroup in, 360 consumption rate, 64 corruption, 50 countertrade, 413 country factors, 424 cultural convergence, 117 cultural groups, 94 cultural toughness, 497 customer care service, 421 customer service, 14 customization product, 466 decision makers, 139 democracy government

stability, 70 developing market, 367 distribution channels,

458, 462 Domino’s Pizza, 482–483 economic growth, 236 economic transformation, 78 economy size, 65–67 emerging economies, 16 entrepreneurial activity, 120 FDI, 18 FDI by Cemex, 229 FDI liberalization, 244 Foreign Corrupt Practices

Act, 52 foreign retailers in, 248–249 freest economy ranking, 77 GNI per capita, 63 government planning, 46 growth rates, 81 Hewlett-Packard (HP), 479 hidden costs, 431 Hinduism, 106–107 Hofstede’s analysis, 114 income levels, 25 intellectual property rights, 83 IT jobs, 172 JCB in, 392–393 jobs transformed to, 172 joint foreign investor law, 83 labor force, 5 labor pool, 23 language, 110 Levi Strauss, 470 living standards, 80 market entry risk, 377 market size, 81, 373 McDonald’s, 92 media business ownership, 243 Microsoft, 431, 493 Microsoft turnover rate, 432 mixed economies, 46 monopolistism, 240 MTV Networks, 355

oil demand, 321 outsource information IT

jobs, 112 outsourced call centers, 25 outsourcing for, 8 and Pakistan, 234 performance evaluations, 501 pharmaceutical industry,

187–188 political ideology, 234, 236 population dispersal, 463–464 price elasticity, 467 property rights, 81 rare earth metals, 220 religions, 101 retail concentration, 458 social democracy, 41 social stratification, 95 software sector, 16–17 sugar producing, 195 tariff rates, 215 telephone-based customer

service, 353 Walmart, 52

Indian education system, 112 Indian employees, 431–432 Indian software sector, 17 Indicators of changing political

economy, 79–80 Indigenous firms, 229 Individualism, 41–42, 96, 114

versus collectivism, 112 Individuals and groups

groups, 97 individuals, 95–98

Indonesia, 10, 16, 44, 49–51, 71, 74, 229, 241, 300, 319, 326, 329, 373, 378, 459–460, 491

Industrial, disruption, 119 Industrial disputes, 100 Industrial goods, 7 Inefficient market, 301 Inefficient market school, 301 Inelastic, 467 Inertia, 492 Infant industry argument,

205, 213 Inflation, 86, 227, 266, 294,

311, 329 Inflation rates, 285 Inform, 437 Informal economy, 223 Information, and communication

technologies, 73 Information technology (IT)

sector, 98, 439 Information technology role,

440–441 Infosys Technologies Ltd., 17, 98,

172, 425 Infrastructure

education in, 185 lack of, 82 problems, 224

ING Group, 376, 384 Initial losses, 205 Innovation, 68, 97

Innovation and entrepreneurship economic progress and

democracy, 70–71 engines of growth, 68 geography, education and

economic development, 71 market economy, 68–69 political systems, 69–70 property rights, 68–69

Inocal, 132 in Myanmar, 133

Inpatriates, 494 Insourced jobs, 433 Institute for International

Development (Harvard), 71 Insurance against foreign

exchange risk currency swaps, 290–291 forward exchange rates,

289–290 spot exchange rates, 289

Integration, backward and vertically, 82

Integration efforts, 389 Intel, 203, 262 Intellectual property, 52 Intellectual property laws, 53, 204 Intellectual property rights, 83,

187, 275 Intelligence-gathering unit, 431 Interest, 104 Interest rate differential, 308 Interest rates, 83, 266 Intermarket segment, 454 Internal barriers, 263 Internal purchasing, versus

external purchasing, 438 Internal stakeholders, 147 Internalization theory, 230, 232 International, markets, 7 International Bank for

Reconstruction and Development (IBRD), 315–316. see also World Bank

International businesses, 490 ethics, 144 management, 29 transactions, 135, 303

International communication barriers

cultural barriers, 461 global advertising, 464–465 noise levels, 462 source and country of origin

effects, 461–462 International Court of

Arbitration, 49 International court of justice, 10 International distribution, 400 International Fisher effect,

298–299 International institutions and

liberalization of FDI, 245 International Labor Organization

(ILO), 506 International labor

organizations, 505

International labor relations approaches to organized labor,

506–507 organized labor concerns, 505 organized labor strategy,

505–506 International market research,

452, 472–475 International marketing, 475 International Monetary Fund

(IMF), 9–10, 213, 268, 311–313, 315

activities of, 326 adjustable parities, 316 Articles of Agreement, 318 lending facilities, 316 loan packages, 328 Malawi, 334–335 Mexican crisis (1995), 327 need for, 328 policies, 330–331

International monetary system Bretton Woods system,

315–317 crisis management by, 326–330 currency management, business

strategy, and government relations, 330–332

exchange rate regimes in practice, 324–326

fixed exchange rate system collapse, 317–318

fixed versus floating exchange rates, 322–325

floating exchange regime, 318–322

gold standard, 313–315 Iceland’s recovery and,

311–314 introduction, 312–313 managerial implications,

330–332 policy prescriptions, 329–330 U.S. Dollar, oil process and

recycling petrodollars, 321 International Orientation

Resources, 495, 498 International pricing

strategy, 466 International regulations, on

multinationals, 505 International sales, 399 International strategy, 360, 493 International trade, 11

and foreign direct investment (FDI), 258

pattern of, 176 political realities to, 196

International Trade Administration, 6, 401

International trade and balance of payments, balance-of- payments accounts, 191–192

International Trade Commission (ITC), 201, 215

International trade secretariats (ITSs), 505

532 Subject Index

International trade theory. see also GATT

about, 159–160 absolute advantage, 163–166 closing case, 187–188 comparative advantage,

166–174 country focus China neo-

mercantilism question, 164–166

country focus moving U.S. white collar jobs offshore, 172

focus on managerial implications, 183–185

Heckscher-Ohin Theory, 174–175

Leontief paradox, 174–175 location, first-mover advantage,

and government theory, 183–185

mercantilism, 163 national competitive advantage,

180–183 new trade theory, 176–180 offshore production, 241 opening case world’s largest

trading zone, 159–160 Porter’s Diamond, 180–185 product-life-cycle theory,

175–176 trade theory, 160–163 summary, 185–186

International trade transactions, 401

Internet, 8, 73, 464 Interorganizational relationships,

439, 441–443 Inventory, lack of, 427 Inventory reduction, 441 Investment, education in, 185 Investment flows, 275 Investment levels, 224 Investor management, 432 Investor psychology, 298–299 Invisible hand, 160 Inward foreign direct

investment, 24 Inward insurance, 225 Inward investment, 16 Inward migration, 172 Ipek, 105 IPEN, 127 IPods, 117 Ipos, 472 Iran, 21, 44, 48, 77, 82, 104–105,

122, 205, 234, 243 Iraq, 28, 205, 456, 470 Ireland, 75, 77, 209, 260, 267–269,

323, 326, 330, 375, 495 Ireland crisis (2010), 326 IRM, role of, 489 Iron Man (franchise), 450 Iron Man movies series, 449–450 Islam, 103–106

economic implications of, 104–106

fundamentalism, 103–104 Islamic fundamentalism,

103–104 principles of, 103 resurgence of, 74

Islamic banking methods, 47–48 Islamic banks, 105 Islamic Calvinism, 105 Islamic countries, 104, 456, 470 Islamic ethics, 100 Islamic fundamentalism, 74 Islamic law, 48, 104 Islamic revolution (Iran), 82 Islamists, cultures in, 94 ISO 9000, 424 iTunes, 420

J J. D. Power and Associates, 427,

447, 472 Jamaica Agreement, 318 Jamco, 3 Japan

agricultural tariffs, 213 Airbus, 3 antidumping policies, 212 APEC, 277 Apple, 460 Apple iPhones, 32 auto parts, 5 automakers, 380 automobile industry, 13, 17, 216 automobile plants in U.S., 505 automobile reliance, 470 balance of payments

accounts, 241 Bank of Japan, 308 Boeing parts, 8 bound tariff rates, 214 Buddhism, 107 carry trade, 308 channel exclusivity, 460 channel length, 459, 462 versus China, 212 Chinese economy versus, 65, 89 chips, 5 civil law system, 47 Clear Vision, 349 Coca-Cola, 456 comparative advantage, 162 competition versus

alliances, 179 competitive advantage,

109–119, 179 corruption, 134 countertrade, 413 cross-functional

integration, 478 cultural change, 116 cultural factors, 91 cultural pride, 475 culture, 113, 138 currencies, 312 currency, 287 current account, 241 current account deficit, 239

domestic market, 7 Domino’s Pizza, 482–483 Earth Summit, 27 economic success, 209 economy recession, 9 education, 111 engineers per capita, 182 ethnocentrism, 118 expatriate Japanese

managers, 491 FDI, 225–226, 230, 235–236 FDI stock, 17 folkways, 93–94 forward exchange rates, 289 freest economy ranking, 77 Fuji-Xerox, 176, 365 GATT impact, 209 global market loss, 21 global products, 31 GNI per capita, 63 gold standard, 314 group affiliation, 119 group identification, 97 Group of Five, 320 Heckscher-Ohlin theory, 175 hormone-treated beef, 204–205 HP subsidiary, 479 import tariffs, 197 informal barriers, 242 Internal Development

Association (IDA), 314 inward FDI, 242 Jamco, 3 Japan yen, 308 just-in-time inventory, 440 Kawasaki, 3 Kobe research center, 479 Kodak, 468 Komatsu, 360 labor relationships, 506 Levi Strauss, 470 licensing example, 380 local content, 240 local responsiveness, 357 location economics, 348–349 long-term orientation level, 113 manufacturing relationships, 459 marketing practices, 355 markets, 210 Matsushita, 468 Mitsubishi Heavy Industries,

3–4 moral hazard issue, 329 new products, 176 petrodollars, 321 pharmaceutical industry, 187 Plaza Accord, 320 population density, 457 Porter on, 111 pragmatic nationalism, 235–236 Procter & Gamble (P&G), 459 productive capacity

expansion, 331 resources, 182 SC Johnson, 456 share of labor levels, 25 Shintoism, 101

social status, 97 Stanley Black & Decker, 305 Starbucks of Japan, 371–372 stock option plan, 371–372 strategic alliances, 363 strategic trade policy, 207 subsides, 198 Suntory, 464 tariff rates, 213–214 telecommunications, 211 Texas Instruments (TI), 383–384 total quality management

(TQM), 423 Toyota, 437 Toys “R” Us, 242 trade barriers, 201, 210 trading nation, 401 TV technology, 381 versus U.S. behavior

conflict, 492 versus U.S. dollar, 319 VERs, 200, 210 Vodaphone, 358 wealth gap, 476 Western expatriate women, 494 world output share, 15–16 yakuza (Japanese mafia), 49 yen impact, 425 Yundong (Cloud Action/

Toyota), 453 “Japan bashing,” 461 Japanese mafia, 49 Japanese Overseas Enterprise

Association, 491 Japanese yen, 288–289, 312

appreciation, 425 exchange rate example, 292 versus U.S. dollar, 308

JCB, 392–393 Jiangsu Five Star Appliance, 90 Job losses, 213, 255, 259, 272. see

also North American Free Trade Agreement (NAFTA)

Job rotation, 506 Job transfers, 498 Joint decision making, 441 Joint venture partnership, 373 Joint ventures, 392

advantages, 383 disadvantages, 383–384 establishment, 377 Japanese figures and

MNES, 243 Lubricating Systems, Inc. and

German company, 362 risks, 383 Walmart and Bharti, 249 Warner Brthers and Chinese

partners, 362 Joint-venture partners, 227 Jollibee Foods Corporation,

377–378 JP Morgan, 360 J-Phone, 358 Judaism, 102 Junk bonds, 83 Jurisdiction, of foreign firms, 134

Subject Index 533

Just distribution, 144 Justice, veil of, 144 Justice theories, 144–152 Just-in-time inventory (JIT),

439–440 Just-in-time role, 440

K Kantar Group, 472–473 Kantian ethics, 143 Kant’s ethical philosophy, 143 Karma, 106 Kawasaki, 3–4 Kayseri, Turkey, 104–105 Kellogg, 465 KFC, 375, 377, 383 Kimberly-Clark, 361, 468 Kmart, 375 Knickerbocker theory, 232, 246 Knowledge and awareness, 400 Knowledge-based jobs, 172 Kodak, 131, 468 Kokuyo, 460 Komatsu, 7, 360, 392 Koran, 48, 104 Korean won, 288, 292, 307, 323,

327, 329 KPMG, 387 Kurds, 269 Kuwait, 380, 494–495 Kwality, 240 Kyat (currency), 62

L Labor

as competitive advantage, 506 low-cost, 174 management of, 108 work packages, 506

Labor abuse, 131 Labor costs, 254, 271, 425, 506 Labor exploitation, 26 Labor laws, 488 Labor productivity, 162 Labor relations, 488 Labor-intensive goods, 169 Lafarge Group, 229 Lag strategy, 304 Laissez-faire approach, 160, 216 Land, appropriation of rural, 70 Landmark Systems of Virginia, 403 Language

and culture, 110 spoken language, 110–111 unspoken language, 111–112

Language differences, 110, 496 Language groups, 119 Language training, 498 Laos, 40, 43–44, 376–377 Last-mover advantages, 81 Latin America, 20–21, 31, 40, 43–

44, 70–71, 73–74, 76, 79–80, 93, 102, 111, 113, 225–226, 236, 273, 275–276, 281, 296, 356, 360, 387, 402, 415–416, 460. see also specific countries

Latvia, 135, 326, 330, 495–496 Law of one price, 293 Laws, and regulations, 82 Laxi, 20 Lead

in paint, 127–128 in plastic, 128–129 pollution, 129

Lead factory, 431 Lead strategy, 304 Leading exporter, 179 Lean production, 231, 427 Learning efforts, 350 Legal environments, 55 Legal risk, 83 Legal systems, 39–40, 62, 79

civil law, 47 common law, 47 different, 47–48 theocractic law, 48

Lenovo, 5, 262, 349, 427, 429, 499 Leontief paradox, 174–175 Letter of credit, 404–405, 407 Leverage points, 441 Leveraging subsidiary skills, 352 Levi Strauss, 116, 133, 452,

470, 481 Levitt, Theodore, 464 Lexus cars, 454 LG Semicon, 201–202 Liability insurance rates, 82 Libya, 135, 326, 330, 495–496 Licenses, 52 Licensing

advantages, 380 described, 229 disadvantages, 380–382 versus FDI, 230, 246 versus franchising, 246 global oligopolies, 245 and high-technology

industries, 244 limitations of, 230–231

Licensing agreement, 380 Licensing contract, 244, 377 Liechtenstein, 256 Life-cycle support, 441 Lifetime employment, 97 Limited government intervention,

162–163 Limited suppliers, 434 Lincoln Electric, 389–390 Literacy levels, 462–463 Living standards, 25, 173 Local agents, 379 Local content requirements,

200–201 Local history, 404–405 Local managers, 375 Local responsiveness, 424 Local sales forces, 461 Local setting, 465 Localization strategy, 359, 428 Location, first mover advantage,

and government theory about, 183 first-mover advantages, 184

government policy, 184–185 location, 184

Location economics, 380 Location economies, 348–350 Location externalities, 425 Location-specific advantages, 233 Lockheed, 134 Logistics, 422 Long-term interest rates, 265 Long-term versus short-term

orientation, 112–113 Lotus (grocery chain), 375 Louvre Accord, 319–322 Low wage rates, 425 Low-cost labor, 174 Low-technology industries, 246 Low-value-added

manufacturing, 331 Loyalty and commitment, 96 Lubricating Systems, Inc., 20 Luxembourg, 260

M Maastricht Treaty, 260, 265–266 Machine tool industry, 185 Machismo cultures, 114 Macroeconomic policy, 227 Mad cow disease, 204 Majority voting rules, 262 Make decision, 434 Make-or-buy decisions, 433–436 Makers, 408 Malawi, 334–335 Malaysia, 5, 15, 28, 48, 71, 103,

219, 226, 244, 277, 288, 300, 319, 325, 349, 372, 375, 404, 411, 467

Malaysian ringgit, 288 Malta, 260, 269 Managed-float system, 316,

322, 324 Management, and labor

classes, 100 Management development,

488, 498 Management focus, general, 9

antiglobalization in France, 24 cultural differences, 109 ethics, corporate responsibility,

and sustainability, 131, 135

exporting, importing and countertrade, 400

exporting with little government help, 403

global marketing and research and development, 463

global production and supply chain management, 432

globalization, 21 national differences, 52, 54

Management focus. specific on corporate responsibility at

Stora Enso, 151–152 of DP world and the US, 236 export strategy at 3M, 404

FCX systems, 400 FDI by Cemex, 229 GE moves manufacturing from

China to U.S., 432 Jollibee phenomenon, 378 Levi Strauss goes local, 470 managing expatriates at Royal

Dutch Shell, 496 Philips in China, 425 Procter and Gamble strategy

evolution, 361 protecting U.S.

Magnesium, 202 Tesco’s international growth

strategy, 375 Unical in Myanmar, 133 Unilever selling to India’s

poor, 463 Vodaphone in Japan, 358 Volkswagen hedging

strategy, 291 Managerial implications, 145–151

benefits, 80–81 costs, 81–82 economic exposure, 304 economic exposure reduction,

304–305 FDI and government

policy, 246 foreign exchange rate risk, 303 location, first-mover advantage,

and government theory, 183–185

other steps for managing, 304–305

overall attractiveness, 83–84 policy implications, 217 risks, 82–83 trade barriers, policy issues, and

firm strategy, 216–217 transaction exposure, 303 translation and transaction

exposure reduction, 304 translation exposure, 303–304

Managerial implications focus cultural change, 117–118 cultural differences, 118–120 currency management, business

strategy, and government relations, 330–333

currency trouble in Malawi, 334–335

ethical decisions internationally, 145–152

ethics, corporate responsibility, and sustainability, 145–151

foreign direct investment, 244–246

foreign exchange market, 303–305

general, 334–335 government policy and

international trade, 216–217

international monetary system, 330–332

534 Subject Index

international trade theory, 183–185

location, first mover advantage, and government theory, 183–185

national differences, 55 national differences in economic

development, 80–84 regional economic integration,

278–280 summary, 333

Managerial mobility, 96 Managers, expatriate versus

local, 375 Mandarin, 109 Manufacturer tariffs, 275 Marginal land, 170 Marginal resources, 170 Market economies, 68 Market economy, 45 Market entrance, choices, 372 Market entry at Starbucks, 371–372 Market imperfections, 230 Market maturation, 176 Market Potential Index

(MPI), 415 Market segmentation, 453–454 Market segments, 454 Market separation, 467 Market size, 373 Market-based economies, 75 Marketing, 231

channels, 450 mix, 452 and product development, 477

Market(s). see also national market(s)

deregulating, 6 developing, markets, 15 export, markets, 15 foreign, markets, 13 globalization of, 8, 10, 12–15,

29, 31, 452, 457, 475 markets, 6

home, markets, 15 implications for, 15 international, markets, 7 Vizio and flat-panel TVs, 6–7

Marlboro cigarettes, 464 “Marlboro man,” 465 Marlin Steel Wire Products,

399, 410 Marshall Plan, 316 Marvel Comics, 450 Marvel Studios, 450 Marxist theory, 234 Masculine value, 113 Masculinity, 139 Masculinity versus femininity,

112–113, 121 Mass advertising, 462 Mass customization, 427 Massachusetts General

Hospital, 172 Material costs, 439

Matrix of Peace (Peace Through Commerce), 74

Matsushita, 21, 119, 230–231, 381, 468, 491

Mazda, 365 McArabia, 453 McCann Erickson, 465 McDonald’s, 6–7, 15, 23–24, 83,

92, 117, 244, 246, 294, 298, 347, 352, 354, 357, 375, 377–378, 382–383, 386, 390, 452–453, 461, 470, 502–503

McDonnell Douglas, 411 McKinsey & Co., 90, 367, 387 MD International, 415–416 Means-tested subsidies, 311 Media availability, 464 Media Saturn Holdings, 262 Medical and pension benefits,

504–505 Mercantilism, 160, 162–163, 185 Mercantilism doctrine, 163 Mercantilism policy, 163 Mercer Management Consulting,

387, 502 Mercosur, 255, 257, 270,

273–274, 281 Mergers, 261 Mergers and acquisitions, 228 Mexican crisis (1995), 327 Mexican economy, and illegal

immigration, 272 Mexico. see also North American

Free Trade Agreement (NAFTA)

Cancún meeting, 215 Cemex and FDI, 229 commitments, 376 currency crisis, 334 currency crisis of 1995,

348–349 democracy, 73 economy growth, 21 emerging market, 11 exports to Brazil, 200 FDI receipt, 18 freest economy ranking, 77 globalization, 5 IMF loans, 10 labor costs, 235, 271 Latin American

economies, 416 lead pollution, 129 Lenovo, 356 Marlin Steel Wire

Products, 399 MMC China, 509 national governments, 30 political stability, 273 Spangler Candy Company, 195 Stanley Black & Decker, 305 tomato growers, 253 translation exposure

example, 303 TV assembly, 9 Walmart, 51–52, 459 world output share, 16

Mexico peso crisis, 327, 330 Mickey Mouse, 450 Micron Technology, 201 Microprocessors, 475 Microsoft, 7–8, 17, 25, 54, 68, 86,

93, 115, 169, 172, 177, 204, 298, 347, 354, 361, 363, 425, 429, 431–432, 467, 476–477, 493–494

Microsoft Office, 298 Middle East, 71, 74, 94, 103, 118,

122, 236, 321, 356, 378, 428, 456, 465, 497

Military dictatorship, 62, 132 Miniature earth project, 66–67 Minimum efficient scale,

426–427 Ministry of International Trade

and Industry (MITI), 401 Minnesota Mining and

Manufacturing Co. see 3M Company

Minolta, 460 Mitsubishi, 460 Mitsubishi Heavy Industries, 3–4,

180, 363, 383 Mitsubishi Motors, 492 Mitsui & Company, 413 Mittal Steel, 236 MMC China, 508–509 MMO Music Group, 399–400 Mobility

of class, 100 inward, 99

Modernization, 104 Monetary easing, 330 Monetary policy, 83, 259 Monetary policy autonomy, 321 Money supply, 314 Money supply and price

inflation, 294 Monki, 445 Monopolies, 41 Monopolists, 45 Monopoly practices, 469 Monsanto, 143, 477, 500 Moore’s Law, 13 Moral agent, 144 Moral compass, 137, 141,

143–144, 149 Moral courage, 149 Moral hazard, 329 Moral imagination, 148 Moral imperialism, 142 Moral intent, 148 Moral principles, 142, 148 Mores, 93–94, 404 Morsi government, 86 Mortgage interest, 311 Mortgage-backed securities/

debts, 83 Movie industry, 451 Mozambique, 40, 75 MRI scans, 8 MTV Networks, 5, 15, 74, 117,

343, 354–355, 452, 464 Mudarabah, 105

Multi-Fiber Agreement (MFA), 199

Multinational corporation, 452 Multinational enterprise,

changing nature mini-multinationals rise,

19–20 non-U.S. multinationals, 19 world order, 20

Multinational enterprise (MNE), 19, 234–235, 237, 243

Multinationals, 19 Multinationals enterprise, 224 Multiple culture nations, 114 Multiplier cultures, 110 Multipoint competition, 232 Multipoint pricing, 468 Murabaha, 105 Murababa contract, 106 Muslim Brotherhood, 86 Muslim nations, 269 Muslims, 103 Myanmar, 61–62, 70, 129,

132–133, 139, 265–267 Inocal in, 133

N Nabisco, 109 NAFTA. see North American

Free Trade Agreement (NAFTA)

Naive immoralist, 142 National competitive advantage,

180–185 demand conditions, 182 factor endowments, 181–182 firm strategy, structure, and

rivalry, 182–183 Porter’s theory evaluation, 183 related and supporting

industries, 182 National competitive advantage

theory, 186 National differences

civil law, 52 contract law differences,

48–52 corruption in Nigeria, 52 democracy and totalitarianism,

43–44 economic systems, 44–46 Ghana as African dynamo,

57–58 introduction, 39 legal systems, 47–48 managerial implications

focus, 55 in political, economic, and legal

systems, 37–50 political systems, 40–44 pseudo-democracies, 44 Putin’s Russia, 37–38 Starbucks trademark case in

China, 54 Venezuela under Chávez, 42 summary, 56

Managerial implications focus (continued )

Subject Index 535

National differences in economic development

about, 62–63 Amarta Sen on development,

66–67 benefits, 80–81 costs, 81–82 country focus, 70, 78 differences in economic

development, 63–65 focus on managerial

implications, 80–84 indicators of changing political

economy, 79–80 legal system, 79 miniature earth project, 66–67 nature of economic

transformation, 77 overall attractiveness, 83–84 political and economic reform

in Myanmar, 61–62 political economy and

economic progress, 68–79 privatization, 77–79 revolution in Egypt, 86 risks, 82–83 states in transition, 72–77 summary, 84–85

National economics, 4 National market(s), 6–7, 79, 178,

232, 239, 279, 282, 297, 352, 356, 359–361, 374, 379, 428, 454, 457, 468–470

National sovereignty, 266, 272 National sovereignty and

autonomy, 259 National unions, 505 National units, 487 Nationalization, 234 Native sales agents, 229 Natural resources, 61 Nature of economic

transformation, deregulation, 77

NatureSweet Ltd., 254 NEC, 262 Negative translation exposure, 304 Negotiations, face-to-face, 400 Neo-mercantilist policies,

163–164 Nepal, 107, 458 Nestlé, 428, 456 The Netherland(s), 10, 17, 41, 93,

201, 226, 260, 465, 472, 496, 508

New jobs, 238 New Line Cinema Marvel

Studio, 449 New products

initial demand for, 175 pre-launch of, 419

New trade theory, 219. see also economies of scale

comparative advantage, 181 described, 186 development of, 162 first-mover advantages, 179, 184

free trade, 205 free trade and, 169, 207 implications of, 179–180 increasing product variety and

reducing costs, 178–179 intervention, 205 luck, 180 pattern of trade, 179 Porter’s theory, 183 strategic trade policy, 206

New United Motor Manufacturing, Inc., 365

The New York Times, 52, 127, 140, 171, 190, 253

New Zealand, 57, 76, 204, 211, 219, 349, 372, 495, 508

NewPage Corporation, 151 New-product opportunities, 475 Nicaragua, 49, 274 Nielsen, 472 Nigeria, 28, 50–51, 57, 144,

223–224, 455 Nike, 130, 138, 147, 155, 453 Nintendo, 7, 476 Nippon Air, 134 Nirvana, 106 Nissan, 232, 235, 240, 382, 387,

506–507 Nissan Motor Co., 240, 505–506 Noble Eightfold Path, 105 Noblesse oblige, 149 Noise levels, 462 Nokia, 419, 421, 465 Nonconvertible currency, 302 Nonconvertiblity, 410 Non-dollar-denominated

assets, 321 Non-tariff barriers, 159–160, 259 Nonverbal cues, 111 Norms, 92–93, 139 North America, 13, 17, 19, 26, 66,

111, 128, 151, 155, 279, 281, 306, 337–339, 347, 349, 354–357, 359, 365, 369, 371–372, 411, 430, 456, 478, 481. see also Canada; Mexico; United States

North American Free Trade Agreement (NAFTA)

agreements, 270–271 arguments against, 26 arguments for, 160 case against, 271–272 case for, 271 contents, 271 dumping, 253 enlargement issue, 273 free trade area, 256, 270–272 impact of, 271 implementation of, 255 job losses, 272 opportunities through, 279 regional economic integration,

253–254 results, 271–273 trade barrier declines, 398

North Korea, 77

Northern Africa, 74, 428 NPD Green, 472

O Obama administration, 86,

198, 410 Occidental Petroleum, 412 Ocean freight, 14 OECD countries, 213 Offset, 412 Offshore factory, 430 Offshore production, 241 Offshoring, 171 Ogilvy and Mather Worldwide, 466 Oil, 259 Oil and gas fields, 21 Oil and gas sectors, 39, 61 Oil crisis (1971), 319 Oil crisis (1979), 319 Oil extraction industries, 223 Oil industry, 237, 257 Oil prices, 42 Oligopolistic industries, 232 Oligopoly, 232 Olivetti, 176 One 2 One, 387 Online advertising, 460 Online surveys, 474 Open economies, 173 Operations

organization, 345–346 primary activities, 342–343 support activities, 343–344

Opportunities, 279 Optimal currency area, 266 Oracle, 68, 86, 172, 233 Ordering, 446 Organization architecture, 345 Organization for Economic

Cooperation and Development (OECD), 25, 51, 213–214, 237, 506

Organization Resource Consulting, 503

Organization structure, 345 Organizational culture, 139, 231,

345, 389 Organizational factors, 138 Orthodox churches, 102 Others-orientation, 497 Outflows of FDI, 224 The Outpost (network), 496 Outpost factory, 431 Outsourcing, 4, 6, 8, 422 Outward foreign direct

investment (FDI), 226 Overall attractiveness, 83–84 Over-performers, with wrong

ethics, 147 Ownership proof, 69 Ownership restraints, 243 Oxford, 99

P P&G. see Proctor & Gamble (P&G) P&O, 236, 321

Pacific Ocean, 43 Packaging, 187, 297, 361,

436–437, 444, 466 Pakistan, 21, 48, 71, 104, 234 Panasonic, 13, 20, 491 Paperwork costs, 401 Par value, 315 Paraguay, 43, 255, 257, 274 “Pardo” (skin shades), 455 Parent-country nationals, 491 Paris Convention for the

Protection of Industrial Properties, 53

Partly free countries, 72 Partner (upstream) function, 443 Partners, 442 Patents, 52–53 Pattern of foreign direct

investment (FDI), 228, 232 Pay

country-specific, 502 expatriate, 503–505

PC manufacturers, 262 Pegged currency, 324 Pegged exchange rate,

312–313, 325 Pegged rate, 312 People, 345 PepsiCo, 7, 14, 452 Pepsi-Cola, 452 Per capital GDP, 5 Perceptual ability, 497 Performance appraisal

guidelines for performance appraisal, 502

performance appraisal problems, 501

Performance evaluations, 488 Permits, 52 Personal factors, 139 Personal relationships, 400 Peru, 43, 69, 211, 257, 273, 381 Petrodollars, 321 Petroleum refining industries, and

foreign direct investment (FDI), 379–380

Pfizer, 475 Pharmaceutical industry, 464, 469 Pharmaceuticals, 78 Pharmaceuticals prices, 187 Pharmaceuticals sectors, 187 Philadelphia Inquirer, 23 Philip Morris, 411, 413, 464 Philippines, 8, 44, 49, 73, 136, 172,

229, 276–277, 377–378 Philips, 13, 424–425, 476, 491 Pioneering costs, 374 Pizza, 482–483 Place, 452 Planned economy, 68 Plaza Accord, 320, 331 Poland, 40, 73, 85, 172, 261, 269,

355, 375, 412 Political, economic, and legal

systems, 37–50 Political and economic reform in

Myanmar, 61–62

536 Subject Index

Political arguments for government intervention

consumer protection, 204–205 foreign policy objectives, 205 human rights protection, 205 job and industry

protection, 203 national security, 203 retaliation, 203–204

Political casts, 421 Political economy, 39, 425, 429 Political economy and economic

progress, innovation and entrepreneurship, 68–71

Political environments, 55 Political freedom, 77 Political ideology, 79, 243,

258, 273 Political ideology and foreign

direct investment, 234–237 free market view, 234–235 pragmatic nationalism, 235 radical view, 234 shifting ideology, 236

Political instability, 223 Political liberty, 144 Political philosophy, 47 Political reactions, 237 Political realities, to international

trade, 196 Political risks, 82, 410 Political stability, 51, 373 Political strife, 51 Political systems, 39–43, 62 Political union, 257 Pollutants, 132 Pollution, 26, 133, 141, 272 Pollution controls, 133 Polycentric approach, 490, 502 Polycentric staffing policy, 492 Ponzi scheme, 155 Porter’s Diamond, 180–185 Porter’s theory, 162, 185 Portugal, 260, 265–267, 326,

368–369 Positive-sum game, 159,

165, 167 Potential world production, 167 Pound (movie), 449 Power distance, 112–113, 139 Power generation, 223 PPF. see production possibly

frontier (PPF) Practical training, 498 Pragmatic nationalism, 234 Predatory pricing, 468 Premier League soccer, 282 Pressures

to be locally responsive, 353 for cost reductions, 353

Pressures for cost reductions and entry mode, 386 pressures to be locally

responsive, 353–357 Pressures for local responsiveness

customer tastes and preferences, 354

customer tastes and preferences in, 354

host government demands, 356 infrastructure and traditional

practices, 355 infrastructure distribution

channels, 355–356 rise of regionalities, 356–357

Price as competitive role, 176 versus product attributes, 456

Price discrimination, 297, 466–467

Price elasticity, 467 Price elasticity of demand, 467 Price inflation, 294, 297, 314,

316, 324 Price markup, 460 Price sensitivity, 91 Price stability, 265 Price support, 195 Price war, 468 Prices and exchange rates

empirical tests of PPP Theory, 296–298

law of one price, 293 money supply and price

inflation, 294–296 purchasing power parity,

293–294 Pricing strategy

price discrimination, 466–467 strategic pricing, 468–469

Primary data, 473 Primary packaging, 437 Principles of Political Economy

(Ricardo, D.), 166–167 Printing money, 325 Private action, 49 Private ownership, 45 Private property, 79 Privatization, 41, 61, 69,

77–79, 225 Proactive behavior, 399 Proactive trade policy, 180 Processes, 345 Proctor & Gamble (P&G), 20,

223–224, 347, 361–362, 459, 468, 477, 484, 491

Product, 452 Product attributes

cultural differences, 455–456 economic development, 456 versus prices, 456 product and technical

standards, 456–457 Product development, 475–480

building global R&D capabilities, 478–479

cross-functional teams, 478 failure rate, 477 and fundamental

integration, 477 integrating R&D, marketing,

and production, 477 issues, 452 and marketing, 477

and production, 477 R&D location, 476–477

Product diversity, 427 Product innovation, 476 Product liability, 54 Product life-cycle theory, 162,

176–177, 185, 246 Product returns, 438 Product safety laws, 54 Production, 7–8, 421

concentration, 429 decentralization of, 430 and product development, 477

Production and consumption, growth of, 176

Production capacity, 433 and cost, 434 overseas, 331

Production facilities, 429 Production factors

locating production facilities, 429–430

product features, 428–429 strategic roles for production

facilities, 430–431 Production flow, 428 Production implications, for, 14 Production possibility frontier

(PPF), 164–166, 169, 171 Production processor, 435 Production runs, 427 Production technology, 429 Productivity, trade versus factor

endowments, 174 Product-life-cycle theory,

175–176 twenty-first century in, 176

Profit growth, 339 Profit sharing, 105 Profitability, 339

and profit growth summary, 352

Project manager, heavyweights, 478

Promise and pitfall of exporting, 398–401

Promotions, 452 Property holders, 69 Property rights, 47, 49, 70, 81 Property rights and corruption

Foreign Corrupt Practiced Act, 50–51

intellectual property protection, 52–54

private action, 49 product safety and product

liability, 54 public action and corruption,

49–50 Protectionism, agriculture, 213 Protectionist measures, 172 Protectionist pressures, 225 Protestant churches, 102 Protestant ethics, 102 Protestant work ethic, 106 Protestantism, 102, 106 Proton (carmaker), 277

Pseudo-democracies, 44 Psychological testing, 497 Public action, 49 Public Opinion Survey, 150 Public-sector deficits, 268 Pull strategy, 462, 464 Punitive sanctions, 204 Punitive trade sanctions, 203 Purchasing, 422

activities, 439 types of, 439

Purchasing power, 79–80, 85, 89–91, 227, 373, 503, 508

Purchasing power parity (PPP), 16, 37, 64–65, 223, 292–294, 296, 298, 355

Purchasing power parity (PPP) theory, 295–297, 299

Push strategy, 462 Push versus pull strategies, 464

channel length, 462 media availability, 464 product type and consumer

sophistication, 462 push-pull mix, 464

Push-pull mix, 464 Putin’s Russia, opening case,

37–38

Q Qatar, 213 Qualcomm, 425 Qualitative methods, 474 Quality, 441 Quality control, 383, 422, 434 Quantitative easing, 297 Quantitative methods, 474 Quantum Corporation, 478 Quota rent, 200 Quotas, 199, 215, 230

R R&D, 475 R&D location, 237 Racism, in Brazil, 455 Radical ideology, 234 Rail, 438 Railroads, 14 Rank-Xerox, 176 Rapid entrance, 376 Rare earth metals, 219–220 Raw materials, 226, 437 Rawls, John, 144–145,

147–148, 153 Rawls’ theory of justice, 147 RCA Corporation, 9, 230–231,

381, 457 Real interest rates, 298 Real-world trade patterns, 162 Reciprocal obligations, 108 Records, inadequate, 79 Red Spot Paint & Varnish

Company, 404–405 Reemployment, 209, 213 Regimes, totalitarian, 69

Subject Index 537

Regional economic integration, 254–256

and culture, 257 economic integration levels,

256–257 elsewhere, 275–280 Greek sovereign debt crisis, 268 Greek TV, 282 introduction, 254–256 opening case: tomato wars,

252–253 regional economic integration

in Europe, 260–270 regional integration case

against, 259 regional integration case for,

257–259 single market in financial

securities, 264 threats, 278–280 summary, 280–281

Regional economic integration elsewhere, 275–280

Asian-Pacific economic cooperation, 277–278

Association of Southeast Asian Nations (ASEAN), 275–277

regional trade blocks in Africa, 278

Regional economic integration in Europe, 260–270

euro establishment, 265–269 European Union evolution, 260 European Union political

structure, 260–263 management focus on

European Commission and Intel, 262

Single European Act, 263–264 Regional economic integration in

the Americas Andean community, 273 Central American Free Trade

Agreement (CAFTA), 274–275

free trade of the Americas, 275 Mercosur, 274 North American Free Trade

Agreement (NAFTA), 270–273

Regional economic integration threats

opportunity, 279 threats, 279–280

Regional integration cases against, 259 economic case for, 258 for, 257–259 impediments to, 258–259 political case for, 258

Regional trade, 255 Regional trade agreements, 254 Regulations, 82 Regulatory barriers, 6 Regulatory influences on

prices, 469

Related and supporting industries, 181

Relationship, 442 Relationship building, 436 Relationship development, 497 Relative factor costs, 425 Religion, 100 Religious and ethnic systems

about, 100 Buddhism, 107–108 Christianity, 102–103 Confucianism, 108–110 Hinduism, 106–107 Islam, 103–106

Relocation, 496 costs, 493

Remittance, 86 Renault SA, 220, 387 Repatriation, 500 Repatriation of expatriates, 499 Reporters Without Borders, 131 Reporting system, 305 Representative democracy, 43 Repressive regimes, 132 Research

analyzing and interpreting, 474

assessing and costs of, 473 leading-edge, 476 reporting, 474

Research and development (R&D), 450

activities, 476 facilities, 477 satellite centers, 476

Research centers, 479 Research fatalities, 183 Reserve currency, 192 Resource utilization, efficiency

of, 170 Resources, assumptions of, 168 Resources utilization, 235 Resource-transfer effects, 243 Responsiveness, 441 Restaurant chains, 482 Restraint, 112 Retail concentration, 458 Retail establishments, 243 Retailers, 463

and import agents, 460 small, 458 versus wholesalers, 458–459

Retailing sector, 248 Retaliatory actions, 216 Revenue and profit stream, 387 Reverse logistic, 438 Reverse resource-transfer

effect, 241 Revlon, 452 Revolution in Egypt, 86 Riba, 104 Ricardian model, 169, 175 Ricardian model extensions

diminishing returns, 169–170 dynamic effects and economic

growth, 170–171 immobile resources, 169

Samuelson critique, 171–173 trade and growth link

evidence, 173 Righteous moralist, 141 Rights theories, 143–144 Rights versus obligation, 144 Right-wing totalitarianism, 44 Risk(s)

benefit cost-risk trade-off, 373 commercial risks, 410 economic risks, 82 failure risk reduction, 389 foreign exchange rate risk, 303 foreign exchange risk, 286,

290, 398 foreign exchange risk insurance,

289–291 globalization risk, 22 joint ventures, 383 legal risk, 83 licensing, 382 market entry risk, 377 political risks, 82, 410 of rapid entry, 376

Rituals, 93 RMC, 229, 240 Road conditions, 458, 463 Road system, 248 Rogue states, 205 Rolex, 53 Rolls-Royce, 7, 412 Roman Catholic churches, 102 Romania, 260–261, 269,

302–303, 411 Royal Dutch Shell, 135, 496, 498 Royalty fee, 231 Rural retail stores, 463 Russia, 10–11, 16, 20, 22, 37–39,

43–44, 46–47, 49–51, 64–65, 73–74, 77, 80, 82, 102, 117, 135, 139, 151, 202, 211, 302, 321, 326, 337, 355–356, 411–413, 460, 479

Russian mafia, 49 Rwanda, 53, 84, 94, 151, 279

S Safety standards, 159 SAIC. see Shanghai Automotive

Industry Corp. (SAIC), 383 Same-store sales growth, 482 Samsung, 9, 13, 176, 355, 375,

419–421, 464, 476, 491 SARS (severe acute respiratory

syndrome), 440 Saudi Arabia, 44, 93–94, 104, 122,

162, 172, 321, 380, 411, 494 SC Johnson, 456 Scale economies, 179 Scandals, 134 Scandinavia, 92–93, 140, 311,

337–338, 464, 508 Schultz, Howard, 371 Scotland, 287 Seattle Coffee, 372 Secondary, data, 473

Secondary packaging, 437 Secular rational vales, 116 See General Agreement on Tariffs

and Trade (GATT), 197, 206, 214

Sega, 477 Self-management work teams,

97, 506 Self-orientation, 497 Sematech, 203 Semiconductors, 32, 172, 182,

199, 201, 203, 206–207, 209–210, 233, 348, 351, 354, 358, 363, 393–394, 424–426, 451–452

Serbia, 82 Server factory, 431 Service Corps of Retired

Executives (SCORE), 402–403

787 Dreamliner, 3, 5 Shadow economy, 64 Shanghai Automotive Industry

Corp. (SAIC), 383 Shanghai Electronic

Corporation, 509 Shared decision making, 441 Sharp, 9, 460, 476 Shell. see Royal Dutch Shell Sherlock Holmes (movie), 449 Shipment consolidation, 441 Shipping costs, 14 Short selling, 298 Short-term exchange rate

momentum, 300 Short-term interest rates, 329 Sight draft, 408 Significance, social mobility, 100 Silicon Valley, 233 Silver, 313 Singapore, 8, 18, 44, 69–71, 76–77,

184, 234, 276, 292, 356, 372, 425, 445, 457, 479, 495

Single European Act, 262 Single marketplace, 264 Sinopec, 437 Six Sigma, 423, 509 Skilled labor, 25, 174, 183 Skilled research facilities, 183 Skin shades, 455 Slovakia, 375 Small Business Administration,

400, 402 Small scale, 404–405 Small-scale entry, 375–376 Smoot-Hawley Act, 209 Social conventions, 93 Social democracy, 41 Social democrats, 40 Social disruption, 119 Social guests, 82 Social investments, 150 Social justice, 104 Social media, 95–96 Social mobility, 98–100 Social organization, 97 Social responsibility, 140–141

538 Subject Index

Social strata, 97 Social stratification, 95, 97–100 Social structure, 95

individuals and groups, 95–98 significance, 100 social stratification, 97–100

Social transformation, 99 Social unrest, 82 Socialism, 40 Socialist ideas, 43 Socialists, 40 Society, 92

mobility of, 100 Softbank, 119 Software, 8 Software programs, 474 Sogo shosha (trading company), 401 Sono-Tek Corp., 397–398 Sony, 5, 7, 13, 20, 109, 119,

230–231, 364, 381, 429, 452–453, 475–477, 493

Sony Corporation, 493 Source and country of origin

effects, 461–462 Source effects, 461 Source factors, 430–431 Source factory, 430 South Africa, 21, 73, 85, 112,

130–132, 205, 243, 255, 402, 470

South America, 43, 66, 151, 255, 257, 275, 348, 351, 381

South Korea, 323 South Korean Banks, 327 Southeast Asia, 20, 28, 31, 48, 61–62,

71, 78, 107, 226, 255, 275–276, 281, 300–301, 397, 497

Southern Ocean Southland One, 229 Sovereign debt, 259, 267–268 Sovereign debt crisis, 259, 269 Soviet Union, 20, 37, 39–40, 42,

74–75, 77, 226, 258, 302, 358, 411. see also Russia

Spangler v. Candy Company, 195 Specialization, 161

gains from, 170 of producing, 179

Specific tariff, 197 Speculation, 288, 323–324 Speculators, 316 Speed money, 52, 134–135 Spider Man, 450 Spin-off effects, 238 Spot exchange rates, 289, 298 Spousal adjustment, 494–495, 498 Spouses, 496 Sprint, 261, 281 Sri Lanka Stable exchange rates, 265 Staffing Staffing policy

ethnocentric approach, types, 490–492, 504

expatriate managers, 494–497 geocentric staffing policy, types,

492–493

global mindset, 497–498 polycentric approach, types,

492–493 staffing policy types, 490–494 summary, 493–494

Stakeholders, 147 Standardization, 451 Standards, minimum

acceptable, 130 Stanley Black & Decker, 305 Stansberry & Associates

Investment Research, 318 Starbucks Corporation, 5–7, 13,

23, 54, 150–151, 298, 348, 371–373, 386

Starbucks Index, 298 Starbucks trademark case in

China, 54 Starwood Hotels & Resorts, 341 State ownership, 40, 46 State-owned assets, 78 State-owned business/companies/

enterprises, 41, 46, 63, 76, 78 States in transition

new world order and global terrorism, 74–75

spread of democracy, 72–74 spread of market-based systems,

75–77 Stavia, 375 Steel imports, 184 Steelmakers, 215 Stock of foreign direct investment

(FDI), 17, 224 Strata, 95, 97 Strategic alliances

advantages of, 362–363 disadvantages of, 363 making alliances work,

364–366 Strategic assets, 228, 236 Strategic commitments, 376 Strategic fit, 433 Strategic flexibility, 331 Strategic levels, 438 Strategic posture, 492 Strategic pricing, 466

experience curve pricing, 469 multipoint pricing strategy,

468–469 predatory pricing, 468

Strategic role of international HRM, 489–490

Strategic trade policies, 163, 180, 199, 205, 207

Strategy, 231, 339, 488–489 Strategy and the firm

firm as a value chain, 342–346 strategic positioning, 341–342 valuation creation, 339–341

Strategy choosing evolution of strategy, 361–362 global standardization strategy,

357–358 international strategy, 360–361 localization strategy, 359 transnational strategy, 359–360

Strategy of international business cost processes and pressures for

local responsiveness, 353 Ford global strategy, 367–368 global expansion, profitability

and profit growth, 346–351

IKEA, 337–338 introduction, 338–339 pressures for cost reductions,

353–356 Procter and Gamble strategy

evolution, 361 strategic alliances, 362–366 strategy and the firm, 339–346 strategy choosing, 357–362 Vodaphone in Japan, 358 summary, 366

Strategy production and supply chain management, 421–424

Straw men cultural relativism, 141 Friedman Doctrine, 140–141 native immoralist, 142 righteous moralist, 141–142

Sub-castes, 99 Subcontractors, 138 Sub-Saharan Africa, 57, 73–74 Subsidiaries, franchising of, 386 Subsidies, 195, 198, 203, 207, 213

cut, 213 to farmers, 199

Successful enterprises, 149 Sudan, 28, 104–105 Sullivan, Leon, 130 Sullivan principle, 131 Sum of the current account

balance, 191 Sunbeam Corporation, 10 Sunnah, 48 Suntory, 464 Supplier (upstream)

function, 443 Suppliers, 332, 442 Supply, 435 Supply chain functions, 422 Supply chain management,

248, 421 Supply chain management

functions, 422 Supply chains, 419

globally dispersed, 441 Support programs, 195 Supranational organizations,

27–28 Survey questions, 474 Survey translations, 474 Survival values, 116 Sustainability, 150 Sustainable strategies, 150 Swap deal, 291 Sweatshop labor, 130 Sweden, 3, 12, 39, 41, 46, 50, 57,

63, 92, 110, 112–113, 140, 182, 197, 237, 243, 256, 258, 260–261, 265–266, 480

Switch trading, 412

Switzerland, 63, 76, 83, 89, 92, 110, 162, 180–182, 211, 229, 256, 348, 372, 506

Symbolic behavior, 93 Synergies, 388

T Taiwan, 9, 15, 18, 22, 32–33, 44,

69–70, 73, 76, 108, 119, 131, 206, 212, 233–234, 356, 375, 424

Tales of Suspense, 449 Tanzanika, 53, 278, 444 TaoBao, Chinese competition,

90–91 Tariff barriers, 160, 213, 278, 298,

379, 392, 421 Tariff rate quotas, 199 Tariff rates, 215, 227 Tariffs. see also barriers; General

Agreement on Tariffs and Trade (GATT)

in 1920’s-1930’s, 11 ad valorem, 197, 199 agricultural, 212–213 free tariff barriers, 259 import, 197, 199 Obama on, 159 rates, 12–17, 213–214, 227 on textile exports, 198 trade policy instruments,

197–198 Tata Group, 493 Tata Oil Mills, 240 Tax breaks, 243 Tax minimization strategies, 420 Tax rules, 242 Taxation, 504 Team

goals, 478 leadership, 478 location, 478

Team results, 478 Technical analysis, 301 Technical competence, 496 Technological factors

flexible manufacturing and mass customization, 427–428

minimum efficient scale, 426–427

Technological innovation, 475 Technological role of change,

drivers, 13–15 Telebrás Brazil, 79 Telecommunication sector, 62 Telecommunication service, 211 Telecommunications, foreign

direct investment in, 79 Telefónica, 387 Teleglobe, 387 Terrorism, global, 75 Tesco, 239, 248, 361, 374–375,

391, 459 Tesla, 220 Texas Instruments (TI), 172, 235,

358, 380, 383–384, 477

Subject Index 539

Textile industry, 161, 258 Thailand, 10, 15–16, 22–23, 28,

53–54, 61, 113, 133, 172, 176, 195, 211, 276, 300, 319, 325–327, 329, 349, 372, 375, 411

The Republic, 23, 40 Theocractic law system, 48 Theocractic totalitarianism, 44 Theories

absolution advantage theory, 185

comparative advantage theory, 185–186

cooperative advantage theory, 167

Dunning’s theory, 233 FDI and government policy,

244–246 foreign direct investment (FDI)

theory, 228–233, 236–242, 244–247, 381

Heckscher-Ohlin theory, 161–162, 174–175, 180–181, 183, 185–186, 196

internalization theory, 230, 232 international trade theory, 74,

159–188, 241 Knickerbocker theory, 232, 246 Leontief paradox, 174–175 location, first mover advantage,

and government theory, 183–185

Marxist theory, 234 national competitive advantage

theory, 186 new trade theory, 162, 169,

176–180, 183–186, 199, 205–207, 219

Porter’s theory, 162, 183, 185 product life-cycle theory, 162,

175–177, 185, 246 purchasing power parity (PPP)

theory, 294–299 Rawls’ theory of justice, 147 Ricardo theory, 174 theory of comparative

advantage, 166, 168, 180, 254, 259

theory of national comparative advantage, 162

trade theory, 160–163 Theories of free trade, 269 Theory of comparative advantage,

166, 168, 180, 254, 259 Theory of national comparative

advantage, 162 Threats, 279–280 3M Company, 404–405, 475 3M Global Trading Inc., 413 TI (Texas Instruments). see Texas

Instruments (TI) Time, 93 Time draft, 408 Time to market, 432 Time Warner, 261, 281

Time Warner and EMI merger, 261 Timing of entry, 374 Ting Hsin, 375 Tokyo foreign exchange

market, 289 Tokyo Round (1972-1973), 209 Top-to-bottom manufacturing

operations, 430 Toshiba, 363–364 Total costs, 421 Total quality management

(TQM), 423 Totalitarian dictatorship, 43 Totalitarian regimes, 69 Totalitarianism, 43, 72 Totalitarianism dictatorship, 80 Toxic waste disposal, 144 Toy industry, 127–128 Toyota, 7, 17, 109, 191, 220,

231–232, 235, 238, 241, 243, 286, 288, 304–305, 308, 347, 354, 357, 365, 399, 427, 437, 447, 453–454, 456, 475, 484, 491

Toys “R” Us, 68, 242, 459 Trade, of currency, 163 Trade acceptance, 408 Trade balance adjustments, 322 Trade barriers, 11, 23, 201, 208,

215, 225, 230–231, 255, 272, 274, 398, 421, 425, 429–430

Trade blocs, 260, 278 Trade creation, 259 Trade deficits, 238, 316, 320, 326 Trade disputes, 204 Trade diversion, 259 Trade fairs, 402 Trade fortress, 280 Trade imbalance, 316 Trade liberalization, 328 Trade patterns, 162, 180 Trade policy, exchange rate of, 315 Trade policy instruments

administrative policies, 201 antidumping policies, 201–202 country focus on China

subsidies, 198 import quotas and export

restraints, 199–200 local content requirements,

200–201 subsidies, 198–199 tariffs, 197–198

Trade Related Aspects of Intellectual Property Rights (TRIPS), 53, 210, 214

Trade sanctions, 205, 211 Trade surplus, 163 Trade theory

international trade pattern, 162 overview, 160–163 trade benefits, 161

Trade unions. see union labor, structures

Trade war, 207–208 Trademarks, 52 Trading arrangements, 412

Trading firms, 413 Trading nations, 226, 401 Trading partners, 272 Tragedy of the commons, 133 Training

costs, 493 cultural, 499 language, 498–499 versus management

development, 498 practical, 498–499

Training and management development

management development and strategy, 500

repatriation of expatriates, 499–500

training for expatriate managers, 498–499

Training for expatriate managers cultural training, 499 language training, 499 practical training, 499

Transaction exposure, 303 Transactional relationship, 442 Transistors, 475 Transit packaging, 437 Translation exposure, 303, 305 Translations, 474 Transnational posture, 492 Transnational strategy, 359, 490 Transparency International, 50 Transportation, 437, 463 Transportation costs, 6, 14, 168,

230–231, 379, 432 Transportation rates, 438 Treaty of Rome, 260 Trends, 22 Tribal totalitarianism, 44 TRIPS. see Trade Related Aspects

of Intellectual Property Rights (TRIPS)

Trucking operations, 248 TRW, Inc., 364–365 Tunisia, 122 Turkey, 10–11, 57, 104–105, 111,

113, 211, 269–270, 326, 330, 376, 405, 428, 470, 482

Turnkey projects, 377, 379 advantages, 379–380 disadvantages, 380

Turnkey strategy, 380 Turnover rate, 432 Tussauds Group, 321 Tutsis, 94 TV broadcasts, 282 TV decoders, 282 20th Century Fox, 449 Twitter, 73, 86, 96, 421

U Uganda, 44, 278 Umicore, 151–152 UN Charter, 10 Unanimity voting, 262 Uncertainty avoidance, 112

Undemocratic governments, 70 Unemployment, 159, 311 Unethical behavior, 139–140 Unethical behavior roots

decision-making processes, 138–139

leadership, 139 organization culture, 139 personal ethics, 137–138 societal culture, 139–140 unrealistic performance

goals, 139 Unethical leadership, 139 Unical in Myanmar, 133 Unilever, 20, 81, 109, 146–147,

149, 156–157, 240, 361, 455, 458, 462–466

Union labor, 505 Union structures, 505 Unit cost curve, 426 Unit cost reductions, 178 Unit costs, 398 United Arab Emirates (UAE), 20,

94, 122, 236, 445 United Arab Emirates (UAE)

citizen, 236 United Auto Workers (UAW), 505 United Kingdom, 11, 15, 17, 25,

39, 48, 122, 225–226, 229, 240, 261–262, 334–335, 357–358, 361, 365, 460, 466, 470, 482, 496

United Nations Convention on Contracts for the International Sale of Goods (CIGs), 48

United Nations Declaration of Human Rights, 143

United Nations (UN), 9–10, 12, 24, 28, 48, 51, 141, 143, 225, 227, 315, 325, 328, 401, 505

United States. see also McDonald’s; Starbucks Corporation

agricultural tariffs, 212 Airbus, 332 aircraft industry, 161–162 AirTouch Communications, 387 American consumers and

American products, 161 antidumping actions, 212 antidumping policies, 201, 469 antidumping regulations, 469 antitrust laws, 45, 261 Apple retail store concept in,

459–460 Apple U.S. employees, 33 auto importance, 457 balance of trade position, 321 balance-of-payments deficit,

318, 320 balance-of-payments position,

240–241, 318 banking sectors, 360 beef sales, 205 biotechnology, 233 and Brazil, 275 budget deficit, 320

540 Subject Index

Business Administration (SBA), 400, 402

business size in, 403 business startup, 38 Buy America Act, 201 cable television, 464 capital flow, 267 channels of distribution, 459 chemical industries, 180 Chinese auto exports and, 198 Chinese R&D center in, 21 civil and criminal liability

law, 54 class systems, 99–100 competitive devaluations, 315 consumer behavior, 456 Contracts for the International

Sale of Goods (CIGS), 48 cost of living, 64 cultural differences, 118 cultural differences versus

China’s, 91 cultural myopia of Japanese

in, 492 currency, 163–164 current account deficit, 189,

191–192, 321 Daimler-Benz, 387 DaimlerChrysler, 135, 331,

387–388 debt, 318 deficit, 210 distribution channels, 355 dollar depreciation and

imports, 305 dollar value, 320 Domino’s Pizza, 482–483 DP World and, 236–237 drug cartels, 273 dumping, 253 DVD equipment, 457 economic growth rates, 66,

80, 89 economic implications of

Christianity, 102 economic risks, 83 economies growth, 320 economy, 192 economy side, 65 economy size, 79 education system, 119 on Egypt situation, 86 engineering education, 173 engineers in, 33 environmental pollution, 26–27 ethical dilemmas for businesses

in, 129 ethical principles, 136 export credit insurance, 410 export replacements, 404 Export-Import Bank (Ex-Im

Bank), 410 exports to China from, 26 FCX Systems and Small

Business Administration loan, 400

Federal Reserve Bank, 155, 308 financial account, 191 financial crisis (2008), 301, 308 Fisher effect, 299 folkways, 93 Foreign Corrupt Practices Act,

50, 134 Foreign Credit Insurance

Association (FCIA), 410 foreign direct investment

(FDI), 17 foreign direct investment (FDI)

direction, 225, 228–229 foreign direct investment (FDI)

outward, 242–243 foreign direct investment (FDI)

source of, 226 foreign official assets, 192 foreign trade position, 317 formal education, 111 4WD sport utility vehicles

in, 456 free tariff barriers concept, 259 free trade agreement

impact, 171 free trade deal with EU,

159–161 Fuji Photo Film Co., 468 gains by trade, 215 GATT, 209 GE moves manufacturing from

China to, 432 geocentric staffing policies, 493 global financial crisis

(2008-2009), 22, 277 global institutions emergence,

9–10 global supply chain

problems, 440 in global web, 349 globalization labor force, 5–6,

8, 13 GNI per capita, 63 gold standard, 314–315, 318 government-mandated product

standards, 457 gross domestic product

(GDP), 215 Group 20, 11 Group of Five, 320 growth rates, 26 Heckscher-Ohlin theory,

174–175 as high-cost location, 349 highly indebted poorer

countries (HIPCs), 29 hollowing of

manufacturing, 172 hormone-treated beef,

23–24, 204 IDA funding, 317 IKEA, 338, 348 import tariffs, 199 importation of Japanese cars

into, 230 importers versus U.S.

producers, 254

imports of Japanese automobiles, 216

indebtedness, 321 individual personal factors, 139 individualism, 42, 97, 113–114 inflation rates, 297, 318–319 infrastructure or traditional

practice differences, 355 ING Group in, 376 inpatriates, 494 International Bank for

Reconstruction and Development (IBRD), 316–317

international market research firms, 472

international trade role, 401 inward investment, 212 “Japan bashing,” 461 Japanese auto plants not

unionized in, 505 Japanese imports, 200 Japanese-owned auto assembly

plants, 365 Jollibee Foods Corporation, 378 jurisdiction, 134 Kodak in, 468 labor and land, 187–192 labor cost, 174 lead market, 476 legal system, 47 Lenovo in, 349 Leontief paradox, 174 Levi Strauss in, 470 liability suits and awards in, 54 Lincoln Electric’s competitive

advantage in, 389 local production facilities, 304 long-term orientation level, 113 Mafia in, 49 magnesium, 202 Malawi assistance, 334–335 managers’ background in, 493 market segmentation in, 454 market-based systems, 76 marketing practices in, 355 Marshall Plan, 316 McDonald’s in, 470 MD International, 415–416 media availability in, 464 Microsoft, 347 MMC factories in, 509–510 monopoly, 476 Monsanto, 500 mores, 94 movie industry in, 451 MTV, 355 new trade theory, 180 Nielsen in, 472 noise levels, 462 nonagricultural goods and

services, 214 non-multinationals, 19 nonverbal communication, 111 North American Free Trade

Agreement (NAFTA), 255, 356

offshore service jobs, 171–172 oil interests, 259 oligopolistic industries, 232 PCs in, 467 pharmaceutical industry,

187–188 pharmaceutical product

advertising, 464 Philippino population, 378 pickup trucks in, 354 piracy rate, 53 political and economic

philosophies, 95 political union, 257 post–World War II period, 476 Procter & Gamble (P&G),

347, 361 product performance in, 456 product returns in, 438 production and consumption

growth, 176 pros and cons of

acquisitions, 387 public debt in, 37 pull strategy, 464 R&D history, 476 racial discrimination history

of, 455 rare earth metals, 219 real labor compensation, 26 regional convergence, 356 repatriation program in, 500 research centers, 479 retail concentration in, 457 retail establishments, 248 reversed logistics, 438 risks, 82–83 Samuelson’s thesis, 172–173 scale of entry, 376 short-term orientation

level, 114 Silicon Valley, 479 skilled labor, 25 Small Business Administration

(SBA), 402 small enterprises exporting, 403 Smoot-Hawley Act, 209 specialists from, 509 standardized advertising, 465 Starbucks Corporation, 348,

371–373 steel imports, 184, 197 sugar industry, 195–196, 200 swap deal, 291 tariff rates, 12–17 technical standards’

differences, 355 technology and market, 9 Teleglobe acquisition in, 387 terrorist attacks (September

2001), 75, 83 textile industry, 25, 161 3M Company in, 404 trade deficits, 320 trade sanctions politically,

205–206 transportation, 14

United States (continued )

Subject Index 541

travel in, 465 TRW in, 365 TV market, 468 United Auto Workers

(UAW), 505 Unocal sale, 235 U.S. Magnesium case, 202 Vodaphone acquisition

in, 387 wage rates, 353 wealth gap, 476 world trade, 15–16 Xerox history in, 176 Zen trademarks in, 107

United Technologies, 149 Unit-load packaging, 437 Universal Declaration of Human

Rights, 143–144, 146 Universal free trade, 213 Universal needs, 354, 430 Universal Pictures, 449 Unrestricted free trade, 162,

167, 169 Unskilled labor, 25–26 Upstream supply chain, 422 Urbanization, 116 Uruguay, 210, 255, 257, 274 Uruguay Round, 10–11,

210–211, 218 U.S. Commercial Service, 401 U.S. Congress, 198 U.S. Consumer Product Safety

Commission (CPSC), 127–128

U.S. Department of Commerce (DOC), 400–403

U.S. Department of Justice (DOJ), 134–135

U.S. Department Office of West Virginia, 400

U.S. dollar, 192, 265, 285, 289, 312

devaluation of, 314 versus euro, 285 versus German deutsche

mark, 319 versus Japanese yen, 308, 319 movement in 1980s/1990s, 331 value history, 319–322

U.S. Equal Employment Opportunity Commission, 492

U.S. Federal Drug Administration (FDA), 188

U.S. Federal Trade Commission (FTC), 200

U.S. government subsides, 199

U.S. labor, high cost of, 175 U.S. mafia, 49 U.S. Magnesium, 202 U.S. Securities and Exchange

Commission (SEC), 134–135 U.S. Small Business

Administration (SBA), 403 Utilitarian and Kantian ethics,

142–143 Utilitarian approaches to ethics,

142, 153

V Value, 139 Value addition, 450 Value chain, 342, 384 Value creation, 340, 450 Values, 92–93 Values and norms, 95, 111 Value-to-weight ratio, 428–429 Variance reduction, 441 Variety (magazine), 109 Variety of goods, 178 Vehicle currencies, 292 Veil of ignorance, 144 Vendor management of inventory

(VMI), 440 Vendors, 442 Vendors (upstream) function, 443 Venezuela, 21, 42–44, 46, 50, 55,

73–74, 77, 82, 229, 236, 257, 273–274, 278, 302–303, 321, 411, 415, 495

Vernon, Raymond, 162, 175–176 VERs (voluntary export

restraints). see voluntary export restraints (VERs)

Vietnam, 28, 40, 43–45, 75, 80, 130, 236, 276–277, 317, 348

Vision Quest Lighting, 397–399 Vizio, 8–9 Vodaphone, 387 Volkswagen AG, 81, 109, 290–291,

305, 307, 347, 368, 453 hedging strategy, 291

Voluntary export restraints (VERs), 200, 210, 215

Voluntary restrictions, 184 Volvo, 387 Vought Aircraft, 4

W Wage gap, 26 Wage rates, 26, 431–432 Walmart, 51–52, 57, 239,

248–249, 343, 351, 353, 361, 375, 458–459, 470

Walt Disney Company, 450 Warehouse management system

(WMS), 441 Warehousing, 427 Warehousing capacity, 248 Warner Brothers, 362 The Wealth of Nations (Smith,

A.), 42 WEF. see World Economic Forum

(WEF) Welfare of society, 45 Well-being values, 116 Wells Fargo, 360 West Germany, 260 Western Africa, 57, 215 Westinghouse, 9 “When in Rome do as the Romans”

concept, 141 Where to produce

country factors, 424–425 hidden costs of foreign locators,

431–432 production factors, 428–431 technological factors,

426–428 Whole Foods Market, 154 Wholesalers, 462

versus retailers, 458 Wholly owned subsidiaries, 377,

379, 384, 393 advantages, 384 disadvantages, 385 versus joint-venture

arrangements, 386 Windam International, 498 Wipro Ltd., 98, 172 Women, role of, 105 Women expatriates, 494 Women’s clothing, 445 Work conditions, and pay, 130 Work ethic, 102 Workforce Management Initiative

(WMI), 487–488 Working conditions, 130 Work-in-process (components

parts), 437 World Bank, 9–10, 16, 210, 313,

315–316 role of, 316–317

World Economic Forum (WEF), 116, 197, 495

World GDP, 15 World Intellectual Property

Organization, 53 World output, 16 World peace, 11 World trade, volume of, 14

World Trade Organization (WTO), 9–10, 23, 28, 187, 197, 199, 209, 239, 244, 254–255, 258, 328

antidumping actions, 212 Doha talks, 215 experience, 211–212 functions, 210–211 future of, 212–215 as global police, 211 market access for

nonagricultural goods and services, 214–215

protectionism in agriculture, 213–214

protectionism in intellectual property, 214

trade agreements expansion, 211–212

World trade volume, 12 World trading system

development information, 208–209 Smith to Great Depression

period, 209 1947 to 1979 period, 209 1980 to1993 period, 209–210 Uruguay Round and WTO,

210–211 World Values Survey, 115–116 WorldCom, 261 WTO, 212, 259

X Xerox, 9, 13, 176, 360–363, 365,

380, 382–384 Xing Ba Ke Coffee Shop, 54 X-Men, 450

Y Yakuza (Japanese mafia), 49 YouTube, 460, 466 YouTube videos, 466 Yuan (currency), 164 Yum Brands Inc., 482

Z Zaire, 28, 77 Zen, 107 Zen orientation, 107 Zen spin, 107 Zero-sum game, 163 Zero-tolerance policies, 142 Zimbabwe, 44, 77 Zodiac, 332 Zoho, 172

ACRONYM PROPER NAME

IDB . . . . . . . . . . . . . . Inter-American Development Bank

IEC . . . . . . . . . . . . . . International Electrotechnical Commission

IFC . . . . . . . . . . . . . . International Finance Corporation

IMF . . . . . . . . . . . . . . International Monetary Fund

IPLC . . . . . . . . . . . . . International Product Life Cycle

IRC . . . . . . . . . . . . . . International Revenue Code

ISA . . . . . . . . . . . . . . International Seabed Authority

ISO . . . . . . . . . . . . . . International Organization for Standardization

ITA . . . . . . . . . . . . . . International Trade Administration

JIT . . . . . . . . . . . . . . Just-in-Time

JV . . . . . . . . . . . . . . . Joint Venture

LAIA . . . . . . . . . . . . . Latin American Integration Association (formerly LAFTA)

LDC . . . . . . . . . . . . . Less Developed Country

LIBOR . . . . . . . . . . . . London Interbank Offer Rate

LOST . . . . . . . . . . . . . Law of the Sea Treaty

Mercosur . . . . . . . . . Free Trade Agreement between Argentina, Brazil, Paraguay, and Uruguay

MNC . . . . . . . . . . . . . Multinational Company

MNE . . . . . . . . . . . . . Multinational Enterprise

NAFTA . . . . . . . . . . . . North American Free Trade Agreement

NATO . . . . . . . . . . . . North Atlantic Treaty Organization

NIC . . . . . . . . . . . . . . Newly Industrializing Country

NTBs . . . . . . . . . . . . . Nontariff Barriers

OECD . . . . . . . . . . . . Organization for Economic Cooperation & Development

OPEC . . . . . . . . . . . . Organizational of Petroleum Exporting Countries

PPP . . . . . . . . . . . . . . Purchasing Power Parity

PRC . . . . . . . . . . . . . People’s Republic of China

PTA . . . . . . . . . . . . . . Preferential Trade Area for Eastern and Southern Africa

SACC . . . . . . . . . . . . Southern African Development Coordination Conference

SBA . . . . . . . . . . . . . Small Business Administration

SBC . . . . . . . . . . . . . Strategic Business Center

SBU . . . . . . . . . . . . . Small Business Unit

SDR . . . . . . . . . . . . . Special Drawing Rights

SEZ . . . . . . . . . . . . . . Special Economic Zone

TQM . . . . . . . . . . . . . Total Quality Management

UN . . . . . . . . . . . . . . United Nations

UNCTAD . . . . . . . . . . UN Conference on Trade and Development

VAT . . . . . . . . . . . . . . Value Added Tax

VER . . . . . . . . . . . . . . Voluntary Export Restraint

VRAs . . . . . . . . . . . . . Voluntary Restraints Agreements

WEC . . . . . . . . . . . . . World Energy Council

WIPO . . . . . . . . . . . . . World Intellectual Property Organization

WTO . . . . . . . . . . . . . World Trade Organization

ACRONYM PROPER NAME

ADB . . . . . . . . . . . . . Asian Development Bank

AfDB . . . . . . . . . . . . . African Development Bank

AFIC . . . . . . . . . . . . . Asian Finance and Investment Corporation

AFTA . . . . . . . . . . . . . ASEAN Free Trade Area

ASEAN . . . . . . . . . . . Association of Southeast Asian Nations

ATPA . . . . . . . . . . . . . Andean Trade Preference Act

BIS . . . . . . . . . . . . . . Bank for International Settlements

BOP . . . . . . . . . . . . . Balance of Payments

CIM . . . . . . . . . . . . . . Computer-Integrated Manufacturing

CIS . . . . . . . . . . . . . . Commonwealth of Independent States

CISG . . . . . . . . . . . . . UN Convention on Contracts for the International Sale of Goods

CEMA . . . . . . . . . . . . Council for Mutual Economic Assistance

CRA . . . . . . . . . . . . . Country Risk Assessment

DB . . . . . . . . . . . . . . Development Bank

DC . . . . . . . . . . . . . . Developed Country

DFIs . . . . . . . . . . . . . Development Finance Institutions

DISC . . . . . . . . . . . . . Domestic International Sales Corporation

EBRD . . . . . . . . . . . . European Bank for Reconstruction and Development

ECOWAS . . . . . . . . . . Economic Community of West African States

EMU . . . . . . . . . . . . . Economic and Monetary Union

EEA . . . . . . . . . . . . . . European Economic Area

EFTA . . . . . . . . . . . . . European Free Trade Association

EMs . . . . . . . . . . . . . Export Management Companies

EMCF . . . . . . . . . . . . European Monetary Cooperation Fund

EMS . . . . . . . . . . . . . European Monetary System

EPO . . . . . . . . . . . . . European Patent Organization

ETC . . . . . . . . . . . . . . Export Trading Company

ETUC . . . . . . . . . . . . . European Trade Union Confederation

EU . . . . . . . . . . . . . . . European Union

FCPA . . . . . . . . . . . . . Foreign Corrupt Practices Act

FDI . . . . . . . . . . . . . . Foreign Direct Investment

FSC . . . . . . . . . . . . . . Foreign Sales Corporation

FTAA . . . . . . . . . . . . . Free Trade Area of the Americas

FTZ . . . . . . . . . . . . . . Foreign Trade Zone

Fx . . . . . . . . . . . . . . . Foreign Exchange

G7 . . . . . . . . . . . . . . Group of Seven

GATT . . . . . . . . . . . . . General Agreement on Tariffs and Trade

GC . . . . . . . . . . . . . . Global Company

GDP . . . . . . . . . . . . . Gross Domestic Product

GNP . . . . . . . . . . . . . Gross National Product

GSP . . . . . . . . . . . . . Generalized System of Preferences

IAC . . . . . . . . . . . . . . International Anti-counterfeiting Coalition

IC . . . . . . . . . . . . . . . International Company

IDA . . . . . . . . . . . . . . International Development Association

COUNTRY CAPITAL COUNTRY CAPITAL COUNTRY CAPITAL

Nigeria . . . . . . . . . . . . . Abuja Norway . . . . . . . . . . . . . Oslo Oman . . . . . . . . . . . . . . Muscat Pakistan . . . . . . . . . . . . Islamabad Palau . . . . . . . . . . . . . . Melekeok Panama . . . . . . . . . . . . Panama City Papua New Guinea . . . . Port Moresby Paraguay . . . . . . . . . . . Asuncion Peru . . . . . . . . . . . . . . . Lima Philippines . . . . . . . . . . Manila Poland . . . . . . . . . . . . . Warsaw Portugal . . . . . . . . . . . . Lisbon Qatar . . . . . . . . . . . . . . Doha Romania . . . . . . . . . . . . Bucharest Russia . . . . . . . . . . . . . Moscow Rwanda . . . . . . . . . . . . Kigali Saint Kitts and Nevis . . . Basseterre Saint Lucia . . . . . . . . . . Castries Saint Vincent and

the Grenadines . . . . . Kingstown Samoa . . . . . . . . . . . . . Apia San Marino . . . . . . . . . . San Marino Sao Tome and

Principe . . . . . . . . . . . Sao Tome Saudi Arabia . . . . . . . . . Riyadh Senegal . . . . . . . . . . . . Dakar Serbia . . . . . . . . . . . . . Belgrade Seychelles . . . . . . . . . . Victoria Sierra Leone . . . . . . . . . Freetown Singapore . . . . . . . . . . . Singapore Slovakia . . . . . . . . . . . . Bratislava Slovenia . . . . . . . . . . . . Ljubljana Solomon Islands . . . . . . Honiara Somalia . . . . . . . . . . . . Mogadishu South Africa . . . . . . . . . Pretoria South Sudan . . . . . . . . . Juba Spain . . . . . . . . . . . . . . Madrid Sri Lanka . . . . . . . . . . . Colombo Sudan . . . . . . . . . . . . . Khartoum Suriname . . . . . . . . . . . Paramaribo Swaziland . . . . . . . . . . . Mbabane Sweden . . . . . . . . . . . . Stockholm Switzerland . . . . . . . . . Bern Syria . . . . . . . . . . . . . . Damascus Taiwan . . . . . . . . . . . . . Taipei Tajikistan . . . . . . . . . . . Dushanbe Tanzania . . . . . . . . . . . . Dar es Salaam Thailand . . . . . . . . . . . . Bangkok Timor-Leste . . . . . . . . . Dili Togo . . . . . . . . . . . . . . . Lome Tonga . . . . . . . . . . . . . . Nuku’alofa Trinidad and Tobago . . . Port of Spain Tunisia . . . . . . . . . . . . . Tunis Turkey . . . . . . . . . . . . . Ankara Turkmenistan . . . . . . . . Ashgabat Tuvalu . . . . . . . . . . . . . Funafuti Uganda . . . . . . . . . . . . . Kampala Ukraine . . . . . . . . . . . . Kyiv United Arab Emirates . . Abu Dhabi United Kingdom . . . . . . London United States . . . . . . . . Washington, DC Uruguay . . . . . . . . . . . . Montevideo Uzbekistan . . . . . . . . . . Tashkent Vanuatu . . . . . . . . . . . . Port-Vila Venezuela . . . . . . . . . . . Caracas Vietnam . . . . . . . . . . . . Hanoi Yemen . . . . . . . . . . . . . Sanaa Zambia . . . . . . . . . . . . . Lusaka Zimbabwe . . . . . . . . . . Harare

Gabon . . . . . . . . . . . . . Libreville The Gambia . . . . . . . . . Banjul Georgia . . . . . . . . . . . . T’bilisi Germany . . . . . . . . . . . Berlin Ghana . . . . . . . . . . . . . Accra Greece . . . . . . . . . . . . . Athens Grenada . . . . . . . . . . . . Saint George’s Guatemala . . . . . . . . . . Guatemala City Guinea . . . . . . . . . . . . . Conakry Guinea-Bissau . . . . . . . Bissau Guyana . . . . . . . . . . . . . Georgetown Haiti . . . . . . . . . . . . . . . Port-au-Prince Holy See . . . . . . . . . . . . Vatican City Honduras . . . . . . . . . . . Tegucigalpa Hungary . . . . . . . . . . . . Budapest Iceland . . . . . . . . . . . . . Reykjavik India . . . . . . . . . . . . . . . New Delhi Indonesia . . . . . . . . . . . Jakarta Iran . . . . . . . . . . . . . . . Tehran Iraq . . . . . . . . . . . . . . . Baghdad Ireland . . . . . . . . . . . . . Dublin Israel . . . . . . . . . . . . . . Jerusalem Italy . . . . . . . . . . . . . . . Rome Jamaica . . . . . . . . . . . . Kingston Japan . . . . . . . . . . . . . . Tokyo Jordan . . . . . . . . . . . . . Amman Kazakhstan . . . . . . . . . Astana Kenya . . . . . . . . . . . . . . Nairobi Kiribati . . . . . . . . . . . . . Tarawa North Korea . . . . . . . . . Pyongyang South Korea . . . . . . . . . Seoul Kosovo . . . . . . . . . . . . . Pristina Kuwait . . . . . . . . . . . . . Kuwait City Kyrgyzstan . . . . . . . . . . Bishkek Laos . . . . . . . . . . . . . . . Vientiane Latvia . . . . . . . . . . . . . . Riga Lebanon . . . . . . . . . . . . Beirut Lesotho . . . . . . . . . . . . Maseru Liberia . . . . . . . . . . . . . Monrovia Libya . . . . . . . . . . . . . . Tripoli Liechtenstein . . . . . . . . Vaduz Lithuania . . . . . . . . . . . Vilnius Luxembourg . . . . . . . . . Luxembourg Macedonia . . . . . . . . . . Skopje Madagascar . . . . . . . . . Antananarivo Malawi . . . . . . . . . . . . . Lilongwe Malaysia . . . . . . . . . . . . Kuala Lumpur Maldives . . . . . . . . . . . . Male Mali . . . . . . . . . . . . . . . Bamako Malta . . . . . . . . . . . . . . Valletta Marshall Islands . . . . . . Majuro Mauritania . . . . . . . . . . Nouakchott Mauritius . . . . . . . . . . . Port Louis Mexico . . . . . . . . . . . . . Mexico City Federated States

of Micronesia . . . . . . . Palikir Moldova . . . . . . . . . . . . Chisinau Monaco . . . . . . . . . . . . Monaco Mongolia . . . . . . . . . . . Ulaanbaatar Montenegro . . . . . . . . . Podgorica Morocco . . . . . . . . . . . . Rabat Mozambique . . . . . . . . Maputo Namibia . . . . . . . . . . . . Windhoek Nauru . . . . . . . . . . . . . . No Official Capital Nepal . . . . . . . . . . . . . . Kathmandu Netherlands . . . . . . . . . Amsterdam New Zealand . . . . . . . . Wellington Nicaragua . . . . . . . . . . . Managua Niger . . . . . . . . . . . . . . Niamey

Afghanistan . . . . . . . . . Kabul Albania . . . . . . . . . . . . . Tirana Algeria . . . . . . . . . . . . . Algiers Andorra . . . . . . . . . . . . Andorra La Vella Angola . . . . . . . . . . . . . Luanda Antigua and

Barbuda . . . . . . . . . . . St. John’s Argentina . . . . . . . . . . . Buenos Aires Armenia . . . . . . . . . . . . Yerevan Aruba . . . . . . . . . . . . . . Oranjestad Australia . . . . . . . . . . . . Canberra Austria . . . . . . . . . . . . . Vienna Azerbaijan . . . . . . . . . . Baku Bahamas . . . . . . . . . . . Nassau Bahrain . . . . . . . . . . . . Manama Bangladesh . . . . . . . . . Dhaka Barbados . . . . . . . . . . . Bridgetown Belarus . . . . . . . . . . . . . Minsk Belgium . . . . . . . . . . . . Brussels Belize . . . . . . . . . . . . . . Belmopan Benin . . . . . . . . . . . . . . Porto-Novo Bermuda . . . . . . . . . . . Hamilton Bhutan . . . . . . . . . . . . . Thimphu Bolivia . . . . . . . . . . . . . La Paz Bosnia and

Herzegovina . . . . . . . . Sarajevo Botswana . . . . . . . . . . . Gaborone Brazil . . . . . . . . . . . . . . Brasilia Brunei . . . . . . . . . . . . . Bandar Seri

Begawan Bulgaria . . . . . . . . . . . . Sofia Burkina Faso . . . . . . . . Ouagadougou Burma . . . . . . . . . . . . . Rangoon Burundi . . . . . . . . . . . . Bujumbura Cambodia . . . . . . . . . . . Phnom Penh Cameroon . . . . . . . . . . Yaounde Canada . . . . . . . . . . . . . Ottawa Cape Verde . . . . . . . . . . Praia Cayman Islands . . . . . . George Town Central African

Republic . . . . . . . . . . Bangui Chad . . . . . . . . . . . . . . N’Djamena Chile . . . . . . . . . . . . . . . Santiago China . . . . . . . . . . . . . . Beijing Colombia . . . . . . . . . . . Bogota Comoros . . . . . . . . . . . . Moroni Democratic Republic

of the Congo . . . . . . . Kinshasa Republic of Congo . . . . Brazzaville Costa Rica . . . . . . . . . . San Jose Cote d’Ivoire . . . . . . . . . Yamoussoukro Croatia . . . . . . . . . . . . . Zagreb Cuba . . . . . . . . . . . . . . Havana Cyprus . . . . . . . . . . . . . Nicosia Czech Republic . . . . . . . Prague Denmark . . . . . . . . . . . Copenhagen Djibouti . . . . . . . . . . . . . Djibouti Dominica . . . . . . . . . . . Roseau Dominican Republic . . . Santo Domingo Ecuador . . . . . . . . . . . . Quito Egypt . . . . . . . . . . . . . . Cairo El Salvador . . . . . . . . . . San Salvador Equatorial Guinea . . . . . Malabo Eritrea . . . . . . . . . . . . . Asmara Estonia . . . . . . . . . . . . . Tallinn Ethiopia . . . . . . . . . . . . Addis Ababa Fiji . . . . . . . . . . . . . . . . Suva Finland . . . . . . . . . . . . . Helsinki France . . . . . . . . . . . . . Paris

Note: The list of the 199 “Countries and Capitals” on this page are from http://globaledge.msu.edu/global-insights/by/country. More information about each country can be found on globalEDGE (including statistics, economy, history, government, culture, risk factors, corporations, trade indices, resources, and country memos).

Cover
Title Page
Copyright Page
About the Authors
Brief Contents
Contents
Acknowledgments
PART ONE Introduction and Overview��

Chapter One Globalization��

Opening Case: The Globalization of Production at Boeing��
Introduction��

What Is Globalization?��
The Globalization of Markets��
The Globalization of Production��

The Emergence of Global Institutions��

Drivers of Globalization��
Declining Trade and Investment Barriers��
The Role of Technological Change��

The Changing Demographics of the Global Economy��

The Changing World Output and World Trade Picture��
The Changing Foreign Direct Investment Picture��
The Changing Nature of the Multinational Enterprise��
The Changing World Order��
The Global Economy of the Twenty-First Century��

The Globalization Debate��

Antiglobalization Protests��
Globalization, Jobs, and Income��
Globalization, Labor Policies, and the Environment��
Globalization and National Sovereignty��
Globalization and the World's Poor��

Managing in the Global Marketplace��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: Who Makes the Apple iPhone?��
Endnotes��

PART TWO National Differences��

Chapter Two National Differences in Political, Economic, and Legal Systems��

Opening Case: Putin's Russia��
Introduction��
Political Systems��

Collectivism and Individualism��
Democracy and Totalitarianism��

Economic Systems��

Market Economy��
Command Economy��
Mixed Economy��

Legal Systems��

Different Legal Systems��
Differences in Contract Law��
Property Rights and Corruption��
The Protection of Intellectual Property��
Product Safety and Product Liability��

Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: Ghana: An African Dynamo��
Endnotes��

Chapter Three National Differences in Economic Development��

Opening Case: Political and Economic Reform in Myanmar��

Introduction��
Differences in Economic Development��
Broader Conceptions of Development: Amartya Sen��

Political Economy and Economic Progress��

Innovation and Entrepreneurship Are the Engines of Growth��
Innovation and Entrepreneurship Require a Market Economy��
Innovation and Entrepreneurship Require Strong Property Rights��
The Required Political System��
Economic Progress Begets Democracy��
Geography, Education, and Economic Development��

States in Transition��

The Spread of Democracy��
The New World Order and Global Terrorism��
The Spread of Market-Based Systems��

The Nature of Economic Transformation��

Deregulation��
Privatization��
Legal Systems��

Implications of Changing Political Economy��
Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: Revolution in Egypt��
Endnotes��

Chapter Four Differences in Culture��

Opening Case: Best Buy and eBay in China��
Introduction��
What Is Culture?��

Values and Norms��
Culture, Society, and the Nation-State��
The Determinants of Culture��

Social Structure��

Individuals and Groups��
Social Stratification��

Religious and Ethical Systems��

Christianity��
Islam��
Hinduism��
Buddhism��
Confucianism��

Language��

Spoken Language��
Unspoken Language��

Education��
Culture and Business��
Cultural Change��
Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: World Expo 2020 in Dubai, UAE��
Endnotes��

Chapter Five Ethics, Corporate Social Responsibility, and Sustainability��

Opening Case: Making Toys Globally��
Introduction��
Ethical Issues in International Business��

Employment Practices��
Human Rights��
Environmental Pollution��
Corruption��

Ethical Dilemmas��
The Roots of Unethical Behavior��

Personal Ethics��
Decision-Making Processes��
Organization Culture��
Unrealistic Performance Goals��
Leadership��
Societal Culture��

Philosophical Approaches to Ethics��

Straw Men��
Utilitarian and Kantian Ethics��
Rights Theories��
Justice Theories��

Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: Bitcoin as an Ethical Dilemma��
Endnotes��

PART THREE The Global Trade and Investment Environment��

Chapter Six International Trade Theory��

Opening Case: Creating the World's Biggest Free Trade Zone��
Introduction��
An Overview of Trade Theory��

The Benefits of Trade��
The Pattern of International Trade��
Trade Theory and Government Policy��

Mercantilism��
Absolute Advantage��
Comparative Advantage��

The Gains from Trade��
Qualifications and Assumptions��
Extensions of the Ricardian Model��

Heckscher-Ohlin Theory��

The Leontief Paradox��

The Product Life-Cycle Theory��

Product Life-Cycle Theory in the Twenty-First Century��

New Trade Theory��

Increasing Product Variety and Reducing Costs��
Economies of Scale, First-Mover Advantages, and the Pattern of Trade��
Implications of New Trade Theory��

National Competitive Advantage: Porter's Diamond��

Factor Endowments��
Demand Conditions��
Related and Supporting Industries��
Firm Strategy, Structure, and Rivalry��
Evaluating Porter's Theory��

Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: The Rise of India's Drug Industry��
Appendix A International Trade and the Balance of Payments��
Endnotes��

Chapter Seven Government Policy and International Trade��

Opening Case: Sugar Subsidies Drive Candy Makers Abroad��
Introduction��
Instruments of Trade Policy��

Tariffs��
Subsidies��
Import Quotas and Voluntary Export Restraints��
Local Content Requirements��
Administration Policies��
Antidumping Policies��

The Case for Government Intervention��

Political Arguments for Intervention��
Economic Arguments for Intervention��

The Revised Case for Free Trade��

Retaliation and Trade War��
Domestic Policies��

Development of the World Trading System��

From Smith to the Great Depression��
1947-1979: GATT, Trade Liberalization, and Economic Growth��
1980-1993: Protectionist Trends��
The Uruguay Round and the World Trade Organization��
WTO: Experience to Date��
The Future of the WTO: Unresolved Issues and the Doha Round��

Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: China Limits Exports of Rare Earth Materials��
Endnotes��

Chapter Eight Foreign Direct Investment��

Opening Case: Foreign Direct Investment in Nigeria��
Introduction��
Foreign Direct Investment in the World Economy��

Trends in FDI��
The Direction of FDI��
The Source of FDI��
The Form of FDI: Acquisitions versus Greenfield Investments��

Theories of Foreign Direct Investment��

Why Foreign Direct Investment?��
The Pattern of Foreign Direct Investment��
The Eclectic Paradigm��

Political Ideology and Foreign Direct Investment��

The Radical View��
The Free Market View��
Pragmatic Nationalism��
Shifting Ideology��

Benefits and Costs of FDI��

Host-Country Benefits��
Host-Country Costs��
Home-Country Benefits��
Home-Country Costs��
International Trade Theory and FDI��

Government Policy Instruments and FDI��

Home-Country Policies��
Host-Country Policies��
International Institutions and the Liberalization of FDI��

Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: Foreign Retailers in India��
Endnotes��

Chapter Nine Regional Economic Integration��

Opening Case: Tomato Wars��
Introduction��

Levels of Economic Integration��

The Case for Regional Integration��

The Economic Case for Integration��
The Political Case for Integration��
Impediments to Integration��

The Case against Regional Integration��
Regional Economic Integration in Europe��

Evolution of the European Union��
Political Structure of the European Union��
The Single European Act��
The Establishment of the Euro��
Enlargement of the European Union��

Regional Economic Integration in the Americas��

The North American Free Trade Agreement��
The Andean Community��
Mercosur��
Central American Common Market, CAFTA, and CARICOM��
Free Trade Area of the Americas��

Regional Economic Integration Elsewhere��

Association of Southeast Asian Nations��
Asia-Pacific Economic Cooperation��
Regional Trade Blocs in Africa��

Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: I Want My Greek TV!��
Endnotes��

PART FOUR The Global Monetary System��

Chapter Ten The Foreign Exchange Market��

Opening Case: Embraer and the Wild Ride of the Brazilian Real��
Introduction��
The Functions of the Foreign Exchange Market��

Currency Conversion��
Insuring against Foreign Exchange Risk��

The Nature of the Foreign Exchange Market��
Economic Theories of Exchange Rate Determination��

Prices and Exchange Rates��
Interest Rates and Exchange Rates��
Investor Psychology and Bandwagon Effects��
Summary of Exchange Rate Theories��

Exchange Rate Forecasting��

The Efficient Market School��
The Inefficient Market School��
Approaches to Forecasting��

Currency Convertibility��
Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: The Rise (and Fall) of the Japanese Yen��
Endnotes��

Chapter Eleven The International Monetary System��

Opening Case: The IMF and Iceland's Economic Recovery��
Introduction��
The Gold Standard��

Mechanics of the Gold Standard��
Strength of the Gold Standard��
The Period between the Wars, 1918-1939��

The Bretton Woods System��

The Role of the IMF��
The Role of the World Bank��

The Collapse of the Fixed Exchange Rate System��
The Floating Exchange Rate Regime��

The Jamaica Agreement��
Exchange Rates since 1973��

Fixed versus Floating Exchange Rates��

The Case for Floating Exchange Rates��
The Case for Fixed Exchange Rates��
Who Is Right?��

Exchange Rate Regimes in Practice��

Pegged Exchange Rates��
Currency Boards��

Crisis Management by the IMF��

Financial Crises in the Post-Bretton Woods Era��
Evaluating the IMF's Policy Prescriptions��

Focus on Managerial Implications��
Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: Currency Trouble in Malawi��
Endnotes��

PART FIVE The Strategy of International Business��

Chapter Twelve The Strategy of International Business��

Opening Case: IKEA��
Introduction��
Strategy and the Firm��

Value Creation��
Strategic Positioning��
Operations: The Firm as a Value Chain��

Global Expansion, Profitability, and Profit Growth��

Expanding the Market: Leveraging Products and Competencies��
Location Economies��
Experience Effects��
Leveraging Subsidiary Skills��
Profitability and Profit Growth Summary��

Cost Pressures and Pressures for Local Responsiveness��
Pressures for Cost Reductions��

Pressures for Local Responsiveness��

Choosing a Strategy��

Global Standardization Strategy��
Localization Strategy��
Transnational Strategy��
International Strategy��
The Evolution of Strategy��

Strategic Alliances��

The Advantages of Strategic Alliances��
The Disadvantages of Strategic Alliances��
Making Alliances Work��

Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: Ford's Global Strategy��
Endnotes��

Chapter Thirteen Entering Foreign Markets��

Opening Case: Market Entry at Starbucks��
Introduction��
Basic Entry Decisions��

Which Foreign Markets?��
Timing of Entry��
Scale of Entry and Strategic Commitments��
Market Entry Summary��

Entry Modes��

Exporting��
Turnkey Projects��
Licensing��
Franchising��
Joint Ventures��
Wholly Owned Subsidiaries��

Selecting an Entry Mode��

Core Competencies and Entry Mode��
Pressures for Cost Reductions and Entry Mode��

Greenfield Venture or Acquisition?��

Pros and Cons of Acquisition��
Pros and Cons of Greenfield Ventures��
Greenfield Venture or Acquisition?��

Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: JCB in India��
Endnotes��

PART SIX International Business Functions��

Chapter Fourteen Exporting, Importing, and Countertrade��

Opening Case: Growing Through Exports��
Introduction��
The Promise and Pitfalls of Exporting��
Improving Export Performance��

An International Comparison��
Information Sources��
Utilizing Export Management Companies��
Export Strategy��

Export and Import Financing��

Lack of Trust��
Letter of Credit��
Draft��
Bill of Lading��
A Typical International Trade Transaction��

Export Assistance��

Export-Import Bank��
Export Credit Insurance��

Countertrade��

The Popularity of Countertrade��
Types of Countertrade��
Pros and Cons of Countertrade��

Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: MD International��
Endnotes��

Chapter Fifteen Global Production and Supply Chain Management��

Opening Case: Apple: The Best Supply Chain in the World?��
Introduction��
Strategy, Production, and Supply Chain Management��
Where to Produce��

Country Factors��
Technological Factors��
Production Factors��
The Hidden Costs of Foreign Locations��

Make-or-Buy Decisions��
Global Supply Chain Functions��

Global Logistics��
Global Purchasing��

Managing a Global Supply Chain��

Role of Just-in-Time Inventory��
Role of Information Technology��
Coordination in Global Supply Chains��
Interorganizational Relationships��

Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: H&M: The Retail-Clothing Giant��
Endnotes��

Chapter Sixteen Global Marketing and Research and Development��

Opening Case: Global Branding of Avengers and Iron Man��
Introduction��
Globalization of Markets and Brands��
Market Segmentation��
Product Attributes��

Cultural Differences��
Economic Development��
Product and Technical Standards��

Distribution Strategy��

Differences Between Countries��
Choosing a Distribution Strategy��

Communication Strategy��

Barriers to International Communication��
Push Versus Pull Strategies��
Global Advertising��

Pricing Strategy��

Price Discrimination��
Strategic Pricing��
Regulatory Influences on Prices��

Configuring the Marketing Mix��
International Market Research��
Product Development��

The Location of R&D��
Integrating R&D, Marketing, and Production��
Cross-Functional Teams��
Building Global R&D Capabilities��

Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: Domino's Pizza Worldwide��
Endnotes��

Chapter Seventeen Global Human Resource Management��

Opening Case: The Strategic Role of Human Resources at IBM��
Introduction��
The Strategic Role of International HRM��
Staffing Policy��

Types of Staffing Policy��
Expatriate Managers��
The Global Mindset��

Training and Management Development��

Training for Expatriate Managers��
Repatriation of Expatriates��
Management Development and Strategy��

Performance Appraisal��

Performance Appraisal Problems��
Guidelines for Performance Appraisal��

Compensation��

National Differences in Compensation��
Expatriate Pay��

International Labor Relations��

The Concerns of Organized Labor��
The Strategy of Organized Labor��
Approaches to Labor Relations��

Key Terms��
Summary��
Critical Thinking and Discussion Questions��
Research Task��
Closing Case: MMC China��
Endnotes��

GLOSSARY��
PHOTO CREDITS��
NAME INDEX��
SUBJECT INDEX��

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2. Preflight Ticket Signature