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GlobalBusinessToday.pdf
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11e GLOBAL BUSINESS TODAY
Charles W. L. Hill
University of Washington
G. Tomas M. Hult
Michigan State University
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GLOBAL BUSINESS TODAY, ELEVENTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2020 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2018, 2016, and 2014. 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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1 2 3 4 5 6 7 8 9 LWI 22 21 20 19 ISBN 978-1-260-08837-3 (bound edition) MHID 1-260-08837-5 (bound edition) ISBN 978-1-260-78061-1 (loose-leaf edition) MHID 1-260-78061-9 (loose-leaf edition)
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All credits appearing on page are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data
Names: Hill, Charles W. L., author. | Hult, G. Tomas M., author. Title: Global business today / Charles W.L. Hill, University of Washington, G. Tomas M. Hult, Michigan State University. Description: 11e [edition]. | New York, NY : McGraw-Hill Education, [2020] Identifiers: LCCN 2018050510| ISBN 9781260088373 (alk. paper) | ISBN 1260088375 (alk. paper) Subjects: LCSH: International business enterprises—Management. |
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International trade. | Investments, Foreign. | Capital market. Classification: LCC HD62.4 .H548 2020 | DDC 658/.049—dc23 LC record available at https://lccn.loc.gov/2018050510
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.
mheducation.com/highered
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Page iiiFor my mother June Hill, and the memory of my father, Mike Hill
—Charles W. L. Hill
For Gert & Margareta Hult, my parents
—G. Tomas M. Hult
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about the authors CHARLES W. L. HILL
University of Washington
Charles W. L. Hill is the Hughes M. and Katherine Blake Professor of Strategy and International Business at the Foster School of Business, University of Washington. Professor Hill has taught in the MBA, Executive MBA, Technology Management MBA, Management, and PhD programs at the University of Washington. During his time at the University of Washington, he has received over 25 awards for teaching excellence, including the Charles E. Summer Outstanding Teaching Award. The Foster School is consistently ranked as a Top-25 business school. Learn more about Professor Hill at http://foster.uw.edu/faculty- research/directory/charles-hill.
A native of the United Kingdom, Professor Hill received his PhD from the University of Manchester, UK. In addition to the University of Washington, he has served on the faculties of the University of Manchester, Texas A&M University, and Michigan State University.
Professor Hill has published over 50 articles in top academic journals, including the Academy of Management Journal, Academy of Management Review, Strategic Management Journal, and Organization Science. Professor Hill has also published several textbooks, including International Business (McGraw-Hill) and Global Business Today (McGraw-Hill). His work is among the most widely cited in international business and strategic management.
Beginning in 2014, Dr. Hill partnered with Dr. Tomas Hult in a formidable co-authorship of the International Business franchise of textbooks (International Business and Global Business Today).This brought together two of the most cited international business scholars in history.
Professor Hill works on a private basis with a number of organizations. His clients have included Microsoft, where he has been teaching in-house executive education courses for two decades. He has also consulted for a variety of other large companies (e.g., AT&T Wireless, Boeing, BF Goodrich, Group Health, Hexcel, Microsoft, Philips Healthcare, Philips Medical Systems, Seattle City Light, Swedish Health Services, Tacoma City Light, Thompson Financial Services, WRQ, and Wizards of the Coast). Professor Hill has also served on the advisory board of several start-up companies.
For recreation, Professor Hill enjoys skiing and competitive sailing!
G. TOMAS M. HULT
Michigan State University
Dr. Tomas Hult is Professor of Marketing, Byington Endowed Chair, and Director of the International Business Center in the Department of Marketing in the Eli Broad College of Business at Michigan State University. He also teaches for the Broad College’s Department of Supply Chain Management and Department of Management. Learn more about Professor Hult at http://broad.msu.edu/facultystaff/hult.
A native of Sweden, Dr. Hult received a mechanical engineer degree in Sweden before obtaining Bachelor and MBA degrees in the United States, followed by a PhD at The University
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of Memphis. In addition to Michigan State University, he has served on the faculties of Florida State University and the University of Arkansas at Little Rock. Dr. Hult holds visiting professorships in the International Business Group of his native Uppsala University, Sweden, and the International Business Division of Leeds University, United Kingdom. Michigan State, Uppsala, and Leeds are all ranked in the top 10 in the world in international business research.
Dr. Hult serves as Executive Director and Board Member of the Academy of International Business (AIB), President and Board Member of the Sheth Foundation, and serves on the U.S. District Export Council. Tomas Hult hosts the radio show globalEDGE Business Beat on the Michigan Business Network.
Hult is one of the world’s leading academic authorities (citations, publications) in marketing strategy, international business, international marketing, strategic management, global supply chains, and complex multinational corporations. He is one of only about 100 Elected Fellows of the Academy of International Business, an accolade achieved by only the elite international business scholars. Dr. Hult was also selected in 2016 as the Academy of Marketing Science/CUTCO-Vector Distinguished Marketing Educator.
He regularly speaks at high profile events (e.g., European Commission, Swedish Entrepreneurship Forum, United Nation's Conference on Trade and Development, U.S. Department of Education, World Investment Forum) and publishes influential op-ed articles (e.g., Time, Fortune, Fortune, World Economic Forum, The Conversation). Tomas has developed a large clientele of the world’s top corporations (e.g., ABB, Albertsons, Avon, BG, Bechtel, Bosch, BP, Defense Logistics Agency, Domino’s, FedEx, Ford, FreshDirect, General Motors, GroceryGateway, HSBC, IBM, Michigan Economic Development Corporation, Masco, NASA, Raytheon, Shell, Siemens, State Farm, Steelcase, Tech Data, and Xerox).
In addition to co-authoring with Charles W. L. Hill the market-share leading textbooks in international business (Global Business Today, now in its 11th edition, and International Business, now in its 12th edition), Dr. Hult has written several popular business trade books (e.g., Second Shift; Global Supply Chain Management; Extending the Supply Chain; and Total Global Strategy).
Tennis, golf, and traveling are his favorite recreational activities.
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brief contents PART ONE Introduction and Overview
Chapter One Globalization 2
PART TWO National Differences
Chapter Two National Differences in Political, Economic, and Legal Systems 36
Chapter Three National Differences in Economic Development 58
Chapter Four Differences in Culture 86
Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 122
PART THREE The Global Trade and Investment Environment
Chapter Six International Trade Theory 150
Chapter Seven Government Policy and International Trade 184
Chapter Eight Foreign Direct Investment 212
Chapter Nine Regional Economic Integration 240
PART FOUR The Global Monetary System
Chapter Ten The Foreign Exchange Market 270
Chapter Eleven The International Monetary System 294
PART FIVE The Strategy of International Business
Chapter Twelve The Strategy of International Business 320
Chapter Thirteen Entering Developed and Emerging Markets 356
PART SIX International Business Functions
Chapter Fourteen Exporting, Importing, and Countertrade 382
Chapter Fifteen Global Production and Supply Chain Management 408
Chapter Sixteen Global Marketing and Business Analytics 438
Chapter Seventeen Global Human Resource Management 474
GLOSSARY 503
NAME INDEX 511
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SUBJECT INDEX 513
ACRONYMS 531
COUNTRIES AND THEIR CAPITALS 532
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the proven choice for international business Current. Application Rich, Relevant. Accessible and Student Focused. Global Business Today (GBT), the worldwide market leader among international business products, has set a new standard for international business teaching. We have focused on creating resources that
Are comprehensive, state of the art, and timely. Are theoretically sound and practically relevant. Focus on applications of international business concepts. Tightly integrate the chapter topics throughout. Are fully integrated with results-driven technology. Take full and integrative advantage of globalEDGE.msu.edu—the Google-ranked #1 web resource for “international business resources.”
International Business (now in its 12th edition, 2019), also co-authored by Charles W. L. Hill and G. Tomas M. Hult, is a more comprehensive and case-oriented version that lends itself to the core course in international business for those that want a deeper focus on the global monetary system, structure of international business, international accounting, and international finance.
GBT has always endeavored to be current, relevant, application rich, accessible, and student- focused. Our goal has always been to cover macro and micro issues equally and in a relevant, practical, accessible, and student-focused approach. We believe that anything short of such a breadth and depth of coverage is a serious deficiency. Many of the students in these international business courses will soon be working in global businesses, and they will be expected to understand the implications of international business for their organization’s strategy, structure, and functions in the context of the global marketplace. We are proud and delighted to have put together this international business learning experience for the leaders of tomorrow.
Over the years, and now through 11 editions, Dr. Charles Hill has worked hard to adhere to these goals. Since the ninth edition, Charles’ co-author, Dr. Tomas Hult, has followed the same approach. In deciding what changes to make, we have been guided not only by our own reading, teaching, and research but also by the invaluable feedback we received from professors and students around the world, from reviewers, and from the editorial staff at McGraw-Hill Education. Our thanks go out to all of them.
Comprehensive and Up-to-Date To be relevant and comprehensive, an international business package must
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Explain how and why the world’s cultures, countries, and regions differ. Cover economics and politics of international trade and investment. Tackle international issues related to ethics, corporate social responsibility, and sustainability. Explain the functions and form of the global monetary system. Examine the strategies and structures of international businesses. Assess the special roles of the various functions of an international business.
Relevance and comprehensiveness also require coverage of the major theories. It has always been a goal to incorporate the insights gleaned from recent academic scholarship into the book. Consistent with this goal, insights from the following research, as a sample of theoretical streams used in the book, have been incorporated:
New trade theory and strategic trade policy. The work of Nobel Prize–winning economist Amartya Sen on economic development. Samuel Huntington’s influential thesis on the “clash of civilizations.” Growth theory of economic development championed by Paul Romer and Gene Grossman. Empirical work by Jeffrey Sachs and others on the relationship between international trade and economic growth. Michael Porter’s theory of the competitive advantage of nations. Robert Reich’s work on national competitive advantage. 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 and complementary theories. Paul Samuelson’s critique of free trade theory. Conceptual and empirical work on global supply chain management—logistics, purchasing (sourcing), operations, and marketing channels.
In addition to including leading-edge theory, in light of the fast-changing nature of the international business environment, we have made every effort to ensure that this product is as up-to-date as possible. A significant amount has happened in the world since we began revisions of this book. By 2016, almost $4 trillion per day were flowing across national borders. 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 continued to become more global. As you can see in Chapter 1 on Globalization, trade across country borders has almost exponentially escalated in the last few years. Several Asian economies, most notably China and India, continued to grow their economies at a rapid rate. New multinationals continued to emerge from developing nations in addition to the world’s established industrial powers.
Increasingly, the globalization of the world economy affected a wide range of firms of all sizes, from the very large to the very small. We take great pride in covering international business for small- and medium-sized enterprises (SMEs), as well as larger multinational corporations. We also take great pride in covering firms from all around the world. Some sixty SMEs and multinational corporations from all six core continents are covered in the chapters’ opening cases, closing cases, and/or Management Focus boxes.
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And unfortunately, global terrorism and the attendant geopolitical risks keep emerging in various places globally, many new and inconceivable just a decade ago. These represent a threat to global economic integration and activity. Plus, with the United Kingdom opting to leave the European Union (Brexit), which has implications past 2019, the election of President Donald Trump in the United States (who espouses views on international trade that break with the long established consensus), and several elections around the world, the globe—in many ways—has paid more attention to nationalistic issues over trade. These topics and many more are integrated into this text for maximum learning opportunities.
WHAT’S NEW IN THE 11TH EDITION The success of the first ten editions of Global Business Today (and its longer, more in-depth textbook option and companion, International Business, now in the 12th edition) was based in part on the incorporation of leading-edge research into the text, the use of the up-to-date examples and statistics to illustrate global trends and enterprise strategy, and the discussion of current events within the context of the appropriate theory. Building on these strengths, our goals for the 11th edition have focused on the following:
1. Incorporate new insights from scholarly research. 2. Make sure the content covers all appropriate issues. 3. Make sure the text is up-to-date with current events, statistics, and examples. 4. Add new and insightful opening and closing cases in most chapters.
5. Incorporate value-added globalEDGETM features in every chapter. 6. Connect every chapter to a focus on managerial implications.
As part of the overall revision process, changes have been made to every chapter in the book. All statistics have been updated to incorporate the most recently available data. As before, we provide the only textbook in International Business that ensures that all material is up-to-date on virtually a daily basis. The copyright for the book is 2020, but you are likely using the text somewhere between the years 2019 to 2022. We keep the textbook updated to each semester you use the text in your course! We do this by integrating Connect and globalEDGETM features in every chapter.
Specifically, combining McGraw Hill’s Connect platform with the Google number-one- ranked globaledge.msu.edu site (for “international business resources”), we can add up-to-date materials and exercises to each chapter to add value to the material and provide relevant data and information. This keeps chapter material constantly and dynamically updated for teachers who want to infuse Connect and globalEDGETM material into the chapter topics, and it keeps students abreast of current developments in international business.
In addition to updating all statistics, figures, and maps to incorporate most recently published data, a chapter-by-chapter selection of changes for the 10th edition include the following:
CHAPTER 1: GLOBALIZATION New opening case: GM and Its Chevrolet Supercar, The Corvette ZR1 New materials on international trade, trade agreements, world production, and world population Explanations of differences in cross-border trade and in-country production; the value of trade agreements; and population implications related to resource constraints Revised Management Focus: Boeing’s Global Production System
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Revised Management Focus: Wanda Group New closing case: Globalization of BMW, Rolls-Royce, and the MINI
CHAPTER 2: NATIONAL DIFFERENCES IN POLITICAL, ECONOMIC, AND LEGAL SYSTEMS
New opening case: Transformation in Saudi Arabia New Country Focus: Putin’s Russia Updated data on corruption Updated Country Focus: Corruption in Brazil New closing case: The Decline of Zimbabwe
CHAPTER 3: NATIONAL DIFFERENCES IN ECONOMIC DEVELOPMENT
New opening case: Brazil’s Struggling Economy Updated statistics and discussion in section Differences in Economic Development Updated Country Focus: Property Rights in China Updated statistics and discussion in section States in Transition New closing case: Economic Development in Bangladesh
CHAPTER 4: DIFFERENCES IN CULTURE New opening case: China, Hong Kong, Macau, and Taiwan Deeper treatment of culture, values, and norms Revised the foundation that most religions are now pro-business Updated the Hofstede culture framework with new research New Country Focus: Determining Your Social Class by Birth New Country Focus: Turkey, Its Religion, and Politics New Management Focus: China and Its Guanxi New closing case: The Swatch Group and Cultural Uniqueness
CHAPTER 5: ETHICS, CORPORATE SOCIAL RESPONSIBILITY, AND SUSTAINABILITY
New opening case: Sustainability Initiatives at Natura, the Bodyshop, and Aesop Deeper focus on corporate social responsibility and sustainability at the country, company, and customer levels New Management Focus: “Emissionsgate” at Volkswagen New closing case: Woolworths’s Corporate Responsibility Strategy
CHAPTER 6: INTERNATIONAL TRADE THEORY New opening case: “Trade Wars Are Good and Easy to Win” Discussion of President Donald Trump’s approach to international trade Updated Country Focus: Is China Manipulating Its Currency in Pursuit of a Neo- Mercantilist Policy? New closing case: The Trans Pacific Partnership (TPP) Is Dead; Long Live the CPTPP! Updated Appendix: International Trade and the Balance of Payments with new data and
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revised discussion
CHAPTER 7: GOVERNMENT POLICY AND INTERNATIONAL TRADE
New opening case: U.S. and South Korea Strike a Revised Trade Deal New section: The World Trading System Under Threat, which discusses the potential ramifications of Brexit and the trade policies of the Trump administration New Closing Case: Boeing and Airbus Are in a Dogfight over Illegal Subsidies
CHAPTER 8: FOREIGN DIRECT INVESTMENT New opening case: Geely Goes Global Updated statistics and discussion in the section Foreign Direct Investment in the World Economy New Management Focus: Burberry Shifts Its Entry Strategy in Japan New closing case: FDI in the Indian Retail Sector
CHAPTER 9: REGIONAL ECONOMIC INTEGRATIONS
New opening case: NAFTA 2.0? Extended discussion of Brexit and its ramifications New section The Future of NAFTA, which discusses the renegotiation of NAFTA by the Trump administration New closing case: Free Trade in Africa: TFTA and CFTA
CHAPTER 10: THE FOREIGN EXCHANGE MARKET New opening case: The Fluctuating Value of the Yuan Gives Chinese Business a Lesson in Foreign Exchange Risk New closing case: The Mexican Peso, the Japanese Yen, and Pokemon Go
CHAPTER 11: THE INTERNATIONAL MONETARY SYSTEM
New opening case: Can Dollarization Save Venezuela? Updated statistics discussion of floating exchange rates through to early 2018 New Country Focus: China’s Exchange Rate Regime New Closing Case: Egypt and the IMF
CHAPTER 12: THE STRATEGY OF INTERNATIONAL BUSINESS
New opening case: Red Bull, a Leader in International Strategy Deeper discussion of the rise of regionalism Integration of global strategy thoughts New Management Focus: IKEA’s Global Strategy
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CHAPTER 13: ENTERING DEVELOPED AND EMERGING MARKETS
New opening case: IKEA Entering India, Finally! New scope of the chapter to include entering developed and emerging markets, as well as aspects of less developed markets New closing case: Cutco Corporation—Sharpening Your Market Entry
CHAPTER 14: EXPORTING, IMPORTING, AND COUNTERTRADE
New opening case: Spotify and SoundCloud New material on company readiness to export and import material New and revised material on globalEDGETM Diagnostic Tools, with a focus on Company Readiness to Export (CORE) New Management Focus: Embraer and Brazilian Importing New Management Focus: Exporting Desserts by a Hispanic Entrepreneur New Management Focus: Two Men and a Truck New closing case: Tata Motors and Exporting
CHAPTER 15: GLOBAL PRODUCTION AND SUPPLY CHAIN MANAGEMENT
New opening case: Procter & Gamble Remakes Its Global Supply Chains Revised and new material on global logistics, global purchasing, and global operations Revised sections Strategic Roles for Production Facilities, Make-or-Buy Decisions, and Global Supply Chain Functions New material in the sections Role of Information Technology, Coordination in Global Supply Chains, and Interorganizational Relationships New Management Focus: IKEA Production in China New Management Focus: Amazon’s Global Supply Chains New closing case: Alibaba and Global Supply Chains
CHAPTER 16: GLOBAL MARKETING AND BUSINESS ANALYTICS
New opening case: Fake News and Alternative Facts Revised section Globalization of Markets and Brands New section on Business Analytics; reordered with International Marketing Research to provide a better flow of the chapter material Revised section International Marketing Research Inclusion of more social media topics throughout Revised positioning of the Product Development and R&D section New Management Focus: Global Branding, Marvel Studios, and Walt Disney Company New Management Focus: Burberry’s Social Media Marketing
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New closing case: ACSI and Satisfying Global Customers
CHAPTER 17: GLOBAL HUMAN RESOURCE MANAGEMENT
New opening case: Global Mobility at Shell New section: Building a Diverse Global Workforce, which looks at the benefits, challenges, and policies for building a diverse global workforce in a multinational enterprise New Closing Case: Sodexo: Building a Diverse Global Workforce
Beyond Uncritical Presentation and Shallow Explanation Many issues in international business are complex and thus necessitate considerations of pros and cons. To demonstrate this to students, we have adopted a critical approach that presents the arguments for and against economic theories, government policies, business strategies, organizational structures, and so on.
Related to this, we have attempted to explain the complexities of the many theories and phenomena unique to international business so the student might fully comprehend the statements of a theory or the reasons a phenomenon is the way it is. We believe that these theories and phenomena are explained in more depth in this work than they are in the competition, which seem to use the rationale that a shallow explanation is little better than no explanation. In international business, a little knowledge is indeed a dangerous thing.
Practical and Rich Applications We have always believed that it is important to show students how the material covered in the text is relevant to the actual practice of international business. 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 considers macro topics. Accordingly, at the end of each chapter in Parts Two, Three, and Four—where the focus is on the environment of international business, as opposed to particular firms—there is a section titled Focus on Managerial Implications. In this section, the managerial implications of the material discussed in the chapter are clearly explained. Additionally, most chapters have at least one Management Focus box. The purpose of these boxes is to illustrate the relevance of chapter material for the practice of international business.
A Did You Know? feature in each chapter challenges students to view the world around them through the lens of international business (e.g., Did you know that sugar prices in the United States are much higher than sugar prices in the rest of the world?). The authors recorded short videos explaining the phenomenon.
In addition, each chapter begins with an opening case that sets the stage for the chapter and ends with a closing case that illustrates the relevance of chapter material for the practice of international business.
To help students go a step further in expanding their application-level understanding of international business, each chapter incorporates two globalEDGETM research tasks designed and written by Tomas Hult. The exercises dovetail with the content just covered.
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Integrated Progression of Topics A weakness of many texts is that they lack a tight, integrated flow of topics from chapter to chapter. This book explains to students in Chapter 1 how the book’s topics are related to each other. Integration has been achieved by organizing the material so that each chapter builds on the material of the previous ones in a logical fashion.
PART ONE Chapter 1 provides an overview of the key issues to be addressed and explains the plan of the book. Globalization of markets and globalization of production is the core focus.
PART TWO Chapters 2 through 4 focus on country differences in political economy and culture, and Chapter 5 on ethics, corporate social responsibility, and sustainability issues in international business. Most international business textbooks place this material at a later point, but we believe it is vital to discuss national differences first. After all, many of the central issues in international trade and investment, the global monetary system, international business strategy and structure, and international business functions arise out of national differences in political economy and culture.
PART THREE Chapters 6 through 9 investigate the political economy of global trade and investment. The purpose of this part is to describe and explain the trade and investment environment in which international business occurs.
PART FOUR Chapters 10 and 11 describe and explain the global monetary system, laying out in detail the monetary framework in which international business transactions are conducted.
PART FIVE In Chapters 12 and 13, attention shifts from the environment to the firm. In other words, we move from a macro focus to a micro focus at this stage of the book. We examine strategies that firms adopt to compete effectively in the international business environment.
PART SIX In Chapters 14 through 17, the focus narrows further to investigate business functions and related operations. These chapters explain how firms can perform their key functions— exporting, importing, and countertrade; global production; global supply chain management; global marketing; global research and development (R&D); human resource management—to compete and succeed in the international business environment.
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 integrated whole. We deliberately bring a management focus to the macro chapters (Chapters 1
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through 11). We also integrate macro themes in covering the micro chapters (Chapters 12 through 17).
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Page xiiiAcknowledgments Numerous people deserve to be thanked for their assistance in preparing this book. First, thank you to all the people at McGraw-Hill Education who have worked with us on this project:
Anke Braun Weekes, Executive Brand Manager
Gabriela G. Velasco, Product Developer
Michael Gedatus, Senior Marketing Manager
Brittany Bernholdt, Marketing Coordinator
Mary Powers, Content Project Manager (Core)
Evan Roberts, Content Project Manager (Assessment)
Jennifer Pickel, Senior Buyer
Srdjan Savanovic, Designer
Lori Hancock, Content Licensing Specialist (Image)
DeAnna Dausener, Content Licensing Specialist (Text)
Second, our thanks go to the reviewers who provided good feedback that helped shape this book:
Ratee Apana, University of Cincinnati
Michael Ba Banutu-Gomez, Rowan University – Glassboro New Jersey
Constant Cheng, George Mason University
Jeongho Choi, St. John Fisher College, Rochester, NY
Susan Dragotta, Waukesha County Technical College
Wade Hampton Britt, IV, Drake University
Ralph Haug, Roosevelt University, Schaumburg, IL
Reinhard Janson, University of Texas Arlington
C. Jayachandran, Montclair State University
David Kelson, Ferris State University
Stephanie E. Kontrim-Baumann, Missouri Baptrist University, Saint Louis
Kim LaFevor, Athens State University-Athens, Alabama
Yunshan Lian, University of Wisconsin-Platteville
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Manveer K. Mann, Montclair State University
John P. Marr, Boise State University
Lilac Nachum, Baruch College
J. Timothy Nolan, SUNY Buffalo State
Louis I. Nzegwu, University of Wisconsin-Platteville
Kathy Pennington, San Diego State University
Jim Ryan, Bradley University
Wayne H. Stewart Jr., Clemson University
Vas Taras, University of North Carolina at Greensboro
Siri Terjesen, American U & NHH
William H. Toel, Bradley University – Peoria, Illinois
A special thanks to David Closs and David Frayer for allowing us to borrow elements of the sections on Strategic Roles for Production Facilities; Make-or-Buy Decisions; Global Supply Chain Functions; Coordination in Global Supply Chains; and Interorganizational Relationships for Chapter 15 of this text from Tomas Hult, David Closs, and David Frayer (2014), Global Supply Chain Management, New York: McGraw-Hill.
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contents PART ONE Introduction and Overview
Chapter one Globalization 2
Opening Case: GM and Its Chevrolet Supercar, the Corvette ZR1 3
Introduction 4
What Is Globalization? 6
The Globalization of Markets 6
The Globalization of Production 8
Management Focus: Boeing’s Global Production System 9
The Emergence of Global Institutions 9
Drivers of Globalization 11
Declining Trade and Investment Barriers 11
Role of Technological Change 15
The Changing Demographics of the Global Economy 16
The Changing World Output and World Trade Picture 17
Country Focus: India’s Software Sector 18
The Changing Foreign Direct Investment Picture 18
The Changing Nature of the Multinational Enterprise 20
Management Focus: Wanda Group 21
The Changing World Order 21
Global Economy of the Twenty-First Century 22
The Globalization Debate 23
Antiglobalization Protests 23
Country Focus: Protesting Globalization in France 24
Globalization, Jobs, and Income 24
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Globalization, Labor Policies, and the Environment 26
Globalization and National Sovereignty 28
Globalization and the World’s Poor 28
Managing in the Global Marketplace 30
Summary 31
Critical Thinking and Discussion Questions 32
Research Task 33
Closing Case: Globalization of BMW, Rolls-Royce, and the MINI 33
Endnotes 34
PART TWO National Differences
Chapter Two National Differences in Political, Economic, and Legal Systems 36
Opening Case: Transformation in Saudi Arabia 37
Introduction 38
Political Systems 39
Collectivism and Individualism 39
Democracy and Totalitarianism 41
Country Focus: Putin’s Russia 42
Economic Systems 44
Market Economy 44
Command Economy 45
Mixed Economy 45
Legal Systems 46
Different Legal Systems 46
Differences in Contract Law 47
Property Rights and Corruption 48
Country Focus: Corruption in Brazil 50
Management Focus: Did Walmart Violate the Foreign Corrupt Practices Act? 51
The Protection of Intellectual Property 51
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Management Focus: Starbucks Wins Key Trademark Case in China 53
Product Safety and Product Liability 53
Focus on Managerial Implications:The Macro Environment Influences Market Attractiveness 54
Summary 55
Critical Thinking and Discussion Questions 55
Research Task 55
Closing Case: The Decline of Zimbabwe 56
Endnotes 57
Chapter Three National Differences in Economic Development 58
Opening Case: Brazil’s Struggling Economy 59
Introduction 60
Differences in Economic Development 60
Broader Conceptions of Development: Amartya Sen 64
Political Economy and Economic Progress 65
Innovation and Entrepreneurship are the Engines of Growth 65
Innovation and Entrepreneurship Require a Market Economy 66
Innovation and Entrepreneurship Require Strong Property Rights 66
Country Focus: Property Rights in China 67
The Required Political System 68
Economic Progress Begets Democracy 68
Geography, Education, and Economic Development 68
States in Transition 69
The Spread of Democracy 69
The New World Order and Global Terrorism 72
The Spread of Market-Based Systems 73
The Nature of Economic Transformation 74
Deregulation 74
Country Focus: India’s Economic Transformation 75
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Privatization 76
Legal Systems 76
Implications of Changing Political Economy 77
Focus on Managerial Implications: Benefits, Costs, Risks, and Overall Attractiveness of Doing Business Internationally 78
Summary 82
Critical Thinking and Discussion Questions 82
Research Task 82
Closing Case: Economic Development in Bangladesh 83
Endnotes 84
Chapter Four Differences in Culture 86
Opening Case: China, Hong Kong, Macau, and Taiwan 87
Introduction 88
What Is Culture? 90
Values and Norms 91
Culture, Society, and the Nation-State 92
Determinants of Culture 93
Social Structure 93
Individuals and Groups 94
Social Stratification 96
Country Focus: Determining Your Social Class by Birth 97
Religious and Ethical Systems 98
Christianity 100
Islam 101
Country Focus: Turkey, Its Religion, and Politics 103
Hinduism 104
Buddhism 105
Confucianism 105
Management Focus: China and Its Guanxi 107
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Language 107
Spoken Language 107
Unspoken Language 108
Education 109
Culture and Business 109
Cultural Change 113
Focus on Managerial Implications:Cultural Literacy and Competitive Advantage 114
Summary 116
Critical Thinking and Discussion Questions 117
Research Task 117
Closing Case: The Swatch Group and Cultural Uniqueness 118
Endnotes 119
Chapter Five Ethics, Corporate Social Responsibility, and Sustainability 122
Opening Case: Sustainability Initiatives at Natura, the Bodyshop, and Aesop 123
Introduction 124
Ethics and International Business 126
Employment Practices 126
Management Focus: “Emissionsgate” at Volkswagen 127
Human Rights 127
Environmental Pollution 129
Corruption 130
Ethical Dilemmas 131
Roots of Unethical Behavior 132
Personal Ethics 133
Decision-Making Processes 133
Organizational Culture 133
Unrealistic Performance Goals 134
Leadership 134
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Philosophical Approaches to Ethics 134
Straw Men 135
Utilitarian and Kantian Ethics 137
Rights Theories 138
Justice Theories 139
Focus on Managerial Implications: Making Ethical Decisions Internationally 140
Management Focus: Corporate Social Responsibility at Stora Enso 144
Summary 146
Critical Thinking and Discussion Questions 146
Research Task 147
Closing Case: Woolworths’ Corporate Responsibility Strategy 147
Endnotes 148
PART THREE The Global Trade and Investment Environment
Chapter Six International Trade Theory 150
Opening Case: “Trade Wars are Good and Easy to Win” 151
Introduction 152
An Overview of Trade Theory 153
The Benefits of Trade 153
The Pattern of International Trade 154
Trade Theory and Government Policy 155
Mercantilism 155
Country Focus: Is China Manipulating Its Currency in Pursuit of a Neo-Mercantilist Policy? 156
Absolute Advantage 157
Comparative Advantage 159
The Gains from Trade 159
Qualifications and Assumptions 160
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Extensions of the Ricardian Model 161
Country Focus: Moving U.S. White-Collar Jobs Offshore 164
Heckscher–Ohlin Theory 165
The Leontief Paradox 166
The Product Life-Cycle Theory 167
Product Life-Cycle Theory in the Twenty-First Century 168
New Trade Theory 168
Increasing Product Variety and Reducing Costs 169
Economies of Scale, First-Mover Advantages, and the Pattern of Trade 169
Implications of New Trade Theory 170
National Competitive Advantage: Porter’s Diamond 171
Factor Endowments 172
Demand Conditions 172
Related and Supporting Industries 173
Firm Strategy, Structure, and Rivalry 173
Evaluating Porter’s Theory 174
Focus on Managerial Implications: Location, First-Mover Advantages, and Government Policy 174
Summary 176
Critical Thinking and Discussion Questions 177
Research Task 177
Closing Case: The Trans Pacific Partnership (TPP) Is Dead; Long Live the CPTPP! 177
Appendix: International Trade and the Balance of Payments 179
Endnotes 182
Chapter Seven Government Policy and International Trade 184
Opening Case: U.S. and South Korea Strike a Revised Trade Deal 185
Introduction 186
Instruments of Trade Policy 187
Tariffs 187
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Subsidies 188
Country Focus: Are the Chinese Illegally Subsidizing Auto Exports? 188
Import Quotas and Voluntary Export Restraints 189
Export Tariffs and Bans 190
Local Content Requirements 190
Administrative Policies 191
Antidumping Policies 191
Management Focus: Protecting U.S. Magnesium 192
The Case for Government Intervention 192
Political Arguments for Intervention 192
Economic Arguments for Intervention 195
The Revised Case for Free Trade 197
Retaliation and Trade War 197
Domestic Policies 197
Development of the World Trading System 198
From Smith to the Great Depression 198
1947–1979: GATT, Trade Liberalization, and Economic Growth 199
1980–1993: Protectionist Trends 199
The Uruguay Round and the World Trade Organization 199
WTO: Experience to Date 200
The Future of the WTO: Unresolved Issues and the Doha Round 201
Country Focus: Estimating the Gains from Trade for America 204
Multilateral and Bilateral Trade Agreements 205
The World Trading System under Threat 205
Focus on Managerial Implications: Trade Barriers, Firm Strategy, and Policy implications 206
Summary 208
Critical Thinking and Discussion Questions 209
Research Task 209
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Closing Case: Boeing and Airbus are in a Dogfight over Illegal Subsidies 209
Endnotes 210
Chapter Eight Foreign Direct Investment 212
Opening Case: Geely Goes Global 213
Introduction 214
Foreign Direct Investment in the World Economy 214
Trends in FDI 214
The Direction of FDI 215
The Source of FDI 216
Country Focus: Foreign Direct Investment in China 216
The Form of FDI: Acquisitions versus Greenfield Investments 217
Theories of Foreign Direct Investment 218
Why Foreign Direct Investment? 218
Management Focus: Burberry Shifts Its Entry Strategy in Japan 219
The Pattern of Foreign Direct Investment 221
The Eclectic Paradigm 222
Political Ideology and Foreign Direct Investment 223
The Radical View 223
The Free Market View 224
Pragmatic Nationalism 224
Shifting Ideology 225
Benefits and Costs of FDI 225
Host-Country Benefits 225
Host-Country Costs 228
Home-Country Benefits 229
Home-Country Costs 229
International Trade Theory and FDI 230
Government Policy Instruments and FDI 230
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Home-Country Policies 230
Host-Country Policies 231
International Institutions and the Liberalization of FDI 232
Focus on Managerial Implications: FDI and Government Policy 232
Summary 235
Critical Thinking and Discussion Questions 235
Research Task 236
Closing Case: FDI in the Indian Retail Sector 236
Endnotes 237
Chapter Nine Regional Economic Integration 240
Opening Case: NAFTA 2.0: The USMCA 241
Introduction 242
Levels of Economic Integration 243
The Case for Regional Integration 245
The Economic Case for Integration 245
The Political Case for Integration 245
Impediments to Integration 246
The Case against Regional Integration 246
Regional Economic Integration in Europe 247
Evolution of the European Union 247
Political Structure of the European Union 248
Management Focus: The European Commission and Intel 249
The Single European Act 250
The Establishment of the Euro 251
Enlargement of the European Union 254
Country Focus: The Greek Sovereign Debt Crisis 255
British Exit from the European Union (Brexit) 256
Regional Economic Integration in the Americas 257
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The North American Free Trade Agreement 257
The Andean Community 260
Mercosur 260
Central American Common Market, CAFTA, and CARICOM 261
Regional Economic Integration Elsewhere 262
Association of Southeast Asian Nations 262
Regional Trade Blocs in Africa 262
Other Trade Agreements 264
Focus on Managerial Implications: Regional Economic Integration Threats 264
Summary 266
Critical Thinking and Discussion Questions 267
Research Task 267
Closing Case: Free Trade in Africa: TFTA and CFTA 267
Endnotes 268
PART FOUR The Global Monetary System
Chapter Ten The Foreign Exchange Market 270
Opening Case: The Fluctuating Value of the Yuan gives Chinese Business a Lesson in Foreign Exchange Risk 271
Introduction 272
The Functions of the Foreign Exchange Market 273
Currency Conversion 273
Insuring against Foreign Exchange Risk 275
Management Focus: Embraer and the Gyrations of the Brazilian Real 276
The Nature of the Foreign Exchange Market 277
Economic Theories of Exchange Rate Determination 278
Prices and Exchange Rates 278
Country Focus: Quantitative Easing, Inflation, and the Value of the U.S. Dollar 282
Interest Rates and Exchange Rates 283
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Investor Psychology and Bandwagon Effects 284
Summary of Exchange Rate Theories 284
Exchange Rate Forecasting 285
The Efficient Market School 285
The Inefficient Market School 285
Approaches to Forecasting 285
Currency Convertibility 286
Focus on Managerial Implications: Foreign Exchange Rate Risk 287
Reducing Translation and Transaction Exposure 288
Reducing Economic Exposure 289
Other Steps for Managing Foreign Exchange Risk 289
Summary 290
Critical Thinking and Discussion Questions 291
Research Task 291
Closing Case: The Mexican Peso, the Japanese Yen, and Pokemon Go 292
Endnotes 292
Chapter Eleven The International Monetary System 294
Opening Case: Can Dollarization Save Venezuela? 295
Introduction 296
The Gold Standard 297
Mechanics of the Gold Standard 298
Strength of the Gold Standard 298
The Period between the Wars: 1918–1939 298
The Bretton Woods System 299
The Role of the IMF 299
The Role of the World Bank 300
The Collapse of the Fixed Exchange Rate System 301
The Floating Exchange Rate Regime 302
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The Jamaica Agreement 302
Exchange Rates Since 1973 302
Fixed versus Floating Exchange Rates 305
The Case for Floating Exchange Rates 305
The Case for Fixed Exchange Rates 306
Who Is Right? 307
Exchange Rate Regimes in Practice 307
Pegged Exchange Rates 307
Country Focus: China’s Exchange Rate Regime 308
Currency Boards 309
Crisis Management by the IMF 309
Financial Crises in the Post–Bretton Woods Era 310
Country Focus: The IMF and Iceland’s Economic Recovery 310
Evaluating the IMF’s Policy Prescriptions 312
Focus on Managerial Implications: Currency Management, Business Strategy, and Government Relations 314
Management Focus: Airbus and the Euro 315
Summary 316
Critical Thinking and Discussion Questions 317
Research Task 318
Closing Case: Egypt and the IMF 318
Endnotes 319
PART FIVE The Strategy of International Business
Chapter Twelve The Strategy of International Business 320
Opening Case: Red Bull, A Leader in International Strategy 321
Introduction 322
Strategy and the Firm 323
Value Creation 324
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Strategic Positioning 325
Management Focus: AB InBev, Beer Globally, and Creating Value 326
Operations: The Firm as a Value Chain 327
Global Expansion, Profitability, and Profit Growth 331
Expanding the Market: Leveraging Products and Competencies 331
Location Economies 332
Experience Effects 334
Leveraging Subsidiary Skills 336
Profitability and Profit Growth Summary 336
Cost Pressures and Pressures for Local Responsiveness 337
Pressures for Cost Reductions 337
Pressures for Local Responsiveness 338
Management Focus: IKEA’s Global Strategy 339
Choosing a Strategy 341
Global Standardization Strategy 342
Management Focus: Unilever’s Global Organization 343
Localization Strategy 343
Transnational Strategy 344
International Strategy 345
The Evolution of Strategy 345
Management Focus: Evolution of Strategy at Procter & Gamble 346
Strategic Alliances 347
The Advantages of Strategic Alliances 347
The Disadvantages of Strategic Alliances 348
Making Alliances Work 348
Summary 351
Critical Thinking and Discussion Questions 352
Research Task 352
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Closing Case: Sony Corporation: An International Innovator? 352
Endnotes 353
Chapter Thirteen Entering Developed and Emerging Markets 356
Opening Case: IKEA Entering India, Finally! 357
Introduction 358
Basic Entry Decisions 359
Which Foreign Markets? 359
Timing of Entry 360
Management Focus: Tesco’s International Growth Strategy 361
Scale of Entry and Strategic Commitments 362
Market Entry Summary 363
Management Focus: The Jollibee Phenomenon 364
Entry Modes 364
Exporting 364
Turnkey Projects 365
Licensing 366
Franchising 367
Joint Ventures 368
Wholly Owned Subsidiaries 369
Selecting an Entry Mode 370
Core Competencies and Entry Mode 370
Pressures for Cost Reductions and Entry Mode 372
Management Focus: General Motors on the Upswing 372
Greenfield Venture or Acquisition? 373
Pros and Cons of Acquisitions 373
Pros and Cons of Greenfield Ventures 375
Which Choice? 375
Summary 376
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Critical Thinking and Discussion Questions 377
Research Task 377
Closing Case: Cutco Corporation—Sharpening Your Market Entry 378
Endnotes 379
PART SIX International Business Functions
Chapter Fourteen Exporting, Importing, and Countertrade 382
Opening Case: Spotify and SoundCloud 383
Introduction 384
The Promise and Pitfalls of Exporting 386
Management Focus: Embraer and Brazilian Importing 388
Improving Export Performance 388
International Comparisons 388
Information Sources 389
Management Focus: Exporting Desserts by a Hispanic Entrepreneur 390
Service Providers 391
Export Strategy 391
Management Focus: Two Men and a Truck 392
The globalEDGE™ Exporting Tool 393
Export and Import Financing 394
Lack of Trust 394
Letter of Credit 396
Draft 396
Bill of Lading 397
A Typical International Trade Transaction 397
Export Assistance 398
Export-Import Bank 398
Export Credit Insurance 399
Countertrade 400
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The Popularity of Countertrade 400
Types of Countertrade 401
Pros and Cons of Countertrade 402
Summary 403
Critical Thinking and Discussion Questions 403
Research Task 404
Closing Case: Tata Motors and Exporting 404
Endnotes 405
Chapter Fifteen Global Production and Supply Chain Management 408
Opening Case: Procter & Gamble Remakes Its Global Supply Chains 409
Introduction 410
Strategy, Production, and Supply Chain Management 411
Where to Produce 414
Country Factors 414
Management Focus: IKEA Production in China 414
Technological Factors 415
Production Factors 418
The Hidden Costs of Foreign Locations 420
Management Focus: Amazon’s Global Supply Chains 421
Make-or-Buy Decisions 422
Global Supply Chain Functions 425
Global Logistics 425
Global Purchasing 427
Managing a Global Supply Chain 427
Role of Just-in-Time Inventory 428
Role of Information Technology 429
Coordination in Global Supply Chains 429
Interorganizational Relationships 430
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Summary 432
Critical Thinking and Discussion Questions 433
Research Task 433
Closing Case: Alibaba and Global Supply Chains 434
Endnotes 435
Chapter Sixteen Global Marketing and Business Analytics 438
Opening Case: Fake News and Alternative Facts 439
Introduction 440
Globalization of Markets and Brands 442
Market Segmentation 443
Management Focus: Global Branding, Marvel Studios, and Walt Disney Company 444
Business Analytics 445
International Marketing Research 446
Product Attributes 449
Cultural Differences 449
Economic Development 450
Product and Technical Standards 450
Distribution Strategy 450
Differences Between Countries 451
Choosing a Distribution Strategy 453
Communication Strategy 453
Management Focus: Burberry’s Social Media Marketing 454
Barriers to International Communication 455
Push versus Pull Strategies 456
Global Advertising 457
Pricing Strategy 458
Price Discrimination 458
Strategic Pricing 459
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Regulatory Influences on Prices 460
Configuring the Marketing Mix 461
Product Development and R&D 463
The Location of R&D 463
Integrating R&D, Marketing, and Production 464
Cross-Functional Teams 465
Building Global R&D Capabilities 466
Summary 467
Critical Thinking and Discussion Questions 468
Research Task 469
Closing Case: ACSI and Satisfying Global Customers 469
Endnotes 470
Chapter Seventeen Global Human Resource Management 474
Opening Case: Global Mobility at Shell 475
Introduction 476
Strategic Role of Global HRM: Managing a Global Workforce 477
Staffing Policy 478
Types of Staffing Policies 479
Expatriate Managers 482
Global Mindset 485
Training and Management Development 486
Training for Expatriate Managers 486
Repatriation of Expatriates 487
Management Focus: Monsanto’s Repatriation Program 488
Management Development and Strategy 488
Performance Appraisal 489
Performance Appraisal Problems 489
Guidelines for Performance Appraisal 489
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Compensation 490
National Differences in Compensation 490
Expatriate Pay 490
Management Focus: McDonald’s Global Compensation Practices 491
Building a Diverse Global Workforce 493
International Labor Relations 494
The Concerns of Organized Labor 494
The Strategy of Organized Labor 495
Approaches to Labor Relations 495
Summary 496
Critical Thinking and Discussion Questions 497
Research Task 497
Closing Case: Sodexo: Building a Diverse Global Workforce 498
Endnotes 499
GLOSSARY 503
NAME INDEX 511
SUBJECT INDEX 513
ACRONYMS 531
COUNTRIES AND THEIR CAPITALS 532
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Part 1 Introduction and Overview
Globalization
Learning Object ives After reading this chapter, you will be able to:
LO1-1 Understand what is meant by the term globalization.
LO1-2 Recognize the main drivers of globalization.
LO1-3 Describe the changing nature of the global economy.
LO1-4 Explain the main arguments in the debate over the impact of globalization.
LO1-5 Understand how the process of globalization is creating opportunities and challenges for management practice.
GM and Its Chevrolet Supercar, the Corvette ZR1
opening case The General Motors Company (gm.com), commonly abbreviated as GM (which is also the company’s symbol on the New York Stock Exchange), is an American multinational corporation headquartered in Detroit, Michigan, that designs, manufactures, markets, and distributes vehicles and vehicle parts. GM
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was founded in Flint, Michigan, on September 16, 1908. In addition, to support its auto operations, GM Financial is a wholly owned captive finance subsidiary of General Motors, albeit headquartered in Fort Worth, Texas (and not at the main headquarters location in Detroit).
Interestingly, GM is a large conglomerate with a one-industry focus on automobiles that operates as a holding company for various vehicle brands. Consequently, there are no General Motors, or GM, branded cars. But the company has been around for more than 100 years making vehicles. Today, there are eight distinctive automotive brands under the General Motors umbrella: Chevrolet, Buick, GMC, Cadillac, Holden, Baojun, Wuling, and Jiefang. At one point the company owned more than 20 automobile brands (e.g., Hummer, McLaughlin, Oakland, Oldsmobile, Opel, Pontiac, Saab, Saturn, and Vauxhall).
Within its current brand umbrella, GM is served by about 180,000 employees who speak some 70 different languages, and operate on five continents across 23 time zones. GM delivers about 9 million vehicles via 12,450 dealers in 125 countries annually. China has become critical to GM’s operations as one of the company’s top markets in recent years, now accounting for about 5 million of the 9 million vehicles sold globally on an annual basis. To support this heavy Chinese focus, GM is building an additional five new manufacturing plants in the country (adding to its already strong Chinese presence of 10 joint ventures and two wholly owned enterprises and more than 58,000 employees).
Within GM, the Chevrolet brand, or vehicle line, occupies a distinctive position for its range of car makes. Amazingly, a Chevrolet is sold somewhere in the world every 8.33 seconds! Louis Chevrolet and then ousted GM founder William C. Durant started Chevrolet in 1911 as the Chevrolet Motor Car Company, and it became part of the General Motors Company in 1918. As of today, Chevrolet-branded vehicles are sold in all markets worldwide. Until 2017, Oceania had been an exception since GM had been represented in that part of the world since the 1980s by its Australian subsidiary, Holden. However, GM has also decided to focus its India manufacturing on producing vehicles for export only and will transition its South Africa manufacturing to Isuzu Motors. Consequently, GM’s Chevrolet brand was phased out of both country markets by the end of 2017.
What is not phased out is the Corvette! Chevrolet’s sports car, Corvette, has been around since it was introduced at the GM Motorama at the New York Auto Show in 1953. Myron Scott is credited for naming the sports car after a relatively small, maneuverable warship called a corvette. As any automobile brand, the “Vette” or “Chevy Corvette,” has several different brand designations, and the car models are priced from a low of about $60,000 to a high of $160,000. Uniquely, the Corvette ZR1 was again introduced in 2019 (produced from mid-year 2018). This particular Corvette designation, ZR1, had been in production from 1969–1971, 1990–1995, and 2009–2013 before it again made a comeback in 2019.
“ZR1 has returned to the throne to push the Corvette legacy to its highest point ever. It’s a supercar that’s at once luxurious and overwhelmingly capable, delivering the icon’s fastest, most powerful, most advanced performance in a production Corvette to date. Drivers, hail the new King.” In much of the world, the Chevrolet Corvette is an instantly recognizable sports car. The pinnacle of its lineup is the ZR1, an extraordinary engine and performance pack that dates back to the 1969 model. But for the 2019 model and on, only 2,000 to 3,000 ZR1s are expected to be produced each year. The car has 755 horsepower, does zero to 60 miles per hour (about 97 kmh) in under 2.85 seconds, and has a top speed of 212 mph (about 341 kmh).
The 2019 ZR1’s aerodynamics benefited in design from Corvette’s racing teams that compete in races around the world (e.g., the annual 24 Hours of Le Mans endurance race in France). The new version has more carbon fiber parts than any Corvette before it. This includes an optional high wing rising from the rear deck that generates such a powerful downforce that it had to be mounted on the Vette’s frame since the trunk would buckle under the pressure. The wing is needed to help keep the car planted solidly on the road at speeds where it might otherwise leave the ground.
Given its periodic dormant production within the Chevrolet Corvette product family, the Corvette ZR1 is a global phenomenon. It is the top of the line Corvette, produced in small numbers, and produced only periodically (and not every year as most other cars). The Corvette is a globally recognizable brand that inspires true passion, engagement, and commitment from its owners.
The global branding and a testament to its staying power are nicely exemplified by the first 2019
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Corvette ZR1 having been sold for $925,000 at a Barrett-Jackson auction in Scottsdale, Arizona. It was sold to Rick Hendrick, Chairman of Hendrick Automotive Group and owner of the Hendrick Motorsports NASCAR team. The price was a hefty markup paid to be first to get the new 2019 version of ZR1, since the Corvette ZR1 starts at about $120,000. However, the full sales price benefited the Stephen Siller Tunnel to Towers Foundation—a charitable foundation—and so the high sticker price went to a good cause. • Sources: “Corvette ZR-1: Consider the Pace Set,” Chevrolet, www.chevrolet.com/performance/corvette-zr1-supercar (accessed April 16, 2018); Hannah Elliott, “GM Takes On Ferrari and Lamborghini with the 2019 Corvette ZR1,” Bloomberg BusinessWeek, November 29, 2017; Bradley Brownell, “The First Corvette ZR1 Just Sold For $925,000,” Jalopnik, January 21, 2018; Mark Phelan, “First Look: 2019 Chevy Corvette ZR1 Convertible Is Faster and More Powerful than Ever,” Detroit Free Press, November 29, 2017; David Hollister, Ray Tadgerson, David Closs, and Tomas Hult, “Second Shift: The Inside Story of the Keep GM Movement,” McGraw-Hill Professional, 2016; and Chris Davies, “2019 Corvette ZR1: 5 Fast Facts About Chevy’s New Supercar,” Slash Gear, November 13, 2017.
Introduction Over the past five decades, a fundamental shift has been occurring in the world economy. We have been moving away from a world in which national economies were relatively self- contained entities, isolated from each other by barriers to cross-border trade and investment; by distance, time zones, and language; and by national differences in government regulation, culture, and business systems. As we will see later on in this chapter and throughout the text, international trade across country borders has become the norm, with an almost exponential increase in trade during the last decade.
We are moving toward a world in which barriers to cross-border trade and investment are declining; perceived distance is shrinking due to advances in transportation and telecommunications technology; material culture is starting to look similar the world over; and national economies are merging into an interdependent, integrated global economic system. The process by which this transformation is occurring is commonly referred to as globalization. At the same time, recent political world events (e.g., increase of terrorism in many parts of the world, the United Kingdom leaving the European Union, and elections globally of nationalistic politicians) create tension and uncertainty regarding the future of global trade activities. These political swings usually temper, or even out, over time in democratic societies, and long-term indications generally are for stability in the marketplace. We are unlikely to backtrack on globalization and global companies’ willingness to satisfy the needs and wants of global customers.
For example, as described in the opening case, General Motors and its Chevrolet brand are an illustration of the trend toward the unique opportunities that globalization can present to a company. It is pretty amazing to think that a Chevrolet is sold somewhere in the world every 8.33 seconds! However, it is clear that within GM’s global product portfolio (Chevrolet, Buick, GMC, Cadillac, Holden, Baojun, Wuling, and Jiefang), the Chevrolet brand occupies a distinctive position. People in the U.S. know Chevrolet along with GM’s other core brands (Buick, GMC, and Cadillac) well but have not been exposed so much to Holden, Baojun, Wuling, and Jiefang. GM uses Holden to focus on Oceania and also manufactures and sells numerous Baojun, Wuling, and Jiefang vehicles in the important Chinese market. As we’ve mentioned, five million of GM’s nine million annual vehicle sales are in the Chinese market.
Proponents of increased global trade argue that cross-cultural engagement and trade across country borders is the future and that returning back to a nationalistic perspective is the past. On the other hand, the nationalistic argument rests in citizens wanting their country to be sovereign, self-sufficient as much as possible, and basically in charge of their own economy and country environment. As with any debate, both sides of the argument have merit. We will explore many
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aspects of today’s global marketplace in this text’s 17 integrated and topical chapters.
Globalization now has an impact on almost everything we do. For example, an American medical doctor—let’s call her Laurie—might drive to work at her pediatric office in a sports utility vehicle (SUV) that was designed in Stuttgart, Germany, and assembled in Leipzig, Germany, and Bratislava, Slovakia, by Porsche from components from parts suppliers worldwide, which in turn were fabricated from Korean steel and Malaysian rubber. Laurie may have filled her car with gasoline at a Shell service station owned by a British-Dutch multinational company. 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, Laurie might talk to her stockbroker (using a hands-free, in-car speaker) on an Apple iPhone that was designed in California and assembled in China using chip sets produced in Japan and Europe, glass made by Corning in Kentucky, and memory chips from South Korea. Perhaps on her way Laurie might tell the stockbroker to purchase shares in Lenovo, a multinational Chinese PC manufacturer whose operational headquarters is in North Carolina and whose shares are listed on the New York Stock Exchange.
This is the world in which we live. In many cases we simply do not know or perhaps even care where a product was designed and where it was made. Just a couple of decades ago, “Made in the USA” or “Made in Germany” (or “Made in the United Kingdom” for Charles W. L. Hill, the first author of this textbook, or “Made in Sweden” for G. Tomas M. Hult, the second author of this textbook) had strong meaning and referred to something. The U.S. often stood for quality and Germany often stood for sophisticated engineering. Now the country of origin for a product has given way to, for example, “Made by BMW,” and the company is the quality assurance platform, not the country. In many cases, it goes even beyond the company to the personal relationship a customer has developed with a representative of the company, and so we focus on what has become known as CRM (Customer Relationship Management).
Whether it is still the quality associated with the country of origin of a product, or the assurance given by a specific company regardless of where they manufacture their product, we live in a world where the volume of goods, services, and investments crossing national borders has expanded faster than world output for more than half a century. It is a world in which international institutions such as the World Trade Organization and gatherings of leaders from the world’s most powerful economies continue to work for even lower barriers to cross-border trade and investment. The symbols of material culture and popular culture are increasingly global, from Coca-Cola and Starbucks, to Sony PlayStation, Facebook, Netflix video streaming service, IKEA stores, and Apple iPads and iPhones. Vigorous and vocal groups protest against globalization, which they blame for a list of ills from unemployment in developed nations to environmental degradation and the Westernization or Americanization of local cultures. These protesters come from environmental groups, which have been around for some time, but more recently also from nationalistic groups focused on their countries being more sovereign.
Will the United States Produce Just Services?
The United States has the largest and most technologically powerful economy in the world, with a per capita GDP (gross domestic product) of $57,466. The country’s overall GDP is valued at $18.57 trillion. Most of the labor force (80 percent) is employed in the services sector, with 19 percent employed in manufacturing industries, and only 1 percent in the agricultural area. China, India, and the European Union have labor forces larger than that of the United States. Data show that the United States has
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become much more of a service economy over the years. Will the United States continue to increase its service sector at the cost of manufacturing and agriculture?
Source: U.S. Central Intelligence Agency, World Factbook, 2019. www.cia.gov.
For businesses, the globalization process has many opportunities. Firms can expand their revenues by selling around the world and/or reduce their costs by producing in nations where key inputs, including labor, are cheap. The global expansion of enterprises has been facilitated by generally favorable political and economic trends. 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. Advances in technology, lower transportation costs, and the rise of skilled workers in developing countries imply that many services no longer need to be performed where they are delivered. As best-selling author Thomas Friedman has argued, the world is becoming “flat.”1 People living in developed nations no longer have the playing field tilted in their favor. Increasingly, enterprising individuals based in India, China, or Brazil have the same opportunities to better themselves as those living in Western Europe, the United States, or Canada.
In this text, we will take a close look at these issues and many more. We will explore how changes in regulations governing international trade and investment, when coupled with changes in political systems and technology, have dramatically altered the competitive playing field confronting many businesses. We will discuss the resulting opportunities and threats and review the strategies that managers can pursue to exploit the opportunities and counter the threats. We will consider whether globalization benefits or harms national economies. We will look at what economic theory has to say about the outsourcing of manufacturing and service jobs to places such as India and China and look at the benefits and costs of outsourcing, not just to business firms and their employees but to entire economies. First, though, we need to get a better overview of the nature and process of globalization, and that is the function of this first chapter.
What Is Globalization? LO 1-1 Understand what is meant by the term globalization.
As used in this text, globalization refers to the shift toward a more integrated and interdependent world economy. Globalization has several facets, including the globalization of markets and the globalization of production.
THE GLOBALIZATION OF MARKETS
The globalization of markets refers to the merging of historically distinct and separate national markets into one huge global marketplace. Falling barriers to cross-border trade and investment have made it easier to sell internationally. It has been argued for some time that the tastes and preferences of consumers in different nations are beginning to converge on some global norm, thereby helping create a global market.2 Consumer products such as Citigroup credit cards, Coca-Cola soft drinks, Sony video games, McDonald’s hamburgers, Starbucks coffee, IKEA furniture, and Apple iPhones are frequently held up as prototypical examples of this trend. The firms that produce these products are more than just benefactors of this trend; they are also facilitators of it. By offering the same basic product worldwide, they help create a global market.
A company does not have to be the size of these multinational giants to facilitate, and benefit
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International Business Resources
from, the globalization of markets. In the United States, for example, according to the International Trade Administration, more than 300,000 small- and medium-size firms with fewer than 500 employees export, accounting for 98 percent of the companies that export. More generally, exports from small- and medium-size companies account for 33 percent of the value of U.S. exports of manufactured goods.3 Typical of these is B&S Aircraft Alloys, a New York company whose exports account for 40 percent of its $8 million annual revenues.4 The situation is similar in several other nations. For example, in Germany, a staggering 98 percent of small and midsize companies have exposure to international markets, via either exports or international production. Since 2009, China has been the world’s largest exporter, sending more than $2 trillion worth of products and services last year to the rest of the world.
globalEDGE™ has been the world’s go-to site online for global business knowledge since 2001. Google ranks the site number 1 in the world for “international business resources.” Created by a 30-member team in the International Business Center in the Eli Broad College of Business at Michigan State University under the supervision of Dr. Tomas Hult, Dr. Tunga Kiyak, and Dr. Sarah Singer, globalEDGE™ is a knowledge resource that connects international business professionals worldwide to a wealth of information, insights, and learning resources on global business activities.
The site offers the latest and most comprehensive international business and trade content for a wide range of topics. Whether conducting extensive market research, looking to improve your international knowledge, or simply browsing, you’re sure to find what you need to sharpen your competitive edge in today’s rapidly changing global marketplace. The easy, convenient, and free globalEDGE™ website’s tagline is “Your Source for Global Business Knowledge.” Take a look at the site at globaledge.msu.edu. We will use globalEDGE throughout this text for exercises, information, data, and to keep every facet of the text up-to-date on a daily basis!
Despite the global prevalence of Citigroup credit cards, McDonald’s hamburgers, Starbucks coffee, and IKEA stores, for example, it is important not to push too far the view that national markets are giving way to the global market. As we shall see in later chapters, significant differences still exist among national markets along many relevant dimensions, including consumer tastes and preferences, distribution channels, culturally embedded value systems, business systems, and legal regulations. Uber, for example, the fast-growing ride-for-hire service, is finding that it needs to refine its entry strategy in many foreign cities in order to take differences in the regulatory regime into account. Such differences frequently require companies to customize marketing strategies, product features, and operating practices to best match conditions in a particular country.
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. Treasury 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.
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In many global markets, the same firms frequently confront each other as competitors in nation after nation. Coca-Cola’s rivalry with PepsiCo is a global one, as are the rivalries between Ford and Toyota; Boeing and Airbus; Caterpillar and Komatsu in earthmoving equipment; General Electric and Rolls-Royce in aero engines; Sony, Nintendo, and Microsoft in video-game consoles; and Samsung and Apple in smartphones. If a firm moves into a nation not currently served by its rivals, many of those rivals are sure to follow to prevent their competitor from gaining an advantage.5 As firms follow each other around the world, they bring with them many of the assets that served them well in other national markets—their products, operating strategies, marketing strategies, and brand names—creating some homogeneity across markets. 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 market,” or “the Japanese market”; for many firms, there is only the global market.
THE GLOBALIZATION OF PRODUCTION
The globalization of production refers to the sourcing of goods and services from locations around the globe to take advantage of national differences in the cost and quality of factors of production (such as labor, energy, land, and capital). By doing this, companies hope to lower their overall cost structure or improve the quality or functionality of their product offering, thereby allowing them to compete more effectively. For example, Boeing has made extensive use of outsourcing to foreign suppliers. Consider Boeing’s 777: eight Japanese suppliers make parts for the fuselage, doors, and wings; a supplier in Singapore makes the doors for the nose landing gear; three suppliers in Italy manufacture wing flaps; and so on.6 In total, some 30 percent of the 777, by value, is built by foreign companies. And for its most recent jet airliner, the 787, Boeing has pushed this trend even further; some 65 percent of the total value of the aircraft is outsourced to foreign companies, 35 percent of which goes to three major Japanese companies.
Part of Boeing’s rationale for outsourcing so much production to foreign suppliers is that these suppliers are the best in the world at their particular activity. A global web of suppliers yields a better final product, which enhances the chances of Boeing winning a greater share of total orders for aircraft than its global rival, Airbus. Boeing also outsources some production to foreign countries to increase the chance that it will win significant orders from airlines based in that country. For a more detailed look at the globalization of production at Boeing, see the accompanying Management Focus.
Did You Know? Did you know why your iPhone was assembled in China? It’s not what you might think. Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
Early outsourcing efforts were primarily confined to manufacturing activities, such as those undertaken by Boeing and Apple. Increasingly, however, companies are taking advantage of modern communications technology, particularly the Internet, to outsource service activities to low-cost producers in other nations. 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 Microsoft, now use Indian engineers to perform test functions on software designed in the United States. The time difference allows Indian engineers to run debugging tests on software written in the United States when U.S. engineers sleep, transmitting the corrected code back to the United States over secure Internet connections so it is ready for U.S. engineers to work on the following day. Dispersing value-creation activities in this way can compress the
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time and lower the costs required to develop new software programs. Other companies, from computer makers to banks, are outsourcing customer service functions, such as customer call centers, to developing nations where labor is cheaper. In another example from health care, workers in the Philippines transcribe American medical files (such as audio files from doctors seeking approval from insurance companies for performing a procedure). Some estimates suggest the outsourcing of many administrative procedures in health care, such as customer service and claims processing, could reduce health care costs in America by more than $100 billion.
The economist Robert Reich has argued that as a consequence of the trend exemplified by companies such as Boeing, Apple, and Microsoft, in many cases it is becoming irrelevant to talk about American products, Japanese products, German products, or Korean products. Increasingly, according to Reich, the outsourcing of productive activities to different suppliers results in the creation of products that are global in nature, that is, “global products.”7 But as with the globalization of markets, companies must be careful not to push the globalization of production too far. As we will see in later chapters, substantial impediments still make it difficult for firms to achieve the optimal dispersion of their productive activities to locations around the globe. 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 sheer managerial challenge of coordinating a globally dispersed supply chain (an issue for Boeing with the 787 Dreamliner, as discussed in the Management Focus). For example, government regulations ultimately limit the ability of hospitals to outsource the process of interpreting MRI scans to developing nations where radiologists are cheaper.
test PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
Nevertheless, the globalization of markets and production will probably continue. Modern firms are important actors in this trend, their very actions fostering increased globalization. These firms, however, are merely responding in an efficient manner to changing conditions in their operating environment—as well they should.
m a n a g e m e n t F O C U S
Boeing’s Global Production System
Executives at the Boeing Corporation, America’s largest exporter, say that building a large commercial jet aircraft like the 787 Dreamliner involves bringing together more than a million parts in flying formation. Half a century ago, when the early models of Boeing’s venerable 737 and 747 jets were rolling off the company’s Seattle-area production lines, foreign suppliers accounted for only 5 percent of those parts on average. Boeing was vertically integrated and manufactured many of the major components that went into the planes. 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 Boeing’s super-efficient 787 Dreamliner, 50 outside suppliers spread around the world account for 65 percent of the value of the
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aircraft. Italian firm Alenia Aeronautica makes the center fuselage and horizontal stabilizer. Kawasaki of Japan makes part of the forward fuselage and the fixed trailing edge of the wing. French firm Messier-Dowty makes the aircraft’s landing gear. German firm Diehl Luftahrt Elektronik supplies the main cabin lighting. Sweden’s Saab Aerostructures makes the access doors. Japanese company Jamco makes parts for the lavatories, flight deck interiors, and galleys. Mitsubishi Heavy Industries of Japan makes the wings. KAA of Korea makes the wing tips. And so on.
Why the change? One reason is that 80 percent of Boeing’s customers are foreign airlines, and to sell into those nations, it often helps to be giving business to those nations. 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 world-class expert in sturdy but light carbon-fiber composites, to supply materials for the fuselage. A third reason for the extensive outsourcing on the 787 was that Boeing wanted to unburden itself of some of the risks and costs associated with developing production facilities for the 787. By outsourcing, it pushed some of those risks and costs onto suppliers, who had to undertake major investments in capacity to ramp up to produce for the 787.
So what did Boeing retain for itself? Engineering design, marketing and sales, and final assembly are done at its Everett plant north of Seattle, all activities where Boeing maintains it is the best in the world. Of major component parts, Boeing made only the tail fin and wing to body fairing (which attaches the wings to the fuselage of the plane). Everything else was outsourced.
As the 787 moved through development, it became clear that Boeing had pushed the outsourcing paradigm too far. Coordinating a globally dispersed production system this extensive turned out to be very challenging. Parts turned up late, some parts didn’t “snap together” the way Boeing had envisioned, and several suppliers ran into engineering problems that slowed down the entire production process. As a consequence, the date for delivery of the first jet was pushed back more than four years, and Boeing had to take millions of dollars in penalties for late deliveries. 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 executives also note that Boeing has lost much of its expertise in wing production over the last 20 years due to outsourcing, and bringing it back in-house for new carbon-fiber wings might enable Boeing to regain these important core skills and strengthen the company’s competitive position.
Sources: M. Ehrenfreund, “The Economic Reality Behind the Boeing Plane Trump Showed Off,” The Washington Post, February 17, 2017; K. Epstein and J. Crown, “Globalization Bites Boeing,” Bloomberg Businessweek, March 12, 2008; H. Mallick, “Out of Control Outsourcing Ruined Boeing’s Beautiful Dreamliner,” 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.
The Emergence of Global Institutions
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As markets globalize and an increasing proportion of business activity transcends national borders, institutions are needed to help manage, regulate, and police the global marketplace and to promote the establishment of multinational treaties to govern the global business system. Over the past half-century, a number of important global institutions have been created to help perform these functions, including the General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization; the International Monetary Fund and its sister institution, the World Bank; and the United Nations. All these institutions were created by voluntary agreement between individual nation-states, and their functions are enshrined in international treaties.
The World Trade Organization (WTO) (like the GATT before it) is primarily responsible for policing the world trading system and making sure nation-states adhere to the rules laid down in trade treaties signed by WTO member states. As of 2017, 164 nations that collectively accounted for 98 percent of world trade were WTO members, thereby giving the organization enormous scope and influence. 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 production is unlikely to have proceeded as far as it has. However, as we shall see in this chapter and in Chapter 7 when we look closely at the WTO, critics charge that the organization is usurping the national sovereignty of individual nation-states.
Can the International Court of Justice Be Effective?
The International Court of Justice (www.icj-cij.org) is the principal judicial organ of the United Nations (UN). Of the six principal organs of the UN, it is the only one not located in New York (United States); instead, the seat of the Court is at the Peace Palace in 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 specialized agencies. But how effective can the UN International Court of Justice really be in the global marketplace with its many legal systems?
Source: www.icj-cij.org/en/court.
The International Monetary Fund (IMF) and the World Bank were both created in 1944 by 44 nations that met at Bretton Woods, New Hampshire. The IMF was established to maintain order in the international monetary system; the World Bank was set up to promote economic development. In the more than seven decades since their creation, both institutions have emerged as significant players in the global economy. The World Bank is the less controversial of the two sister institutions. It has focused on making low-interest loans to cash-strapped governments in poor nations that wish to undertake significant infrastructure investments (such as building dams or roads).
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 troubled states including Argentina, Indonesia, Mexico, Russia, South Korea, Thailand, and Turkey. More recently, the IMF took a proactive role in helping countries cope with some of the effects of the 2008–2009
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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 governments what economic policies they must adopt, the IMF, like the WTO, is usurping the sovereignty of nation-states. We will look at the debate over the role of the IMF in Chapter 11.
The United Nations (UN) was established October 24, 1945, by 51 countries committed to preserving peace through international cooperation and collective security. Today, nearly every nation in the world belongs to the United Nations; membership now totals 193 countries. When states become members of the United Nations, they agree to accept the obligations of the UN Charter, an international treaty that establishes basic principles of international relations. According to the charter, the UN has four purposes: to maintain international peace and security, to develop friendly relations among nations, to cooperate in solving international problems and in promoting respect for human rights, and to be a center for harmonizing the actions of nations. Although the UN is perhaps best known for its peacekeeping role, one of the organization’s central mandates is the promotion of higher standards of living, full employment, and conditions of economic and social progress and development—all issues that are central to the creation of a vibrant global economy. As much as 70 percent of the work of the UN system is devoted to accomplishing this mandate. To do so, the UN works closely with other international institutions such as the World Bank. Guiding the work is the belief that eradicating poverty and improving the well-being of people everywhere are necessary steps in creating conditions for lasting world peace.8
Another institution in the news is the Group of Twenty (G20). Established in 1999, the G20 comprises the finance ministers and central bank governors of the 19 largest economies in the world, plus representatives from the European Union and the European Central Bank. Collectively, the G20 represents 90 percent of global GDP and 80 percent of international global trade. Originally established to formulate a coordinated policy response to financial crises in developing nations, in 2008 and 2009 it became the forum through which major nations attempted to launch a coordinated policy response to the global financial crisis that started in America and then rapidly spread around the world, ushering in the first serious global economic recession since 1981.
How Important is the European Union Among the Group of Twenty (G20)?
There have been twelve G20 Leaders’ Summits since they started in 2008. The Group of Twenty includes 19 prominent countries and the European Union (Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, United States, and the European Union). G20 members represent about 85 percent of global GDP, 80 percent of global trade, and about two-thirds of the world’s population. Now, is it really right for the G20 to include 19 countries and one union entity (the European Union), or should the European Union countries be selected individually (as some already are)?
Source: www.g20.org/en.
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Drivers of Globalization LO 1-2 Recognize the main drivers of globalization.
Two macro factors underlie the trend toward greater globalization.9 The first is the decline in barriers to the free flow of goods, services, and capital that has occurred in recent decades. The second factor is technological change, particularly the dramatic developments in communication, information processing, and transportation technologies.
DECLINING TRADE AND INVESTMENT BARRIERS
During the 1920s and 1930s, many of the world’s nation-states erected formidable barriers to international trade and foreign direct investment. International trade occurs when a firm exports goods or services to consumers in another country. Foreign direct investment (FDI) occurs when a firm invests resources in business activities outside its home country. Many of the barriers to international trade took the form of high tariffs on imports of manufactured goods. 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 demand and contributed to the Great Depression of the 1930s.
Having learned from this experience, the advanced industrial nations of the West committed themselves after World War II to progressively reducing barriers to the free flow of goods, services, and capital among nations.10 This goal was enshrined in the General Agreement on Tariffs and Trade. Under the umbrella of GATT, eight rounds of negotiations among member states worked to lower barriers to the free flow of goods and services. The first round of negotiations went into effect in 1948. 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.11 Table 1.1 summarizes the impact of GATT agreements on average tariff rates for manufactured goods among several developed nations. As can be seen, average tariff rates have fallen significantly since 1950 and now stand at about 2.0–3.0 percent. Comparable tariff rates in 2017 for China and India were about 8 percent. However, it should be noted that while the long term trend has been towards lower tariff rates, it is possible that recent increases in tariff rates imposed by the Trump Administration in the U.S. could signify a reversal of this trend.
1.1 TABLE
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Average Tariff Rates on Manufactured Products as Percentage 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. The 2017 data are from the World Development Indicators, World Bank.
Knowledge Society and Trade Agreements Figure 1.1 reports on the value of world trade, world production, and active regional trade agreements in the world along with the world population from 1960 to 2020 (the last three years being forecast data). Trade and production are indexed to 100 in 1960 (the index calculation is based on current prices and not adjusted for inflation). The figure illustrates some interesting changing globalization trends. For example, according to the World Trade Organization, the value of world trade in merchandised goods has grown consistently faster than the world economy since 1960, and the chart shows that this growth has been markedly higher since the turn of the century (note that the index values in the chart are based on current prices, and are not adjusted for inflation).
1.1 FIGURE
Index value of world trade and world production (1960=100), world population (billions), and number of regional trade agreements.
Sources: World Bank, 2018; World Trade Organization, 2018; United Nations, 2018.
As a consequence, when adjusted for inflation, by 2020 the value of world trade is expected to be around 21 times larger than it was in 1960, whereas the world economy will be around 9.3 times larger. This trend has continued into the modern era. Between 2000 and 2017, the value of world trade increased 98 percent whereas the world economy has increased by 74 percent in real terms (adjusted for inflation). The forecast is that world trade will continue to increase more rapidly than world production for the foreseeable future.
The difference in the growth rates of world production and world trade is why studying international business is so important. While we produce more goods and services today compared with before, a far greater proportion of that production is being traded across national borders than at any time in modern history. Moreover, the knowledge society that we live in has resulted in consumers knowing more than ever about goods and services being produced worldwide. From a customer perspective, this is driving demand for internationally traded goods. Thus, the larger the difference between the growth rates of world trade and world
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Page 13 production, the greater the extent of globalization and the more important it becomes to understand international business.
Additionally, despite the recent wave of nationalism around the world (e.g., Brexit, the 2016 U.S. presidential election), many countries have been progressively removing restrictions to foreign direct investment over the past 20 years. According to the United Nations, some 80 percent of the 1,440 changes made worldwide since 2000 in the laws governing foreign direct investment created a more favorable environment for FDI. Basically, the pressure from customers to make available any goods and services anywhere for their needs and wants has been facilitated by country governments removing restrictions on imports to their countries.
Such customer pressures and restrictions removal by countries have been driving both the globalization of markets and the globalization of production. 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.
Another important facilitator of trade across country borders is the increased number of trade agreements that have been implemented in the world. Figure 1.1 reports on regional trade agreements in force today (more than two countries involved), with another roughly 300 bilateral trade agreements between two countries also active worldwide. There is no doubt that trade at least between the countries in a trade agreement has been a strong reason for the increase overall in world trade. Figure 1.1 illustrates the almost 1:1 match of the trade agreement and world trade curves on the chart. That is, as regional trade agreements in force increase year- by-year, so does world trade across country borders at the same pace.
Two additional implications can be gleaned from the data in Figure 1.1 that could become important for the global marketplace. These are illustrated in separate charts in Figure 1.2. The first implication relates to sustainability—a topic we will cover much more in Chapter 5. In 2000, the United Nations established the Millennium Development Goals to reduce the number of people who live in extreme poverty by 2015. Subsequently, in September 2015, the United Nations and its 193 member countries ratified the Sustainable Development Goals that set targets to end poverty, protect the planet, and ensure prosperity for all countries by 2030 as part of a new sustainability agenda.12 The urgency of delivering on the UN’s Sustainable Development Goals can be traced to the difference between the world production and population data. As world production approaches the total population curve, we can infer that resource availability for all of our needs and wants in the world’s 260 countries and territories will potentially be drastically constrained.
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1.2 FIGURE
Comparisons of index of world trade and world population; index of world trade and number of regional trade agreements; world population and index of world production; and world population and index of world trade (index 1960 = 100).
Sources: World Bank, 2019; World Trade Organization, 2018; United Nations, 2018.
©Ariel Skelley/Blend Images LLC
The chart in Figure 1.1 also indicates that our needs worldwide are still rather “spiky” and not as flat as Tom Friedman projected in 2004. Trading across country borders is significantly more pronounced today than ever before, growing at a rate above the population growth of the world. These two curves are likely to not intersect any time soon, and coupled with the large difference between world trade and world production, especially in the last 20 years, we will see a world consumer market where localized needs and wants are still very much unique in a large set of industries and product categories. Overall, though, the fact that the volume of world trade has been growing faster than world GDP implies several things.
The fact that the volume of world trade has been growing faster than world GDP implies
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several things. First, more firms are doing what Boeing does with the 777 and 787: dispersing parts of their production process to different locations around the globe to drive down production costs and increase product quality. Second, the economies of the world’s nation- states are becoming ever more intertwined. As trade expands, nations are becoming increasingly dependent on each other for important goods and services. Third, the world has become significantly wealthier in the last two decades. The implication is that rising trade is the engine that has helped pull the global economy along.
Evidence also suggests that foreign direct investment is playing an increasing role in the global economy as firms increase their cross-border investments. The average yearly outflow of FDI increased from $14 billion in 1970 to about $1.5 trillion today, audited by the United Nations Conference on Trade and Development (UNCTAD).13 As a result of the strong FDI flow, the global stock of FDI is about $28 trillion. More than 80,000 parent companies had more than 800,000 affiliates in foreign markets that collectively employed more than 75 million people abroad and generated value accounting for about 11 percent of global GDP. The foreign affiliates of multinationals had $36 trillion in global sales, higher than the value of global exports of goods and services, which stood at close to $23.4 trillion.14
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 industry 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.
ROLE OF TECHNOLOGICAL CHANGE
The lowering of trade barriers made globalization of markets and production a theoretical possibility. Technological change has made it a tangible reality. Every year that goes by comes with unique and oftentimes major advances in communication, information processing, and transportation technology, including the explosive emergence of the “Internet of Things.”
Communications Perhaps the single most important innovation since World War II has been the development of the microprocessor, which enabled the explosive growth of high-power, low-cost computing, vastly increasing the amount of information that can be processed by individuals and firms. 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, wireless technologies, and of course the Internet. These technologies rely on the microprocessor to encode, transmit, and decode the
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vast amount of information that flows along these electronic highways. The cost of microprocessors continues to fall, while their power increases (a phenomenon known as Moore’s law, which predicts that the power of microprocessor technology doubles and its cost of production falls in half every 18 months).15
The Internet The explosive growth of the Internet since 1994, when the first web browser was introduced, has revolutionized communications and commerce. In 1990, fewer than 1 million users were connected to the Internet. By 1995, the figure had risen to 50 million. By 2017, the Internet had 3.8 billion users, or 51 percent of the global population.16 Thus, 2017 marked the first year that more than half of the world’s population were Internet users. It is no surprise that the Internet has developed into the information backbone of the global economy.
In North America alone, e-commerce retail sales will surpass $520 billion in 2020 (up from almost nothing in 1998), while global e-commerce sales surpassed $2 trillion for the first time in 2017.17 Viewed globally, the Internet has emerged as an equalizer. It rolls back some of the constraints of location, scale, and time zones.18 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 technology, several major innovations in transportation technology have occurred since the 1950s. In economic terms, the most important are probably the development of commercial jet aircraft and superfreighters and the introduction of containerization, which simplifies transshipment from one mode of transport to another. 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 responsible for carrying about 90 percent of the volume of world trade in goods, this has been an extremely important development.19 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 longshore workers to unload a ship and reload goods onto trucks and trains. With the advent of widespread containerization in the 1970s and 1980s, the whole process can now be executed by a handful of longshore workers in a couple of days. As a result of the efficiency gains associated with containerization, transportation costs have plummeted, making it much more economical to ship goods around the globe, thereby helping drive the globalization of markets and production. Between 1920 and 1990, the average ocean freight and port charges per ton of U.S. export and import cargo fell from $95 to $29 (in 1990 dollars).20 Today, the typical cost of transporting a 20-foot container from Asia to Europe carrying more than 20 tons of cargo is about the same as the economy airfare for a single passenger on the same journey.
Implications for the Globalization of Production As transportation costs associated with the globalization of production have declined, dispersal of production to geographically separate locations has become more economical. As a result of the technological innovations discussed earlier, the real costs of information processing and communication have fallen dramatically in the past two decades. 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
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businesses. For example, Dell uses the Internet to coordinate and control a globally dispersed production system to such an extent that it holds only three days’ worth of inventory at its assembly locations. Dell’s Internet-based system records orders for computer equipment as they are submitted by customers via the company’s website and then immediately transmits the resulting orders for components to various suppliers around the world, which have a real-time look at Dell’s order flow and can adjust their production schedules accordingly. Given the low cost of airfreight, Dell can use air transportation to speed up the delivery of critical components to meet unanticipated demand shifts without delaying the shipment of final product to consumers. Dell has also used modern communications technology to outsource its customer service operations to India. When U.S. customers call Dell with a service inquiry, they are routed to Bangalore in India, where English-speaking service personnel handle the call.
Implications for the Globalization of Markets In addition to the globalization of production, technological innovations have facilitated the globalization of markets. Low-cost global communications networks, including those built on top of the Internet, are helping create electronic global marketplaces. As noted earlier, low-cost transportation has made it more economical to ship products around the world, thereby helping create global markets. In addition, low-cost jet travel has resulted in the mass movement of people between countries. This has reduced the cultural distance between countries and is bringing about some convergence of consumer tastes and preferences. At the same time, global communications networks and global media are creating a worldwide culture. U.S. television networks such as CNN and HBO are now received in many countries, Hollywood films are shown the world over, while non-U.S. news networks such as the BBC and Al Jazeera also have a global footprint. In any society, the media are primary conveyors of culture; as global media develop, we must expect the evolution of something akin to a global culture. A logical result of this evolution is the emergence of global markets for consumer products. Clear signs of this are apparent. It is now as easy to find a McDonald’s restaurant in Tokyo as it is in New York, to buy an iPad in Rio as it is in Berlin, and to buy Gap jeans in Paris as it is in San Francisco.
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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
LO 1-3 Describe the changing nature of the global economy.
Hand in hand with the trend toward globalization has been a fairly dramatic change in the demographics of the global economy over the past decades. Half a century ago, four facts described the demographics of the global economy. 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, multinational U.S. firms
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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 Western international businesses. All four of these facts have changed rapidly.
THE CHANGING WORLD OUTPUT AND WORLD TRADE PICTURE
In the early 1960s, the United States was still by far the world’s dominant industrial power. In 1960, the United States accounted for 38.3 percent of world output, measured by gross domestic product (GDP). By 2018, the United States accounted for 24 percent of world output, with China now at 15.2 percent of world output and the global leader in this category (see Table 1.2). The United States was not the only developed nation to see its relative standing slip. The same occurred to Germany, France, Italy, the United Kingdom, and Canada—as just a few examples. These were all nations that were among the first to industrialize globally.
1.2 TABLE Changing Demographics of World Output and World Exports
Sources: Output data from World Bank database, 2019. Trade data from WTO Statistical Database, 2019.
Of course, the change in the U.S. position was not an absolute decline because the U.S. economy grew significantly between 1960 and 2018 (the economies of Germany, France, Italy, the United Kingdom, and Canada also grew during this time). Rather, it was a relative decline, reflecting the faster economic growth of several other economies, particularly China as well as several other nations in Asia. For example, as can be seen from Table 1.2, from 1960 to today, China’s share of world output increased from a trivial amount to 15.2 percent, making it the world’s second largest economy in terms of its share in world output (the U.S. is still the largest economy overall). Other countries that markedly increased their share of world output 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 being challenged. Over the past 30 years, U.S. dominance in export markets has waned as Japan, Germany, and a number of newly industrialized countries such as South Korea and China have taken a larger share of world exports. During the 1960s, the United States routinely accounted for 20 percent of world exports of manufactured goods. But as Table 1.2 shows, the U.S. share of world exports of goods and services has slipped to 8.2 percent, significantly behind that of China.
As emerging economies such as Brazil, Russia, India, and China—coined the BRIC countries —continue to grow, a further relative decline in the share of world output and world exports accounted for by the United States and other long-established developed nations seems likely.
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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 continued 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 industrialized countries such as the United Kingdom, Germany, Japan, and the United States. The United Kingdom, in particular, presents an interesting case study with Britain’s exit from the European Union (Brexit) looming. Perhaps more important, if current trends continue, the Chinese economy could ultimately be larger than that of the United States on a purchasing power parity basis as well, while the economy of India will become the third largest by 2030.21
Overall, the World Bank has estimated that today’s developing nations may account for more than 60 percent of world economic activity by 2025, while today’s rich nations, which currently account for more than 55 percent of world economic activity, may account for only about 38 percent. Forecasts are not always correct, but these suggest that a shift in the economic geography of the world is now under way, although the magnitude of that shift is not totally evident. For international businesses, the implications of this changing economic geography are clear: Many of tomorrow’s economic opportunities may be found in the developing nations of the world, and many of tomorrow’s most capable competitors will probably also emerge from these regions. A case in point has been the dramatic expansion of India’s software sector, which is profiled in the accompanying Country Focus.
c o u n t r y F O C U S
India’s Software Sector Some 30 years ago, a number of small software enterprises were established in Bangalore, India. Typical of these enterprises was Infosys Technologies, which was started by seven Indian entrepreneurs with about $1,000 among them. Infosys now has annual revenues of $10.2 billion and some 200,000 employees, but it is just one of more than 100 software companies clustered around Bangalore, which has become the epicenter of India’s fast-growing information technology sector. From a standing start in the mid-1980s, this sector is now generating export sales of more than $100 billion.
The growth of the Indian software sector has been based on four factors. First, the country has an abundant supply of engineering talent. Every year, Indian universities graduate some 400,000 engineers. Second, labor costs in the Indian software sector have historically been low. As recently as 2008, the cost to hire an Indian graduate was roughly 12 percent of the cost of hiring an American graduate (however, this gap is narrowing fast with pay in the sector now only 30–40 percent less than in the United States). 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, creating unique time efficiencies and an around-the-clock work environment.
Initially, Indian software enterprises focused on the low end of the software industry, supplying basic software development and testing services to Western firms. But as the industry has grown in size and sophistication, Indian firms have moved up the market. Today, the leading Indian companies compete directly with the likes of IBM and EDS for large software development projects, business process outsourcing contracts, and information technology consulting services. Over the past 15 years, these markets have boomed, with Indian enterprises capturing a large slice of the pie. One response of Western firms to this emerging competitive threat has been to invest in India to garner the same kind of economic advantages that Indian firms enjoy. IBM, for example, has invested $2 billion in its Indian operations and now has 150,000 employees located there, more than in any other country. Microsoft,
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too, has made major investments in India, including a research and development (R&D) center in Hyderabad that employs 4,000 people and was located there specifically to tap into talented Indian engineers who did not want to move to the United States.
Sources: “Ameerpet, India’s Unofficial IT Training Hub,” The Economist, March 30, 2017; “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.
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.22 Several European governments, most notably France, talked of limiting inward investment by U.S. firms.
However, as the barriers to the free flow of goods, services, and capital fell, and as other countries increased their shares of world output, non-U.S. firms increasingly began to invest across national borders. The motivation for much of this foreign direct investment by non-U.S. firms was the desire to disperse production activities to optimal locations and to build a direct presence in major foreign markets. Thus, beginning in the 1970s, European and Japanese firms began to shift labor-intensive manufacturing operations from their home markets to developing nations where labor costs were lower. In addition, many Japanese firms invested in North America and Europe—often as a hedge against unfavorable currency movements and the possible imposition of trade barriers. For example, Toyota, the Japanese automobile company, rapidly increased its investment in automobile production facilities in the United States and Europe during the late 1980s and 1990s. Toyota executives believed that an increasingly strong Japanese yen would price Japanese automobile exports out of foreign markets; therefore, production in the most important foreign markets, as opposed to exports from Japan, made sense. Toyota also undertook these investments to head off growing political pressures in the United States and Europe to restrict Japanese automobile exports into those markets.
One consequence of these developments is illustrated in Figure 1.3, which shows how the stock of foreign direct investment by the United States, China, Japan, United Kingdom, European Union countries, Developed Economies, and the World changed between 1995 and today. (The stock of foreign direct investment (FDI) refers to the total cumulative value of foreign investments as a percentage of the country’s GDP.) As expected, in all cases in Figure 1.3, we invest more today outside of our own country than we did in 1995. For example, in 1995 the stock of FDI held by U.S. firms was equivalent to 17.8 percent of U.S. GDP; today the figure is 34.4 percent. Collectively, the global stock of FDI is now equal to 34.6% of global GDP, an increase from 12.8% in 1995. Bottom line, the world is becoming more globalized in investment mentality and opportunities are no longer as restricted to the home country of a firm as they used to be even as recently as 1995.
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1.3 FIGURE Share of FDI outward stock as a percentage of GDP.
Sources: OECD data 2017, FDI stocks.
Figure 1.4 illustrates two other important trends—the sustained growth in cross-border flows of foreign direct investment that has occurred since 1990 and the increasing importance of developing nations as the destination of foreign direct investment. 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 2004, 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 at “normal” levels for that time in 2005 and continued upwards through 2007, when it hit record levels, only to slow again in 2008 and 2009 as the global financial crisis took hold. However, throughout this period, the growth of foreign direct investment into developing nations remained robust. Among developing nations, the largest recipient has been China, which received about $250 billion in inflows last year. As we shall see later in this text, the sustained flow of foreign investment into developing nations is an important stimulus for economic growth in those countries, which bodes well for the future of countries such as China, Mexico, and Brazil —all leading beneficiaries of this trend.
1.4 FIGURE FDI inflows (in millions of dollars).
Source: United Nations Conference on Trade and Development, World Investment Report 2018. (Data for 2019– 2020 are forecast.)
THE CHANGING NATURE OF THE MULTINATIONAL ENTERPRISE
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A multinational enterprise (MNE) is any business that has productive activities in two or more countries. In the last half a century, two notable trends in the demographics of the multinational enterprise have been (1) the rise of non-U.S. multinationals and (2) the growth of mini- multinationals.
Non-U.S. Multinationals In the 1960s, global business activity was dominated by large U.S. multinational corporations. With U.S. firms accounting for about two-thirds of foreign direct investment during the 1960s, one would expect most multinationals to be U.S. enterprises. According to the data summarized in Figure 1.5, in 2003 when Forbes started compiling its ranking of the top 2000 multinational corporations, 38.8 percent of the world’s 2000 largest multinationals were U.S. firms (776 of the 2000 on the list). The second-largest source country was Japan with 16.6 percent of the largest multinationals. The United Kingdom accounted for 6.6 percent of the world’s largest multinationals at the time. The large number of U.S. multinationals has long reflected U.S. economic dominance in the half a century after World War II, while the large number of British multinationals reflected that country’s industrial dominance in the early decades of the twentieth century, which has carried on to some degree until today.
1.5 FIGURE National share of largest multinational corporations.
Source: Forbes Global 2000 in 2003 and 2017.
By now, things have shifted. Some 27 percent, or 540 firms, of the top 2000 global firms are now U.S. multinationals, a drop of 236 firms among the top 2000 global firms in only about a decade and a half. Japan and the United Kingdom also saw drops in their firms’ inclusion among the top 2000 firms in the world.
These shifts in powerful multinational corporations and their home bases can be expected to continue. Specifically, we expect that even firms from developing nations will emerge as important competitors in global markets, further shifting the axis of the world economy away from North America and Western Europe and challenging the long dominance of companies from the so-called developed world. One such rising competitor, the Dalian Wanda Group, is profiled in the accompanying Management Focus.
The Rise of Mini-Multinationals Another trend in international business has been the growth of small- and medium-size multinationals (mini-multinationals).23 When people think of international businesses, they tend to think of firms such as ExxonMobil, General Motors, Ford, Panasonic, Procter & Gamble, Sony, and Unilever—large, complex multinational corporations with operations that span the globe. Although most international trade and investment is still conducted by large firms, many medium-size and small businesses are becoming increasingly
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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 multinational, yet more than $2 million of the company’s sales are generated by exports to a score of countries, including Japan, Israel, and the United Arab Emirates. Lubricating Systems has also set up a joint venture with a German company to serve the European market.24
Consider also Lixi Inc., a small U.S. manufacturer of industrial X-ray equipment; more than half of Lixi’s $24.4 million in revenues comes from exports to Japan.25 Or take G. W. Barth, a manufacturer of cocoa-bean roasting machinery based in Ludwigsburg, Germany. Employing just 65 people, this small company has captured 70 percent of the global market for cocoa-bean roasting machines.26 International business is conducted not just by large firms but also by medium-size and small enterprises.
m a n a g e m e n t F O C U S
Wanda Group
The Dalian Wanda Group is perhaps the world’s largest real estate company, although as yet it is little known outside of China. Established in 1988, Dalian Wanda Group is the largest owner of five-star hotels in the world. The company’s real estate portfolio includes 133 Wanda shopping malls and 84 hotels. It also has extensive activities in the film business, sports holdings, tourism, and children’s entertainment. The stated ambition of Dalian Wanda is to become a world-class multinational by 2020 with assets of $200 billion, revenue of $100 billion, and net profits of $10 billion.
In 2012, Dalian Wanda made a significant step in this direction when it acquired the U.S. cinema chain AMC Entertainment Holdings for $2.6 billion. At the time, the acquisition was the largest ever of a U.S. company by a Chinese enterprise, surpassing the $1.8 billion takeover of IBM’s PC business by Lenovo in 2005. AMC is the second-largest cinema operator in North America, where moviegoers spend more than $10 billion a year on tickets. After the acquisition was completed, the headquarters of AMC remained in Kansas City. Dalian, however, indicated that it would inject capital into AMC to upgrade its theaters to show more IMAX and 3D movies.
In 2015, Wanda followed its AMC acquisition with the purchase of Hoyts Group, an Australian cinema operator with more than 150 cinemas. By combining AMC movie theaters with Hoyts and its already extensive movie properties in China, Dalian Wanda has become the largest cinema operator in the world with more than 500 cinemas. This puts Wanda in a strong position when negotiating distribution terms with movie studios.
Wanda is also expanding its international real estate operations. In 2014, it announced that it won a bid for a prime plot of land in Beverly Hills, Los Angeles. Wanda plans to invest $1.2 billion to construct a mixed-use development. The company also has a sizable project in Chicago, where it is investing $900 million to build the third-tallest building in the city. In addition, Wanda has real estate projects in Spain, Australia, and London.
Today, the Wanda Group is already among the top 400 companies in the world with some 130,000 employees, $90 billion in assets, and about $45 billion in revenue.
Sources: Keith Weir, “China’s Dalian Wanda to Acquire Australia’s Hoyts for $365.7 Million,” Reuters, June 24, 2015; Zachary Mider, “China’s Wanda to Buy AMC Cinema Chain for $2.6 Billion,” Bloomberg Businessweek, May 21, 2012; and Wanda Group Corporate, www.wanda-group.com.
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THE CHANGING WORLD ORDER
Historically, between 1989 and 1991, a series of democratic revolutions swept the communist world. For reasons that are explored in more detail in Chapter 3, in country after country throughout eastern Europe and eventually in the Soviet Union itself, Communist Party governments collapsed. The Soviet Union receded into history, replaced by 15 independent republics. Czechoslovakia divided itself into two states, while Yugoslavia dissolved into a bloody civil war among its five successor states.
Which Is More Important—Similarities or Differences?
International strategy has seen significant changes in recent years. Multinational enterprises now have to evaluate their core uniqueness and how they can drive their uniqueness to be leveraged in the global marketplace better. For some, such thinking may represent a major shift—to focus on similarities across nations and customers instead of differences. This could be an important shift because companies and their people are trained to look for differences and form strategies based on satisfying the needs of customers with slight or significant differences across the globe. In the future, we may be looking for similarities first and then focusing on the similarities that outweigh the differences in tastes, wants, and needs. Do you agree that focusing on similarities across countries is a better way to developing strategy than focusing on differences?
Source: globalEDGE.msu.edu/content/gbr/gbr7-2.pdf.
Since then, many of the former communist nations of Europe and Asia have seemed to share a commitment to democratic politics and free market economics. For half a century, these countries were essentially closed to Western international businesses. Now, they present a host of export and investment opportunities. Three decades later, the economies of many of the former communist states are still relatively undeveloped, however, and their continued commitment to democracy and market-based economic systems cannot be taken for granted. Disturbing signs of growing unrest and totalitarian tendencies are seen in several eastern European and central Asian states, including Russia, which has shown signs of shifting back toward greater state involvement in economic activity and authoritarian government.27 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 and Russia some time ago. China suppressed its pro-democracy movement in the bloody Tiananmen Square massacre of 1989. On the other hand, China continues to move progressively toward greater free market reforms. If what is occurring in China continues for two more decades, China may move from third-world to industrial superpower status even more rapidly than Japan did. If China’s GDP per capita grows by an average of 6 to 7 percent, which is slower than the 8 to 10 percent growth rate achieved during the past decade, then by 2030 this nation of 1.4 billion people could boast an average GDP per capita of about $23,000, roughly the same as that of Chile or Poland today.
The potential consequences for international business are enormous. On the one hand, China
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represents a huge and largely untapped market. Reflecting this, between 1983 and today, annual foreign direct investment in China increased from less than $2 billion to $250 billion annually. On the other hand, China’s new firms are proving to be very capable competitors, and they could take global market share away from Western and Japanese enterprises (see the Management Focus on the Wanda Group). Thus, the changes in China are creating both opportunities and threats for established international businesses.
As for Latin America, both democracy and free market reforms have been evident there too. For decades, most Latin American countries were ruled by dictators, many of whom seemed to view Western international businesses as instruments of imperialist domination. Accordingly, they restricted direct investment by foreign firms. In addition, the poorly managed economies of Latin America were characterized by low growth, high debt, and hyperinflation—all of which discouraged investment by international businesses. In the past two decades, much of this has changed. Throughout most of Latin America, debt and inflation are down, governments have sold state-owned enterprises to private investors, foreign investment is welcomed, and the region’s economies have expanded. Brazil, Mexico, and Chile have led the way. These changes have increased the attractiveness of Latin America, both as a market for exports and as a site for foreign direct investment. At the same time, given the long history of economic mismanagement in Latin America, there is no guarantee that these favorable trends will continue. Indeed, Bolivia, Ecuador, and most notably Venezuela have seen shifts back toward greater state involvement in industry in the past few years, and foreign investment is now less welcome than it was during the 1990s. In these nations, the government has seized control of oil and gas fields from foreign investors and has limited the rights of foreign energy companies to extract oil and gas from their nations. Thus, as in the case of eastern Europe, substantial opportunities are accompanied by substantial risks.
GLOBAL ECONOMY OF THE TWENTY-FIRST CENTURY
The past quarter century has seen rapid changes in the global economy. Barriers to the free flow of goods, services, and capital have been coming down. As their economies advance, more nations are joining the ranks of the developed world. A generation ago, South Korea and Taiwan were viewed as second-tier developing nations. Now they boast large economies, and firms based there are major players in many global industries, from shipbuilding and steel to electronics and chemicals. The move toward a global economy has been further strengthened by the widespread adoption of liberal economic policies by countries that had firmly opposed them for two generations or more. In short, current trends indicate the world is moving toward an economic system that is more favorable for international business.
But it is always hazardous to use established trends to predict the future. The world may be moving toward a more global economic system, but globalization is not inevitable. Countries may pull back from the recent commitment to liberal economic ideology if their experiences do not match their expectations. There are clear signs, for example, of a retreat from liberal economic ideology in Russia. If Russia’s hesitation were to become more permanent and widespread, the liberal vision of a more prosperous global economy based on free market principles might not occur as quickly as many hope. Clearly, this would be a tougher world for international businesses.
Also, greater globalization brings with it risks of its own. This was starkly demonstrated in 1997 and 1998, when a financial crisis in Thailand spread first to other East Asian nations and then to Russia and Brazil. Ultimately, the crisis threatened to plunge the economies of the developed world, including the United States, into a recession. We explore the causes and
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consequences of this and other similar global financial crises in Chapter 11. Even from a purely economic perspective, globalization is not all good. The opportunities for doing business in a global economy may be significantly enhanced, but as we saw in 1997–1998, the risks associated with global financial contagion are also greater. Indeed, during 2008–2009, a crisis that started in the financial sector of America, where banks had been too liberal in their lending policies to homeowners, swept around the world and plunged the global economy into its deepest recession since the early 1980s, illustrating once more that in an interconnected world a severe crisis in one region can affect the entire globe. Still, as explained later in this text, firms can exploit the opportunities associated with globalization while reducing the risks through appropriate hedging strategies. These hedging strategies may also become more and more important as the world balances globalization efforts with a potential increase in nationalistic tendencies by some countries (e.g., recently in the United States and United Kingdom).
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The Globalization Debate LO 1-4 Explain the main arguments in the debate over the impact of globalization.
Is the shift toward a more integrated and interdependent global economy a good thing? Many influential economists, politicians, and business leaders seem to think so.28 They argue that falling barriers to international trade and investment are the twin engines driving the global economy toward greater prosperity. They say increased international trade and cross-border investment will result in lower prices for goods and services. They believe that globalization stimulates economic growth, raises the incomes of consumers, and helps create jobs in all countries that participate in the global trading system. The arguments of those who support globalization are covered in detail in Chapters 6, 7, and 8. As we shall see, there are good theoretical reasons for believing that declining barriers to international trade and investment do stimulate economic growth, create jobs, and raise income levels. Moreover, as described in Chapters 6, 7, and 8, empirical evidence lends support to the predictions of this theory. However, despite the existence of a compelling body of theory and evidence, globalization has its critics.29 Some of these critics are vocal and active, taking to the streets to demonstrate their opposition to globalization. Here, we look at the nature of protests against globalization and briefly review the main themes of the debate concerning the merits of globalization. In later chapters, we elaborate on many of these points.
ANTIGLOBALIZATION PROTESTS
Popular demonstrations against globalization date back to December 1999, when more than 40,000 protesters blocked the streets of Seattle in an attempt to shut down a World Trade Organization meeting being held in the city. The demonstrators were protesting against a wide range of issues, including job losses in industries under attack from foreign competitors, downward pressure on the wage rates of unskilled workers, environmental degradation, and the cultural imperialism of global media and multinational enterprises, which was seen as being dominated by what some protesters called the “culturally impoverished” interests and values of
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the United States. All of these ills, the demonstrators claimed, could be laid at the feet of globalization. The World Trade Organization was meeting to try to launch a new round of talks to cut barriers to cross-border trade and investment. As such, it was seen as a promoter of globalization and a target for the protesters. The protests turned violent, transforming the normally placid streets of Seattle into a running battle between “anarchists” and Seattle’s bemused and poorly prepared police department. Pictures of brick-throwing protesters and armored police wielding their batons were duly recorded by the global media, which then circulated the images around the world. Meanwhile, the WTO meeting failed to reach an agreement, and although the protests outside the meeting halls had little to do with that failure, the impression took hold that the demonstrators had succeeded in derailing the meetings.
Emboldened by the experience in Seattle, antiglobalization protesters have made a habit of turning up at major meetings of global institutions. Smaller-scale protests have periodically occurred in several countries, such as France, where antiglobalization activists destroyed a McDonald’s restaurant in 1999 to protest the impoverishment of French culture by American imperialism (see the accompanying Country Focus for details). While violent protests may give the antiglobalization effort a bad name, it is clear from the scale of the demonstrations that support for the cause goes beyond a core of anarchists. Large segments of the population in many countries believe that globalization has detrimental effects on living standards, wage rates, and the environment. Indeed, the strong support for President Donald Trump in the 2016 U.S. election was primarily based on his repeated assertions that trade deals had exported U.S. jobs overseas and created unemployment and low wages in America.
c o u n t r y F O C U S
Protesting Globalization in France It all started one night in August 1999, but it might as well have been today. Back in 1999, 10 men under the leadership of local sheep farmer and rural activist José Bové crept into the town of Millau in central France and vandalized a McDonald’s restaurant under construction, causing an estimated $150,000 in damage. 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 (EU) had banned imports of hormone-treated beef from the United States, primarily because of fears that it might lead to health problems (although EU scientists had concluded there was no evidence of this). After a careful review, the World Trade Organization stated the EU ban was not allowed under trading rules that the EU and United States were party to and that the EU would have to lift it or face retaliation. The EU refused to comply, so the U.S. government imposed a 100 percent tariff on imports of certain EU products, including French staples such as foie gras, mustard, and Roquefort cheese. On farms near Millau, Bové and others raised sheep whose milk was used to make Roquefort. They felt incensed by the American tariff and decided to vent their frustrations on McDonald’s.
Bové and his compatriots were arrested and charged. About the same time in the Languedoc region of France, California winemaker Robert Mondavi had reached agreement with the mayor and council of the village of Aniane and regional authorities to turn 125 acres of wooded hillside belonging to the village into a vineyard. Mondavi planned to invest $7 million in the project and hoped to produce top- quality wine that would sell in Europe and the United States for $60 a bottle. However, local environmentalists objected to the plan, which they claimed would destroy the area’s unique ecological heritage. José Bové, basking in sudden fame, offered his support to the opponents, and the protests started. In May 2001, the socialist mayor who had approved the project was defeated in local elections in which the Mondavi project had become the major issue. He was replaced by a communist, Manuel Diaz, who denounced the project as a capitalist plot designed to enrich wealthy U.S. shareholders at the
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cost of his villagers and the environment. Following Diaz’s victory, Mondavi announced he would pull out of the project. A spokesperson noted, “It’s a huge waste, but there are clearly personal and political interests at play here that go way beyond us.”
So, are the French opposed to foreign investment? The experience of McDonald’s and Mondavi seems to suggest so, as does the associated news coverage, but look closer and a different reality seems to emerge. Today, McDonald’s has more than 1,200 restaurants in France. McDonald’s employs 69,000 workers in the country. France is the most profitable market for McDonald’s after the United States. In short, 20 years after the protests, France is a major success story for McDonald’s. Moreover, France has long been one of the most favored locations for inward foreign direct investment, receiving more than $700 billion of foreign investment between 2000 and 2017, which makes it one of the top destinations for foreign investment in Europe. American companies have always accounted for a significant percentage of this investment. French enterprises have also been significant foreign investors; some 1,100 French multinationals have about $1.1 trillion of assets in other nations. For all of the populist opposition to globalization, French corporations and consumers appear to be embracing it.
Sources: “Behind the Bluster,” 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; United Nations, World Investment Report, 2014 (New York & Geneva: United Nations, 2011); and Rob Wile, “The True Story of How McDonald’s Conquered France,” Business Insider, August 22, 2014.
Both theory and evidence suggest that many of these fears are exaggerated; both politicians and businesspeople need to do more to counter these fears. Many protests against globalization are tapping into a general sense of loss at the passing of a world in which barriers of time and distance, and significant differences in economic institutions, political institutions, and the level of development of different nations produced a world rich in the diversity of human cultures. However, while the rich citizens of the developed world may have the luxury of mourning the fact that they can now see McDonald’s restaurants and Starbucks coffeehouses on their vacations to exotic locations such as Thailand, fewer complaints are heard from the citizens of those countries, who welcome the higher living standards that progress brings.
GLOBALIZATION, JOBS, AND INCOME
One concern frequently voiced by globalization opponents is that falling barriers to international trade destroy manufacturing jobs in wealthy advanced economies such as the United States and Western Europe. Critics argue that falling trade barriers allow firms to move manufacturing activities to countries where wage rates are much lower.30 Indeed, due to the entry of China, India, and states from eastern Europe into the global trading system, along with global population growth, the pool of global labor has increased more than fivefold between 1990 and today. Other things being equal, we might conclude that this enormous expansion in the global labor force, when coupled with expanding international trade, would have depressed wages in developed nations.
This fear is often supported by anecdotes. For example, D. L. Bartlett and J. B. Steele, two journalists for the Philadelphia Inquirer who gained notoriety for their attacks on free trade, cite the case of Harwood Industries, a U.S. clothing manufacturer that closed its U.S. operations, where it paid workers $9 per hour, and shifted manufacturing to Honduras, where textile workers received 48 cents per hour.31 Because of moves such as this, argue Bartlett and Steele, the wage rates of poorer Americans have fallen significantly over the past quarter of a century.
In the past few years, the same fears have been applied to services, which have increasingly been outsourced to nations with lower labor costs. The popular feeling is that when corporations
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such as Dell, IBM, or Citigroup outsource service activities to lower-cost foreign suppliers—as all three have done—they are “exporting jobs” to low-wage nations and contributing to higher unemployment and lower living standards in their home nations (in this case, the United States). Some U.S. lawmakers have responded by calling for legal barriers to job outsourcing.
Supporters of globalization reply that critics of these trends miss the essential point about free trade agreements—the benefits outweigh the costs.32 They argue that free trade will result in countries specializing in the production of those goods and services that they can produce most efficiently, while importing goods and services that they cannot produce as efficiently. When a country embraces free trade, there is always some dislocation—lost textile jobs at Harwood Industries or lost call-center jobs at Dell—but the whole economy is better off as a result. According to this view, it makes little sense for the United States to produce textiles at home when they can be produced at a lower cost in Honduras or China. Importing textiles from China leads to lower prices for clothes in the United States, which enables consumers to spend more of their money on other items. At the same time, the increased income generated in China from textile exports increases income levels in that country, which helps the Chinese purchase more products produced in the United States, such as pharmaceuticals from Amgen, Boeing jets, microprocessors made by Intel, Microsoft software, and Cisco routers.
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 computers. U.S. consumers benefit from this development. As prices for computers fall, Americans can spend more of their money on other goods and services. Moreover, the increase in income levels in India allows Indians to purchase more U.S. goods and services, which helps create jobs in the United States. In this manner, supporters of globalization argue that free trade benefits all countries that adhere to a free trade regime.
If the critics of globalization are correct, three things must be shown. First, the share of national income received by labor, as opposed to the share received by the owners of capital (e.g., stockholders and bondholders), should have declined in advanced nations as a result of downward pressure on wage rates. Second, even though labor’s share of the economic pie may have declined, this does not mean lower living standards if the size of the total pie has increased sufficiently to offset the decline in labor’s share—in other words, if economic growth and rising living standards in advanced economies have offset declines in labor’s share (this is the position argued by supporters of globalization). 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.33 First, the data suggest that over the past two decades, the share of labor in national income has declined. However, detailed analysis suggests the share of national income enjoyed by skilled labor has actually increased, suggesting that the fall in labor’s share has been due to a fall in the share taken by unskilled labor. A study by the IMF suggested the earnings gap between workers in skilled and unskilled sectors has widened by 25 percent over the past two decades.34 Another study that focused on U.S. data found that exposure to competition from imports led to a decline in real wages for workers who performed unskilled tasks, while having no discernible impact on wages in skilled occupations. The same study found that skilled and unskilled workers in sectors where exports grew saw an increase in their real wages.35 These figures suggest that unskilled labor in sectors that have been exposed to more efficient foreign competition probably has seen its share of national income decline over the past three decades.
However, this does not mean that the living standards of unskilled workers in developed nations have declined. It is possible that economic growth in developed nations has offset the fall in the share of national income enjoyed by unskilled workers, raising their living standards.
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Page 26Evidence suggests that real labor compensation has expanded in most developed nations since the 1980s, including the United States. Several studies by the Organisation for Economic Co-operation and Development (OECD), whose members include the 34 richest economies in the world, conclude that while the gap between the poorest and richest segments of society in OECD countries has widened, in most countries real income levels have increased for all, including the poorest segment. In one study, the OECD found that real household income (adjusted for inflation) increased by 1.7 percent annually among its member states. 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, while that of the richest 10 percent grew by 1.9 percent annually.36
As noted earlier, globalization critics argue that the decline in unskilled wage rates is due to the migration of low-wage manufacturing jobs offshore and a corresponding reduction in demand for unskilled workers. However, supporters of globalization see a more complex picture. They maintain that the weak growth rate in real wage rates for unskilled workers owes far more to a technology-induced shift within advanced economies away from jobs where the only qualification was a willingness to turn up for work every day and toward jobs that require significant education and skills. They point out that many advanced economies report a shortage of highly skilled workers and an excess supply of unskilled workers. Thus, growing income inequality is a result of the wages for skilled workers being bid up by the labor market and the wages for unskilled workers being discounted. In fact, evidence suggests that technological change has had a bigger impact than globalization on the declining share of national income enjoyed by labor.37 This suggests that a solution to the problem of slow real income growth among the unskilled is to be found not in limiting free trade and globalization but in increasing society’s investment in education to reduce the supply of unskilled workers.38
Finally, it is worth noting that the wage gap between developing and developed nations is closing as developing nations experience rapid economic growth. For example, one estimate suggests that wages in China will approach Western levels in two decades.39 To the extent that this is the case, any migration of unskilled jobs to low-wage countries is a temporary phenomenon representing a structural adjustment on the way to a more tightly integrated global economy.
GLOBALIZATION, LABOR POLICIES, AND THE ENVIRONMENT
A second source of concern is that free trade encourages firms from advanced nations to move manufacturing facilities to less developed countries that lack adequate regulations to protect labor and the environment from abuse by the unscrupulous.40 Globalization critics often argue that adhering to labor and environmental regulations significantly increases the costs of manufacturing enterprises and puts them at a competitive disadvantage in the global marketplace vis-à-vis firms based in developing nations that do not have to comply with such regulations. Firms deal with this cost disadvantage, the theory goes, by moving their production 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
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in firms from advanced nations exploiting the labor of less developed nations.41 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.42 Interestingly, some of the same arguments are now materializing again with the Donald Trump presidency in the United States. Many of his followers and supporters have been presenting similar arguments against NAFTA. Consequently, the United States, Canada, and Mexico appear set to renegotiate a number of the agreements included in the overall NAFTA agreement.
Supporters of free trade and greater globalization express doubts about this scenario. They argue that tougher environmental regulations and stricter labor standards go hand in hand with economic progress.43 In general, as countries get richer, they enact tougher environmental and labor regulations.44 Because free trade enables developing countries to increase their economic growth rates and become richer, this should lead to tougher environmental and labor laws. In this view, the critics of free trade have got it backward: Free trade does not lead to more pollution and labor exploitation; it leads to less. By creating wealth and incentives for enterprises to produce technological innovations, the free market system and free trade could make it easier for the world to cope with pollution and population growth. Indeed, while pollution levels are rising in the world’s poorer countries, they have been falling in developed nations. In the United States, for example, the concentration of carbon monoxide and sulfur dioxide pollutants in the atmosphere has decreased by 60 percent since 1978, while lead concentrations have decreased by 98 percent—and these reductions have occurred against a background of sustained economic expansion.45
A number of econometric studies have found consistent evidence of a hump-shaped relationship between income levels and pollution levels (see Figure 1.6.).46 As an economy grows and income levels rise, initially pollution levels also rise. However, past some point, rising income levels lead to demands for greater environmental protection, and pollution levels then fall. A seminal study by Grossman and Krueger found that the turning point generally occurred before per capita income levels reached $8,000.47
1.6 FIGURE Income levels and environmental pollution.
Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).
While the hump-shaped relationship depicted in Figure 1.6 seems to hold across a wide range of pollutants—from sulfur dioxide to lead concentrations and water quality—carbon dioxide
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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. In the view of most economists, the most effective way to do this would be to put a price on carbon-intensive energy generation through a carbon tax. To ensure that this tax does not harm economic growth, economists argue that it should be revenue neutral, with increases in carbon taxes offset by reductions in income or consumption taxes.48
Although UN-sponsored talks have had reduction in carbon dioxide emissions as a central aim since the 1992 Earth Summit in Rio de Janeiro, until recently there has been little success in moving toward the ambitious goals for reducing carbon emissions laid down in the Earth Summit and subsequent talks in Kyoto, Japan, in 1997, Copenhagen in 2009, and Paris in 2015, for example. In part, this is because the largest emitters of carbon dioxide, the United States and China, failed to reach agreements about how to proceed. China, a country whose carbon emissions are increasing at a rapid rate, has until recently shown little appetite for tighter pollution controls. As for the United States, political divisions in Congress and a culture of denial have made it difficult for the country to even acknowledge, never mind move forward with, legislation designed to tackle climate change. However, in late 2014, the United States and China struck a historic deal under which both countries agreed to potentially significant reductions in carbon emissions. This was followed by a broadly based multilateral agreement reached in Paris in 2015 that has committed the nations of the world to carbon reduction targets. If these agreements hold, progress may be made on this important issue.
Notwithstanding this, supporters of free trade point out that it is possible to tie free trade agreements to the implementation of tougher environmental and labor laws in less developed countries. NAFTA, for example, was passed only after side agreements had been negotiated that committed Mexico to tougher enforcement of environmental protection regulations. Thus, supporters of free trade argue that factories based in Mexico are now cleaner than they would have been without the passage of NAFTA.49
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 behaving in an ethical manner and would be unlikely to move production offshore just so they could pump more pollution into the atmosphere or exploit labor. Furthermore, the relationship between pollution, labor exploitation and production costs may not be that suggested by critics. In general, a well-treated labor force is productive, and it is productivity rather than base wage rates that often has the greatest influence on costs. The vision of greedy managers who shift production to low-wage countries to exploit their labor force may be misplaced.
GLOBALIZATION AND NATIONAL SOVEREIGNTY
Another concern voiced by critics of globalization is that today’s increasingly interdependent global economy shifts economic power away from national governments and toward supranational organizations such as the World Trade Organization, the European Union, and the United Nations. As perceived by critics, unelected bureaucrats now impose policies on the democratically elected governments of nation-states, thereby undermining the sovereignty of those states and limiting the nation’s ability to control its own destiny.50
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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 among its 162 member states. 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.51
In contrast to Nader, many economists and politicians maintain that the power of supranational organizations such as the WTO is limited to what nation-states collectively agree to grant. 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 100 years or so the gap between the rich and poor nations of the world has gotten wider. In 1870, the average income per capita in the world’s 17 richest nations was 2.4 times that of all other countries. In 1990, the same group was 4.5 times as rich as the rest. In 2019, the 34 member states of the Organisation for Economic Co-operation and Development (OECD), which includes most of the world’s rich economies, had an average gross national income (GNI) per person of more than $40,000, whereas the world’s 40 least developed countries had a GNI of under $1,000 per capita—implying that income per capita in the world’s 34 richest nations was 40 times that in the world’s 40 poorest.52
While recent history has shown that some of the world’s poorer nations are capable of rapid periods of economic growth—witness the transformation that has occurred in some Southeast Asian nations such as South Korea, 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, and a third had growth rates of less than 0.05 percent.53 Critics argue that if globalization is such a positive development, this divergence between the rich and poor should not have occurred.
Although the reasons for economic stagnation vary, several factors stand out, none of which has anything to do with free trade or globalization.54 Many of the world’s poorest countries have suffered from totalitarian governments, economic policies that destroyed wealth rather than facilitated its creation, endemic corruption, scant protection for property rights, and prolonged
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civil war. A combination of such factors helps explain why countries such as Afghanistan, Cuba, Haiti, Iraq, Libya, Nigeria, Sudan, Syria, North Korea, and Zimbabwe have failed to improve the economic lot of their citizens during recent decades. A complicating factor is the rapidly expanding populations in many of these countries. Without a major change in government, population growth may exacerbate their problems. Promoters of free trade argue that the best way for these countries to improve their lot is to lower their barriers to free trade and investment and to implement economic policies based on free market economics.55
Many of the world’s poorer nations are being held back by large debt burdens. Of particular concern are the 40 or so “highly indebted poorer countries” (HIPCs), which are home to some 700 million people. Among these countries, the average government debt burden has been as high as 85 percent of the value of the economy, as measured by gross domestic product, and the annual costs of serving government debt have consumed 15 percent of the country’s export earnings.56 Servicing such a heavy debt load leaves the governments of these countries with little left to invest in important public infrastructure projects, such as education, health care, roads, and power. The result is the HIPCs are trapped in a cycle of poverty and debt that inhibits economic development. Free trade alone, some argue, is a necessary but not sufficient prerequisite to help these countries bootstrap themselves out of poverty. Instead, large-scale debt relief is needed for the world’s poorest nations to give them the opportunity to restructure their economies and start the long climb toward prosperity. Supporters of debt relief also argue that new democratic governments in poor nations should not be forced to honor debts that were incurred and mismanaged long ago by their corrupt and dictatorial predecessors.
In the late 1990s, a debt relief movement began to gain ground among the political establishment in the world’s richer nations.57 Fueled by high-profile endorsements from Irish rock star Bono (who has been a tireless and increasingly effective advocate for debt relief), the Dalai Lama, and influential Harvard economist Jeffrey Sachs, the debt relief movement was instrumental in persuading the United States to enact legislation in 2000 that provided $435 million in debt relief for HIPCs. More important perhaps, the United States also backed an IMF plan to sell some of its gold reserves and use the proceeds to help with debt relief. 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. Consistent with this, in June 2005, the finance ministers from several of the world’s richest economies (including the United States) agreed to provide enough funds to the World Bank and IMF to allow them to cancel a further $55 billion in debt owed by the HIPCs. The goal was to enable the HIPCs to redirect resources from debt payments to health and education programs, and for alleviating poverty.
The richest nations of the world also can help by reducing barriers to the importation of products from the world’s poorest nations, particularly tariffs on imports of agricultural products and textiles. High-tariff barriers and other impediments to trade make it difficult for poor countries to export more of their agricultural production. The World Trade Organization has estimated that if the developed nations of the world eradicated subsidies to their agricultural producers and removed tariff barriers to trade in agriculture, this would raise global economic welfare by $128 billion, with $30 billion of that going to poor 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.58
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Despite the large gap between the rich and poor nations, there is some evidence that progress is being made. In 2015, the United Nations adopted what were known as the Sustainable Development Goals. These were 17 economic and human development goals for the world. We address these goals in Chapter 5. Overall, it is hard to escape the conclusion that globalization and lower barriers to cross-border trade and investment are major factors in this remarkable prospect.
Managing in the Global Marketplace LO 1-5 Understand how the process of globalization is creating opportunities and
challenges for management practice.
Much of this text is concerned with the challenges of managing in an international business. An international business is any firm that engages in international trade or investment. A firm does not have to become a multinational enterprise, investing directly in operations in other countries, to engage in international business, although multinational enterprises are international businesses. All a firm has to do is export or import products from other countries. As the world shifts toward a truly integrated global economy, more firms—both large and small—are becoming international businesses. What does this shift toward a global economy mean for managers within an international business?
As their organizations increasingly engage in cross-border trade and investment, managers need to recognize that the task of managing an international business differs from that of managing a purely domestic business in many ways. At the most fundamental level, the differences arise from the simple fact that countries are different. Countries differ in their cultures, political systems, economic systems, legal systems, and levels of economic development. Despite all the talk about the emerging global village and despite the trend toward globalization of markets and production, as we shall see in this text, many of these differences are very profound and enduring.
Differences among countries require that an international business vary its practices country by country. Marketing a product in Brazil may require a different approach from marketing the product in Germany; managing U.S. workers might require different skills from managing Japanese workers; maintaining close relations with a particular level of government may be very important in Mexico and irrelevant in Great Britain; the business strategy pursued in Canada might not work in South Korea; and so on. Managers in an international business must not only be sensitive to these differences but also adopt the appropriate policies and strategies for coping with them. Much of this text is devoted to explaining the sources of these differences and the methods for successfully coping with them.
A further way in which international business differs from domestic business is the greater complexity of managing an international business. In addition to the problems that arise from the differences between countries, a manager in an international business is confronted with a range of other issues that the manager in a domestic business never confronts. The managers of an international business must decide where in the world to site production activities to minimize costs and 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
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how best to coordinate and control globally dispersed production activities (which, as we shall see later in the text, is not a trivial problem). The managers in an international business also must decide which foreign markets to enter and which to avoid. They must choose the appropriate mode for entering a particular foreign country. Is it best to export its product to the foreign country? Should the firm allow a local company to produce its product under license in that country? Should the firm enter into a joint venture with a local firm to produce its product in that country? Or should the firm set up a wholly owned subsidiary to serve the market in that country? As we shall see, the choice of entry mode is critical because it has major implications for the long-term health of the firm.
Conducting business transactions across national borders requires understanding the rules governing the international trading and investment system. Managers in an international business must also deal with government restrictions on international trade and investment. They must find ways to work within the limits imposed by specific governmental interventions. As this text explains, even though many governments are nominally committed to free trade, they often intervene to regulate cross-border trade and investment. Managers within international businesses must develop strategies and policies for dealing with such interventions.
Cross-border transactions also require that money be converted from the firm’s home currency into a foreign currency and vice versa. Because currency exchange rates vary in response to changing economic conditions, managers in an international business must develop policies for dealing with exchange rate movements. A firm that adopts the wrong policy can lose large amounts of money, whereas one that adopts the right policy can increase the profitability of its international transactions.
In sum, managing an international business is different from managing a purely domestic business for at least four reasons: (1) countries are different, (2) the range of problems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business, (3) an international business must find ways to work within the limits imposed by government intervention in the international trade and investment system, and (4) international transactions involve converting money into different currencies.
In this text, we examine all these issues in depth, paying close attention to the different strategies and policies that managers pursue to deal with the various challenges created when a firm becomes an international business. Chapters 2, 3, and 4 explore how countries differ from each other with regard to their political, economic, legal, and cultural institutions. Chapter 5 takes a detailed look at the ethical issues, corporate social responsibility, and sustainability issues that arise in international business. Chapters 6, 7, 8, and 9 look at the global trade and investment environment within which international businesses must operate. Chapters 10 and 11 review the global monetary system. These chapters focus on the nature of the foreign exchange market and the emerging global monetary system. Chapters 12 and 13 explore the strategy, organization, and market entry choices of an international business. Chapters 14, 15, 16, and 17 look at the management of various functional operations within an international business, including exporting, importing, countertrade, production, supply chain management, marketing, R&D, and human resources. By the time you complete this text, you should have a good grasp of the issues that managers working in international business have to grapple with on a daily basis, and you should be familiar with the range of strategies and operating policies available to compete more effectively in today’s rapidly emerging global economy.
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Key Terms
globalization, p. 6 globalization of markets, p. 6 globalization of production, p. 8 factors of production, p. 8 General Agreement on Tariffs and Trade (GATT), p. 9 World Trade Organization (WTO), p. 9 International Monetary Fund (IMF), p. 10 World Bank, p. 10 United Nations (UN), p. 10 Group of Twenty (G20), p. 10 international trade, p. 11 foreign direct investment (FDI), p. 11 Moore’s law, p. 15 stock of foreign direct investment (FDI), p. 19 multinational enterprise (MNE), p. 20 international business, p. 30
Summary
This chapter has shown how the world economy is becoming more global and reviewed the main drivers of globalization, arguing that they seem to be thrusting nation-states toward a more tightly integrated global economy. It looked at how the nature of international business is changing in response to the changing global economy, discussed concerns raised by rapid globalization, and reviewed implications of rapid globalization for individual managers. The chapter made the following points:
1. Over the past three decades, we have witnessed the globalization of markets and production.
2. The globalization of markets implies that national markets are merging into one huge marketplace. However, it is important not to push this view too far.
3. The globalization of production implies that firms are basing individual productive activities at the optimal world locations for the particular activities. As a consequence, it is increasingly irrelevant to talk about American products, Japanese products, or German products because these are being replaced by “global” products. Or, in some cases, they are simply replaced by products made by specific companies, such as Apple, Sony, or Microsoft products.
4. Two factors seem to underlie the trend toward globalization: declining trade barriers and changes in communication, information, and transportation technologies.
5. Since the end of World War II, barriers to the free flow of goods, services, and capital have been lowered significantly. More than anything else, this has facilitated the trend toward the globalization of production and has enabled firms to view the world as a single market.
6. As a consequence of the globalization of production and markets, in the last decade, world trade has grown faster than world output, foreign direct investment has surged, imports have penetrated more deeply into the world’s industrial nations, and competitive pressures
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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 2020s, the U.S. share of world output will have been cut in half, with major shares now being accounted for by European and Southeast Asian economies. The U.S. share of worldwide foreign direct investment will have fallen by about two-thirds. U.S. multinationals will be facing competition from a large number of multinationals. In addition, the emergence of mini-multinationals was noted.
10. One of the most dramatic developments of the past 30 years has been the collapse of communism in eastern Europe, which has created enormous opportunities for international businesses. In addition, the move toward free market economies in China and Latin America is creating opportunities (and threats) for Western international businesses.
11. 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, national sovereignty, and extreme poverty in the world’s poorest nations.
12. Managing an international business is different from managing a domestic business for at least four reasons: (a) countries are different, (b) the range of problems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business, (c) managers in an international business must find ways to work within the limits imposed by governments’ intervention in the international trade and investment system, and (d) international transactions involve converting money into different currencies.
Critical 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 the United Kingdom? 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?
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6. If current trends continue, China may be the world’s largest economy by 2035. Discuss the possible implications of such a development for
a. the world trading system b. the world monetary system c. the business strategy of today’s European and U.S.-based global corporations d. global commodity prices
7. Reread the Management Focus “Boeing’s Global Production System” and answer the following questions:
a. What are the benefits to Boeing of outsourcing manufacturing of components of the Boeing 787 to firms based in other countries?
b. What are the potential costs and risks to Boeing of outsourcing? c. In addition to foreign subcontractors and Boeing, who else benefits from Boeing’s
decision to outsource component part manufacturing assembly to other nations? Who are the potential losers?
d. If Boeing’s management decided to keep all production in America, what do you think the effect would be on the company, its employees, and the communities that depend on it?
e. On balance, do you think that the kind of outsourcing undertaken by Boeing is a good thing or a bad thing for the American economy? Explain your reasoning.
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. As the drivers of globalization continue to pressure both the globalization of markets and the globalization of production, we continue to see the impact of greater globalization on worldwide trade patterns. HSBC, a large global bank, analyzes these pressures and trends to identify opportunities across markets and sectors through its trade forecasts. Visit the HSBC Global Connections site and use the trade forecast tool to identify which export routes are forecast to see the greatest growth over the next 15 to 20 years. What patterns do you see? What types of countries dominate these routes?
2. You are working for a company that is considering investing in a foreign country. Investing in countries with different traditions is an important element of your company’s long-term strategic goals. Management has requested a report regarding the attractiveness of alternative countries based on the potential return of FDI. Accordingly, the ranking of the top 25 countries in terms of FDI attractiveness is a crucial ingredient for your report. A colleague mentioned a potentially useful tool called the Foreign Direct Investment (FDI) Confidence Index. 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.
Global iza t ion of BMW, Rol ls -Royce , and the MINI
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clos ing case
Bayerische Motoren Werke, which is German for Bavarian Motor Works, is better known globally for its acronym BMW (bmwgroup.com). BMW was created as a combination of three German manufacturing companies: Rapp Motorenwerke and Bayerische Flugzeugwerke in Bavaria and Fahrzeugfabrik Eisenach in Thuringia. Aircraft engine manufacturer Rapp Motorenwerke became Bayerische Motorenwerke in 1916, and the company added motorcycles to its product repertoire in 1923. BMW expanded to automobiles in 1929 when it purchased Fahrzeugfabrik Eisenach, which built Austin 7 cars under a license from Dixi. Fittingly, the first BMW car was called the BMW Dixi.
Globally, BMW is known for streamlined design, incredible luxury, and top-notch performance. The company has more than 125,000 employees, delivers about 2.4 million vehicles annually, and has a revenue of €95 billion (about $103 billion in U.S. dollars). Its leadership spans products in automobiles, motorcycles, and aircraft engines. Innovation is one of the main success factors for the BMW Group, and innovation is infused into all of BMW’s product lines. The company claims that focusing on the future is an important part of BMW’s identity and day-to-day work, and the reason for its global success. In addition to the well-known BMW brand, BMW also owns the iconic Rolls-Royce brand and the distinctive MINI automobiles.
BMW and “driving pleasure” are synonymous, even by people not owning a BMW! BMW creates driving pleasure from the perfect combination of dynamic, sporty performance; ground-breaking innovations; and breath-taking design. With a range of car models, a unique feature of BMW is its “M” designation models that takes the “driving pleasure” to another level. BMW “M” (for Motorsport) was initially created to facilitate BMW’s racing program but has since become a supplement to BMW’s vehicles portfolio with specially modified higher trim features. BMW M is part of an outstanding motorsports heritage and stands for high performance out of passion, with the latest addition to the line being the BMW M760. It’s the evolutionary link that connects BMW and Rolls-Royce, bridging the gap between the 7 Series and the entry-level Rolls-Royce Ghost.
Rolls-Royce is considered the most exclusive luxury automobile brand in the world. This reputation is rooted in the brand’s long history and rich tradition. Rolls-Royce delivers the promise of effortless power, luxury, quality, and perfect sanctuary. The entry-level Rolls-Royce Ghost carries a price tag around $250,000, and the models escalate from that price point. Rolls-Royce has, from its early days of daring experimentation, created a vision for luxury that is rooted in constantly chasing perfection. This perfection drives the supreme quality, exquisite hand craftsmanship, and attention to the finest detail to maintain its global position as the pinnacle luxury automobile manufacturer in the world. Like Rolls- Royce, the MINI also traces its roots to the United Kingdom.
MINI is a car brand owned by BMW that specializes in small cars. The full platform of MINI cars is small, with the idea of maximizing the experience and concentrating on the essential. A long- standing attention to clever solutions with distinctive designs unlocks urban driving and caters to customers’ individual needs. The most iconic is the MINI Cooper, named after British racing legend John Cooper. The MINI Cooper product line has a uniquely sporting blend of classic British mini-car heritage and appeal with precise German engineering and construction. According to the MINI team, they are targeting affluent urban dwellers in their 20s and 30s who enjoy the fun, freedom, and individuality that the MINI cars offer—or perhaps we should just say they target newly graduated college students living in cities!
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To help with its targeting of affluent urban dwellers for the MINI or the even more affluent clientele for the BMW or Rolls-Royce, the BMW Group’s leaders have studied brands outside of the automobile industry to create the company’s future retail strategy. Enter the “product genius.” BMW’s product genius is a noncommissioned car expert who will spend whatever time it takes or is needed to educate customers about their car choices, options, and any issue that the customer wants to get more information on. This shifts the “performance” from closing the sale of a car to making the customer satisfied, which lessens the typical pressure most customers feel when walking in to a car dealership (and likewise lessens the pressure of the salesperson to sell a car to get commission).
Sources: Jonathan M. Gitlin, “The 2017 BMW M760i Is a Hell of a Car, but Is It an M?” ARS Technica, February 8, 2017; “BMW at 100: Bavarian Rhapsody,” The Economist, March 12, 2016; Carmine Gallo, “BMW Radically Rethinks the Car Buying Experience,” Forbes, April 18, 2014; “How German Cars Beat British Motors—and Kept Going,” BBC News, August 2, 2013; and Hannah Elliott, “The Best Luxury Sedan Is Still a BMW,” Bloomberg BusinessWeek, June 6, 2016.
CASE DISCUSSION QUESTIONS 1. How do you think BMW integrates its various unique brands into a global effort that
works for them (BMW, Rolls-Royce, and the MINI) across the world’s many global markets?
2. What is your reaction to the global brand of BMW when you hear the name, think of the brand, and see the BMW vehicles on the road?
3. The Rolls-Royce chase of perfection drives the supreme quality, exquisite hand craftsmanship, and attention to the finest detail to maintain its global position as the pinnacle luxury automobile manufacturer in the world. How do you think the Rolls- Royce brand helps, or hurts, the other BMW brands globally (BMW, the MINI)?
4. The MINI is a unique car offering in the BMW portfolio. It has long-standing attention to clever solutions with distinctive designs that unlock urban driving and cater to customers’ individual needs—at least that is what the target focus is for the MINI. Do you agree that this is the focus, and do you think it is working as advertised globally?
Endnotes
1. Thomas L. Friedman, The World Is Flat (New York: Farrar, Straus and Giroux, 2005). 2. T. Levitt, “The Globalization of Markets,” Harvard Business Review, May–June 1983, pp.
92–102. 3. U.S. Department of Commerce, Internal Trade Administration, “Profile of U.S. Exporting
and Importing Companies, 2012–2013,” April 2015. 4. C. M. Draffen, “Going Global: Export Market Proves Profitable for Region’s Small
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Businesses,” Newsday, March 19, 2001, p. C18. 5. See F. T. Knickerbocker, Oligopolistic Reaction and Multinational Enterprise (Boston:
Harvard Business School Press, 1973); R. E. Caves, “Japanese Investment in the U.S.: Lessons for the Economic Analysis of Foreign Investment,” The World Economy 16 (1993), pp. 279–300.
6. I. Metthee, “Playing a Large Part,” Seattle Post-Intelligencer, April 9, 1994, p. 13. 7. R. B. Reich, The Work of Nations (New York: Knopf, 1991). 8. United Nations, “About the United Nations,” www.un.org/en/about-un. 9. J. A. Frankel, “Globalization of the Economy,” National Bureau of Economic Research,
working paper no. 7858, 2000. 10. J. Bhagwati, Protectionism (Cambridge, MA: MIT Press, 1989). 11. F. Williams, “Trade Round Like This May Never Be Seen Again,” Financial Times, April
15, 1994, p. 8. 12. United Nations Sustainable Development Goals, 2015,
www.un.org/sustainabledevelopment/sustainable-development-goals. 13. United Nations Conference on Trade and Development (UNCTAD), June 22, 2017. 14. United Nations, World Investment Report, 2015. 15. Moore’s law is named after Intel founder Gordon Moore. 16. Data compiled from various sources and listed at www.internetworldstats.com/stats.htm. 17. From www.census.gov/mrts/www/ecomm.html. See also S. Fiegerman, “Ecommerce Is
Now a Trillion Dollar Industry,” Mashable Business, February 5, 2013. 18. For a counterpoint, see “Geography and the Net: Putting It in Its Place,” The Economist,
August 11, 2001, pp. 18–20. 19. International Chamber of Shipping, Key Facts, www.ics-shipping.org/shipping-facts/key-
facts. 20. Frankel, “Globalization of the Economy.” 21. Raj Kumar Ray, “India’s Economy to Become 3rd Largest, Surpass Japan, Germany by
2030,” Hindustan Times, April 28, 2017. 22. N. Hood and J. Young, The Economics of the Multinational Enterprise (New
York: Longman, 1973). 23. S. Chetty, “Explosive International Growth and Problems of Success Among Small and
Medium Sized Firms,” International Small Business Journal, February 2003, pp. 5–28. 24. R. A. Mosbacher, “Opening Up Export Doors for Smaller Firms,” Seattle Times, July 24,
1991, p. A7. 25. “Small Companies Learn How to Sell to the Japanese,” Seattle Times, March 19, 1992. 26. W. J. Holstein, “Why Johann Can Export, but Johnny Can’t,” BusinessWeek, November 3,
1991. Archived at www.businessweek.com/stories/1991-11-03/why-johann-can-export-but- johnny-cant.
27. N. Buckley and A. Ostrovsky, “Back to Business—How Putin’s Allies Are Turning Russia into a Corporate State,” Financial Times, June 19, 2006, p. 11.
28. J. E. Stiglitz, Globalization and Its Discontents (New York: W. W. Norton, 2003); J. Bhagwati, In Defense of Globalization (New York: Oxford University Press, 2004); Friedman, The World Is Flat.
29. See, for example, Ravi Batra, The Myth of Free Trade (New York: Touchstone Books,
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1993); William Greider, One World, Ready or Not: The Manic Logic of Global Capitalism (New York: Simon & Schuster, 1997); D. Radrik, Has Globalization Gone Too Far? (Washington, DC: Institution for International Economics, 1997).
30. E. Goldsmith, “The Winners and the Losers,” in The Case Against the Global Economy, ed. J. Mander and E. Goldsmith (San Francisco: Sierra Club, 1996); Lou Dobbs, Exporting America (New York: Time Warner Books, 2004).
31. D. L. Bartlett and J. B. Steele, “America: Who Stole the Dream,” Philadelphia Inquirer, September 9, 1996.
32. For example, see Paul Krugman, Pop Internationalism (Cambridge, MA: MIT Press, 1996).
33. For example, see B. Milanovic and L. Squire, “Does Tariff Liberalization Increase Wage Inequality?” National Bureau of Economic Research, working paper no. 11046, January 2005; B. Milanovic, “Can We Discern the Effect of Globalization on Income Distribution?” World Bank Economic Review 19 (2005), pp. 21–44. Also see the summary in Thomas Piketty, “The Globalization of Labor,” in Capital in the Twenty First Century (Cambridge, MA: Harvard University Press, 2014).
34. See Piketty, “The Globalization of Labor.” 35. A. Ebenstein, A. Harrison, M. McMillam, and S. Phillips, “Estimating the Impact of Trade
and Offshoring on American Workers Using the Current Population Survey,” Review of Economics and Statistics 67 (October 2014), pp. 581–95.
36. M. Forster and M. Pearson, “Income Distribution and Poverty in the OECD Area,” OECD Economic Studies 34 (2002); OECD, “Growing Income Inequality in OECD Countries,” OECD Forum, May 2, 2011.
37. See Piketty, “The Globalization of Labor.” 38. See Krugman, Pop Internationalism; D. Belman and T. M. Lee, “International Trade and
the Performance of U.S. Labor Markets,” in U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996).
39. R. B. Freeman, “Labor Market Imbalances: Shortages, Surpluses, or What?” Volume 51, Conference Series, Federal Reserve Bank of Boston, 2006.
40. E. Goldsmith, “Global Trade and the Environment,” in The Case Against the Global Economy, eds. J. Mander and E. Goldsmith (San Francisco: Sierra Club, 1996).
41. P. Choate, Jobs at Risk: Vulnerable U.S. Industries and Jobs Under NAFTA (Washington, DC: Manufacturing Policy Project, 1993).
42. P. Choate, Jobs at Risk: Vulnerable U.S. Industries and Jobs Under NAFTA (Washington, DC: Manufacturing Policy Project, 1993).
43. B. Lomborg, The Skeptical Environmentalist (Cambridge, UK: Cambridge University Press, 2001).
44. H. Nordstrom and S. Vaughan, Trade and the Environment, World Trade Organization Special Studies No. 4 (Geneva: WTO, 1999).
45. Figures are from “Freedom’s Journey: A Survey of the 20th Century. Our Durable Planet,” The Economist, September 11, 1999, p. 30.
46. For an exhaustive review of the empirical literature, see B. R. Copeland and M. Scott Taylor, “Trade, Growth and the Environment,” Journal of Economic Literature, March 2004, pp. 7–77.
47. G. M. Grossman and A. B. Krueger, “Economic Growth and the Environment,” Quarterly Journal of Economics 110 (1995), pp. 353–78.
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48. For an economic perspective on climate change, see William Nordhouse, The Climate Casino (Princeton, NJ: Yale University Press, 2013).
49. Krugman, Pop Internationalism. 50. R. Kuttner, “Managed Trade and Economic Sovereignty,” in U.S. Trade Policy and Global
Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996). 51. Ralph Nader and Lori Wallach, “GATT, NAFTA, and the Subversion of the Democratic
Process,” U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996), pp. 93–94.
52. Lant Pritchett, “Divergence, Big Time,” Journal of Economic Perspectives 11, no. 3 (Summer 1997), pp. 3–18. The data are from the World Bank’s World Development Indicators, 2015.
53. Lant Pritchett, “Divergence, Big Time,” Journal of Economic Perspectives 11, no. 3 (Summer 1997), pp. 3–18. The data are from the World Bank’s World Development Indicators, 2015.
54. W. Easterly, “How Did Heavily Indebted Poor Countries Become Heavily Indebted?” World Development, October 2002, pp. 1677–96; J. Sachs, The End of Poverty (New York: Penguin Books, 2006).
55. See D. Ben-David, H. Nordstrom, and L. A. Winters, Trade, Income Disparity and Poverty. World Trade Organization Special Studies No. 5 (Geneva: WTO, 1999).
56. William Easterly, “Debt Relief,” Foreign Policy, November–December 2001, pp. 20–26. 57. Jeffrey Sachs, “Sachs on Development: Helping the World’s Poorest,” The Economist,
August 14, 1999, pp. 17–20. 58. World Trade Organization, Annual Report 2003 (Geneva: WTO, 2004).
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Part 2 National Differences
National Differences in Political, Economic, and Legal Systems
Learning Object ives After reading this chapter, you will be able to:
LO2-1 Understand how the political systems of countries differ.
LO2-2 Understand how the economic systems of countries differ.
LO2-3 Understand how the legal systems of countries differ.
LO2-4 Explain the implications for management practice of national differences in political economy.
Transformation in Saudi Arabia
opening case The desert kingdom of Saudi Arabia is a rarity in the modern world, an absolute monarchy whose laws are based upon interpretations of a religious text, the Qur’an, the holy book of Islam. Despite its adherence to an archaic form of government, the Saudi economy has historically performed well, primarily due to the country’s position as the world’s largest oil exporter. In 2017, the country’s GDP per capita on a purchasing power parity basis was $55,300, not far behind the $59,500 GDP per capita
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of the United States.
The oil sector accounts for around 87 percent of government revenues, 42 percent of GDP, and 90 percent of export earnings. In times of high oil prices, the Saudi government has used oil revenues to finance a sprawling government apparatus and to subsidize energy prices, which are among the lowest in the world. In 2014, however, oil prices collapsed, wiping out an annual government surplus. In 2015, the government deficit ballooned to 15 percent of GDP, and it hit 20 percent of GDP in 2016, forcing the country to issue more debt and draw down its foreign exchange reserves.
To compound matters, Saudi Arabia has a young population—some 70 percent of the population is under the age of 30—and unemployment is high at 12 percent, a combination of factors that many see as a recipe for social unrest. The high unemployment reflects the fact that while there are jobs available outside of the government sector, most of them are taken by low-paid foreign workers, who account for 80 percent of the labor force.
Following the death of his brother, in January 2015 Salman bin Abd al-Aziz Al Saud became King. Breaking with tradition, the aging King quickly devolved substantial power to his son, crown prince Muhammad bin Salman (commonly known as “MBS”). The young crown prince articulated a different vision for Saudi Arabia. Known as Vision 2030, this calls for reducing the kingdom’s dependence on oil revenues, privatizing the state-owned oil company Saudi Aramco, cutting energy and water subsidies, growing the private sector, investing $500 billion in a new city called NEOM that will serve as a hub for private and foreign investment, and introducing a value-added tax in order to close the government deficit. At the same time, the crown prince is seeking to loosen the stifling moral codes that have limited cultural life and to promote a “moderate Islam open to the world and all religions.”
Not surprisingly, this vision has met with resistance, particularly from members of the sprawling royal family and conservative clergy who have benefited from the status quo. To counter this, the crown prince consolidated his power, removing members of the royal family that disagreed with him and putting his allies in positions of power. This culminated in an unprecedented shake-up in November 2017 when scores of people, including some of the most powerful princes in the kingdom, were arrested in a massive anticorruption sweep and jailed in, of all places, Riyadh’s opulent Ritz Carlton.
Whether this power grab will help the crown prince achieve his goals for Saudi Arabia remains to be seen. The government has had to backtrack on plans to reduce subsidies after strong resistance from the population, but it did introduce a 5 percent value-added tax in January 2018. Plans for the privatization of Saudi Aramco are under way, and the government budget deficit has been cut in half since 2015— although stronger oil prices have had a lot to do with that. Some of the stricter laws have also been relaxed. Women are now allowed to drive and some banned cultural entertainments once seen as decadent, including going to the cinema, may soon be allowed. In the long run though, transforming the Saudi economy will require growth in the non-oil private sector, and that is a challenging task. Moreover, the scandal surrounding the murder of journalist Jamal Khoshoggi by Saudi operatives in Turkey in October 2018 has at the very least potentially weakened the power of the crown prince and the resulting fallout may constitute a significant setback to his reform efforts. • Sources: Asa Fitch, “Saudi Arabia Plans Record Spending in New Budget,” The Wall Street Journal, December 19, 2017; Brittany De Lea, “Saudi Citizens Plagued by New Taxes, High Unemployment after Oil Price Collapse,” Fox Business, October 26, 2017; and “Saudi Arabia’s Unprecedented Shake-up,” The Economist, November 5, 2017.
Introduction International business is much more complicated than domestic business because countries differ in many ways. Countries have different political, economic, and legal systems. They vary significantly in their level of economic development and future economic growth trajectory. 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 international business. They have a profound impact on the benefits, costs, and risks associated with doing business in different countries; the way in which operations in different countries should be
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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.
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 with and influence each other, and in doing so, they affect the level of economic well-being. In Chapter 3, we build on the concepts discussed here to explore in detail how differences in political, economic, and legal systems influence the economic development of a nation-state and its likely future growth trajectory. In Chapter 4, we look at differences in societal culture and at how these differences influence the practice of international business. Moreover, as we will see in Chapter 4, societal culture has an influence on the political, economic, and legal systems in a nation and thus its level of economic well- being. We also discuss how the converse may occur: how political, economic, and legal systems may also shape societal culture.
The opening case illustrates some of the issues discussed in this chapter. Saudi Arabia is an absolute monarchy where the state controls large portions of economic activity and where laws are directly informed by religious teachings taken from the Qur’an. In this regard, the country could not be more different than an advanced Western nation such as the United States. At the same time, Saudi Arabia is now actively trying to change its economic system, diversifying activity away from oil, and in doing so seeks to attract more foreign investment, creating an opportunity for international business. To be successful in the country, however, international businesses need to understand the political economy and the culture of the Saudi nation. Moreover, the kind of transformation in political economy and culture that Saudi Arabia is embarking upon is risky, and failure is possible—a fact that anyone seeking to invest in the Kingdom needs to take into account.
The “Get Insights by Country” section of globalEDGE™ (globaledge.msu.edu/global-insights/by/country) is your source for information and statistical data for nearly every country around the world (more than 200 countries). As related to Chapter 2 of the text, globalEDGE™ has a wealth of information and data on national differences in political economy. 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 abbreviated fingertip access to current information. At a minimum, we suggest that you take a look at the country pages of the United Kingdom and Sweden because the authors of this text are from those countries—have you figured out who is from the UK and who is from Sweden yet?
Political Systems LO 2-1 Understand how the political systems of countries differ.
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The political system of a country shapes its economic and legal systems.1 Thus, we need to understand the nature of different political systems before discussing economic and legal systems. By political system, we mean the system of government in a nation. Political systems can be assessed according to two dimensions. 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 collectivism is emphasized, the needs of society as a whole are generally viewed as being more important than individual freedoms. In such circumstances, an individual’s right to do something may be restricted on the grounds that it runs counter to “the good of society” or to “the common good.” Advocacy of collectivism can be traced to the ancient Greek philosopher Plato (427–347 B.C.), who, in 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 society would be forced down to subsistence levels. He argued that capitalists expropriate for their own use the value created by workers, while paying workers only subsistence wages in return. According to Marx, the pay of workers does not reflect the full value of their labor. To correct this perceived wrong, Marx advocated state ownership of the basic means of production, distribution, and exchange (i.e., businesses). His logic was that if the state owned the means of production, the state could ensure that workers were fully compensated for their labor. 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
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republics, many of which were at least nominally structured as democracies. Communism was swept out of eastern Europe by the largely bloodless revolutions of 1989. Although China is still nominally a communist state with substantial limits to individual political freedom, in the economic sphere, the country has moved sharply away from strict adherence to communist ideology. Old-style communism, with state control over all economic activity, hangs on in only a handful of small fringe states, most notably North Korea.
Social democracy also seems to have passed a high-water mark, although the ideology may prove to be more enduring than communism. Social democracy has had perhaps its greatest influence in a number of democratic Western nations, including Australia, Denmark, Finland, France, Germany, Great Britain, Norway, Spain, and Sweden, where social democratic parties have often held political power. Other countries where social democracy has had an important influence include India and Brazil. Consistent with their Marxist roots, after World War II social democratic government in some nations nationalized some private companies, transforming them into state-owned enterprises to be run for the “public good rather than private profit.” This trend was most marked in Great Britain where by the end of the 1970s state-owned companies had a monopoly in the telecommunications, electricity, gas, coal, railway, and shipbuilding industries, as well as substantial interests in the oil, airline, auto, and steel industries.
However, experience demonstrated that state ownership of the means of production ran counter to the public interest. In many countries, state-owned companies performed poorly. Protected from competition by their monopoly position and guaranteed government financial support, many became increasingly inefficient. Individuals paid for the luxury of state ownership through higher prices and higher taxes. As a consequence, a number of Western democracies voted many social democratic parties out of office in the late 1970s and early 1980s. 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 economics. 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 were now 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 precedence over the interests of the state. Like collectivism, individualism can be traced to an ancient Greek philosopher, in this case Plato’s disciple Aristotle (384–322 B.C.). In contrast to Plato, Aristotle argued that individual diversity and private ownership are desirable. In a passage that might have been taken from a speech by contemporary politicians who adhere to a free market ideology, he argued that private property is more highly productive than communal property and will thus stimulate progress. According to Aristotle, communal property receives little care, whereas property that is owned by an individual will receive the greatest care and therefore be most productive.
Individualism was reborn as an influential political philosophy in the Protestant trading nations of England and the Netherlands during the sixteenth century. The philosophy was refined in the work of a number of British philosophers, including David Hume (1711–1776), Adam Smith (1723–1790), and John Stuart Mill (1806–1873). Individualism exercised a profound influence on those in the American colonies that sought independence from Great Britain. Indeed, the concept underlies the ideas expressed in the Declaration of Independence. In the twentieth century, several Nobel Prize–winning economists—including Milton Friedman, Friedrich von Hayek, and James Buchanan—championed the philosophy.
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What About People’s Future Rights?
Individualism versus collectivism is a centuries-old debate topic and an inherently interesting issue. For example, does an individual’s life belong to him or her or to the community, society, or country in which he or she resides? Most people have a direct and immediate answer, but there is no consensus on which answer, depending on which country you reside in or which personal “compass” you subscribe to. Everyone has tendencies toward being both individualistic and collectivistic but prefers one way more than the other. So, which of these ideas—individualism or collectivism—do you think is correct, and which cultural belief do you prefer and why?
Source: Objective Standard, March 3, 2014. www.theobjectivestandard.com.
Individualism is built on two central tenets. The first is an emphasis on the importance of guaranteeing individual freedom and self-expression. The second tenet of individualism is that the welfare of society is best served by letting people pursue their own economic self-interest, as opposed to some collective body (such as government) dictating what is in society’s best interest. Or, as Adam Smith put it in a famous passage from The Wealth of Nations, “an individual who intends his own gain is led by an invisible hand to promote an end that was no part of his intention. Nor is it always worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. 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 individual; 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, championed by the United States. From the late 1980s until about 2005, the waning of collectivism was matched by the ascendancy of individualism. Democratic ideals and market economics replaced socialism and communism in many states. Since 2005, there have been some signs of a small swing back toward left-leaning socialist ideas in several countries, including several Latin America nations such as Venezuela, Bolivia, and Paraguay, along with Russia (see the Country Focus for details). Also, the global financial crisis of 2008–2009 caused some reevaluation of the trends toward individualism, and it remains possible that the pendulum might tilt back the other way.
DEMOCRACY AND TOTALITARIANISM
Democracy and totalitarianism are at different ends of a political dimension. Democracy refers to a political system in which government is by the people, exercised either directly or through elected representatives. Totalitarianism is a form of government in which one person or political party exercises absolute control over all spheres of human life and prohibits opposing political parties. The democratic–totalitarian dimension is not independent of the individualism– collectivism dimension. Democracy and individualism go hand in hand, as do the communist version of collectivism and totalitarianism. However, gray areas exist; it is possible to have a democratic state in which collective values predominate, and it is possible to have a totalitarian state that is hostile to collectivism and in which some degree of individualism—particularly in the economic sphere—is encouraged. For example, China and Vietnam have seen a move
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toward greater individual freedom in the economic sphere, but those countries are stilled ruled by parties that have a monopoly on political power and constrain political freedom.
Democracy 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. The United States, for example, is a constitutional republic that operates as a representative democracy. In a representative democracy, citizens periodically elect individuals to represent them. 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.
c o u n t r y F O C U S
Putin’s Russia The modern Russian state was born in 1991 after the dramatic collapse of the Soviet Union. Early in the post-Soviet era, Russia embraced ambitious policies designed to transform a communist dictatorship with a centrally planned economy into a democratic state with a market-based economic system. 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 privatization of many state-owned enterprises was done in such a way as to leave large shareholdings in the hands of the politically connected, many of whom were party officials and factory managers under the old Soviet system. Corruption was also endemic, and organized crime was able to seize control of some newly privatized enterprises. In 1998, the poorly managed Russian economy went through a financial crisis that nearly bought the country to its knees.
Fast-forward to 2018, and Russia still is a long way from being a modern democracy with a functioning free market–based economic system. On the positive side, the economy grew at a healthy clip during most of the 2000s, helped in large part by high prices for oil and gas, Russia’s largest exports (in 2013 oil and gas accounted for 75 percent of all Russian exports). Between 2000 and 2013, Russia’s gross domestic product (GDP) per capita more than doubled when measured by purchasing power parity. The country now boasts the world’s 12th-largest economy. Thanks to government oil revenues, public debt is also low by international standards—at just 12 percent of GDP in 2017 (in the United States, by comparison, public debt amounts to 70 percent of GDP). Indeed, Russia has run a healthy trade surplus on the back of strong oil and gas exports for the last decade.
On the other hand, the economy is overly dependent on commodities, particularly oil and gas. This was exposed in mid-2014 when the price of oil started to tumble as a result of rapidly increasing supply from the United States. Between mid-2014 and early 2016, the price of oil fell from $110 a barrel to a low of around $27 before rebounding to $50. This drove a freight train through Russia’s public finances. Much of Russia’s oil and gas production remains in the hands of enterprises in which the state still has a significant ownership stake. The government has a controlling ownership position in Gazprom and Rosneft, two of the country’s largest oil and gas companies. The government used the rise in oil and gas revenues between 2004 and 2014 to increase public spending through state-led investment projects and increases in wages and pensions for government workers. While this boosted private consumption, there has been a dearth of private investment, and productivity growth remains low. This is particularly true among many state-owned enterprises that collectively still account for about half of the Russian economy. Now with lower oil prices, Russia is having to issue more debt to finance public spending.
Russian private enterprises are also hamstrung by bureaucratic red tape and endemic corruption. The World Bank ranks Russia 92nd in the world in terms of the ease of doing business and 88th when it
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comes to starting a business (for comparison, the United States is ranked 4th and 20th, respectively). Transparency International, which ranks countries by the extent of corruption, ranked Russia 135 out of 176 nations in 2017. 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 becoming less democratic with every passing year. Since 1999, Vladimir Putin has exerted increasingly tight control over Russian politics, either as president or as prime minister. Under Putin, potential opponents have been sidelined, civil liberties have been progressively reduced, and the freedom of the press has been diminished. For example, in response to opposition protests in 2011 and 2012, the Russian government passed laws increasing its control over the Internet, dramatically raising fines for participating in “unsanctioned” street protests, and expanded the definition of treason to further limit opposition activities. Vocal opponents of the régime—from business executives who do not toe the state line to protest groups such as the punk rock protest band Pussy Riot—have found themselves jailed on dubious charges. To make matters worse, Putin has recently been tightening his grip on the legal system. In late 2013, Russia’s parliament, which is dominated by Putin supporters, gave the president more power to appoint and fire prosecutors, thereby diminishing the independence of the legal system.
Freedom House, which produces an annual ranking tracking freedom in the world, classifies Russia as “not free” and gives it low scores for political and civil liberties. Freedom House notes that in the March 2012 presidential elections, Putin benefited from preferential treatment by state-owned media, numerous abuses of incumbency, and procedural “irregularities” during the vote count. Putin won 63.6 percent of the vote against a field of weak, hand-chosen opponents, led by Communist Party leader Gennadiy Zyuganove, with 17.2 percent of the vote. Under a Putin-inspired 2008 constitutional amendment, the term of the presidency was expanded from four years to six. Putin was elected to another six-year term in 2018 in an election that many observers thought was a sham.
In 2014, Putin burnished his growing reputation for authoritarianism when he took advantage of unrest in the neighboring country of Ukraine to annex the Crimea region and to support armed revolt by Russian-speaking separatists in eastern Ukraine. Western powers responded to this aggression by imposing economic sanctions on Russia. Taken together with the rapid fall in oil prices, this pushed the once-booming Russian economy into a recession. In 2014, the economy grew by just 0.6 percent, while the Russian ruble tumbled, losing half of its value against other major currencies. The economy contracted by 2.8 percent in 2015 and another 0.2 percent in 2016 before growing by 1.8 percent in 2017. Despite economic weaknesses, there is no sign that Putin’s hold on power has been diminished; in fact, quite the opposite seems to have occurred.
Sources: “Putin’s Russia: Sochi or Bust,” The Economist, February 1, 2014; “Russia’s Economy: The S Word,” The Economist, November 9, 2013; Freedom House, “Freedom in the World 2017: Russia,” www.freedomhouse.org; and K. Hille, “Putin Tightens Grip on Legal System,” Financial Times, November 27, 2013.
To guarantee that elected representatives can be held accountable for their actions by the electorate, an ideal representative democracy has a number of safeguards that are typically enshrined in constitutional law. 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 system; (7) a nonpolitical state bureaucracy; (8) a nonpolitical police force and armed service; and (9) relatively free access to state information.5
Totalitarianism In a totalitarian country, all the constitutional guarantees on which representative democracies are built—an individual’s right to freedom of expression and organization, a free media, and regular elections—are denied to the citizens. In most totalitarian states, political repression is widespread, free and fair elections are lacking, media are heavily censored, basic civil liberties are denied, and those who question the right of the rulers to rule
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find themselves imprisoned or worse.
Four major forms of totalitarianism exist in the world today. Until recently, the most widespread was communist totalitarianism. Communism, however, is in decline worldwide, and most of the Communist Party dictatorships have collapsed since 1989. Exceptions to this trend (so far) are China, Vietnam, Laos, North Korea, and Cuba, although most of these states exhibit clear signs that the Communist Party’s monopoly on political power is eroding. In many respects, the governments of China, Vietnam, and Laos are communist in name only because those nations have adopted wide-ranging, market-based economic reforms. 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 government of the late Hugo Chávez displayed totalitarian tendencies. The same is true in Russia, where the government of Vladimir Putin has become increasingly totalitarian over time (see the Country Focus).
A second form of totalitarianism might be labeled theocratic totalitarianism. Theocratic 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 boundaries drawn by the old European colonial powers rather than tribal realities. Consequently, the typical African country contains a number of tribes (e.g., in Kenya there are more than 40 tribes). Tribal totalitarianism occurs when a political party that represents the interests of a particular tribe (and not always the majority tribe) monopolizes power. In Kenya, for example, politicians from the Kikuyu tribe have long dominated the political system.
A fourth major form of totalitarianism might be described as right-wing totalitarianism. Right-wing totalitarianism generally permits some individual economic freedom but restricts individual political freedom, frequently on the grounds that it would lead to the rise of communism. A common feature of many right-wing dictatorships is an overt hostility to socialist or communist ideas. Many right-wing totalitarian governments are backed by the military, and in some cases, the government may be made up of military officers. 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 dictatorships, were common throughout Latin America (e.g., Brazil was ruled by a military dictatorship between 1964 and 1985). 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.
Is Representative Democracy the Best Way?
Chile is a country in South America that borders the South Pacific Sea. Neighboring countries include Argentina, Bolivia, and Peru—also representative democracies. Chile has a strategic location relative to sealanes between the Atlantic and Pacific Oceans, including the Strait of Magellan, the Beagle Channel,
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and the Drake Passage. Chile has a market-oriented economy in which the prices of goods and services are determined in a free price system. 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.
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 toe the official line. However, Putin has used his position to systematically limit the political and civil liberties of opposition groups. His control is not yet perfect, though. Voices opposing Putin are still heard in Russia, and in theory, elections are still contested. But in practice, it is becoming increasingly difficult to challenge a man and régime that have systematically extended their political, legal, and economic power over the past two decades (see the Country Focus).
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Economic Systems LO 2-2 Understand how the economic systems of countries differ.
It should be clear from the previous section that political ideology and economic systems are connected. In countries where individual goals are given primacy over collective goals, we are more likely to find market-based economic systems. In contrast, in countries where collective goals are given preeminence, the state may have taken control over many enterprises; markets in such countries are likely to be restricted rather than free. We can identify three broad types of economic systems: a market economy, a command economy, and a mixed economy.
MARKET ECONOMY
In the archetypal pure market economy, all productive activities are privately owned, as opposed to being owned by the state. The goods and services that a country produces are not planned by anyone. Production is determined by the interaction of supply and demand and signaled to producers through the price system. If demand for a product exceeds supply, prices will rise, signaling producers to produce more. If supply exceeds demand, prices will fall, signaling producers to produce less. In this system, consumers are sovereign. The purchasing patterns of consumers, as signaled to producers through the mechanism of the price system, determine what is produced and in what quantity.
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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. Although this is good for the monopolist, it is bad for the consumer, who has to pay higher prices. It also is probably bad for the welfare of society. Because a monopolist has no competitors, it has no incentive to search for ways to lower production costs. Rather, it can simply pass on cost increases to consumers in the form of higher prices. 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, one role of government in a market economy is to encourage vigorous free and fair competition between private producers. Governments do this by banning restrictive business practices designed to monopolize a market (antitrust laws serve this function in the United States and European Union). Private ownership also encourages vigorous competition and economic efficiency. Private ownership ensures that entrepreneurs have a right to the profits generated by their own efforts. This gives entrepreneurs an incentive to search for better ways of serving consumer needs. That may be through introducing new products, by developing more efficient production processes, by pursuing better marketing and after-sale service, or simply through managing their businesses more efficiently than their competitors. In turn, the constant improvement in product and process that results from such an incentive has been argued to have a major positive impact on economic growth and development.6
COMMAND ECONOMY
In a pure command economy, the government plans the goods and services that a country produces, the quantity in which they are produced, and the prices at which they are sold. Consistent with the collectivist ideology, the objective of a command economy is for government to allocate resources for “the good of society.” In addition, in a pure command economy, all businesses are state owned, the rationale being that the government can then direct them to make investments that are in the best interests of the nation as a whole rather than in the interests of private individuals. Historically, command economies were found in communist countries where collectivist goals were given priority over individual goals. Since the demise of communism in the late 1980s, the number of command economies has fallen dramatically. Some elements of a command economy were also evident in a number of democratic nations led by socialist-inclined governments. France and India both experimented with extensive government planning and state ownership, although government planning has fallen into disfavor in both countries.
While the objective of a command economy is to mobilize economic resources for the public good, the opposite often seems to have occurred. In a command economy, state-owned enterprises have little incentive to control costs and be efficient because they cannot go out of business. Also, the abolition of private ownership means there is no incentive for individuals to look for better ways to serve consumer needs; hence, dynamism and innovation are absent from command economies. Instead of growing and becoming more prosperous, such economies tend to stagnate.
MIXED ECONOMY
Mixed economies can be found between market and command economies. In a mixed economy,
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certain sectors of the economy are left to private ownership and free market mechanisms, while other sectors have significant state ownership and government planning. Mixed economies were once common throughout much of the developed world, although they are becoming less so. Until the 1980s, Great Britain, France, and Sweden were mixed economies, but extensive privatization has reduced state ownership of businesses in all three nations. A similar trend occurred in many other countries where there was once a large state-owned sector, such as Brazil, Italy, and India (although there are still state-owned enterprises in all of these nations). As a counterpoint, the involvement of the state in economic activity has been on the rise again in countries such as Russia and Venezuela, where authoritarian regimes have seized control of the political structure, typically by first winning power through democratic means and then subverting those same structures to maintain their grip on power.
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North Korean leader Kim Jong-un visiting a factory.
©AFP/Getty Images
In mixed economies, governments also tend to take into state ownership troubled firms whose continued operation is thought to be vital to national interests. For example, in 2008 the U.S. government took an 80 percent stake in AIG to stop that financial institution from collapsing, the theory being that if AIG did collapse, it would have very serious consequences for the entire financial system. 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 troubled enterprises in highly unusually circumstances. As soon as it was able to, the government sold these stakes. In early 2010, for example, the U.S. government sold its stake in Citigroup. The government stake in AIG was sold off in 2012, and by 2014, it had also disposed of its stake in GM.
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Legal Systems LO 2-3 Understand how the legal systems of countries differ.
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 government of a country defines the legal framework within which firms do business, and often the laws that regulate business reflect the rulers’ dominant political ideology. For example, collectivist- inclined totalitarian states tend to enact laws that severely restrict private enterprise, whereas the laws enacted by governments in democratic states where individualism is the dominant political philosophy tend to be pro-private enterprise and pro-consumer.
Here, we focus on several issues that illustrate how legal systems can vary—and how such variations can affect international business. First, we look at some basic differences in legal systems. Next we look at contract law. 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 interpretation sets a precedent that may be followed in future cases. As new precedents arise, laws may be altered, clarified, or amended to deal with new situations.
Civil Law A civil law system is based on a detailed set of laws organized into codes. When law courts interpret civil law, they do so with regard to these codes. More than 80 countries— including Germany, France, Japan, and Russia—operate with a civil law system. A civil law system tends to be less adversarial than a common law system because the judges rely on detailed legal codes rather than interpreting tradition, precedent, and custom. Judges under a civil law system have less flexibility than those under a common law system. Judges in a common law system have the power to interpret the law, whereas judges in a civil law system have the power only to apply the law.
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Theocratic Law A theocratic law system is one in which the law is based on religious teachings. Islamic law is the most widely practiced theocratic legal system in the modern world, although usage of both Hindu and Jewish law persisted into the twentieth century. Islamic law is primarily a moral rather than a commercial law and is intended to govern all aspects of life.7 The foundation for Islamic law is the holy book of Islam, the Koran, along with the Sunnah, or decisions and sayings of the Prophet Muhammad, and the writings of Islamic scholars who have derived rules by analogy from the principles established in the Koran and the Sunnah. Because the Koran and Sunnah are holy documents, the basic foundations of Islamic law cannot be changed. However, in practice, Islamic jurists and scholars are constantly debating the application of Islamic law to the modern world. In reality, many Muslim countries have legal systems that are a blend of Islamic law and a common or civil law system.
Do You Agree with the Unique System of Islamic Banking?
How can a banking system operate without interest (riba in Arabic)? 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?
Although Islamic law is primarily concerned with moral behavior, it has been extended to cover certain commercial activities. An example is the payment or receipt of interest, which is considered usury and outlawed by the Koran. To the devout Muslim, acceptance of interest payments is seen as a grave sin; the giver and the taker are equally damned. 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, there were some 500 Islamic financial institutions in the world, and as of 2014, they collectively managed more than $1 trillion in assets. In addition to Pakistan, Islamic financial institutions are found in many of the Gulf states, Egypt, Malaysia, and Iran.9
DIFFERENCES IN CONTRACT LAW
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 business 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.
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Because common law tends to be relatively ill specified, contracts drafted under a common law framework tend to be very detailed with all contingencies spelled out. In civil law systems, however, contracts tend to be much shorter and less specific because many of the issues are already covered in a civil code. 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. International businesses need to be sensitive to these differences; approaching a contract dispute in a state with a civil law system as if it had a common law system may backfire, and vice versa.
When contract disputes arise in international trade, there is always the question of which country’s laws to apply. To resolve this issue, a number of countries, including the United States, have ratified the United Nations Convention on Contracts for the International Sale of Goods (CISG). The CISG establishes a uniform set of rules governing certain aspects of the making and performance of everyday commercial contracts between sellers and buyers who have their places of business in different nations. By adopting the CISG, a nation signals to other adopters that it will treat the convention’s rules as part of its law. The CISG applies automatically to all contracts for the sale of goods between different firms based in countries that have ratified the convention, unless the parties to the contract explicitly opt out. One problem with the CISG, however, is that as of 2016, only 83 nations had ratified the convention (the CISG went into effect in 1988).10 Some of the world’s important trading nations, including India and the United Kingdom, have not ratified the CISG.
When firms do not wish to accept the CISG, they often opt for arbitration by a recognized arbitration court to settle contract disputes. 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 property refers to a resource over which an individual or business holds a legal title, that is, a resource that it owns. Resources include land, buildings, equipment, capital, mineral rights, businesses, and intellectual property (ideas, which are protected by patents, copyrights, and trademarks). Property rights refer to the legal rights over the use to which a resource is put and over the use made of any income that may be derived from that resource.12 Countries differ in the extent to which their legal systems define and protect property rights. Almost all countries now have laws on their books that protect property rights. Even China, still nominally a communist state despite its booming market economy, finally enacted a law to protect the rights of private property holders in 2007 (the law gives individuals the same legal protection for their property as the state has).13 However, in many countries these laws are not enforced by the authorities, and property rights are violated. Property rights can be violated in two ways: through private action and through public action.
Private Action In terms of violating property rights, private action refers to theft, piracy, blackmail, and the like by private individuals or groups. Although theft occurs in all countries, a weak legal system allows a much higher level of criminal action. For example, in the chaotic period following the collapse of communism in Russia, an outdated legal system, coupled with a weak police force and judicial system, offered both domestic and foreign businesses scant protection from blackmail by the “Russian Mafia.” Successful business owners in Russia often had to pay “protection money” to the Mafia or face violent retribution, including bombings and assassinations (about 500 contract killings of businessmen occurred per year in the 1990s).14
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Russia is not alone in having organized crime 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, resources, or the property itself from property holders. This can be done through legal mechanisms such as levying excessive taxation, requiring expensive licenses or permits from property holders, taking assets into state ownership without compensating the owners, or redistributing assets without compensating the prior owners. It can also be done through illegal means, or corruption, by demanding bribes from businesses in return for the rights to operate in a country, industry, or location.16
Corruption has been well documented in every society, from the banks of the Congo River to the palace of the Dutch royal family, from Japanese politicians to Brazilian bankers, and from government officials in Zimbabwe to the New York City Police Department. 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 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. This seems to have been the case in Brazil until recently; the situation there may be evolving in a more positive direction.
According to Transparency International, an independent nonprofit organization dedicated to exposing and fighting corruption, businesses and individuals spend some $400 billion a year worldwide on bribes related to government procurement contracts alone.17 Transparency International has also measured the level of corruption among public officials in different countries.18 As can be seen in Figure 2.1, the organization rated countries such as New Zealand and Sweden as clean; it rated others, such as Russia, India, Zimbabwe and Venezuela, as corrupt. Somalia ranked last out of all 180 countries in the survey (the country is often described as a “failed state”).
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2.1 FIGURE Rankings of corruption by country, 2017.
Source: Constructed by the author from raw data from Transparency International, Corruption Perceptions Index 2017.
Economic evidence suggests that high levels of corruption significantly reduce the foreign direct investment, level of international trade, and economic growth rate in a country.19 By siphoning off profits, corrupt politicians and bureaucrats reduce the returns to business investment and, hence, reduce the incentive of both domestic and foreign businesses to invest in that country. 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 lower rate of economic growth than might otherwise have been the case. A detailed example of the negative effect that corruption can have on economic development is given in the accompanying Country Focus, which looks at the impact of corruption on economic growth in Brazil.
c o u n t r y F O C U S
Corruption in Brazil Brazil is the seventh-largest economy in the world with a gross domestic product of $2 trillion. The country has a democratic government and an economy characterized by moderately free markets, although the country’s largest oil producer (Petrobras) and one of its top banks (Banco do Brazil) are both state owned. Many economists, however, have long felt that the country has never quite lived up to its considerable economic potential. A major reason for this has been an endemically high level of corruption that favors those with political connections and discourages investment by more ethical
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businesses.
Transparency International, a nongovernmental organization that evaluates countries based on perceptions of how corrupt they are, ranked Brazil 96th out of the 180 countries it looked at in its 2017 report. The problems it identifies in Brazil include public officials who demand bribes in return for awarding government contracts and “influence peddling,” in which elected officials use their position in government to obtain favors or preferential treatment. Consistent with this, according to a study by the World Economic Forum, Brazil ranks 135th out of 144 countries in the proper use of public funds.
Over the last decade, several corruption scandals have come to light that serve to emphasize Brazil’s corruption problem. In 2005, a scandal known as the mensalao (the monthly payoff scandal) broke. The scandal started when a midlevel postal official was caught on film pocketing a modest bribe in exchange for promises to favor certain businesses in landing government contracts. Further investigation uncovered a web of influence peddling in which fat monthly payments were given to lawmakers willing to back government initiatives in National Congress. After a lengthy investigation, in late 2012 some 25 politicians and business executives were found guilty of crimes that included bribery, money laundering, and corruption.
The public uproar surrounding the mensalao scandal was just starting to die down when in March 2014 another corruption scandal captured the attention of Brazilians. This time it involved the state- owned oil company, Petrobras. Under a scheme that seems to have been operating since 1997, construction firms wanting to do business with Petrobras agreed to pay bribes to the company’s executives. Many of these executives were themselves political appointees. The executives would inflate the value of contracts they awarded, adding a 3 percent “fee,” which was effectively a kickback. The 3 percent fee was shared among Petrobras executives, construction industry executives, and politicians. The construction companies established shell companies to make payments and launder the money. According to prosecutors investigating the case, the total value of bribes may have exceeded $3.7 billion.
Four former Petrobras officials and at least 23 construction company executives have been charged with crimes that include corruption and money laundering. In addition, Brazil’s Supreme Court has given prosecutors the go-ahead to investigate 48 current or former members of Congress, including the former Brazilian President Fernando Collor de Mello. The Brazilian president, Dilma Rousseff, was also tainted by the scandal. In June 2016, she was suspended from the presidency pending an impeachment trial. She was chair of Petrobras during the time this was occurring. She is also a member of the governing Workers’ Party, several members of which seem to have been among the major beneficiaries of the kickback scandal. Although there is no evidence that Rousseff knew of the bribes or profited from them, her ability to govern effectively has been severely damaged by association. The scandal has so rocked Brazil that it has pushed the country close to a recession. In August 2016, Rousseff was impeached and removed from the presidency.
If there is a bright spot in all of this, it is that the scandals are coming to light. Backed by Supreme Court rulings and public outrage, corrupted politicians, government officials, and business executives are being prosecuted. In the past, that was far less likely to occur.
Sources: Will Conners and Luciana Magalhaes, “Brazil Cracks Open Vast Bribery Scandal,” The Wall Street Journal, April 7, 2015; Marc Margolis, “In Brazil’s Trial of the Century, Lula’s Reputation Is at Stake,” Newsweek, July 27, 2012; “The Big Oily,” The Economist, January 3, 2015; Donna Bowater, “Brazil’s Continuing Corruption Problem,” BBC News, September 18, 2015; Simon Romero, “Dilma Rousseff Is Ousted as Brazil’s President in Impeachment Vote,” The New York Times, August 31, 2016.
Foreign Corrupt Practices Act In the 1970s, the United States passed the Foreign Corrupt Practices Act (FCPA) following revelations that U.S. companies had bribed government officials in foreign countries in an attempt to win lucrative contracts. This law makes it illegal 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
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violation of the act has occurred. In 2012, evidence emerged that in its eagerness to expand in Mexico, Walmart may have run afoul of the FCPA (for details, see the Management Focus feature).
In 1997, trade and finance ministers from the member states of the Organisation for Economic Co-operation and Development (OECD), an association of 34 major economies including most Western economies (but not Russia, India or China), adopted the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions.20 The convention obliges member states to make the bribery of foreign public officials a criminal offense.
Did You Know? Did you know that it’s illegal for Americans to bribe public officials to gain business in a foreign country, even if bribery is commonplace in that nation? Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
m a n a g e m e n t F O C U S
Did Walmart Violate the Foreign Corrupt Practices Act?
In the early 2000s, Walmart wanted to build a new store in San Juan Teotihuacan, Mexico, barely a mile from ancient pyramids that drew tourists from around the world. 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 Bentonville, Arkansas. He told them that Walmart de Mexico routinely resorted to bribery, citing the altered zoning map as just one example. Alarmed, executives at Walmart started their own investigation. Faced with growing evidence of corruption in Mexico, top Walmart executives decided to engage in damage control, rather than coming clean. Walmart’s top lawyer shipped the case files back to Mexico and handed over responsibility for the investigation to the general council of Walmart de Mexico. 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 enabled Walmart to build a Sam’s Club in one of Mexico City’s most densely populated neighborhoods without a construction license, an environmental permit, an urban impact assessment, or even a traffic permit. Similarly, thanks to nine bribe payments totaling $765,000, Walmart built a vast refrigerated distribution center in an environmentally fragile flood basin north of Mexico City, in an area where electricity was so scarce that many smaller developers were turned away.
Walmart responded to The New York Times article by ramping up a second internal investigation into bribery that it had initiated in 2011. By mid-2015, there were reportedly more than 300 outside lawyers working on the investigation, and it had cost more than $612 million in fees. In addition, the U.S. Department of Justice and the Securities and Exchange Commission both announced that they had
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started investigations into Walmart’s practices. In November 2012, Walmart reported that its own investigation into violations had extended beyond Mexico to include China and India. Among other things, it was looking into the allegations by the Times that top executives at Walmart, including former CEO Lee Scott Jr., had deliberately squashed earlier investigations. In late 2016 people familiar with the matter stated that the federal investigation had not uncovered evidence of widespread bribery. In November 2017 it was reported that Walmart had settled with the Justice Department and paid a $283 million fine, significantly less than had been expected.
Sources: David Barstow, “Vast Mexican Bribery Case Hushed Up by Wal-Mart after Top Level Struggle,” 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; Nathan Vardi, “Why Justice Department Could Hit Wal-Mart Hard over Mexican Bribery Allegations,” Forbes, April 22, 2012; Phil Wahba,“Walmart Bribery Probe by Feds Finds No Major Misconduct in Mexico,” Fortune, October 18, 2015; T. Schoenberg and M. Robinson, “Wal-Mart Balks at Paying $600 Million in Bribery Case,” Bloomberg, October 6, 2016; and Sue Reisinger, “Wal-Mart Reserves $283 million to Settle Mexico FCPA Case,” Corporate Counsel, November 17, 2017.
Both the U.S. law and OECD convention include language that allows exceptions known as facilitating or expediting payments (also called grease payments or speed money), the purpose of which is to expedite or to secure the performance of a routine governmental action.21 For example, they allow small payments made to speed up the issuance of permits or licenses, process paperwork, or just get vegetables off the dock and on their way to market. The explanation for this exception to general antibribery provisions is that while grease payments are, technically, bribes, they are distinguishable from (and, apparently, less offensive than) bribes used to obtain or maintain business because they merely facilitate performance of duties that the recipients are already obligated to perform.
THE PROTECTION OF INTELLECTUAL PROPERTY
Intellectual property refers to property that is the product of intellectual activity, such as computer software, a screenplay, a music score, or the chemical formula for a new drug. Patents, copyrights, and trademarks establish ownership rights over intellectual property. A patent grants the inventor of a new product or process exclusive rights for a defined period to the manufacture, use, or sale of that invention. Copyrights are the exclusive legal rights of authors, composers, playwrights, artists, and publishers to publish and disperse their work as they see fit. Trademarks are designs and names, officially registered, by which merchants or manufacturers designate and differentiate their products (e.g., Christian Dior clothes). In the high-technology “knowledge” economy of the twenty-first century, intellectual property has become an increasingly important source of economic value for businesses. Protecting intellectual property has also become increasingly problematic, particularly if it can be rendered in a digital form and then copied and distributed at very low cost via pirated DVDs or over the Internet (e.g., computer software, music, and video recordings).22
The philosophy behind intellectual property laws is to reward the originator of a new invention, book, musical record, clothes design, restaurant chain, and the like for his or her idea and effort. Such laws stimulate innovation and creative work. 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 expensive, difficult, and time-consuming basic research required to generate new drugs (it can cost $1 billion in R&D and take 12 years to get a new drug on the market). Without the guarantees provided by patents, companies would be unlikely to commit
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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 Intellectual Property Organization, all of which have signed international treaties designed to protect intellectual property, including the oldest such treaty, the Paris Convention for the Protection of Industrial Property, which dates to 1883 and has been signed by more than 170 nations. Weak enforcement encourages the piracy (theft) of intellectual property. China and 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. A study published in 2012 suggested that violations of intellectual property rights cost personal computer software firms revenues equal to $63 billion a year.24 According to the study’s sponsor, the Business Software Alliance, a software industry association, some 42 percent of all software applications used in the world were pirated. One of the worst large countries was China, where the piracy rate ran at 77 percent and cost the industry more than $9.8 billion in lost sales, up from $444 million in 1995. 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.25
How Important Are Intellectual Property Rights?
Burundi is a landlocked country in the Great Lake region of eastern Africa. Neighboring countries include Rwanda, Tanzania, and the Democratic Republic of the Congo. Burundi is hilly and mountainous, with access to Lake Tanganyika. The government system is a republic, with the chief of state and head of government being the president. Burundi has a traditional economic system in which the allocation of available resources is made on the basis of primitive methods, and many citizens engage in subsistence agriculture. At the same time, Burundi was last of the 131 countries ranked in the 2013 International Property Rights Index (IPRI). The IPRI is conducted by a partnership of 74 international organizations. The IPRI takes into account legal and political environment, physical property rights, and intellectual property rights. How much should companies focus on intellectual property rights in deciding where to (1) produce their products and (2) sell their products? Does it differ if you produce or sell in the country?
Source: www.internationalpropertyrightsindex.org.
International businesses have a number of possible responses to violations of their intellectual property. They can lobby their respective governments to push for international agreements to ensure that intellectual property rights are protected and that the law is enforced. Partly as a result of such actions, international laws are being strengthened. As we shall see in Chapter 7, the most recent world trade agreement, signed in 1994, for the first time extends the scope of the General Agreement on Tariffs and Trade to cover intellectual property. Under the new agreement, known as the Trade-Related Aspects of Intellectual Property Rights (TRIPS), as of 1995 a council of the World Trade Organization is overseeing enforcement of much stricter intellectual property regulations. 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
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author. Rich countries had to comply with the rules within a year. Poor countries, in which such protection generally was much weaker, had five years of grace, and the very poorest have 10 years.26 (For further details of the TRIPS agreement, see Chapter 7.)
m a n a g e m e n t F O C U S
Starbucks Wins Key Trademark Case in China
Starbucks has big plans for China. It believes the fast-growing nation will become the company’s second-largest market after the United States. Starbucks entered the country in 1999, and by the end of 2016 it had opened more than 1,300 stores. But in China, copycats of well-established Western brands are common. Starbucks faced competition from a look-alike, Shanghai Xing Ba Ke Coffee Shop, whose stores closely matched the Starbucks format, right down to a green-and-white Xing Ba Ke circular logo that mimics Starbucks’ ubiquitous logo. 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 Organization have been pushing China hard recently to start respecting intellectual property rights.
Sources: M. Dickie, “Starbucks Wins Case against Chinese Copycat,” Financial Times, January 3, 2006, p. 1; “Starbucks: Chinese Court Backs Company over Trademark Infringement,” 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.
In addition to lobbying governments, firms can file lawsuits on their own behalf. For example, Starbucks won a landmark trademark copyright case in China against a copycat that signaled a change in the approach in China (see the accompanying Management Focus for details). Firms may also choose to stay out of countries where intellectual property laws are lax, rather than risk having their ideas stolen by local entrepreneurs. Firms also need to be on the alert to ensure that pirated copies of their products produced in countries with weak intellectual property laws don’t turn up in their home market or in third countries. U.S. computer software giant Microsoft, for example, discovered that pirated Microsoft software, produced illegally in Thailand, was being sold worldwide 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 holding a firm and its officers responsible when a product causes injury, death,
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or damage. Product liability can be much greater if a product does not conform to required safety standards. Both civil and criminal product liability laws exist. Civil laws call for payment and monetary damages. Criminal liability laws result in fines or imprisonment. Both civil and criminal liability laws are probably more extensive in the United States than in any other country, although many other Western nations also have comprehensive liability laws. Liability laws are typically the least extensive in less developed nations. A boom in product liability suits and awards in the United States resulted in a dramatic increase in the cost of liability insurance. Many business executives argue that the high costs of liability insurance make American businesses less competitive in the global marketplace. Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
In addition to the competitiveness issue, country differences in product safety and liability laws raise an important ethical issue for firms doing business abroad. When product safety laws are tougher in a firm’s home country than in a foreign country or when liability laws are more lax, should a firm doing business in that foreign country follow the more relaxed local standards or should it adhere to the standards of its home country? While the ethical thing to do is undoubtedly to adhere to home-country standards, firms have been known to take advantage of lax safety and liability laws to do business in a manner that would not be allowed at home.
test PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
Focus on Managerial Implications LO 2-4 Explain the implications for management practice of national differences in political
economy.
THE MACRO ENVIRONMENT INFLUENCES MARKET ATTRACTIVENESS
The material discussed in this chapter has two broad implications for international business. First, the political, economic, and legal systems of a country raise important ethical issues that have implications for the practice of international business. For example, what ethical implications are associated with doing business in totalitarian countries where citizens are denied basic human rights, corruption is rampant, and bribes are necessary to gain permission to do business? Is it right to operate in such a setting? A full discussion of the ethical implications of country differences in political economy is reserved for Chapter 5, where we explore ethics in international business in much greater depth.
Second, the political, economic, and legal environments of a country clearly influence the attractiveness of that country as a market or investment site. 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 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,
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we will delay a detailed discussion of how political economy impacts the benefits, costs, and risks of doing business in different nation-states until the end of the next chapter, when we have a full grasp of all the relevant variables that are important for assessing benefits, costs, and risks.
For now, other things being equal, a nation with democratic political institutions, a market- based economic system, and strong legal system that protects property rights and limits corruption is clearly more attractive as a place in which to do business than a nation that lacks democratic institutions, where economic activity is heavily regulated by the state, and where corruption is rampant and the rule of law is not respected. On this basis, for example, a country like Canada is a better place in which to do business than the Russia of Vladimir Putin (see the Country Focus: Putin’s Russia). 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 has been strong (although it faltered in 2015–2016), legal protection of property rights has been improving, and China is already the second largest economy in the world and could ultimately replace the United States as the world’s largest. 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 affect the attractiveness of a nation as a place in which to do business in Chapter 3.
Key Terms
political economy, p. 39 political system, p. 39 collectivism, p. 39 socialists, p. 39 communists, p. 39 social democrats, p. 39 privatization, p. 40 individualism, p. 40 democracy, p. 41 totalitarianism, p. 41 representative democracy, p. 41 communist totalitarianism, p. 43 theocratic totalitarianism, p. 43 tribal totalitarianism, p. 43 right-wing totalitarianism, p. 43 market economy, p. 44 command economy, p. 45 legal system, p. 46 common law, p. 46 civil law system, p. 46 theocratic law system, p. 47 contract, p. 47 contract law, p. 47 United Nations Convention on Contracts for the International Sale of Goods (CISG), p. 48 property rights, p. 48 private action, p. 48 public action, p. 48
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Foreign Corrupt Practices Act (FCPA), p. 50 intellectual property, p. 51 patent, p. 51 copyrights, p. 52 trademarks, p. 52 World Intellectual Property Organization, p. 52 Paris Convention for the Protection of Industrial Property, p. 52 product safety laws, p. 53 product liability, p. 53
Summary
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 function of its political, economic, and legal systems. The chapter made the following points:
1. Political systems can be assessed according to two dimensions: the degree to which they emphasize collectivism as opposed to individualism and the degree to which they are democratic or totalitarian.
2. Collectivism is an ideology that views the needs of society as being more important than the needs of the individual. Collectivism translates into an advocacy for state intervention in economic activity and, in the case of communism, a totalitarian dictatorship.
3. Individualism is an ideology that is built on an emphasis of the primacy of the individual’s freedoms in the political, economic, and cultural realms. Individualism translates into an advocacy for democratic ideals and free market economics.
4. Democracy and totalitarianism are at different ends of the political spectrum. In a representative democracy, citizens periodically elect individuals to represent them, and political freedoms are guaranteed by a constitution. In a totalitarian state, political power is monopolized by a party, group, or individual, and basic political freedoms are denied to citizens of the state.
5. 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
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investment in Russia or Poland. Both investments promise the same long-run return, so your choice is driven by risk considerations. Assess the various risks of doing business in each of these nations. Which investment would you favor and why?
5. Read the Management Focus “Did Walmart Violate the Foreign Corrupt Practices Act?” What is your opinion? If you think it did, what do you think the consequences will be for Walmart?
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. 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 around the world. Compare Brazil, Ghana, India, New Zealand, the United States, Sweden, and Turkey in terms of how easily contracts are enforced, how property can be registered, and how investors can be protected. Identify in which area you see the greatest variation from one country to the next.
The Decl ine of Zimbabwe clos ing case
In 1980, the southern African state of Zimbabwe gained independence from its colonial master, Great Britain. Speaking at the time, the late Tanzanian President, Julius Nyerere, described Zimbabwe as “the jewel of Africa.” It was a country that boasted a strong economy, abundant natural resources, and a vibrant agricultural sector. As part of the independence process, the British bequeathed Zimbabwe with democratic political institutions.
Zimbabwe’s birth as an independent nation was a difficult one. In 1965, the minority white rulers of what was then known as Rhodesia unilaterally declared independence from Britain, setting up an apartheid state where blacks were excluded from power. The British government wanted majority rule, stated that the declaration of independence was an illegal rebellion, and imposed sanctions on Rhodesia. Other nations that followed suit included the United States. An armed conflict ensued with two guerrilla movements waging war against Rhodesia’s white government. One of those guerrilla movements, the Zimbabwe African National Union (ZANU) was headed by Robert Mugabe, who aligned himself and his movement with the Maoist version of communism. A combination of international sanctions and guerrilla activity eventually forced the white minority rulers of Rhodesia to end their rebellion. In 1979, Rhodesia reverted to British colonial status.
The following year Zimbabwe gained legal independence. Robert Mugabe was elected as the country’s first prime minister. Thirty-seven years later Mugabe was still in power, now as President. His ZANU-PF party had won every election since independence. Once a largely ceremonial position, Mugabe had systematically consolidated power in the Presidency and restricted his political opponents.
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He was re-elected as President in 2013 in a general election which like many in the Mugabe era was widely seen as rigged. The country has also been beset by endemic corruption. Corruption watchdog Transparency International recently ranked Zimbabwe as one of the most corrupt nations in the world.
Zimbabwe’s economic performance in recent years ranks among the worst in the world. Although the economy maintained a positive economic growth rate through the 1980s and 1990s, it has deteriorated rapidly since 2000. Between 1999 and 2009 Zimbabwe saw the lowest economic growth rate ever recorded, with an annual decline of 6.1 percent in GDP.
©Philimon Bulawayo/Reuters
The decline occurred after Mugabe launched a “fast-track” land reform program that encouraged the seizure by the state without compensation of land owned by white farmers. At the time, some 4,000 white farmers were the backbone of the country’s strong agricultural sector. The land was given to members of the ZANU-PF party and other supporters of Mugabe, who lacked experience with modern agricultural practices and had never farmed at all. In the wake of the land reform program, agricultural productivity slumped and the country is now a net importer of food.
Another drag on the country’s growth was the 2008 Indigenisation and Economic Empowerment Act, which required that enterprises doing business in Zimbabwe have at least 51 percent local ownership. In practice, this often meant high-ranking ZANU-PF party members. After the act was passed, a number of foreign corporations doing business in the country pulled out.
The country’s mining sector remains potentially lucrative, with large platinum and diamond deposits mined by private enterprises, but almost all of the licensing revenues due to the state have reportedly disappeared into the hands of army officers and ZANU-PF politicians. Taxes and tariffs are high for private enterprises, which discourages private business formation, while state-owned enterprises are strongly subsidized. Tourism, once a big revenue earner, has declined as Zimbabwe’s wildlife has been decimated by poaching and deforestation. As economic activity slumped, the country’s formal unemployment rate reached a staggering 80 percent.
To complicate matters, Zimbabwe was devastated by the AIDS epidemic, with HIV infection rates hitting a high of 40 percent of the population in 1998. Due to AIDS and other public health problems, life expectancy fell to just 43.1 years in 2003, down from 61.6 years in 1986. By 2014, with HIV prevalence down to 15 percent, life expectancy had risen back to 54 years.
With tax revenues collapsing, Mugabe funded government programs by printing money. Inflation quickly spiraled out of control, reaching 231,000,000 percent in 2008 and requiring the Central Bank to introduce a 100 trillion Zimbabwe dollar note! In April 2009, the Zimbabwe dollar was suspended (at the time the trillion dollar note was worth around $0.40 USD). Zimbabwe allowed trade to be conducted using other currencies, particularly the U.S. dollar, the South Africa Rand, the euro, and the British pound.
Despite the country’s economic implosion, the World Bank still believes that Zimbabwe has enormous potential for sustained economic growth given its generous endowment of natural resources, its existing stock of public infrastructure, and comparatively skilled human resources. Attaining that potential will require a change in leadership and policies.
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Mugabe showed no signs of giving up the reins of power. In February 2017, he held a lavish 93rd birthday party for himself and stated that he wanted to stand for another five-year term as president in 2018. However, much to the surprise of many observers, in November 2017, Mugabe was forced to resign from office after his own party started impeachment proceedings against him. He was quickly replaced by his former vice president, Emmerson Mnangagwa, whom Mugabe had fired on November 6th in an action that precipitated the impeachment hearings. Mnangagwa has stated that he will get rid of Mugabe’s more ruinous policies in an effort to improve Zimbabwe’s battered economy.
Sources: “Will Emmerson Mnangagwa Be Better than Robert Mugabe?” The Economist, November 30, 2017; “How Robert Mugabe Ruined Zimbabwe,” The Economist, February 26, 2017; Irwin Chifera, “What Happened to Zimbabwe, Once Known as the Jewel of Africa?” VoaZimbabwe, April 17, 2015; “The Real Balancing Rocks on Every Zimbabwe Dollar,” Slate, January 23, 2017; “Diamonds in the Rough,” Human Rights Watch Report, June 26, 2009; “Zimbabwe,” The World Bank, http://www.worldbank.org/en/country/zimbabwe/overview.
CASE DISCUSSION QUESTIONS 1. Why has Zimbabwe’s economic performance been so poor? 2. Do you think that Zimbabwe’s economic performance would have been better under a
different system of government? Which one? Explain your reasoning. 3. What steps need to be taken now to improve the economic outlook for Zimbabwe?
Endnotes
1. As we shall see, there is not a strict one-to-one correspondence between political systems and economic systems. A. O. Hirschman, “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 collectivism and individualism can be found in M. Friedman and R. Friedman, Free to Choose (London: Penguin Books, 1980).
3. For a classic summary of the tenets of Marxism, see A. Giddens, Capitalism and Modern Social Theory (Cambridge, UK: Cambridge University Press, 1971).
4. Adam Smith, The Wealth of Nations, 1776. 5. R. Wesson, Modern Government—Democracy and Authoritarianism, 2nd ed. (Englewood
Cliffs, NJ: Prentice Hall, 1990). 6. For a detailed but accessible elaboration of this argument, see Friedman and Friedman,
Free to Choose. Also see P. M. Romer, “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; S. Timewell, “Islamic Finance—Virtual Concept to Critical Mass,” The Banker, March 1, 2008, pp. 10–16; Lydia Yueh, “Islamic Finance Growing Fast, But Can It Be More Than a Niche Market?” BBC News, April 14, 2014.
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.
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12. D. North, Institutions, Institutional Change, and Economic Performance (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; “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, 2014,” www.transparency.org, 2014.
18. Transparency International, Corruption Perceptions Index 2016, www.transparency.org. 19. J. Coolidge and S. Rose Ackerman, “High Level Rent Seeking and Corruption in African
Regimes,” World Bank policy research working paper no. 1780, June 1997; K. Murphy, A. Shleifer, and R. Vishny, “Why Is Rent-Seeking So Costly to Growth?” AEA Papers and Proceedings, May 1993, pp. 409–14; M. Habib and L. Zurawicki, “Corruption and Foreign Direct Investment,” Journal of International Business Studies 33 (2002), pp. 291–307; J. E. Anderson and D. Marcouiller, “Insecurity and the Pattern of International Trade,” Review of Economics and Statistics 84 (2002), pp. 342–52; T. S. Aidt, “Economic Analysis of Corruption: A Survey,” The Economic Journal 113 (November 2003), pp. 632–53; D. A. Houston, “Can Corruption Ever Improve an Economy?” Cato Institute 27 (2007), pp. 325– 43; S. Rose Ackerman and B.J. Palifka, Corruption and Government, 2nd ed. (Cambridge, UK: Cambridge University Press, 2016).
20. Details can be found at www.oecd.org/corruption/oecdantibriberyconvention.htm. 21. D. Stackhouse and K. Ungar, “The Foreign Corrupt Practices Act: Bribery, Corruption,
Record Keeping and More,” Indiana Lawyer, April 21, 1993. 22. For an interesting discussion of strategies for dealing with the low cost of copying and
distributing digital information, see the chapter on rights management in C. Shapiro and H. R. Varian, Information Rules (Boston: Harvard Business School Press, 1999). Also see C. W. L. Hill, “Digital Piracy,” Asian Pacific Journal of Management, 2007, pp. 9–25.
23. Douglass North has argued that the correct specification of intellectual property rights is one factor that lowers the cost of doing business and, thereby, stimulates economic growth and development. See North, Institutions, Institutional Change, and Economic Performance.
24. Business Software Alliance, “Ninth Annual BSA Global Software Piracy Study,” May 2012, www.bsa.org.
25. Business Software Alliance, “Ninth Annual BSA Global Software Piracy Study,” May 2012, www.bsa.org.
26. “Trade Tripwires,” The Economist, August 27, 1994, p. 61.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education
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3 Part 2 National Differences
National Differences in Economic Development
Learning Object ives After reading this chapter, you will be able to:
LO3-1 Explain what determines the level of economic development of a nation.
LO3-2 Identify the macropolitical and macroeconomic changes occurring worldwide.
LO3-3 Describe how transition economies are moving toward market-based systems.
LO3-4 Explain the implications for management practice of national difference in political economy.
Brazil’s Struggling Economy
opening case Between 2000 and 2012, Brazil had one of the fastest growing economies in the world, expanding by over 5 percent per year. In 2012, the Brazilian economy temporarily surpassed that of the United Kingdom, making it the world’s sixth largest economy. However, since then Brazil has been beset by a deep economic malaise. Economic growth decelerated in 2013. The economy entered into a serious
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recession in 2014. Economic activity contracted by over 3.5 percent in both 2015 and 2016 before growing by a sluggish 0.7 percent in 2017.
Brazil’s economic problems were partly due to a fall in global commodity prices—Brazil is a major exporter of coffee, soybeans, and iron ore—but the country has other deep structural problems. Under the leadership of President Dilma Rousseff and her left of center Workers’ Party, between 2011 and 2014 the government spent extravagantly and unwisely on higher pensions and unproductive tax breaks for favored industries. When the recession hit, unemployment surged to over 12 percent and tax revenues slumped. As a result of higher outlays and lower tax revenues, the fiscal deficit swelled from 2 percent of GDP in 2010 to 10 percent in 2015. This pushed up total government debt to 70 percent of GDP and required higher interest rates to sell government bonds, which were seen as increasingly risky. The government also raised interest rates to keep inflation in check, which historically has been a problem in Brazil. Because of high interest rates, the cost of servicing government debt expanded to 7 percent of GDP—and of course, higher interest rates, by raising borrowing costs for consumers and businesses, further depressed economic activity.
Given high interest rates, the only way for the government to get the fiscal deficit under control is to cut spending and raise taxes. This has not been easy to do. A central problem in Brazil is the country’s pension obligations. The pension system entitles Brazilians to retire, on average, at just 54. Pension obligations already account for 13 percent of GDP. Without reform, that figure could balloon to 25 percent by mid-century as the population ages.
In addition, tariff barriers protecting inefficient local enterprises from foreign competition, labor laws, and burdensome tax laws have long been seen as a drag on the Brazilian economy. A typical manufacturing firm spends 2,600 hours a year complying with the country’s complex tax code; the Latin American average is 356 hours. Labor laws make it expensive to fire even incompetent workers. And protection from international competition has resulted in manufacturing productivity that is low by international standards. To compound matters, the country has been beset by a massive corruption scandal that has reached into the highest levels of government. This resulted in the impeachment of Rousseff in 2016 and further damaged confidence in the economy (see the Country Focus “Corruption in Brazil” in Chapter 2).
In 2016, Michel Temer replaced Rousseff as President. He made a promising start to reforming the economy. Public spending has been frozen in real terms for the next twenty years. He also overhauled the country’s labor laws, making it much easier to fire unproductive workers. Inflation has moderated significantly and global economic recovery, together with a rise in commodity prices, has helped increase exports. This has allowed the central bank to reduce interest rates to 6.75 percent (they were as high as 12 percent), further boosting economic growth. There has also been a rash of privatizations—including that of the leading electric utility, Eletrobras—as the government seeks to raise capital by selling state assets and tries to increase the efficiency of the economy. As a consequence of such actions, in 2018 the International Monetary Fund (IMF) forecasts that the Brazilian economy will grow by close to 2 percent.
What remains is to fix the country’s pension problems. At a minimum, this will require raising the retirement age significantly. Temer is running up against strong resistance. His initial proposals failed to garner enough votes in the Brazilian congress to change the law on pensions. Unless these can be changed, government debt will continue to grow as the population ages, and Brazil could fall back into a crisis. • Sources: Denise Chrispim Marin, “Brazil’s Half Glass Economy,” Global Finance, October 3, 2017; “Michel Temer Is Trying to Fix Brazil’s Pension Systems,” The Economist, February 15, 2018; “Will Brazil’s Future Arrive?” The Economist, August 17, 2017; and “Brazil’s Fall,” The Economist, January 2, 2016.
Introduction In Chapter 2, we described how countries differ with regard to their political systems, economic systems, and legal systems. In this chapter, we build on this material to explain how these
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differences influence the level of economic development of a nation and, thus, how attractive it is as a place for doing business. We also look at how economic, political, and legal systems are changing around the world and what the implications of this are for the future rate of economic development of nations and regions. The past three decades have seen a general move toward more democratic forms of government, market-based economic reforms, and adoption of legal systems that better enforce property rights. Taken together, these trends have helped foster greater economic development around the world and have created a more favorable environment for international business. In the final section of this chapter, we pull all this material together to explore how differences in political, economic, and legal institutions affect the benefits, costs, and risks of doing business in different nations.
The opening case, which looks at the state of the Brazilian economy, highlights some of the issues that we will discuss in this chapter. Brazil is one of the world’s largest emerging economies (together with China and India). This nation of 210 million people enjoyed strong economic growth from 2000 to 2012 due to market-based reforms and strong export growth, making it an attractive location for international business. Since then, however, the economy has stalled. The reasons include poor economic management by the government of Dilma Rousseff, corruption scandals that sapped confidence in the economy, trade barriers that protected inefficient local enterprises from foreign competition, labor laws that made it difficult to remove unproductive employees, and pension obligations that, if left unreformed, could result in higher tax rates and slower economic growth down the road. Fixing the economy and unleashing Brazil’s considerable potential requires economic reforms, and while progress has been made in key areas, significant structural problems still remain, particularly with regard to pension obligations and trade barriers. Unless these structural problems are fixed by the government, they will negatively impact economic growth in Brazil, and reduce the attractiveness of the country going forward as a location for investment by international businesses.
Differences in Economic Development LO 3-1 Explain what determines the level of economic development of a nation.
Different countries have dramatically different levels of economic development. One common measure of economic development is a country’s gross national income (GNI) per head of population. GNI is regarded as a yardstick for the economic activity of a country; it measures the total annual income received by residents of a nation. Map 3.1 summarizes the GNI per capita of the world’s nations in 2017. As can be seen, countries such as Japan, Sweden, Switzerland, the United States, and Australia are among the richest on this measure, whereas the large developing countries of China and India are significantly poorer. Japan, for example, had a 2017 GNI per capita of $38,550, but China achieved only $8,690 and India just $1,820.1
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3.1 MAP GNI per capita, 2017.
GNI per person figures can be misleading because they don’t consider differences in the cost of living. For example, although the 2017 GNI per capita of Switzerland at $80,560 exceeded that of the United States by a wide margin, the higher cost of living in Switzerland meant that U.S. citizens could actually afford almost as many goods and services as the average Swiss citizen. To account for differences in the cost of living, one can adjust GNI per capita by purchasing power. Referred to as a purchasing power parity (PPP) adjustment, it allows a more direct comparison of living standards in different countries. 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 on whether the cost of living is lower or higher than in the United States. For example, in 2017 the GNI per capita for China was $8,690, but the PPP per capita was $15,500, suggesting that the cost of living was lower in China and that $8,260 in China would buy as much as $16,760 in the United States. Table 3.1 gives the GNI per capita measured at PPP in 2017 for a selection of countries, along with their GNI per capita and their growth rate in gross domestic product (GDP) from 2008 to 2017. Map 3.2 summarizes the GNI PPP per capita in 2017 for the nations of the world.
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3.1 TABLE Economic Data for Select Countries
Source: World Development Indicators Online, 2018.
3.2 MAP GNI PPP per capita, 2017.
Did You Know? Did you know that the United States has an economy that is 70 percent larger than that of China and has four times the standard of living?
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Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
As can be seen, there are striking differences in the standards of living among countries. Table 3.1 suggests the average Indian citizen can afford to consume only about 12 percent of the goods and services consumed by the average U.S. citizen on a PPP basis. Given this, we might conclude that despite having a population of 1.2 billion, India is unlikely to be a very lucrative market for the consumer products produced by many Western international businesses. However, this would be incorrect because India has a fairly wealthy middle class of close to 250 million people, despite its large number of poor citizens. In absolute terms, the Indian economy now rivals that of Russia.
To complicate matters, in many countries the “official” figures do not tell the entire story. Large amounts of economic activity may be in the form of unrecorded cash transactions or barter agreements. People engage in such transactions to avoid paying taxes, and although the share of total economic activity accounted for by such transactions may be small in developed economies such as the United States, in some countries (India being an example), they are reportedly very significant. Known as the black economy or shadow economy, estimates suggest that in India it may be around 50 percent of GDP, which implies that the Indian economy is half as big again as the figures reported in Table 3.1. Estimates produced by the European Union suggest that the shadow economy accounted for between 10 and 12 percent of GDP in the United Kingdom and France but 21 percent in Italy and as much as 23 percent in Greece.2
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 development that are discussed in this chapter. At the basic level, if the earth were a community of 100 people, 61 people would be Asian, 13 African, 12 European, 8 North American, 5 South American, and 1 would be from Oceania. Twenty people would own 75 percent of the financial wealth. If you could decide, how would you redistribute wealth among the 100 people? Make some richer, make the wealth among people more even, or let market forces distribute wealth as we have it now?
Source: www.miniature-earth.com.
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. Table 3.1 gives the rate of growth in gross domestic product (GDP) per capita achieved by a number of countries between 2008 and 2017. Map 3.3 summarizes the annual average percentage growth rate in GDP from 2008 to 2017. Although countries such as China and India are currently relatively poor, their economies are already large in absolute terms and growing far more rapidly than those of many advanced nations. They are already huge markets for the products of international businesses. In 2010, China overtook Japan to become the second- largest economy in the world after the United States. Indeed, if both China and the United States maintain their current economic growth rates, China will become the world’s largest economy sometime during the next decade. On current trends, India too will be among the largest
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Country Comparator
economies in the world. Given that potential, many international businesses are trying to establish a strong presence in these markets.
3.3 MAP Average annual growth rate in GDP (%), 2008–2017.
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, the globalEDGE™ Country Comparator tool is an effective way to statistically get an overview of the political economy and economic development by country worldwide. Comparisons of up to 20 countries at a time can be made in table format. Sometimes we talk about the BRIC countries when referring to Brazil, Russia, India, and China—in essence, we broadly classify them as “superstar” emerging markets, but are they really that similar? Using the Country Comparator tool on globalEDGE, we find that the GDP adjusted for purchasing power parity is by far the greatest in Russia. Where do you think Brazil, India, and China fall on the GDP PPP scale?
BROADER CONCEPTIONS OF DEVELOPMENT: AMARTYA SEN
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 capabilities
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and opportunities that people enjoy.3 According to Sen, development should be seen as a process of expanding the real freedoms that people experience. Hence, development requires the removal of major impediments to freedom: poverty as well as tyranny, poor economic opportunities as well as systematic social deprivation, and neglect of public facilities as well as the intolerance of repressive states. In Sen’s view, development is not just an economic process but a political one too, and to succeed requires the “democratization” of political communities to give citizens a voice 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 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 2015, the most recent year for which data is available.
3.4 MAP
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Human Development Index, 2015.
test PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
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 processes, new organizations, new management practices, and new strategies. Thus, Uber’s strategy of letting riders hail a cab using a smartphone application can be seen as an innovation because it was the first company to pursue this strategy in its industry. Similarly, the development of mass-market online retailing by Amazon.com can be seen as an innovation. Innovation and entrepreneurial activity help increase economic activity by creating new products and markets that did not previously exist. Moreover, innovations in production and business processes lead to an increase in the productivity of labor and capital, which further boosts economic growth rates.5
Innovation is also seen as the product of entrepreneurial activity. Often, entrepreneurs first commercialize innovative new products and processes, and entrepreneurial activity provides much of the dynamism in an economy. For example, the U.S. economy has benefited greatly from a high level of entrepreneurial activity, which has resulted in rapid innovation in products and process. Firms such as Apple, Google, Facebook, Amazon, Dell, Microsoft, Oracle, and Uber were all founded by entrepreneurial individuals to exploit new technology. All these firms created significant economic value and boosted productivity by helping commercialize innovations in products and processes. Thus, we can conclude that if a country’s economy is to sustain long-run economic growth, the business environment must be conducive to the consistent production of product and process innovations and to entrepreneurial activity.
INNOVATION AND ENTREPRENEURSHIP REQUIRE A MARKET ECONOMY
This leads logically to a further question: What is required for the business 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
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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, entrepreneurial individuals have few economic incentives to develop valuable new innovations because it is the state, rather than the individual, that captures most of the gains. The lack of economic freedom and incentives for innovation was probably a main factor in the economic stagnation of many former communist states and led ultimately to their collapse at the end of the 1980s. Similar stagnation occurred in many mixed economies in those sectors where the state had a monopoly (such as coal mining and telecommunications in Great Britain). 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 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, Switzerland, Singapore, the United States, Canada, and Germany) were also all in the top 10 in terms of economic growth rates. In contrast, no country with persistently low economic freedom achieved a respectable growth rate. In the 16 countries for which the index of economic freedom declined the most during 1975 to 1995, gross domestic product fell at an annual rate of 0.6 percent. Other studies have reached broadly similar conclusions.
INNOVATION AND ENTREPRENEURSHIP REQUIRE STRONG PROPERTY RIGHTS
Strong legal protection of property rights is another requirement for a business environment to be conducive to innovation, entrepreneurial activity, and hence economic growth.8 Both individuals and businesses must be given the opportunity to profit from innovative ideas. Without strong property rights protection, businesses and individuals run the risk that the profits from their innovative efforts will be expropriated, either by criminal elements or by the state. 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–winning economist Douglass North, throughout history many governments have displayed a tendency to engage in such behavior.9 Inadequately enforced property rights reduce the incentives for innovation and entrepreneurial activity—because the profits from such activity are “stolen”—and hence reduce the rate of economic growth.
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
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the property they own. As an example of the scale of the problem, he cites the situation in Haiti, where individuals must take 176 steps over 19 years to own land legally. Because most property in poor countries is informally “owned,” the absence of legal proof of ownership means that property holders cannot convert their assets into capital, which could then be used to finance business ventures. Banks will not lend money to the poor to start businesses because the poor possess no proof that they own property, such as farmland, that can be used as collateral for a loan. By de Soto’s calculations, the total value of real estate held by the poor in third-world and former communist states amounted to more than $9.3 trillion in 2000. If those assets could be converted into capital, the result could be an economic revolution that would allow the poor to bootstrap their way out of poverty. Interestingly enough, the Chinese seem to have taken de Soto’s arguments to heart. Despite still being nominally a communist country, in October 2007 the government passed a law that gave private property owners the same rights as the state, which significantly improved the rights of urban and rural landowners to the land that they use (see the accompanying Country Focus).
c o u n t r y F O C U S
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 economic activity is in the hands of private enterprises.
Although all land in China still technically belongs to the state—an ideological necessity in a country where the government still claims to be guided by Marxism—urban landholders had been granted 40- to 70-year leases to use the land, while rural farmers had 30-year leases. However, the lack of legal title meant that landholders were at the whim of the state. Large-scale appropriation of rural land for housing and factory construction had rendered millions of farmers landless. Many were given little or no compensation, and they drifted to the cities where they added to a growing underclass. In both urban and rural areas, property and land disputes had become a leading cause of social unrest. According to government sources, in 2006 there were about 23,000 “mass incidents” of social unrest in China, many related to disputes over property rights.
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 compensated if the land is required for other purposes, and it gives individuals the same legal protection for their property as the state. Taken together with a 2004 change in China’s constitution, which stated that private property “was not to be encroached upon,” the new law significantly strengthens property rights in China.
Nevertheless, the law has its limitations; most notably, it still falls short of giving peasants marketable ownership rights to the land they farm. If they could sell their land, tens of millions of underemployed farmers might find more productive work elsewhere. Those who stayed could acquire bigger landholdings that could be used more efficiently. Also, farmers might be able to use their landholdings as security against which they could borrow funds for investments to boost productivity.
Recognizing such limitations, in 2016 the ruling Communist Party released a set of guidelines for further shoring up property rights protection, including better legal enforcement of property rights. There is no doubt that additional protection is needed. Chinese firms and residents have continued to suffer under poor property protections, facing eviction to make way for new developments and facing fierce competition as patents and copyrights are repeatedly violated. Whether these new guidelines will improve matters, however, remains to be seen.
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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; Z. Keliang and L. Ping, “Rural Land Rights under the PRC Property Law,” China Law and Practice, November 2007, pp. 10–15; and Sara Hsu, “China Is Finally Improving Property Rights Protection,” Forbes, November 30, 2016.
THE REQUIRED POLITICAL SYSTEM
Much debate surrounds which kind of political system best achieves a functioning market economy with strong protection for property rights.11 People in the West tend to associate a representative democracy with a market economic system, strong property rights protection, and economic progress. Building on this, we tend to argue that democracy is good for growth. However, some totalitarian regimes have fostered a market economy and strong property rights protection and have experienced rapid economic growth. Five of the fastest-growing economies of the past 40 years—China, South Korea, Taiwan, Singapore, and Hong Kong—had one thing in common at the start of their economic growth: undemocratic governments. At the same time, countries with stable democratic governments, such as India, experienced sluggish economic growth for long periods. In 1992, Lee Kuan Yew, Singapore’s leader for many years, told an audience, “I do not believe that democracy necessarily leads to development. I believe that a country needs to develop discipline more than democracy. 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 property rights is capable of promoting economic growth. Also, there is no guarantee that a dictatorship will continue to pursue such progressive policies. Dictators are rarely benevolent. Many are tempted to use the apparatus of the state to further their own private ends, violating property rights and stalling economic growth. Given this, it seems likely that democratic regimes are far more conducive to long-term economic growth than are dictatorships, even benevolent ones. Only in a well-functioning, mature democracy are property rights truly secure.13 Nor should we forget Amartya Sen’s arguments reviewed earlier. Totalitarian states, by limiting human freedom, also suppress human development and therefore are detrimental to progress.
ECONOMIC PROGRESS BEGETS DEMOCRACY
While it is possible to argue that democracy is not a necessary precondition for a market economy in which property rights are protected, subsequent economic growth often leads to establishment of a democratic regime. Several of the fastest-growing Asian economies adopted more democratic governments during the past three decades, including South Korea and Taiwan. Thus, although democracy may not always be the cause of initial economic progress, it seems to be one consequence of that progress.
Democracy in the Arab World: New Realities in an Ancient Land?
Democracy is finally making an appearance in the ancient lands of the Middle East, as witnessed by the
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recent uprisings known as the “The Arab Spring.” Wissam Yafi, an expert in technology and international development, believes geo-economic, geosocial, technological, and geo-political forces will lead to inevitable changes in the Arab world. Economic forces will make these governments cut many of the social services offered, putting people out of work, which will lead toward democratic alternatives. Technology is another major binding force connecting populations across the Middle East, which will mean less censorship—something that has been widespread in many parts of the Arab world. People will continue to challenge the status quo as rapid urbanization, population growth, and movements toward self-determination grow. Wissam Yafi has a lot of guesses on what will happen. Do you agree with his forecasts?
Source: carnegieendowment.org.
A strong belief that economic progress leads to adoption of a democratic regime underlies the fairly permissive attitude that many Western governments have adopted toward human rights violations in China. Although China has a totalitarian government in which human rights are violated, many Western countries have been hesitant to criticize the country too much for fear that this might hamper the country’s march toward a free market system. 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 ECONOMIC DEVELOPMENT
While a country’s political and economic systems are probably the big engine driving its rate of economic development, other factors are also important. One that has received attention is geography.14 But the belief that geography can influence economic policy, and hence economic growth rates, goes back to Adam Smith. The influential economist Jeffrey Sachs argues that
throughout history, coastal states, with their long engagements in international trade, have been more supportive of market institutions than landlocked states, which have tended to organize themselves as hierarchical (and often militarised) societies. Mountainous states, as a result of physical isolation, have often neglected market-based trade. Temperate climes have generally supported higher densities of population and thus a more extensive division of labour than tropical regions.15
Sachs’s point is that by virtue of favorable geography, certain societies are more likely to engage in trade than others and are thus more likely to be open to and develop market-based economic systems, which in turn promotes faster economic growth. He also argues that, irrespective of the economic and political institutions a country adopts, adverse geographic conditions—such as the high rate of disease, poor soils, and hostile climate that afflict many tropical countries—can have a negative impact on development. Together with colleagues at Harvard’s Institute for International Development, Sachs tested for the impact of geography on a country’s economic growth rate between 1965 and 1990. He found that landlocked countries grew more slowly than coastal economies and that being entirely landlocked reduced a country’s growth rate by roughly 0.7 percent per year. He also found that tropical countries grew 1.3 percent more slowly each year than countries in the temperate zone.
Education emerges as another important determinant of economic development (a point that Amartya Sen emphasizes). The general assertion is that nations that invest more in education will have higher growth rates because an educated population is a more productive population. Anecdotal comparisons suggest this is true. In 1960, Pakistanis and South Koreans were on equal footing economically. However, just 30 percent of Pakistani children were enrolled in
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primary schools, while 94 percent of South Koreans were. By the mid-1980s, South Korea’s GNP per person was three times that of Pakistan.16 A survey of 14 statistical studies that looked at the relationship between a country’s investment in education and its subsequent growth rates concluded investment in education did have a positive and statistically significant impact on a country’s rate of economic growth.17 Similarly, the work by Sachs discussed earlier suggests that investments in education help explain why some countries in Southeast Asia, such as Indonesia, Malaysia, and Singapore, have been able to overcome the disadvantages associated with their tropical geography and grow far more rapidly than tropical nations in Africa and Latin America.
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States in Transition LO 3-2 Identify the macropolitical and macroeconomic changes occurring worldwide.
The political economy of many of the world’s nation-states has changed radically since the late 1980s. Three trends have been evident. First, during the late 1980s and early 1990s, a wave of democratic revolutions swept the world. Totalitarian governments fell and were replaced by democratically elected governments that were typically more committed to free market capitalism than their predecessors had been. Second, over the same period, there has been a move away from centrally planned and mixed economies and toward a more free market economic model. Third, and somewhat counter to the two prior trends, since 2012 there has been a shift back toward greater authoritarianism in some nations, and there are some signs that certain nations may be retreating from the free market model, particularly in the area of international trade where protectionism is on the rise again.
THE SPREAD OF DEMOCRACY
One notable development of the last 30 years has been the spread of democracy (and, by extension, the decline of totalitarianism). Map 3.5 reports on the extent of totalitarianism in the world as determined by Freedom House.18 This map charts political freedom in 2018, grouping countries into three broad groupings: free, partly free, and not free. In “free” countries, citizens enjoy a high degree of political and civil freedoms. “Partly free” 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.
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3.5 MAP Freedom in the world, 2018.
Source: The Freedom House Survey Team, “Freedom in the World 2018,” www.freedomhouse.org.
Freedom House classified some 88 countries as free in 2018, accounting for about 45 percent of the world’s nations. These countries respect a broad range of political rights. Another 58 countries accounting for 30 percent of the world’s nations were classified as partly free, while 49 countries representing approximately 25 percent of the world’s nations were classified as not free. The number of democracies in the world has increased from 69 nations in 1987 to 125 in 2018. But not all democracies are free, according to Freedom House, because some democracies still restrict certain political and civil liberties. For example, although Russia is nominally a democracy, it has consistently been rated “not free” since the early 2000s. According to Freedom House,
Russia’s step backwards into the Not Free category is the culmination of a growing trend . . . to concentrate political authority, harass and intimidate the media, and politicize the country’s law-enforcement system.19
Similarly, Freedom House argues that democracy was restricted in Venezuela under the leadership of the late Hugo Chávez, a trend that continued under his successor Nicolas Maduro.
Many of the newer democracies are to be found in eastern Europe and Latin America, although there also have been notable gains in Africa during this time, including South Africa and Nigeria. Entrants into the ranks of the world’s democracies during the last 25 years include Mexico, which held its first fully free and fair presidential election in 2000 after free and fair parliamentary and state elections in 1997 and 1998; Senegal, where free and fair presidential elections led to a peaceful transfer of power; Myanmar, where in 2015, after decades of rule by a military dictatorship, the opposition party won a landslide victory in elections that were mostly free and fair; and Nigeria, where in 2015 for the first time the opposition won
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an election and there was a peaceful transfer of power.
Three main reasons account for the spread of democracy.20 First, many totalitarian regimes failed to deliver economic progress to the vast bulk of their populations. The collapse of communism in eastern Europe, for example, was precipitated by the growing gulf between the vibrant and wealthy economies of the West and the stagnant economies of the communist East. In looking for alternatives to the socialist model, the populations of these countries could not have failed to notice that most of the world’s strongest economies were governed by representative democracies. Today, the economic success of many of the newer democracies— such as Poland and the Czech Republic in the former communist bloc, the Philippines and Taiwan in Asia, and Chile in Latin America—has strengthened the case for democracy as a key component of successful economic advancement.
Voters wait in a queue in front of the election center in the city of Lagos, Nigeria.
©Anadolu Agency/Getty Images
Second, new information and communication technologies—including satellite television, desktop publishing, and, most important, the Internet and associated social media—have reduced a state’s ability to control access to uncensored information. 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 enforcement of contracts, are another force pressing for more accountable and open government.
Despite this, it would be naive to conclude that the global spread of democracy will continue unchallenged. Democracy is still rare in large parts of the world. In sub-Saharan Africa in 2018, only 9 countries were considered free, 21 were partly free, and 19 were not free. Among the post-communist countries in eastern and central Europe and the former Soviet Union, only 13 are classified as free (primarily in eastern Europe). And there are only 2 free states among the 18 nations of the Middle East and North Africa. Although the wave of unrest that spread across the Middle East during 2011–2013 created hope for change, with the exception of Tunisia, this as not been realized.
Moreover, authoritarianism has been gaining ground in several countries where political and civil liberties have been progressively limited in recent years, including Russia, Ukraine, Indonesia, Ecuador, and Venezuela. An increasingly autocratic Russia annexed the Crimea
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region from the Ukraine in 2014 and has actively supported pro-Russian rebels in eastern Ukraine. Libya, where there was hope that a democracy might be established, appears to have slipped into anarchy. In Egypt, after a brief flirtation with democracy, the military stepped in, removing the government of Mohamed Morsi, after Morsi and his political movement, the Muslim Brotherhood, had exhibited its own authoritarian tendencies. The military-backed government, however, has also acted in an authoritarian manner, effectively reversing much of the progress that had occurred after the revolution of 2011. Indeed, Freedom House observes that since the mid-2000s, there has been a notable decline in civil and political freedoms in many parts of the world, suggesting that the shift toward greater democracy that occurred during the 1985–2005 period has peaked for the time being and that there have been some notable reversals in states such as Russia and Venezuela. Freedom House also expressed concerns that under the leadership of Donald Trump, America has withdrawn from its traditional role of promoting democracy and human rights around the world, a development that it views with some alarm since pressure from the United States has historically helped to spread democratic ideals.
Is World Peace Through Commerce Possible?
Interested in world peace? Business students worldwide can participate in Peace Through Commerce’s “Matrix of Peace,” an integrated 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, consciousness, and laws and structure. As the AACSB puts it: “If we educate students that it is their responsibility to advance society, over a generation we may be able to have more impact than governments have had.” What do you think? Can business people advance global societies more than governments if educated according to the framework of the “Matrix of Peace”?
Source: www.peacethroughcommerce.com.
THE NEW WORLD ORDER AND GLOBAL TERRORISM
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. In an influential book, 25 years ago author Francis Fukuyama argued, “We may be witnessing . . . the end of history as such: that is, the end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of human government.”22 Fukuyama went on to argue that the war of ideas may be at an end and that liberal democracy has triumphed.
Many questioned Fukuyama’s vision of a more harmonious world dominated by a universal civilization characterized by democratic regimes and free market capitalism. In a controversial book, the late influential political scientist Samuel Huntington argued there is no “universal” civilization based on widespread acceptance of Western liberal democratic ideals.23 Huntington maintained that while many societies may be modernizing—they are adopting the material paraphernalia of the modern world, from automobiles and Facebook to Coca-Cola and
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smartphones—they are not becoming more Western. On the contrary, Huntington theorized that modernization in non-Western societies can result in a retreat toward the traditional, such as the resurgence of Islam in many traditionally Muslim societies. He wrote,
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 indigenization trends in non-Western societies: urbanization, social mobilization, higher levels of literacy and education, intensified communication and media consumption, and expanded interaction with Western and other cultures. 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 Muslims caught in the process of modernization. Muslims feel a need to return to Islamic ideas, practices, and institutions to provide the compass and the motor of modernization.24
Thus, the rise of Islamic fundamentalism is portrayed as a response to the alienation produced by modernization.
In contrast to Fukuyama, Huntington envisioned a world split into different civilizations, each of which has its own value systems and ideology. Huntington predicted conflict between the West and Islam and between the West and China. While some commentators originally dismissed Huntington’s thesis, in the aftermath of the terrorist attacks on the United States on September 11, 2001, Huntington’s views received new attention. The dramatic rise of the Islamic State (ISIS) in war-torn Syria and neighboring Iraq during 2014–2015 drew further attention to Huntington’s thesis, as has the growing penchant for ISIS to engage in terrorist acts outside the Middle East, as in Paris in 2015.
If Huntington’s views are even partly correct, they have important implications for international business. They suggest many countries may be difficult places in which to do business, either because they are shot through with violent conflicts or because they are part of a civilization that is in conflict with an enterprise’s home country. Huntington’s views are speculative and controversial. More likely than his predictions coming to pass is the evolution of a global political system that is positioned somewhere between Fukuyama’s universal global civilization based on liberal democratic ideals and Huntington’s vision of a fractured world. That would still be a world, however, in which geopolitical forces limit the ability of business enterprises to operate in certain foreign countries.
As for terrorism, in Huntington’s thesis, global terrorism is a product of the tension between civilizations and the clash of value systems and ideology. The terror attacks undertaken by al- Qaeda and ISIS are consistent with this view. Others point to terrorism’s roots in long-standing conflicts that seem to defy political resolution—the Palestinian, Kashmir, and Northern Ireland conflicts being obvious examples. It is also true that much of the terrorism perpetrated by al-Qaeda affiliates in Iraq during the 2000s and more recently by ISIS in Iraq and Syria can be understood in part as a struggle between radicalized Sunni and Shia factions within Islam. Moreover, a substantial amount of terrorist activity in some parts of the world, such as Colombia, has been interwoven with the illegal drug trade. As former U.S. Secretary of State Colin Powell has maintained, terrorism represents one of the major threats to world peace and economic progress in the twenty-first century.25
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Chinese construction workers build the new African Union Buildings in Addis Ababa, Ethiopia.
©Per-Anders Pettersson/Getty Images
THE SPREAD OF MARKET-BASED SYSTEMS
Paralleling the spread of democracy since the 1980s has been the transformation from centrally planned command economies to market-based economies. More than 30 countries that were in the former Soviet Union or the eastern European communist bloc have changed their economic systems. A complete list of countries where change is now occurring also would include Asian states such as China and Vietnam, as well as African countries such as Angola, Ethiopia, and Mozambique.26 There has been a similar shift away from a mixed economy. Many states in Asia, Latin America, and Western Europe have sold state-owned businesses to private investors (privatization) and deregulated their economies to promote greater competition.
The rationale for economic transformation has been the same the world over. In general, command and mixed economies failed to deliver the kind of sustained economic performance that was achieved by countries adopting market-based systems, such as the United States, Switzerland, Hong Kong, and Taiwan. As a consequence, even more states have gravitated toward the market-based model.
Map 3.6, based on data from the Heritage Foundation, a politically conservative U.S. research foundation, gives some idea of the degree to which the world has shifted toward market-based economic systems. 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, freedom from corruption, and labor freedom. A country can score between 100 (freest) 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.
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3.6 MAP Index of economic freedom, 2018.
Source: The Heritage Foundation, "2018 Index of Economic Freedom," www.heritage.org/index/heatmap.
According to the 2018 index, which is summarized in Map 3.6, the world’s freest economies are (in rank order) Hong Kong, Singapore, New Zealand, Switzerland, Australia, Ireland, Estonia, United Kingdom, Canada, and the United Arab Emirates. The United States was ranked 17, Germany came in at 25, Japan at 30, Mexico at 63, France at 71, Russia at 107, China at 110, India at 130, and Brazil at 153. The economies of Zimbabwe, Venezuela, Cuba, and North Korea are to be found at the bottom of the rankings.27
Economic freedom does not necessarily equate with political freedom, as detailed in Map 3.6. For example, the two top states in the Heritage Foundation index, Hong Kong and Singapore, cannot be classified as politically free. Hong Kong was reabsorbed into communist China in 1997, and the first thing Beijing did was shut down Hong Kong’s freely elected legislature. Singapore is ranked as only partly free on Freedom House’s index of political freedom due to practices such as widespread press censorship.
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The Nature of Economic Transformation LO 3-3 Describe how transition economies are moving toward market-based systems.
The shift toward a market-based economic system often entails a number of steps: deregulation, privatization, and creation of a legal system to safeguard property rights.28
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DEREGULATION
Deregulation involves removing legal restrictions to the free play of markets, the establishment of private enterprises, and the manner in which private enterprises operate. Before the collapse of communism, the governments in most command economies exercised tight control over prices and output, setting both through detailed state planning. 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 controls, thereby allowing prices to be set by the interplay between demand and supply; abolishing laws regulating the establishment and operation of private enterprises; and relaxing or removing restrictions on direct investment by foreign enterprises and international trade.
In mixed economies, the role of the state was more limited; but here, too, in certain sectors the state set prices, owned businesses, limited private enterprise, restricted investment by foreigners, and restricted international trade. For these countries, deregulation has involved the same kind of initiatives that we have seen in former command economies, although the transformation has been easier because these countries often had a vibrant private sector. India is an example of a country that has substantially deregulated its economy over the past two decades (see the Country Focus on India).
c o u n t r y F O C U S
India’s Economic Transformation After gaining independence from Britain in 1947, India adopted a democratic system of government. The economic system that developed in India after 1947 was a mixed economy characterized by a large number of state-owned enterprises, centralized planning, and subsidies. This system constrained the growth of the private sector. Private companies could expand only with government permission. It could take years to get permission to diversify into a new product. Much of heavy industry, such as auto, chemical, and steel production, was reserved for state-owned enterprises. Production quotas and high tariffs on imports also stunted the development of a healthy private sector, as did labor laws that made it difficult to fire employees.
By the early 1990s, it was clear this system was incapable of delivering the kind of economic progress that many Southeast Asian nations had started to enjoy. In 1994, India’s economy was still smaller than Belgium’s, despite having a population of 950 million. Its GDP per capita was a paltry $310, less than half the population could read, only 6 million had access to telephones, and only 14 percent had access to clean sanitation; the World Bank estimated that some 40 percent of the world’s desperately poor lived in India, and only 2.3 percent of the population had an annual household income in excess of $2,484.
The lack of progress led the government to embark on an ambitious economic reform program. Starting in 1991, much of the industrial licensing system was dismantled. Several areas once closed to the private sector were opened, including electricity generation, parts of the oil industry, steelmaking, air transport, and some areas of the telecommunications industry. Investment by foreign enterprises, formerly allowed only grudgingly and subject to arbitrary ceilings, was suddenly welcomed. Approval was made automatic for foreign equity stakes of up to 51 percent in an Indian enterprise, and 100 percent foreign ownership was allowed under certain circumstances. Raw materials and many industrial goods could be freely imported, and the maximum tariff that could be levied on imports was reduced from 400 percent to 65 percent. 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
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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 7 percent from 1997 to 2017. Foreign investment, a key indicator of how attractive foreign companies thought the Indian economy was, jumped from $150 million in 1991 to over $40 billion in 2017. In the information technology sector, India has emerged as a vibrant global center for software development with sales of $150 billion and exports of $117 billion in 2017, up from sales of just $150 million in 1990. In pharmaceuticals, too, Indian companies are emerging as credible players in the global marketplace, primarily by selling low-cost, generic versions of drugs that have come off patent in the developed world.
However, the country still has a long way to go. Attempts to further reduce import tariffs have been stalled by political opposition from employers, employees, and politicians who fear that if barriers come down, a flood of inexpensive Chinese products will enter India. The privatization program continues to hit speed bumps—the latest in September 2003 when the Indian Supreme Court ruled that the government could not privatize two state-owned oil companies without explicit approval from the parliament. State-owned firms still account for 38 percent of national output in the nonfarm sector, yet India’s private firms are 30 to 40 percent more productive than state-owned enterprises. There has also been strong resistance to reforming many of India’s laws that make it difficult for private business to operate efficiently. For example, labor laws make it almost impossible for firms with more than 100 employees to fire workers, creating a disincentive for entrepreneurs to increase their enterprises beyond 100 employees. Other laws mandate that certain products can be manufactured only by small companies, effectively making it impossible for companies in these industries to attain the scale required to compete internationally.
Sources: “India’s Breakthrough Budget?” The Economist, March 3, 2001; “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; “Battling the Babu Raj,” The Economist, March 8, 2008, pp. 29–31; Rishi Lyengar, “India Tops Foreign Investment Rankings Ahead of U.S. and China,” Time, October 11, 2015; and “FDI in India,” Indian Brand Equity Foundation, March 2018.
PRIVATIZATION
Hand in hand with deregulation has come a sharp increase in privatization. Privatization, as discussed in Chapter 2, transfers the ownership of state property into the hands of private individuals, frequently by the sale of state assets through an auction.29 Privatization is seen as a way to stimulate gains in economic efficiency by giving new private owners a powerful incentive—the reward of greater profits—to search for increases in productivity, to enter new markets, and to exit losing ones.30
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 allowing other firms to compete head to head with BT, deregulation ensured that privatization did not simply replace a state-owned monopoly with a private monopoly. Since the 1980s, privatization has become a worldwide phenomenon. More than 8,000 acts of privatization were completed around the world between 1995 and 1999.31 Some of the most dramatic privatization programs occurred
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in the economies of the former Soviet Union and its eastern European satellite states. In the Czech Republic, for example, three-quarters of all state-owned enterprises were privatized between 1989 and 1996, helping push the share of gross domestic product accounted for by the private sector up from 11 percent in 1989 to 60 percent in 1995.32
Privatization is still ongoing today. For example, in 2017 the Brazilian government announced the privatization of a state-owned electric company, airports, highways, ports, and the lottery (see the opening case). In Saudi Arabia, the government has plans to privatize the state-owned oil company, Saudi Aramco. Conversely, in China the privatization of inefficient state-owned enterprises has slowed down somewhat as the state pursues a “mixed ownership” strategy.33
Despite this three-decade trend, large amounts of economic activity are still in the hands of state-owned enterprises in many nations. In China, for example, state-owned companies still dominate the banking, energy, telecommunications, health care, and technology sectors. Overall, they account for about 40 percent of the country’s GDP. 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.34
As privatization has proceeded, it has become clear that simply selling state-owned assets to private investors is not enough to guarantee economic growth. Studies of privatization have shown that the process often fails to deliver predicted benefits if the newly privatized firms continue to receive subsidies from the state and if they are protected from foreign competition by barriers to international trade and foreign direct investment.35 In such cases, the newly privatized firms are sheltered from competition and continue acting like state monopolies. When these circumstances prevail, the newly privatized entities often have little incentive to restructure their operations to become more efficient. For privatization to work, it must also be accompanied by a more general deregulation and opening of the economy. 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 investment in telecommunications services. This action ensured that the newly privatized entities would face significant competition and thus would have to improve their operating efficiency to survive.
Is Selling in China a Good Strategy?
If China and the United States continue to grow like they did in recent years, some estimates indicate that China will be the world’s largest economy by 2030. Let’s assume this is true. 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 period). Also, by 2020 China is expected to have some 190 million customers in the middle- and upper-income categories, making this the largest population segment of any country’s middle-/upper-income citizens. If you were a global manager for a company, would you concentrate on selling your products in China without having a production facility in the country?
Source: solutions.mckinsey.com/insightschina.
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Page 77LEGAL SYSTEMS
As noted in Chapter 2, a well-functioning market economy requires laws protecting private property rights and providing mechanisms for contract enforcement. Without a legal system that protects property rights and without the machinery to enforce that system, the incentive to engage in economic activity can be reduced substantially by private and public entities, including organized crime, that expropriate the profits generated by the efforts of private-sector entrepreneurs. For example, when communism collapsed in eastern Europe, many countries lacked the legal structure required to protect property rights, all property having been held by the state. Although many nations have made big strides toward instituting the required system, it may be years before the legal system is functioning as smoothly as it does in the West. For example, in most eastern European nations, the title to urban and agricultural property is often uncertain because of incomplete and inaccurate records, multiple pledges on the same property, and unsettled claims resulting from demands for restitution from owners in the pre-communist era. Also, although most countries have improved their commercial codes, institutional weaknesses still undermine contract enforcement. Court capacity is often inadequate, and procedures for resolving contract disputes out of court are often lacking or poorly developed.36 Nevertheless, progress is being made. In 2004, for example, China amended its constitution to state that “private property was not to be encroached upon,” and in 2007 it enacted a new law on property rights that gave property holders many of the same protections as those enjoyed by the state (see the Country Focus “Property Rights in China”).37
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Implications of Changing Political Economy The global changes in political and economic systems discussed earlier have several implications 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 more widespread. Although command economies remain and totalitarian dictatorships can still be found around the world, the tide has been running in favor of free markets and greater democracy for 30 years. It remains to be seen, however, whether the global financial crisis of 2008–2009 and the recession that followed will lead to a retrenchment. Certainly many commentators have blamed the problems that led to this crisis on a lack of regulation, and some reassessment of Western political ideology seems likely.
Notwithstanding the crisis of 2008–2009, the trends of the past 30 years have enormous implications for business. For nearly 50 years, half of the world was off-limits to Western businesses. Now much of that has changed. Many of the national markets of eastern Europe, Latin America, Africa, and Asia may still be underdeveloped, but they are potentially enormous. With a population of more than 1.3 billion, the Chinese market alone is potentially bigger than that of the United States, the European Union, and Japan combined. Similarly, India, with about 1.2 billion people, is a potentially huge market. Latin America has another 600 million potential consumers. It is unlikely that China, Russia, Vietnam, or any of the other states now moving toward a market system will attain the living standards of the West soon. Nevertheless, the upside potential is so large that companies need to consider making inroads now. For example, if
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China and the United States continue to grow at the rates they did during 1996–2017, China will surpass the United States to become the world’s largest national economy within the next two decades.
Just as the potential gains are large, so are the risks. There is no guarantee that democracy will thrive in many of the world’s newer democratic states, particularly if these states have to grapple with severe economic setbacks. Totalitarian dictatorships could return, although they are unlikely to be of the communist variety. Although the bipolar world of the Cold War era has vanished, it may be replaced by a multipolar world dominated by a number of civilizations. In such a world, much of the economic promise inherent in the global shift toward market-based economic systems may stall in the face of conflicts between civilizations. While the long-term potential for economic gain from investment in the world’s new market economies is large, the risks associated with any such investment are also substantial. It would be foolish to ignore these. The financial system in China, for example, is not transparent, and many suspect that Chinese banks hold a high proportion of nonperforming loans on their books. If true, these bad debts could trigger a significant financial crisis during the next decade in China, which would dramatically lower growth rates.
test PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
Focus on Managerial Implications LO 3-4 Explain the implications for management practice of national difference in political
economy.
BENEFITS, COSTS, RISKS, AND OVERALL ATTRACTIVENESS OF DOING BUSINESS INTERNATIONALLY
As noted in Chapter 2, the political, economic, and legal environments of a country clearly influence the attractiveness of that country as a market or investment site. In this chapter, we argued that countries with democratic regimes, market-based economic policies, and strong protection of property rights are more likely to attain high and sustained economic growth rates and are thus a more attractive location for international business. It follows that the benefits, costs, and risks associated with doing business in a country are a function of that country’s political, economic, and legal systems. 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. Here, we consider the determinants of benefits, costs, and risks.
Benefits In the most general sense, the long-run monetary benefits of doing business in a country are a function of the size of the market, the present wealth (purchasing power) of consumers in that market, and the likely future wealth of consumers. While some markets are very large when measured by number of consumers (e.g. India), relatively low living standards may imply limited purchasing power and, therefore, a relatively small market when measured in
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economic terms. International businesses need to be aware of this distinction, but they also need to keep in mind the likely future prospects of a country. In 1960, South Korea was viewed as just another impoverished third-world nation. By 2017, it had the world’s 11th-largest economy. International firms that recognized South Korea’s potential in 1960 and began to do business in that country may have reaped greater benefits than those that wrote off South Korea.
By identifying and investing early in a potential future economic star, international firms may build brand loyalty and gain experience in that country’s business practices. 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 strategy, early entrants into potential future economic stars may be able to reap substantial first-mover advantages, while late entrants may fall victim to late-mover disadvantages.38 (First-mover advantages are the advantages that accrue to early entrants into a market. Late-mover disadvantages are the handicaps that late entrants might suffer.) This kind of reasoning has been driving significant inward investment into China, which may become the world’s largest economy by 2030 if it continues growing at current rates (China is already the world’s second- largest national economy). For more than two decades, China has been the largest recipient of foreign direct investment in the developing world as international businesses—including General Motors, Volkswagen, Coca-Cola, and Unilever—try to establish a sustainable advantage in this nation.
Coca-Cola has been in China for about 40 years, and about 140 million servings of the company’s products are enjoyed daily in China.
©testing/Shutterstock
A country’s economic system and property rights regime are reasonably good predictors of economic prospects. Countries with free market economies in which property rights are protected tend to achieve greater economic growth rates than command economies or economies where property rights are poorly protected. It follows that a country’s economic system, property rights regime, and market size (in terms of population) probably constitute reasonably good indicators of the potential long-run benefits of doing business in a country. In contrast, countries where property rights are not well respected and where corruption is rampant tend to have lower levels of economic growth. We must be careful about generalizing too much from this, however, because both China and India have achieved high growth rates despite relatively weak property
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rights regimes and high levels of corruption. In both countries, the shift toward a market-based economic system has produced large gains despite weak property rights and endemic corruption.
Costs A number of political, economic, and legal factors determine the costs of doing business in a country. With regard to political factors, a company may be pushed to pay off politically powerful entities in a country before the government allows it to do business there. The need to pay what are essentially bribes is greater in closed totalitarian states than in open democratic societies where politicians are held accountable by the electorate (although this is not a hard- and-fast distinction). Whether a company should actually pay bribes in return for market access should be determined on the basis of the legal and ethical implications of such action. We discuss this consideration in Chapter 5, when we look closely at the issue of business ethics.
With regard to economic factors, one of the most important variables is the sophistication of a country’s economy. It may be more costly to do business in relatively primitive or undeveloped economies because of the lack of infrastructure and supporting businesses. At the extreme, an international firm may have to provide its own infrastructure and supporting business, which obviously raises costs. When McDonald’s decided to open its first restaurant in Moscow, it found that to serve food and drink indistinguishable from that served in McDonald’s restaurants elsewhere, it had to vertically integrate backward to supply its own needs. 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, environmental pollution, and the like (because adhering to such regulations is costly). It can also be more costly to do business in a country like the United States, where the absence of a cap on damage awards has meant spiraling liability insurance rates. It can be more costly to do business in a country that lacks well-established laws for regulating business practice (as is the case in many of the former communist nations). In the absence of a well-developed body of business contract law, international firms may find no satisfactory way to resolve contract disputes and, consequently, routinely face large losses from contract violations. Similarly, local laws that fail to adequately protect intellectual property can lead to the theft of an international business’s intellectual property and lost income.
Risks As with costs, the risks of doing business in a country are determined by a number of political, economic, and legal factors. Political risk has been defined as the likelihood that political forces will cause drastic changes in a country’s business environment that adversely affect the profit and other goals of a business enterprise.39 So defined, political risk tends to be greater in countries experiencing social unrest and disorder or in countries where the underlying nature of a society increases the likelihood of social unrest. Social unrest typically finds expression in strikes, demonstrations, terrorism, and violent conflict. Such unrest is more likely to be found in countries that contain more than one ethnic nationality, in countries where competing ideologies are battling for political control, in countries where economic mismanagement has created high inflation and falling living standards, or in countries that straddle the “fault lines” between civilizations.
Social unrest can result in abrupt changes in government and government policy or, in some cases, in protracted civil strife. Such strife tends to have negative economic implications for the profit goals of business enterprises. For example, in the aftermath of the 1979 Islamic revolution in Iran, the Iranian assets of numerous U.S. companies were seized by the new Iranian government without compensation. Similarly, the violent disintegration of the Yugoslavian
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federation into warring states, including Bosnia, Croatia, and Serbia, precipitated a collapse in the local economies and in the profitability of investments in those countries.
More generally, a change in political regime can result in the enactment of laws that are less favorable to international business. In Venezuela, for example, the populist socialist politician Hugo Chávez held power from 1998 until his death in 2013. Chávez declared himself to be a “Fidelista,” a follower of Cuba’s Fidel Castro. He pledged to improve the lot of the poor in Venezuela through government intervention in private business and frequently railed against American imperialism, all of which is of concern to Western enterprises doing business in the country. Among other actions, he increased the royalties that foreign oil companies operating in Venezuela had to pay the government from 1 to 30 percent of sales.
Other risks may arise from a country’s mismanagement of its economy. An economic risk can be defined as the likelihood that economic mismanagement will cause drastic changes in a country’s business environment that hurt the profit and other goals of a particular business enterprise. Economic risks are not independent of political risk. Economic mismanagement may give rise to significant social unrest and, hence, political risk. Nevertheless, economic risks are worth emphasizing as a separate category because there is not always a one-to-one relationship between economic mismanagement and social unrest. One visible indicator of economic mismanagement tends to be a country’s inflation rate. Another is the level of business and government debt in the country.
The collapse in oil prices that occurred in 2014–2015 exposed economic mismanagement and increased economic risk in a number countries that had been overly dependent upon oil revenues to finance profligate government spending. In countries such as Russia, Saudi Arabia, and Venezuela, high oil prices had enabled national governments to spend lavishly on social programs and public sector infrastructure. As oil prices collapsed, these countries saw government revenues tumble. Budget deficits began to climb sharply, their currencies fell on foreign exchange markets, price inflation began to accelerate as the price of imports rose, and their economies started to contract, increasing unemployment and creating the potential for social disruption. None of this was good for those countries, nor did it benefit foreign business that had invested in those economies.
On the legal front, risks arise when a country’s legal system fails to provide adequate safeguards in the case of contract violations or to protect property rights. When legal safeguards are weak, firms are more likely to break contracts or steal intellectual property if they perceive it as being in their interests to do so. 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 international business depends on balancing the benefits, costs, and risks associated with doing business in that country (see Figure 3.1). Generally, the costs and risks associated with doing business in a foreign country are typically lower in economically advanced and politically stable democratic nations and greater in less developed and politically unstable nations. The calculus is complicated, however, because the potential long-run benefits are dependent not only on a nation’s current stage of economic development or political stability
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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 dramatic upsurge in either inflation rates or private-sector debt. It is likely to be least favorable in politically unstable developing nations that operate with a mixed or command economy or in developing nations where speculative financial bubbles have led to excess borrowing.
3.1 FIGURE Country attractiveness.
Key Terms
gross national income (GNI), p. 60 purchasing power parity (PPP), p. 61 Human Development Index (HDI), p. 64 innovation, p. 65 entrepreneurs, p. 66 deregulation, p. 74 first-mover advantages, p. 79 late-mover disadvantages, p. 79 political risk, p. 80 economic risk, p. 80 legal risk, p. 80
Summary
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
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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.
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.
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 investing 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 “India’s Economic Transformation,” and answer the following questions:
a. What kind of economic system did India operate under during 1947–1990? What kind of system is it moving toward today? What are the impediments to completing this transformation?
b. How might widespread public ownership of businesses and extensive government regulations have affected (i) the efficiency of state and private businesses and (ii) the rate of new business formation in India during the 1947–1990 time frame? How do you think these factors affected the rate of economic growth in India during this time frame?
c. How would privatization, deregulation, and the removal of barriers to foreign direct investment affect the efficiency of business, new business formation, and the rate of economic growth in India during the post-1990 period?
d. India now has pockets of strengths in key high-technology industries such as software and pharmaceuticals. Why do you think India is developing strength in these areas? How might success in these industries help generate growth in the other sectors of the Indian economy?
e. Given what is now occurring in the Indian economy, do you think the country represents an attractive target for inward investment by foreign multinationals selling consumer products? Why?
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Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. Increased instability in the global marketplace can introduce unanticipated risks in a company’s daily transactions. Your company must evaluate these commercial transaction risks for its foreign operations in Argentina, China, Egypt, Poland, and South Africa. A risk analyst at your firm said that you could evaluate both the political and commercial risk of these countries simultaneously. Provide a commercial transaction risk overview of all five countries for top management. In your evaluation, indicate possible corrective measures in the countries with considerably high political and/or commercial risk.
2. Managers at your firm are very concerned about the influence of terrorism on its long-term strategy. To counter this issue, the CEO has indicated you must identify the countries where terrorism threat and political risk are minimal. 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.
Economic Development in Bangladesh clos ing case
When Bangladesh gained independence from Pakistan in 1971 after a brutal civil war that may have left as many as 3 million dead, the U.S. National Security Adviser, Henry Kissinger, referred to the country as a “basket case.” Kissinger’s assessment was accurate enough. At the time, Bangladesh was one of the world’s poorest nations. Although most of the country is dominated by the fertile Ganges-Brahmaputra delta, a lack of other natural resources, coupled with poor infrastructure, political instability, and high levels of corruption, long held the country back. To compound matters, Bangladesh is prone to natural disasters. Most of Bangladesh is less than 12 meters above sea level. The extensive low-lying areas are vulnerable to tropical cyclones, floods, and tidal bores.
Beginning in the mid-1990s, however, Bangladesh began to climb the ladder of economic progress. From the early 2000s onward, the country grew its economy at around 6 percent per annum compounded. Today, this Muslim majority country of 160 million people has joined the ranks of lower- middle-income nations. Poverty reduction has been dramatic, with the percentage of the population living in poverty falling from 44.2 percent in 1991 to 18.5 percent in 2010, an achievement that raised 20.5 million people out of abject poverty. Today the country ranks 64th out of the 154 countries included in the World Bank’s global poverty database. It has a considerable way to go, but it is no longer one of the world’s poorest countries.
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Garment workers working inside a factory in Gazipur in Bangladesh, on May 14, 2017. Bangladesh is the second largest apparel exporter in the world after China.
©NurPhoto/Contributor/Getty Images
Several reasons underlie Bangladesh’s relative economic success. In its initial post-independence period, Bangladesh adopted socialist policies, nationalizing many companies and subsidizing the costs of agricultural production and basic food products. These policies failed to deliver the anticipated gains. Policy reforms in the 1980s were directed toward the withdrawal of food and agricultural subsidies, the privatization of state-owned companies, financial liberalization, and the withdrawal of some import restrictions. Further reforms aimed at liberalizing the economy were launched in the 1990s. These included making the currency convertible (which led to a floating exchange rate in 2003), reducing import duties to much lower levels, and removing most of the controls on the movement of foreign private capital (which allowed for more foreign direct investment). The reforms of the 1990s coincided with the transition to a parliamentary democracy from semi-autocratic rule.
Bangladesh’s private sector has expanded rapidly since then. Leading the growth has been the country’s vibrant textile sector, which is now the second-largest exporter of ready-made garments in the world after China. Textiles account for 80 percent of Bangladesh’s exports. The development of the textile industry has been helped by the availability of low-cost labor, managerial skills, favorable trade agreements, and government policies that eliminated import duties on inputs for the textile business, such as raw materials. The Bangladesh economy has also benefited from its productive agricultural sector and remittances from more than 10 million Bangladesh citizens who work in other nations. Bangladesh is also home of the microfinance movement, which has enabled entrepreneurs with no prior access to the banking system to borrow small amounts of capital to start businesses.
This being said, the country still faces considerable impediments to sustaining its growth. Infrastructure remains poor; corruption continues to be a major problem; and the political system is, at best, an imperfect democracy where opposition is stifled. The country is too dependent upon its booming textile sector and needs to diversify its industrial base. Bangladesh is also one of the countries most prone to the adverse affects of climate change. A one-meter rise in sea level would leave an estimated 10 percent of the country under water and increase the potential for damaging floods in much of the remainder. Nevertheless, according to the U.S. investment bank Goldman Sachs, Bangladesh is one of the 11 lower-middle-income nations poised for sustained growth.
Sources: W. Mahmud, S. Ahmed, and S. Mahajan, “Economic Reforms, Growth, and Governance: The Political Economy Aspects of Bangladesh’s Development Surprise,” World Bank Commission on Development and Growth, 2008; “Freedom in the World 2016,” Freedom House; “Tiger in the Night,” The Economist, October 15, 2016; Sanjay Kathuria, “How Will Bangladesh Reach High Levels of Prosperity?” World Bank blog, January 5, 2017; and Qimiao Fan, “Bangladesh: Setting a Global Standard in Ending Poverty,” World Bank blog, October 5, 2016.
CASE DISCUSSION QUESTIONS
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1. What were the principal reasons for the economic stagnation of Bangladesh after its war for independence?
2. Explain how the liberalization program in the 1990s enabled Bangladesh to start climbing the ladder of economic progress.
3. Bangladesh is dependent for its prosperity upon agriculture and textile exports. What are the risks here? How might Bangladesh diversify its industrial and commercial base?
Endnotes
1. World Bank, World Development Indicators Online, 2018. 2. Brindusa Mihaela Tudose and Raluca Irina Clipa, “An Analysis of the Shadow Economy in
EU Countries,” CES Working Papers,” Volume 111, Issue 2, pp. 303–312, 2018. www.ceswp.uaic.ro/articles/CESWP2016_VIII2_TUD.pdf.
3. A. Sen, Development as Freedom (New York: Knopf, 1999). 4. G. M. Grossman and E. Helpman, “Endogenous Innovation in the Theory of Growth,”
Journal of Economic Perspectives 8, no. 1 (1994), pp. 23–44; 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 Affairs, 1996); C. Doucouliagos and M. Ali Ulubasoglu, “Economic Freedom and Economic Growth: Does Specification Make a Difference?” European Journal of Political Economy 22 (March 2006), pp. 60–81.
8. D. North, Institutions, Institutional Change, and Economic Performance (Cambridge, UK: Cambridge University Press, 1991). See also K. M. Murphy, A. Shleifer, and R. Vishney, “Why Is Rent Seeking So Costly to Growth?,” American Economic Review 83, no. 2 (1993), pp. 409–14; K. E. Maskus, “Intellectual Property Rights in the Global Economy,” Institute for International Economics, 2000.
9. North, Institutions, Institutional Change and Economic Performance. 10. H. de Soto, 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 between Political and Economic
Progress,” American Economic Review 84, no. 2 (1994), pp. 343–48; A. Przeworski and F. Limongi, “Political Regimes and Economic Growth,” Journal of Economic Perspectives 7, no. 3 (1993), pp. 51–59.
12. Hirschman, “The On-and-Off Again Connection between Political and Economic Progress.”
13. For details of this argument, see M. Olson, “Dictatorship, Democracy, and Development,” American Political Science Review, September 1993.
14. For example, see Jared Diamond’s Pulitzer Prize–winning book Guns, Germs, and Steel (New York: Norton, 1997). Also see J. Sachs, “Nature, Nurture and Growth,” The Economist, June 14, 1997, pp. 19–22; J. Sachs, The End of Poverty (New York: Penguin Books, 2005).
15. Sachs, “Nature, Nurture and Growth.”
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16. “What Can the Rest of the World Learn from the Classrooms 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 2018,” and associated materials, www.freedomhouse.org.
19. “Russia Downgraded to Not Free,” Freedom House (Press Release), December 20, 2004, www.freedomhouse.org.
20. Freedom House, “Democracies Century: A Survey of Political Change in the Twentieth Century, 1999,” www.freedomhouse.org.
21. L. Conners, “Freedom to Connect,” Wired, August 1997, pp. 105–6. 22. F. Fukuyama, “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. Huntington, The Clash of Civilizations and the Remaking of World Order. 25. U.S. National Counterterrorism Center, Reports on Incidents of Terrorism, 2005, April 11,
2006. 26. S. Fischer, R. Sahay, and C. A. Vegh, “Stabilization and the Growth in Transition
Economies: The Early Experience,” Journal of Economic Perspectives 10 (Spring 1996), pp. 45–66.
27. M. Miles et al., 2018 Index of Economic Freedom (Washington, DC: Heritage Foundation, 2018).
28. International Monetary Fund, World Economic Outlook: Focus on Transition Economies (Geneva: IMF, October 2000). “Transition Economies, an IMF Perspective on Progress and Prospects,” IMF, November 3, 2000.
29. J. C. Brada, “Privatization Is Transition—Is It?” Journal of Economic Perspectives, Spring 1996, pp. 67–86.
30. See S. Zahra et al., “Privatization and Entrepreneurial Transformation,” Academy of Management Review 3, no. 25 (2000), pp. 509–24.
31. N. Brune, G. Garrett, and B. Kogut, “The International Monetary Fund and the Global Spread of Privatization,” IMF Staff Papers 51, no. 2 (2003), pp. 195–219.
32. Fischer et al., “Stabilization and Growth in Transition Economies.” 33. Shannon Sims, “Brazil’s Privatization Push,” US News and World Reports, October 11,
2017; Jane Cai, “Forget Privatization, Xi Has Other Big Plans for Bloated State Firms,” South China Morning Post, September 6, 2017.
34. “China 2030,” World Bank, 2012. 35. J. Sachs, C. Zinnes, and Y. Eilat, “The Gains from Privatization in Transition Economies:
Is Change of Ownership Enough?” CAER discussion paper no. 63 (Cambridge, MA: Harvard Institute for International Development, 2000).
36. M. S. Borish and M. Noel, “Private Sector Development in the Visegrad Countries,” World Bank, March 1997.
37. “Caught between Right and Left,” The Economist, March 8, 2007. 38. For a discussion of first-mover advantages, see M. Liberman and D. Montgomery, “First-
Mover Advantages,” Strategic Management Journal 9 (Summer Special Issue, 1988), pp. 41–58.
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39. S. H. Robock, “Political Risk: Identification and Assessment,” Columbia Journal of World Business, July–August 1971, pp. 6–20.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education
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Part 2 National Differences
Differences in Culture
Learning Object ives After reading this chapter, you will be able to:
LO4-1 Explain what is meant by the culture of a society.
LO4-2 Identify the forces that lead to differences in social culture.
LO4-3 Identify the business and economic implications of differences in culture.
LO4-4 Recognize how differences in social culture influence values in business.
LO4-5 Demonstrate an appreciation for the economic and business implications of cultural change.
China, Hong Kong, Macau, and Taiwan
opening case A lot of international business discussion today centers on how much economic power, political influence, and international competitiveness the People’s Republic of China (PRC) has achieved and is forecast to gain in the next decades. China along with India, Brazil, and Russia form the BRIC (an acronym formulated using their initial letters) countries, which have been viewed as the business engines of tomorrow (especially China) based on their immense economic potential. The BRICs, which cover a quarter of the world’s landmass and contain 40 percent of its population, had a combined GDP of $20 trillion in 2001. Today, these increasingly market-oriented economies boast a GDP of $37 trillion
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(or 22 percent of global GDP), a figure forecast to reach $120 trillion by 2050. Together, they control more than 43 percent of the world’s currency reserves ($4 trillion) and 20 percent of its trade.
Basically, size of the population and size of the market were the two overriding factors that led former Goldman Sachs chief economist Jim O’Neill to first coin the acronym BRIC to highlight the immense collective economic potential of these four emerging markets. However, despite many countries’ and companies’ enthusiasm for increased global interaction and economic exchange with the BRIC economies, especially China and India, many have found that cultural differences hinder their ability to conduct business in these countries. Not only is the culture different between each BRIC country and most other of the globe’s remaining 192 countries, but the business and societal cultures within the BRIC countries are also vastly different from each other.
The outlook for the BRICs may not be as positive as we have been led to believe anyway. For example, the structural transformation of China, which has been the main driver of the BRICs, from an export-driven economy to one relying more on domestic consumption, has added some woes. The likelihood is that the trend of annual increases of exports to China from much of the developed world also will slow down (but that we will see trade increases nevertheless, just not as significantly as in the past decade).
Importantly, China is still trying to implement the “one country, two systems” approach—a constitutional principle formulated by Deng Xiaoping—which involves how to merge mainland China with Hong Kong and Macau. In addition, Taiwan presents an even bigger ongoing structural, legal, and cultural challenge for China.
Hong Kong, a business port located off the southeast coast of China in eastern Asia, traces its history to the Old Stone Age, and really became entrenched in today’s infrastructure with its inclusion into the Chinese empire during the Qin dynasty (221–206 B.C.). However, Hong Kong was a self-governing British colony from 1841 to 1997, at which time Hong Kong became a Special Administrative Region (SAR) of the People’s Republic of China (on July 1, 1997), pursuant to the 1984 Sino-British Joint Declaration. The backdrop is that, throughout the colonial era, Hong Kong’s citizens developed a distinctive “Hong Kong identity.” To this day, the cultural differences between mainland China and Hong Kong are often pronounced, and they are potentially becoming more contentious with mainland China asserting its influence. The sentiment in Hong Kong is that it needs to be recognized as having a unique culture and “national identity.” Hong Kong is in many ways often at odds with mainland China, and periodic clashes flare between Hong Kong and China, as happened in 2012.
Prior to 1999, Macau was a Portuguese colony, followed by being an overseas province under Portuguese administration from 1887 to 1999. Macau was both the first and last European colony in China. Just before its return to China in 1999, Macau had been experiencing a number of economic difficulties. Macau’s biggest revenue items—gaming and tourism—decreased in 1993, followed by the collapse of the property market in 1994, and then the economic crisis in 1997 that affected much of Asia. By the time 1999 came around for a handover from Portugal to China, most locals welcomed the change because of deteriorating public order, rising crime rates, and widespread corruption that had infiltrated the culture during the last years of the Portuguese-Macau government. Today, Macau is being positioned as a key diplomatic player in China’s relations with Portuguese-speaking countries.
Taiwan, officially the Republic of China (ROC), is an island nation (Island of Taiwan, formerly Formosa). It is the most populous country and the largest economy that is not a member of the United Nations. Taiwan was ceded by the Qing dynasty to Japan in 1895 after the Sino-Japanese War. The Republic of China was established in 1912 after the fall of the Qing dynasty while Taiwan was under Japanese rule. However, China has consistently claimed sovereignty over Taiwan and asserted that the Republic of China is no longer in legitimate existence. Under its One-China Policy, China even refuses to engage in diplomatic relations with any country that recognizes Taiwan. In this semi-independent state, Taiwan has experienced solid economic growth and industrialization, creating a stable industrial economy. The culture blends Confucianist Han Chinese and Taiwanese aboriginal influences.
When we combine mainland China, Hong Kong, Macau, and Taiwan, we often talk about the entity “Greater China” or the “Greater China Region.” Obviously, there is no legal entity or sovereignty associated with this “greater region,” except in business/economic development terms. Some argue that
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the “region” can be seen as being culturally homogeneous but such arguments do not hold up well given the clashes between mainland China and Hong Kong and Taiwan. Interestingly, Macau has been more positive about its relationship or partnership with China, perhaps due to experiencing such serious financial difficulties immediately prior to the 1999 handover (that were essentially solved in the China partnership). Given the strained relationships and the nuances of political issues between China and its close cultural neighbors, the phrase “sinophone world” (“Chinese-speaking world”) is often used instead of Greater China to incorporate mainland China, Hong Kong, Macau, and Taiwan. • Sources: Tomas Hult, “The U.S. Shouldn’t Fret over Cheaper Yuan,” Time, August 14, 2015; Tomas Hult, “Why the Fed Is No Longer Center of the Financial Universe,” Fortune, September 17, 2015; Tomas Hult, “Does the Global Stock Market Sell-Off Signal the BRIC Age Is Already Over?” The Conversation, August 28, 2015; Tomas Hult, “U.S. Shouldn’t Fret over Cheaper Yuan: China’s Growing Middle Class Will Keep Buying ‘Made In America,’” The Conversation, August 13, 2015; Tomas Hult, “The BRIC Countries,” globalEDGE Business Review, 3 (4), 2009; Bruce Keillor, Tomas Hult, Robert Erffmeyer, and Emin Babakus, “NATID: The Development and Application of a National Identity Measure for Use in International Marketing,” Journal of International Marketing, 4 (2), 1996, pp. 57–73; Erkan Ozkaya, Cornelia Droge, Tomas Hult, Roger Calantone, and Elif Ozkaya, “Market Orientation, Knowledge Competence, and Innovation,” International Journal of Research in Marketing, 32 (3), 2015, pp. 309–18; and Mark Esposito, Amit Kapoor, and Deepti Mathur, “What Is the State of the BRICS Economies?” World Economic Forum, April 19, 2016.
Introduction In Chapters 2 and 3, we saw how national differences in political, economic, and legal systems influence the benefits, costs, and risks associated with doing business in different countries. In this “cultural” chapter, we explore how differences in culture across and within countries can have an effect on the development and implementation of a company’s international business strategies. This includes a focus on the operations of all types of multinational companies—from small to medium to large companies. Several themes run through this chapter. The first is that business success in many, if not most, countries requires what we call cross- cultural literacy. By cross-cultural literacy, we mean an understanding of how cultural differences across and within nations can affect the way business is practiced. It is sometimes easy to forget how different various cultures really are, even today.1 Underneath the veneer of modernism and globalization, deep cultural differences often remain.2
The opening case on China, Hong Kong, Macau, and Taiwan highlights that deep cultural differences exist in what many would consider to be a region with a very similar cultural background, i.e., Greater China. Instead, what we find is that throughout the colonial era, Hong Kong’s citizens developed a distinct “Hong Kong identity” that seeks to be recognized as a unique culturally based “national identity.” Meanwhile, the Taiwanese culture, a blend of Confucian Han Chinese and Taiwanese aboriginal cultures, is often at odds with mainland China. Interestingly, Macau has had a better experience with the Chinese takeover due to the economic difficulties that preceded the handover from Portugal in 1999, resulting in a much better partnership between China and Macau. Macau is being positioned as a key diplomatic player in China’s relations with Portuguese-speaking countries. While some observers around the world may simply refer to the Greater China Region as “Chinese,” the deeply ingrained cultural values and norms in the region are very different from each other as a practical matter.
The chapter’s closing case on The Swatch Group illustrates the various cultural differences that exist in the world and how these cultural differences can be used when developing watches that fit a large number of global customer segments. While Swatch has become a very well- known company and most people would recognize a Swatch watch from a distance, Swatch’s large-scale production of watches and jewelry is used to help create individually and culturally based customer uniqueness. The company thrives on playing to country-specific cultures that make people different from each other as well as personal characteristics people showcase in their individualized Swatch use. The company encourages this individuality via the tags
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#MySwatch and #YourMove. In this chapter, we make a case that it is important for foreign businesses to gain an understanding of the culture that prevails in countries where they do business and indeed that success requires a foreign enterprise to adapt, at least to some degree for most products and services, to the macro (overall) culture of its host country as well as to dominant subcultures within the country.3
Another theme that we will develop in this chapter is that a relationship may exist between culture and the cost of doing business in a country or region. Different countries will be either more or less supportive of the market-based mode of production and sales to customers (i.e., where supply and demand set the prices for products and services). For example, cultural factors may have lowered the costs of doing business in Japan and may help explain Japan’s rapid economic ascent as an industrialized and competitive nation in the world about half a century ago.4 Cultural factors can sometimes also raise the costs of doing business. Historically, class divisions were an important aspect of British culture, and for a long time, firms operating in the United Kingdom found it difficult to achieve cooperation between management and labor. Class divisions led to a high level of industrial disputes in that country during the same period that Japan was developing into a global force. This raised the costs of doing business in Britain relative to the costs in countries such as Germany, Japan, Norway, Sweden, and Switzerland, where class conflict was historically less prevalent.
The examples of Japan and the United Kingdom bring us to another theme that we explore in this chapter. Culture is not static. Culture is rooted in the values and norms that we have as people, and those are generally tied to doing something over a period of time. Think about it: If you do the same thing over and over, it becomes a habit and then you almost take it for granted. But sometimes you break the habit and start something new. Culture is very much the same. Culture can and does evolve, although the rate at which culture can change is the subject of dispute (how easy or often do we change habits?). Generally, culture evolves as behaviors of people become ingrained and coded in their values and norms. A cultural mindset develops consistent with people’s behavior over time. But things happen sometimes to cause people’s behavior to change, and so culture evolves.
Did You Know? Did you know arriving late is expected in some cultures? Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
You may recognize how your own personal cultural values and norms are hard to change. The same goes for the culture of a society, which evolves when large population segments in a country or region adopt values based on common ways of behaving, which change only slowly. Finally, multinational corporations operating across national cultures can themselves have unique values and norms. Individuals may operate a certain way in their personal lives, a different way at work, and yet a different way in society. This is not to say that there are not overlaps—but many people also act differently in each context.
What Is Culture? LO 4-1 Explain what is meant by the culture of a society.
People have a hard time agreeing on a simple definition of culture. This makes it difficult to build culture into companies’ global operations across the world’s 196 countries. In the 1870s, anthropologist Edward Tylor defined culture as “that complex whole which includes knowledge,
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belief, art, morals, law, custom, and other capabilities acquired by man as a member of society.”5 Since then, thousands of definitions have been offered by diverse experts from many cultures—in other words culture actually affects how different people define culture itself!
Florence Kluckhohn and Fred Strodtbeck’s values orientation theory of culture states that all definitions of culture must answer a limited number of universal problems, that the value-based solutions are limited in number and universally known, and that different cultures have different preferences among them.6 Following their work, other prominent specialists have supported the idea of a universal set of human values serving as the basis for culture; see Milton Rokeach’s work on “the nature of human values” and Shalom Schwartz’s work on the “theory of basic human values.”7
Also supportive of a finite set of human values, Geert Hofstede, a Dutch expert on cross- cultural differences and international management, defined culture as “the collective programming of the mind which distinguishes the members of one human group from another.”8 Hofstede’s work is by far the most used culture research in both scholarship and business practice over the last half a century, and we have relied on his scientific approach to understand how, when, and why culture has an impact on multinational corporations. Culture includes systems of values, and values are among the building blocks of culture.9 Another complementary definition of culture comes from sociologists Zvi Namenwirth and Robert Weber, who see culture as a system of ideas and argue that these ideas constitute a design for living.10
As authors of this textbook, we subscribe to the definitions of Hofstede and the team of Namenwirth and Weber by viewing culture as a system of values and norms that are shared among a group of people and that when taken together constitute a design for living. By values, we mean ideas about what a group believes to be good, right, and desirable. Put differently, values are shared assumptions about how things ought to be.11 By norms, we mean the social rules and guidelines that prescribe appropriate behavior in particular situations. We use the term society to refer to a group of people sharing a common set of values and norms. While a society may be equivalent to a country, some countries have several societies or subcultures, and some societies embrace more than one country. For example, the Scandinavian countries of Denmark, Finland, Iceland, Norway, and Sweden are often viewed as culturally being one society for the purpose of a multinational corporation engaging in that marketplace. So, if one Scandinavian country’s people like a product from a company, there is a very good chance customers from the other Scandinavian countries will as well.
Geert Hofstede, often viewed as the foremost expert on cross-cultural differences in international business, presents his work in Istanbul, Turkey, at the Academy of International Business conference.
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©Academy of International Business (AIB)
VALUES AND NORMS
Values form the bedrock of a culture. Values provide the context within which a society’s norms are established and justified. They may include a society’s attitudes toward such concepts as individual freedom, democracy, truth, justice, honesty, loyalty, social obligations, collective responsibility, women, love, sex, marriage, and so on. Values are not just abstract concepts; they are invested with considerable emotional significance. People argue, fight, and even die over values, such as freedom. Freedom and security are often the core reasons the U.S. political leadership uses when justifying the country engaging in various parts of the world, in some way, as the “global police” force. Values are also often reflected in the economic systems of a society. As we saw in Chapter 2, democratic free market capitalism is a reflection of a philosophical value system that emphasizes individual freedom.12
Norms are the social rules that govern people’s actions toward one another. These norms can be subdivided into two major categories: folkways and mores. Both of these categories were coined a long time ago in 1906 by William Graham Sumner, an American sociologist, and they are still applicable and embedded in our societies. Folkways are the routine conventions of everyday life. Generally, folkways are actions of little moral significance. Rather, they are social conventions that deal with things like appropriate dress code in a particular situation, good social manners, eating with the correct utensils, neighborly behavior, and so on. Although folkways define the way people are expected to behave, violation of them is not normally a serious matter. People who violate folkways may be thought of as eccentric or ill-mannered, but they are not usually considered to be evil or bad. In many countries, foreigners may initially be excused for violating folkways. However, traveling managers are increasingly expected to know about specific dress codes, social and professional manners, eating with the correct utensils, and business etiquette. The evolution of norms now demands that business partners at least try to behave according to the folkways in the country in which they are doing business.
A good example of a folkway is people’s attitude toward time. People are very aware of what time it is, the passage of time, and the importance of time in the United States and northern European cultures such as Germany, Netherlands, and the Scandinavian countries (Denmark, Finland, Iceland, Norway, and Sweden). In these cultures, businesspeople are very conscious about scheduling their time and are quickly irritated when time is wasted because a business associate is late for a meeting or if they are kept waiting. Time is really money in the minds of these businesspeople.
The opposite of the time-conscious Americans, Germans, Dutch, and Scandinavians, businesspeople in many Arabic, Latin, and African cultures view time as more elastic. Keeping to a schedule is viewed as less important than building a relationship or finishing an interaction with people. For example, an American businessperson might feel slighted if he or she is kept waiting for 30 minutes outside the office of a Latin American executive before a meeting. However, the Latin American person may simply be completing an interaction with an associate and view the information gathered from this as more important than sticking to a rigid schedule. 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 times and schedules.
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Planning on Doing Business Internationally?
If a company is planning to export a product, two basic questions need to be asked. Is the product ready to be exported? And, is the company ready to export the product (i.e., does the company have the infrastructure, knowledge, and skills to export the product)? Culturally, the product is either ready for a global market or not (and, if not, the company can modify it if the market is important enough). Company readiness is much more culturally sensitive. Having the appropriate cultural knowledge and skills is important. If you have the basic information about a company, you can use globalEDGE’s diagnostic tool called CORE (Company Readiness to Export) to assess both product and company readiness to export. Which do you think is the most important: product readiness or company readiness?
Sources: globalEDGE’s CORE diagnostic tool, http://globalEDGE.msu.edu; Badenhausen, K., “America’s Best Small Companies,” Forbes, October 9, 2013.
Folkways also include rituals and symbolic behavior. Rituals and symbols are the most visible manifestations of a culture and constitute the outward expression of deeper values. For example, upon meeting a foreign business executive, a Japanese executive will hold his business card in both hands and bow while presenting the card to the foreigner.13 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 examine it carefully (Japanese often have business cards with Japanese printed on one side and English printed on the other), which is a way of returning respect and acknowledging the card giver’s position in the hierarchy. 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 important folkway and is considered rude.
Mores refer to norms that are more widely observed, have greater moral significance than folkways, and are central to the functioning of a society and to its social life. Mores have a much greater significance than folkways. Violating mores can bring serious retribution, ill will, and the collapse of any business deal. Mores are often so important that they have been enacted into law. Mores, to use extreme examples, include laws against theft, adultery, incest, and cannibalism. All advanced societies have laws against theft and cannibalism, among other things, but in modern times not necessarily adultery. Many mores (and laws) differ across cultures. In the United States, for example, drinking alcohol is widely accepted, whereas in Saudi Arabia the consumption of alcohol is viewed as violating important social mores and is punishable by imprisonment (as some Western citizens working in Saudi Arabia have discovered to their dismay). That said, countries like Saudi Arabia and the United Arab Emirates are becoming more tolerant of Westerners behaving like Westerners in their countries—such as drinking alcohol if they do not flaunt it. Over time, mores may be implemented differently depending on where you are and who you are, and it pays to know the difference.
CULTURE, SOCIETY, AND THE NATION-STATE
We have defined a society as a group of people who share a common set of values and norms; that is, people who are bound together by a common culture. There is not a strict one-to-one correspondence between a society and a nation-state. Nation-states are political creations. While nation-states are often studied for their “national identity,” “national character,” and even
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“competitive advantage of nations,” in reality they may contain a single culture or several subcultures.14 The French nation can be thought of as the political embodiment of French culture. However, the nation of Canada has a French culture too, and at least three cultures—an Anglo culture, a French-speaking “Quebecois” culture, and a Native American culture. Similarly, many of the 55 African nations have important cultural differences among tribal groups, as horrifically exhibited in the early 1990s when Rwanda dissolved into a bloody civil war between two tribes, the Tutsis and Hutus. Africa is not alone in this regard. India, for example, is composed of many distinct cultural groups with their own rich history and traditions (e.g., Andhras, Gonds, Gujaratis, Marathas, Oriya, Rajputs, Tamils).
Cultures can also embrace several nations, as the Scandinavian countries of Denmark, Finland, Iceland, Norway, and Sweden. There is a strong case that we can consider Islamic society as a culture that is shared by the citizens of many different nations in the Middle East, Asia, and Africa. There are nuances to the Islamic world—those who adhere to various degrees, or to different elements, of Islam. As you will recall from Chapter 3, this view of expansive cultures that embrace several nations underpins Samuel Huntington’s view of a world that is fragmented into different civilizations, including Western, Islamic, and Sinic (Chinese).15
To complicate things further, it is also possible to talk about culture at different levels. It is reasonable to talk about “American society” and “American culture,” but there are several societies within America, each with its own culture. For example, in the United States, one can talk about African American culture, Cajun culture, Chinese American culture, Hispanic culture, Indian culture, Irish American culture, Southern culture, and many more cultural groups. In some way, this means that the relationship between culture and country is often ambiguous. Even if a country can be characterized as having a single homogeneous culture, often that national culture is a mosaic of subcultures. To honor these cultural nuances, businesspeople need to be aware of the delicate issues that pertain to folkways, and they also need to make sure not to violate mores in the country or culture in which they intend to do business. Increased globalization has meant an increased number of business relationships across countries and cultures, but not necessarily an increased cultural understanding to go with it. Culture is a complex phenomenon with multiple dimensions and multiple levels always worthy of study.16
DETERMINANTS OF CULTURE
LO 4-2 Identify the forces that lead to differences in social culture.
The values and norms of a culture do not emerge fully formed. They evolve over time in response to a number of factors, including prevailing political and economic philosophies, the social structure of a society, and the dominant religion, language, and education (see Figure 4.1). We discussed political and economic philosophies in Chapter 2. Such philosophies clearly influence the value systems of a society. For example, the values found in communist North Korea toward freedom, justice, and individual achievement are clearly different from the values found in Sweden, precisely because each society operates according to different political and economic philosophies. In the next sections of this chapter, we discuss the influence of social structure, religion, language, and education. 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.
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4.1 FIGURE Determinants of culture.
test PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
Social Structure A society’s social structure refers to its basic social organization. In essence, we are talking about how a society is organized in terms of its values, norms, and the relationships that are part of the society’s fabric. How society operates and how people, groups, and companies treat each other both emerge from and are determinants of the behaviors of individuals in the specific society. Although the social structure consists of many different aspects, two dimensions are particularly important when explaining differences. The first is the degree to which the basic unit of a social organization is the individual, as opposed to the group, or even company for which a person works. In general, western societies tend to emphasize the importance of the individual, whereas groups tend to figure much larger in many other non- western societies. 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 (India); other societies are characterized by a low degree of social stratification and high mobility between strata (the United States).
INDIVIDUALS AND GROUPS
A group is an association of two or more individuals who have a shared sense of identity and who interact with each other in structured ways on the basis of a common set of expectations about each other’s behavior.17 Human social life is group life. Individuals are involved in families, work groups, social groups, recreational groups, and potentially a myriad of other groups. Social media have expanded the boundaries of what is included in group life and placed an added emphasis on what we can call extended social groups. Social media clearly did not enter into the equation of what was possible in terms of group life. But, social media as a vehicle to the creation of group life has unique possibilities that affect both individuals within a social group and the group itself. For example, consumers are significantly more likely to buy from the
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brands they follow on Instagram, Twitter, Facebook, or LinkedIn, or that they get exposed to via Snapchat, due to group influences. However, while groups are found in all societies, some societies differ according to the degree to which the group is viewed as the primary means of social organization.18 In some societies, individual attributes and achievements are viewed as being more important than group membership; in others, the reverse is true.
LO 4-3 Identify the business and economic implications of differences in culture.
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 systems 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 individual performance in whatever work setting they choose. More and more, individuals are regarded as “independent contractors” even though they belong to and work for a company. 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 person’s capabilities. In science, the label “star scientist” has become synonymous with these individual high-producers of innovative products based on their knowledge, skills, and experience.19
The emphasis on individual performance has both beneficial and harmful aspects. In the United States, the emphasis on individual performance finds expression in an admiration of rugged individualism, entrepreneurship, and innovation. One benefit of this is the high level of entrepreneurial activity in the United States, in Europe, and throughout many of the so-called developed nations. Over time, entrepreneurial individuals in the United States have created lots of new products and new ways of doing business (personal computers, photocopiers, computer software, biotechnology, supermarkets, discount retail stores). One can argue that the dynamism of the U.S. economy owes much to the philosophy of individualism. Highly individualistic societies are often synonymous with those capable of constantly innovating by their creative ideas for products and services.
Individualism also finds expression in a high degree of managerial mobility between companies, as our “personal brand” example illustrated earlier, and this is not always a good thing. Although moving from company to company may be good for individual managers who are trying to build impressive résumés and increase their salaries, it is not necessarily a good thing for companies. The lack of loyalty and commitment to a company and the tendency to move on for a better offer can result in managers who have good general skills but lack the knowledge, experience, and network of contacts that come from years of working for the same company. An effective manager draws on company-specific experience, knowledge, and a network of contacts to find solutions to current problems, and companies may suffer if their managers lack these attributes. One positive aspect of high managerial mobility, however, is that executives are exposed to different ways of doing business. The ability to compare business practices helps executives identify how good practices and techniques developed in one firm might be profitably applied to other firms.
Is Social Class Determined by Income?
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In the text, we say that a class system is a less rigid form of social stratification than caste, in which social mobility is possible. Class is a form of open stratification in which the position a person has by birth can be changed through his or her own achievements or luck. Social class can broadly be divided into three levels, the upper (or rich), middle, and lower (or poor). These levels appear to be tied to income, but does a high income automatically bring power and prestige? Is it the income that determines social class, or is it the social class that will determine the income? Or, is income just a small portion of social class status?
Source: D. Francis, “Where Do You Fall in the American Economic Class System?” US News and World Report, September 13, 2012.
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.20 In traditional Japanese society, the group was the family or village to which an individual belonged. Today, the group has frequently come to be associated with the work team or business organization. In a now-classic study of Japanese society, Nakane noted how this expresses itself in everyday life:
When a Japanese faces the outside (confronts another person) and affixes some position to himself socially he is inclined to give precedence to institution over kind of occupation. Rather than saying, “I am a typesetter” or “I am a filing clerk,” he is likely to say, “I am from B Publishing Group” or “I belong to S company.”21
Nakane goes on to observe that the primacy of the group often evolves into a deeply emotional attachment in which identification with the group becomes very important in a person’s life. For example, as a student, you will often identify yourself as going to XYZ University or, soon enough, as a graduate of XZY University—and the latter identification as an alumnus of a university is something that you carry with you for life. In many cases, we also extend that group thinking beyond a company, organization, or university. For example, we talk about being a part of a university-related conference—for example, “I’m going to Michigan State University, and we are part of the Big Ten Conference.”
At the country level, one central value of Japanese culture is the importance attached to group membership. 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, as Nakane maintains is the case in Japan, this creates a strong incentive for individual members of the group to work together for the common good. Some argue that the success of some Japanese companies in the global economy has been based partly on their ability to achieve close cooperation between individuals within a company and between companies. 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 cooperation between a company and its suppliers on issues such as design, quality control, and inventory reduction.22 In all these cases, cooperation is driven by the need to improve the performance of the group.
The primacy of the value of group identification also discourages managers and other workers, in many cases, moving from company to company. Lifetime employment in a particular company was long the norm in certain sectors of the Japanese economy (estimates suggest that between 20 and 40 percent of all Japanese employees have formal or informal lifetime employment guarantees), albeit those norms have changed significantly in recent
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decades, with much more movement being seen between companies today. Over the years, managers and workers build up knowledge, experience, and a network of interpersonal business contacts. All these things can help managers perform their jobs more effectively and achieve cooperation with others.
However, the primacy of the group is not always beneficial. Just as U.S. society is characterized by a great deal of dynamism and entrepreneurship, reflecting the primacy of values associated with individualism, some argue that Japanese society is characterized by a corresponding lack of dynamism and entrepreneurship. Although the long-run consequences are unclear, one implication is that the United States could continue to create more new industries than Japan and continue to be more successful at pioneering radically new products and new ways of doing business. By most estimates, the United States has led the world in innovation for some time, especially radically new products and services, and the country’s individualism is a strong contributor to this innovative mindset. At the same time, some group-oriented countries such as Japan do very well in innovation, especially non-radical “normal” innovations, according to the GE Global Innovation Barometer.23 This is an indication that multiple paths to being innovative exist in both individualistic and group-oriented cultures, drawing from the uniqueness of the particular culture and what core competencies are reflected in the culture.24 Some argue that individualistic societies are great at creating innovative ideas while collectivist, or group-oriented, societies are better at the implementation of those ideas (taking the idea to the market).
SOCIAL STRATIFICATION
LO 4-2 Identify the forces that lead to differences in social culture.
All societies are stratified on a hierarchical basis into social categories—that is, into social strata. 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 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 between social strata. Second, they differ with regard to the significance attached to social strata in business contexts. Overall, social stratification is based on four basic principles:25
1. Social stratification is a trait of society, not a reflection of individual differences. 2. Social stratification carries over a generation to the next generation. 3. Social stratification is generally universal but variable. 4. Social stratification involves not just inequality but also beliefs.
Social Mobility 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 individual’s lifetime. Often, a caste position carries with it a specific occupation. Members of one caste might be shoemakers, members of another might be butchers, and so on. These occupations are embedded in the caste and passed down through the family to succeeding generations. Although the
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number of societies with caste systems diminished rapidly during the twentieth century, one partial example still remains. India has four main castes and several thousand subcastes. Even though the caste system was officially abolished in 1949, two years after India became independent, it is still a force in rural Indian society where occupation and marital opportunities are still partly related to caste (for more details, see the accompanying Country Focus on the caste system in India today).26
A class system is a less rigid form of social stratification in which social mobility is possible. It is a form of open stratification in which the position a person has by birth can be changed through his or her own achievements or luck. Individuals born into a class at the bottom of the hierarchy can work their way up; conversely, individuals born into a class at the top of the hierarchy can slip down.
While many societies have class systems, social mobility within a class system varies from society to society. For example, some sociologists have argued that the United Kingdom has a more rigid class structure than certain other western societies, such as the United States.27 Historically, British society was divided into three main classes: the upper class, which was made up of individuals whose families for generations had wealth, prestige, and occasionally power; the middle class, whose members were involved in professional, managerial, and clerical occupations; and the working class, whose members earned their living from manual occupations. The middle class was further subdivided into the upper-middle class, whose members were involved in important managerial occupations and the prestigious professions (lawyers, accountants, doctors), and the lower-middle class, whose members were involved in clerical work (bank tellers) and the less prestigious professions (schoolteachers).
c o u n t r y F O C U S
Determining Your Social Class by Birth Modern India is a country of dramatic contrasts. The country’s information technology (IT) sector is among the most vibrant in the world, with companies such as Tata Consultancy Services, Cognizant Technology Solutions, Infosys, and Wipro as powerful global players. Cognizant is an interesting company in that it was founded as a technology arm of Dun & Bradstreet (USA), but it is typically considered an Indian IT company because a majority of its employees are based in India. In fact, many IT companies locate or operate in India because of its strong IT knowledge, human capital, and culture.
Traditionally, India has had one of the strongest caste systems in the world. Somewhat sadly, this caste system still exists today even though it was officially abolished in 1949, and many Indians actually prefer it this way! At the core, the caste system has no legality in India, and discrimination against lower castes is illegal. India has also enacted numerous new laws and social initiatives to protect and improve living conditions of lower castes in the country.
Historically, India’s caste system was an impediment to social mobility. But the stranglehold on people’s socioeconomic conditions is steadily becoming a fading memory among the educated, urban middle-class Indians who make up the majority of employees in the high-tech economy. Unfortunately, the same is not true in rural India, where some 70 percent of the nation’s population still resides. In the rural part of the country, the caste remains a pervasive influence.
For example, a young female engineer at Infosys, who grew up in a small rural village and is a dalit (sometimes called a “scheduled caste”), recounts how she never entered the house of a Brahmin, India’s elite priestly caste, even though half of her village were Brahmins. And when a dalit was hired to cook at the school in her native village, Brahmins withdrew their children from the school. The engineer
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herself is the beneficiary of a charitable training scheme developed by Infosys. Her caste, making up about 16 percent of the country (or around 165 million people), is among the poorest in India, with some 91 percent making less than $100 a month, compared to 65 percent of Brahmins.
To try to correct this historical inequality, politicians have talked for years about extending the employment quota system to private enterprises. The government has told private companies to hire more dalits and members of tribal communities and have been warned that “strong measures” will be taken if companies do not comply. Private employers are resisting attempts to impose quotas, arguing with some justification that people who are guaranteed a job by a quota system are unlikely to work very hard.
At the same time, progressive employers realize they need to do something to correct the inequalities, and unless India taps into the lower castes, it may not be able to find the employees required to staff rapidly growing high-technology enterprises. As a consequence, the Confederation of Indian Industry implemented a package of dalit-friendly measures, including scholarships for bright lower-caste children. Building on this, Infosys is leading the way among high-tech enterprises. The company provides special training to low-caste engineering graduates who have failed to get a job in industry after graduation. While the training does not promise employment, so far almost all graduates who completed the seven-month training program have been hired by Infosys and other enterprises. Positively, Infosys programs are a privatized version of the education offered in India to try to break down India’s caste system.
Sources: Mari Marcel Thekaekara, “India’s Caste System Is Alive and Kicking—and Maiming and Killing,” The Guardian, August 15, 2016; Noah Feldman, “India’s High Court Favors Nationalism over Democracy,” Bloomberg View, January 8, 2017; “Why Some of India’s Castes Demand to Be Reclassified,” The Economist, February 16, 2016.
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 children to a select group of private schools, where they wouldn’t mix with lower-class children and where they picked up many of the speech accents and social norms that marked them as being from the higher strata of society. 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.
According to some commentators, modern British society is now rapidly leaving behind this class structure and moving toward a classless society. However, sociologists continue to dispute this finding and present evidence that this is not the case. For example, one study reported that state schools in the London Borough (suburb) of Islington, which now has a population of 230,000, had only 79 candidates for university, while one prestigious private school alone, Eton, sent more than that number to Oxford and Cambridge.28 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 empirical literature, a sociologist noted that class differentials in educational achievement have changed surprisingly little over the last few decades in many societies, despite assumptions to the contrary.29
Another society for which class divisions have historically been of some importance has been China, where there has been a long-standing difference between the life chances of the rural peasantry and urban dwellers. Ironically, this historic division was strengthened during the high point of communist rule because of a rigid system of household registration that restricted most Chinese to the place of their birth for their lifetime. Bound to collective farming, peasants were
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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 following the reforms of a few decades ago, and as a consequence, migrant peasant laborers have flooded into China’s cities looking for work. Sociologists now hypothesize that a new class system is emerging in China based less on the rural–urban divide and more on urban occupation.30
The class system in the United States is less pronounced than in India, the United Kingdom, and China and mobility is greater. Like the UK, the United States has its own upper, middle, and working classes. However, class membership is determined to a much greater degree by individual economic achievements, as opposed to background and schooling. 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.
LO 4-3 Identify the business and economic implications of differences in culture.
Significance From a business perspective, the stratification of a society is significant if it affects the operation of business organizations. In American society, the high degree of social mobility and the extreme emphasis on individualism limit the impact of class background on business operations. The same is true in Japan, where most of the population perceives itself to be middle class. In a country such as the United Kingdom or India, however, the relative lack of class mobility and the differences between classes have resulted in the emergence of 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. However, the past two decades have seen a dramatic reduction in industrial disputes, which bolsters the arguments of those who claim that the country is moving toward a classless society. Alternatively, as noted earlier, class consciousness may be reemerging in urban China, and it may ultimately prove to be significant in the country.
An antagonistic relationship between management and labor classes, and the resulting lack of cooperation and high level of industrial disruption, tends to raise the costs of production in countries characterized by significant class divisions. This can make it more difficult for companies based in such countries to establish a competitive advantage in the global economy.
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Religious and Ethical Systems LO 4-2 Identify the forces that lead to differences in social culture.
Religion may be defined as a system of shared beliefs and rituals that are concerned with the
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realm of the sacred.31 An ethical system refers to a set of moral principles, or values, that are used to guide and shape behavior.32 Most of the world’s ethical systems are the product of religions. 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 2.20 billion adherents, Islam with around 1.60 billion adherents, Hinduism with 1.10 billion adherents (primarily in India), and Buddhism with about 535 million adherents (see Map 4.1). Although many other religions have an important influence in certain parts of the modern world (e.g., Shintoism in Japan, with roughly 40 million followers, and Judaism, which has 18 million adherents and accounts for 75 percent of the population of Israel), their numbers pale in comparison with these dominant religions (although as the precursor of both Christianity and Islam, Judaism has an indirect influence that goes beyond its numbers). We review these four religions, along with Confucianism, focusing on their potential business implications.
4.1 MAP World religions.
Source: “Map 14,” in Allen, John L., and Sutton, Christopher J., Student Atlas of World Politics, 10th ed. New York, NY: McGraw-Hill Companies, Inc., 2013.
Some scholars have theorized that the most important business implications of religion center on the extent to which different religions shape attitudes toward work and entrepreneurship and the degree to which the religious ethics affect the costs of doing business in a country. However, it is hazardous to make sweeping generalizations about the nature of the relationship between
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religion and ethical systems and business practice. While some professionals argue that there is a relationship between religious and ethical systems and business practice in a society, in a world where nations with Catholic, Protestant, Muslim, Hindu, and Buddhist majorities all show evidence of entrepreneurial activity and sustainable economic growth, it is important to view such proposed relationships with a degree of skepticism. 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 Rachel McCleary does suggest that strong religious beliefs, particularly beliefs in heaven, hell, and an afterlife, have a positive impact on economic growth rates, irrespective of the particular religion in question.33 Barro and McCleary looked at religious beliefs and economic growth rates in 59 countries. Their conjecture was that higher religious beliefs stimulate economic growth because they help sustain aspects of individual behavior that lead to higher productivity.
CHRISTIANITY
Christianity is the most widely practiced religion in the world with some 2.20 billion followers. 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 monotheistic religion (monotheism is the belief in one God). A religious division in the eleventh century led to the establishment of two major Christian organizations—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 countries (especially 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 (Baptist, Methodist, Calvinist, and so on).
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Christianity Several sociologists have argued that of the main branches of Christianity—Catholic, Orthodox, and Protestant—the latter has the most important economic implications. In 1904, prominent German sociologist Max Weber made a connection between Protestant ethics and “the spirit of capitalism” that has since become famous.34 Weber noted that capitalism emerged in Western Europe, where
business leaders and owners of capital, as well as the higher grades of skilled labor, and even more the higher technically and commercially trained personnel of modern enterprises, are overwhelmingly Protestant.35
Weber theorized that there was a relationship between Protestantism and the emergence of modern capitalism. He argued that Protestant ethics emphasizes the importance of hard work and wealth creation (for the glory of God) and frugality (abstinence from worldly pleasures). According to Weber, this kind of value system was needed to facilitate the development of capitalism. Protestants worked hard and systematically to accumulate wealth. However, their ascetic beliefs suggested that rather than consuming this wealth by indulging in worldly pleasures, they should invest it in the expansion of capitalist enterprises. 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.
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Protestantism also may have encouraged capitalism’s development in another way. By breaking away from the hierarchical domination of religious and social life that characterized the Catholic Church for much of its history, Protestantism gave individuals significantly more freedom to develop their own relationship with God. 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 individualism as an economic and political philosophy. As we saw in Chapter 2, such a philosophy forms the bedrock on which entrepreneurial free market capitalism is based. Building on this, some scholars claim there is a connection between individualism, as inspired by Protestantism, and the extent of entrepreneurial activity in a nation.36 Again, we must be careful not to generalize too much from this historical sociological view. While nations with a strong Protestant tradition such as Britain, Germany, and the United States were early leaders in the Industrial Revolution, nations with Catholic or Orthodox majorities show significant and sustained entrepreneurial activity and economic growth in the modern world.
ISLAM
LO 4-2 Identify the forces that lead to differences in social culture.
With about 1.60 billion adherents, Islam is the second largest of the world’s major religions. Islam dates to 610 A.D. when the Prophet Muhammad began spreading the word, although the Muslim calendar begins in 622 A.D. when, to escape growing opposition, Muhammad left Mecca for the oasis settlement of Yathrib, later known as Medina. Adherents of Islam are referred to as Muslims. Muslims constitute a majority 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 principle of Islam is that there is but the one true omnipotent God (Allah). Islam requires unconditional acceptance of the uniqueness, power, and authority of God and the understanding that the objective of life is to fulfill the dictates of His will in the hope of admission to paradise. According to Islam, worldly gain and temporal power are an illusion. 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.37 Obvious parallels exist with many of the central principles of both Judaism and Christianity.
Islam is an all-embracing way of life governing the totality of a Muslim’s being.38 As God’s surrogate in this world, a Muslim is not a totally free agent but is circumscribed by religious principles—by a code of conduct for interpersonal relations—in social and economic activities. Religion is paramount in all areas of life. 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.
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Islamic Fundamentalism The past three decades have witnessed the growth of a social movement often referred to as Islamic fundamentalism.39 In the West, Islamic fundamentalism is associated in the media with militants, terrorists, and violent upheavals, such as the bloody conflict occurring in Algeria, the killing of foreign tourists in Egypt, and the September 11, 2001, attacks on the World Trade Center and Pentagon in the United States. For most, this characterization is misleading. Just as Christian fundamentalists are motivated by deeply held religious values that are firmly rooted in their faith, so are Islamic fundamentalists.
A small minority of radical “fundamentalists” who have hijacked the religion to further their own political and violent ends perpetrate the violence that the Western media associates with Islamic fundamentalism. Radical Islamic fundamentalists exist in various forms today, but the most notorious is probably ISIS—an acronym for Islamic State of Iraq and Syria. Now, the violence associated with radical Islamic fundamentalists can be seen across other religions as well. Some Christian “fundamentalists” have incited their own political engagement and violence. The vast majority of Muslims point out that Islam teaches peace, justice, and tolerance, not violence and intolerance. In fact, the foundation is that Islam explicitly repudiates the violence that a radical minority practices.
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, modernization has been accompanied by a growing gap between a rich urban minority and an impoverished urban and rural majority. For the impoverished majority, modernization has offered little in the way of tangible economic progress, while threatening the traditional value system. 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 fundamentalism has become a cultural anchor.
Fundamentalists demand a commitment to traditional religious beliefs and rituals. The result has been a marked increase in the use of symbolic gestures that confirm Islamic values. In areas where fundamentalism is strong, women have resumed wearing floor-length, long-sleeved dresses and covering their hair; religious studies have increased in universities; the publication of religious tracts has increased; and public religious orations have risen.40 Also, the sentiments of some fundamentalist groups are often anti-Western. Rightly or wrongly, Western influence is blamed for a range of social ills, and many fundamentalists’ actions are directed against Western governments, cultural symbols, businesses, and even individuals.
In several Muslim countries, fundamentalists have gained political power and have used this to try to make Islamic law (as set down in the Koran, the bible of Islam) the law of the land. There are grounds for this in Islamic doctrine. Islam makes no distinction between church and state. It is not just a religion; Islam is also the source of law, a guide to statecraft, and an arbiter of social behavior. Muslims believe that every human endeavor is within the purview of the faith —and this includes political activity—because the only purpose of any activity is to do God’s will.41 (Some Christian fundamentalists also share this view.) Muslim fundamentalists have been most successful in Iran, where a fundamentalist party has held power since 1979, but they also have had an influence in many other countries, such as Afghanistan, Algeria, Egypt, Pakistan, Saudi Arabia, and the Sudan.
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Islam The Koran establishes some explicit economic principles, many of which are pro-free enterprise.42 The Koran speaks approvingly of free
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enterprise and of earning legitimate profit through trade and commerce (the Prophet Muhammad 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 disadvantaged. Put simply, in Muslim countries, it is fine to earn a profit, so long as that profit is justly earned and not based on the exploitation of others for one’s own advantage. It also helps if those making profits undertake charitable acts to help the poor. Furthermore, Islam stresses the importance of living up to contractual obligations, keeping one’s word, and abstaining from deception. For a closer look at how Islam, capitalism, and globalization can coexist, see the accompanying Country Focus on the region around Kayseri in central Turkey.
Given the Islamic proclivity to favor market-based systems, Muslim countries are likely to be receptive to international businesses as long as those businesses behave in a manner that is consistent with Islamic ethics, customs, and business practices. Businesses that are perceived as making an unjust profit through the exploitation of others, by deception, or by breaking contractual obligations are unlikely to be welcomed in an Islamic country. In Islamic countries where fundamentalism is on the rise, general hostility toward Western-owned businesses is likely to increase.
One economic principle of Islam prohibits the payment or receipt of interest, which is considered usury. 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 exploitative and unjust. For many years, banks operating in Islamic countries conveniently ignored this condemnation, but starting in the 1970s with the establishment of an Islamic bank in Egypt, Islamic banks opened in predominantly Muslim countries. Now there are hundreds of Islamic banks in more than 50 countries with assets of around $1.6 trillion; plus more than $1 trillion is managed by mutual funds that adhere to Islamic principles.43 Even conventional banks are entering the market: both Citigroup and HSBC, two of the world’s largest financial institutions, now offer Islamic financial services. While only Iran and Sudan enforce Islamic banking conventions, in an increasing number of countries customers can choose between conventional banks and Islamic banks.
c o u n t r y F O C U S
Turkey, Its Religion, and Politics For years now, Turkey has been lobbying the European Union to allow it to join the free trade bloc as a member state. If the EU says yes, it will be the first Muslim state in the union. But this is unlikely to happen any time soon; after all, it has been half a century in the making!
Many critics in the EU worry that Islam and Western-style capitalism do not mix well and that, as a consequence, allowing Turkey into the EU would be a mistake. However, a close look at what is going on in Turkey suggests this view may be misplaced. Consider the area around the city of Kayseri in central Turkey. Many dismiss this poor, largely agricultural region of Turkey as a non-European backwater, far removed from the secular bustle of Istanbul. It is a region where traditional Islamic values hold sway. And yet it is a region that has produced so many thriving Muslim enterprises that it is
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sometimes called the “Anatolian Tiger.” Businesses based here include large food manufacturers, textile companies, furniture manufacturers, and engineering enterprises, many of which export a substantial percentage of their production.
Local business leaders attribute the success of companies in the region to an entrepreneurial spirit that they say is part of Islam. They point out that the Prophet Muhammad, who was himself a trader, preached merchant honor and commanded that 90 percent of a Muslim’s life be devoted to work in order to put food on the table. Outside observers have gone further, arguing that what is occurring around Kayseri is an example of Islamic Calvinism, a fusion of traditional Islamic values and the work ethic often associated with Protestantism in general and Calvinism in particular.
However, not everyone agrees that Islam is the driving force behind the region’s success. Saffet Arslan, the managing director of Ipek, the largest furniture producer in the region (which exports to more than 30 countries), says another force is at work: globalization! According to Arslan, over the past three decades, local Muslims who once eschewed making money in favor of focusing on religion are now making business a priority. 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 traditional attitudes toward the role of women in the workplace and the low level of female employment in the region. According to a report by the European Stability Initiative, the same group that holds up the Kayseri region as an example of Islamic Calvinism, the low participation of women in the local workforce is the Achilles’ heel of the economy and may stymie the attempts of the region to catch up with the countries of the European Union.
Sources: Marc Champion, “Turkey’s President Is Close to Getting What He’s Always Wanted,” Bloomberg BusinessWeek, February 8, 2017; “Dress in a Muslim Country: Turkey Covers Up,” The Economist, January 26, 2017; “Turkey’s Future Forward to the Past: Can Turkey’s Past Glories Be Revived by Its Grandiose Islamist President?” The Economist, January 3, 2015.
Conventional banks make a profit on the spread between the interest rate they have to pay to depositors and the higher interest rate they charge borrowers. Because Islamic banks cannot pay or charge interest, they must find a different way of making money. Islamic banks have experimented with two different banking methods—the mudarabah and the murabaha.44
A mudarabah contract is similar to a profit-sharing scheme. Under mudarabah, when an Islamic bank lends money to a business, rather than charging that business interest on the loan, it takes a share in the profits that are derived from the investment. Similarly, when a business (or individual) deposits money at an Islamic bank in a savings account, the deposit is treated as an equity investment in whatever activity the bank uses the capital for. Thus, the depositor receives a share in the profit from the bank’s investment (as opposed to interest payments) according to an agreed-upon ratio. Some Muslims claim this is a more efficient system than the Western banking system because it encourages both long-term savings and long-term 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.
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Culture on globalEDGE
©Glow Images
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 Country” section (globaledge.msu.edu/global-insights/by/country), with coverage of more than 200 countries and states, has culture coverage (e.g., what to do and not to do when visiting a country). In Chapter 4, we cover a lot of material on culture, and Geert Hofstede’s research has been the most influential on culture and business for about half a century. globalEDGE™ has “The Hofstede Centre” as one of its cultural reference sources. This reference focuses on Hofstede’s research on cultural dimensions, including scores for countries, regions, charts, and graphs. Are you interested in the scores for a country that we do not illustrate in Table 4.1? If so, check out “The Hofstede Centre” and its “Culture Compass,” and see what the scores are for your favored country.
4.1 TABLE Work-Related Values for 15 Selected Countries
Source: Geert Hofstede, “The Cultural Relativity of Organizational Practices and Theories,” Journal of International Business Studies 14 (Fall 1983), pp. 75–89.
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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
LO 4-2 Identify the forces that lead to differences in social culture.
Hinduism has approximately 1.10 billion adherents, most of them on the Indian subcontinent. Hinduism began in the Indus Valley in India more than 4,000 years ago, making it the world’s oldest major religion. Unlike Christianity and Islam, its founding is not linked to a particular person. Nor does it have an officially sanctioned sacred book such as the Bible or the Koran. Hindus believe that a moral force in society requires the acceptance of certain responsibilities, called dharma. Hindus believe in reincarnation, or rebirth into a different body, after death. Hindus also believe in karma, the spiritual progression of each person’s soul. A person’s karma is affected by the way he or she lives. 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 reincarnation no longer necessary. Many Hindus believe that the way to achieve nirvana is to lead a severe ascetic lifestyle of material and physical self-denial, devoting life to a spiritual rather than material quest.
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Hinduism Max Weber, famous for expounding on the Protestant work ethic, also argued that the ascetic principles embedded in Hinduism do not encourage the kind of entrepreneurial activity in pursuit of wealth creation that we find in Protestantism.45 According to Weber, traditional Hindu values emphasize that individuals should be judged not by their material achievements but by their spiritual achievements. Hindus perceive the pursuit of material well-being as making the attainment of nirvana more difficult. Given the emphasis on an ascetic lifestyle, Weber thought that devout Hindus would be less likely to engage in entrepreneurial activity than devout Protestants.
Mahatma Gandhi, the famous Indian nationalist and spiritual leader, was certainly the embodiment of Hindu asceticism. It has been argued that the values of Hindu asceticism and self-reliance that Gandhi advocated had a negative impact on the economic development of postindependence India.46 But we must be careful not to read too much into Weber’s rather old arguments. Modern India is a very dynamic entrepreneurial society, and millions of hardworking entrepreneurs form the economic backbone of the country’s rapidly growing economy, especially in the information technology sector.47
Historically, Hinduism also supported India’s caste system. 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 progression and reincarnation. An individual can be reborn into a higher caste in his or her next life if he or she achieves spiritual development in this life. Although the caste system has been abolished in India, as discussed
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earlier in the chapter, it still casts a long shadow over Indian life.
BUDDHISM
LO 4-2 Identify the forces that lead to differences in social culture.
Buddhism, with some 535 million adherents, was founded in the sixth century B.C. by Siddhartha Gautama in what is now Nepal. Siddhartha renounced his wealth to pursue an ascetic lifestyle and spiritual perfection. His adherents claimed he achieved nirvana but decided to remain on earth to teach his followers how they, too, could achieve this state of spiritual enlightenment. Siddhartha became known as the Buddha (which means “the awakened one”). Today, most Buddhists are found in Central and Southeast Asia, China, Korea, and Japan. According to Buddhism, suffering originates in people’s desires for pleasure. Cessation of suffering can be achieved by following a path for transformation. Siddhartha offered the Noble Eightfold Path as a route for transformation. 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.
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Buddhism The emphasis on wealth creation that is embedded in Protestantism is historically not found in Buddhism. Thus, in Buddhist societies, we do not see the same kind of cultural stress on entrepreneurial behavior that Weber claimed could be found in the Protestant West. But unlike Hinduism, the lack of support for the caste system and extreme ascetic behavior suggests that a Buddhist society may represent a more fertile ground for entrepreneurial activity than a Hindu culture. In effect, innovative ideas and entrepreneurial activities may take hold throughout society independent of which caste a person may belong to, but again, each culture is uniquely oriented toward its own types of entrepreneurial behavior.
In Buddhism, societies were historically more deeply rooted to their local place in the natural world.48 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 separation between people and also between people and the natural world. Plus, as the economy grows, it is difficult to understand and appreciate the potential effects people have on the natural world. Both of these separations are antithetical to the Buddha’s teachings.
Interestingly, recent trends actually bring in the “Zen” orientation from Buddhism into business in the Western world.49 Now there are some 700 trademarks containing the word Zen in the United States alone, according to the U.S. Patent and Trademark Office. “In business, ‘Zen’ is often a synonym for ordinary nothingness,” blogged Nancy Friedman, a corporate copywriter who consults with businesses on naming and branding. She said that “Zen can be combined with mail to describe ‘an incoming e-mail message with no message or attachments.’ Zen spin is a verb meaning ‘to tell a story without saying anything at all.’ And to zen a computing problem means to figure it out in an intuitive flash—perhaps while you’re plugged into the earphones of your ZEN MP3 player, available from Creative.”50
CONFUCIANISM
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LO 4-2 Identify the forces that lead to differences in social culture.
Confucianism was founded in the fifth century B.C. by K’ung-Fu-tzu, more generally known as Confucius. For more than 2,000 years until the 1949 communist revolution, Confucianism was the official ethical system of China. While observance of Confucian ethics has been weakened in China since 1949, many people still follow the teachings of Confucius, principally in China, Korea, and Japan. Confucianism teaches the importance of attaining personal salvation through right action. Although not a religion, Confucian ideology has become deeply embedded in the culture of these countries over the centuries and, through that, has an impact on the lives of many millions more.51 Confucianism is built around a comprehensive ethical code that sets down guidelines for relationships with others. High moral and ethical conduct and loyalty to others are central to Confucianism. Unlike religions, Confucianism is not concerned with the supernatural and has little to say about the concept of a supreme being or an afterlife.
LO 4-3 Identify the business and economic implications of differences in culture.
Economic Implications of Confucianism Some scholars maintain that Confucianism may have economic implications as profound as those Weber argued were to be found in Protestantism, although they are of a different nature.52 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 absolute obligation. In modern organizations based in Confucian cultures, the loyalty that binds employees to the heads of their organization can reduce the conflict between management and labor that we find in more class-conscious societies. Cooperation between management and labor can be achieved at a lower cost in a culture where the virtue of loyalty is emphasized in the value systems.
However, in a Confucian culture, loyalty to one’s superiors, such as a worker’s loyalty to management, is not blind loyalty. The concept of reciprocal obligations is important. Confucian ethics stresses that superiors are obliged to reward the loyalty of their subordinates by bestowing blessings on them. If these “blessings” are not forthcoming, then neither will be the loyalty. This Confucian ethic is central to the Chinese concept of guanxi, which refers to relationship networks supported by reciprocal obligations.53 Guanxi means relationships, although in business settings it can be better understood as connections. Today, Chinese will often cultivate a guanxiwang, or “relationship network,” for help. Reciprocal obligations are the glue that holds such networks together. If those obligations are not met—if favors done are not paid back or reciprocated—the reputation of the transgressor is tarnished, and the person will be less able to draw on his or her guanxiwang for help in the future. 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 accompanying Management Focus on China.
A third concept found in Confucian ethics is the importance attached to honesty. Confucian thinkers emphasize that although dishonest behavior may yield short-term benefits for the transgressor, dishonesty does not pay in the long run. The importance attached to honesty has major economic implications. When companies can trust each other not to break contractual
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obligations, the costs of doing business are lowered. Expensive lawyers are not needed to resolve contract disputes. In a Confucian society, people may be less hesitant to commit substantial resources to cooperative ventures than in a society where honesty is less pervasive. When companies adhere to Confucian ethics, they can trust each other not to violate the terms of cooperative agreements. Thus, the costs of achieving cooperation between companies may be lower in societies such as Japan relative to societies where trust is less pervasive.
For example, it has been argued that the close ties between the automobile companies and their component parts suppliers in Japan are facilitated by a combination of trust and reciprocal obligations. 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.54 Similarly, the combination of trust and reciprocal obligations is central to the workings and persistence of guanxi networks in China.
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m a n a g e m e n t F O C U S
China and Its Guanxi
A few years ago, DMG emerged as one of China’s fastest-growing advertising agencies with a client list that includes Budweiser, Unilever, Sony, Nabisco, Audi, Volkswagen, China Mobile, and dozens of other Chinese brands. Dan Mintz, the company’s founder, says that the success of DMG was connected strongly to what the Chinese call guanxi.
Guanxi literally means relationships, although in business settings it can be better understood as connections. Guanxi has its roots in the Confucian philosophy of valuing social hierarchy and reciprocal obligations. Confucian ideology has a 2,000-year-old history in China. Confucianism stresses the importance of relationships, both within the family and between master and servant. Confucian ideology teaches that people are not created equal. In Confucian thought, loyalty and obligations to one’s superiors (or to family) are regarded as a sacred duty, but at the same time, this loyalty has its price. Social superiors are obligated to reward the loyalty of their social inferiors by bestowing “blessings” upon them; thus, the obligations are reciprocal. Chinese will often cultivate a guanxiwang, or “relationship network,” for help. 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 connections. 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 traditional Chinese characters, which had been banned by Chairman Mao during the cultural revolution in favor of simplified versions. To get permission to use the
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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 government contacts, they were able to shut down the Bund to make the shoot. Steven Spielberg had been able to close down only a portion of the street when he filmed Empire of the Sun. DMG has also filmed inside Beijing’s Forbidden City, even though it is against the law to do so. Using his contacts, Mintz persuaded the government to lift the law for 24 hours. As Mintz has noted, “We don’t stop when we come across regulations. There are restrictions everywhere you go. You have to know how get around them and get things done.”*
Today, DMG Entertainment has expanded into being a Chinese-based production and distribution company. While it began as an advertising agency, the company started distributing non-Chinese movies in the Chinese market in the late 2000s (e.g., Iron Man 3, the sixth-highest-grossing film of all time in China) as well as producing Chinese films, the first being Founding of a Republic, a movie that marked the 60th anniversary of the People’s Republic of China. In these activities, DMG is also enjoying guanxi in the country. Variety reported that DMG benefited from “strong connections” with Chinese government officials and the state-run China Film Group Corporation.
*Graser, M., “Featured Player,” Variety, October 18, 2004, p. 6.
Sources: Rob Cain, “Chinese Studio DMG Emerges as Bidder for Major Stake in Paramount Pictures,” Media and Entertainment, March 15, 2016; Ali Jaafar, “China’s DMG Inks Deal with Hasbro to Launch First ‘Transformers’ Live Action Attraction,” Deadline Hollywood, January 16, 2016; A. Busch, “China’s DMG and Valiant Entertainment Partner to Expand Superhero Universe,” Deadline Hollywood, March 12, 2015; C. Coonan, “DMG’s Dan Mintz: Hollywood’s Man in China,” Variety, June 5, 2013; and Simon Montlake, “Hollywood’s Mr China: Dan Mintz, DMG,” Forbes, August 29, 2012.
Language One obvious way in which many countries differ is language. By language, we mean both the spoken and the unspoken means of communication. Language is also one of the defining characteristics of a culture. Oftentimes, learning a language entails learning a culture and vice versa. Some would even argue that a person cannot get entrenched in a culture without knowing its dominant language.
SPOKEN LANGUAGE
Language does far more than just enable people to communicate with each other. The nature of a language also structures the way we perceive 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 phenomenon is that whereas the English language has but one word for snow, the language of the Inuit (Eskimos) lacks a general term for it. Instead, distinguishing different forms of snow is so important in the lives of the Inuit that they have 24 words that describe different types of snow (e.g., powder snow, falling snow, wet snow, drifting snow).55
Because language shapes the way people perceive the world, it also helps define culture. Countries with more than one language often have more than one culture. Canada has an English-speaking culture and a French-speaking culture. Tensions between the two can run quite high, with a substantial proportion of the French-speaking minority demanding independence from a Canada “dominated by English speakers.” The same phenomenon can be observed in
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many other countries. Belgium is divided into Flemish and French speakers, and tensions between the two groups exist; in Spain, a Basque-speaking minority with its own distinctive culture has been agitating for independence from the Spanish-speaking majority for decades; on the Mediterranean island of Cyprus, the culturally diverse Greek- and Turkish-speaking populations of the island continually engage in some level of conflict. The island is now partitioned into two parts as a consequence. While it does not necessarily follow that language differences create differences in culture and, therefore, separatist pressures (witness the harmony in Switzerland, where four languages are spoken), there certainly seems to be a tendency in this direction.56
Can You Speak the Most Important Languages?
Mastering your own native language is important to doing business in your home country. Mastering the language of a foreign country is also an added value in any cross-cultural relationship. English leads the way in terms of business languages, but which languages are important after English? Spanish? No, not necessarily. 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 Resources on globalEDGETM (globalEDGE.msu.edu/global- resources/language-resources), and learn a new language (including Mandarin, French, Arabic, and Spanish).
Source: S. Kim, “Top 3 Useful Foreign Languages for Business Excludes Spanish,” ABC News, September 1, 2011, http://abcnews.go.com/business/t/blogEntry?id=14427844.
Mandarin (Chinese) is the mother tongue of the largest number of people, followed by English and Hindi, which is spoken in India. However, the most widely spoken language in the world is English, followed by French, Spanish, and Mandarin (many people speak English as a second language). English is increasingly becoming the language of international business throughout the world, as it has been in much of the developed world for years. When Japanese and German businesspeople get together to do business, it is almost certain that they will communicate in English. However, although English is widely used, learning the local language yields considerable advantages. Most people prefer to converse in their own language, and being able to speak the local language can build rapport and goodwill, which may be very important for a business deal. International businesses that do not understand the local language can make major blunders through improper translation.
For example, the Sunbeam Corporation used the English words for its “Mist-Stick” mist- producing hair-curling iron when it entered the German market, only to discover after an expensive advertising campaign that mist means excrement in German. General Motors was troubled by the lack of enthusiasm among Puerto Rican dealers for its new Chevrolet Nova. When literally translated into Spanish, nova means star. However, when spoken it sounds like “no va,” which in Spanish means “it doesn’t go.” General Motors changed the name of the car to Caribe.57 Ford made a similar and somewhat embarrassing mistake in Brazil. 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). Unfortunately, Jättebra resembles the Thai slang word for sex. Pepsi’s slogan “come alive with the Pepsi Generation” did not quite work in China. People in
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China took it literally to mean “bring your ancestors back from the grave.”
UNSPOKEN LANGUAGE
LO 4-2 Identify the forces that lead to differences in social culture.
Unspoken language refers to nonverbal communication. We all communicate with each other by a host of nonverbal cues. 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 nonverbal cues of another culture can lead to a communication failure. For example, making a circle with the thumb and the forefinger is a friendly gesture in the United States, but it is a vulgar sexual invitation in Greece and Turkey. Similarly, while most Americans and Europeans use the thumbs-up gesture to indicate that “it’s all right,” in Greece the gesture is obscene.
Another aspect of nonverbal communication is personal space, which is the comfortable amount of distance between you and someone you are talking with. In the United States, the customary distance apart adopted by parties in a business discussion is five to eight feet. In Latin America, it is three to five feet. Consequently, many North Americans unconsciously feel that Latin Americans are invading their personal space and can be seen backing away from them during a conversation. Indeed, the American may feel that the Latin is being aggressive and pushy. In turn, the Latin American may interpret such backing away as aloofness. The result can be a regrettable lack of rapport between two businesspeople from different cultures.
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Education LO 4-2 Identify the forces that lead to differences in social culture.
Formal education plays a key role in a society, and it is usually the medium through which individuals learn many of the languages and other skills that are indispensable in a modern society. Formal education also 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, honesty, 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.58
From an international business perspective, one important aspect of education is its role as a determinant of national competitive advantage.59 The availability of a pool of skilled and knowledgeable workers is a major determinant of the likely economic success of a country. In analyzing the competitive success of Japan, for example, Harvard Business School Professor Michael Porter notes that after the last World War, Japan had almost nothing except for a pool of skilled and educated human resources:
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With a long tradition of respect for education that borders on reverence, Japan possessed a large pool of literate, educated, and increasingly skilled human resources. . . . Japan has benefited from a large pool of trained engineers. Japanese universities graduate many more engineers per capita than in the United States. . . . A first-rate primary and secondary education system in Japan operates based on high standards and emphasizes math and science. Primary and secondary education is highly competitive. . . . Japanese education provides most students all over Japan with a sound education for later education and training. A Japanese high school graduate knows as much about math as most American college graduates.60
Porter’s point is that Japan’s excellent education system is an important factor explaining the country’s postwar economic success. Not only is a good education system a determinant of national competitive advantage, but it is also an important factor guiding the location choices of international businesses. 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 was not available, no matter how attractive the country might seem on other dimensions. It might make sense to base production operations that require only unskilled labor in such a country.
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 50 percent of the population is illiterate is unlikely to be a good market for popular books. But perhaps more importantly, promotional material containing written descriptions of mass-marketed products is unlikely to have an effect in a country where a half of the population cannot read. It is far better to use pictorial promotions in such circumstances.
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Culture and Business LO 4-4 Recognize how differences in social culture influence values in business.
Of considerable importance for a multinational corporation, or any company—small, medium or large—with operations in different countries is how a society’s culture affects the values found in the workplace. Management processes and practices may need to vary according to culturally determined work-related values. For example, if the cultures of Brazil and the United Kingdom or the United States and Sweden result in different work-related values, a company with operations in the different countries should vary its management processes and practices to account for these differences.
The most famous study of how culture relates to values in the workplace was undertaken by Geert Hofstede.61 As part of his job as a psychologist working for IBM, Hofstede collected data on employee attitudes and values for more than 116,000 individuals. Respondents were matched on occupation, age, and gender. The data later on enabled him to compare dimensions of culture across 50 countries. Hofstede initially isolated four dimensions that he claimed summarized the
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different cultures62—power distance, uncertainty avoidance, individualism versus collectivism, and masculinity versus femininity—and then, later on, he added a fifth dimension inspired by Confucianism that he called long-term versus short-term orientation.63
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.64 Bond used input from “Eastern minds,” as Hofstede called it, to develop the Chinese Value Survey. Bond also references Chinese scholars as helping him create the values that exemplify this new long-term versus short-term orientation. In his original research, Bond called the fifth dimension “Confucian work dynamism,” but Hofstede said that in practical terms, the dimension refers to a long-term versus short-term orientation.
Hofstede’s power distance dimension focused on how a society deals with the fact that people are unequal in physical and intellectual capabilities. According to Hofstede, high power distance cultures were found in countries that let inequalities grow over time into inequalities of power and wealth. Low power distance cultures were found in societies that tried to play down such inequalities as much as possible.
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, people were born into collectives, such as extended families, and everyone was supposed to look after the interest of his or her collective.
Hofstede’s uncertainty avoidance dimension measured the extent to which different cultures socialized their members into accepting ambiguous situations and tolerating uncertainty. Members of high uncertainty avoidance cultures placed a premium on job security, career patterns, retirement benefits, and so on. They also had a strong need for rules and regulations; the manager was expected to issue clear instructions, and subordinates’ initiatives were tightly controlled. Lower uncertainty avoidance cultures were characterized by a greater readiness to take risks and less emotional resistance to change.
Hofstede’s masculinity versus femininity dimension looked at the relationship between gender and work roles. In masculine cultures, sex roles were sharply differentiated, and traditional “masculine values,” such as achievement and the effective exercise of power, determined cultural ideals. In feminine cultures, sex roles were less sharply distinguished, and little differentiation was made between men and women in the same job.
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, protection 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 individualism, power distance, uncertainty avoidance, masculinity, and for long-term orientation.65 By using the company IBM, Hofstede was able to hold company constant across cultures. Thus, any differences across the country cultures would by design be due to differences in the countries’ cultures and not the company’s culture. He averaged the scores for all employees from a given country to create an index score between 0 and 100.
A strong movement is under way to add a sixth dimension to Hofstede’s work. Geert Hofstede, working with Michael Minkov’s analysis of the World Values Survey, added a promising new dimension called indulgence versus restraint (IND) in 2010.66 On January 17,
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2011, Hofstede delivered a webinar for SIETAR Europe called “New Software of the Mind” to introduce the third edition of Cultures and Organizations, in which the results of Minkov’s analysis were included to support this sixth dimension. In addition, in a keynote delivered at the annual meeting of the Academy of International Business (http://aib.msu.edu) in Istanbul, Turkey, on July 6, 2013, Hofstede again presented results and theoretical rationale to support the indulgence versus restraint dimension. Indulgence refers to a society that allows relatively free gratification of basic and natural human drives related to enjoying life and having fun. Restraint refers to a society that suppresses gratification of needs and regulates it by means of strict social norms.
Table 4.1 summarizes data for 15 selected countries for the five established dimensions of individualism versus collectivism, power distance, uncertainty avoidance, masculinity versus femininity, and long-term versus short-term orientation (the Hofstede data were collected for 50 countries and the Bond data were collected for 23 countries; numerous other researchers have also added to the country samples). Western nations such as the United States, Canada, and United Kingdom score high on the individualism scale and low on the power distance scale. Latin American and Asian countries emphasize collectivism over individualism and score high on the power distance scale. Table 4.1 also reveals that Japan’s culture has strong uncertainty avoidance and high masculinity. 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 differences among cultures. Many of Hofstede’s findings are consistent with standard stereotypes about cultural differences. For example, many people believe Americans are more individualistic and egalitarian than the Japanese (they have a lower power distance), who in turn are more individualistic and egalitarian than Mexicans. Similarly, many might agree that Latin countries place a higher emphasis on masculine value—they are machismo cultures—than the Scandinavian countries of Denmark and Sweden. As might be expected, East Asian countries such as Japan and Thailand scored high on long-term orientation, while nations such as the United States and Canada scored low.
However, we should be careful about reading too much into Hofstede’s research. It has been criticized on a number of points.67 First, Hofstede assumes there is a one-to-one correspondence between culture and the nation-state, but as we discussed earlier, many countries have more than one culture. Second, Hofstede’s research may have been culturally bound. The research team was composed of Europeans 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 surprising 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, as we also pointed out earlier.
How Strong Is Your National Identity?
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As we have found out in this chapter, a lot of measures exist to assess cultural values and norms. Self- assessment is one of the best ways to better know yourself, and we encourage you to take a rigorous cultural personality test such as what Hofstede has developed. But let’s have some easy fun! How strong is your personal national identity? On a scale from 1 to 7, with 1 being “strongly disagree” and 7 being “strongly agree” (and with scores of 2, 3, 4, 5, and 6 being in between those two extremes), rate yourself on these four questions:
1. My country has a strong historical heritage (national heritage). 2. People from my country are proud of their nationality (cultural homogeneity). 3. A true native of my country would never reject their religious beliefs (belief system). 4. It is always best to purchase products made from my home country (consumer
ethnocentrism).
If you scored above 23 in total for the four questions, you have a strong “national identity”; if you scored below 9, you have a weak “national identity.” Most people fall in between these two extremes.
Sources: B. Keillor and T. Hult, “A Five-Country Study of National Identity: Implications for International Marketing Research and Practice,” International Marketing Review, 1999, pp. 65–82; B. Keillor, T. Hult, R. Erffmeyer, and E. Babakus, “NATID: The Development and Application of a National Identity Measure for Use in International Marketing,” Journal of International Marketing, vol. 4, 1996.
Still, Hofstede’s work is the leading research the world has seen on culture. It represents a great starting point for managers trying to figure out how cultures differ and what that might mean for management practices. Also, several other scholars have found strong evidence that differences in culture affect values and practices in the workplace, and Hofstede’s basic results have been replicated using more diverse samples of individuals in different settings.68 Nevertheless, managers should use the results with caution. One reason for caution is the plethora of new cultural values surveys and data points that are starting to become important additions to Hofstede’s work. Two additional cultural values frameworks that have been examined and have been related to work-related and/or business-related issues are the Global Leadership and Organizational Behavior Effectiveness instrument and the World Values Survey.
The Global Leadership and Organizational Behavior Effectiveness (GLOBE) instrument is designed to address the notion that a leader’s effectiveness is contextual.69 It is embedded in the societal and organizational norms, values, and beliefs of the people being led. 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 avoidance, 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.70 The WVS includes dimensions for support for democracy; tolerance of foreigners and ethnic minorities; support for gender equality; the role of religion and changing levels of religiosity; the impact of globalization; attitudes toward the environment, work, family, politics, national identity, culture, diversity, and insecurity; and subjective well-being.
As a reminder, culture is just one of many factors that might influence the economic success of a nation. While culture’s importance should not be ignored, neither should it be overstated. 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 potential to complement and perhaps even supplant Hofstede’s work with additional validation and
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connection to work-related values, business, and marketplace issues. At the same time, the factors discussed in Chapters 2 and 3—economic, political, and legal systems—are probably more important than culture in explaining differential economic growth rates over time.
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Cultural Change LO 4-5 Demonstrate an appreciation for the economic and business implications of cultural
change.
An important point we want to make in this chapter on culture is that culture is not a constant; it evolves over time.71 Changes in value systems can be slow and painful for a society. Change, however, does occur and can often be quite profound. At the beginning of the 1960s, the idea that women might hold senior management positions in major corporations was not widely accepted. Today, of course, it is a reality, and most people in the United States could not fathom it any other way. For example, in 2012 Virginia (“Ginni”) Rometty became the CEO of IBM; Mary Teresa Barra became the CEO of General Motors in 2014. Barra, as but one of many examples (in 2018, 27 of the CEO positions at S&P 500 companies were held by women), was named to the Time 100, and Forbes named her one of the World’s 100 Most Powerful Women. No one in the mainstream of American society now questions the development or the capability of women in the business world. American culture has changed.
General Motors Chair and CEO, Mary Barra, making an announcement about the Chevrolet Bolt autonomous vehicles at a news conference in Detroit, Michigan.
©Cook/Reuters
For another illustration of cultural change, consider Japan. Some business professionals argue that a cultural shift has been occurring in Japan, with a move toward greater individualism.72 The Japanese office worker, or “salary person,” is characterized as being loyal to his or her boss and the organization to the point of giving up evenings, weekends, and vacations to serve the organization. However, a new generation of office workers may not fit this model. An individual from the new generation is likely to be more direct than the traditional Japanese. This new- generation person acts more like a Westerner, a gaijin. He or she does not live for the company and will move on if he or she gets an offer of a better job or has to work too much overtime.73
Several studies have suggested that economic advancement and globalization may be important factors in societal change.74 There is evidence that economic progress is accompanied by a shift in values away from collectivism and toward individualism.75 As Japan has become
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richer, the cultural emphasis on collectivism has declined and greater individualism is being witnessed. One reason for this shift may be that richer societies exhibit less need for social and material support built on collectives, whether the collective is the extended family or the company. People are better able to take care of their own needs. As a result, the importance attached to collectivism declines, while greater economic freedoms lead to an increase in opportunities for expressing individualism.
The culture of societies may also change as they become richer because economic progress affects a number of other factors, which in turn influence culture. For example, increased urbanization and improvements in the quality and availability of education are both a function of economic progress, and both can lead to declining emphasis on the traditional values associated with poor rural societies. 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.76 As countries get richer, a shift occurs away from “traditional values” linked to religion, family, and country, and toward “secular-rational” values. Traditionalists say religion is important in their lives. 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.
The merging or convergence of cultures can also be traced to the world today being more globalized than ever. Advances in transportation and communication, technology, and international trade have set the tone for global corporations (e.g., Disney, Microsoft, Google) to be part of bringing diverse cultures together into a form of homogeneity we have not seen before.77 The examples are endless—McDonald’s hamburgers in China, The Gap in India, iPhones in South Africa, and MTV in Sweden—of global companies helping to foster a ubiquitous youth culture. Plus, with countries around the world climbing the ladder of economic progress, some argue that the conditions for less cultural variation have been created. There may be a slow but steady convergence occurring across different cultures toward some universally accepted values and norms: This is known as the convergence hypothesis.78
At the same time, we should not ignore important countertrends, such as the shift toward Islamic fundamentalism in several countries; the continual separatist movement in Quebec, Canada; ethnic strains and separatist movements in Russia; nationalist movements in the United Kingdom (Brexit); and the election of a populist, nationally oriented Donald Trump as the 45th president of the United States. Such countertrends are a reaction to the pressures for cultural convergence. In an increasingly modern and materialistic world, some societies are trying to reemphasize their cultural roots and uniqueness. It is also important to note that while some elements of culture change quite rapidly—particularly the use of material symbols—other elements change slowly if at all. 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, we should not assume that they have also adopted American (or Western) values—for often they have not.79 Thus, a distinction needs to be made between the visible material aspects of culture and the deep structure, particularly core social values and norms. The deep structure changes only slowly, and differences are often far more persistent.
test PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
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CULTURAL LITERACY AND COMPETITIVE ADVANTAGE
International business is different from national business because countries and societies are different. Societies differ because their cultures vary. Their cultures vary because of differences in social structure, religion, language, education, economic philosophy, and political philosophy. Three important implications for international business flow from these differences. 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 Chapter 5.
Cross-Cultural Literacy One of the biggest dangers confronting a company that goes abroad for the first time is the danger of being ill-informed. International businesses that are ill- informed about another culture are likely to fail. Doing business in different cultures requires adaptation to conform to the value systems and norms of that culture. Adaptation can embrace all aspects of an international firm’s operations in a foreign country. The way in which deals are negotiated, appropriate incentive pay systems for salespeople, the structure of the organization, name of a product, tenor of relations between management and labor, the manner in which the product is promoted, and so on, are all sensitive to cultural differences. What works in one culture might not work in another.
To combat the danger of being ill-informed, international businesses should consider employing local citizens to help them do business in a particular culture. They must also ensure that home-country executives are well-versed enough to understand how differences in culture affect the practice of business. Transferring executives globally at regular intervals to expose them to different cultures will help build a cadre of knowledgeable executives. An international business must also be constantly on guard against the dangers of ethnocentric behavior. Ethnocentrism is a belief in the superiority of one’s own ethnic group or culture. Hand in hand with ethnocentrism goes a disregard or contempt for the culture of other countries. Unfortunately, ethnocentrism is all too prevalent; many Americans are guilty of it, as are many French people, Japanese people, British people, and so on.
Anthropologist Edward T. Hall has described how Americans, who tend to be informal in nature, react strongly to being corrected or reprimanded in public.80 This can cause problems in Germany, where a cultural tendency toward correcting strangers can shock and offend most Americans. For their part, Germans can be a bit taken aback by the tendency of Americans to call people by their first name. This is uncomfortable enough among executives of the same rank, but it can be seen as insulting when a junior American executive addresses a more senior German manager by his or her first name without having been invited to do so. Hall concludes it can take a long time to get on a first-name basis with a German; if you rush the process, you will be perceived as over friendly and rude—and that may not be good for business.
Hall also notes that cultural differences in attitude to time can cause myriad problems. He notes that in the United States, giving a person a deadline is a way of increasing the urgency or relative importance of a task. However, in the Middle East, giving a deadline can have exactly the opposite effect. 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, with the Arab going slow as a reaction to the American’s rudeness. The American may believe that an Arab associate is being rude if he shows up late to a meeting
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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, finishing the discussion with a friend is more important than adhering to a strict schedule. Indeed, the Arab may be puzzled as to why the American attaches so much importance to time and schedule.
Culture and Competitive Advantage One theme that surfaces in this chapter is the relationship between culture and national competitive advantage.81 Put simply, the value systems and norms of a country influence the costs of doing business in that country. The costs of doing business in a country influence the ability of firms to establish a competitive advantage. We have seen how attitudes toward cooperation between management and labor, toward work, and toward the payment of interest are influenced by social structure and religion. It can be argued that the class-based conflict between workers and management in class-conscious societies raises the costs of doing business. Similarly, some sociologists have argued that the ascetic “other-worldly” ethics of Hinduism may not be as supportive of capitalism as the ethics embedded in Protestantism and Confucianism. Islamic laws banning interest payments may raise the costs of doing business by constraining a country’s banking system.
Some scholars have argued that the culture of modern Japan lowers the costs of doing business relative to the costs in most Western nations. Japan’s emphasis on group affiliation, loyalty, reciprocal obligations, honesty, and education all boost the competitiveness of Japanese companies—at least that is the argument. 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.” In addition, the availability of a pool of highly skilled labor, particularly engineers, has helped Japanese enterprises develop cost-reducing process innovations that have boosted their productivity.82 Thus, cultural factors may help explain the success enjoyed by many Japanese businesses. 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.83
It also has been argued that the Japanese culture is less supportive of entrepreneurial activity than, say, American society. In many ways, entrepreneurial activity is a product of an individualistic mindset, not a classic characteristic of the Japanese. This may explain why American enterprises, rather than Japanese corporations, dominate industries where entrepreneurship and innovation are highly valued, such as computer software and biotechnology. Of course, exceptions to this generalization exist. Masayoshi Son recognized the potential of software far faster than any of Japan’s corporate giants; set up his company, Softbank, in 1981; and over the past 30 years has built it into Japan’s top software distributor. Similarly, dynamic entrepreneurial individuals established major Japanese companies such as Sony and Matsushita.
For international business, the connection between culture and competitive advantage is important for two reasons. First, the connection suggests which countries are likely to produce the most viable competitors. For example, we might argue that U.S. enterprises are likely to see continued growth in aggressive, cost-efficient competitors from those Pacific Rim nations where a combination of free-market economics, Confucian ideology, group-oriented social structures, and advanced education systems can all be found (e.g., South Korea, Taiwan, Japan, and, increasingly, China). Second, the connection between culture and competitive advantage has important implications for the choice of countries in which to locate production facilities and do business.
Consider a hypothetical case where a company has to choose between two countries, A and B, for locating a production facility. Both countries are characterized by low labor costs and
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Country B probably does. In country A, the conflict between management and labor, and between different language groups, can be expected to lead to social and industrial disruption, thereby raising the costs of doing business.84 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 decide where to push its products, country A or B. Again, country B would be the logical choice because cultural factors suggest that in the long run, country B is the nation most likely to achieve the greatest level of economic growth.
But as important as culture is to people, companies, and society, it is probably less important than economic, political, and legal systems in explaining differential economic growth between nations. Cultural differences are significant, but we should not overemphasize their importance in the economic sphere. For example, earlier we noted that Max Weber argued that the ascetic principles embedded in Hinduism do not encourage entrepreneurial activity. While this is an interesting academic thesis, recent years have seen an increase in entrepreneurial activity in India, particularly in the information technology sector, where India is rapidly becoming an important global player. The ascetic principles of Hinduism and caste-based social stratification have apparently not held back entrepreneurial activity in this sector.
Key Terms
cross-cultural literacy, p. 89 culture, p. 90 values, p. 90 norms, p. 90 society, p. 90 folkways, p. 91 mores, p. 92 social structure, p. 93 group, p. 94 social strata, p. 96 social mobility, p. 96 caste system, p. 96 class system, p. 96 class consciousness, p. 98 religion, p. 98 ethical system, p. 98 power distance, p. 110 individualism versus collectivism, p. 110 uncertainty avoidance, p. 110 masculinity versus femininity, p. 110 long-term versus short-term orientation, p. 110 ethnocentrism, p. 114
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Summary
This chapter has looked at the nature of culture and discussed a number of implications for business practice. The chapter made the following points:
1. Culture is a complex phenomenon that includes knowledge, beliefs, art, morals, law, customs, and other capabilities acquired by people as members of society.
2. Values and norms are the central components of a culture. Values are abstract ideals about what a society believes to be good, right, and desirable. Norms are social rules and guidelines that prescribe appropriate behavior in particular situations.
3. Values and norms are influenced by political forces, economic philosophy, social structure, religion, language, and education. And, the value systems and norms of a country can affect the costs of doing business in that country.
4. 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 a social organization. These societies emphasize individual achievements above all else. In other societies, the group is the basic building block of the social organization. These societies emphasize group membership and group achievements above all else.
6. Virtually all societies are stratified into different classes. Class-conscious societies are characterized by low social mobility and a high degree of stratification. Less class- conscious societies are characterized by high social mobility and a low degree of stratification.
7. Religion may be defined as a system of shared beliefs and rituals that is concerned with the realm of the sacred. Ethical systems refer to a set of moral principles, or values, that are used to guide and shape behavior. The world’s major religions are Christianity, Islam, Hinduism, and Buddhism. 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.
9. Formal education is the medium through which individuals learn knowledge and skills as well as become socialized into the values and norms of a society. Education plays an important role in the determination of national competitive advantage.
10. Geert Hofstede studied how culture relates to values in the workplace. He isolated five dimensions that summarized different cultures: power distance, uncertainty avoidance, individualism versus collectivism, masculinity versus femininity, and long-term versus short-term orientation.
11. Culture is not a constant; it evolves. Economic progress and globalization are two important engines of cultural change.
12. One danger confronting a company that goes abroad is being ill-informed. To develop cross-cultural literacy, companies operating globally should consider employing host- country nationals, build a cadre of cosmopolitan executives, and guard against the dangers of ethnocentric behavior.
Critical Thinking and Discussion Questions
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1. Outline why the culture of a country might influence the costs of doing business in that country. Illustrate your answer with examples.
2. Do you think that business practices in an Islamic country are likely to differ from business practices in a Christian country? If so, how?
3. Choose two countries that appear to be culturally diverse. Compare the cultures of those countries, and then indicate how cultural differences influence (a) the costs of doing business in each country, (b) the likely future economic development of that country, and (c) business practices.
4. Reread the Country Focus “Turkey, Its Religion, and Politics.” Then answer the following questions:
a. Can you see anything in the values and norms of Islam that is hostile to business? Explain.
b. What does the experience of the region around Kayseri teach about the relationship between Islam and business?
c. What are the implications of Islamic values toward business for the participation of a country such as Turkey in the global economy or becoming a member of the European Union?
5. Reread the Management Focus “China and Its Guanxi” and answer the follow questions: a. Why do you think it is so important to cultivate guanxi and guanxiwang in China? b. What does the experience of DMG tell us about the way things work in China? What
would likely happen to a business that obeyed all the rules and regulations, rather than trying to find a way around them as Dan Mintz does?
c. What ethical issues might arise when drawing on guanxiwang to get things done in China? What does this suggest about the limits of using guanxiwang for a Western business committed to high ethical standards?
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. You are preparing for a business trip to Chile, where you will need to interact extensively with local professionals. As a result, you want to collect information about the local culture and business practices prior to your departure. A colleague from Latin America recommends that you visit the Centre for Intercultural Learning and read through the country insights provided for Chile. Prepare a short description of the most striking cultural characteristics that may affect business interactions in this country.
2. Typically, cultural factors drive the differences in business etiquette encountered during international business travel. In fact, Middle Eastern cultures exhibit significant differences in business etiquette when compared to Western cultures. Prior to leaving for your first business trip to the region, a colleague informed you that a guide named Business Etiquette around the World may help you. Identify five tips regarding business etiquette in the Middle Eastern country of your choice.
The Swatch Group and Cul tura l Uniqueness
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clos ing case
The Swatch Group (swatchgroup.com) with its headquarters in Biel, Switzerland (Europe), is a manufacturer of watches and jewelry. The company was founded in 1983 by Lebanese-born Nicolas Hayek from the merging of Allgemeine Gesellschaft der Schweizerischen Uhrenindustrie and Société Suisse pour l’Industrie Horlogère. It is now the world’s biggest watchmaker.
©PSL Images/Alamy Stock Photo
Nicolas’s daughter, Nayla Hayek, has been chair of the board of directors of the Swatch Group since her father’s death in 2010, and she is also CEO of the luxury jeweler Harry Winston Inc., which was acquired by the Swatch Group in 2013. Georges Nicolas “Nick” Hayek Jr. has been the CEO and president of the Swatch Group since 2003. Today, the Hayek family controls nearly 40 percent of the company.
Swatch and its 37 global subsidiaries employ about 37,000 people, and the company’s revenue is about 9 billion Swiss francs (CHF), or about $9 billion in U.S. dollars. The company’s headquarters in Biel sits on the language border between French- and German-speaking parts of Switzerland and is, by design, bilingual and culturally diverse. In fact, everything that Swatch engages in is based on diversity and culture. This cultural diversity is embedded in its overall brand and global strategizing.
For example, many of the Swatch brands have become cultural icons among a strong core following of customers in the global marketplace. Some even talk about the “Swatch Revolution” that began when Nicolas Hayek founded the company. It was the combination of legendary Swiss watch making (with the Swiss being famous for watch brands such as Patek Philippe, Rolex, Jaeger-LeCoultre) and the unexpected appearance of an affordable plastic watch that turned the watch world upside down.
Suddenly, a watch was more than a way to measure time. It was a new individualized culture, a new language, and a way to speak from the heart without words. By definition, “swatch” means a sample of material or color, oftentimes referring to a small piece of fabric. It is remarkable how Swatch has been able to develop culturally unique watches while also building the fabric for a globally integrated world by its watch making.
The Swatch Group’s brands go far beyond the iconic Swatch watches, though. They also include top Swiss brands like Blancpain, Breguet, and Omega along with unique and classic products such as Balmain, Calvin Klein watches and jewelry, Certina, Flik Flak, Glashütte, Hamilton, Harry Winston, Jaquet Droz, Léon Hatot, Longines, Mido, Original, Rado, Tissot, Tourbillon, and Union Glashütte. These brands form the “art” of Swatch—a focus that is almost always emphasized upfront in the company’s annual report and something the Swatch Group nurtures in various ways, such as via its Instagram account.
On Swatch’s Instagram (instagram.com/swatch), the storyline is clear. Swatch wants you to create your own unique way of accessorizing by the use of a Swatch watch. A person can showcase his or her individualized Swatch use by tagging #MySwatch. The new line of “Skin” watches also helps users “dance with the unknown,” break down barriers, and make #YourMove with Skin. The product is minimalist in style but unique, stylish, yet culturally diverse—much like Swatch has created its cultural uniqueness for decades in the global marketplace. Swatch’s own description of its brand captures this
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cultural uniqueness:
Everyone knows a Swatch when they see one. There’s clearly something that makes Swatch different from every other watch brand. What is it? The look, the colors, the plastic? The design, perhaps, or the fact that it’s Swiss made and versatile enough to be worn with almost anything. There are Swatch watches for people of all ages, and a Swatch for every occasion. But there’s more to Swatch than market coverage. Swatch is an attitude, an approach to life, a way of seeing. The sight of a Swatch excites emotion. Wearing one is a way to communicate, to speak without speaking. Heart to heart.
The Swatch Group is not just about being culturally diverse, or a company marketing products globally to customers of different cultures. In many respects the company is actually creating the values, beliefs, norms, and artifacts that form a globally unique culture worldwide. So, Swatch’s large-scale production of watches and jewelry is used to help create individually and culturally based customer uniqueness.
Sources: Corinne Gretler, “Swatch CEO Nick Hayek Sees Swiss Watch Turnaround in 2017,” Bloomberg BusinessWeek, February 2, 2017; Silke Koltrowitz, “Swatch Group Seeing Strong Demand So Far in 2017,” Reuters, March 16, 2017 (www.reuters.com/article/us-swatch-results-idUSKBN16N15B); “The Amazing Adventures of the Second Watch,” Swatch History 2017 (www.swatch.com/en_us/explore/history); “Swatch Is Challenging Google and Apple with Its Own Operating System,” Fortune, March 16, 2017.
CASE DISCUSSION QUESTIONS 1. With the Hayek family controlling nearly 40 percent of The Swatch Group, how do you
think the family influence impacts the type of corporate culture in the company? What about the company’s international culture being impacted by the Hayek family?
2. Many of the Swatch brands have become cultural icons among a strong core following of customers in the global marketplace. Some even talk about the “Swatch Revolution” that began when Nicolas Hayek founded the company. Why do you think Swatch has such a strong cultural following?
3. Swatch wants you to create your own unique way of accessorizing by the use of a Swatch watch. A person can showcase his or her individualized Swatch use by tagging #MySwatch. Is a watch a way to show who a person is culturally? Does a watch get embedded into a person’s culture? Can a watch create a cultural image?
4. According to the company, “ Swatch is an attitude, an approach to life, a way of seeing. The sight of a Swatch excites emotion. Wearing one is a way to communicate, to speak without speaking. Heart to heart.” Do you buy this overarching “branding” of a Swatch watch as a cultural icon?
Endnotes
1. D. Barry, Exporters! The Wit and Wisdom of Small Businesspeople Who Sell Globally (Washington, DC: International Trade Administration, 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 Research: Assessment and Guidelines,” Journal of International Business Studies, 2008, pp. 1027–44; 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 International Business: Recent Advances and Their Implications for Future Research,” Journal of International Business Studies, 2005, pp. 357–78. Several
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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: Recontextualization, Semantic Fit, and the Semiotics of Foreignness,” Academy of Management Review, 2004, pp. 593–616.
4. See R. Dore, Taking Japan Seriously (Stanford, CA: Stanford University Press, 1987). 5. E. B. Tylor, Primitive Culture (London: Murray, 1871). 6. F. Kluckhohn and F. Strodtbeck, Variations in Value Orientations (Evanston, IL: Row,
Peterson, 1961); 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).
7. M. Rokeach, The Nature of Human Values (New York: Free Press, 1973); S. Schwartz, “Universals in the Content and Structure of Values: Theory and Empirical Tests in 20 Countries,” in M. Zanna (Ed.), Advances in Experimental Social Psychology, vol. 25 (New York: Academic Press, 1992), pp. 1–65.
8. G. Hofstede, Culture’s Consequences: International Differences in Work-Related Values (Thousand Oaks CA: Sage, 1984), p. 21.
9. G. Hofstede, Culture’s Consequences: International Differences in Work-Related Values (Beverly Hills, CA: Sage, 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 (Thousand Oaks, CA: Sage, 2001).
13. E. T. Hall and M. R. Hall, Hidden Differences: Doing Business with the Japanese (New York: Doubleday, 1987).
14. 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; M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990).
15. S. P. Huntington, The Clash of Civilizations (New York: Simon & Schuster, 1996). 16. F. Vijver, D. Hemert, and Y. Poortinga, Multilevel Analysis of Individuals and Cultures
(New York: Taylor & Francis, 2010). 17. M. Thompson, R. Ellis, and A. Wildavsky, Cultural Theory (Boulder, CO: Westview Press,
1990). 18. M. Douglas, In the Active Voice (London: Routledge, 1982), pp. 183–254. 19. L. Zucker and M. Darby, “Star-Scientist Linkages to Firms in APEC and European
Countries: Indicators of Regional Institutional Differences Affecting Competitive Advantage,” International Journal of Biotechnology, 1999, pp. 119–31.
20. C. Nakane, Japanese Society (Berkeley: University of California Press, 1970). 21. C. Nakane, Japanese Society (Berkeley: University of California Press, 1970). 22. For details, see M. Aoki, Information, Incentives, and Bargaining in the Japanese Economy
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(Cambridge, UK: Cambridge University Press, 1988); M. L. Dertouzos, R. K. Lester, and R. M. Solow, Made in America (Cambridge, MA: MIT Press, 1989).
23. Global Innovation Barometer 2018 is a product by Ideas Lab and supported by General Electric (GE). The GE Global Innovation Barometer explores how business leaders around the world view innovation and how those perceptions are influencing business strategies in an increasingly complex and globalized environment. It is the largest global survey of business executives dedicated to innovation. GE is now surveying more than 3,000 executives in 25 countries, www.ge.com/reports/innovation-barometer-2018.
24. 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); T. Davenport and L. Prusak, Working Knowledge: How Organizations Manage What They Know (Boston, MA: Harvard Business School Press, 1998).
25. G. Macionis and L. John, Sociology (Toronto, Ontario: Pearson Canada, Inc., 2010), pp. 224–25.
26. E. Luce, The Strange Rise of Modern India (Boston: Little, Brown, 2006); 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.
27. 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); J. Gerteis and M. Savage, “The Salience of Class in Britain and America: A Comparative Analysis,” British Journal of Sociology, June 1998.
28. Adonis and Pollard, A Class Act. 29. J. H. Goldthorpe, “Class Analysis and the Reorientation of Class Theory: The Case of
Persisting Differentials in Education Attainment,” British Journal of Sociology, 2010, pp. 311–35.
30. Y. Bian, “Chinese Social Stratification and Social Mobility,” Annual Review of Sociology 28 (2002), pp. 91–117.
31. N. Goodman, An Introduction to Sociology (New York: HarperCollins, 1991). 32. O. C. Ferrell, J. Fraedrich, and L. Ferrell, Business Ethics: Ethical Decision Making and
Cases (Mason, OH: Cengage Learning, 2012). 33. R. J. Barro and R. McCleary, “Religion and Economic Growth across
Countries,” American Sociological Review, October 2003, pp. 760–82; R. McCleary and R. J. Barro, “Religion and Economy,” Journal of Economic Perspectives, Spring 2006, pp. 49–72.
34. M. Weber, The Protestant Ethic and the Spirit of Capitalism (New York: Scribner’s, 1958, original 1904–1905). For an excellent review of Weber’s work, see A. Giddens, Capitalism and Modern Social Theory (Cambridge, UK: Cambridge University Press, 1971).
35. M. Weber, The Protestant Ethic and the Spirit of Capitalism, 1905, p. 35. 36. A. S. Thomas and S. L. Mueller, “The Case for Comparative Entrepreneurship,” Journal of
International Business Studies 31, no. 2 (2000), pp. 287–302; S. A. Shane, “Why Do Some Societies Invent More than Others?” Journal of Business Venturing 7 (1992), pp. 29–46.
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37. 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; R. H. Dekmejian, Islam in Revolution: Fundamentalism in the Arab World (Syracuse, NY: Syracuse University Press, 1995).
38. T. W. Lippman, Understanding Islam (New York: Meridian Books, 1995). 39. Dekmejian, Islam in Revolution. 40. M. K. Nydell, Understanding Arabs (Yarmouth, ME: Intercultural Press, 1987). 41. Lippman, Understanding Islam. 42. The material in this section is based largely on Abbasi et al., “Islamic Economics.” 43. “Sharia Calling,” The Economist, November 12, 2010; N. Popper, “Islamic Banks, Stuffed
with Cash, Explore Partnerships in West,” The New York Times, December 26, 2013. 44. “Forced Devotion,” The Economist, February 17, 2001, pp. 76–77. 45. For details of Weber’s work and views, see Giddens, Capitalism and Modern Social
Theory. 46. See, for example, the views expressed in “A Survey of India: The Tiger Steps Out,” The
Economist, January 21, 1995. 47. “High-Tech Entrepreneurs Flock to India,” PBS News Hour, February 9, 2014,
www.pbs.org/newshour/bb/high-tech-entrepreneurs-flock-india, accessed March 7, 2014. 48. H. Norberg-Hodge, “Buddhism in the Global Economy,” International Society for Ecology
and Culture, www.localfutures.org/publications/online-articles/buddhism-in-the-global- economy, accessed March 7, 2014.
49. 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.
50. 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.
51. Hofstede, Culture’s Consequences. 52. See Dore, Taking Japan Seriously; C. W. L. Hill, “Transaction Cost Economizing as a
Source of Comparative Advantage: The Case of Japan,” Organization Science 6 (1995). 53. 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. 54. See Aoki, Information, Incentives, and Bargaining; J. P. Womack, D. T. Jones, and D.
Roos, The Machine That Changed the World (New York: Rawson Associates, 1990). 55. 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; B. L. Whorf, Language, Thought, and Reality (Cambridge, MA: MIT Press, 1956).
56. 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.
57. D. A. Ricks, Big Business Blunders: Mistakes in Multinational Marketing (Homewood, IL: Dow Jones–Irwin, 1983).
58. Goodman, An Introduction to Sociology. 59. Porter, The Competitive Advantage of Nations. 60. Porter, The Competitive Advantage of Nations, pp. 395–97.
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61. G. Hofstede, “The Cultural Relativity of Organizational Practices and Theories,” Journal of International Business Studies, Fall 1983, pp. 75–89; G. Hofstede, Cultures and Organizations: Software of the Mind (New York: McGraw-Hill USA, 1997); Hofstede, Culture’s Consequences.
62. Hofstede, “The Cultural Relativity of Organizational Practices and Theories”; Hofstede, Cultures and Organizations.
63. Hofstede, Culture’s Consequences. 64. G. Hofstede and M. Bond, “Hofstede’s Culture Dimensions: An Independent Validation
Using Rokeach’s Value Survey,” Journal of Cross-Cultural Psychology 15 (December 1984), pp. 417–33.
65. The factor scores for the long-term versus short-term orientation, using Bond’s survey, were brought into a 0–100 range by a linear transformation (LTO = 50 × F + 50, in which F is the factor score). However, the data for China came in after Hofstede and Bond had standardized the scale, and they put China outside the range at LTO = 118 (which indicates a very strong long-term orientation).
66. G. Hofstede, G. J. Hofstede, and M. Minkov, Cultures and Organizations: Software of the Mind, 3d ed. (New York: McGraw-Hill, 2010).
67. For a more detailed critique, see Mead, International Management, pp. 73–75. 68. For example, see W. J. Bigoness and G. L. Blakely, “A Cross-National Study of
Managerial Values,” Journal of International Business Studies, December 1996, p. 739; D. H. Ralston, D. H. Holt, R. H. Terpstra, and Y. Kai-Cheng, “The Impact of National Culture and Economic Ideology on Managerial Work Values,” Journal of International Business Studies 28, no. 1 (1997), pp. 177–208; P. B. Smith, M. F. Peterson, and Z. Ming Wang, “The Manager as a Mediator of Alternative Meanings,” Journal of International Business Studies 27, no. 1 (1996), pp. 115–37; L. Tang and P. E. Koves, “A Framework to Update Hofstede’s Cultural Value Indices,” Journal of International Business Studies 39 (2008), pp. 1045–63.
69. R. House, P. Hanges, M. Javidan, P. Dorfman, and V. Gupta, Culture, Leadership, and Organizations: The GLOBE Study of 62 Societies (Thousand Oaks, CA: Sage, 2004); 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: Routledge, 2012).
70. R. Inglehart, Modernization and Postmodernization: Cultural, Economic, and Political Change in 43 Societies (Princeton, NJ: Princeton University Press, 1997). Information and data on the World Values Survey can be found at www.worldvaluessurvey.org.
71. For evidence of this, see R. Inglehart, “Globalization and Postmodern Values,” The Washington Quarterly, Winter 2000, pp. 215–28.
72. Mead, International Management, chap. 17. 73. “Free, Young, and Japanese,” The Economist, December 21, 1991. 74. Namenwirth and Weber, Dynamics of Culture; Inglehart, “Globalization and Postmodern
Values.” 75. G. Hofstede, “National Cultures in Four Dimensions,” International Studies of
Management and Organization 13, no. 1 (1983), pp. 46–74; Tang and Koves, “A Framework to Update Hofstede’s Cultural Value Indices.”
76. See Inglehart, “Globalization and Postmodern Values.” For updates, see www.isr.umich.edu/cps/project_wvs.html.
77. Hofstede, “National Cultures in Four Dimensions.”
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78. 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.
79. See Leung et al., “Culture and International Business.” 80. Hall and Hall, Understanding Cultural Differences. 81. Porter, The Competitive Advantage of Nations. 82. See Aoki, Information, Incentives, and Bargaining; Dertouzos et al., Made in America;
Porter, The Competitive Advantage of Nations, pp. 395–97. 83. See Dore, Taking Japan Seriously; Hill, “Transaction Cost Economizing as a Source of
Comparative Advantage.” 84. For empirical work supporting such a view, see Annett, “Social Fractionalization, Political
Instability, and the Size of Government.”
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education
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Part 2 National Differences
Ethics, Corporate Social Responsibility, and Sustainability
Learning Object ives After reading this chapter, you will be able to:
LO5-1 Understand the ethical, corporate social responsibility, and sustainability issues faced by international businesses.
LO5-2 Recognize an ethical, corporate social responsibility, and/or sustainability dilemma.
LO5-3 Identify the causes of unethical behavior by managers as they relate to business, corporate social responsibility, or sustainability.
LO5-4 Describe the different philosophical approaches to business ethics that apply globally.
LO5-5 Explain how global managers can incorporate ethical considerations into their decision making in general and for corporate social responsibility and sustainability initiatives.
Sustainability Initiatives at Natura, the Bodyshop, and Aesop
opening case
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Corporate Knights, a research firm from Toronto, Canada, puts together the Global 100, a ranking of the world’s most sustainable companies, based on annual data analytics. Using data available publicly, Corporate Knights rates large firms on 17 key measures, evaluating their management of resources, finances, and employees (e.g., energy, carbon footprint, water use, waste productivity, clean air). They consider about 4,000 companies worldwide with market values of at least $2 billion.
For several years, Natura & Co SA from Brazil has been among the world’s leaders, ranking number 14 in the latest ranking. It is also the world’s largest cosmetics company. Natura (naturaeco.com), headquartered in São Paulo, Brazil, was founded in 1969. It has more than 18,000 employees and revenue of about $4.4 billion (R$15 billion Brazilian Real). Natura has three prominent subsidiaries that strive to be as sustainable in their operations as possible. They include Natura Cosmetics, which has become synonymous with Natura & Co SA in general, and its more standalone brands of The Body Shop and Aesop.
Natura Cosmetics develops, produces, distributes, and sells cosmetics, fragrances, and hygiene products. Natura’s products include creams, deodorants, lipsticks, lotions, makeup accessories, perfumes, shampoos, shaving creams, soaps, and sunscreens, among others. Its portfolio is made up of brand names such as Amo, Ekos, Tododia, Aguas, Chronos, Erva Doce, Homem, Horus, Seve, and Luna. Natura employs more than 7,000 people in seven countries: Brazil, Argentina, Chile, Mexico, Peru, Colombia, and France.
Sustainable development has been Natura’s guiding principle since it was founded in 1969. A passion for Customer Relationship Management (CRM) led the company to adopt direct sales as its main commercial strategy. To support its direct sales model, more than 1,421,000 consultants around the world (most in Brazil) promote the company's values and products to consumers. Innovation is at the heart of Natura’s sustainable development policy. For example, last year the company spent about $75 million on product development, launching 164 products and achieving an innovation index of 64.8 percent (percentage of revenue from products launched in the last two years).
The Body Shop International Limited, trading as The Body Shop, is a well-known, formerly British cosmetics, skin care, and perfume company that was founded in 1976 by Anita and Gordon Roddick. It currently has more than 1,000 products, which it sells in some 3,100 owned and franchised stores internationally in 66 countries. The company is still based in East Croydon and Littlehampton, West Sussex, United Kingdom, but was bought from French cosmetics company L'Oréal (which owned The Body Shop from 2006 to 2017) in June 2017 for $1.2 billion (£880 million).
Famously, The Body Shop has been a leader in banning animal testing of cosmetics products worldwide. The Body Shop has been against animal testing since the 1980s but is also tirelessly working to ban animal testing in general in the cosmetics industry. This position also feeds into its sustainability initiatives. Anita Roddick said that “My hope for the future of The Body Shop is primarily vested in those people who will be the custodians of our culture and values.” This custodianship includes the pledge of being the world’s most ethical, sustainable company. For example, in 2016, to mark its 40th anniversary, The Body Shop unveiled a global CSR strategy—Enrich Not Exploit™—that will underpin all aspects of its operations. The pioneering commitment reaffirmed the global cosmetics brand’s positioning as a leader in ethical and sustainable business practices.
Aesop was founded by hairdresser Dennis Paphitis in 1987 in Melbourne, Australia. Suzanne Santos, as Aesop’s first employee, was also instrumental in the foundation and growth of the company. Aesop is viewed as an Australian skin care brand, owned fully by Natura since 2016 (although Natura had part ownership since 2012). The brand has been identified as a unique way of doing marketing in today’s social media world. In a somewhat unorthodox way, this includes not using traditional advertisements or discount sales to promote its products. Instead, Aesop gets its promotional communication mostly by word-of-mouth for the design of its products, stores, and events, which are a singular mix of indulgent product experiences, thoughtful language, and modern minimalist design (compare with the Swedish furniture giant that often receives similar reviews of minimalist but superb design in the furniture business).
With its core subsidiaries (Natura Cosmetics, The Body Shop, and Aesop), Natura & Co SA has redefined success in business on a global scale. In 2014, it became the first publicly traded company to become a “Certified B Corporation.” A Certified B Corporation is a company that focuses on two
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specific sustainability issues. First, it has reached a threshold standard for its impact on society and the environment. Second, the company must have committed to consider the impact of its business decisions on its wider stakeholders, not just its shareholders. Currently, only 2,200 B Corps exist worldwide, and their core sustainability focus is on the interdependence between society, environment, and economy. Importantly, Natura’s actions show that it is possible to make a positive difference for the environment while also ensuring the financial viability of the company by profit making. This mindset also drove Natura’s purchase of The Body Shop in 2017, the first billion-dollar B Corp acquisition by another B Corp. • Sources: “Building for the Future,” The Body Shop Annual Report 2014/2015; Deanna Utroske, “The Body Shop Launches New Campaign for UN Animal Testing Ban,” Cosmetics Design, March 22, 2018; Andres Schipani, “Body Shop Owner Natura Targets Global Growth,” Financial Times, February 4, 2018; Corporate Knights, “2018 Global 100 Results,” www.corporateknights.com/reports/2018-global-100; “The Body Shop Marks 40th Year with Pledge to Be World's Most Ethical, Sustainable Global Company,” Sustainable Brands, February 12, 2016; Charmain Love, Katie Hill, and Marcel Fukayama, “Building Bridges: Natura, Aesop and The Body Shop Join Their Businesses as Forces for Good,” B the Change, September 13, 2017.
Introduction Ethics, corporate social responsibility, and sustainability are intertwined issues facing companies, industries, countries, and regional societies worldwide. These “social” issues arise frequently in international business, often because business practices and regulations differ from nation to nation. With regard to lead pollution, for example, what is allowed in Mexico is outlawed in the United States. The tricky part is also that what is ethical, socially responsible, or sustainable often is not a legal obligation that companies and countries face.
Instead, “doing good” is often a self-correcting measure that companies or industries place on themselves and countries adopt as a business model (it may be a legal issue within one country but seldom carries universally to all other countries in the world). Ultimately, differences in “sustainable” practices can create dilemmas for businesses. Understanding the nature of these dilemmas and deciding the course of action to pursue when confronted with them is a central theme in this chapter. We blend a lot of business ethics with corporate social responsibility and sustainability issues to capture a global understanding of the issues around the world.
globalEDGE™ has a series of interactive “online course modules”—free educational learning opportunities for businesspeople, policy officials, and students. These modules focus on issues that are important to international business. Each module includes a wealth of content, a case study or anecdotes, glossary of terms, questions to consider, and a list of references. See more at globaledge.msu.edu/reference-desk/online-course-modules. The combination of the Hill and Hult textbook and the globalEDGE™ online course modules serves as an excellent resource that you can use to prepare for NASBITE’s Certified Global Business Professional Credential. Achieving the industry-leading CGBP credential ensures that employees are able to practice global business at the professional level—including ethics, corporate social responsibility, and sustainability— required in today’s competitive global environment. View the questions in the module as a test of your readiness to achieve the CGBP credential.
This are not easy issues to capture, understand, or even buy into at all times. For example, we know that some toy manufacturers have been violating safety regulations for decades, and many companies will likewise continue to do so in the future across all product and industry
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categories. For the toy industry specifically, time will tell, assuming we can track the ingredients in the materials being used to make toys. What we do know is that about a third of the toys that are exported out of China are currently tainted with heavy metals above the norm. Unfortunately, it is not illegal to use lead, for example, in plastics at this time. It is an ethical issue and perhaps also a sustainability issue—and usually a voluntary one—that some companies tackle and others choose to sidestep. The obvious reason some companies take shortcuts is simple math or capitalism—the large size of market opportunities in the toy industry. A basic question then is: Can it be considered unethical to manufacture toys that include heavy metals that are bad for children to ingest and come in contact with when using the toys in their proper way? What about corporate social responsibility among a country’s companies or the companies’ sustainable business practices?
As the opening case illustrates, some companies tackle these issues head-on within their global strategy of doing business. Specifically, with its core subsidiaries (Natura Cosmetics, The Body Shop, and Aesop), Natura & Co SA has redefined success in business on a global scale, with the idea that sustainability should be integrated throughout everything the company does. Being a “Certified B Corporation,” the first publicly traded company to become certified, Natura has to have (1) reached a threshold standard for its impact on society and the environment and (2) committed to consider the impact of its business decisions on its wider stakeholders, not just its shareholders. As we stated, it is important to note that Natura’s “positive business” actions show that it is possible to make a difference for the environment while also ensuring that the company is profitable. This mindset drove Natura’s purchase of The Body Shop in 2017, the first billion-dollar B Corp acquisition by another B Corp, with The Body Shop being a longstanding advocate of no animal testing in product development.
The core starting point for this chapter is ethics. Ethics serves as the foundation for what people do or do not do, and ultimately ethical behavior of employees results in corporate social responsibility and sustainability practices engaged in by the company. Companies’ involvement in corporate social responsibility practices and sustainability initiatives can be traced to the ethical foundation of its employees and other stakeholders, such as customers, shareholders, suppliers, regulators, and communities.1 Ethics refers to accepted principles of right or wrong that govern the conduct of a person, the members of a profession, or the actions of an organization. Business ethics are the accepted principles of right and wrong governing the conduct of businesspeople, and an ethical strategy is a strategy, or course of action, that does not violate these accepted principles.
Broadly, as a start, we look at how ethical issues should be incorporated into decision making in an international business. We also review the reasons for poor ethical decision making and discuss different philosophical approaches to business ethics. Then, using the ethical decision- making process as our platform, we present a series of illustrations via two Management Focus boxes related to VW and Stora Enso. The chapter closes by reviewing the different processes that managers can adopt to make sure that ethical considerations are incorporated into decision making in international business and how these decisions filter into corporate social responsibility and sustainability efforts.
Ethics and International Business LO 5-1 Understand the ethical, corporate social responsibility, and sustainability issues
faced by international businesses.
Many of the ethical issues in international business are rooted in differences in political systems, laws, economic development, and culture across countries. What is considered normal practice
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in one nation may be considered unethical in another. Also, what is illegal in one country may even be normal ethical business practice in another.
These unique complexities make it incredibly difficult to come up with global standards in ethics, corporate social responsibility, and sustainability. Managers in a multinational corporation need to be particularly sensitive to these differences when they do business throughout the world. Many businesspeople try to advocate or even enforce their home country view on companies in other countries without much thinking about the implications for the relationship. In the international business setting, the most common ethical issues involve employment practices, human rights, environmental regulations, corruption, and the moral obligation of multinational corporations.
EMPLOYMENT PRACTICES
When work conditions in another country (host nation) are inferior to those in a multinational corporation’s home nation, which standards should be applied? 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 different can they be before we find it to be unacceptable? For example, while 12-hour workdays, extremely low pay, and a failure to protect workers against toxic chemicals may be common in some less developed and so-called emerging nations, does this mean that it is okay for a multinational company to tolerate such working conditions in its subsidiaries or to condone it by using local subcontractors in those countries? Without taking into account the potential financial implications, it would be easy to simply say that every company should be as ethical, socially responsible, and sustainable as its home- country environment dictates. But it’s not really that simple.
Some time ago, Nike found itself in the center of a storm of protests when news reports revealed that working conditions at many of its subcontractors were poor. A 48 Hours report on CBS painted a picture of young women who worked with toxic materials six days a week in poor conditions for only 20 cents an hour at a Vietnamese subcontractor. 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 questions were raised about the ethics of using “sweatshop labor” to make what were essentially fashion accessories. It may have been legal, but was it ethical to use subcontractors who, by developed-nation standards, clearly exploited their workforce? Nike’s critics thought not, and the company found itself the focus of a wave of demonstrations and consumer boycotts. These exposés surrounding Nike’s use of subcontractors forced the company to reexamine its policies. Realizing that even though it was breaking no law, its subcontracting policies were perceived as unethical, Nike’s management established a code of conduct for its subcontractors and instituted annual monitoring by independent auditors of all subcontractors.2
As the Nike case demonstrates, a strong argument can be made that it is not appropriate for a multinational firm to tolerate poor working conditions in its foreign operations or those of subcontractors. However, this still leaves unanswered the question of which standards should be applied. We shall return to and consider this issue in more detail later in the chapter. For now, note that establishing minimal acceptable standards that safeguard the basic rights and dignity of employees, auditing foreign subsidiaries and subcontractors on a regular basis to make sure those standards are met, and taking corrective action if they are not up to standards are a good way to guard against ethical abuses. For another example of problems with working practices among suppliers, read the accompanying Management Focus, which looks at Volkswagen and the company’s staggering public debacle regarding software used by VW to unethically lower the output data for air polluting emissions.
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m a n a g e m e n t F O C U S
“Emissionsgate” at Volkswagen
Volkswagen, often abbreviated as VW, is a German automaker that was founded by the German Labor Front. The company is headquartered in Wolfsburg. It is the flagship marquee of the Volkswagen Group and, for the first time ever, became the top automaker in the world in 2017 and has maintained that number one position. Volkswagen said it delivered 10.8 million vehicles worldwide, while the nearest competitors Renault Nissan Mitsubishi (10.3 million) and Toyota (10.3 million) had very similar global sales, some 500,000 units below VW (with General Motors following just behind due to strong sales in China).
To go along with its car numbers, VW had sales of about $129 billion (€106 billion) and an employee workforce of some 630,000 people. These staggering numbers and the new ranking as the top automobile manufacturer in the world came at the same time VW was facing perhaps its biggest challenge in its 80-year history (the company was founded in 1937).
Sometimes referred to as “emissionsgate” or “dieselgate,” the Volkswagen emissions scandal began in September 2015 when the U.S. Environmental Protection Agency (EPA) issued a notice of violation of the Clean Air Act to the German automaker. EPA is an agency of the U.S. federal government that was created to protect human health and the environment by writing and enforcing regulations based on laws passed by the U.S. Congress. The EPA has been around since 1970, although the Trump administration has proposed a series of more than 40 cuts to the EPA (slashing the EPA workforce by more than 3,000 people and $2 billion in funding).
In a rather astonishing finding, the EPA determined that Volkswagen had intentionally programmed engines to activate emissions controls only during lab testing. The unethical programming by VW caused the vehicles’ nitrogen oxide output—which is the most relevant factor for air pollution standards —to register at lower levels to meet strict U.S. standards during the crucial laboratory regulatory testing. In reality, the vehicles emitted up to 40 times more NOx on the streets. Volkswagen used this unethical and very sophisticated computer programming in about 11 million cars worldwide, out of which 500,000 vehicles were in use in the United States (for model years 2009–2015).
VW went to great lengths to make this work. The software in the cars sensed when the car was being tested in a regulatory lab, and then the software automatically activated equipment in the vehicle that reduced emissions. Think about that in terms of the decision making that had to go into making this unethical choice! Additionally, the software turned the car’s equipment down during regular driving on the streets or highways, resulting in increasing emissions way above legal limits. The only reasoning for doing this is to save fuel or to improve the car’s torque and acceleration. Thus, not only were the emissions off, and unethically adjusted, the car’s performance statistics were also affected in a positive way—which, obviously, can be seen as another unethical decision or by-product of the emissions software.
The software was modified to adjust components such as catalytic converters or valves that were used to recycle a portion of the exhaust gases. These are the components that are meant to reduce emissions of nitrogen oxide, an air pollutant that can cause emphysema, bronchitis, and several other respiratory diseases. The severity of this air pollution resulted in a $4.3 billion settlement with U.S. regulators. VW also agreed to sweeping reforms, new audits, and oversight by an independent monitor for three years. Internally, VW disciplined dozens of engineers, which is interesting because it at least implies that the top-level managers were not aware of the software installation and unethical use.
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The 2011 Volkswagen Jetta on display January 27, 2011 at the 2011 Washington Auto Show at the Washington Convention Center in Washington, DC.
©KAREN BLEIER/AFP/Getty Images
Sources: Nathan Bomey, “Volkswagen Passes Toyota as World’s Largest Automaker Despite Scandal,” USA Today, January 30, 2017; Bertel Schmitt, “It’s Official: Volkswagen Is World‘s Largest Automaker in 2016. Or Maybe Toyota,” Forbes, January 30, 2017; Rob Davis, “Here Are 42 of President Donald Trump’s Planned EPA Budget Cuts,” The Oregonian, March 2, 2017; “VW Expects to Sanction More Employees in Emissions Scandal: Chairman,” CNBC, March 7, 2017.
HUMAN RIGHTS
Basic human rights still are not respected in a large number of nations, and several historical and current examples exist to illustrate this point. Rights taken for granted in developed nations, such as freedom of association, freedom of speech, freedom of assembly, freedom of movement, and freedom from political repression, for example, are not universally accepted worldwide (see Chapter 2 for details). One of the most obvious historical examples was South Africa during the days of white rule and apartheid, which did not end until 1994. This may seem like a long time ago, but the effects of the old system still linger to this day. Also, in many countries today we see an increase in authoritarian populists who are attacking human rights principles and fueling distrust of democratic institutions.
South Africa represents an example that most people can relate to, most likely remember, and is relatively easy to understand (compared with authoritarian populists politicians infringing on human rights, which is often more difficult to understand and see in practice). 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, businesses from developed nations operated in South Africa for decades before changes started happening. In the decade prior to apartheid’s abolishment, however, many questioned the ethics of doing so. They argued that inward investment by foreign multinationals supported the repressive apartheid regime, at least indirectly, by boosting the South African economy. Thankfully, several businesses started to change their policies in the 1990s and 2000s.3 Gearing up for the 2020s and beyond, the assumption is that most businesses will follow the idea of, for example, the United Nation’s Sustainable Development Goals 2030 (established in September 2015). In doing so, more and more companies are now using ethical behavior as a core philosophy when competing for work.
General Motors, which had significant activities in South Africa, was at the forefront of this trend. GM adopted what came to be called the Sullivan principles, named after Leon Sullivan,
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an African American Baptist minister and a member of GM’s board of directors. Sullivan argued that it was ethically justified for GM to operate in South Africa so long as two conditions were fulfilled. First, the company should not obey the apartheid laws in its own South African operations (a form of passive resistance). Second, the company should do everything within its power to promote the abolition of apartheid laws. As a practical matter, Sullivan’s principles ultimately became widely adopted by U.S. firms operating in South Africa. The beginning of the end of apartheid, we think, was when these foreign companies, like GM, violated the South African apartheid laws and the government of South Africa did not take any action against the companies. Clearly, South Africa did not want to antagonize important foreign investors, which then led to more and more foreign companies operating in the country choosing to disobey the apartheid laws.
After 10 years, Leon Sullivan concluded that simply following the two principles was not sufficient to break down the apartheid regime and that American companies, even those adhering to his principles, could not ethically justify their continued presence in South Africa. Over the next few years, numerous companies divested their South African operations, including Exxon, General Motors, IBM, and Xerox. At the same time, many state pension funds signaled they would no longer hold stock in companies that did business in South Africa, which helped persuade several companies to divest their South African operations. 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. This is when Nelson Mandela was elected president of South Africa, after having served 27 years in prison for conspiracy and sabotage to overthrow the white government of South Africa (Mandela won the Nobel Peace Prize in 1993 and passed away in 2013). Ultimately, adopting an ethical stance by these large multinational corporations was argued to have helped improve human rights in South Africa.4
Although change has come in South Africa, many repressive regimes still exist in the world. In fact, according to the Freedom House, only about 45 percent of the world's population of 7.6 billion people are living in free democratic countries (30 percent are partly free and 25 percent are not free). People in countries that are not considered free by the Freedom House typically face severe consequences if they try to exercise their most basic rights, such as expressing their views, assembling peacefully, and organizing independently of the countries in which they live.
This lack of universal freedom in many countries begs the question: Is it ethical for multinational corporations to do business in these repressive countries? As an answer, it is often argued that inward investment by a multinational can be a force for economic, political, and social progress that ultimately improves the rights of people in repressive regimes. This position was first discussed in Chapter 2, when we noted that economic progress in a nation could create pressure for democratization. In general, this belief suggests that it is ethical for a multinational to do business in nations that lack the democratic structures and human rights records of developed nations. Investment in China, for example, is frequently justified on the grounds that although China’s human rights record is often questioned by human rights groups and although the country is not a democracy, continuing inward investment will help boost economic growth and raise living standards. These developments will ultimately create pressures from the Chinese people for more participatory government, political pluralism, and freedom of expression and speech.
There is a limit to this argument. As in the case of South Africa, some regimes are so repressive that investment cannot be justified on ethical grounds. Another example would be Myanmar (formerly known as Burma). Ruled by a military dictatorship since 1962, Myanmar has one of the worst human rights records in the world. Beginning in the mid-1990s, many companies exited Myanmar, judging the human rights violations to be so extreme that doing
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business there could not be justified on ethical grounds. However, a cynic might note that Myanmar has a small economy and that divestment carries no great economic penalty for firms, unlike, for example, divestment from China. Interestingly, after decades of pressure from the international community, the military government of Myanmar finally acquiesced and allowed limited democratic elections to be held, resulting in the country being rated as “partly free” today according to the Freedom House.
ENVIRONMENTAL POLLUTION
Ethical, social responsibility, and sustainability issues can arise when environmental regulations in host nations are inferior to those in the home nation. Ethics drive what people decide to do, and corporate social responsibility and sustainability drive what companies ultimately decide to do. Many developed nations have substantial regulations governing the emission of pollutants, the dumping of toxic chemicals, the use of toxic materials in the workplace, and so on. Those regulations are often lacking in developing nations, and, according to critics, the result can be higher levels of pollution from the operations of multinationals than would be allowed at home.
From a practical and moneymaking standpoint, we can ask: Should a multinational corporation feel free to pollute in a developing nation? The answer seems simplistic: to do so hardly seems ethical. Is there a danger that amoral management might move production to a developing nation precisely because costly pollution controls are not required and the company is, therefore, free to despoil the environment and perhaps endanger local people in its quest to lower production costs and gain a competitive advantage? What is the right and moral thing to do in such circumstances: pollute to gain an economic advantage or make sure that foreign subsidiaries adhere to common standards regarding pollution controls?
People wearing breathing masks walk at Tian’anmen Square in China’s capital city, Beijing.
©Kevin Frayer/Getty Images
These questions take on added importance because some parts of the environment are a public good that no one owns but anyone can despoil. Even so, many companies answer illogically and say that some degree of pollution is acceptable. If the issue becomes degree of pollution instead of preventing as much pollution as possible, then the strategic decision has been turned around—everyone will start arguing about the degree that is acceptable instead of what to do to prevent pollution in the first place. The problematic part of this argument and equation for measuring pollution is that no one owns the atmosphere or the oceans, but polluting both, no matter where the pollution originates, harms all.5 In such cases, a phenomenon known as the tragedy of the commons becomes applicable. The tragedy of the commons occurs when a resource held in common by all but owned by no one is overused by individuals, resulting in its degradation. The phenomenon was first named by Garrett Hardin when describing a particular
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problem in sixteenth-century England. Large open areas, called commons, were free for all to use as pasture. The poor put out livestock on these commons and supplemented their meager incomes. It was advantageous for each to put out more and more livestock, but the social consequence was far more livestock than the commons could handle. The result was overgrazing, degradation of the commons, and the loss of this much-needed supplement.6
Corporations can contribute to the global tragedy of the commons by moving production to locations where they are free to pump pollutants into the atmosphere or dump them in oceans or rivers, thereby harming these valuable global commons. While such action may be legal, is it ethical? Again, such actions seem to violate basic societal notions of ethics and corporate social responsibility. This issue is taking on greater importance as concerns about human-induced global warming move to center stage. Most climate scientists argue that human industrial and commercial activity is increasing the amount of carbon dioxide in the atmosphere; carbon dioxide is a greenhouse gas, which reflects heat back to the earth’s surface, warming the globe; and as a result, the average temperature of the earth is increasing. The accumulated scientific evidence from numerous databases supports this argument.7 Consequently, societies around the world are starting to restrict the amount of carbon dioxide that can be emitted into the atmosphere as a by-product of industrial and commercial activity. However, regulations differ from nation to nation. Given this, is it ethical for a company to try to escape tight emission limits by moving production to a country with lax regulations, when doing so will contribute to global warming? Again, many would argue that doing so violates basic ethical principles.
CORRUPTION
As noted in Chapter 2, corruption has been a problem in almost every society in history, and it continues to be one today.8 There always have been and always will be corrupt government officials. International businesses can gain and have gained economic advantages by making payments to those officials. A classic example concerns a well-publicized incident involving Carl Kotchian, then president of Lockheed. He made a $12.6 million payment to Japanese agents and government officials to secure a large order for Lockheed’s TriStar jet from Nippon Air. When the payments were discovered, U.S. officials charged Lockheed with falsification of its records and tax violations. Although such payments were supposed to be an accepted business practice in Japan (they might be viewed as an exceptionally lavish form of gift giving), the revelations created a scandal there too. The government ministers in question were criminally charged, one committed suicide, the government fell in disgrace, and the Japanese people were outraged. Apparently, such a payment was not an accepted way of doing business in Japan! The payment was nothing more than a bribe, paid to corrupt officials, to secure a large order that might otherwise have gone to another manufacturer, such as Boeing. Kotchian clearly engaged in unethical behavior—and to argue that the payment was an “acceptable form of doing business in Japan” was self-serving and incorrect.
The Lockheed case was the impetus for the Foreign Corrupt Practices Act (FCPA) in the United States, discussed in Chapter 2. The act outlawed paying of bribes to foreign government officials to gain business, and this was the case even if other countries’ companies could do it. Some U.S. businesses immediately objected that the act would put U.S. firms at a competitive disadvantage (there is no evidence that has occurred).9 The act was subsequently amended to allow for “facilitating payments.” Sometimes known as speed money or grease payments, facilitating payments are not payments to secure contracts that would not otherwise be secured, nor are they payments to obtain exclusive preferential treatment. Rather they are payments to ensure receiving the standard treatment that a business ought to receive from a foreign government but might not due to the obstruction of a foreign official.
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The trade and finance ministers from the member states of the Organization for Economic Co-operation and Development (OECD) later on followed the U.S. lead and adopted the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions.10 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.
While facilitating payments, or speed money, are excluded from both the Foreign Corrupt Practices Act and the OECD convention on bribery, the ethical implications of making such payments are unclear. From a practical standpoint, giving bribes might be the price that must be paid to do a greater good (assuming the investment creates jobs and assuming the practice is not illegal). Several economists advocate this reasoning, suggesting that in the context of pervasive and cumbersome regulations in developing countries, corruption may improve efficiency and help growth! 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.11 Arguments such as this persuaded the U.S. Congress to exempt facilitating payments from the FCPA.
In contrast, other economists have argued that corruption reduces the returns on business investment and leads to low economic growth.12 In a country where corruption is common, unproductive bureaucrats who demand side payments for granting the enterprise permission to operate may siphon off the profits from a business activity. 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.13 Another study found that firms that paid more in bribes are likely to spend more, not less, management time with bureaucrats negotiating regulations and that this tended to raise the costs of the firm.14
Should the United States Have Jurisdiction over Foreign Firms?
The U.S. Foreign Corrupt Practices Act (FCPA) is not just imposed on U.S. companies that operate globally. It also has jurisdiction over foreign companies operating in the U.S. and what they do internationally. Settling a FCPA investigation, Siemens—Europe’s largest engineering company and the largest electronics company in the world—was fined $800 million by the U.S. Department of Justice and the U.S. Securities and Exchange Commission. Together with various penalties imposed in Germany, Siemens’ home country, the penalties total $1.6 billion. The settlement involved at least 4,200 allegedly corrupt payments totaling some $1.4 billion over six years to foreign officials in numerous countries. Meetings, negotiations, and bank account transfers were taking place in the United States between Siemens and officials from other countries. Is it appropriate that the U.S. government can use the FCPA to investigate and fine foreign companies doing business in other countries?
Sources: U.S. Department of Justice, www.justice.gov; “Siemens: A Giant Awakens,” The Economist, September 10, 2010; J. Ewing, “Siemens Settlement: Relief, But Is It Over?” BusinessWeek, December 15, 2008.
Consequently, many multinationals have adopted a zero-tolerance policy. For example, the large oil multinational BP has a zero-tolerance approach toward facilitating payments. Other corporations have a more nuanced approach. Dow Corning used to formally state a few years ago in its Code of Conduct that “in countries where local business practice dictates such [facilitating] payments and there is no alternative, facilitating payments are to be for the
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minimum amount necessary and must be accurately documented and recorded.”15 This statement recognized that business practices and customs differ from country to country. At the same time, Dow Corning allowed for facilitating payments when “there is no alternative,” although they were also stated to be strongly discouraged. More recently, the latest version of Dow Corning’s Code of Conduct has removed the section on “international business guidelines” altogether, so our assumption has to be that the company is taking a stronger zero-tolerance approach.
At the same time, as with many companies, Dow Corning may have realized that the nuances between a bribe and a facilitating payment are unclear. Many U.S. companies have sustained FCPA violations due to facilitating payments that were made but did not fall within the general rules allowing such payments. For example, global freight forwarder Con-way paid a $300,000 penalty for making hundreds of what could be considered small payments to various customs officials in the Philippines. In total, Con-way distributed some $244,000 to these officials who were induced to violate customs regulations, settle disputes, and not enforce fines for administrative violations.16
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Ethical Dilemmas LO 5-2 Recognize an ethical, corporate social responsibility, and/or sustainability dilemma.
The ethical obligations of a multinational corporation toward employment conditions, human rights, corruption, and environmental pollution are not always clear-cut. However, what is becoming clear-cut is that managers and their companies are feeling more of the marketplace pressures from customers and other stakeholders to be transparent in their ethical decision making. At the same time, there is no universal worldwide agreement about what constitutes accepted ethical principles. From an international business perspective, some argue that what is ethical depends on one’s cultural perspective.17 In the United States, it is considered acceptable to execute murderers, but in many cultures, this type of punishment is not acceptable—execution is viewed as an affront to human dignity, and the death penalty is outlawed. Many Americans find this attitude strange, but, for example, many Europeans find the American approach barbaric. For a more business-oriented example, consider the practice of “gift giving” between the parties to a business negotiation. While this is considered right and proper behavior in many Asian cultures, some Westerners view the practice as a form of bribery and therefore unethical, particularly if the gifts are substantial.
International managers often confront very real ethical dilemmas where the appropriate course of action is not clear. For example, imagine that a visiting American executive finds that a foreign subsidiary in a poor nation has hired a 12-year-old girl to work on a factory floor. Appalled to find that the subsidiary is using child labor in direct violation of the company’s own ethical code, the American instructs the local manager to replace the child with an adult. The local manager dutifully complies. The girl, an orphan, who is the only breadwinner for herself and her six-year-old brother, is unable to find another job, so in desperation she turns to prostitution. Two years later, she dies of AIDS. Had the visiting American understood the gravity of the girl’s situation, would he still have requested her replacement? Would it have been
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better to stick with the status quo and allow the girl to continue working? Probably not, because that would have violated the reasonable prohibition against child labor found in the company’s own ethical code. What then would have been the right thing to do? What was the obligation of the executive given this ethical dilemma?
A young girl making cigarettes in Bagan, Myanmar.
©Angela N Perryman/Shutterstock
There are no easy answers to these questions. That is the nature of ethical dilemmas— situations in which none of the available alternatives seems ethically acceptable.18 In this case, employing child labor was not acceptable, but given that she was employed, neither was denying the child her only source of income. What this American executive needs, what all managers need, is a moral compass, or perhaps an ethical algorithm, to guide them through such an ethical dilemma to find an acceptable solution. Later, we will outline what such a moral compass, or ethical algorithm, might look like. For now, it is enough to note that ethical dilemmas exist because many real-world decisions are complex; difficult to frame; and involve first-, second-, and third-order consequences that are hard to quantify. Doing the right thing, or even knowing what the right thing might be, is often far from easy.19
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Roots of Unethical Behavior LO 5-3 Identify the causes of unethical behavior by managers as they relate to
business, corporate social responsibility, or sustainability.
Examples are plentiful of international managers behaving in a manner that might be judged unethical in an international business setting. Why do managers behave in an unethical manner? There is no simple answer to this question because the causes are complex, but some generalizations can be made and these issues are rooted in six determinants of ethical behavior: personal ethics, decision-making processes, organizational culture, unrealistic performance goals, leadership, and societal culture (see Figure 5.1).20
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5.1 FIGURE Determinants of ethical behavior.
PERSONAL ETHICS
Societal business ethics are not divorced from personal ethics, which are the generally accepted principles of right and wrong governing the conduct of individuals. Personal ethics have an effect on business ethics, which ultimately, as we will see in the Focus on Managerial Implications section of this chapter, have an effect on a company’s socially responsibility practices and sustainability activities. As individuals, we are typically taught that it is wrong to lie and cheat—it is unethical—and that it is right to behave with integrity and honor and to stand up for what we believe to be right and true. This is generally true across societies. The personal ethical code that guides our behavior comes from a number of sources, including our parents, our schools, our religion, and the media. Our personal ethical code exerts a profound influence on the way we behave as businesspeople. An individual with a strong sense of personal ethics is less likely to behave in an unethical manner in a business setting. It follows that the first step to establishing a strong sense of business ethics is for a society to emphasize strong personal ethics.
Home-country managers working abroad in multinational firms (expatriate managers) may experience more than the usual degree of pressure to violate their personal ethics. They are away from their ordinary social context and supporting culture, and they are psychologically and geographically distant from the parent company. They may be based in a culture that does not place the same value on ethical norms important in the manager’s home country, and they may be surrounded by local employees who have less rigorous ethical standards. The parent company may pressure expatriate managers to meet unrealistic goals that can only be fulfilled by cutting corners or acting unethically. For example, to meet centrally mandated performance goals, expatriate managers might give bribes to win contracts or might implement working conditions and environmental controls that are below minimal acceptable standards. Local managers might encourage the expatriate to adopt such behavior. Due to its geographic distance, the parent company may be unable to see how expatriate managers are meeting goals or may choose not to see how they are doing so, allowing such behavior to flourish and persist.
DECISION-MAKING PROCESSES
Several studies of unethical behavior in a business setting have concluded that businesspeople
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sometimes do not realize they are behaving unethically, primarily because they simply fail to ask, “Is this decision or action ethical?”21 Instead, they apply a straightforward business calculus to what they perceive to be a business decision, forgetting that the decision may also have an important ethical dimension. 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. Those decisions were probably made based on good economic logic. Subcontractors were probably chosen based on business variables such as cost, delivery, and product quality, but the key managers simply failed to ask, “How does this subcontractor treat its workforce?” If they thought about the question at all, they probably reasoned that it was the subcontractor’s concern, not theirs.
To improve ethical decision making in a multinational firm, the best starting point is to better understand how individuals make decisions that can be considered ethical or unethical in an organizational environment.22 Two assumptions must be taken into account. First, too often it is assumed that individuals in the workplace make ethical decisions in the same way as they would if they were home. Second, too often it is assumed that people from different cultures make ethical decisions following a similar process (see Chapter 4 for more on cultural differences). Both of these assumptions are problematic. First, within an organization, there are very few individuals who have the freedom (e.g., power) to decide ethical issues independent of pressures that may exist in an organizational setting (e.g., should we make a facilitating payment or resort to bribery?). Second, while the process for making an ethical decision may largely be the same in many countries, the relative emphasis on certain issues is unlikely to be the same. Some cultures may stress organizational factors (Japan), while others stress individual personal factors (United States), yet some may base a decision purely on opportunity (Myanmar) and others base it on the importance to their superiors (India).
ORGANIZATIONAL CULTURE
The culture in some businesses does not encourage people to think through the ethical consequences of business decisions. This brings us to the third cause of unethical behavior in businesses: an organizational culture that deemphasizes business ethics, reducing all decisions to the purely economic. The term organizational culture refers to the values and norms that are shared among employees of an organization. You will recall from Chapter 4 that values are abstract ideas about what a group believes to be good, right, and desirable, while norms are the social rules and guidelines that prescribe appropriate behavior in particular situations. Just as societies have cultures, so do business organizations, as we discussed in Chapter 4. Together, values and norms shape the culture of a business organization, and that culture has an important influence on the ethics of business decision making.
For example, paying bribes to secure business contracts was long viewed as an acceptable way of doing business within certain companies. It was, in the words of an investigator of a case against Daimler, “standard business practice” that permeated much of the organization, including departments such as auditing and finance that were supposed to detect and halt such behavior. It can be argued that such a widespread practice could have persisted only if the values and norms of the organization implicitly approved of paying bribes to secure business.
UNREALISTIC PERFORMANCE GOALS
A fourth cause of unethical behavior has already been hinted at: pressure from the parent company to meet unrealistic performance goals that can be attained only by cutting corners or acting in an unethical manner. In these cases, bribery may be viewed as a way to hit challenging
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performance goals. The combination of an organizational culture that legitimizes unethical behavior, or at least turns a blind eye to such behavior, and unrealistic performance goals may be particularly toxic. In such circumstances, there is a greater than average probability that managers will violate their own personal ethics and engage in unethical behavior. Conversely, an organization’s culture can do just the opposite and reinforce the need for ethical behavior. At Hewlett-Packard, for example, Bill Hewlett and David Packard, the company’s founders, propagated a set of values known as 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 establish the culture of an organization, and they set the example, rules, and guidelines that others follow as well as the structure and processes for operating both strategically and in daily operations. Employees often operate and work within a defined structure with a mindset very much similar to the overall culture of the organization that employs them.
Additionally, employees in a business often take their cue from business leaders, and if those leaders do not behave in an ethical manner, the employees might not either. It is not just what leaders say that matters but what they do or do not do. What message, then, did the leaders at Daimler send about corrupt practices? Presumably, they did very little to discourage them and may have encouraged such behavior.
SOCIETAL CULTURE
Societal culture may well have an impact on the propensity of people and organizations to behave in an unethical manner. One study of 2,700 firms in 24 countries found that there were significant differences among the ethical policies of firms headquartered in different countries.23 Using Hofstede’s dimensions of social culture (see Chapter 4), the study found that enterprises headquartered in cultures where individualism and uncertainty avoidance are strong were more likely to emphasize the importance of behaving ethically than firms headquartered in cultures where masculinity and power distance are important cultural attributes. Such analysis suggests that enterprises headquartered in a country such as Russia, which scores high on masculinity and power distance measures, and where corruption is endemic, are more likely to engage in unethical behavior than enterprises headquartered in Scandinavia.
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Philosophical Approaches to Ethics LO 5-4 Describe the different philosophical approaches to business ethics that apply
globally.
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In this section, we look at several different philosophical approaches to business ethics in the global marketplace. Basically, all individuals adopt a process for making ethical (or unethical) decisions. 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, we hope you agree, dismissed the straw men, we move on to consider approaches that are favored by most moral philosophers and form the basis for current models of ethical behavior in international businesses.
STRAW MEN
Straw men approaches to business ethics are raised by business ethics scholars primarily to demonstrate that they offer inappropriate guidelines for ethical decision making in a multinational enterprise. Four such approaches to business ethics are commonly discussed in the literature. These approaches can be characterized as the Friedman doctrine, cultural relativism, the righteous moralist, and the naive immoralist. All these approaches have some inherent value, but all are unsatisfactory in important ways. Nevertheless, sometimes companies adopt these approaches.
The Friedman Doctrine The Nobel Prize–winning economist Milton Friedman wrote an article in The New York Times in 1970 that has since become a classic straw man example that business ethics scholars outline only to then tear down.24 Friedman’s basic position is that “the social responsibility of business is to increase profits,” so long as the company stays within the rules of law. He explicitly rejects the idea that businesses should undertake social expenditures beyond those mandated by the law and required for the efficient running of a business. For example, his arguments suggest that improving working conditions beyond the level required by the law and necessary to maximize employee productivity will reduce profits and is therefore not appropriate. His belief is that a firm should maximize its profits because that is the way to maximize the returns that accrue to the owners of the firm, its shareholders. If the shareholders then wish to use the proceeds to make social investments, that is their right, according to Friedman, but managers of the firm should not make that decision for them.
Although Friedman is talking about social responsibility and “ethical custom,” rather than business ethics per se, many business ethics scholars equate social responsibility with ethical behavior and thus believe Friedman is also arguing against business ethics. However, the assumption that Friedman is arguing against ethics is not quite true, for Friedman does argue that there is only one social responsibility of business: to increase the profitability of the enterprise so long as it stays within the law, which is taken to mean that it engages in open and free competition without deception or fraud.25
There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say that it engages in open and free competition without deception or fraud.26
In other words, Friedman argues that businesses should behave in a socially responsible manner, according to ethical custom and without deception and fraud.
Critics charge that Friedman’s arguments break down under examination. This is particularly true in international business, where the “rules of the game” are not well established and differ from country to country. Consider again the case of sweatshop labor. Child labor may not be against the law in a developing nation, and maximizing productivity may not require that a
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multinational firm stop using child labor in that country, but it is still immoral to use child labor because the practice conflicts with widely held views about what is the right and proper thing to do. Similarly, there may be no rules against pollution in a less developed nation and spending money on pollution control may reduce the profit rate of the firm, but generalized notions of morality would hold that it is still unethical to dump toxic pollutants into rivers or foul the air with gas releases. In addition to the local consequences of such pollution, which may have serious health effects for the surrounding population, there is also a global consequence as pollutants degrade those two global commons so important to us all: the atmosphere and the oceans.
Cultural Relativism Another straw man often raised by business ethics scholars is cultural relativism, which is the belief that ethics are nothing more than the reflection of a culture—all ethics are culturally determined—and that accordingly, a firm should adopt the ethics of the culture in which it is operating.27 This approach is often summarized by the maxim when in Rome, do as the Romans do. As with Friedman’s approach, cultural relativism does not stand up to a closer look. At its extreme, cultural relativism suggests that if a culture supports slavery, it is okay to use slave labor in a country. Clearly, it is not! Cultural relativism implicitly rejects the idea that universal notions of morality transcend different cultures, but as we argue later in the chapter, some universal notions of morality are found across cultures.
While dismissing cultural relativism in its most sweeping form, some ethicists argue there is residual value in this approach.28 We agree. As we noted in Chapter 3, societal values and norms do vary from culture to culture, and customs do differ, so it might follow that certain business practices are ethical in one country but not another. Indeed, the facilitating payments allowed in the Foreign Corrupt Practices Act can be seen as an acknowledgment that in some countries, the payment of speed money to government officials is necessary to get business done, and, if not ethically desirable, it is at least ethically acceptable.
“When in Rome, Behave Like a Swede,” Really?
You would think that as one of the authors of this book is from Sweden, it seemed convenient to revise the ancient proverb “when in Rome, do as the Romans do” to “when in Rome, behave like a Swede.” But instead, this slightly reworded saying was coined in an article in 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 do” or “when in Rome, behave like a Swede”?
Sources: “The Corruption Eruption,” The Economist, April 29, 2010; Ethical Business Ethics, May 6, 2010, http://ethicalbusinessethics.blogspot.com/2010/05/when-in-rome-should-you-do-as-romans-do.html.
The Righteous Moralist A righteous moralist claims that a multinational’s home-country standards of ethics are the appropriate ones for companies to follow in foreign countries. This approach is typically associated with managers from developed nations. While this seems reasonable at first blush, the approach can create problems. Consider the following example: An American bank manager was sent to Italy and was appalled to learn that the local branch’s accounting department recommended grossly underreporting the bank’s profits for income tax
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purposes.29 The manager insisted that the bank report its earnings accurately, American style. When he was called by the Italian tax department to the firm’s tax hearing, he was told the firm owed three times as much tax as it had paid, reflecting the department’s standard assumption that each firm underreports its earnings by two-thirds. Despite his protests, the new assessment stood. In this case, the righteous moralist has run into a problem caused by the prevailing cultural norms in the country where he was doing business. How should he respond? The righteous moralist would argue for maintaining the position, while a more pragmatic view might be that in this case, the right thing to do is to follow the prevailing cultural norms because there is a big penalty for not doing so.
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 always follow that the appropriate thing to do is adopt home-country standards. For example, U.S. laws set down strict guidelines with regard to minimum wage and working conditions. Does this mean it is ethical to apply the same guidelines in a foreign country, paying people the same as they are paid in the United States, providing the same benefits and working conditions? Probably not, because doing so might nullify the reason for investing in that country and therefore deny locals the benefits of inward investment by the multinational. Clearly, a more nuanced approach is needed.
The Naive Immoralist A naive immoralist asserts that if a manager of a multinational sees that firms from other nations are not following ethical norms in a host nation, that manager should not either. The classic example to illustrate the approach is known as the drug lord problem. In one variant of this problem, an American manager in Colombia routinely pays off the local drug lord to guarantee that her plant will not be bombed and that none of her employees will be kidnapped. The manager argues that such payments are ethically defensible because everyone is doing it.
The objection is twofold. First, to say that an action is ethically justified if everyone is doing it is not sufficient. If firms in a country routinely employ 12-year-olds and make them work 10- hour days, is it therefore ethically defensible to do the same? Obviously not, and the company does have a clear choice. It does not have to abide by local practices, and it can decide not to invest in a country where the practices are particularly odious. Second, the multinational must recognize that it does have the ability to change the prevailing practice in a country. It can use its power for a positive moral purpose. This is what BP is doing by adopting a zero-tolerance policy with regard to facilitating payments. BP is stating that the prevailing practice of making facilitating payments is ethically wrong, and it is incumbent upon the company to use its power to try to change the standard. While some might argue that such an approach smells of moral imperialism and a lack of cultural sensitivity, if it is consistent with widely accepted moral standards in the global community, it may be ethically justified.
UTILITARIAN AND KANTIAN ETHICS
In contrast to the straw men just discussed, most moral philosophers see value in utilitarian and Kantian approaches to business ethics. These approaches were developed in the eighteenth and nineteenth centuries, and although they have been largely superseded by more modern approaches, they form part of the tradition on 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.30 An action is judged desirable if it leads to the best possible balance of good
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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.
Many businesses have adopted specific tools such as cost–benefit analysis and risk assessment that are firmly rooted in a utilitarian philosophy. Managers often weigh the benefits and costs of an action before deciding whether to pursue it. An oil company considering drilling in the Alaskan wildlife preserve must weigh the economic benefits of increased oil production and the creation of jobs against the costs of environmental degradation in a fragile ecosystem. An agricultural biotechnology company such as Monsanto must decide whether the benefits of genetically modified crops that produce natural pesticides outweigh the risks. The benefits include increased crop yields and reduced need for chemical fertilizers. The risks include the possibility that Monsanto’s insect-resistant crops might make matters worse over time if insects evolve a resistance to the natural pesticides engineered into Monsanto’s plants, rendering the plants vulnerable to a new generation of superbugs.
The utilitarian philosophy does have some serious drawbacks as an approach to business ethics. One problem is measuring the benefits, costs, and risks of a course of action. In the case of an oil company considering drilling in Alaska, how does one measure the potential harm done to the region’s ecosystem? The second problem with utilitarianism is that the philosophy omits the consideration of justice. The action that produces the greatest good for the greatest number of people may result in the unjustified treatment of a minority. Such action cannot be ethical, precisely because it is unjust. For example, suppose that in the interests of keeping down health insurance costs, the government decides to screen people for the HIV virus and deny insurance coverage to those who are HIV positive. By reducing health costs, such action might produce significant benefits for a large number of people, but the action is unjust because it discriminates unfairly against a minority.
Kantian ethics is based on the philosophy of Immanuel Kant (1724–1804). Kantian ethics holds that people should be treated as ends and never purely as means to the ends of others. People are not instruments, like a machine. People have dignity and need to be respected as such. Employing people in sweatshops, making them work long hours for low pay in poor working conditions, is a violation of ethics, according to Kantian philosophy, because it treats people as mere cogs in a machine and not as conscious moral beings that have dignity. Although contemporary moral philosophers tend to view Kant’s ethical philosophy as incomplete—for example, his system has no place for moral emotions or sentiments such as sympathy or caring —the notion that people should be respected and treated with dignity resonates in the modern world.
RIGHTS THEORIES
Developed in the twentieth century, rights theories recognize that human beings have fundamental rights and privileges that transcend national boundaries and cultures. Rights establish a minimum level of morally acceptable behavior. One well-known definition of a fundamental right construes it as something that takes precedence over or “trumps” a collective good. Thus, we might say that the right to free speech is a fundamental right that takes precedence over all but the most compelling collective goals and overrides, for example, the interest of the state in civil harmony or moral consensus.31 Moral theorists argue that fundamental human rights form the basis for the moral compass that managers should navigate
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by when making decisions that have an ethical component. More precisely, they should not pursue actions that violate these rights.
The notion that there are fundamental rights that transcend national borders and cultures was the underlying motivation for the United Nations Universal Declaration of Human Rights, adopted in 1948, which has been ratified by almost every country on the planet and lays down basic principles that should always be adhered to irrespective of the culture in which one is doing business.32 Echoing Kantian ethics, Article 1 of this declaration states
All human beings are born free and equal in dignity and rights. They are endowed with reason and conscience and should act towards one another in a spirit of brotherhood.33
Article 23 of this declaration, which relates directly to employment, states:
1. Everyone has the right to work, to free choice of employment, to just and favorable conditions of work, and to protection against unemployment.
2. Everyone, without any discrimination, has the right to equal pay for equal work. 3. Everyone who works has the right to just and favorable remuneration ensuring for himself
and his family an existence worthy of human dignity, and supplemented, if necessary, by other means of social protection.
4. Everyone has the right to form and to join trade unions for the protection of his interests.34
Clearly, the rights to “just and favorable conditions of work,” “equal pay for equal work,” and remuneration that ensures an “existence worthy of human dignity” embodied in Article 23 imply that it is unethical to employ child labor in sweatshop settings and pay less than subsistence wages, even if that happens to be common practice in some countries. These are fundamental human rights that transcend national borders.
It is important to note that along with rights come obligations. Because we have the right to free speech, we are also obligated to make sure that we respect the free speech of others. The notion that people have obligations is stated in Article 29 of the Universal Declaration of Human Rights:
1. Everyone has duties to the community in which alone the free and full development of his personality is possible.35
Within the framework of a theory of rights, certain people or institutions are obligated to provide benefits or services that secure the rights of others. Such obligations also fall on more than one class of moral agent (a moral agent is any person or institution that is capable of moral action such as a government or corporation).
For example, to escape the high costs of toxic waste disposal in the West, several firms shipped their waste in bulk to African nations, where it was disposed of at a much lower cost. At one time, five European ships unloaded toxic waste containing dangerous poisons in Nigeria. Workers wearing sandals and shorts unloaded the barrels for $2.50 a day and placed them in a dirt lot in a residential area. They were not told about the contents of the barrels.36 Who bears the obligation for protecting the rights of workers and residents to safety in a case like this? According to rights theorists, the obligation rests not on the shoulders of one moral agent but on the shoulders of all moral agents whose actions might harm or contribute to the harm of the workers and residents. Thus, it was the obligation not just of the Nigerian government but also of the multinational firms that shipped the toxic waste to make sure it did no harm to residents and workers. In this case, both the government and the multinationals apparently failed to recognize their basic obligation to protect the fundamental human rights of others.
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JUSTICE THEORIES
Justice theories focus on the attainment of a just distribution of economic goods and services. A just distribution is one that is considered fair and equitable. There is no one theory of justice, and several theories of justice conflict with each other in important ways.37 Here, we focus on one particular theory of justice that is both very influential and has important ethical implications. The theory is attributed to philosopher John Rawls.38 Rawls argues that all economic goods and services should be distributed equally except when an unequal distribution would work to everyone’s advantage.
Are Human Rights a Moral Compass?
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 the one on which the Nobel Peace Prize is awarded annually. One human right that we discuss in the text is the right to free speech; by the same token, we have an obligation to respect free speech. But are there issues, situations, or reasons where free speech should not be granted?
Sources: “The Universal Declaration of Human Rights,” United Nations, www.un.org/en/universal-declaration-human- rights/index.html; the official site of the Nobel Prize, www.nobelprize.org.
According to Rawls, valid principles of justice are those with which all persons would agree if they could freely and impartially consider the situation. Impartiality is guaranteed by a conceptual device that Rawls calls the veil of ignorance. Under the veil of ignorance, everyone is imagined to be ignorant of all of his or her particular characteristics, for example, race, sex, intelligence, nationality, family background, and special talents. Rawls then asks what system people would design under a veil of ignorance. Under these conditions, people would unanimously agree on two fundamental principles of justice.
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.
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 distribution also benefits the least-advantaged members of society. One can argue that a well-regulated, market-based economy and free trade, by promoting economic growth, benefit the least-advantaged members of society. In principle at least, the inequalities inherent in such systems are therefore just (in other words, the rising tide of wealth created by a market-based economy and free trade lifts all boats, even those of the most disadvantaged).
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In the context of international business ethics, Rawls’s theory creates an interesting perspective. Managers could ask themselves whether the policies they adopt in foreign operations would be considered just under Rawls’s veil of ignorance. Is it just, for example, to pay foreign workers less than workers in the firm’s home country? Rawls’s theory would suggest it is, so long as the inequality benefits the least-advantaged members of the global society (which is what economic theory suggests). Alternatively, it is difficult to imagine that managers operating under a veil of ignorance would design a system where foreign employees were paid subsistence wages to work long hours in sweatshop conditions and where they were exposed to toxic materials. Such working conditions are clearly unjust in Rawls’s framework, and therefore, it is unethical to adopt them. Similarly, operating under a veil of ignorance, most people would probably design a system that imparts some protection from environmental degradation to important global commons, such as the oceans, atmosphere, and tropical rain forests. To the extent that this is the case, it follows that it is unjust, and by extension unethical, for companies to pursue actions that contribute toward extensive degradation of these commons. Thus, Rawls’s veil of ignorance is a conceptual tool that contributes to the moral compass that managers can use to help them navigate through difficult ethical dilemmas.
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Focus on Managerial Implications
MAKING ETHICAL DECISIONS INTERNATIONALLY
LO 5-5 Explain how global managers can incorporate ethical considerations into their decision making in general and for corporate social responsibility and sustainability initiatives.
What, then, is the best way for managers in a multinational firm to make sure that ethical considerations figure into international business decisions?
How do managers decide on an ethical course of action when confronted with decisions pertaining to working conditions, human rights, corruption, and environmental pollution? From an ethical perspective, how do managers determine the moral obligations that flow from the power of a multinational? In many cases, there are no easy answers to these questions: Many of the most vexing ethical problems arise because there are very real dilemmas inherent in them and no obvious correct action. Nevertheless, managers can and should do many things to make sure that basic ethical principles are adhered to and that ethical issues are routinely inserted into international business decisions.
Here, we focus on seven actions that an international business and its managers can take to make sure ethical issues are considered in business decisions: (1) favor hiring and promoting people with a well-grounded sense of personal ethics; (2) build an organizational culture and exemplify leadership behaviors that place a high value on ethical behavior; (3) put decision- making processes in place that require people to consider the ethical dimension of business decisions; (4) institute ethics officers in the organization; (5) develop moral courage; (6) make corporate social responsibility a cornerstone of enterprise policy; and (7) pursue strategies that are sustainable.
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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 expect a business to not promote people, and perhaps to fire people, whose behavior does not match generally accepted ethical standards. However, actually doing so is very difficult. How do you know that someone has a poor sense of personal ethics? In our society, we have an incentive to hide a lack of personal ethics from public view. Once people realize that you are unethical, they will no longer trust you.
Is there anything that businesses can do to make sure they do not hire people who subsequently turn out to have poor personal ethics, particularly given that people have an incentive to hide this from public view (indeed, the unethical person may lie about his or her nature)? Businesses can give potential employees psychological tests to try to discern their ethical predispositions, and they can check with prior employers or other employees regarding someone’s reputation (e.g., by asking for letters of reference and talking to people who have worked with the prospective employee). 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 organizational culture values the need for ethical behavior and where leaders act accordingly.
Not only should businesses strive to identify and hire people with a strong sense of personal ethics, but it also is in the interests of prospective employees to find out as much as they can about the ethical climate in an organization. Who wants to work at a multinational such as Enron, which ultimately entered bankruptcy because unethical executives had established risky partnerships that were hidden from public view and that existed in part to enrich those same executives?
Organizational Culture and Leadership To foster ethical behavior, businesses need to build an organizational culture that values ethical behavior. Three things are particularly important in building an organizational culture that emphasizes ethical behavior. First, the businesses must explicitly articulate values that emphasize ethical behavior. Many companies now do this by drafting a code of ethics, which is a formal statement of the ethical priorities a business adheres to. Often, the code of ethics draws heavily on documents such as the UN Universal Declaration of Human Rights, which itself is grounded in Kantian and rights-based theories of moral philosophy. Others have incorporated ethical statements into documents that articulate the values or mission of the business. For example, the Academy of International Business (the top professional organization in international business) has a Code of Ethics for its leadership (as well as a COE for its members):39
AIB’s Motivation for the Code of Ethics of the Leadership: The leadership of an organization is ultimately responsible for the creation of the values, norms and practices that permeate the organization and its membership. A strong ethically grounded organization is only possible when it is governed by a strong ethical committee. The term “committee” is used for succinctness; it includes all organizational structures that have managerial, custodial, decision-making or financial authority within an organization.
Having articulated values in a code of ethics or some other document, leaders in the business must give life and meaning to those words by repeatedly emphasizing their importance and then acting on them. This means using every relevant opportunity to stress the importance of business ethics and making sure that key business decisions not only make good economic sense but also are ethical. Many companies have gone a step further by hiring independent auditors to make sure they are behaving in a manner consistent with their ethical codes. Nike, for example, has hired independent auditors to make sure that subcontractors used by the company are living up to Nike’s code of conduct.
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Finally, building an organizational culture that places a high value on ethical behavior requires incentive and reward systems, including promotions that reward people who engage in ethical behavior and sanction those who do not. At General Electric, for example, the former CEO Jack Welch has described how he reviewed the performance of managers, dividing them into several different groups. These included overperformers who displayed the right values and were singled out for advancement and bonuses and overperformers who displayed the wrong values and were let go. Welch was not willing to tolerate leaders within the company who did not act in accordance with the central values of the company, even if they were in all other respects skilled managers.40
Decision-Making Processes In addition to establishing the right kind of ethical culture in an organization, businesspeople must be able to think through the ethical implications of decisions in a systematic way. To do this, they need a moral compass, and both rights theories and Rawls’s theory of justice help provide such a compass. Beyond these theories, some experts on ethics have proposed a straightforward practical guide—or ethical algorithm—to determine whether a decision is ethical.41 According to these experts, a decision is acceptable on ethical grounds if a businessperson can answer yes to each of these questions:
Does my decision fall within the accepted values or standards that typically apply in the organizational environment (as articulated in a code of ethics or some other corporate statement)? Am I willing to see the decision communicated to all stakeholders affected by it—for example, by having it reported in newspapers, on television, or via social media? Would the people with whom I have a significant personal relationship, such as family members, friends, or even managers in other businesses, approve of the decision?
Others have recommended a five-step process to think through ethical problems (this is another example of an ethical algorithm).42 In step 1, businesspeople should identify which stakeholders a decision would affect and in what ways. A firm’s stakeholders are individuals or groups that have an interest, claim, or stake in the company, in what it does, and in how well it performs.43 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 stakeholders such as employees, the board of directors, and shareholders. External stakeholders are all the other individuals and groups that have some direct or indirect claim on the firm. Typically, this group comprises primary stakeholders such as customers, suppliers, governments, and local communities as well as secondary stakeholders such as special-interest groups, competitors, trade associations, mass media, and social media.44
All stakeholders are in an exchange relationship with the company.45 Each stakeholder group supplies the organization with important resources (or contributions), and in exchange each expects its interests to be satisfied (by inducements).46 For example, employees provide labor, skills, knowledge, and time and in exchange expect commensurate income, job satisfaction, job security, and good working conditions. Customers provide a company with its revenues and in exchange want quality products that represent value for money. Communities provide businesses with local infrastructure and in exchange want businesses that are responsible citizens and seek some assurance that the quality of life will be improved as a result of the business firm’s existence.
Stakeholder analysis involves a certain amount of what has been called moral imagination.47 This means standing in the shoes of a stakeholder and asking how a proposed decision might impact that stakeholder. For example, when considering outsourcing to subcontractors, managers might need to ask themselves how it might feel to be working under
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substandard health conditions for long hours.
Step 2 involves judging the ethics of the proposed strategic decision, given the information gained in step 1. Managers need to determine whether a proposed decision would violate the fundamental rights of any stakeholders. For example, we might argue that the right to information about health risks in the workplace is a fundamental entitlement of employees. Similarly, the right to know about potentially dangerous features of a product is a fundamental entitlement of customers (something tobacco companies violated when they did not reveal to their customers what they knew about the health risks of smoking). Managers might also want to ask themselves whether they would allow the proposed strategic decision if they were designing a system under Rawls’s veil of ignorance. For example, if the issue under consideration was whether to outsource work to a subcontractor with low pay and poor working conditions, managers might want to ask themselves whether they would allow such action if they were considering it under a veil of ignorance, where they themselves might ultimately be the ones to work for the subcontractor.
The judgment at this stage should be guided by various moral principles that should not be violated. The principles might be those articulated in a corporate code of ethics or other company documents. In addition, certain moral principles that we have adopted as members of society—for instance, the prohibition on stealing—should not be violated. The judgment at this stage will also be guided by the decision rule that is chosen to assess the proposed strategic decision. Although maximizing long-run profitability is the decision rule that most businesses stress, it should be applied subject to the constraint that no moral principles are violated—that the business behaves in an ethical manner.
Step 3 requires managers to establish moral intent. This means the business must resolve to place moral concerns ahead of other concerns in cases where either the fundamental rights of stakeholders or key moral principles have been violated. At this stage, input from top management might be particularly valuable. Without the proactive encouragement of top managers, middle-level managers might tend to place the narrow economic interests of the company before the interests of stakeholders. They might do so in the (usually erroneous) belief that top managers favor such an approach.
Step 4 requires the company to engage in ethical behavior. Step 5 requires the business to audit its decisions, reviewing them to make sure they were consistent with ethical principles, such as those stated in the company’s code of ethics. This final step is critical and often overlooked. Without auditing past decisions, businesspeople may not know if their decision process is working and if changes should be made to ensure greater compliance with a code of ethics.
Ethics Officers To make sure that a business behaves in an ethical manner, firms now must have oversight by a high-ranking person or people known to respect legal and ethical standards. These individuals—often referred to as ethics officers—are responsible for managing their organization’s ethics and legal compliance programs. They are typically responsible for (1) assessing the needs and risks that an ethics program must address; (2) developing and distributing a code of ethics; (3) conducting training programs for employees; (4) establishing and maintaining a confidential service to address employees’ questions about issues that may be ethical or unethical; (5) making sure that the organization is in compliance with government laws and regulations; (6) monitoring and auditing ethical conduct; (7) taking action, as appropriate, on possible violations; and (8) reviewing and updating the code of ethics periodically.48 Because of these broad topics covered by the ethics officer, in many businesses ethics officers act as an internal ombudsperson with responsibility for handling confidential inquiries from employees, investigating complaints from employees or others, reporting findings, and making recommendations for change.
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For example, United Technologies, a multinational aerospace company with worldwide revenues of more than $30 billion, has had a formal code of ethics since 1990.49 United Technologies has some 450 business practice officers (the company’s name for ethics officers), who are responsible for making sure the code is followed. United Technologies also established an “ombudsperson” program in 1986 that lets employees inquire anonymously about ethics issues. The program has received some 60,000 inquiries since 1986, and more than 10,000 cases have been handled by the ombudsperson.
Moral Courage It is important to recognize that employees in an international business may need significant moral courage. Moral courage enables managers to walk away from a decision that is profitable but unethical. Moral courage gives an employee the strength to say no to a superior who instructs her to pursue actions that are unethical. Moral courage gives employees the integrity to go public to the media and blow the whistle on persistent unethical behavior in a company. Moral courage does not come easily; there are well-known cases where individuals have lost their jobs because they blew the whistle on corporate behaviors they thought unethical, telling the media about what was occurring.50
However, companies can strengthen the moral courage of employees by committing themselves to not retaliate against employees who exercise moral courage, say no to superiors, or otherwise complain about unethical actions. For example, consider the following excerpt from the Academy of International Business Code of Ethics:
AIB Statement of Commitment by Its Leadership: In establishing policy for and on behalf of the Academy of International Business’s members, I am a custodian in trust of the assets of this organization. The AIB’s members recognize the need for competent and committed elected committee members to serve their organization and have put their trust in my sincerity and abilities. In return, the members deserve my utmost effort, dedication, and support. Therefore, as a committee member of the AIB, I acknowledge and commit that I will observe a high standard of ethics and conduct as I devote my best efforts, skills and resources in the interest of the AIB and its members. I will perform my duties as a committee member in such a manner that the members’ confidence and trust in the integrity, objectivity and impartiality of the AIB are conserved and enhanced. To do otherwise would be a breach of the trust which the membership has bestowed upon me.51
This statement ensures that all members serving in leadership positions within the Academy of International Business adhere to and uphold the highest commitment and responsibility to be ethical in their AIB leadership activities. A freestanding and independent AIB Ombuds Committee handles all ethical issues and violations to ensure independence and the highest moral code.
Did You Know? Did you know corporate social responsibility is not as new as it seems? Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
Corporate Social Responsibility Multinational corporations have power that comes from their control over resources and their ability to move production from country to country. Although that power is constrained not only by laws and regulations but also by the discipline of the market and the competitive process, it is substantial. Some moral philosophers argue that with power comes the social responsibility for multinationals to give something back to the societies that enable them to prosper and grow.corporate social responsibility (CSR) refers to the idea that businesspeople should consider the social consequences of economic actions when
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making business decisions and that there should be a presumption in favor of decisions that have both good economic and social consequences.52 In its purest form, corporate social responsibility can be supported for its own sake simply because it is the right way for a business to behave. Advocates of this approach argue that businesses, particularly large successful businesses, need to recognize their noblesse oblige and give something back to the societies that have made their success possible. Noblesse oblige is a French term that refers to honorable and benevolent behavior considered the responsibility of people of high (noble) birth. In a business setting, it is taken to mean benevolent behavior that is the responsibility of successful enterprises. This has long been recognized by many businesspeople, resulting in a substantial and venerable history of corporate giving to society, with businesses making social investments designed to enhance the welfare of the communities in which they operate.
m a n a g e m e n t F O C U S
Corporate Social Responsibility at Stora Enso
Stora Enso is a Finnish pulp and paper manufacturer that was formed by the merger of Swedish mining and forestry products company Stora and Finnish forestry products company Enso-Gutzeit Oy in 1998. The company is headquartered in Helsinki, the capital of Finland, and it has approximately 25,000 employees. In 2000, the company bought Consolidated Papers in North America. Stora Enso also expanded into South America, Asia, and Russia. By 2005, Stora Enso had become the world’s largest pulp and paper manufacturer as measured by production capacity. However, the North American operations were sold in 2007 to NewPage Corporation.
To this day, Stora Enso has a long-standing tradition of corporate social responsibility on a global scale. As part of the company’s section “Global Responsibility in Stora Enso,” the company states that “for Stora Enso, Global Responsibility means realizing concrete actions that will help us fulfil [sic] our Purpose, which is to do good for the people and the planet.” Stora Enso continues to state:
Our purpose “do good for the people and the planet” is the ultimate reason why we run our business. It is the overriding rule that guides us in all that we do: producing and selling our renewable products, buying trees from a local forest-owner in Finland, selling electricity generated at Stora Enso Skoghall Mill, or managing our logistics on a global scale.54
Interestingly, Stora Enso also asserts that it realizes that this statement is rather bold and perhaps not even fully believable. But the company suggests that it makes the company accountable for its actions; that is, setting its purpose boldly in writing. At the same time, Stora Enso positions the company as though it has always been attending to the “socially responsible” needs of doing good for the people and the planet. It illustrates this by maintaining that it has created and enhanced communities around its mills, developed innovative systems to reduce the use of scarce resources, and maintained good relationships with key stakeholders such as forest owners, their own employees, governments, and local communities near its mills.
Tracing its past and reflecting on its future, Stora Enso has adopted three lead areas for its global responsibility strategy: people and ethics, forests and land use, and environment and efficiency. For people and ethics, the company focuses on conducting business in a socially responsible manner throughout its global value chain. For forests and land use, it focuses on an innovative and responsible approach on forestry and land use to make it a preferred partner and a good local community citizen. For the environment and efficiency, the focus is on resource-efficient operations that help the company achieve superior environmental performance related to its products.
While a number of companies have corporate social responsibility statements incorporated as part of their websites, annual reports, and talking points, Stora Enso also presents clear targets and performance
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goals that are assessed by established metrics. Its overall operations are guided by corporate-level targets for environmental and social performance, aptly named Stora Enso’s Global Responsibility Key Performance Indicators (KPIs). Targets are publicly listed in a document titled “Targets and Performance” and include two to five basic categories of measures for each of the three lead areas. For people and ethics, the dimensions cover health and safety, human rights, ethics and compliance, sustainable leadership, and responsible sourcing. For forests and land use, the dimensions cover efficiency of land use and sustainable forestry. For environment and efficiency, the dimensions cover climate and energy, material efficiency, and process water discharges. The “Targets and Performance” document also lists performance in the prior year, targets in the current year, and strategic objectives related to each dimension.
Sources: “Global Responsibility in Stora Enso,” www.storaenso.com; K. Vita, “Stora Enso Falls as UBS Plays Down Merger Talk: Helsinki Mover,” Bloomberg Businessweek, September 30, 2013; M. Huuhtanen, “Paper Maker Stora Enso Selling North American Mills,” USA Today, September 21, 2007.
Power itself is morally neutral; how power is used is what matters. It can be used in a positive way to increase social welfare, which is ethical, or it can be used in a manner that is ethically and morally suspect. Managers at some multinationals have acknowledged a moral obligation to use their power to enhance social welfare in the communities where they do business. BP, one of the world’s largest oil companies, has made it part of the company policy to undertake “social investments” in the countries where it does business.53 In Algeria, BP has been investing in a major project to develop gas fields near the desert town of Salah. When the company noticed the lack of clean water in Salah, it built two desalination plants to provide drinking water for the local community and distributed containers to residents so they could take water from the plants to their homes. 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 accompanying Management Focus feature on the Finnish company Stora Enso.
Sustainability As managers in international businesses strive to translate ideas about corporate social responsibility into strategic actions, many are gravitating toward strategies that are viewed as sustainable. By sustainable strategies, we refer to strategies that not only help the multinational firm make good profits, but that also do so without harming the environment while simultaneously ensuring that the corporation acts in a socially responsible manner with regard to its stakeholders.55 The core idea of sustainability is that the organization—through its actions—does not exert a negative impact on the ability of future generations to meet their own economic needs and that its actions impart long-run economic and social benefits on stakeholders.56
A company pursuing a sustainable strategy would not adopt business practices that deplete the environment for short-term economic gain because doing so would impose a cost on future generations. In other words, international businesses that pursue sustainable strategies try to ensure that they do not precipitate or participate in a situation that results in a tragedy of the commons 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.
Is Sustainability Bad for Profits?
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Most customers prefer that the companies they buy products and services from engage in business- focused sustainability practices. Eighty-three percent of the respondents in the Public Opinion Survey on Sustainability said that they think companies should try to accomplish their performance goals while also trying to improve society and the environment. At the same time, multinational firms are overwhelmed by the varied stakeholder needs they face. And the Global Reporting Initiative, with its some 80 equally important sustainability indicators, is not giving companies a clear set of sustainability proprieties. Meanwhile, sustainability executives in companies have not exactly been elevated to the importance levels of other top managers. If you had to pay more for a product, like gasoline for your automobile, how much more would you be willing to pay to buy from a highly rated sustainability- oriented company—5 percent, 10 percent, 25 percent, 40 percent?
Sources: Epstein-Reeves, J., “The Pain of Sustainability,” Forbes, January 18, 2012; “Consumers Expect Action from Companies on Sustainability,” Second Annual Public Opinion Survey on Sustainability; Global Reporting Initiative, www.globalreporting.org.
Nor would a company pursuing a sustainable strategy adopt policies that negatively affect the well-being of key stakeholders such as employees and suppliers because managers would recognize that in the long run, this would harm the company. The company that pays its employees so little that it forces them into poverty, for example, may find it hard to recruit employees in the future and may have to deal with high employee turnover, which imposes its own costs on an enterprise. Similarly, a company that drives down the prices it pays to its suppliers so far that the suppliers cannot make enough money to invest in upgrading their operations may find that in the long run, its business suffers poor-quality inputs and a lack of innovation among its supplier base.
Starbucks has a goal of ensuring that 100 percent of its coffee is ethically sourced. By this, it means that the farmers who grow the coffee beans it purchases use sustainable farming methods that do not harm the environment and that they treat their employees well and pay them fairly. Starbucks agronomists work directly with farmers in places such as Costa Rica and Rwanda to make sure that they use environmentally responsible farming methods. The company also provides loans to farmers to help them upgrade their production methods. As a result of these policies, some 9 percent of Starbucks coffee beans are “fair trade” sourced and the remaining 91 percent are ethically sourced.
Key Terms
business ethics, p. 125 ethical strategy, p. 125 Foreign Corrupt Practices Act (FCPA), p. 130 Convention on Combating Bribery of Foreign Public Officials in International Business Transactions, p. 130 ethical dilemma, p. 132 organizational culture, p. 133 cultural relativism, p. 135 righteous moralist, p. 136 naive immoralist, p. 136 utilitarian approach to ethics, p. 137 Kantian ethics, p. 137 rights theories, p. 138 Universal Declaration of Human Rights, p. 138 just distribution, p. 139 code of ethics, p. 141 stakeholders, p. 141
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internal stakeholders, p. 141 external stakeholders, p. 141 corporate social responsibility (CSR), p. 143 sustainable strategies, p. 145
Summary
This chapter discussed the source and nature of ethical issues in international businesses, the different philosophical approaches to business ethics, the steps managers can take to ensure that ethical issues are respected in international business decisions, and the roles of corporate social responsibility and sustainability in practice. 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. An ethical strategy is one that does not violate these accepted principles.
2. Ethical issues and dilemmas in international business are rooted in the variations among political systems, law, economic development, and culture from country to country.
3. 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 personal ethics, societal culture, psychological and geographic distances of a foreign subsidiary from the home office, a failure to incorporate ethical issues into strategic and operational decision making, a dysfunctional culture, and failure of leaders to act in an ethical manner.
6. Moral philosophers contend that approaches to business ethics such as the Friedman doctrine, cultural relativism, the righteous moralist, and the naive immoralist are unsatisfactory in important ways.
7. 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,
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managers should (a) favor hiring and promoting people with a well-grounded sense of personal ethics, (b) build an organizational culture and exemplify leadership behaviors that place a high value on ethical behavior, (c) put decision-making processes in place that require people to consider the ethical dimension of business decisions, (d) establish ethics officers in the organization with responsibility for ethical decision making, (e) be morally courageous and encourage others to do the same, (f) make corporate social responsibility a cornerstone of enterprise policy, and (g) pursue strategies that are sustainable.
13. Multinational corporations that are practicing business-focused sustainability integrate a focus on market orientation, addressing the needs of multiple stakeholders, and adhering to corporate social responsibility principles.
Critical 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 on John Rawls’s concept of the veil of ignorance, develop an ethical code that will (a) guide the decisions of a large oil multinational toward environmental protection and (b) influence the policies of a clothing company in their potential decision of outsourcing their manufacturing operations.
3. Under what conditions is it ethically defensible to outsource production to the developing world where labor costs are lower when such actions also involve laying off long-term employees in the firm’s home country?
4. Do you think facilitating payments (speed payments) should be ethical? Does it matter in which country, or part of the world, such payments are made?
5. A manager from a developing country is overseeing a multinational’s operations in a country where drug trafficking and lawlessness are rife. One day, a representative of a local “big man” approaches the manager and asks for a “donation” to help the big man provide housing for the poor. 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 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. Can a company be good at corporate social responsibility but not be sustainability oriented? Is it possible to focus on sustainability but not corporate social responsibility? Based on reading the Focus on Managerial Implications section, discuss how much CSR and sustainability are related and how much the concepts differ from each other.
*M. Friedman, “The Social Responsibility of Business Is to Increase Profits,” The New York Times Magazine, September 13, 1970.
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Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. Promoting respect for universal human rights is a central dimension of many countries’ foreign policy. As history has shown, human rights abuses are an important concern worldwide. Some countries are more ready to work with other governments and civil society organizations to prevent abuses of power. Begun in 1977, the annual Country Reports on Human Rights Practices are designed to assess the state of democracy and human rights around the world, call attention to violations, and—where needed—prompt needed changes in U.S. policies toward particular countries. Find the latest annual Country Reports on Human Right Practices for the BRIC countries (Brazil, Russia, India, and China), and create a table to compare the findings under the “Worker Rights” sections. What commonalities do you see? What differences are there?
2. 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?
Woolworths’ Corpora te Responsib i l i ty St ra tegy clos ing case
The Woolworths Group (woolworthsgroup.com.au) is an Australian conglomerate corporation founded in 1924. The headquarters is in Bella Vista in New South Wales. Colloquially known as “Woolies,” the company has extensive retail interests in the Oceania region, particularly in Australia and New Zealand, but it also has a foothold in India. The Woolworths Group consists of three core businesses (Woolworths Food Group, Endeavour Drinks, and Portfolio Businesses); employs more than 200,000 people; and has revenue of about $60 billion Australian dollars, or $46 billion in U.S. dollars. Across the three core businesses, Woolworths has 13 different business subsidiaries.
Integrating these 13 subsidiaries into a corporate social responsibility program is a challenge for a company with more than 200,000 employees and diverse interests. To accomplish its objective, Woolworths Group’s Corporate Responsibility Strategy 2020 identifies 20 corporate responsibility and sustainability goals that the company plans to implement by the year 2020. These goals cover a broad range of Woolworths’ stakeholders (e.g., customers, team members, suppliers, and local communities in which Woolworths operates). Woolworths’ Corporate Responsibility Strategy is based on a framework of People, Planet, and Prosperity.
The focus on People is about encouraging diversity. The target goals include striving for gender equity by targeting at least 40 percent of executive and senior manager positions to be held by women. Woolworths is also setting a goal of no salary wage gap between male and female employees of equivalent positions at all levels of the company. And rooted in Australian business, the company is embracing diversity by increasing the number of Indigenous employees in line with the company’s stated commitments under the Australian Federal Government’s Employment Parity Initiative.
The focus on the Planet includes two major initiatives. Woolworths is working toward zero food
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waste going to landfills. According to the U.S. Environmental Protection Agency, 20 percent of what goes into municipal landfills is food. Woolworths is also trying to reduce its carbon emissions or footprint by 10 percent. Many of our daily activities (e.g., using electricity, driving a car, or disposing of waste) cause greenhouse gas emissions. A carbon footprint is defined as the total set of greenhouse gas emissions caused by an individual, event, organization, or product, and it is expressed as a carbon dioxide equivalent. Such emissions trap heat in the atmosphere, which according to most scientists contributes to disruptive climate change.
©Takatoshi Kurikawa/Alamy Stock Photo
The focus on Prosperity is founded on trusted relationships. Woolworths’ targets are to achieve a top quartile ranking in how the business engages fairly and equitably with its suppliers, as measured by independent supplier surveys. Inspiration is also built into prosperity in the form of the company implementing activities to inspire customers to consume all of Woolworths’ products in a healthy, sustainable way. The most transparent Prosperity initiative, though, is to invest the equivalent of 1 percent of total earnings in community partnerships and programs.
Woolworths’ People-Planet-Prosperity strategies drive how the company does business. The strategies state that Woolworths is committed to hard work and that its integrity is resolute. The foundation is a down-to-earth culture and family friendly values. Every aspect of Woolworths’ business exists for the purpose of making the customers’ lives simpler, easier, and better. Underpinning Woolworths’ operations is a working relationship built on mutual trust with suppliers. More than 80 percent of the company’s suppliers have been strategic partners with Woolworths for a decade or longer.
Sources: Dimitri Sotiropoulos, “Woolworths Sets Sights on Sustainability,” Inside Retail (Australia), February 14, 2017; Justin Smith, “How Woolworths Is Building Resilience in Its Food Supply Chain,” Sustainable Brands, April 11, 2016; Jason LaChappelle, “Woolworths Sees Benefits of Working with Sustainability Standards,” Iseal Alliance, September 19, 2014; “Woolworths Group’s Corporate Responsibility Strategy 2020,” https://woolworthsgroup.com.au/page/community- and-responsibility/group-responsibility.
CASE DISCUSSION QUESTIONS 1. What challenges do you think a company like Woolworths Group is facing when
developing and implementing a companywide corporate social responsibility strategy that takes into account the more than 200,000 employees, diverse interests, and stakeholders?
2. The focus on People is about encouraging diversity. The idea is to increase the number of Indigenous employees in line with the company’s stated commitments under the Australian Federal Government’s Employment Parity Initiative. Does such a diversity approach enhance, or not, the company’s sustainability strategy. How?
3. Woolworths Group is trying to reduce its carbon emissions or footprint by 10 percent. Based on where we are as a world, is 10 percent enough of a reduction? Perhaps global warming is not real, albeit the vast majority of scientists clearly suggest it is; what do you think?
4. Woolworths’ targets are to achieve a top quartile ranking in how the business engages fairly and equitably with its suppliers. How do supplier relationships and the fairness in dealing with suppliers relate to sustainability and “doing good” for society (and the
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company)?
Endnotes
1. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!” Journal of the Academy of Marketing Science 39 (2011), pp. 1–6; T. Hult, J. Mena, O. C. Ferrell, and L. Ferrell, “Stakeholder Marketing: A Definition and Conceptual Framework,” AMS Review 1 (2011), pp. 44–65.
2. S. Greenhouse, “Nike Shoe Plant in Vietnam Is Called Unsafe for Workers,” The New York Times, November 8, 1997; V. Dobnik, “Chinese Workers Abused Making Nikes, Reeboks,” Seattle Times, September 21, 1997, p. A4.
3. R. K. Massie, Loosing the Bonds: The United States and South Africa in the Apartheid Years (New York: Doubleday, 1997).
4. Not everyone agrees that the divestment trend had much influence on the South African economy. For a counterview, see S. H. Teoh, I. Welch, and C. P. Wazzan, “The Effect of Socially Activist Investing on the Financial Markets: Evidence from South Africa,” The Journal of Business 72, no. 1 (January 1999), pp. 35–60.
5. Peter Singer, One World: The Ethics of Globalization (New Haven, CT: Yale University Press, 2002).
6. Garrett Hardin, “The Tragedy of the Commons,” Science 162, no. 1 (1968), pp. 243–48. 7. For a summary of the evidence, see S. Solomon, D. Qin, M. Manning, Z. Chen, M.
Marquis, K. B. Averyt, M. Tignor, and H. L. Miller, eds., Contribution of Working Group I to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change (Cambridge, UK: Cambridge University Press, 2007).
8. J. Everett, D. Neu, and A. S. Rahaman, “The Global Fight against Corruption,” Journal of Business Ethics 65 (2006), pp. 1–18.
9. R. T. De George, Competing with Integrity in International Business (Oxford, UK: Oxford University Press, 1993).
10. Details can be found at www.oecd.org/corruption/oecdantibriberyconvention.htm. 11. B. Pranab, “Corruption and Development,” Journal of Economic Literature 36 (September
1997), pp. 1320–46. 12. A. Shleifer and R. W. Vishny, “Corruption,” Quarterly Journal of Economics 108 (1993),
pp. 599–617; I. Ehrlich and F. Lui, “Bureaucratic Corruption and Endogenous Economic Growth,” Journal of Political Economy 107 (December 1999), pp. 270–92.
13. P. Mauro, “Corruption and Growth,” Quarterly Journal of Economics 110 (1995), pp. 681– 712.
14. D. Kaufman and S. J. Wei, “Does Grease Money Speed up the Wheels of Commerce?” World Bank policy research working paper, January 11, 2000.
15. Center for the Study of Ethics in the Professions, http://ethics.iit.edu. 16. B. Vitou, R. Kovalevsky, and T. Fox, “Time to Call a Spade a Spade. Facilitation Payments
and Why Neither Bans Nor Exemption Work,” http://thebriberyact.com/2011/02/03/time- to-call-a-spade-a-spade-facilitation-payments-why-neither-bans-nor-exemptions-work, accessed March 8, 2014.
17. This is known as the “when in Rome perspective.” T. Donaldson, “Values in Tension: Ethics Away from Home,” Harvard Business Review, September–October 1996.
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18. De George, Competing with Integrity in International Business. 19. For a discussion of the ethics of using child labor, see J. Isern, “Bittersweet Chocolate: The
Legacy of Child Labor in Cocoa Production in Cote d’Ivoire,” Journal of Applied Management and Entrepreneurship 11 (2006), pp. 115–32.
20. S. W. Gellerman, “Why Good Managers Make Bad Ethical Choices,” in Ethics in Practice: Managing the Moral Corporation, ed. K. R. Andrews (Cambridge, MA: Harvard Business School Press, 1989).
21. D. Messick and M. H. Bazerman, “Ethical Leadership and the Psychology of Decision Making,” Sloan Management Review 37 (Winter 1996), pp. 9–20.
22. O. C. Ferrell, J. Fraedrich, and L. Ferrell, Business Ethics, 9th ed. (Mason, OH: Cengage, 2013).
23. B. Scholtens and L. Dam, “Cultural Values and International Differences in Business Ethics,” Journal of Business Ethics, 2007.
24. M. Friedman, “The Social Responsibility of Business Is to Increase Profits,” The New York Times Magazine, September 13, 1970. Reprinted in T. L. Beauchamp and N. E. Bowie, Ethical Theory and Business, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).
25. Friedman, “The Social Responsibility of Business Is to Increase Profits.” 26. Friedman, “The Social Responsibility of Business Is to Increase Profits.” 27. For example, see Donaldson, “Values in Tension: Ethics Away from Home.” See also N.
Bowie, “Relativism and the Moral Obligations of Multinational Corporations,” in T. L. Beauchamp and N. E. Bowie, Ethical Theory and Business, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).
28. For example, see De George, Competing with Integrity in International Business. 29. This example is often repeated in the literature on international business ethics. It was first
outlined by A. Kelly in “Case Study—Italian Style Mores,” in T. Donaldson and P. Werhane, Ethical Issues in Business (Englewood Cliffs, NJ: Prentice Hall, 1979).
30. See Beauchamp and Bowie, Ethical Theory and Business. 31. T. Donaldson, The Ethics of International Business (Oxford: Oxford University Press,
1989). 32. Found at www.un.org/Overview/rights.html. 33. UN Universal Declaration of Human Rights, Article 1. 34. UN Universal Declaration of Human Rights, Article 23. 35. UN Universal Declaration of Human Rights, Article 29. 36. Donaldson, The Ethics of International Business. 37. See Chapter 10 in Beauchamp and Bowie, Ethical Theory and Business. 38. J. Rawls, A Theory of Justice, rev. ed. (Cambridge, MA: Belknap Press, 1999). 39. https://aib.msu.edu/aboutleadership.asp. 40. J. Bower and J. Dial, “Jack Welch: General Electric’s Revolutionary,” Harvard Business
School Case 9–394–065, April 1994. 41. For example, see R. E. Freeman and D. Gilbert, Corporate Strategy and the Search for
Ethics (Englewood Cliffs, NJ: Prentice Hall, 1988); T. Jones, “Ethical Decision Making by Individuals in Organizations,” Academy of Management Review 16 (1991), pp. 366–95; J. R. Rest, Moral Development: Advances in Research and Theory (New York: Praeger, 1986).
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42. Freeman and Gilbert, Corporate Strategy and the Search for Ethics; Jones, “Ethical Decision Making by Individuals in Organizations”; Rest, Moral Development.
43. See E. Freeman, Strategic Management: A Stakeholder Approach (Boston: Pitman Press, 1984); C. W. L. Hill and T. M. Jones, “Stakeholder-Agency Theory,” Journal of Management Studies 29 (1992), pp. 131–54; J. G. March and H. A. Simon, Organizations (New York: Wiley, 1958).
44. Hult et al., “Stakeholder Marketing.” 45. Hult, “Market-Focused Sustainability: Market Orientation Plus!”; Hult et al., “Stakeholder
Marketing.” 46. Hill and Jones, “Stakeholder-Agency Theory”; March and Simon, Organizations. 47. De George, Competing with Integrity in International Business. 48. “Our Principles,” Unilever, www.unilever.com. 49. The code can be accessed at the United Technologies website, www.utc.com. 50. C. Grant, “Whistle Blowers: Saints of Secular Culture,” Journal of Business
Ethics, September 2002, pp. 391–400. 51. “Statement of Commitment,” Academy of International Business Code of Ethics,
https://aib.msu.edu/aboutleadership.asp. 52. S. A. Waddock and S. B. Graves, “The Corporate Social Performance–Financial
Performance Link,” Strategic Management Journal 8 (1997), pp. 303–19; I. Maignan, O. C. Ferrell, and T. Hult, “Corporate Citizenship: Cultural Antecedents and Business Benefits,” Journal of the Academy of Marketing Science 27 (1999), pp. 455–69.
53. Details can be found at BP’s website, www.bp.com. 54. Hult, T., “Market-Focused Sustainability: Market Orientation Plus!” Journal of the
Academy of Marketing Science, vol. 39, no.1, 2011. 55. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!” 56. M. Clarkson, “A Stakeholder Framework for Analyzing and Evaluating Corporate Social
Performance,” Academy of Management Review 20 (1995), pp. 92–117; R. Freeman, Strategic Management: A Stakeholder Approach(Marshfield, MA: Pitman, 1984); T. Hult, J. Mena, O. Ferrell, and L. Ferrell, “Stakeholder Marketing: A Definition and Conceptual Framework,” AMS Review 1 (2011), pp. 44–65.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education
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Part 3 The Global Trade and Investment Environment
International Trade Theory
Learning Object ives After reading this chapter, you will be able to:
LO6-1 Understand why nations trade with each other.
LO6-2 Summarize the different theories explaining trade flows between nations.
LO6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.
LO6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.
LO6-5 Understand the important implications that international trade theory holds for management practice.
“Trade Wars Are Good and Easy to Win”
opening case At 3:50 a.m. on March 2, 2018, Donald Trump, the 45th President of the United States, took to Twitter
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to espouse his view on an important policy issue: international trade. He tweeted “When a country (USA) is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good, and easy to win. When we are down $100 billion with a certain country and they get cute, don’t trade anymore—we win big. It’s easy!”
Trump’s tweet was a response to backlash over his decision to impose a 25 percent tariff on imports of steel, and a 10 percent tariff on imports of aluminum. The Trump administration claimed that these tariffs were necessary to protect two industries that were important for national security. His critics had a different take. They argued that the tariffs would raise input costs for consumers of steel and aluminum, which included construction companies, manufacturers of construction equipment, appliance makers, auto manufacturers, makers of containers and packaging (e.g. beer cans), and aerospace companies. Among those hit by higher costs due to these tariffs would be two of America's largest exporters, Boeing and Caterpillar Tractor. The critics also noted that there are only 140,000 people employed in the steel and aluminum industries, whereas 6.5 million Americans are employed in industries that use steel and aluminum, where input prices have just gone up.
Trump’s actions should not have been a surprise. In contrast to all U.S. presidents since World War II, Donald Trump has long voiced strong opposition to trade deals designed to lower tariff barriers and foster the free flow of goods and services between the United States and its trading partners. During the presidential election campaign, he called the North American Free Trade Agreement (NAFTA) “the worst trade deal maybe ever signed anywhere.” Upon taking office, his administration launched a renegotiation of NAFTA with the aim of making the treaty more favorable to America. As a candidate, he vowed to “kill” the Trans Pacific Partnership (TPP), a free trade deal among 12 Pacific Rim countries, including the United States (but excluding China), negotiated by the Obama administration. In his first week in office, he signed an executive order formally withdrawing the United States from the TPP. He has even threatened to pull the United States out of the World Trade Organization (WTO) if the global trade body interferes with his plans to impose tariffs.
Trump’s position seems to be based on a belief that trade is a game that America needs to win. He appears to equate winning with running a trade surplus. He sees the persistent U.S. trade deficit as a sign of American weakness. In his words, “you only have to look at our trade deficit to see that we are being taken to the cleaners by our trading partners.” He believes that other countries have taken advantage of the United States in trade deals, and the result has been a sharp decline in manufacturing jobs in the United States. China and Mexico have been frequent targets of his criticisms. He has argued that China’s trade surplus with the United States is a result of that country’s currency manipulation, which has made Chinese exports artificially cheap. He seems to think that America can win at the trade game by becoming a tougher negotiator and extracting favorable terms from foreign nations that want access to the U.S. market. He has even characterized previous American trade negotiators as “stupid people,” “political hacks and diplomats,” and “saps” and suggested that he should become “negotiator in chief.”
In contrast to Donald Trump’s espoused position, the pro trade policies of the last 70 years were based upon a substantial body of economic theory and evidence that suggests free trade has a positive impact on the economic growth rate of all nations that participate in a free trade system. According to this work, free trade doesn’t destroy jobs; it creates jobs and raises national income. To be sure, some sectors will lose jobs when a nation moves to a free trade regime, but the argument is that jobs created elsewhere in the economy will more than compensate for such losses, and in aggregate, the nation will be better off.
The United States has long been the world’s largest economy, largest foreign investor, and one of the three largest exporters (along with China and Germany). As a result of America’s economic power, Americans’ long adherence to free trade policies has helped to set the tone for the world trading system. In large part, the post–World War II international trading system, with its emphasis on lowering barriers to international trade and investment, was only possible because of vigorous American leadership. Now with the ascendancy of Donald Trump to the presidency, that seems to be changing. Pro–free traders argue that if Trump continues to push for more protectionist trade policies—and his rhetoric and cabinet picks suggest he will—the unintended consequences could include retaliation from America’s trading partners, a trade war characterized by higher tariffs, a decline in the volume of world trade, substantial job losses in the United States, and lower economic growth around the world. As evidence, they point to
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the last time such protectionist policies were implemented. That was in the early 1930s, when a trade war between nations deepened the Great Depression. • Sources: “Donald Trump on Free Trade,” On the Issues, www.ontheissues.org/2016/Donald_Trump_Free_Trade.htm; Keith Bradsher, “Trump’s Pick on Trade Could Put China in a Difficult Spot,” The New York Times, January 13, 2017; William Mauldin, “Trump Threatens to Pull U.S. Out of World Trade Organization,” The Wall Street Journal, July 24, 2016; “Trump’s Antitrade Warriors,” The Wall Street Journal, January 16, 2017; “Donald Trump’s Trade Bluster,” The Economist, December 10, 2016; and Chad Brown, “Trump’s Steel and Aluminum Tariffs Are Counterproductive,” Peterson Institute for International Economics, March 7, 2018.
Introduction As discussed in the opening case of this chapter, thanks to the rise of Donald Trump, trade policy is currently at the center of political discourse in the United States and elsewhere. President Trump has made statements and taken actions that suggest he may be the most protectionist president in modern history. His administration could upend 70 years of American- led policy designed to lower barriers to the free flow of goods and services between and among nations. That policy was founded on the belief that free trade promotes economic growth in all nations that participate in a free trade system. Free trade is what economists call a positive-sum game; it is a policy under which all nations win. The Trump administration, in contrast, appears to see trade as a zero-sum game, in which there are winners and losers.
To truly understand the debate over trade, we need to take a close look at the intellectual foundations for trade policy; at the impact of trade policy on jobs, income, and economic growth; and at how global trade policy has evolved over the last 70 years. We should also consider the reasons for foreign direct investment (FDI) by corporations because FDI may be a substitute for trade (i.e., exports), or it may support greater global trade. For example, many car companies invest in production facilities in Mexico because that is a good base from which to export finished cars to many other countries.
This is the first of four chapters that deal with the global trade and investment environment. In this chapter, we focus on the theoretical foundations of trade policy. We will also look at what the economic evidence tells us about the relationship between trade policies and economic growth. In Chapter 7, we chart the development of the world trading system, discuss different aspects of trade policy, and look at how trade policy is managed by national and global institutions. In Chapter 8, we discuss the reasons for foreign direct investment and the government policies adopted to manage foreign investment. In Chapter 9, we look at the reasons for creating trading blocks such as the European Union and NAFTA, and we discuss how these transnational agreements have worked out in practice. By the time you have finished these four chapters, you should have a very solid understanding of the international trade and investment environment, and you should be able to analyze in depth and critique the policy positions taken both by free traders and by people who share Donald Trump’s views. You will also understand the extremely important impact that trade and investment policies have upon the practice of international business.
An Overview of Trade Theory We open this chapter with a discussion of mercantilism. Propagated in the sixteenth and seventeenth centuries, mercantilism advocated that countries should simultaneously encourage exports and discourage imports. Although mercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the trade policies of many
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countries. Indeed, some have argued that Donald Trump espouses mercantilist views. Next, we look at Adam Smith’s theory of absolute advantage. Proposed in 1776, Smith’s theory was the first to explain why unrestricted free trade is beneficial to a country. Free trade refers to a situation in which a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country. Smith argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exports. His arguments imply that such a laissez-faire stance toward trade was in the best interests of a country. Building on Smith’s work are two additional theories that we review. One is the theory of comparative advantage, advanced by the nineteenth-century English economist David Ricardo. This theory is the intellectual basis of the modern argument for unrestricted free trade. In the twentieth century, Ricardo’s work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher–Ohlin theory.
THE BENEFITS OF TRADE
LO 6-1 Understand why nations trade with each other.
The great strength of the theories of Smith, Ricardo, and Heckscher–Ohlin is that they identify with precision the specific benefits of international trade. Common sense suggests that some international trade is beneficial. For example, nobody would suggest that Iceland should grow its own oranges. Iceland can benefit from trade by exchanging some of the products that it can produce at a low cost (fish) for some products that it cannot produce at all (oranges). Thus, by engaging in international trade, Icelanders are able to add oranges to their diet of fish.
The theories of Smith, Ricardo, and Heckscher–Ohlin go beyond this commonsense notion, however, to show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. This is a difficult concept for people to grasp. For example, many people in the United States believe that American consumers should buy products made in the United States by American companies whenever possible to help save American jobs from foreign competition. The same kind of nationalistic sentiments can be observed in many other countries.
However, the theories of Smith, Ricardo, and Heckscher–Ohlin tell us that a country’s economy may gain if its citizens buy certain products from other nations that could be produced at home. The gains arise because international trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, while importing products that can be produced more efficiently in other countries.
Did You Know? Did you know that sugar prices in the United States are much higher than sugar prices in the rest of the world? Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
Thus, it may make sense for the United States to specialize in the production and export of commercial jet aircraft because the efficient production of commercial jet aircraft requires resources that are abundant in the United States, such as a highly skilled labor force and cutting- edge technological know-how. On the other hand, it may make sense for the United States to import textiles from Bangladesh because the efficient production of textiles requires a relatively cheap labor force—and cheap labor is not abundant in the United States.
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Trade Tutorials
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In this chapter, we discuss benefits and costs associated with free trade, discuss the benefits of international trade, and explain the pattern of international trade in today’s world economy. The general idea is that international trade theories explain why it can be beneficial for a country to engage in trade across country borders, even though countries are at different stages of development, have different product needs, and produce different types of products. International trade theory assumes that countries—through their governments, laws, and regulations— engage in more or less trade across borders. In reality, the vast majority of trade happens across borders by companies from different countries. As related to this chapter, check out globalEDGE™’s “trade tutorials” section, where lots of information, data, and tools are compiled related to trading internationally (globaledge.msu.edu/global-resources/trade-tutorials). The potpourri of trade resources includes export tutorials, online course modules, a glossary, a free trade agreement tariff tool, and much more. The glossary includes lots of terms related to trade. For example, “trade surplus” is defined as a situation in which a country’s exports exceeds its imports (i.e., it represents a net inflow of domestic currency from foreign markets). The opposite is called trade deficit and is considered a net outflow, but how is it really defined? The globalEDGE™ glossary can help.
Of course, this economic argument is often difficult for segments of a country’s population to accept. With their future threatened by imports, U.S. textile companies and their employees have tried hard to persuade the government to limit the importation of textiles by demanding quotas and tariffs. Although such import controls may benefit particular groups, such as textile businesses and their employees, the theories of Smith, Ricardo, and Heckscher–Ohlin suggest that the economy as a whole is hurt by such action. One of the key insights of international trade theory is that limits on imports are often in the interests of domestic producers but not domestic consumers.
THE PATTERN OF INTERNATIONAL TRADE
The theories of Smith, Ricardo, and Heckscher–Ohlin help explain the pattern of international trade that we observe in the world economy. Some aspects of the pattern are easy to understand. Climate and natural resource endowments explain why Ghana exports cocoa, Brazil exports coffee, Saudi Arabia exports oil, and China exports crawfish. However, much of the observed pattern of international trade is more difficult to explain. For example, why does Japan export automobiles, consumer electronics, and machine tools? Why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Bangladesh export garments? David Ricardo’s theory of comparative advantage offers an explanation in terms of international differences in labor productivity. The more sophisticated Heckscher–Ohlin theory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, and capital) are available in different countries and the proportions in which they are needed for producing particular goods. This explanation rests on the assumption that countries have varying endowments of the various factors of production. Tests of this theory, however, suggest that it is a less powerful explanation of real-world trade patterns than once thought.
One early response to the failure of the Heckscher–Ohlin theory to explain the observed pattern of international trade was the product life-cycle theory. Proposed by Raymond Vernon, this theory suggests that early in their life cycle, most new products are produced in and exported from the country in which they were developed. As a new product becomes widely accepted internationally, however, production starts in other countries. As a result, the theory suggests, the product may ultimately be exported back to the country of its original innovation.
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A Rolex Group logo sits on display above a luxury wristwatch store in Vienna, Austria.
©Bloomberg/Getty Images
In a similar vein, during the 1980s, economists such as Paul Krugman developed what has come to be known as the new trade theory. New trade theory (for which Krugman won the Nobel Prize in economics in 2008) stresses that in some cases, countries specialize in the production and export of particular products not because of underlying differences in factor endowments but because in certain industries the world market can support only a limited number of firms. (This is argued to be the case for the commercial aircraft industry.) In such industries, firms that enter the market first are able to build a competitive advantage that is subsequently difficult to challenge. Thus, the observed pattern of trade between nations may be due in part to the ability of firms within a given nation to capture first-mover advantages. The United States is a major exporter of commercial jet aircraft because American firms such as Boeing were first movers in the world market. Boeing built a competitive advantage that has subsequently been difficult for firms from countries with equally favorable factor endowments to challenge (although Europe’s Airbus has succeeded in doing that). In a work related to the new trade theory, Michael Porter developed a theory referred to as the theory of national competitive advantage. This attempts to explain why particular nations achieve international success in particular industries. In addition to factor endowments, Porter points out the importance of country factors such as domestic demand and domestic rivalry in explaining a nation’s dominance in the production and export of particular products.
TRADE THEORY AND GOVERNMENT POLICY
Although all these theories agree that international trade is beneficial to a country, they lack agreement in their recommendations for government policy. Mercantilism makes a case for government involvement in promoting exports and limiting imports (one could argue that Donald Trump seems to advocate such policies). The theories of Smith, Ricardo, and Heckscher–Ohlin form part of the case for unrestricted free trade. The argument for unrestricted free trade is that both import controls and export incentives (such as subsidies) are self-defeating and result in wasted resources. Both the new trade theory and Porter’s theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain export-oriented industries. We discuss the pros and cons of this argument, known as strategic trade policy, as well as the pros and cons of the argument for unrestricted free trade, in Chapter 7.
test PREP
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Mercantilism LO 6-2 Summarize the different theories explaining trade flows between nations.
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 outflow of gold and silver from those countries. The main tenet of mercantilism was that it was in a country’s best interests to maintain a trade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige, and power. As the English mercantilist writer Thomas Mun put it in 1630:
The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value.1
Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. The mercantilists saw no virtue in a large volume of trade. Rather, they recommended policies to maximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, while exports were subsidized.
The classical economist David Hume pointed out an inherent inconsistency in the mercantilist doctrine in 1752. According to Hume, if England had a balance-of-trade surplus with France (it exported more than it imported), the resulting inflow of gold and silver would swell the domestic money supply and generate inflation in England. In France, however, the outflow of gold and silver would have the opposite effect. France’s money supply would contract, and its prices would fall. This change in relative prices between France and England would encourage the French to buy fewer English goods (because they were becoming more expensive) and the English to buy more French goods (because they were becoming cheaper). The result would be a deterioration in the English balance of trade and an improvement in France’s trade balance, until the English surplus was eliminated. Hence, according to Hume, in the long run, no country could sustain a surplus on the balance of trade and so accumulate gold and silver as the mercantilists had envisaged.
The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in which a gain by one country results in a loss by another.) It was left to Adam Smith and David Ricardo to show the limitations of this approach and to demonstrate that trade is a positive-sum game, or a situation in which all countries can benefit. Despite this, the mercantilist doctrine is by no means dead. Donald Trump appears to advocate neo-mercantilist policies.2 Neo-mercantilists equate political power with economic power and economic power with a balance-of-trade surplus. Critics argue that several nations have adopted a neo-mercantilist strategy that is designed to simultaneously boost exports and limit imports.3 For example, critics charge that China long pursued a neo-mercantilist policy, deliberately keeping its currency value low against the U.S. dollar in order to sell more goods to the United States and other developed nations, and thus amass a trade surplus and foreign exchange reserves (see the accompanying Country Focus).
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c o u n t r y F O C U S
Is China Manipulating Its Currency in Pursuit of a Neo-Mercantilist Policy? China’s rapid rise in economic power has been built on export-led growth. For decades, the country’s exports have been growing faster than its imports. This has led some critics to claim that China is pursuing a neo-mercantilist policy, trying to amass record trade surpluses and foreign currency that will give it economic power over developed nations. By the end of 2014, its foreign exchange reserves exceeded $3.8 trillion, some 60 percent of which were held in U.S.-denominated assets such as U.S. Treasury bills. Observers worried that if China ever decided to sell its holdings of U.S. currency, that would depress the value of the dollar against other currencies and increase the price of imports into America.
America’s trade deficit with China has been a particular cause for concern. In 2017, this reached a record $375 billion. At the same time, China has long resisted attempts to let its currency float freely against the U.S. dollar. Many have claimed that China’s currency has been too cheap and that this keeps the prices of China’s goods artificially low, which fuels the country’s exports. China, the critics charge, is guilty of currency manipulation.
So is China manipulating the value of its currency to keep exports artificially cheap? The facts of the matter are less clear than the rhetoric. China actually started to allow the value of the yuan (China’s currency) to appreciate against the dollar in July 2005, albeit at a slow pace. In July 2005, one U.S. dollar purchased 8.11 yuan. By January 2014 one U.S. dollar purchased 6.05 yuan, which implied a 25 percent increase in the price of Chinese exports, not what one would expect from a country that was trying to keep the price of its exports low through currency manipulation.
Moreover, in 2015 and 2016, the rate of growth in China started to slow significantly. China’s stock market fell sharply, and capital started to leave the country, with investors selling yuan and buying U.S. dollars. To stop the yuan from declining in value against the U.S. dollar, China began to spend about $100 billion of its foreign exchange reserves every month to buy yuan on the open market. Far from allowing its currency to decline against the U.S. dollar, thereby giving a boost to its exports, China was trying to prop up its value, running down its foreign exchange reserves by $2 trillion in the process. This action seems inconsistent with the charges that the country is pursuing a neo-mercantilist policy by artificially depressing the value of its currency. In recognition of these developments, in late 2017 the U.S. Treasury Department declined to name China a currency manipulator and moderated its criticism of the country’s foreign exchange policies. On the other hand, The Treasury said that it remained concerned by the lack of progress in reducing China’s bilateral trade surplus with the United States.
Sources: S. H. Hanke, “Stop the Mercantilists,” Forbes, June 20, 2005, p. 164; G. Dyer and A. Balls, “Dollar Threat as China Signals Shift,” Financial Times, January 6, 2006; Richard Silk, “China’s Foreign Exchange Reserves Jump Again,” The Wall Street Journal, October 15, 2013; Terence Jeffrey, “U.S. Merchandise Trade Deficit with China Hit Record in 2015,” cnsnews.com, February 9, 2016; “Trump’s Chinese Currency Manipulation,” The Wall Street Journal, December 7, 2016; Elena Holodny, “The Treasury Department Backs Down on Some of Its Criticisms of China’s Currency Policies,” Business Insider, October 18, 2017; and Ana Swanson,“U.S.-China Trade Deficit Hits Record, Fueling Trade Fight,” The New York Times, February 6, 2018.
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Absolute Advantage LO 6-2 Summarize the different theories explaining trade flows between nations.
In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently. In his time, the English, by virtue of their superior manufacturing processes, were the world’s most efficient textile manufacturers. Due to the combination of favorable climate, good soils, and accumulated expertise, the French had the world’s most efficient wine industry. The English had an absolute advantage in the production of textiles, while the French had an absolute advantage in the production of wine. Thus, a country has an absolute advantage in the production of a product when it is more efficient than any other country at producing it.
According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for those produced by other countries. In Smith’s time, this suggested the English should specialize in the production of textiles, while the French should specialize in the production of wine. England could get all the wine it needed by selling its textiles to France and buying wine in exchange. Similarly, France could get all the textiles it needed by selling wine to England and buying textiles in exchange. Smith’s basic argument, therefore, is that a country should never produce goods at home that it can buy at a lower cost from other countries. Smith demonstrates that by specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade.
Consider the effects of trade between two countries, Ghana and South Korea. The production of any good (output) requires resources (inputs) such as land, labor, and capital. Assume that Ghana and South Korea both have the same amount of resources and that these resources can be used to produce either rice or cocoa. Assume further that 200 units of resources are available in each country. Imagine that in Ghana it takes 10 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between these two extremes. The different combinations that Ghana could produce are represented by the line GG′ in Figure 6.1. This is referred to as Ghana’s production possibility frontier (PPF). Similarly, imagine that in South Korea it takes 40 resources to produce 1 ton of cocoa and 10 resources to produce 1 ton of rice. Thus, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination between these two extremes. The different combinations available to South Korea are represented by the line KK′ in Figure 6.1, which is South Korea’s PPF. Clearly, Ghana has an absolute advantage in the production of cocoa. (More resources are needed to produce a ton of cocoa in South Korea than in Ghana.) By the same token, South Korea has an absolute advantage in the production of rice.
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6.1 FIGURE The theory of absolute advantage.
Now consider a situation in which neither country trades with any other. Each country devotes half its resources to the production of rice and half to the production of cocoa. Each country must also consume what it produces. Ghana would be able to produce 10 tons of cocoa and 5 tons of rice (point A in Figure 6.1), while South Korea would be able to produce 10 tons of rice and 2.5 tons of cocoa (point B in Figure 6.1). Without trade, the combined production of both countries would be 12.5 tons of cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons in Ghana and 10 tons in South Korea). If each country were to specialize in producing the good for which it had an absolute advantage and then trade with the other for the good it lacks, Ghana could produce 20 tons of cocoa, and South Korea could produce 20 tons of rice. Thus, by specializing, the production of both goods could be increased. Production of cocoa would increase from 12.5 tons to 20 tons, while production of rice would increase from 15 tons to 20 tons. The increase in production that would result from specialization is therefore 7.5 tons of cocoa and 5 tons of rice. Table 6.1 summarizes these figures.
6.1 TABLE Absolute Advantage and the Gains from Trade
Which Products Should Always Be Produced at Home?
One of the key insights of international trade theory is that limits on imports are often in the interests of domestic producers but not domestic consumers. 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
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are willing to pay. But what about the comparative advantage theory that was originally conceptualized by David Ricardo and then refined by Eli Heckscher and Bertil Ohlin? Comparative advantage theory argues that a country should consider not producing products that it can actually produce reasonably well if the country can produce something else even more efficiently. In reality, not a single country has stopped all production of products they produce less efficiently than some other country. The reason is that countries always engage in a strategic balancing act! They prefer to be as efficient as possible (engage in international trade when advantageous) while also being as self-sufficient as possible (produce inside their country). So, what types of products should always be produced in the home country and which products should always be considered for importing if other countries can produce them more efficiently?
By engaging in trade and swapping 1 ton of cocoa for 1 ton of rice, producers in both countries could consume more of both cocoa and rice. Imagine that Ghana and South Korea swap cocoa and rice on a one-to-one basis; that is, the price of 1 ton of cocoa is equal to the price of 1 ton of rice. If Ghana decided to export 6 tons of cocoa to South Korea and import 6 tons of rice in return, its final consumption after trade would be 14 tons of cocoa and 6 tons of rice. This is 4 tons more cocoa than it could have consumed before specialization and trade and 1 ton more rice. Similarly, South Korea’s final consumption after trade would be 6 tons of cocoa and 14 tons of rice. This is 3.5 tons more cocoa than it could have consumed before specialization and trade and 4 tons more rice. Thus, as a result of specialization and trade, output of both cocoa and rice would be increased, and consumers in both nations would be able to consume more. Thus, we can see that trade is a positive-sum game; it produces net gains for all involved.
Comparative Advantage LO 6-2 Summarize the different theories explaining trade flows between nations.
David Ricardo took Adam Smith’s theory one step further by exploring what might happen when one country has an absolute advantage in the production of all goods.4 Smith’s theory of absolute advantage suggests that such a country might derive no benefits from international trade. In his 1817 book Principles of Political Economy, Ricardo showed that this was not the case. According to Ricardo’s theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.5 While this may seem counterintuitive, the logic can be explained with a simple example.
Assume that Ghana is more efficient in the production of both cocoa and rice; that is, Ghana has an absolute advantage in the production of both products. In Ghana it takes 10 resources to produce 1 ton of cocoa and 13.33 resources to produce 1 ton of rice. Thus, given its 200 units of resources, Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or any combination in between on its PPF (the line GG′ in Figure 6.2). In South Korea, it takes 40 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, South Korea can produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or any combination on its PPF (the line KK′ in Figure 6.2). Again assume that without trade, each country uses half its resources to produce rice and half to produce cocoa. Thus, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice (point A in Figure 6.2), while South Korea will produce 2.5 tons of cocoa and 5 tons of rice (point B in Figure 6.2).
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6.2 FIGURE The theory of comparative advantage.
In light of Ghana’s absolute advantage in the production of both goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it has a comparative advantage only in the production of cocoa: Ghana can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice.
Without trade the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade each country must consume what it produces. By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods.
THE GAINS FROM TRADE
Imagine that Ghana exploits its comparative advantage in the production of cocoa to increase its output from 10 tons to 15 tons. 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.
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6.2 TABLE Comparative Advantage and the Gains from Trade
Not only is output higher, but both countries also can now benefit from trade. If Ghana and South Korea swap cocoa and rice on a one-to-one basis, with both countries choosing to exchange 4 tons of their export for 4 tons of the import, both countries are able to consume more cocoa and rice than they could before specialization and trade (see Table 6.2). 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 ton more than it had before specialization. Similarly, after swapping 4 tons of rice with Ghana, South Korea still ends up with 6 tons of rice, which is more than it had before specialization. In addition, the 4 tons of cocoa it receives in exchange is 1.5 tons more than it produced before trade. Thus, consumption of cocoa and rice can increase in both countries as a result of specialization and trade.
The basic message of the theory of comparative advantage is that potential world production is greater with unrestricted free trade than it is with restricted trade. Ricardo’s theory suggests that consumers in all nations can consume more if there are no restrictions on trade. This occurs even in countries that lack an absolute advantage in the production of any good. In other words, to an even greater degree than the theory of absolute advantage, the theory of comparative advantage suggests that trade is a positive-sum game in which all countries that participate realize economic gains. This theory provides a strong rationale for encouraging free trade. So powerful is Ricardo’s theory that it remains a major intellectual weapon for those who argue for free trade.
QUALIFICATIONS AND ASSUMPTIONS
LO 6-3 Recognize why many economists believe that unrestricted free trade between
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nations will raise the economic welfare of countries that participate in a free trade system.
The conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple model. Our simple model includes many unrealistic assumptions:
1. We have assumed a simple world in which there are only two countries and two goods. In the real world, there are many countries and many goods.
2. We have assumed away transportation costs between countries. 3. We have assumed away differences in the prices of resources in different countries. We
have said nothing about exchange rates, simply assuming that cocoa and rice could be swapped on a one-to-one basis.
4. We have assumed that resources can move freely from the production of one good to another within a country. In reality, this is not always the case.
5. We have assumed constant returns to scale; that is, that specialization by Ghana or South Korea has no effect on the amount of resources required to produce one ton of cocoa or rice. In reality, both diminishing and increasing returns to specialization exist. The amount of resources required to produce a good might decrease or increase as a nation specializes in production of that good.
6. We have assumed that each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resources. This static assumption makes no allowances for the dynamic changes in a country’s stock of resources and in the efficiency with which the country uses its resources that might result from free trade.
7. We have assumed away the effects of trade on income distribution within a country.
Given these assumptions, can the conclusion that free trade is mutually beneficial be extended to the real world of many countries, many goods, positive transportation costs, volatile exchange rates, immobile domestic resources, nonconstant returns to specialization, and dynamic changes? Although a detailed extension of the theory of comparative advantage is beyond the scope of this book, economists have shown that the basic result derived from our simple model can be generalized to a world composed of many countries producing many different goods.6 Despite the shortcomings of the Ricardian model, research suggests that the basic proposition that countries will export the goods that they are most efficient at producing is borne out by the data.7
However, once all the assumptions are dropped, the case for unrestricted free trade, while still positive, has been argued by some economists associated with the “new trade theory” to lose some of its strength.8 We return to this issue later in this chapter and in the next when we discuss the new trade theory. In a recent and widely discussed analysis, the Nobel Prize–winning economist Paul Samuelson argued that contrary to the standard interpretation, in certain circumstances the theory of comparative advantage predicts that a rich country might actually be worse off by switching to a free trade regime with a poor nation.9 We consider Samuelson’s critique in the next section.
EXTENSIONS OF THE RICARDIAN MODEL
Let us explore the effect of relaxing three of the assumptions identified earlier in the simple comparative advantage model. Next, we relax the assumptions that resources move freely from the production of one good to another within a country, that there are constant returns to scale, and that trade does not change a country’s stock of resources or the efficiency with which those resources are utilized.
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Immobile Resources In our simple comparative model of Ghana and South Korea, we assumed that producers (farmers) could easily convert land from the production of cocoa to rice and vice versa. While this assumption may hold for some agricultural products, resources do not always shift quite so easily from producing one good to another. A certain amount of friction is involved. For example, embracing a free trade regime for an advanced economy such as the United States often implies that the country will produce less of some labor-intensive goods, such as textiles, and more of some knowledge-intensive goods, such as computer software or biotechnology products. Although the country as a whole will gain from such a shift, textile producers will lose. A textile worker in South Carolina is probably not qualified to write software for Microsoft. Thus, the shift to free trade may mean that she becomes unemployed or has to accept another less attractive job, such as working at a fast-food restaurant.
Resources do not always move easily from one economic activity to another. The process creates friction and human suffering too. While the theory predicts that the benefits of free trade outweigh the costs by a significant margin, this is of cold comfort to those who bear the costs. Accordingly, political opposition to the adoption of a free trade regime typically comes from those whose jobs are most at risk. In the United States, for example, textile workers and their unions have long opposed the move toward free trade precisely because this group has much to lose from free trade. Governments often ease the transition toward free trade by helping retrain those who lose their jobs as a result. The pain caused by the movement toward a free trade regime is a short-term phenomenon, while the gains from trade once the transition has been made are both significant and enduring.
Diminishing Returns The simple comparative advantage model developed above assumes constant returns to specialization. By constant returns to specialization we mean the units of resources required to produce a good (cocoa or rice) are assumed to remain constant no matter where one is on a country’s production possibility frontier (PPF). Thus, we assumed that it always took Ghana 10 units of resources to produce 1 ton of cocoa. However, it is more realistic to assume diminishing returns to specialization. Diminishing returns to specialization occur when more units of resources are required to produce each additional unit. While 10 units of resources may be sufficient to increase Ghana’s output of cocoa from 12 tons to 13 tons, 11 units of resources may be needed to increase output from 13 to 14 tons, 12 units of resources to increase output from 14 tons to 15 tons, and so on. Diminishing returns imply a convex PPF for Ghana (see Figure 6.3), rather than the straight line depicted in Figure 6.2.
6.3 FIGURE Ghana’s PPF under diminishing returns.
It is more realistic to assume diminishing returns for two reasons. First, not all resources are
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of the same quality. As a country tries to increase its output of a certain good, it is increasingly likely to draw on more marginal resources whose productivity is not as great as those initially employed. The result is that it requires ever more resources to produce an equal increase in output. For example, some land is more productive than other land. As Ghana tries to expand its output of cocoa, it might have to utilize increasingly marginal land that is less fertile than the land it originally used. As yields per acre decline, Ghana must use more land to produce 1 ton of cocoa.
A second reason for diminishing returns is that different goods use resources in different proportions. For example, imagine that growing cocoa uses more land and less labor than growing rice and that Ghana tries to transfer resources from rice production to cocoa production. The rice industry will release proportionately too much labor and too little land for efficient cocoa production. To absorb the additional resources of labor and land, the cocoa industry will have to shift toward more labor-intensive methods of production. The effect is that the efficiency with which the cocoa industry uses labor will decline, and returns will diminish.
Diminishing returns show that it is not feasible for a country to specialize to the degree suggested by the simple Ricardian model outlined earlier. Diminishing returns to specialization suggest that the gains from specialization are likely to be exhausted before specialization is complete. In reality, most countries do not specialize, but instead produce a range of goods. However, the theory predicts that it is worthwhile to specialize until that point where the resulting gains from trade are outweighed by diminishing returns. Thus, the basic conclusion that unrestricted free trade is beneficial still holds, although because of diminishing returns, the gains may not be as great as suggested in the constant returns case.
LO 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.
Dynamic Effects and Economic Growth The simple comparative advantage model assumed that trade does not change a country’s stock of resources or the efficiency with which it utilizes those resources. This static assumption makes no allowances for the dynamic changes that might result from trade. If we relax this assumption, it becomes apparent that opening an economy to trade is likely to generate dynamic gains of two sorts.10 First, free trade might increase a country’s stock of resources as increased supplies of labor and capital from abroad become available for use within the country. For example, this has been occurring in eastern Europe since the early 1990s, with many western businesses investing significant capital in the former communist countries.
Second, free trade might also increase the efficiency with which a country uses its resources. Gains in the efficiency of resource utilization could arise from a number of factors. For example, economies of large-scale production might become available as trade expands the size of the total market available to domestic firms. Trade might make better technology from abroad available to domestic firms; better technology can increase labor productivity or the productivity of land. (The so-called green revolution had this effect on agricultural outputs in developing countries.) Also, opening an economy to foreign competition might stimulate domestic producers to look for ways to increase their efficiency. Again, this phenomenon has arguably been occurring in the once-protected markets of eastern Europe, where many former state monopolies have had to increase the efficiency of their operations to survive in the competitive world market.
Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized will cause a country’s PPF to shift outward. This is illustrated in Figure 6.4, where the shift from PPF1 to PPF2 results from the dynamic gains that arise from free trade.
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As a consequence of this outward shift, the country in Figure 6.4 can produce more of both goods than it did before introduction of free trade. The theory suggests that opening an economy to free trade not only results in static gains of the type discussed earlier but also results in dynamic gains that stimulate economic growth. If this is so, then one might think that the case for free trade becomes stronger still, and in general it does. However, as noted, 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.
6.4 FIGURE The influence of free trade on the PPF.
Trade, Jobs and Wages: The Samuelson Critique Paul Samuelson’s critique looks at what happens when a rich country—the United States—enters into a free trade agreement with a poor country—China—that rapidly improves its productivity after the introduction of a free trade regime (i.e., there is a dynamic gain in the efficiency with which resources are used in the poor country). Samuelson’s model suggests that in such cases, the lower prices that U.S. consumers pay for goods imported from China following the introduction of a free trade regime may not be enough to produce a net gain for the U.S. economy if the dynamic effect of free trade is to lower real wage rates in the United States. As he stated in a New York Times interview, “Being able to purchase groceries 20 percent cheaper at Wal-Mart (due to international trade) does not necessarily make up for the wage losses (in America).”11
Samuelson was particularly concerned about the ability to offshore service jobs that traditionally were not internationally mobile, such as software debugging, call-center jobs, accounting jobs, and even medical diagnosis of MRI scans (see the accompanying Country Focus for details). Advances in communications technology since the development of the World Wide Web in the early 1990s have made this possible, effectively expanding the labor market for these jobs to include educated people in places such as India, the Philippines, and China. When coupled with rapid advances in the productivity of foreign labor due to better education, the effect on middle-class wages in the United States, according to Samuelson, may be similar to mass inward migration into the country: It will lower the market clearing wage rate, perhaps by enough to outweigh the positive benefits of international trade.
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Moving U.S. White-Collar Jobs Offshore Economists have long argued that free trade produces gains for all countries that participate in a free trading system. As globalization continues to sweep through the U.S. economy, many people are wondering if this is true. During the 1980s and 1990s, free trade was associated with the movement of low-skill, blue-collar manufacturing jobs out of rich countries such as the United States and toward low- wage countries—textiles to Costa Rica, athletic shoes to the Philippines, steel to Brazil, electronic products to Thailand, and so on. While many observers bemoaned the “hollowing out” of U.S. manufacturing, economists stated that high-skill and high-wage white-collar jobs associated with the knowledge-based economy would stay in the United States. Computers might be assembled in Thailand, so the argument went, but they would continue to be designed in Silicon Valley by highly skilled U.S. engineers, and software applications would be written in the United States by programmers at Apple, Microsoft, Adobe, Oracle, and the like.
Developments over the past several decades have people questioning this assumption. Many American companies have been moving white-collar, knowledge-based jobs to developing nations where they can be performed for a fraction of the cost. For example, a few years ago Bank of America cut nearly 5,000 jobs from its 25,000-strong, U.S.-based information technology workforce. Some of these jobs were transferred to India, where work that costs $100 an hour in the United States could be done for $20 an hour. One beneficiary of Bank of America’s downsizing is Infosys Technologies Ltd., a Bangalore, India, information technology firm where 250 engineers now develop information technology applications for the bank. Other Infosys employees are busy processing home loan applications for U.S. mortgage companies. Nearby in the offices of another Indian firm, Wipro Ltd., radiologists interpret 30 CT scans a day for Massachusetts General Hospital that are sent over the Internet. At yet another Bangalore business, engineers earn $10,000 a year designing leading-edge semiconductor chips for Texas Instruments. Nor is India the only beneficiary of these changes.
Some architectural work also is being outsourced to lower-cost locations. Flour Corp., a Texas-based construction company, employs engineers and drafters in the Philippines, Poland, and India to turn layouts of industrial facilities into detailed specifications. For a Saudi Arabian chemical plant Flour designed, 200 young engineers based in the Philippines earning less than $3,000 a year collaborated in real time over the Internet with elite U.S. and British engineers who make up to $100,000 a year. Why did Flour do this? According to the company, the answer was simple. Doing so reduces the prices of a project by 15 percent, giving the company a cost-based competitive advantage in the global market for construction design. Also troubling for future job growth in the United States, some high-tech start-ups are outsourcing significant work right from inception. For example, Zoho Corporation, a California- based start-up offering online web applications for small businesses, has about 20 employees in the United States and more than 1,000 in India!
Employees walk below the Infosys Ltd. logo at the company’s campus in Electronics City in Bangalore, India.
©Vivek Prakash/Bloomberg/Getty Images
Sources: P. Engardio, A. Bernstein, and M. Kripalani, “Is Your Job Next?” BusinessWeek, February 3, 2003, pp. 50–60; “America’s Pain, India’s Gain,” 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
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Wall Street Journal, August 16, 2010, p. 6; and J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” The Wall Street Journal, January 18, 2012, p. B1.
Having said this, it should be noted that Samuelson concedes that free trade has historically benefited rich countries (as data discussed later seem to confirm). Moreover, he notes that introducing protectionist measures (e.g., trade barriers) to guard against the theoretical possibility that free trade may harm the United States in the future may produce a situation that is worse than the disease they are trying to prevent. To quote Samuelson: “Free trade may turn out pragmatically to be still best for each region in comparison to lobbyist-induced tariffs and quotas which involve both a perversion of democracy and non-subtle deadweight distortion losses.”12
One notable recent study by MIT economist David Autor and his associates found evidence in support of Samuelson’s thesis. The study has been widely quoted in the media and cited by politicians. Autor and his associates looked at every county in the United States for its manufacturers’ exposure to competition from China.13 The researchers found that regions most exposed to China tended not only to lose more manufacturing jobs, but also to see overall employment decline. Areas with higher exposure to China also had larger increases in workers receiving unemployment insurance, food stamps, and disability payments. The costs to the economy from the increased government payments amounted to two-thirds of the gains from trade with China. In other words, many of the ways trade with China has helped the United States—such as providing inexpensive goods to U.S. consumers—have been wiped out. Even so, like Samuelson the authors of this study argued that in the long run, free trade is a good thing. They note, however, that the rapid rise of China has resulted in some large adjustment costs that, in the short run, significantly reduce the gains from trade.
Other economists have dismissed Samuelson’s fears.14 While not questioning his analysis, they note that as a practical matter, developing nations are unlikely to be able to upgrade the skill level of their workforce rapidly enough to give rise to the situation in Samuelson’s model. In other words, they will quickly run into diminishing returns. However, such rebuttals are at odds with data suggesting that Asian countries are rapidly upgrading their educational systems. For example, about 56 percent of the world’s engineering degrees awarded in 2008 were in Asia, compared with 4 percent in the United States!15
Evidence for the Link between Trade and Growth Many economic studies have looked at the relationship between trade and economic growth.16 In general, these studies suggest that as predicted by the standard theory of comparative advantage, countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade. Jeffrey Sachs and Andrew Warner created a measure of how “open” to international trade an economy was and then looked at the relationship between “openness” and economic growth for a sample of more than 100 countries from 1970 to 1990.17 Among other findings, they reported
We find a strong association between openness and growth, both within the group of developing and the group of developed countries. Within the group of developing countries, the open economies grew at 4.49 percent per year, and the closed economies grew at 0.69 percent per year. Within the group of developed economies, the open economies grew at 2.29 percent per year, and the closed economies grew at 0.74 percent per year.18
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
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experienced, on average, increases in their annual growth rates of 1.5–2.0 percent compared to preliberalization times.19 An exhaustive survey of 61 studies published between 1967 and 2009 concluded: “The macroeconomic evidence provides dominant support for the positive and significant effects of trade on output and growth.”20
The message seems clear: Adopt an open economy and embrace free trade, and your nation will be rewarded with higher economic growth rates. Higher growth will raise income levels and living standards. This last point has been confirmed by a study that looked at the relationship between trade and growth in incomes. The study, undertaken by Jeffrey Frankel and David Romer, found that on average, a 1 percentage point increase in the ratio of a country’s trade to its gross domestic product increases income per person by at least 0.5 percent.21 For every 10 percent increase in the importance of international trade in an economy, average income levels will rise by at least 5 percent. Despite the short-term adjustment costs associated with adopting a free trade regime, which can be significant, trade would seem to produce greater economic growth and higher living standards in the long run, just as the theory of Ricardo would lead us to expect.22
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Heckscher–Ohlin Theory LO 6-2 Summarize the different theories explaining trade flows between nations.
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 depends on how productively it uses its resources. Ricardo stressed labor productivity and argued that differences in labor productivity between nations underlie the notion of comparative advantage. Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of comparative advantage. They argued that comparative advantage arises from differences in national factor endowments.23 By factor endowments they meant the extent to which a country is endowed with such resources as land, labor, and capital. Nations have varying factor endowments, and different factor endowments explain differences in factor costs; specifically, the more abundant a factor, the lower its cost. The Heckscher–Ohlin theory predicts that countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. Thus, the Heckscher–Ohlin theory attempts to explain the pattern of international trade that we observe in the world economy. Like Ricardo’s theory, the Heckscher–Ohlin theory argues that free trade is beneficial. Unlike Ricardo’s theory, however, the Heckscher–Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments, rather than differences in productivity.
The Heckscher–Ohlin theory has commonsense appeal. For example, the United States has long been a substantial exporter of agricultural goods, reflecting in part its unusual abundance of arable land. In contrast, China has excelled in the export of goods produced in labor-intensive manufacturing industries. This reflects China’s relative abundance of low-cost labor. The United States, which lacks abundant low-cost labor, has been a primary importer of these goods. Note that it is relative, not absolute, endowments that are important; a country may have larger
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absolute amounts of land and labor than another country but be relatively abundant in one of them.
THE LEONTIEF PARADOX
The Heckscher–Ohlin theory has been one of the most influential theoretical ideas in international economics. Most economists prefer the Heckscher–Ohlin theory to Ricardo’s theory because it makes fewer simplifying assumptions. Because of its influence, the theory has been subjected to many empirical tests. Beginning with a famous study published in 1953 by Wassily Leontief (winner of the Nobel Prize in economics in 1973), many of these tests have raised questions about the validity of the Heckscher–Ohlin theory.24 Using the Heckscher–Ohlin theory, Leontief postulated that because the United States was relatively abundant in capital compared to other nations, the United States would be an exporter of capital-intensive goods and an importer of labor-intensive goods. To his surprise, however, he found that U.S. exports were less capital intensive than U.S. imports. Because this result was at variance with the predictions of the theory, it has become known as the Leontief paradox.
No one is quite sure why we observe the Leontief paradox. One possible explanation is that the United States has a special advantage in producing new products or goods made with innovative technologies. Such products may be less capital intensive than products whose technology has had time to mature and become suitable for mass production. Thus, the United States may be exporting goods that heavily use skilled labor and innovative entrepreneurship, such as computer software, while importing heavy manufacturing products that use large amounts of capital. Some empirical studies tend to confirm this.25 Still, tests of the Heckscher– Ohlin theory using data for a large number of countries tend to confirm the existence of the Leontief paradox.26
Should Factor Endowments or Productivity Drive Trade?
Ricardo’s theory of trade suggests that it makes sense for a country to specialize in production of those products that it produces most efficiently and to buy the products that it produces less efficiently from other countries, even if this means that the country is buying products that in reality it could produce more efficiently itself. This means that Ricardo showed that a country can derive advantages by trade even though it has an absolute advantage in producing all products. The Heckscher-Ohlin theory of trade suggests that comparative advantage for a country arises from differences in national factor endowments (i.e., the extent to which a country is endowed with such resources as land, labor, and capital). Ricardo’s argument focused on relative productivity, while Heckscher-Ohlin’s argument focused on having important resources. If you can only have one of the two—better relative productivity or lots of resources such as land, labor, and capital—which would you prefer, and why?
This leaves economists with a difficult dilemma. They prefer the Heckscher–Ohlin theory on theoretical grounds, but it is a relatively poor predictor of real-world international trade patterns. On the other hand, the theory they regard as being too limited, Ricardo’s theory of comparative advantage, actually predicts trade patterns with greater accuracy. The best solution to this dilemma may be to return to the Ricardian idea that trade patterns are largely driven by international differences in productivity. Thus, one might argue that the United States exports commercial aircraft and imports textiles not because its factor endowments are especially suited to aircraft manufacture and not suited to textile manufacture, but because the United States is
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Page 167relatively 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.27 Thus, Japan’s success in exporting automobiles from the 1970s onward has been based not only on the relative abundance of capital but also on its development of innovative manufacturing technology that enabled it to achieve higher productivity levels in automobile production than other countries that also had abundant capital. Empirical work suggests that this theoretical explanation may be correct.28 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.
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The Product Life-Cycle Theory LO 6-2 Summarize the different theories explaining trade flows between nations.
Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s.29 Vernon’s theory was based on the observation that for most of the twentieth century, a very large proportion of the world’s new products had been developed by U.S. firms and sold first in the U.S. market (e.g., mass-produced automobiles, televisions, instant cameras, photocopiers, personal computers, and semiconductor chips). To explain this, Vernon argued that the wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new consumer products. In addition, the high cost of U.S. labor gave U.S. firms an incentive to develop cost- saving process innovations.
Just because a new product is developed by a U.S. firm and first sold in the U.S. market, it does not follow that the product must be produced in the United States. It could be produced abroad at some low-cost location and then exported back into the United States. However, Vernon argued that most new products were initially produced in America. Apparently, the pioneering firms believed it was better to keep production facilities close to the market and to the firm’s center of decision making, given the uncertainty and risks inherent in introducing new products. Also, the demand for most new products tends to be based on nonprice factors. Consequently, firms can charge relatively high prices for new products, which obviates the need to look for low-cost production sites in other countries.
Vernon went on to argue that early in the life cycle of a typical new product, while demand is starting to grow rapidly in the United States, demand in other advanced countries is limited to high-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
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facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States.
As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon. As this occurs, cost considerations start to play a greater role in the competitive process. Producers based in advanced countries where labor costs are lower than in the United States (e.g., Italy and Spain) might now be able to export to the United States. If cost pressures become intense, the process might not stop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated once more, as developing countries (e.g., Thailand) begin to acquire a production advantage over advanced countries. Thus, the locus of global production initially switches from the United States to other advanced nations and then from those nations to developing countries.
The consequence of these trends for the pattern of world trade is that over time, the United States switches from being an exporter of the product to an importer of the product as production becomes concentrated in lower-cost foreign locations.
PRODUCT LIFE-CYCLE THEORY IN THE TWENTY- FIRST CENTURY
Historically, the product life-cycle theory seems to be an accurate explanation of international trade patterns. Consider photocopiers: The product was first developed in the early 1960s by Xerox in the United States and sold initially to U.S. users. Originally, Xerox exported photocopiers from the United States, primarily to Japan and the advanced countries of Western Europe. As demand began to grow in those countries, Xerox entered into joint ventures to set up production in Japan (Fuji-Xerox) and Great Britain (Rank-Xerox). In addition, once Xerox’s patents on the photocopier process expired, other foreign competitors began to enter the market (e.g., Canon in Japan and Olivetti in Italy). As a consequence, exports from the United States declined, and U.S. users began to buy some photocopiers from lower-cost foreign sources, particularly Japan. More recently, Japanese companies found that manufacturing costs are too high in their own country, so they have begun to switch production to developing countries such as Thailand. Thus, initially the United States and now other advanced countries (e.g., Japan and Great Britain) have switched from being exporters of photocopiers to importers. This evolution in the pattern of international trade in photocopiers is consistent with the predictions of the product life-cycle theory that mature industries tend to go out of the United States and into low- cost assembly locations.
However, the product life-cycle theory is not without weaknesses. Viewed from an Asian or European perspective, Vernon’s argument that most new products are developed and introduced in the United States seems ethnocentric and dated. Although it may be true that during U.S. dominance of the global economy (from 1945 to 1975), most new products were introduced in the United States, there have always been important exceptions. These exceptions appear to have become more common in recent years. Many new products are now first introduced in Japan (e.g., video-game consoles) or South Korea (e.g., Samsung smartphones). Moreover, with the increased globalization and integration of the world economy discussed in Chapter 1, an increasing number of new products (e.g., tablet computers, smartphones, and digital cameras) are now introduced simultaneously in the United States and many European and Asian nations. This may be accompanied by globally dispersed production, with particular components of a new product being produced in those locations around the globe where the mix of factor costs and skills is most favorable (as predicted by the theory of comparative advantage). In sum, although Vernon’s theory may be useful for explaining the pattern of international trade during
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the period of American global dominance, its relevance in the modern world seems more limited.
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New Trade Theory LO 6-2 Summarize the different theories explaining trade flows between nations.
The new trade theory began to emerge in the 1970s when a number of economists pointed out that the ability of firms to attain economies of scale might have important implications for international trade.30 Economies of scale are unit cost reductions associated with a large scale of output. Economies of scale have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipment. Economies of scale are a major source of cost reductions in many industries, from computer software to automobiles and from pharmaceuticals to aerospace. For example, Microsoft realizes economies of scale by spreading the fixed costs of developing new versions of its Windows operating system, which runs to about $10 billion, over the 2 billion or so personal computers on which each new system is ultimately installed. Similarly, automobile companies realize economies of scale by producing a high volume of automobiles from an assembly line where each employee has a specialized task.
New trade theory makes two important points: First, through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average cost of those goods. Second, in those industries in which the output required to attain economies of scale represents a significant proportion of total world demand, the global market may be able to support only a small number of enterprises. 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
LO 6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.
Imagine first a world without trade. In industries where economies of scale are important, both the variety of goods that a country can produce and the scale of production are limited by the size of the market. If a national market is small, there may not be enough demand to enable producers to realize economies of scale for certain products. Accordingly, those products may not be produced, thereby limiting the variety of products available to consumers. Alternatively, they may be produced but at such low volumes that unit costs and prices are considerably higher than they might be if economies of scale could be realized.
Now consider what happens when nations trade with each other. Individual national markets are combined into a larger world market. As the size of the market expands due to trade, individual firms may be able to better attain economies of scale. The implication, according to
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new trade theory, is that each nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods; thus, trade offers an opportunity for mutual gain even when countries do not differ in their resource endowments or technology.
Suppose there are two countries, each with an annual market for 1 million automobiles. By trading with each other, these countries can create a combined market for 2 million cars. In this combined market, due to the ability to better realize economies of scale, more varieties (models) of cars can be produced, and cars can be produced at a lower average cost, than in either market alone. For example, demand for a sports car may be limited to 55,000 units in each national market, while a total output of at least 100,000 per year may be required to realize significant scale economies. Similarly, demand for a minivan may be 80,000 units in each national market, and again a total output of at least 100,000 per year may be required to realize significant scale economies. Faced with limited domestic market demand, firms in each nation may decide not to produce a sports car, because the costs of doing so at such low volume are too great. Although they may produce minivans, the cost of doing so will be higher, as will prices, than if significant economies of scale had been attained. Once the two countries decide to trade, however, a firm in one nation may specialize in producing sports cars, while a firm in the other nation may produce minivans. The combined demand for 110,000 sports cars and 160,000 minivans allows each firm to realize scale economies. Consumers in this case benefit from having access to a product (sports cars) that was not available before international trade and from the lower price for a product (minivans) that could not be produced at the most efficient scale before international trade. Trade is thus mutually beneficial because it allows the specialization of production, the realization of scale economies, the production of a greater variety of products, and lower prices.
Can We Continue to Rely on Economies of Scale?
Economies of scale are unit cost reductions associated with a large scale of output. As we discuss in the text, economies of scale have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized employees and equipment. Economies of scale have been a major source of cost reductions in many industries—from computer software to automobiles and from pharmaceuticals to aerospace. But some of these economies of scale advantages were realized when production platforms for computers, automobiles, and so on were used for years and spread across large numbers of customers. With more and more innovations coming on the market faster and faster every year and more and more customers wanting customized products (even if the customization is small), how can companies continue to rely on economies of scale as a strategic advantage? Will large, mass market–type companies that are selling large quantities of specific products always have economies of scale advantages vis-à-vis small and medium-sized companies?
ECONOMIES OF SCALE, FIRST-MOVER ADVANTAGES, AND THE PATTERN OF TRADE
A second theme in new trade theory is that the pattern of trade we observe in the world economy may be the result of economies of scale and first-mover advantages. First-mover advantages are the economic and strategic advantages that accrue to early entrants into an industry.31 The ability to capture scale economies ahead of later entrants, and thus benefit from a lower cost
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structure, is an important first-mover advantage. New trade theory argues that for those products where economies of scale are significant and represent a substantial proportion of world demand, the first movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match. Thus, the pattern of trade that we observe for such products may reflect first-mover advantages. Countries may dominate in the export of certain goods because economies of scale are important in their production and because firms located in those countries were the first to capture scale economies, giving them a first-mover advantage.
For example, consider the commercial aerospace industry. In aerospace, there are substantial scale economies that come from the ability to spread the fixed costs of developing a new jet aircraft over a large number of sales. It has cost Airbus some $15 billion to develop its superjumbo jet, the 550-seat A380. To recoup those costs and break even, Airbus will have to sell at least 250 A380 planes. If Airbus can sell more than 350 A380 planes, it will apparently be a profitable venture. Total demand over the next 20 years for this class of aircraft is estimated to be between 400 and 600 units. Thus, the global market can probably profitably support only one producer of jet aircraft in the superjumbo category. It follows that the European Union might come to dominate in the export of very large jet aircraft, primarily because a European-based firm, Airbus, was the first to produce a superjumbo jet aircraft and realize scale economies. Other potential producers, such as Boeing, might be shut out of the market because they will lack the scale economies that Airbus will enjoy. By pioneering this market category, Airbus may have captured a first-mover advantage based on scale economies that will be difficult for rivals to match, and that will result in the European Union becoming the leading exporter of very large jet aircraft.
IMPLICATIONS OF NEW TRADE THEORY
New trade theory has important implications. The theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology. Trade allows a nation to specialize in the production of certain products, attaining scale economies and lowering the costs of producing those products, while buying products that it does not produce from other nations that specialize in the production of other products. By this mechanism, the variety of products available to consumers in each nation is increased, while the average costs of those products should fall, as should their price, freeing resources to produce other goods and services.
The theory also suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good. Because they are able to gain economies of scale, the first movers in an industry may get a lock on the world market that discourages subsequent entry. First-movers’ ability to benefit from increasing returns creates a barrier to entry. In the commercial aircraft industry, the fact that Boeing and Airbus are already in the industry and have the benefits of economies of scale discourages new entry and reinforces the dominance of America and Europe in the trade of midsize and large jet aircraft. This dominance is further reinforced because global demand may not be sufficient to profitably support another producer of midsize and large jet aircraft in the industry. So although Japanese firms might be able to compete in the market, they have decided not to enter the industry but to ally themselves as major subcontractors with primary producers (e.g., Mitsubishi Heavy Industries is a major subcontractor for Boeing on the 777 and 787 programs).
New trade theory is at variance with the Heckscher–Ohlin theory, which suggests a country will predominate in the export of a product when it is particularly well endowed with those factors used intensively in its manufacture. New trade theorists argue that the United States is a major exporter of commercial jet aircraft not because it is better endowed with the factors of
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production required to manufacture aircraft, but because one of the first movers in the industry, Boeing, was a U.S. firm. The new trade theory is not at variance with the theory of comparative advantage. Economies of scale increase productivity. Thus, the new trade theory identifies an important source of comparative advantage.
This theory is quite useful in explaining trade patterns. Empirical studies seem to support the predictions of the theory that trade increases the specialization of production within an industry, increases the variety of products available to consumers, and results in lower average prices.32 With regard to first-mover advantages and international trade, a study by Harvard business historian Alfred Chandler suggests the existence of first-mover advantages is an important factor in explaining the dominance of firms from certain nations in specific industries.33 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.34 New trade theorists stress the role of luck, entrepreneurship, and innovation in giving a firm first-mover advantages. According to this argument, the reason Boeing was the first mover in commercial jet aircraft manufacture—rather than firms such as Great Britain’s De Havilland and Hawker Siddeley or Holland’s Fokker, all of which could have been—was that Boeing was both lucky and innovative. One way Boeing was lucky is that De Havilland shot itself in the foot when its Comet jet airliner, introduced two years earlier than Boeing’s first jet airliner, the 707, was found to be full of serious technological flaws. Had De Havilland not made some serious technological mistakes, Great Britain might have become the world’s leading exporter of commercial jet aircraft. Boeing’s innovativeness was demonstrated by its independent development of the technological know-how required to build a commercial jet airliner. Several new trade theorists have pointed out, however, that Boeing’s research and development (R&D) was largely paid for by the U.S. government; the 707 was a spin-off from a government-funded military program (the entry of Airbus into the industry was also supported by significant government subsidies). Herein is a rationale for government intervention: By the sophisticated and judicious use of subsidies, could a government increase the chances of its domestic firms becoming first movers in newly emerging industries, as the U.S. government apparently did with Boeing (and the European Union did with Airbus)? If this is possible, and the new trade theory suggests it might be, we have an economic rationale for a proactive trade policy that is at variance with the free trade prescriptions of the trade theories we have reviewed so far. We consider the policy implications of this issue in Chapter 7.
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National Competitive Advantage: Porter’s Diamond
LO 6-2 Summarize the different theories explaining trade flows between nations.
Michael Porter, the famous Harvard strategy professor, has also written extensively on
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international trade.35 Porter and his team looked at 100 industries in 10 nations. Like the work of the new trade theorists, Porter’s work was driven by a belief that existing theories of international trade told only part of the story. For Porter, the essential task was to explain why a nation achieves international success in a particular industry. Why does Japan do so well in the automobile industry? Why does Switzerland excel in the production and export of precision instruments and pharmaceuticals? Why do Germany and the United States do so well in the chemical industry? These questions cannot be answered easily by the Heckscher–Ohlin theory, and the theory of comparative advantage offers only a partial explanation. The theory of comparative advantage would say that Switzerland excels in the production and export of precision instruments because it uses its resources very productively in these industries. Although this may be correct, this does not explain why Switzerland is more productive in this industry than Great Britain, Germany, or Spain. Porter tries to solve this puzzle.
Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage (see Figure 6.5). These attributes are
6.5 FIGURE The determinants of national competitive advantage: Porter’s diamond.
Source: Michael E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990; republished with a new introduction, 1998), p. 72.
Factor endowments—a nation’s position in factors of production, such as skilled labor or the infrastructure necessary to compete in a given industry. Demand conditions—the nature of home demand for the industry’s product or service. Related and supporting industries—the presence or absence of supplier industries and related industries that are internationally competitive. Firm strategy, structure, and rivalry—the conditions governing how companies are created, organized, and managed and the nature of domestic rivalry.
Porter speaks of these four attributes as constituting the diamond. He argues that firms are most likely to succeed in industries or industry segments where the diamond is most favorable. He also argues that the diamond is a mutually reinforcing system. The effect of one attribute is contingent on the state of others. For example, Porter argues favorable demand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firms to respond to them.
Porter maintains that two additional variables can influence the national diamond in important ways: chance and government. Chance events, such as major innovations, can reshape industry structure and provide the opportunity for one nation’s firms to supplant another’s. Government, by its choice of policies, can detract from or improve national advantage. For
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example, regulation can alter home demand conditions, antitrust policies can influence the intensity of rivalry within an industry, and government investments in education can change factor endowments.
FACTOR ENDOWMENTS
Factor endowments lie at the center of the Heckscher–Ohlin theory. While Porter does not propose anything radically new, he does analyze the characteristics of factors of production. He recognizes hierarchies among factors, distinguishing between basic factors (e.g., natural resources, climate, location, and demographics) and advanced factors (e.g., communication infrastructure, sophisticated and skilled labor, research facilities, and technological know-how). He argues that advanced factors are the most significant for competitive advantage. Unlike the naturally endowed basic factors, advanced factors are a product of investment by individuals, companies, and governments. Thus, government investments in basic and higher education, by improving the general skill and knowledge level of the population 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 provide an initial advantage that is subsequently reinforced and extended by investment in advanced factors. Conversely, disadvantages in basic factors can create pressures to invest in advanced factors. An obvious example of this phenomenon is Japan, a country that lacks arable land and mineral deposits and yet through investment has built a substantial endowment of advanced factors. Porter notes that Japan’s large pool of engineers (reflecting a much higher number of engineering graduates per capita than almost any other nation) has been vital to Japan’s success in many manufacturing industries.
DEMAND CONDITIONS
Porter emphasizes the role home demand plays in upgrading competitive advantage. Firms are typically most sensitive to the needs of their closest customers. Thus, the characteristics of home demand are particularly important in shaping the attributes of domestically made products and in creating pressures for innovation and quality. Porter argues that a nation’s firms gain competitive advantage if their domestic consumers are sophisticated and demanding. Such consumers pressure local firms to meet high standards of product quality and to produce innovative products. For example, Porter notes that Japan’s sophisticated and knowledgeable buyers of cameras helped stimulate the Japanese camera industry to improve product quality and to introduce innovative models.
RELATED AND SUPPORTING INDUSTRIES
The third broad attribute of national advantage in an industry is the presence of suppliers or related industries that are internationally competitive. The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally. Swedish strength in fabricated steel products (e.g., ball bearings and cutting tools) has drawn on strengths in Sweden’s specialty steel industry. Technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in personal computers and several other technically advanced electronic products. Similarly, Switzerland’s success in pharmaceuticals is closely related to its previous international success in the technologically related dye industry.
One consequence of this process is that successful industries within a country tend to be
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grouped into clusters of related industries. This was one of the most pervasive findings of Porter’s study. One such cluster Porter identified was in the German textile and apparel sector, which included high-quality cotton, wool, synthetic fibers, sewing machine needles, and a wide range of textile machinery. Such clusters are important because valuable knowledge can flow between the firms within a geographic cluster, benefiting all within that cluster. Knowledge flows occur when employees move between firms within a region and when national industry associations bring employees from different companies together for regular conferences or workshops.36
FIRM STRATEGY, STRUCTURE, AND RIVALRY
The fourth broad attribute of national competitive advantage in Porter’s model is the strategy, structure, and rivalry of firms within a nation. Porter makes two important points here. First, different nations are characterized by different management ideologies, which either help them or do not help them build national competitive advantage. For example, Porter noted the predominance of engineers in top management at German and Japanese firms. He attributed this to these firms’ emphasis on improving manufacturing processes and product design. In contrast, Porter noted a predominance of people with finance backgrounds leading many U.S. firms. He linked this to U.S. firms’ lack of attention to improving manufacturing processes and product design. He argued that the dominance of finance led to an overemphasis on maximizing short- term financial returns. According to Porter, one consequence of these different management ideologies was a relative loss of U.S. competitiveness in those engineering-based industries where manufacturing processes and product design issues are all-important (e.g., the automobile industry).
How Important Is Education?
Both the Heckscher-Ohlin and Michael Porter theories of trade focus to a large degree on “factor endowments.” The Heckscher-Ohlin theory specifies endowments such as resources as land, labor, and capital as being critical, while the Porter theory recognizes hierarchies among these factor endowments. Education-related endowments such as skilled labor, research facilities, and technological know-how are what Porter calls “advanced factors.” A long-standing argument across multiple governmental organizations, research studies, and prominent individuals is that education drives economic, social, and environmental well-being of countries (i.e., countries adopt sustainability principles the more educated the people in the country are relative to people in the global marketplace—see Chapter 5). The extension of this argument is that education helps people become better citizens of a country. But what do you think education does to a customer’s product needs and wants? Do they want more foreign products if they have more years of education (e.g., graduate degree) compared with fewer years of education (e.g., high school)? Or does education not influence the type of products bought by customers (i.e., foreign- made or home-country made)?
Sources: T. Healy and S. Cote, “The Well-Being of Nations: The Role of Human and Social Capital,” Organisation for Economic Cooperation and Development (OECD) (2001); S. Samuel, “Importance of Education in a Country’s Progress,” HowToLearn.com, March 13, 2013; K. Matsui, “The Economic Benefits of Educating Women,” Bloomberg Businessweek, March 7, 2013.
Porter’s second point is that there is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competitors. Domestic rivalry creates pressures to innovate, to improve quality, to
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reduce costs, and to invest in upgrading advanced factors. All this helps create world-class competitors. Porter cites the case of Japan:
Nowhere is the role of domestic rivalry more evident than in Japan, where it is all-out warfare in which many companies fail to achieve profitability. With goals that stress market share, Japanese companies engage in a continuing struggle to outdo each other. Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings measure which companies are most popular with university graduates. The rate of new product and process development is breathtaking.37
EVALUATING PORTER’S THEORY
LO 6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.
Porter contends that the degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry. He argues that the presence of all four components is usually required for this diamond to boost competitive performance (although there are exceptions). Porter also contends that government can influence each of the four components of the diamond—either positively or negatively. Factor endowments can be affected by subsidies, policies toward capital markets, policies toward education, and so on. Government can shape domestic demand through local product standards or with regulations that mandate or influence buyer needs. Government policy can influence supporting and related industries through regulation and influence firm rivalry through such devices as capital market regulation, tax policy, and antitrust laws.
If Porter is correct, we would expect his model to predict the pattern of international trade that we observe in the real world. Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable. Is he correct? We simply do not know. Porter’s theory has not been subjected to detailed empirical testing. Much about the theory rings true, but the same can be said for the new trade theory, the theory of comparative advantage, and the Heckscher–Ohlin theory. It may be that each of these theories, which complement each other, explains something about the pattern of international trade.
test PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
Focus on Managerial Implications
LOCATION, FIRST-MOVER ADVANTAGES, AND GOVERNMENT POLICY
LO 6-5 Understand the important implications that international trade theory holds for management practice.
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Why does all this matter for business? There are at least three main implications for international businesses of the material discussed in this chapter: location implications, first-mover implications, and government policy implications.
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, according to the theory of international trade, they can be performed most efficiently. If design can be performed most efficiently in France, that is where design facilities should be located; if the manufacture of basic components can be performed most efficiently in Singapore, that is where they should be manufactured; and if final assembly can be performed most efficiently in China, that is where final assembly should be performed. The result is a global web of productive activities, with different activities being performed in different locations around the globe depending on considerations of comparative advantage, factor endowments, and the like. If the firm does not do this, it may find itself at a competitive disadvantage relative to firms that do.
First-Mover Advantages According to the new trade theory, firms that establish a first- mover advantage with regard to the production of a particular new product may subsequently dominate global trade in that product. This is particularly true in industries where the global market can profitably support only a limited number of firms, such as the aerospace market, but early commitments may also seem to be important in less concentrated industries. For the individual firm, the clear message is that it pays to invest substantial financial resources in trying to build a first-mover, or early mover, advantage, even if that means several years of losses before a new venture becomes profitable. The idea is to preempt the available demand, gain cost advantages related to volume, build an enduring brand ahead of later competitors, and, consequently, establish a long-term sustainable competitive advantage. Although the details of how to achieve this are beyond the scope of this book, many publications offer strategies for exploiting first-mover advantages and for avoiding the traps associated with pioneering a market (first-mover disadvantages).38
Government Policy The theories of international trade also matter to international businesses because firms are major players on the international trade scene. Business firms produce exports, and business firms import the products of other countries. Because of their pivotal role in international trade, businesses can exert a strong influence on government trade policy, lobbying to promote free trade or trade restrictions. The theories of international trade claim that promoting free trade is generally in the best interests of a country, although it may not always be in the best interest of an individual firm. Many firms recognize this and lobby for open markets.
For example, when the U.S. government announced its intention to place a tariff on Japanese imports of liquid crystal display (LCD) screens in the 1990s, IBM and Apple Computer protested strongly. Both IBM and Apple pointed out that (1) Japan was the lowest-cost source of LCD screens; (2) they used these screens in their own laptop computers; and (3) the proposed tariff, by increasing the cost of LCD screens, would increase the cost of laptop computers produced by IBM and Apple, thus making them less competitive in the world market. In other words, the tariff, designed to protect U.S. firms, would be self-defeating. In response to these pressures, the U.S. government reversed its posture.
Unlike IBM and Apple, however, businesses do not always lobby for free trade. In the United States, for example, restrictions on imports of steel have periodically been put into place in response to direct pressure by U.S. firms on the government (the latest example being in March 2018 when the Trump administration placed a 25 percent tariff on imports of foreign steel). In
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some cases, the government has responded to pressure from domestic companies seeking protection by getting foreign companies to agree to “voluntary” restrictions on their imports, using the implicit threat of more comprehensive formal trade barriers to get them to adhere to these agreements (historically, this has occurred in the automobile industry). In other cases, the government used what are called “antidumping” actions to justify tariffs on imports from other nations (these mechanisms will be discussed in detail in Chapter 7).
As predicted by international trade theory, many of these agreements have been self- defeating, such as the voluntary restriction on machine tool imports agreed to in 1985. Shielded from international competition by import barriers, the U.S. machine tool industry had no incentive to increase its efficiency. Consequently, it lost many of its export markets to more efficient foreign competitors. Because of this misguided action, the U.S. machine tool industry shrunk during the period when the agreement was in force. For anyone schooled in international trade theory, this was not surprising.39
Finally, Porter’s theory of national competitive advantage also contains policy implications. Porter’s theory suggests that it is in the best interest of business for a firm to invest in upgrading advanced factors of production (for example, to invest in better training for its employees) and to increase its commitment to research and development. It is also in the best interests of business to lobby the government to adopt policies that have a favorable impact on each component of the national diamond. Thus, according to Porter, businesses should urge government to increase investment in education, infrastructure, and basic research (because all these enhance advanced factors) and to adopt policies that promote strong competition within domestic markets (because this makes firms stronger international competitors, according to Porter’s findings).
Key Terms
free trade, p. 153 new trade theory, p. 155 mercantilism, p. 155 zero-sum game, p. 156 absolute advantage, p. 157 constant returns to specialization, p. 162 factor endowments, p. 166 economies of scale, p. 168 first-mover advantages, p. 169 balance-of-payments accounts, p. 179 current account, p. 180 current account deficit, p. 180 current account surplus, p. 180 capital account, p. 180 financial account, p. 180
Summary
This chapter reviewed a number of theories that explain why it is beneficial for a country to engage in international trade and explained the pattern of international trade observed in the world economy. The theories of Smith, Ricardo, and Heckscher–Ohlin all make strong cases for unrestricted free trade. In contrast, the mercantilist doctrine and, to a lesser extent, the new trade theory can be interpreted to support government intervention to promote exports through
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subsidies and to limit imports through tariffs and quotas.
In explaining the pattern of international trade, this chapter shows that, with the exception of mercantilism, which is silent on this issue, the different theories offer largely complementary explanations. Although no one theory may explain the apparent pattern of international trade, taken together, the theory of comparative advantage, the Heckscher–Ohlin theory, the product life-cycle theory, the new trade theory, and Porter’s theory of national competitive advantage do suggest which factors are important. Comparative advantage tells us that productivity differences are important; Heckscher–Ohlin tells us that factor endowments matter; the product life-cycle theory tells us that where a new product is introduced is important; the new trade theory tells us that increasing returns to specialization and first-mover advantages matter; Porter tells us that all these factors may be important insofar as they affect the four components of the national diamond. The chapter made the following points:
1. Mercantilists argued that it was in a country’s best interests to run a balance-of-trade surplus. They viewed trade as a zero-sum game, in which one country’s gains cause losses for other countries.
2. The theory of absolute advantage suggests that countries differ in their ability to produce goods efficiently. The theory suggests that a country should specialize in producing goods in areas where it has an absolute advantage and import goods in areas where other countries have absolute advantages.
3. The theory of comparative advantage suggests that it makes sense for a country to specialize in producing those goods that it can produce most efficiently, while buying goods that it can produce relatively less efficiently from other countries—even if that means buying goods from other countries that it could produce more efficiently itself.
4. The theory of comparative advantage suggests that unrestricted free trade brings about increased world production—that is, that trade is a positive-sum game.
5. The theory of comparative advantage also suggests that opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. The empirical evidence seems to be consistent with this claim.
6. The Heckscher–Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce.
7. The product life-cycle theory suggests that trade patterns are influenced by where a new product is introduced. In an increasingly integrated global economy, the product life-cycle theory seems to be less predictive than it once was.
8. New trade theory states that trade allows a nation to specialize in the production of certain goods, attaining scale economies and lowering the costs of producing those goods, while buying goods that it does not produce from other nations that are similarly specialized. By this mechanism, the variety of goods available to consumers in each nation is increased, while the average costs of those goods should fall.
9. New trade theory also states that in those industries where substantial economies of scale imply that the world market will profitably support only a few firms, countries may predominate in the export of certain products simply because they had a firm that was a first mover in that industry.
10. Some new trade theorists have promoted the idea of strategic trade policy. The argument is that government, by the sophisticated and judicious use of subsidies, might be able to increase the chances of domestic firms becoming first movers in newly emerging industries.
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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? Why?
5. Reread the Country Focus “Is China Manipulating Its Currency in Pursuit of a Neo- Mercantilist Policy?”
a. Do you think China is pursuing a currency policy that can be characterized as neo- mercantilist?
b. What should the United States, and other countries, do about this? 6. Reread the Country Focus “Moving U.S. White-Collar Jobs Offshore.”
a. Who benefits from the outsourcing of skilled white-collar jobs to developing nations? Who are the losers?
b. Will developed nations like the United States suffer from the loss of high-skilled and high-paying jobs?
c. Is there a difference between the transference of high-paying white-collar jobs, such as computer programming and accounting, to developing nations, and low-paying blue- collar jobs? If so, what is the difference, and should government do anything to stop the flow of white-collar jobs out of the country to countries such as India?
7. Drawing upon the new trade theory and Porter’s theory of national competitive advantage, outline the case for government policies that would build national competitive advantage in biotechnology. What kinds of policies would you recommend that the government adopt? Are these policies at variance with the basic free trade philosophy?
8. 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.
Research Task http://globalEDGE.msu.edu
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Use the globalEDGETM 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 is an integral part of understanding different countries, cultures, and lifestyles. You run a chain of high-end premium restaurants in the United States, and you are looking for unique Australian wines you can import. However, you must first identify which Australian suppliers can 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 about to select which one to work with.
The Trans Paci f ic Par tnership (TPP) Is Dead; Long Live the CPTPP! clos ing case
On February 4, 2016, ministers from 12 governments signed off on the Trans Pacific Partnership (TPP), a free trade deal among 12 countries, including the United States, Japan, Australia, New Zealand, Chile, Canada, Mexico, and Vietnam. China was not part of the deal. Together, these countries accounted for 36 percent of the world’s GDP and 26 percent of world trade. In the United States, critics of the deal were quick to register their opposition. Donald Trump, now president of the United States, said that the “TPP is a terrible deal.” Bernie Sanders, one of the leading Democratic contenders, called it “disastrous” and “a victory for Wall Street and other big corporations.” Many other politicians, wary of the fact that 2016 was a general election year in the United States, were also quick to criticize the deal. In contrast, the administration of Barack Obama heralded the TPP as a historic deal of major importance. Editorials in influential publications such as The Wall Street Journal and The Economist urged the U.S. Congress to ratify the deal.
The TPP planned to eliminate or reduce about 18,000 tariffs, taxes, and nontariff barriers such as quotas on trade between and among the member countries. By expanding market access and lowering prices for consumers, economists claimed that the deal would boost economic growth rates among TPP countries and add about $285 billion to global GDP by 2025. Because the United States already has very low tariff barriers, most of the tariff reductions would occur in other countries.
U.S. agriculture would have been a big beneficiary. The TPP would eliminate import tariffs as high as 40 percent on U.S. poultry products and fruit and 35 percent on soybeans—all products where the United States has a comparative advantage in production. Cargill Inc., a giant U.S. grain exporter and meat producer, urged lawmakers to support the pact. A number of large, efficient U.S. manufacturers also came out in support of the deal, which would eliminate import tariffs as high as 59 percent on U.S. machinery exports to TPP countries. Boeing, the country’s largest exporter, said that the deal would help it compete overseas, where it gets 70 percent of its revenue. Several technology companies, including Intel, voiced support for the deal, pointing out that it would eliminate import taxes as high as 35 percent on the sale of information and communication technology to some other TPP countries.
Some U.S. companies urged Congress to vote against the deal. Ford opposed the deal because it would phase out a 2.5 percent tariff on imports of Japanese cars into the United States and a 25 percent tariff on imports of light trucks—even though under the agreement, those tariffs would be phased down
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over 30 years. Labor unions opposed the deal, arguing that it would result in further losses of U.S. manufacturing jobs and lead to lower wages. The tobacco company Philip Morris opposed the deal because it would prevent tobacco companies from suing foreign governments over antismoking measures that restrict tobacco companies from using their logos and brands to market tobacco products. Several big drug companies also opposed the deal because it only protected new biotechnology products from generic competition for 5 years, rather than the 12 years they had before.
Data supporting these various claims and counterclaims was offered by a number of independent studies, including those from the World Bank, the Institute of International Economics (IIE), and Tufts University. Both the World Bank and the IIE concluded that by creating more overseas demand for American goods and services, by 2030 the TPP would raise U.S. wages slightly above what they would have been without the deal. The IIE study estimated that the TPP would increase annual U.S. exports by $357 billion, or 9 percent, by 2030. The IIE study also calculated that overall, there would be no job losses in the United States. Although some sectors would see job losses, the IIE suggested that these would be offset by job gains elsewhere. The study from Tufts University was the most pessimistic, estimating that the deal would result in the loss of 450,000 jobs in the United States over 10 years. To put this in context, between 2010 and 2015, the U.S. economy created 13 million new jobs, so the worst-case estimate of losses amounted to no more than two months of job growth during the 2010– 2015 period.
Just three days into his administration, President Donald Trump withdrew the United States from the TPP, calling it a “ridiculous trade deal.” Many predicted that without the United States, the deal would quickly collapse—but that did not happen. Instead, led by Japan, the remaining 11 nations pressed ahead with a revamped deal. Renamed the Comprehensive and Progressive Trans Pacific Partnership (CPTPP) —or TPP for short—the deal signed in Chile on March 8, 2018, will dramatically lower tariffs and other trade barriers between the 11 nations. The revised agreement, which still excludes China, covers 500 million people in nations that produce more than 13 percent of global gross domestic product. According to David Parker, New Zealand’s Trade Minister:
©Fiona Goodall/Getty Images
I think this agreement serves as an antidote to the protectionist trend we’re seeing in the world. I think the CPTPP is more important than it was a year ago. This rise of protectionism is worrisome. . . . Countries that are in the agreement have got a different route where they can club together in a friendly manner, and facilitate the growth of their own economies for the benefit of their people.
Although the United States is no longer party to this deal, several leaders of the signatory nations have indicated that they would welcome the U.S. back into the fold, although this seems unlikely to happen so long as Donald Trump is president. There are also indications that a post-Brexit Britain might seek to join the CPTPP.
Sources: Caitlin McGee, “Controversial TPP Pact Signed amid New Zealand Protests,” Aljazeera, February 4, 2016; Catherine Ho, “Fact Checking the Campaigns for and against the TPP Trade Deal,” Washington Post, February 11, 2016; Tripp Mickle and Theo Francis, “Trade Pact Sealed,” The Wall Street Journal, October 6, 2015; Peter Petri, and Michael Plummer, “The Economic Effects of the Trans Pacific Partnership: New Estimates,” Peterson Institute for International Economics, working paper 16-2, January 1, 2016; “China Picks Up the U.S. Trade Fumble,” The Wall Street Journal, November 17, 2016; “The New TPP Trade Deal: Going Ahead without Trump,” Aljazeera News, March 24, 2018; and “Japan Approves Bill to Ratify Successor to TPP Free Trade Pact,” Japan Times, March 24, 2018.
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CASE DISCUSSION QUESTIONS 1. What were the proposed benefits of the TPP? 2. What were the potential drawbacks of the U.S. entering the TPP? What would be the
drawbacks to other nations? 3. Why do you think that Donald Trump was so adamantly opposed to the TPP? 4. Why do you think the 11 remaining signatories went ahead with a revised deal after the
United States withdrew? 5. Is the CPTTP a threat to American economic interests? 6. What is the opportunity cost to the United States of withdrawing from the TPP?
appendix
International Trade and the Balance of Payments International trade involves the sale of goods and services to residents in other countries (exports) and the purchase of goods and services from residents in other countries (imports). A country’s balance-of-payments accounts keep track of the payments to and receipts from other countries for a particular time period. 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 2017 is given in Table A.1. In this appendix, we briefly describe the form of the balance-of-payments accounts, and we discuss whether a current account deficit, often a cause of much concern in the popular press, is something to worry about.
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A.1 TABLE U.S. Balance-of-Payments Accounts, 2017
BALANCE-OF-PAYMENTS ACCOUNTS
Balance-of-payments accounts are divided into three main sections: the current account, the capital account, and the financial account (to confuse matters, what is now called the capital account until recently was part of the current account, and the financial account used to be called the capital account). The current account records transactions that pertain to four categories, all of which can be seen in Table A.1. The first category, goods, refers to the export or import of physical goods (e.g., agricultural foodstuffs, autos, computers, chemicals). The second category is the export or import of services (e.g., intangible products such as banking and insurance services, royalty payments on intellectual property, and earnings from foreign tourists who visit the U.S.). The third category, primary income receipts or payments, refers to income from foreign investments or payments to foreign investors (e.g., interest and dividend receipts or payments). The third category also includes payments that foreigners have made to U.S. residents for work performed outside the United States and payments that U.S. entities make to foreign residents. The fourth category, secondary income receipts or payments, refers to the transfer of a good, service, or asset to the U.S. government or U.S. private entities, or the transfer to a foreign government or entity in the case of payments (this includes tax payments, foreign pension payments, cash transfers, etc.).
A current account deficit occurs when a country imports more goods, services, and income than it exports. A current account surplus occurs when a country exports more goods, services, and income than it imports. Table A.1 shows that in 2017 the United States ran a current account deficit of $466.25 billion. This is often a headline-grabbing figure and is widely reported in the news media. The U.S. current account deficit reflects the fact that America imports far more
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physical goods than it exports. (The United States typically runs a surplus on trade in services and on income payments.)
The 2006 current account deficit of $803 billion was the largest on record and was equivalent to about 6.5 percent of the country’s GDP. The deficit has shrunk since then. The 2017 current account deficit represented just 2.4 percent of GDP. Many people find the fact that the United States runs a persistent deficit on its current account to be disturbing, the common assumption being that high import of goods displaces domestic production, causes unemployment, and reduces the growth of the U.S. economy. However, the issue is more complex than this. Fully understanding the implications of a large and persistent deficit requires that we look at the rest of the balance-of-payments accounts.
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 $24.8 billion in 2017.
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 financial account. This is because capital is flowing into the country. When capital flows out of the United States, it enters the financial account as a debit.
The financial account is comprised of a number of elements. The net U.S. acquisition of financial assets includes the change in foreign assets owned by the U.S. government (e.g., U.S. official reserve assets) and the change in foreign assets owned by private individuals and corporations (including changes in assets owned through foreign direct investment). As can be seen from Table A.1, in 2017 there was a $1.212 trillion increase in U.S. ownership of foreign assets, which tells us that the U.S. government and U.S. private entities were purchasing more foreign assets than they were selling. The net U.S. incurrence of liabilities refers to the change in U.S. assets owned by foreigners. In 2017 foreigners increased their holdings of U.S. assets by $1.587 trillion, signifying that foreigners were net acquirers of U.S. stocks, bonds (including Treasury bills), and physical assets such as real estate.
A basic principle of balance-of-payments accounting is double-entry bookkeeping. Every international transaction automatically enters the balance of payments twice—once as a credit and once as a debit. Imagine that you purchase a car produced in Japan by Toyota for $20,000.
Because your purchase represents a payment to another country for goods, it will enter the balance of payments as a debit on the current account. Toyota now has the $20,000 and must do something with it. If Toyota deposits the money at a U.S. bank, Toyota has purchased a U.S. asset—a bank deposit worth $20,000—and the transaction will show up as a $20,000 credit on the financial account. Or Toyota might deposit the cash in a Japanese bank in return for Japanese yen. Now the Japanese bank must decide what to do with the $20,000. Any action that it takes will ultimately result in a credit for the U.S. balance of payments. For example, if the bank lends the $20,000 to a Japanese firm that uses it to import personal computers from the United States, then the $20,000 must be credited to the U.S. balance-of- payments current account. Or the Japanese bank might use the $20,000 to purchase U.S. government bonds, in which case it will show up as a credit on the U.S. balance-of-payments financial account.
Thus, any international transaction automatically gives rise to two offsetting entries in the balance of payments. Because of this, the sum of the current account balance, the capital account, and the financial account balance should always add up to zero. In practice, this does
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not always occur due to the existence of “statistical discrepancies,” the source of which need not concern us here (note that in 2017, the statistical discrepancy amounted to $92.2 billion).
DOES THE CURRENT ACCOUNT DEFICIT MATTER?
As discussed earlier, there is some concern when a country is running a deficit on the current account of its balance of payments.40 In recent years, a number of rich countries, including most notably the United States, have run persistent current account deficits. When a country runs a current account deficit, the money that flows to other countries can then be used by those countries to purchase assets in the deficit country. 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 increasing liabilities 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 foreign landowners, and dividends to foreign stockholders. One might argue that such payments to foreigners drain resources from a country and limit the funds available for investment within the country. Because investment within a country is necessary to stimulate economic growth, a persistent current account deficit can choke off a country’s future economic growth. This is the basis of the argument that persistent deficits are bad for an economy. However, things are not this simple. For one thing, in an era of global capital markets, money is efficiently directed toward its highest value uses, and over the past quarter of a century, many of the highest value uses of capital have been in the United States. So even though capital is flowing out of the United States in the form of payments to foreigners, much of that capital finds its way right back into the country to fund productive investments in the United States. In short, it is not clear that the current account deficit chokes off U.S. economic growth. In fact, notwithstanding the 2008– 2009 recession, the U.S. economy has grown substantially over the past 30 years, despite running a persistent current account deficit and despite financing that deficit by selling U.S. assets to foreigners. This is precisely because foreigners reinvest much of the income earned from U.S. assets and from exports to the United States right back into the United States. This revisionist view, which has gained in popularity in recent years, suggests that a persistent current account deficit might not be the drag on economic growth it was once thought to be.41
Having said this, there is still a nagging fear that at some point, the appetite that foreigners have for U.S. assets might decline. If foreigners suddenly reduced their investments in the United States, what would happen? In short, instead of reinvesting the dollars that they earn from exports and investment in the United States back into the country, they would sell those dollars for another currency, European euros, Japanese yen, or Chinese yuan, for example, and invest in euro-, yen-, and yuan-denominated assets instead. This would lead to a fall in the value of the dollar on foreign exchange markets, and that in turn would increase the price of imports and lower the price of U.S. exports, making them more competitive, which should reduce the overall level of the current account deficit. Thus, in the long run, the persistent U.S. current account deficit could be corrected via a reduction in the value of the U.S. dollar. The concern is that such adjustments may not be smooth. Rather than a controlled decline in the value of the dollar, the dollar might suddenly lose a significant amount of its value in a very short time, precipitating a “dollar crisis.”42 Because the U.S. dollar is the world’s major reserve currency and is held by many foreign governments and banks, any dollar crisis could deliver a body blow to the world economy and at the very least trigger a global economic
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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. Binyamin Applebaum, “On Trade, Donald Trump Breaks with 200 Years of Economic Orthodoxy,” The New York Times, March 10, 2016.
3. M. Solis, “The Politics of Self-Restraint: FDI Subsidies and Japanese Mercantilism,” The World Economy 26 (February 2003), pp. 153–70; Kevin Hamlin, “China Is a Growing Threat to Global Competitors, Kroeber Says,” Bloomberg News, June 28, 2016.
4. S. Hollander, The Economics of David Ricardo (Buffalo: University of Toronto Press, 1979).
5. D. Ricardo, The Principles of Political Economy and Taxation (Homewood, IL: Irwin, 1967, first published in 1817).
6. For example, R. Dornbusch, S. Fischer, and P. Samuelson, “Comparative Advantage: Trade and Payments in a Ricardian Model with a Continuum of Goods,” American Economic Review 67 (December 1977), pp. 823–39.
7. B. Balassa, “An Empirical Demonstration of Classic Comparative Cost Theory,” Review of Economics and Statistics, 1963, pp. 231–38.
8. See P. R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1 (Fall 1987), pp. 131–44.
9. P. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization,” Journal of Economic Perspectives 18, no. 3 (Summer 2004), pp. 135–46.
10. P. Samuelson, “The Gains from International Trade Once Again,” Economic Journal 72 (1962), pp. 820–29.
11. S. Lohr, “An Elder Challenges Outsourcing’s Orthodoxy,” The New York Times, September 9, 2004, p. C1.
12. P. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization,” Journal of Economic Perspectives 18, no. 3 (Summer 2004), p. 143.
13. D. H. Autor, D. Dorn, and Gordon H. Hanson, “The China Syndrome: Local Labor Market Effects of Import Competition in the United States,” American Economic Review 103, no. 6 (October 2013).
14. See A. Dixit and G. Grossman, “Samuelson Says Nothing about Trade Policy,” Princeton University, 2004, accessed from http://depts.washington.edu/teclass/ThinkEcon/readings/Kalles/Dixit%20and%20Grossman%20on%20Samuelson.pdf.
15. J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” The Wall Street Journal, January 18, 2012, p. B1.
16. For example, J. D. Sachs and A. Warner, “Economic Reform and the Process of Global Integration,” Brookings Papers on Economic Activity, 1995, pp. 1–96; J. A. Frankel and D. Romer, “Does Trade Cause Growth?” American Economic Review 89, no. 3 (June 1999), pp. 379–99; D. Dollar and A. Kraay, “Trade, Growth and Poverty,” working paper, Development Research Group, World Bank, June 2001. Also, for an accessible discussion of the relationship between free trade and economic growth, see T. Taylor, “The Truth about Globalization,” Public Interest, Spring 2002, pp. 24–44; D. Acemoglu, S. Johnson,
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and J. Robinson, “The Rise of Europe: Atlantic Trade, Institutional Change and Economic Growth,” American Economic Review 95, no. 3 (2005), pp. 547–79; T. Singh, “Does International Trade Cause Economic Growth?” The World Economy 33, no. 11 (2010), pp. 1517–64.
17. Sachs and Warner, “Economic Reform and the Process of Global Integration.” 18. Sachs and Warner, “Economic Reform and the Process of Global Integration,” pp. 35–36. 19. R. Wacziarg and K. H. Welch, “Trade Liberalization and Growth: New Evidence,” World
Bank Economic Review 22, no. 2 (June 2008). 20. T. Singh, “Does International Trade Cause Economic Growth?” The World Economy 33,
no. 11 (November 2010), pp. 1517–64. 21. J. A. Frankel and D. H. Romer, “Does Trade Cause Growth?” American Economic Review
89, no. 3 (June 1999), pp. 370–99. 22. A recent skeptical review of the empirical work on the relationship between trade and
growth questions these results. See F. Rodriguez and D. Rodrik, “Trade Policy and Economic Growth: A Skeptic’s Guide to the Cross-National Evidence,” National Bureau of Economic Research Working Paper Series, working paper no. 7081 (April 1999). Even these authors, however, cannot find any evidence that trade hurts economic growth or income levels.
23. B. Ohlin, Interregional and International Trade (Cambridge, MA: Harvard University Press, 1933). For a summary, see R. W. Jones and J. P. Neary, “The Positive Theory of International Trade,” in Handbook of International Economics, R. W. Jones and P. B. Kenen, eds. (Amsterdam: North Holland, 1984).
24. W. Leontief, “Domestic Production and Foreign Trade: The American Capital Position Re- examined,” Proceedings of the American Philosophical Society 97 (1953), pp. 331–49.
25. R. M. Stern and K. Maskus, “Determinants of the Structure of U.S. Foreign Trade,” Journal of International Economics 11 (1981), pp. 207–44.
26. See H. P. Bowen, E. E. Leamer, and L. Sveikayskas, “Multicountry, Multifactor Tests of the Factor Abundance Theory,” American Economic Review 77 (1987), pp. 791–809.
27. D. Trefler, “The Case of the Missing Trade and Other Mysteries,” American Economic Review 85 (December 1995), pp. 1029–46.
28. D. R. Davis and D. E. Weinstein, “An Account of Global Factor Trade,” American Economic Review 91, no. 5 (December 2001), pp. 1423–52.
29. R. Vernon, “International Investments and International Trade in the Product Life Cycle,” Quarterly Journal of Economics, May 1966, pp. 190–207; R. Vernon and L. T. Wells, The Economic Environment of International Business, 4th ed. (Englewood Cliffs, NJ: Prentice Hall, 1986).
30. For a good summary of this literature, see E. Helpman and P. Krugman, Market Structure and Foreign Trade: Increasing Returns, Imperfect Competition, and the International Economy (Boston: MIT Press, 1985). Also see P. Krugman, “Does the New Trade Theory Require a New Trade Policy?” World Economy 15, no. 4 (1992), pp. 423–41.
31. M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 (Summer 1988), pp. 41–58; W. T. Robinson and Sungwook Min, “Is the First to Market the First to Fail?” Journal of Marketing Research 29 (2002), pp. 120–28.
32. J. R. Tybout, “Plant and Firm Level Evidence on New Trade Theories,” National Bureau of Economic Research Working Paper Series, working paper no. 8418 (August 2001), www.nber.org; S. Deraniyagala and B. Fine, “New Trade Theory versus Old Trade Policy:
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A Continuing Enigma,” Cambridge Journal of Economics 25 (November 2001), pp. 809– 25.
33. A. D. Chandler, Scale and Scope (New York: Free Press, 1990). 34. Krugman, “Does the New Trade Theory Require a New Trade Policy?” 35. M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990). For a
good review of this book, see R. M. Grant, “Porter’s Competitive Advantage of Nations: An Assessment,” Strategic Management Journal 12 (1991), pp. 535–48.
36. B. Kogut, ed., Country Competitiveness: Technology and the Organizing of Work (New York: Oxford University Press, 1993).
37. Porter, The Competitive Advantage of Nations, p. 121. 38. Lieberman and Montgomery, “First-Mover Advantages.” See also Robinson and Min, “Is
the First to Market the First to Fail?”; W. Boulding and M. Christen, “First-Mover Disadvantage,” Harvard Business Review, October 2001, pp. 20–21; R. Agarwal and M. Gort, “First-Mover Advantage and the Speed of Competitive Entry,” Journal of Law and Economics 44 (2001), pp. 131–59.
39. C. A. Hamilton, “Building Better Machine Tools,” Journal of Commerce, October 30, 1991, p. 8; “Manufacturing Trouble,” The Economist, October 12, 1991, p. 71.
40. P. Krugman, The Age of Diminished Expectations (Cambridge, MA: MIT Press, 1990); J. Bernstein and Dean Baker, “Why Trade Deficits Matter,” The Atlantic, December 8, 2016.
41. D. Griswold, “Are Trade Deficits a Drag on U.S. Economic Growth?” Free Trade Bulletin, March 12, 2007; O. Blanchard, “Current Account Deficits in Rich Countries,” National Bureau of Economic Research Working Paper Series, working paper no. 12925, February 2007.
42. S. Edwards, “The U.S. Current Account Deficit: Gradual Correction or Abrupt Adjustment?” National Bureau of Economic Research Working Paper Series, working paper no. 12154, April 2006.
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Part 3 The Global Trade and Investment Environment
Government Policy and International Trade
Learning Object ives After reading this chapter, you will be able to:
LO7-1 Identify the policy instruments used by governments to influence international trade flows.
LO7-2 Understand why governments sometimes intervene in international trade.
LO7-3 Summarize and explain the arguments against strategic trade policy.
LO7-4 Describe the development of the world trading system and the current trade issue.
LO7-5 Explain the implications for managers of developments in the world trading system.
U.S. and South Korea Strike a Revised Trade Deal
opening case In 2012, a free trade deal between the United States and South Korea went into effect. In 2016, the United States exported $63.8 billion in goods and services to South Korea, and imported $80.8 billion,
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resulting in a trade deficit of $17 billion. During the U.S. election campaign in 2016, Donald Trump, who became President in 2017, called the deal “horrible” and a “job killer.”
Given Trump’s hostility to the free trade deal, it was no surprise when in January 2018, the U.S. announced that it was entering into negotiations with South Korea to revise the terms of the agreement. Complicating matters were two factors. First, in early March 2018, the Trump administration placed a 25 percent tariff on imports of steel. As the third largest supplier of foreign steel to the United States, these tariffs threatened to harm the South Korean steel industry. Moreover, the global tariffs were technically in violation of the World Trade Organization treaty, to which both the United States and South Korea were signatories. Second, South Korea is an important U.S. ally. The country’s support was crucial in putting pressure on North Korea to halt its nuclear weapons program. Given this, many observers wondered why the Trump Administration was pressuring South Korea at a time when it needed to work together with the nation to keep North Korea in check.
Perhaps because of geopolitical considerations, the negotiations proceeded very quickly. Trade in automobiles was central to the negotiations, since the Trump Administration saw that as a primary cause of the trade deficit. In 2017, the United States imported nearly $16 billion worth of South Korean passenger cars, but exported only $1.5 billion worth to South Korea. It should also be noted that significant automobile production in the U.S. is concentrated in swing states such as Michigan and Ohio, which helped elect Trump to the presidency.
In late March, the two countries announced that they had reached a revised deal. Under the terms of this deal, South Korea would be exempt from the 25 percent tariff on steel imports into the United States. Instead, South Korea agreed to a quota which would limit its steel exports to the U.S. to about 70 percent of what they had been in 2017.
In return, South Korea made two concessions. First, the deal extended for 20 years a 25 percent tariff on exports of South Korean light trucks to the United States (under the original agreement, the 25 percent tariff was set to expire in 2021). This will likely be a significant boon to U.S. auto manufactures, since the light truck segment is one that they dominate. Second, the Koreans agreed to lift their annual quota on imports of U.S. cars into the country from 25,000 per manufacturer to 50,000 per manufacturer. Beyond that, U.S. cars sold in South Korea would have to adhere to Korea’s stringent safety and environmental standards, which the Trump Administration has characterized as “burdensome regulations” designed to make it difficult for U.S. companies to sell vehicles in Korea. That being said, the reality is that U.S. auto companies were not even close to reaching the old quota limit of 25,000 cars a year, so lifting the cap may be primarily symbolic.
The deal will also establish a side agreement between the United States and South Korea that is intended to deter “competitive devaluation” of both countries’ currencies—which can artificially lower the cost of imports bought by consumers—and to create more transparency on issues of monetary policy. Administration officials suggested that this new type of arrangement was likely to be replicated in other trade deals, though they acknowledged that it was not enforceable.
The deal allows President Trump to claim that his “get tough” approach to trade negotiations works. For their part, the South Koreans were reportedly pleased that they didn’t have to give ground on opening up their agricultural industry to U.S. imports, where administrative tariff barriers have limited importation of some low-priced American foodstuffs such as rice and potatoes. • Sources: Michael Shear and Alan Rappeport, “Trump Secures Trade Deal with South Korea Ahead of Nuclear Talks,” The New York Times, March 27, 2018; Scott Horsley, “Trump Administration Strikes Trade Deal with South Korea,” NPR Politics, March 27, 2018; Patrick Gillespie, “New US Deal with South Korea: What You Need to Know,” CNN Money, March 28, 2018.
Introduction 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. Countries will specialize in
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products they can make most efficiently, while importing products they can produce less efficiently. Chapter 6 also laid out the intellectual case for free trade. Remember, free trade refers to a situation in which a government does not attempt to restrict what its citizens can buy from or sell to another country. As we saw in Chapter 6, the theories of Smith, Ricardo, and Heckscher–Ohlin predict that the consequences of free trade include both static economic gains (because free trade supports a higher level of domestic consumption and more efficient utilization of resources) and dynamic economic gains (because free trade stimulates economic growth and the creation of wealth).
This chapter looks at the political reality of international trade. Although many nations are nominally committed to free trade, they tend to intervene in international trade to protect the interests of politically important groups or promote the interests of key domestic producers. For example, the opening case suggests that the United States renegotiated a free trade deal with South Korea in order to protect the interests of U.S. automobile companies, particularly in the profitable light truck segment where Korean imports will face a 25 percent tariff for another 20 years (the tariff was set to expire in 2021). This chapter explores the political and economic reasons that governments have for intervening in international trade. When governments intervene, they often do so by restricting imports of goods and services into their nation while adopting policies that promote domestic production and exports (one could argue that this was the case with the South Korean trade deal). Normally, their motives are to protect domestic producers (in this case, U.S. steel and auto producers). In recent years, social issues have also intruded into the decision-making calculus. In the United States, for example, a movement is growing to ban imports of goods from countries that do not abide by the same labor, health, and environmental regulations as the United States.
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 economic motives for intervention follows. In the third section of this chapter, we consider how the case for free trade stands up in view of the various justifications given for government intervention in international trade. 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 World Trade Organization. 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 LO 7-1 Identify the policy instruments used by governments to influence international trade
flows.
Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary export restraints, local content requirements, administrative policies, and antidumping duties. Tariffs are the oldest and simplest instrument of trade policy. As we shall see later in this chapter, they are also the instrument that the GATT and WTO have been most successful in limiting. A fall in tariff barriers in recent decades has been accompanied by a rise in nontariff barriers, such as subsidies, quotas, voluntary export restraints, and antidumping duties.
TARIFFS
A tariff is a tax levied on imports (or exports). Tariffs fall into two categories. Specific tariffs are levied as a fixed charge for each unit of a good imported (e.g., $3 per barrel of oil). Ad
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valorem tariffs are levied as a proportion of the value of the imported good. In most cases, tariffs are placed on imports to protect domestic producers from foreign competition by raising the price of imported goods. However, tariffs also produce revenue for the government. Until the income tax was introduced, for example, the U.S. government received most of its revenues from tariffs.
Did You Know? Did you know that the high price of SUVs in the United States is the result of the “chicken tariff”? Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
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 producers gain because the tariff affords them some protection against foreign competitors by increasing the cost of imported foreign goods. Consumers lose because they must pay more for certain imports. For example, in 2002 the U.S. government placed an ad valorem tariff of 8 to 30 percent on imports of foreign steel. The idea was to protect domestic steel producers from cheap imports of foreign steel. In this case, however, the effect was to raise the price of steel products in the United States between 30 and 50 percent. A number of U.S. steel consumers, ranging from appliance makers to automobile companies, objected that the steel tariffs would raise their costs of production and make it more difficult for them to compete in the global marketplace. Whether the gains to the government and domestic producers exceed the loss to consumers depends on various factors, such as the amount of the tariff, the importance of the imported good to domestic consumers, the number of jobs saved in the protected industry, and so on. In the steel case, many argued that the losses to steel consumers apparently outweighed the gains to steel producers. In November 2003, the World Trade Organization declared that the tariffs represented a violation of the WTO treaty, and the United States removed them in December of that year. Interestingly, this ruling did not stop Donald Trump from imposing a 25 percent tariff on imports of foreign steel in March 2018. If the tariffs are challenged, as seems likely, the WTO will in all probability reach a similar conclusion.
In general, two conclusions can be derived from economic analysis of the effect of import tariffs.1 First, tariffs are generally pro-producer and anticonsumer. While they protect producers from foreign competitors, this restriction of supply also raises domestic prices. For example, a study by Japanese economists calculated that tariffs on imports of foodstuffs, cosmetics, and chemicals into Japan cost the average Japanese consumer about $890 per year in the form of higher prices. Almost all studies find that import tariffs impose significant costs on domestic consumers in the form of higher prices. Second, import tariffs reduce the overall efficiency of the world economy. They reduce efficiency because a protective tariff encourages domestic firms to produce products at home that could be produced more efficiently abroad. The consequence is an inefficient utilization of resources.2
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
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indicates that relatively small Nordic countries such as Finland and Sweden are viewed as being as competitive as the United States and Japan? Should larger countries, with more people and a larger economy be given preferential treatment in ranking such as when the topic is on “global competitiveness”?
Source: www.weforum.org.
Sometimes tariffs are levied on exports of a product from a country. Export tariffs are less common than import tariffs. In general, export tariffs have two objectives: first, to raise revenue for the government, and second, to reduce exports from a sector, often for political reasons. For example, in 2004 China imposed a tariff on textile exports. The primary objective was to moderate the growth in exports of textiles from China, thereby alleviating tensions with other trading partners. China also had tariffs on steel exports but removed many of those in late 2015.
SUBSIDIES
A subsidy is a government payment to a domestic producer. Subsidies take many forms, including cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. By lowering production costs, subsidies help domestic producers in two ways: (1) competing against foreign imports and (2) gaining export markets. Agriculture tends to be one of the largest beneficiaries of subsidies in most countries. 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 inefficient domestic producers with farm subsidies. According to the World Trade Organization, in mid-2000 countries spent some $300 billion on subsidies, $250 billion of which was spent by 21 developed nations.3 In response to a severe sales slump following the global financial crisis, between mid-2008 and mid-2009, some developed nations gave $45 billion in subsidies to their automobile makers. While the purpose of the subsidies was to help them survive a very difficult economic climate, one of the consequences was to give subsidized companies an unfair competitive advantage in the global auto industry. Somewhat ironically, given the government bailouts of U.S. auto companies during the global financial crisis, in 2012 the Obama administration filed a complaint with the WTO arguing that the Chinese were illegally subsidizing exports of autos and auto parts. Details are given in the accompanying Country Focus feature.
c o u n t r y F O C U S
Are the Chinese Illegally Subsidizing Auto Exports? In late 2012, during that year’s presidential election campaign, the Obama administration filed a complaint against China with the World Trade Organization. The complaint claimed that China was providing export subsidies to its auto and auto parts industries. The subsidies included cash grants for exporting, grants for R&D, subsidies to pay interest on loans, and preferential tax treatment.
The United States estimated the value of the subsidies to be at least $1 billion between 2009 and 2011. The complaint also pointed out that in the years 2002 through 2011, the value of China’s exports of autos and auto parts increased more than ninefold from $7.4 billion to $69.1 billion. The United States was China’s largest market for exports of auto parts during this period. The United States asserted
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that, to some degree, this growth may have been helped by subsidies. The complaint went on to claim that these subsidies hurt producers of automobiles and auto parts in the United States. This is a large industry in the United States, employing more than 800,000 people and generating some $350 billion in sales.
While some in the labor movement applauded the move, the response from U.S. auto companies and auto parts producers was muted. One reason for this is that many U.S. producers do business in China and, in all probability, want to avoid retaliation from the Chinese government. GM, for example, has a joint venture and two wholly owned subsidiaries in China and is doing very well there. In addition, some U.S. producers benefit by purchasing cheap Chinese auto parts, so any retaliatory tariffs imposed on those imports might actually raise their costs.
More cynical observers saw the move as nothing more than political theater. The week before the complaint was filed, the Republican presidential candidate, Mitt Romney, had accused the Obama administration of “failing American workers” by not labeling China a currency manipulator. So perhaps the complaint was in part simply another move on the presidential campaign chessboard.
In February 2014, the United States expanded its complaint with the WTO against China, arguing that the country had an illegal export subsidy program that includes not only auto parts, but also textiles, apparel and footwear, advanced materials and metals, speciality chemicals, medical products and agriculture. In 2016, after pressure from the WTO and U.S., China agreed to eliminate a wide range of subsidies for its exporters. Michael Froman, the U.S. Trade Representative, announced the deal, calling it “a win for Americans employed in seven diverse sectors that run the gamut from agriculture to textiles.”
Sources: James Healey, “U.S. Alleges Unfair China Auto Subsidies in WTO Action,” USA Today, September 17, 2012; M. A. Memoli, “Obama to Tell WTO That China Illegally Subsidizes Auto Imports,” Los Angeles Times, September 17, 2012; Vicki Needham, “US Launches Trade Case against China’s Export Subsidy Program,” The Hill, February 11, 2014; and David J. Lynch, “China Eliminates Subsidies for Its Exporters,” Financial Times, April 14, 2016.
The main gains from subsidies accrue to domestic producers, whose international competitiveness is increased as a result. Advocates of strategic trade policy (which, as you will recall from Chapter 6, is an outgrowth of the new trade theory) favor subsidies to help domestic firms achieve a dominant position in those industries in which economies of scale are important and the world market is not large enough to profitably support more than a few firms (aerospace and semiconductors are two such industries). According to this argument, subsidies can help a firm achieve a first-mover advantage in an emerging industry. If this is achieved, further gains to the domestic economy arise from the employment and tax revenues that a major global company can generate. However, government subsidies must be paid for, typically by taxing individuals and corporations.
Whether subsidies generate national benefits that exceed their national costs is debatable. In practice, many subsidies are not that successful at increasing the international competitiveness of domestic producers. Rather, they tend to protect the inefficient and promote excess production. One study estimated that if advanced countries abandoned subsidies to farmers, global trade in agricultural products would be 50 percent higher and the world as a whole would be better off by $160 billion.4 Another study estimated that removing all barriers to trade in agriculture (both subsidies and tariffs) would raise world income by $182 billion.5 This increase in wealth arises from the more efficient use of agricultural land.
IMPORT QUOTAS AND VOLUNTARY EXPORT RESTRAINTS
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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 individuals 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. Similarly, under the terms of a new trade agreement, South Korea has agreed to a quota on exports of its steel to the United States (see the opening case).
A common hybrid of a quota and a tariff is known as a tariff rate quota. Under a tariff rate quota, a lower tariff rate is applied to imports within the quota than those over the quota. For example, as illustrated in Figure 7.1, an ad valorem tariff rate of 10 percent might be levied on 1 million tons of rice imports into South Korea, after which an out-of-quota rate of 80 percent might be applied. 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.
7.1 FIGURE Hypothetical tariff rate quota.
A variant on the import quota is the voluntary export restraint. A voluntary export restraint (VER) is a quota on trade imposed by the exporting country, typically at the request of the importing country’s government. For example, in 2012 Brazil imposed what amounts to voluntary export restraints on shipments of vehicles from Mexico to Brazil. 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 producers agree to VERs because they fear more damaging punitive tariffs or import quotas might follow if they do not. Agreeing to a VER is seen as a way to make the best of a bad situation by appeasing protectionist pressures in a country.
As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting import competition. As with all restrictions on trade, quotas do not benefit consumers. An import quota or VER always raises the domestic price of an imported good. When imports are limited to a low percentage of the market by a quota or VER, the price is bid up for that limited foreign supply. The extra profit that producers make when supply is artificially limited by an import quota is referred to as a quota rent.
If a domestic industry lacks the capacity to meet demand, an import quota can raise prices for
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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 limited the amount foreign producers can sell in the U.S. market. According to one study, import quotas have caused the price of sugar in the United States to be as much as 40 percent greater than the world price.7 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.
EXPORT TARIFFS AND BANS
An export tariff is a tax placed on the export of a good. The goal behind an export tariff is to discriminate against exporting in order to ensure that there is sufficient supply of a good within a country. For example, in the past, China has placed an export tariff on the export of grain to ensure that there is sufficient supply in China. Similarly, during its infrastructure building boom, China had an export tariff in place on certain kinds of steel products to ensure that there was sufficient supply of steel within the country. The steel tariffs were removed in late 2015. Because most countries try to encourage exports, export tariffs are relatively rare.
An export ban is a policy that partially or entirely restricts the export of a good. One well- known example was the ban on exports of U.S. crude oil production that was enacted by Congress in 1975. At the time, Organization of the Petroleum Exporting Countries (OPEC) was restricting the supply of oil in order to drive up prices and punish Western nations for their support of Israel during conflicts between Arab nations and Israel. The export ban in the United States was seen as a way of ensuring a sufficient supply of domestic oil at home, thereby helping to keep the domestic price down and boosting national security. The ban was lifted in 2015 after lobbying from American oil producers, who believed that they could get higher prices for some of their output if they were allowed to sell on world markets.
LOCAL CONTENT REQUIREMENTS
A local content requirement (LCR) is a requirement that some specific fraction of a good be produced domestically. 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 percent of the value of this product must be produced locally). Local content regulations have been widely used by developing countries to shift their manufacturing base from the simple assembly of products whose parts are manufactured elsewhere into the local manufacture of component parts. 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 the United States, the Buy America Act, specifies that government agencies must give preference 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 “American” 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 ensure that at least 51 percent of the product by value is manufactured in the United States.
Local content regulations provide protection for a domestic producer of parts in the same way an import quota does: by limiting foreign competition. 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
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regulations tend to benefit producers and not consumers.
Is Having a Local Content Requirement a Good Idea?
Local content requirements refer to a specific fraction of a product that needs to be manufactured domestically. Basically, LCRs establish a minimum level of local content required under trade law when giving foreign companies the right to manufacture in a particular place. In the wake of the economic downturn in 2008, many economists feared that some governments would institute protectionist policies similar to the tariff escalations during the Great Depression of the 1930s. However, most public policy officials avoided traditional forms of protection (e.g., tariffs, quotas). 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 had become increasingly popular. As a (1) citizen of a specific country and (2) as a global customer, do you think local content requirements help you as a citizen of a country, as a global customer, as both, or as neither?
Source: G. C. Hufbauer and J. J. Scott, “Local Content Requirements: A Global Problem,” Washington, D.C., Peterson Institute for Global Economics, 2013.
ADMINISTRATIVE POLICIES
In addition to the formal instruments of trade policy, governments of all types sometimes use informal or administrative policies to restrict imports and boost exports. Administrative trade policies are bureaucratic rules designed to make it difficult for imports to enter a country. It has been argued that the Japanese are the masters of this trade barrier. In recent decades, Japan’s formal tariff and nontariff barriers have been among the lowest in the world. However, critics charge that the country’s informal administrative barriers to imports more than compensate for this. For example, Japan’s car market has been hard for foreigners to crack. In 2016, only 6 percent of the 4.9 million cars sold in Japan were foreign, and only 1 percent were U.S. cars. American car makers have argued for decades that Japan makes it difficult to compete by setting up regulatory hurdles, such as vehicle parts standards, that don’t exist anywhere else in the world. Ironically, the Trans Pacific Partnership (TPP) addressed this issue. America would have reduced tariffs on imports of Japanese light trucks in return for Japan adopting U.S. standards on auto parts, which would have made it easier to import and sell American cars in Japan. However, President Donald Trump pulled America out of the TPP in January 2017.8
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 substantial profits from their home markets to subsidize prices in a foreign market with a view to driving indigenous competitors out of that market. Once this has been achieved, so the argument goes, the predatory firm can raise prices and earn substantial profits.
Antidumping policies are designed to punish foreign firms that engage in dumping. The
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ultimate objective is to protect domestic producers from unfair foreign competition. Although antidumping policies vary from country to country, the majority are similar to those used in the United States. If a domestic producer believes that a foreign firm is dumping production in the U.S. market, it can file a petition with two government agencies, the Commerce Department and the International Trade Commission (ITC). If a complaint has merit, the Commerce Department may impose an antidumping duty on the offending foreign imports (antidumping duties are often called countervailing duties). These duties, which represent a special tariff, can be fairly substantial and stay in place for up to five years. The accompanying Management Focus discusses how a firm, U.S. Magnesium, used antidumping legislation to gain protection from unfair foreign competitors.
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m a n a g e m e n t F O C U S
Protecting U.S. Magnesium
In February 2004, U.S. Magnesium, the sole surviving U.S. producer of magnesium, a metal that is primarily used in the manufacture of certain automobile parts and aluminum cans, filed a petition with the U.S. International Trade Commission (ITC) contending that a surge in imports had caused material damage to the U.S. industry’s employment, sales, market share, and profitability. According to U.S. Magnesium, Russian and Chinese producers had been selling the metal at prices significantly below market value. During 2002 and 2003, imports of magnesium into the United States rose 70 percent, while prices fell by 40 percent, and the market share accounted for by imports jumped to 50 percent from 25 percent.
“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 demand due to additional capacity coming on stream not from Russia or China but from a new Canadian plant that opened in 2001 and from a planned Australian plant. 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 levels. A spokesperson for Alcoa, which mixes magnesium with aluminum to make alloys for cans, predicted that if antidumping duties were imposed, high magnesium prices in the United States would force Alcoa to move some production out of the United States. Alcoa also noted that in 2003, U.S. Magnesium was unable to supply all of Alcoa’s needs, forcing the company to turn to imports. Consumers of magnesium in the automobile industry asserted that high prices in the United States would drive engineers to design magnesium out of automobiles or force manufacturing elsewhere, which would ultimately hurt everyone.
The six members of the ITC were not convinced by these arguments. In March 2005, the ITC ruled
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that both China and Russia had been dumping magnesium in the United States. The government decided to impose duties ranging from 50 percent to more than 140 percent on imports of magnesium from China. Russian producers faced duties ranging from 19 percent to 22 percent. 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 the duties on Chinese producers. They were finally removed by the ITC in 2014.
According to U.S. Magnesium, the initial favorable ruling allowed the company to reap the benefits of nearly $50 million in investments made in its manufacturing plant and enabled the company to boost its capacity by 28 percent by the end of 2005. Commenting on the favorable ruling, a U.S. Magnesium spokesperson noted, “Once unfair trade is removed from the marketplace we’ll be able to compete with anyone.”
U.S. Magnesium’s customers and competitors, however, did not view the situation as one of unfair trade. While the imposition of antidumping duties no doubt helped to protect U.S. Magnesium and the 400 people it employed from foreign competition, magnesium consumers in the United States felt they were the ultimate losers, a view that seemed to be confirmed by price data. In early 2010, the price for magnesium alloy in the United States was $2.30 per pound, compared to $1.54 in Mexico, $1.49 in Europe, and $1.36 in China.
Sources: D. Anderton, “U.S. Magnesium Lands Ruling on Unfair Imports,” Deseret News, October 1, 2004, p. D10; “U.S. Magnesium and Its Largest Consumers Debate before U.S. ITC,” Platt’s Metals Week, February 28, 2005, p. 2; S. Oberbeck, “U.S. Magnesium Plans Big Utah Production Expansion,” Salt Lake Tribune, March 30, 2005; “US to Keep Anti-dumping Duty on China Pure Magnesium,” Chinadaily.com, September 13, 2012.; Lance Duronl, “No Duties for Chinese Magnesium Exporter, CIT Affirms,” Law360, June 2, 2015; and Dan Ikenson, “Death by Antidumping,” Forbes, January 3, 2011.
The Case for Government Intervention LO 7-2 Understand why governments sometimes intervene in international trade.
Now that we have reviewed the various instruments of trade policy that governments can use, it is time to look at the case for government intervention in international trade. Arguments for government intervention take two paths: political and economic. Political arguments for intervention are concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consumers), or with achieving some political objective that lies outside the sphere of economic relationships, such as protecting the environment or human rights. Economic arguments for intervention are typically concerned with boosting the overall wealth of a nation (to the benefit of all, both producers and consumers).
POLITICAL ARGUMENTS FOR INTERVENTION
Political arguments for government intervention cover a range of issues, including preserving jobs, protecting industries deemed important for national security, retaliating against unfair foreign competition, protecting consumers from “dangerous” products, furthering the goals of foreign policy, and advancing the human rights of individuals in exporting countries.
Protecting Jobs and Industries Perhaps the most common political argument for government intervention is that it is necessary for protecting jobs and industries from unfair foreign competition. Competition is most often viewed as unfair when producers in
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Trade Law
an exporting country are subsidized in some way by their government. For example, it has been repeatedly claimed that Chinese enterprises in several industries, including aluminum, steel, and auto parts, have benefited from extensive government subsidies. Such logic was behind the complaint that the Obama administration filed with the WTO against Chinese auto parts producers in 2012 (see the Country Focus “Are the Chinese Illegally Subsidizing Auto Exports?” in this chapter). More generally, Robert Scott of the Economic Policy Institute has claimed that the growth in the U.S.–China trade deficit between 2001 and 2015 was, to a significant degree, the result of unfair competition, including direct subsidies to Chinese producers and currency manipulations. Scott estimated that as many as 3.4 million U.S. jobs were lost as a consequence.9 Donald Trump tapped into anxiety about job losses due to unfair trade from China during his successful 2016 presidential run.
On the other hand, critics charge that claims of unfair competition are often overstated for political reasons. For example, President George W. Bush placed tariffs on imports of foreign steel in 2002 as a response to “unfair competition,” but critics were quick to point out that many of the U.S. steel producers that benefited from these tariffs were located in states that Bush needed to win reelection in 2004. A political motive also underlay establishment of the Common Agricultural Policy (CAP) by the European Union. The CAP was designed to protect the jobs of Europe’s politically powerful farmers by restricting imports and guaranteeing prices. However, the higher prices that resulted from the CAP have cost Europe’s consumers dearly. This is true of many attempts to protect jobs and industries through government intervention. For example, the imposition of steel tariffs in 2002 raised steel prices for American consumers, such as automobile companies, making them less competitive in the global marketplace.
Protecting National Security Countries sometimes argue that it is necessary to protect certain industries because they are important for national security. Defense-related industries often get this kind of attention (e.g., aerospace, advanced electronics, and semiconductors). Although now uncommon, this argument is still made sometimes. When the Trump Administration announced tariffs on imports of foreign steel and aluminum on March 1, 2018, national security issues were cited as a primary justification. This was the first time since 1986 that a national security threat was used to justify tariffs imposed by the United States. In 2017, the United States was importing about 30 percent of steel used in the country, with the largest source of imports being Canada and Mexico. Interestingly, and counter to the argument of the Trump Administration, critics argued that by raising input prices for many U.S. defense contractors, who tend to be big consumers of steel and aluminum, the tariffs would actually harm the U.S. defense industry and have a negative impact on national security.10
Government policy and international trade is the core focus of this chapter. 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 individuals can and cannot do globally when trading. The globalEDGE™ section “Trade Law” (globaledge.msu.edu/global-resources/trade-law) is a unique compilation of globalEDGE™ partner- designed “compendiums of trade laws,” country- and region-specific trade law, free online learning modules created for globalEDGE™ on various aspects of trade law, and much more. One fascinating resource related to trade law is the Anti-Counterfeiting and Product Protection Program (A-CAPPP). A- CAPPP includes counterfeiting-related webinars, presentations, and research-related materials and working papers. Do you know what counterfeiting is? Take a look at the “Trade Law” section of globalEDGE™ and especially the A-CAPPP site to become more familiar with the topic. (Is China
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really as bad as many in the international community think?)
Retaliating Some argue that governments should use the threat to intervene in trade policy as a bargaining tool to help open foreign markets and force trading partners to “play by the rules of the game.” The U.S. government has used the threat of punitive trade sanctions to try to get the Chinese government to enforce its intellectual property laws. Lax enforcement of these laws had given rise to massive copyright infringements in China that had been costing U.S. companies such as Microsoft hundreds of millions of dollars per year in lost sales revenues. After the United States threatened to impose 100 percent tariffs on a range of Chinese imports and after harsh words between officials from the two countries, the Chinese agreed to tighter enforcement of intellectual property regulations.11
If it works, such a politically motivated rationale for government intervention may liberalize trade and bring with it resulting economic gains. It is a risky strategy, however. A country that is being pressured may not back down and instead may respond to the imposition of punitive tariffs by raising trade barriers of its own. This is exactly what the Chinese government threatened to do when pressured by the United States, although it ultimately did back down. If a government does not back down, the results could be higher trade barriers all around and an economic loss to all involved.
Protecting Consumers Many governments have long had regulations to protect consumers from unsafe products. 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 designed to protect consumers from what was seen to be an unsafe product. Together, Japan and South Korea accounted for about $2 billion of U.S. beef sales, so the ban had a significant impact on U.S. beef producers. After two years, both countries lifted the ban, although they placed stringent requirements on U.S. beef imports to reduce the risk of importing beef that might be tainted by mad cow disease (e.g., Japan required that all beef must come from cattle under 21 months of age).
Furthering Foreign Policy Objectives Governments sometimes use trade policy to support their foreign policy objectives.12 A government may grant preferential trade terms to a country with which it wants to build strong relations. Trade policy has also been used several times to pressure or punish “rogue states” that do not abide by international law or norms. Iraq labored under extensive trade sanctions after the UN coalition defeated the country in the 1991 Gulf War until the 2003 invasion of Iraq by U.S.-led forces. 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 maintained long-running trade sanctions against Cuba (despite the move by the Obama administration to “normalize” relations with Cuba, these sanctions are still in place). Their principal function is to impoverish Cuba in the hope that the resulting economic hardship will lead to the downfall of Cuba’s communist government and its replacement with a more democratically inclined (and pro-U.S.) regime. 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. interests and building weapons of mass destruction. In late 2003, the sanctions against Libya seemed to yield some returns when that country announced it would terminate a program to build nuclear weapons. 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. Following a 2015 agreement to limit Iran’s nuclear program, it relaxed some of those sanctions.
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Other countries can undermine unilateral trade sanctions. The U.S. sanctions against Cuba, for example, did not stop other Western countries from trading with Cuba. The U.S. sanctions have done little more than help create a vacuum into which other trading nations, such as Canada and Germany, have stepped.
The famous cigar maker Jose Castelar Cairo, better known as El Cueto, about to roll a cigar, in Havana, Cuba.
Esben Hansen/123RF
Protecting Human Rights Protecting and promoting human rights in other countries is an important element of foreign policy for many democracies. Governments sometimes use trade policy to try to improve the human rights policies of trading partners. For example, as discussed in Chapter 5, the U.S. government long had trade sanctions in place against the nation of Myanmar, in no small part due to the poor human rights practices in that nation. In late 2012, the United States said that it would ease trade sanctions against Myanmar in response to democratic reforms in that country. Similarly, in the 1980s and 1990s, Western governments used trade sanctions against South Africa as a way of pressuring that nation to drop its apartheid policies, which were seen as a violation of basic human rights.
ECONOMIC ARGUMENTS FOR INTERVENTION
With the development of the new trade theory and strategic trade policy (see Chapter 6), the economic arguments for government intervention have undergone a renaissance in recent years. Until the early 1980s, most economists saw little benefit in government intervention and strongly advocated a free trade policy. This position has changed at the margins with the development of strategic trade policy, although as we will see in the next section, there are still strong economic arguments for sticking to a free trade stance.
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 advantage in manufacturing, but new manufacturing industries cannot initially compete with established
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industries in developed countries. To allow manufacturing to get a toehold, the argument is that governments should temporarily support new industries (with tariffs, import quotas, and subsidies) until they have grown strong enough to meet international competition.
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 competition does no good unless the protection helps make the industry efficient. In case after case, however, protection seems to have done little more than foster the development of inefficient industries that have little hope of ever competing in the world market. Brazil, for example, built the world’s 10th- largest auto industry behind tariff barriers and quotas. Once those barriers were removed in the late 1980s, however, foreign imports soared, and the industry was forced to face up to the fact that after 30 years of protection, the Brazilian auto industry was one of the world’s most inefficient.13
Second, the infant industry argument relies on an assumption that firms are unable to make efficient long-term investments by borrowing money from the domestic or international capital market. Consequently, governments have been required to subsidize long-term investments. Given the development of global capital markets over the past 20 years, this assumption no longer looks as valid as it once did. Today, if a developing country has a potential comparative advantage in a manufacturing industry, firms in that country should be able to borrow money from the capital markets to finance the required investments. Given financial support, firms based in countries with a potential comparative advantage have an incentive to endure the necessary initial losses in order to 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 protection would be those that are not worthwhile.
Strategic Trade Policy Some new trade theorists have proposed the strategic trade policy argument.14 We reviewed the basic argument in Chapter 6 when we considered the new trade theory. The new trade theory argues that in industries in which the existence of substantial economies of scale implies that the world market will profitably support only a few firms, countries may predominate in the export of certain products simply because they have firms that were able to capture first-mover advantages. 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 government should use subsidies to support promising firms that are active in newly emerging industries. Advocates of this argument point out that the substantial R&D grants that the U.S. government gave Boeing in the 1950s and 1960s probably helped tilt the field of competition in the newly emerging market for passenger jets in Boeing’s favor. (Boeing’s first commercial jet airliner, the 707, was derived from a military plane.) Similar arguments have been made with regard to Japan’s rise to dominance in the production of liquid crystal display screens (used in computers). Although these screens were invented in the United States, the Japanese government, in cooperation with major electronics companies, targeted this industry for research support in the late 1970s and early 1980s. 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
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government to intervene in an industry by helping domestic firms overcome the barriers to entry created by foreign firms that have already reaped first-mover advantages. This argument underlies government support of Airbus, Boeing’s major competitor (see the opening case). Formed in 1966 as a consortium of four companies from Great Britain, France, Germany, and Spain, Airbus had less than 5 percent of the world commercial aircraft market when it began production in the mid-1970s. By 2017, it was splitting the market with Boeing. How did Airbus achieve this? According to the U.S. government, the answer is an $18 billion subsidy from the governments of Great Britain, France, Germany, and Spain.15 Without this subsidy, Airbus would never have been able to break into the world market.
If these arguments are correct, they support a rationale for government intervention in international trade. Governments should target technologies that may be important in the future and use subsidies to support development work aimed at commercializing those technologies. Furthermore, government should provide export subsidies until the domestic firms have established first-mover advantages in the world market. Government support may also be justified if it can help domestic firms overcome the first-mover advantages enjoyed by foreign competitors and emerge as viable competitors in the world market (as in the Airbus and semiconductor examples). In this case, a combination of home-market protection and export- promoting subsidies may be needed.
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The Revised Case for Free Trade LO 7-3 Summarize and explain the arguments against strategic trade policy.
The strategic trade policy arguments of the new trade theorists suggest an economic justification 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 appealing in theory, in practice it may be unworkable. This response to the strategic trade policy argument constitutes the revised case for free trade.16
RETALIATION AND TRADE WAR
Krugman argues that a strategic trade policy aimed at establishing domestic firms in a dominant position in a global industry is a beggar-thy-neighbor policy that boosts national income at the expense of other countries. A country that attempts to use such policies will probably provoke retaliation. In many cases, the resulting trade war between two or more interventionist governments will leave all countries involved worse off than if a hands-off approach had been adopted in the first place. If the U.S. government were to respond to the Airbus subsidy by increasing its own subsidies to Boeing, for example, the result might be that the subsidies would cancel each other out. In the process, both European and U.S. taxpayers would end up supporting an expensive and pointless trade war, and both Europe and the United States would
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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 supported by government subsidies; that is, how should Boeing and the United States respond to the subsidization of Airbus? According to Krugman, the answer is probably not to engage in retaliatory action but to help establish rules of the game that minimize the use of trade-distorting subsidies. This is what the World Trade Organization seeks to do. It should also be noted that antidumping policies can be used to target competitors supported by subsidies who are selling goods at prices that are below their costs of production.
DOMESTIC POLICIES
Governments do not always act in the national interest when they intervene in the economy; politically important interest groups often influence them. 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 formulating detailed policy for many industries is not realistic; to establish a blanket policy of free trade, with exceptions granted only under extreme pressure, may not be the optimal policy according to the theory but may be the best policy that the country is likely to get.17
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Development of the World Trading System
LO 7-4 Describe the development of the world trading system and the current trade issue.
Economic arguments support unrestricted free trade. While many governments have recognized the value of these arguments, they have been unwilling to unilaterally lower their trade barriers for fear that other nations might not follow suit. Consider the problem that two neighboring countries, say, Brazil and Argentina, face when deciding whether to lower trade barriers between them. In principle, the government of Brazil might favor lowering trade barriers, but it might be unwilling to do so for fear that Argentina will not do the same. Instead, the government might fear that the Argentineans will take advantage of Brazil’s low barriers to enter the Brazilian market while continuing to shut Brazilian products out of their market through high trade barriers. 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
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lower barriers for fear that the other might not follow.18
Such a deadlock can be resolved if both countries negotiate a set of rules to govern cross- border trade and lower trade barriers. But who is to monitor the governments to make sure they are playing by the trade rules? And who is to impose sanctions on a government that cheats? Both governments could set up an independent body to act as a referee. This referee could monitor trade between the countries, make sure that no side cheats, and impose sanctions on a country if it does cheat in the trade game.
While it might sound unlikely that any government would compromise its national sovereignty by submitting to such an arrangement, since World War II an international trading framework has evolved that has exactly these features. For its first 50 years, this framework was known as the General Agreement on Tariffs and Trade (GATT). Since 1995, it has been known as the World Trade Organization (WTO). Here, we look at the evolution and workings of the GATT and WTO.
FROM SMITH TO THE GREAT DEPRESSION
As noted in Chapter 5, the theoretical case for free trade dates to the late eighteenth century and the work of Adam Smith and David Ricardo. Free trade as a government policy was first officially embraced by Great Britain in 1846, when the British Parliament repealed the Corn Laws. 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.
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 Benefits of Free Trade: Addressing the Myths (Washington, DC: Mercatus Center, George Mason University, 2013).
By the 1930s, the British attempt to stimulate free trade was buried under the economic rubble of the Great Depression. Economic problems were compounded in 1930, when the U.S. Congress passed the Smoot–Hawley tariff. Aimed at avoiding rising unemployment by
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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.19
1947–1979: GATT, TRADE LIBERALIZATION, AND ECONOMIC GROWTH
Economic damage caused by the beggar-thy-neighbor trade policies that the Smoot–Hawley Act ushered in exerted a profound influence on the economic institutions and ideology of the post– World War II world. 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. leadership, the GATT was established in 1947.
The GATT was a multilateral agreement whose objective was to liberalize trade by eliminating tariffs, subsidies, import quotas, and the like. From its foundation in 1947 until it was superseded by the WTO, the GATT’s membership grew from 19 to more than 120 nations. 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 average tariff declined by nearly 92 percent in the United States between the Geneva Round of 1947 and the Tokyo Round of 1973–1979. Consistent with the theoretical arguments first advanced by Ricardo and reviewed in Chapter 5, the move toward free trade under the GATT appeared to stimulate economic growth.
1980–1993: PROTECTIONIST TRENDS
During the 1980s and early 1990s, the trading system erected by the GATT came under strain as pressures for greater protectionism increased around the world. 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 second-largest economy and its largest exporter. Japan’s success in such industries as automobiles and semiconductors might have been enough to strain the world trading system. Things were made worse by the widespread perception in the West that despite low tariff rates and subsidies, Japanese markets were closed to imports and foreign investment by administrative trade barriers.
Second, the world trading system was strained by the persistent trade deficit in the world’s largest economy, the United States. 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 protection against imports.
A third reason for the trend toward greater protectionism was that many countries found ways to get around GATT regulations. Bilateral voluntary export restraints (VERs) circumvented GATT agreements, because neither the importing country nor the exporting country complained to the GATT bureaucracy in Geneva—and without a complaint, the GATT bureaucracy could
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do nothing. Exporting countries agreed to VERs to avoid more damaging punitive tariffs. One of the best-known examples was the automobile VER between Japan and the United States, under which Japanese producers promised to limit their auto imports into the United States as a way of defusing growing trade tensions. According to a World Bank study, 16 percent of the imports of industrialized countries in 1986 were subjected to nontariff trade barriers such as VERs.20
THE URUGUAY ROUND AND THE WORLD TRADE ORGANIZATION
Against the background of rising pressures for protectionism, in 1986, GATT members embarked on their eighth round of negotiations to reduce tariffs, the Uruguay Round (so named because it occurred in Uruguay). 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 intellectual 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 following provisions:
1. Tariffs on industrial goods were to be reduced by more than one-third, and tariffs were to be scrapped on more than 40 percent of manufactured goods.
2. Average tariff rates imposed by developed nations on manufactured goods were to be reduced to less than 4 percent of value, the lowest level in modern history.
3. Agricultural subsidies were to be substantially reduced. 4. GATT fair trade and market access rules were to be extended to cover a wide range of
services. 5. GATT rules also were to be extended to provide enhanced protection for patents,
copyrights, and trademarks (intellectual property). 6. Barriers on trade in textiles were to be significantly reduced over 10 years. 7. 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 in 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, member countries are no longer able to block adoption of arbitration reports. Arbitration panel reports on trade disputes between member countries are automatically adopted by the WTO unless there is a consensus to reject them. Countries that have been found by the arbitration panel to violate GATT rules may appeal to a permanent appellate body, but its verdict is binding. If offenders fail to comply with the recommendations of the arbitration panel, trading partners have the right to compensation or, in the last resort, to impose (commensurate) trade sanctions. Every stage of the procedure is subject
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to strict time limits. Thus, the WTO has something that the GATT never had—teeth.21
WTO: EXPERIENCE TO DATE
By 2017, the WTO had 164 members, including China, which joined at the end of 2001, and Russia, which joined in 2012. WTO members collectively account for 98 percent of world trade. Since its formation, the WTO has remained at the forefront of efforts to promote global free trade. Its creators expressed the belief that the enforcement mechanisms granted to the WTO would make it more effective at policing global trade rules than the GATT had been. The great hope was that the WTO might emerge as an effective advocate and facilitator of future trade deals, particularly in areas such as services. The experience so far has been mixed. After a strong early start, since the late 1990s the WTO has been unable to get agreements to further reduce barriers to international trade and trade and investment. There has been very slow progress with the current round of trade talks (the Doha Round). There was also a shift back toward some limited protectionism following the global financial crisis of 2008–2009. More recently, the 2016 vote by the British to leave the European Union (Brexit) and the election of Donald Trump to the presidency in the United States have suggested that the world may be shifting back toward greater protectionism. These developments 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 suggest that its policing and enforcement mechanisms are having a positive effect.22 Between 1995 and 2017, more than 500 trade disputes between member countries were brought to the WTO.23 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 consultations between the disputing countries. Resolving the remainder has involved more formal procedures, but these have been largely successful. In general, countries involved have adopted the WTO’s recommendations. The fact that countries are using the WTO represents an important vote of confidence in the organization’s dispute resolution procedures.
Expanded Trade Agreements As explained earlier, the Uruguay Round of GATT negotiations extended global trading rules to cover trade in services. 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 countries to agree to open their telecommunication markets to competition, allowing foreign operators to purchase ownership stakes in domestic telecommunication providers and establishing a set of common rules for fair competition. Most of the world’s biggest markets—including the United States, European Union, and Japan—were fully liberalized by January 1, 1998, when the pact went into effect. All forms of basic telecommunication service are covered, including voice telephone, data, and satellite and radio communications. Many telecommunication companies responded positively to the deal, pointing out that it would give them a much greater ability to offer their business customers one-stop shopping—a global, seamless service for all their corporate needs and a single bill.
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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 licensing processes and requirements, which some described as “protectionist.” Should there be a standardized process and timeline for processing import licenses in member countries of the World Trade Organization?
Source: World Trade Organization, “Members Continue to Criticize Argentina’s Import Licensing,” 2012, www.wto.org/english/news_e/news12_e/impl_27apr12_e.htm.
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 open (to varying degrees) their banking, securities, and insurance sectors to foreign competition. In common with the telecommunication deal, the accord covers not just cross- border trade but also foreign direct investment. Seventy countries agreed to dramatically lower or eradicate barriers to foreign direct investment in their financial services sector. 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 countries made important concessions that allow significant foreign participation in their financial services sectors for the first time.
THE FUTURE OF THE WTO: UNRESOLVED ISSUES AND THE DOHA ROUND
Since the successes of the 1990s, the World Trade Organization has struggled to make progress on the international trade front. Confronted by a slower growing world economy after 2001, many national governments have been reluctant to agree to a fresh round of policies designed to reduce trade barriers. Political opposition to the WTO has been growing in many nations. As the public face of globalization, some politicians and nongovernmental organizations blame the WTO for a variety of ills, including high unemployment, environmental degradation, poor working conditions in developing nations, falling real wage rates among the lower paid in developed nations, and rising income inequality. The rapid rise of China as a dominant trading nation has also played a role here. Reflecting sentiments like those toward Japan 25 years ago, many perceive China as failing to play by the international trading rules, even as it embraces the WTO.
Against this difficult political backdrop, much remains to be done on the international trade front. Four issues at the forefront of the agenda of the WTO are antidumping policies, the high level of protectionism in agriculture, the lack of strong protection for intellectual property rights in many nations, and continued high tariff rates on nonagricultural goods and services in many nations. We shall look at each in turn before discussing the latest round of talks between WTO members aimed at reducing trade barriers, the Doha Round, which began in 2001 and now seem to be stalled.
Antidumping Actions Antidumping actions proliferated during the 1990s and 2000s. WTO rules allow countries to impose antidumping duties on foreign goods that are being sold cheaper
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than at home or below their cost of production when domestic producers can show that they are being harmed. Unfortunately, the rather vague definition of what constitutes “dumping” has proved to be a loophole that many countries are exploiting to pursue protectionism.
Between 1995 and mid-2016, WTO members had reported implementation of some 5,132 antidumping actions to the WTO. India initiated the largest number of antidumping actions, some 818; the EU initiated 485 over the same period, and the United States, 593. China accounted for 1,170 complaints, South Korea for 384, the United States for 273, Taipei for 279, and Japan for 202. Antidumping actions seem to be concentrated in certain sectors of the economy, such as basic metal industries (e.g., aluminum and steel), chemicals, plastics, and machinery and electrical equipment.24 These sectors account for approximately 70 percent of all antidumping actions reported to the WTO. Since 1995, these four sectors have been characterized by periods of intense competition and excess productive capacity, which have led to low prices and profits (or losses) for firms in those industries. It is not unreasonable, therefore, to hypothesize that the high level of antidumping actions in these industries represents an attempt by beleaguered manufacturers to use the political process in their nations to seek protection from foreign competitors, which they claim are engaging in unfair competition. While some of these claims may have merit, the process can become very politicized as representatives of businesses and their employees lobby government officials to “protect domestic jobs from unfair foreign competition,” and government officials, mindful of the need to get votes in future elections, oblige by pushing for antidumping actions. The WTO is clearly worried by the use of antidumping policies, suggesting that it reflects persistent protectionist tendencies and pushing members to strengthen the regulations governing the imposition of antidumping duties.
Protectionism in Agriculture Another focus of the WTO has been the high level of tariffs and subsidies in the agricultural sector of many economies. Tariff rates on agricultural products are generally much higher than tariff rates on manufactured products or services. For example, the average tariff rates on nonagricultural products among developed nations are around 4 percent. On agricultural products, however, the average tariff rates are 15.4 percent for Canada, 11.9 percent for the European Union, 17.4 percent for Japan, and 4.8 percent for the United States.25 The implication is that consumers in countries with high tariffs are paying significantly higher prices than necessary for agricultural products imported from abroad, which leaves them with less money to spend on other goods and services.
Production operations at J.M. Larson Dairy.
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The historically high tariff rates on agricultural products reflect a desire to protect domestic agriculture and traditional farming communities from foreign competition. In addition to high tariffs, agricultural producers also benefit from substantial subsidies. According to estimates from the Organisation for Economic Co-operation and Development (OECD), government subsidies on average account for about 17 percent of the cost of agricultural production in Canada, 21 percent in the United States, 35 percent in the European Union, and 59 percent in Japan.26 OECD countries spend more than $300 billion a year in agricultural subsidies.
Not surprisingly, the combination of high tariff barriers and subsidies introduces significant distortions into the production of agricultural products and international trade of those products. 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 around 10 percent of total merchandized trade, the WTO argues that removing tariff barriers and subsidies could significantly boost the overall level of trade, lower prices to consumers, and raise global economic growth by freeing consumption and investment resources for more productive uses. According to estimates from the International Monetary Fund, removal of tariffs and subsidies on agricultural products would raise global economic welfare by $128 billion annually.27 Others suggest gains as high as $182 billion.28
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 producers in developing nations. In contrast, developing nations have been pushing hard for reforms that would allow their producers greater access to the protected markets of the developed nations. Estimates suggest that removing all subsidies on agricultural production alone in OECD countries could return to the developing nations of the world three times more than all the foreign aid they currently receive from the OECD nations.29 In other words, free trade in agriculture could help jump-start economic growth among the world’s poorer nations and alleviate global poverty.
Protection of Intellectual Property Another issue that has become increasingly important to the WTO has been protecting intellectual property. The 1995 Uruguay agreement that established the WTO also contained an agreement to protect intellectual property (the Trade- Related Aspects of Intellectual Property Rights, or TRIPS, agreement). 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 five 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, trademarks, and copyrights must be an essential element of the international trading system. Inadequate protections for intellectual property reduce the incentive for innovation. Because innovation is a central engine of economic growth and rising living standards, the argument has been that a multilateral agreement is needed to protect intellectual property.
Without such an agreement, it is feared that producers in a country—let’s say, India—might market imitations of patented innovations pioneered in a different country—say, the United States. 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 argue that because the size of the total world market for the innovator is reduced, its incentive to pursue risky and expensive
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innovations is also reduced. The net effect would be less innovation in the world economy and less economic growth.
Market Access for Nonagricultural Goods and Services Although the WTO and the GATT have made big strides in reducing the tariff rates on nonagricultural products, much work remains. Although most developed nations have brought their tariff rates on industrial products down 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 developed nations, which limit market access and economic growth. For example, Australia and South Korea, both OECD countries, still have bound tariff rates of 15.1 percent and 24.6 percent, respectively, on imports of transportation equipment (bound tariff rates are the highest rate that can be charged, which is often, but not always, the rate that is charged). In contrast, the bound tariff rates on imports of transportation equipment into the United States, European Union, and Japan are 2.7 percent, 4.8 percent, and 0 percent, respectively. A particular area for concern is high tariff rates on imports of selected goods from developing nations into developed nations.
In addition, tariffs on services remain higher than on industrial goods. 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.30 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 Doha negotiations could increase world income by $263 billion annually, of which $109 billion would go to poor countries.31 Another estimate from the OECD suggests a figure closer to $300 billion annually.32 See the accompanying Country Focus for estimates of the benefits to the American economy from free trade.
Looking farther out, the WTO would like to bring down tariff rates on imports of nonagricultural goods into developing nations. Many of these nations use the infant industry argument to justify the continued imposition of high tariff rates; however, ultimately these rates need to come down for these nations to reap the full benefits of international trade. For example, the bound tariff rates of 53.9 percent on imports of transportation equipment into India and 33.6 percent on imports into Brazil, by raising domestic prices, help protect inefficient domestic producers and limit economic growth by reducing the real income of consumers who must pay more for transportation equipment and related services.
c o u n t r y F O C U S
Estimating the Gains from Trade for America A study published by the Institute for International Economics tried to estimate the gains to the American economy from free trade. According to the study, due to reductions in tariff barriers under the GATT and WTO since 1947, by 2003 the gross domestic product (GDP) of the United States was 7.3 percent higher than would otherwise be the case. The benefits of that amounted to roughly $1 trillion a
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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 employment disruption that would be caused by a move to universal free trade. Jobs would be lost in certain sectors and gained in others if the country abolished all tariff barriers. Using historical data as a guide, they estimated that 226,000 jobs would be lost every year due to expanded trade, although some two-thirds of those losing jobs would find reemployment after a year. Reemployment, however, would be at a wage that was 13 to 14 percent lower. 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.
Source: 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).
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 15 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 2017, the goal was to reduce tariffs for manufactured and agricultural goods by 60 to 70 percent and to cut subsidies to half of their current level—but getting nations to agree to these goals was proving exceedingly difficult.
MULTILATERAL AND BILATERAL TRADE AGREEMENTS
In response to the apparent failure of the Doha Round to progress, many nations have pushed forward with multilateral or bilateral trade agreements, which are reciprocal trade agreements between two or more partners. For example, in 2014 Australia and China entered
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into a bilateral free trade agreement. Similarly, in March 2012 the United States entered into a bilateral free trade agreement with South Korea. Under this agreement, 80 percent of U.S. exports of consumer and industrial products became duty free, and 95 percent of bilateral trade in industrial and consumer products will be duty free by 2017 (this agreement was revised in 2018, see the opening case). The agreement is estimated to boost U.S. GDP by some $10 to $12 billion. Under the Obama Administration the United States was pursuing two major multilateral trade agreements, one with 11 other Pacific Rim countries including Australia, New Zealand, Japan, Malaysia, and Chile (the TPP), and another with the European Union. However, following the accession of Donald Trump to the presidency in the United States, the U.S. withdrew from the TPP (although the remaining 11 nations went ahead with a revised agreement) and the trade agreement being negotiated with the EU was put on ice.
Multilateral and bilateral trade agreements are designed to capture gain from trade beyond those agreements currently attainable under WTO treaties. Multilateral and bilateral trade agreements are allowed under WTO rules, and countries entering into these agreements are required to notify the WTO. As of 2017, more than 440 regional or bilateral trade agreements were in force. Reflecting the lack of progress on the Doha Round, the number of such agreements has increased significantly since the early 2000s, when fewer than 100 were in force.
THE WORLD TRADING SYSTEM UNDER THREAT
In 2016, two events challenged the long-held belief that there was a global consensus behind the 70-year push to embrace free trade and lower barriers to the cross-border flow of goods and services. The first was the decision by the British to withdraw from the European Union following a national referendum (Brexit). We discuss Brexit in more detail in Chapter 9, but it is worth noting that the British intention to withdraw from what is arguably one of the most successful free trade zones in the world is a big setback for those who argue that free trade is a good thing. The second event was the victory of Donald Trump in the 2016 U.S. presidential election. As discussed in Chapter 6, Trump appears to hold mercantilist views on trade. He seems opposed to many free trade deals. Indeed, one of his first actions was to pull the United States out of the Trans Pacific Partnership, a 12-nation free trade zone that was close to ratification. In early 2018, he placed tariffs on imports of solar panels, washing machines, steel, and aluminum into the United States, in all probability in violation of WTO rules. Trump also initiated the renegotiation of NAFTA and has expressed hostility to the WTO. The significance of these developments is that heretofore both Britain and America have been leaders in the global push toward greater free trade. While Britain still seems committed to free trade, despite the Brexit decision, the position of the United States, the world’s largest economy, is less clear. If the U.S. continues to turn its back on new free trade deals (such as the TPP) and dismantles existing ones (as Trump has threatened to do with NAFTA), other nations could follow. If this happens, the impact on the world economy will almost certainly be negative, resulting in greater protectionism, slower economic growth, and higher unemployment around the globe.
test PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
Focus on Managerial Implications
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TRADE BARRIERS, FIRM STRATEGY, AND POLICY IMPLICATIONS
LO 7-5 Explain the implications for managers of developments in the world trading system.
What are the implications for business practice? Why should the international manager care about the political economy of free trade or about the relative merits of arguments for free trade and protectionism? 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 Chapter 6. Drawing on the theories of international trade, we discussed how it makes sense for the firm to disperse its various production activities to those countries around the globe where they can be performed most efficiently. 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 relative to indigenous competitors in that country. In response, the firm may then find it economical to locate production facilities in that country so that it can compete on even footing. Second, quotas may limit a firm’s ability to serve a country from locations outside that country. Again, the response by the firm might be to set up production facilities in that country—even though it may result in higher production costs.
Such reasoning was one of the factors behind the rapid expansion of Japanese automaking capacity in the United States during the 1980s and 1990s. This followed the establishment of a VER agreement between the United States and Japan that limited U.S. imports of Japanese automobiles. Today, Donald Trump’s threat to impose high tariffs on companies that shift their production to other nations in order to reduce costs—and then export goods back to the United States—is forcing some enterprises to rethink their outsourcing strategy. In particular, a number of automobile companies, including Ford and General Motors, have modified their plans to shift some production to factories in Mexico and have announced plans to expand U.S. production in order to appease the Trump administration.33
Third, to conform to local content regulations, a firm may have to locate more production activities in a given market than it would otherwise. Again, from the firm’s perspective, the consequence might be to raise costs above the level that could be achieved if each production activity were dispersed to the optimal location for that activity. And finally, even when trade barriers do not exist, the firm may still want to locate some production activities in a given country to reduce the threat of trade barriers being imposed in the future.
All these effects are likely to raise the firm’s costs above the level that could be achieved in a world without trade barriers. The higher costs that result need not translate into a significant competitive disadvantage relative to other foreign firms, however, if the countries imposing trade barriers do so to the imported products of all foreign firms, irrespective of their national origin. But when trade barriers are targeted at exports from a particular nation, firms based in that nation are at a competitive disadvantage to firms of other nations. 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
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targeted by the specific trade barrier.
Finally, the threat of antidumping action limits the ability of a firm to use aggressive pricing to gain market share in a country. Firms in a country also can make strategic use of antidumping measures to limit aggressive competition from low-cost foreign producers. For example, the U.S. steel industry has been very aggressive in bringing antidumping actions against foreign steelmakers, particularly in times of weak global demand for steel and excess capacity. For example, in 1998 and 1999, the United States faced a surge in low-cost steel imports as a severe recession in Asia left producers there with excess capacity. The U.S. producers filed several complaints with the International Trade Commission. One argued that Japanese producers of hot rolled steel were selling it at below cost in the United States. The ITC agreed and levied tariffs ranging from 18 to 67 percent on imports of certain steel products from Japan (these tariffs are separate from the steel tariffs discussed earlier).34
Policy Implications As noted in Chapter 6, business firms are major players on the international trade scene. Because of their pivotal role in international trade, firms can and do exert a strong influence on government policy toward trade. 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 intervention in the form of tariffs, quotas, antidumping actions, and subsidies helping firms and industries establish a competitive advantage in the world economy. In general, however, the arguments contained in this chapter and in Chapter 6 suggest that government intervention has three drawbacks. Intervention can be self-defeating because it tends to protect the inefficient rather than help firms become efficient global competitors. Intervention is dangerous; it may invite retaliation and trigger a trade war. Finally, intervention is unlikely to be well executed, given the opportunity for such a policy to be captured by special-interest groups. Does this mean that business should simply encourage government to adopt a laissez-faire free trade policy?
Most economists would probably argue that the best interests of international business are served by a free trade stance but not a laissez-faire stance. It is probably in the best long-run interests of the business community to encourage the government to aggressively promote greater free trade by, for example, strengthening the WTO. Business probably has much more to gain from government efforts to open protected markets to imports and foreign direct investment than from government efforts to support certain domestic industries in a manner consistent with the recommendations of strategic trade policy.
This conclusion is reinforced by a phenomenon we touched on in Chapter 1—the increasing integration of the world economy and internationalization of production that has occurred over the past two decades. We live in a world where many firms of all national origins increasingly depend on globally dispersed production systems for their competitive advantage. Such systems are the result of freer trade. Freer trade has brought great advantages to firms that have exploited it and to consumers who benefit from the resulting lower prices. Given the danger of retaliatory action, business firms that lobby their governments to engage in protectionism must realize that by doing so, they may be denying themselves the opportunity to build a competitive advantage by constructing a globally dispersed production system. By encouraging their governments to engage in protectionism, their own activities and sales overseas may be jeopardized if other governments retaliate. 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.
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Key Terms
free trade, p. 186 General Agreement on Tariffs and Trade (GATT), p. 186 tariff, p. 187 specific tariff, p. 187 ad valorem tariff, p. 187 subsidy, p. 188 import quota, p. 189 tariff rate quota, p. 189 voluntary export restraint (VER), p. 189 quota rent, p. 190 export tariff, p. 190 export ban, p. 190 local content requirement (LCR), p. 190 administrative trade policies, p. 191 dumping, p. 191 antidumping policies, p. 191 countervailing duties, p. 191 infant industry argument, p. 195 strategic trade policy, p. 196 Smoot-Hawley Act, p. 198 multilateral or bilateral trade agreements, p. 205
Summary
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 reported the various instruments of trade policy, reviewed the political and economic arguments for government intervention in international trade, reexamined the economic case for free trade in light of the strategic trade policy argument, and looked at the evolution of the world trading framework. While a policy of free trade may not always be the theoretically optimal policy (given the arguments of the new trade theorists), in practice it is probably the best policy for a government to pursue. In particular, the long-run interests of business and consumers may be best served by strengthening international institutions such as the WTO. Given the danger that isolated protectionism might escalate into a trade war, business probably has far more to gain from government efforts to open protected markets to imports and foreign direct investment (through the WTO) than from government efforts to protect domestic industries from foreign competition. 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.
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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.
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?
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?
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Research Task http://globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. You work for a pharmaceutical company that hopes to provide products and services in New Zealand. Yet management’s current knowledge of this country’s trade policies and barriers is limited. After searching a resource that summarizes the import and export regulations, outline the most important foreign trade barriers your firm’s managers must keep in mind while developing a strategy for entry into New Zealand’s pharmaceutical market.
2. 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 the WTO’s website to identify a list of current members and observers. Identify the last five countries that joined the WTO as members. Also, examine the list of current observer countries. Do you notice anything in particular about the countries that have recently joined or have observer status?
Boeing and Airbus are in a Dogf ight over I l legal Subsid ies c los ing case
Boeing (boeing.com) and Airbus (airbus.com) are the dominant players in the global market for large commercial jet aircraft of 100 seats or more. The two companies are locked in a relentless battle for market share. For decades, these two companies have been accusing each other of benefiting from government subsidies. In its early years, Airbus received 100 percent of the funds it needed to develop new aircraft from the governments of four European countries where Airbus’s operations were based: Germany, France, Spain, and the United Kingdom. These funds were provided in the form of loans at below-market interest rates. For its part, Airbus claimed that Boeing has long been the recipient of R&D grants from the U.S. Department of Defense and NASA, which amount to indirect subsidies. For example, Boeing’s first commercial jet aircraft, the 707, was a derivative of an aerial refueling tanker, the KC-135, originally developed for the United States Air Force under a Pentagon contract.
The two companies reached an agreement on phasing out subsidies back in 1992, but Boeing walked away from that deal in 2004, claiming that Airbus was still benefiting from billions in illegal development subsidies. In 2006, the U.S. government filed a case with the World Trade Organization (WTO) alleging that Airbus had received $25 billion in illegal subsidies, mostly in the form of launch aid for developing new aircraft. In 2010, the WTO ruled that Airbus had benefited from $18 billion in illegal government subsidies, including $15 billion in launch aid. The WTO gave the European governments until December 2011 to remove the harmful effects of the subsidies.
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In September 2016, the WTO issued another ruling criticizing the Europeans for failing to comply with its 2010 ruling and, moreover, for giving another $5 billion to Airbus in the form of noncommercial loans to help develop its latest aircraft, the A350. In this latest ruling, the WTO stated that “it is apparent that the A350 could not have been launched and brought to market in the absence of launch aid.” In total, the WTO calculated that Boeing had lost 104 wide-bodied jet orders and 271 narrow-bodied jet orders as a result of Airbus launch subsidies. This latest ruling opens the door for the United States to apply retaliatory trade sanctions against noncompliant European governments.
However, it seems unlikely that the United States will apply retaliatory sanctions any time soon. Part of the reason is the the United States itself has been countersued by the EU through the WTO for providing illegal subsidies to Boeing. In November 2016, the WTO ruled that Boeing would receive around $5.7 billion in illegal tax breaks from Washington State, where Boeing’s main production facilities are located. The State of Washington had promised to give Boeing these tax breaks between 2020 and 2040 on the condition that the company kept the production of the wings for the wide-bodied 777X aircraft in the state. According to Airbus, these tax breaks give the 777X an unfair advantage against its rival aircraft, an assessment that the WTO seems to agree with.
In 2017, the WTO issued a report largely clearing the United States of maintaining unfair support for Boeing. However, the WTO noted that the U.S. had failed to withdraw tax breaks offered by Washington State where most of its planes are assembled, and it continued to suggest that those tax breaks have adverse effects. It remains to be seen what the final outcome will be. The WTO has yet to rule on how much damage the tax breaks Boeing has received for the 777X program might impose upon Airbus. For its part, Boeing claims that the benefits from the subsidies to the 777X program only amount to $50 million a year, an assessment that Airbus vigorously disagrees with. A final ruling isn’t expected until at least 2018.
Sources: Dominic Gates, “Airbus Scoffs, Boeing Crows as WTO Slams EU for Failing to Address Illegal Subsidies,” Seattle Times, September 22, 2016; “Boeing Illegally Given $5.7 Billion in Tax Breaks by Washington State, WTO Rules,” Associated Press, November 28, 2016; Robert Wall and Doug Cameron, “EU Failed to Cut Off Illegal Subsidies to Airbus, WTO Rules,” The Wall Street Journal, September 22, 2016; and Tom Miles, “WTO Largely Backs Boeing in Trade Row, Faults Tax Breaks,” Reuters, June 9, 2017.
CASE DISCUSSION QUESTIONS 1. Are there any circumstances under which the subsidies that Airbus received in its early
years might be justified? 2. Do you think that Boeing originally benefited from subsidies? If they did, could they be
justified? 3. Boeing and Airbus have allegedly been receiving subsidies for decades. How might
ongoing subsidies distort the market for large commercial jet aircraft? 4. Who benefits from government subsidies to Boeing and Airbus? Who loses? 5. Under what circumstances, if any, should national governments subsidize the
development of new technologies? 6. What would be the optimal outcome (in terms of economic welfare) of the ongoing trade
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dispute between the U.S. and the EU countries backing Airbus? How might such an agreement be enforced?
Endnotes
1. For a detailed welfare analysis of the effect of a tariff, see P. R. Krugman and M. Obstfeld, International Economics: Theory and Policy (New York: HarperCollins, 2000), ch. 8.
2. Christian Henn and Brad McDonald, “Crisis Protectionism: The Observed Trade Impact,” IMF Economic Review 62, no. 1 (April 2014), pp. 77–118.
3. World Trade Organization, World Trade Report 2006 (Geneva: WTO, 2006). 4. The study was undertaken by Kym Anderson of the University of Adelaide. See “A Not So
Perfect Market,” The Economist: Survey of Agriculture and Technology, March 25, 2000, pp. 8–10.
5. K. Anderson, W. Martin, and D. van der Mensbrugghe, “Distortions to World Trade: Impact on Agricultural Markets and Farm Incomes,” Review of Agricultural Economics 28 (Summer 2006), pp. 168–94.
6. J. B. Teece, “Voluntary Export Restraints Are Back; They Didn’t Work the Last Time,” Automotive News, April 23, 2012.
7. G. Hufbauer and Z. A. Elliott, Measuring the Costs of Protectionism in the United States (Washington, DC: Institute for International Economics, 1993).
8. Sean McLain, “American Cars in Japan: Lost in Translation,” The Wall Street Journal, January 26, 2017.
9. Robert E. Scott. “Growth in US-China Trade Deficit Between 2001–2015 Cost 3.4 Million Jobs,” Economic Policy Institute, January 31, 2017.
10. Alan Goldstein, “Sematech Members Facing Dues Increase; 30% Jump to Make Up for Loss of Federal Funding,” Dallas Morning News, July 27, 1996, p. 2F.
11. N. Dunne and R. Waters, “U.S. Waves a Big Stick at Chinese Pirates,” Financial Times, January 6, 1995, p. 4.
12. Peter S. Jordan, “Country Sanctions and the International Business Community,” American Society of International Law Proceedings of the Annual Meeting 20, no. 9 (1997), pp. 333– 42.
13. “Brazil’s Auto Industry Struggles to Boost Global Competitiveness,” Journal of Commerce, October 10, 1991, p. 6A.
14. For reviews, see J. A. Brander, “Rationales for Strategic Trade and Industrial Policy,” in Strategic Trade Policy and the New International Economics, P. R. Krugman, ed. (Cambridge, MA: MIT Press, 1986); P. R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1 (1987), pp. 131–44; P. R. Krugman, “Does the New Trade Theory Require a New Trade Policy?” World Economy 15, no. 4 (1992), pp. 423–41.
15. “Airbus and Boeing: The Jumbo War,” The Economist, June 15, 1991, pp. 65– 66.
16. For details, see Krugman, “Is Free Trade Passé?”; Brander, “Rationales for Strategic Trade and Industrial Policy.”
17. Krugman, “Is Free Trade Passe?” 18. 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
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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: Norton, 1991).
19. Note that the Smoot-Hawley Act did not cause the Great Depression. However, the beggar- thy-neighbor trade policies that it ushered in certainly made things worse. See J. Bhagwati, Protectionism (Cambridge, MA: MIT Press, 1988).
20. World Bank, World Development Report (New York: Oxford University Press, 1987). 21. Frances Williams, “WTO—New Name Heralds New Powers,” Financial Times, December
16, 1993, p. 5; Frances Williams, “GATT’s Successor to Be Given Real Clout,” Financial Times, April 4, 1994, p. 6.
22. W. J. Davey, “The WTO Dispute Settlement System: The First Ten Years,” Journal of International Economic Law, March 2005, pp. 17–28; WTO Annual Report, 2016, archived at www.wto.org/english/res_e/publications_e/anrep16_e.htm.
23. Information provided on WTO website, www.wto.org/english/tratop_e/dispu_e/dispu_status_e.htm.
24. Data at www.wto.org/english/tratop_e/adp_e/adp_e.htm. 25. World Trade Organization, World Tariff Profiles 2017 (Geneva: WTO, 2017). 26. World Trade Organization, Annual Report by the Director General 2003 (Geneva: WTO,
2003). 27. World Trade Organization, Annual Report by the Director General 2003 (Geneva: WTO,
2003). 28. Anderson et al., “Distortions to World Trade.” 29. World Trade Organization, Annual Report 2002 (Geneva: WTO, 2002). 30. S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “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).
31. World Bank, Global Economic Prospects 2005 (Washington, DC: World Bank, 2005). 32. “Doha Development Agenda,” OECD Observer, September 2006, pp. 64–67. 33. Peter Nicholas, “Trump Warns Auto Executive on Moving Business Overseas,” The Wall
Street Journal, January 24, 2017. 34. “Punitive Tariffs Are Approved on Imports of Japanese Steel,” The New York Times, June
12, 1999, p. A3.
Design elements: Modern textured halftone: ©VIPRESIONA/Shutterstock; globalEDGE icon: ©globalEDGE; All others: ©McGraw-Hill Education
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Part 3 The Global Trade and Investment Environment
Foreign Direct Investment
Learning Object ives After reading this chapter, you will be able to:
LO8-1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.
LO8-2 Explain the different theories of FDI.
LO8-3 Understand how political ideology shapes a government’s attitudes toward FDI.
LO8-4 Describe the benefits and costs of FDI to home and host countries.
LO8-5 Explain the range of policy instruments that governments use to influence FDI.
LO8-6 Identify the implications for managers of the theory and government policies associated with FDI.
Geely Goes Global
opening case Zhejiang Geely Holding Group Co., Ltd (zgh.com)—or Geely for short—is a Chinese auto manufacturer that started in 1986 as a manufacturer of refrigerators. Founded by Li Shufu, an energetic entrepreneur and car enthusiast, the Hangzhou-based company did not enter the automobile business until 1997. Today, it is the second largest private automobile manufacturer in China’s booming car market.
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Li Shufu reportedly has a great appreciation for design. He scrapped three batches of poorly designed and built models before finally arriving at one that met his expectations, a four-door subcompact sedan introduced in 2002 known as the Ziyoujian (Free Cruiser in English). In a clear sign that Geely had yet to develop its own design and engineering skills, the car was actually designed by the South Korean firm Daewoo Motors.
It was around this time that Li started to think about owning Volvo, his personal favorite car maker. Based in Sweden, Volvo had been acquired by Ford Motor Company in 1999 for $6.45 billion. Li got his chance in 2009 when Ford, battered by the great recession that had hammered the auto market in the United States and Europe, announced that it would sell many of its specialty car brands, including Volvo. In 2010, Geely reached an agreement to purchase Volvo for $1.8 billion. At the time this was the largest overseas acquisition by a Chinese automobile maker.
Many observers had low expectations for the acquisition, but they have been proved wrong. The marriage of Volvo’s brand and engineering design skills with Geely’s manufacturing capabilities has proved to be a winning combination. Today Volvo cars are still engineered, designed, and tested in Gothenburg Sweden, but they are manufactured at three plants in China and one in South Carolina.
China has emerged as a major market for the Volvo, where the brand is valued for its safety and elegance. The company’s aim is to produce the safest car on the road that handles well under any roadside conditions. Geely has pledge to produce a “death-proof” car by 2020, with a commitment that no one should be seriously injured or killed in a new Volvo. The technologies required to achieve this include auto steering, adaptive cruise control, and pedestrian and animal detection for collision warnings and avoidance, all technologies that are being developed in Gothenburg.
The proof of the strategy is in the sales figures. In 2017, sales rose 7 percent year-on-year to a new record high. All regions contributed to the nearly 600,000 units sold, with performance in the Asia Pacific region growing by more than 20 percent on the back of record sales in China, now the largest market for the Volvo brand.
Emboldened by its success with Volvo, Geely is now making more foreign investments. In 2017, it acquired a controlling stake in the British sports car manufacturer Lotus Cars, a 49.9 percent stake in Proton, Malaysia’s largest car company, and minority stakes in the Swedish Truck Company, the Volvo Group (the one time parent of Volvo Cars), and Daimler Benz. • Sources: Pamela Ambler, “Volvo and Geely: The Unlikely Marriage of Swedish Tech and Chinese Manufacturing,” Forbes, January 23, 2018; Sui-Lee Wee, “Geely Buys Stake in Volvo Trucks,” The New York Times, December 27, 2017; “Volvo Cars Sales Rise to Fresh Record,” Reuters, January 4, 2018.
Introduction Foreign direct investment (FDI) occurs when a firm invests directly in facilities to produce or market a good or service in a foreign country. According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of 10 percent or more in a foreign business entity. Once a firm undertakes FDI, it becomes a multinational enterprise. The investment by Geely in Volvo discussed in the opening case is an example of FDI. While much FDI takes the form greenfield ventures—building up subsidiaries from scratch—acquisitions are also an important vehicle for foreign investment.
This chapter begins by looking at the importance of FDI in the world economy. Next, we review the theories that have been used to explain why enterprises undertake foreign direct investment. These theories can explain why Geely acquired Volvo. Geely needed Volvo’s engineering design skills and access to a powerful brand like Volvo. Although Geely perhaps could have built these skills and the associated brand equity internally, it was quicker (and probably cheaper in this instance) to acquire Volvo. The foreign investment, by combining Geely’s manufacturing capabilities with Volvo’s design engineering skills and brand, has
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enabled Geely to transform itself from a little-known Chinese automobile company into a global player in the luxury car segment. After discussing theories of FDI, the chapter moves on to look at government policy toward foreign direct investment. The chapter closes with a section on implications of the material discussed in the chapter for management practice.
Foreign Direct Investment in the World Economy
LO 8-1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.
When discussing foreign direct investment, it is important to distinguish between the flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI undertaken 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 25 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 $250 billion in 1990 to $1.43 trillion in 2017 (see Figure 8.1).1 Over the past 25 years, the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1990 and 2017, the total flow of FDI from all countries increased around sixfold, while world trade by value grew fourfold and world output by around 60 percent.2 As a result of the strong FDI flows, by 2017 the global stock of FDI was about $32 trillion. The foreign affiliates of multinationals had $31 trillion in global sales in 2017, compared to $22.5 trillion in global exports, and accounted for more than one-third of all cross-border trade in goods and services.3 Clearly, by any measure, FDI is a very important phenomenon in the global economy.
8.1 FIGURE FDI outflows, 1990–2017 ($ billions).
Source: UNCTAD statistical data set, http://unctadstat.unctad.org.
FDI has grown more rapidly than world trade and world output for several reasons. First,
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despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Given the rising pressures for protectionism associated with the election of Donald Trump as president in the United States and the decision by the British to leave the European Union, this seems likely to continue for some time. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world’s developing nations. 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 environment for FDI.4
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 example, a third of the revenues and as much as 40 percent of the profits of firms in the S&P 500 index are generated abroad. For reasons that we explore later in this book, many firms now believe it is important to have production facilities close to their major customers. This too creates pressure for greater FDI.
THE DIRECTION OF FDI
Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the others’ markets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favorite target for FDI inflows. 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 $275 billion in 2017. The developed nations of Europe have also been recipients of significant FDI inflows, principally from the United States and other European nations. In 2017, inward investment into Europe was $334 billion. The United Kingdom and France have historically been the largest recipients of inward FDI.5
8.2 FIGURE FDI inflows by region, 1995–2017 ($ billions).
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Source: UNCTAD statistical data set, http://unctadstat.unctad.org.
Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations and the transition economies of eastern Europe and the old Soviet Union has increased markedly (see Figure 8.2). Most recent inflows into developing nations have been targeted at the emerging economies of Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI, which attracted about $60 billion of FDI in 2004 and rose steadily to hit a record $136 billion in 2017.6 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 2017, total inward investments into this region reached $151 billion. Brazil has historically been the top recipient of inward FDI in Latin America. In Central America, Mexico has been a big recipient of inward investment thanks to its proximity to the United States and to NAFTA. In 2017, some $27 billion of investments were made by foreigners in Mexico. At the other end of the scale, Africa has long received the smallest amount of inward investment, $42 billion in 2017. In recent years, Chinese enterprises have emerged as major investors in Africa, particularly in extraction industries, where they seem to be trying to ensure future supplies of valuable raw materials. The inability of Africa to attract greater investment is in part a reflection of the political unrest, armed conflict, and frequent changes in economic policy in the region.7
THE SOURCE OF FDI
Since World War II, the United States has consistently been the largest source country for FDI. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries accounted for 60 percent of all FDI outflows for 1998–2018 (see Figure 8.3). As might be expected, these countries also predominate in rankings of the world’s largest multinationals.8 These nations dominate primarily because they were the most developed nations with the largest economies during much of the postwar period and therefore home to many of the largest and best-capitalized enterprises. Many of these countries also had a long history as trading nations and naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises based there have been at the forefront of foreign investment trends.
8.3 FIGURE Cumulative FDI outflows, 1998–2017 ($ billions).
Source: UNCTAD statistical data set, http://unctadstat.unctad.org.
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c o u n t r y F O C U S
Foreign Direct Investment in China Beginning in late 1978, China’s leadership decided to move the economy away from a centrally planned socialist system to one that was more market driven. The result has been 40 years of sustained high economic growth rates of around 6–10 percent, compounded annually. 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 $133 billion in 2016 (with another $108 billion going into Hong Kong). Over the past 20 years, this inflow has resulted in the establishment of more than 300,000 foreign-funded enterprises in China. The total stock of FDI in mainland China grew from almost nothing in 1978 to $1.35 trillion in 2016 (another $1.6 trillion of FDI stock was in Hong Kong).
The reasons for this investment are fairly obvious. With a population of more than 1.3 billion people, China represents the world’s largest market. Historically, import tariffs made it difficult to serve this market via exports, so FDI was required if a company wanted to tap into the country’s huge potential. China joined the World Trade Organization in 2001. As a result, average tariff rates on imports have fallen from 15.4 percent to about 8 percent today. Even so, avoiding the tariff on imports is still a motive for investing in China (at 8 percent, tariffs are still above the average of 3.5 percent found in many developed nations). Notwithstanding tariff rates, many foreign firms believe that doing business in China requires a substantial presence in the country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combination of relatively inexpensive labor and tax incentives, particularly for enterprises that establish themselves in special economic zones, makes China an attractive base from which to serve Asian or world markets with exports (although rising labor costs in China are now making this less important).
Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. For one thing, despite decades of growth, China still lags far behind developed nations in the wealth and sophistication of its consumer market. This limits opportunities for Western firms. The average annual wage in 2014 was only $8,655. Moreover, half of the 770 million labor force works in rural areas and only earns around $2,000 a year. The middle class, which accounts for about 20 percent of the workforce, has an average income of $12,000 a year, still way below Western levels. Only 0.2 percent of the population earns more than $50,000 a year.
Other problems include a highly regulated environment, which can make it problematic to conduct business transactions, and shifting tax and regulatory regimes. Then there are problems with local joint- venture partners that are inexperienced, opportunistic, or simply operate according to different goals. One U.S. manager explained that when he laid off 200 people to reduce costs, his Chinese partner hired them all back the next day. When he inquired why they had been hired back, the Chinese partner, which was government owned, explained that as an agency of the government, it had an “obligation” to reduce unemployment. Western firms also need to be concerned about protecting their intellectual property because there is a history of intellectual property not being respected in China, although this may now be starting to change.
Sources: Interviews by the author while in China; United Nations, World Investment Report, 2017; Linda Ng and C. Tuan, “Building a Favorable Investment Environment: Evidence for the Facilitation of FDI in China,” The World Economy, 2002, pp. 1095–114; S. Chan and G. Qingyang, “Investment in China Migrates Inland,” Far Eastern Economic Review, May 2006, pp. 52–57; Rachel Chang, “Here’s What China’s Middle Classes Really Earn—and Spend,” Bloomberg, March 9, 2016; Gordon Orr, “A Pocket Guide to Doing Business in China,” McKinsey, October 2014, archived at www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/a-pocket-guide-to- doing-business-in-china.
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Did You Know? Did you know that America is the world’s largest foreign investor and the largest recipient of foreign investment? Visit your instructor’s Connect® course and click on your eBook or Smartbook® to view a short video explanation from the authors.
That being said, it is noteworthy that Chinese firms have started to emerge as major foreign investors. In 2005, Chinese firms invested some $12 billion internationally. Since then, the figure has risen steadily, reaching a record $196 billion in 2016 before declining to $125 billion in 2017. Firms based in Hong Kong accounted for another $60 billion of outward FDI in 2016 and $83 billion in 2017. Much of the outward investment by Chinese firms has been directed at extractive industries in less developed nations (e.g., China has been a major investor in African countries). A major motive for these investments has been to gain access to raw materials, of which China is one of the world’s largest consumers. There are signs, however, that Chinese firms are starting to turn their attention to more advanced nations. In 2017, Chinese firms invested $25 billion in the United States, up from $146 million in 2003.9
THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS
FDI takes two main forms. The first is a greenfield investment, which involves the establishment of a new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country. UN estimates indicate that some 40 to 80 percent of all FDI inflows were in the form of mergers and acquisitions between 1998 and 2017.10 However, FDI flows into developed nations differ markedly from those into developing nations. In the case of developing nations, only about one-third or less of FDI is in the form of cross- border mergers and acquisitions. The lower percentage of mergers and acquisitions may simply reflect the fact that there are fewer target firms to acquire in developing nations.
Which Is Better, an Acquisition or a Greenfield Investment?
A greenfield investment is an establishment of a new operation in a foreign country (i.e., a parent company starts a new venture in a foreign country by building new production facilities from the ground up). The acquisition approach refers to buying or merging operations with an existing firm in a foreign country. In this chapter and Chapter 13, we discuss reasons for greenfield and acquisition-based investments in a foreign country. While mergers and acquisitions (M&A) are typically quicker to execute than building something from literally the ground up, M&A often fails to gain the advantages expected. 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 mergers and acquisitions and the sums of money spent on M&A are increasingly consistently every year. If you were making the decision, would you prefer to make a greenfield investment or to engage in either a merger or acquisition in a foreign country?
Source: Y. Weber, C. Oberg, and S. Tarba, “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).
When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments? We consider this question in depth in Chapter 15. For now,
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Page 218we can make a few basic observations. First, mergers and acquisitions are quicker to execute than greenfield investments. This is an important consideration in the modern business world where markets evolve very rapidly. Many firms apparently believe that if they do not acquire a desirable target firm, then their global rivals will. Second, foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trademarks or patents, distribution systems, production systems, and the like (this was clearly a factor in the acquisition of Volvo by Geely—see the opening case). It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through a greenfield investment. Third, firms make acquisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or management skills. However, as we discuss in Chapter 15, there is evidence that many mergers and acquisitions fail to realize their anticipated gains.11
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Theories of Foreign Direct Investment LO 8-2 Explain the different theories of FDI.
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 perspective, known as the eclectic paradigm, attempts to combine the two other perspectives into a single holistic explanation of foreign direct investment (this theoretical perspective is eclectic because the best aspects of other theories are taken and combined into a single explanation).
WHY FOREIGN DIRECT INVESTMENT?
Why do firms go to the trouble of establishing operations abroad through foreign direct investment when two alternatives, exporting and licensing, are available to them for exploiting the profit opportunities in a foreign market? Exporting involves producing goods at home and then shipping them to the receiving country for sale. Licensing involves granting a foreign entity (the licensee) the right to produce and sell the firm’s product in return for a royalty fee on every unit sold. The question is important, given that a cursory examination of the topic suggests that foreign direct investment may be both expensive and risky compared with exporting and licensing. FDI is expensive because a firm must bear the costs of establishing production facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because of the problems associated with doing business in a different culture where the rules of the game may be very different. Relative to indigenous firms, there is a greater probability that a foreign firm undertaking FDI in a country for the first time will make costly mistakes due to its ignorance. When a firm exports, it need not bear the costs associated with FDI, and it can reduce the risks
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associated with selling abroad by using a native sales agent. Similarly, when a firm allows another enterprise to produce its products under license, the licensee bears the costs or risks (e.g., fashion retailer Burberry originally entered Japan via a licensing contract with a Japanese retailer—see the accompanying Management Focus). So why do so many firms apparently prefer FDI over either exporting or licensing? 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 exporting physical goods is often constrained by transportation costs and trade barriers. When transportation costs are added to production costs, it becomes unprofitable to ship some products over a large distance. This is particularly true of products that have a low value-to-weight ratio and that can be produced in almost any location. For such products, the attractiveness of exporting decreases, relative to either FDI or licensing. This is the case, for example, with cement. Thus, Cemex, the large Mexican cement maker, has expanded internationally by pursuing FDI, rather than exporting. For products with a high value- to-weight ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software, etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI.
m a n a g e m e n t F O C U S
Burberry Shifts Its Entry Strategy in Japan
Burberry, the icon British luxury apparel company best known for its high-fashion outerwear, has been operating in Japan for nearly half a century. Until recently, its branded products were sold under a licensing agreement with Sanyo Shokai. The Japanese company had considerable discretion as to how it utilized the Burberry brand. It sold everything from golf bags to miniskirts and Burberry-clad Barbie dolls in its 400 stores around the country, typically at prices significantly below those Burberry charged for its high-end products in the United Kingdom.
For a long time, it looked like a good deal for Burberry. Sanyo Shokai did all of the market development in Japan, generating revenues of around $800 million a year and paying Burberry $80 million in annual royalty payments. However, by 2007, Burberry’s CEO, Angela Ahrendts, was becoming increasingly dissatisfied with the Japanese licensing deal and 22 others like it in countries around the world. In Ahrendts’s view, the licensing deals were diluting Burberry’s core brand image. Licensees such as Sanyo Shokai were selling a wide range of products at a much lower price point than Burberry charged for products in its own stores. “In luxury,” Ahrendts once remarked, “ubiquity will kill you—it means that you’re not really luxury anymore.” Moreover, with an increasing number of customers buying Burberry products online and on trips to Britain, where the brand was considered very upmarket, Ahrendts felt that it was crucial for Burberry to tightly control its global brand image.
Ahrendts was determined to rein in licensees and regain control of Burberry’s sales in foreign markets, even if it meant taking a short-term hit to sales. She started off the process of terminating licensees before leaving Burberry to run Apple’s retail division in 2014. Her hand-picked successor as CEO, Christopher Bailey, who rose through the design function at Burberry, has continued to pursue this strategy.
In Japan, the license was terminated in 2015. Sanyo Shokai was required to close nearly 400 licensed Burberry stores. Burberry is not giving up on Japan, however. After all, Japan is the world’s second- largest market for luxury goods. Instead, the company will now sell products through a limited number of wholly owned stores. The goal is to have 35 to 50 stores in the most exclusive locations in Japan by 2018. They will offer only high-end products, such as Burberry’s classic $1,800 trench coat. In general,
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Rankings
the price point will be 10 times higher than was common for most Burberry products in Japan. The company realizes the move is risky and fully expects sales to initially fall before rising again as it rebuilds its brand, but CEO Bailey argues that the move is absolutely necessary if Burberry is to have a coherent global brand image for its luxury products.
Sources: Kathy Chu and Megumi Fujikawa, “Burberry Gets a Grip on Brand in Japan,” The Wall Street Journal, August 15–16, 2015; Angela Ahrendts, “Burberry’s CEO on Turning an Aging British Icon into a Global Luxury Brand,” Harvard Business Review, January–February 2013; Tim Blanks, “The Designer Who Would be CEO,” The Wall Street Journal Magazine, June 18, 2015; and G. Fasol, “Burberry Solves Its ‘Japan Problem,’ at Least for Now,” Japan Strategy, August 19, 2015.
Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods, governments can increase the cost of exporting relative to foreign direct investment and licensing. Similarly, by limiting imports through quotas, governments increase the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese auto companies in the United States that started in the mid 1980s and continues to this day has been partly driven by protectionist threats from Congress and by tariffs on the importation of Japanese vehicles, particularly light trucks (SUVs), which still face a 25 percent import tariff into the United States. For Japanese auto companies, these factors decreased the profitability of exporting and increased that of foreign direct investment. In this context, it is important to understand that trade barriers do not have to be physically in place for FDI to be favored over exporting. Often, the desire to reduce the threat that trade barriers might be imposed is enough to justify foreign direct investment as an alternative to exporting.
Cross-border investments have been ramped up to a relatively large degree in the last decade. Even with the economic downturn that started in 2008, the world continued to see a great deal of foreign direct investment by companies in the last decade. Now, when the economic prosperity is likely to be better, given that we are removed from those downturn days, the expectation is that more foreign direct investment will be considered by companies. On globalEDGE™, there are myriad opportunities to gain more knowledge about foreign direct investment (FDI). The “Rankings” section is a great starting point (globaledge.msu.edu/global-resources/rankings). In this section, globalEDGE™ features several reports by A.T. Kearney—with one of them squarely centered on foreign direct investment and a “confidence index” for FDI. 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?
Limitations of Licensing A branch of economic theory known as internalization theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering foreign markets (this approach is also known as the market imperfections approach).12 According to internalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities. First, licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor. In a classic example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks
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associated with foreign direct investment. However, Matsushita and Sony quickly assimilated RCA’s technology and used it to enter the U.S. market to compete directly against RCA. As a result, RCA was relegated to being a minor player in its home market, while Matsushita and Sony went on to have a much bigger market share.
A second problem is that licensing does not give a firm the tight control over production, marketing, and strategy in a foreign country that may be required to maximize its profitability. With licensing, control over production (of a good or a service), marketing, and strategy are granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. One reason for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition because it would likely reduce the licensee’s profit, or it might even cause the licensee to take a loss. Another reason for wanting control over the strategy of a foreign entity is to make sure that the entity does not damage the firm’s brand. This was the primary reason fashion retailer Burberry recently terminated its licensing agreement in Japan and switched to a strategy of direct ownership of its own retail stores in the Japanese market (see the Management Focus about Burberry above for details).
One reason for wanting control over the operations of a foreign entity is that the firm might wish to take advantage of differences in factor costs across countries, producing only part of its final product in a given country, while importing other parts from where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement because it would limit the licensee’s autonomy. For reasons such as these, when tight control over a foreign entity is desirable, foreign direct investment is preferable to licensing.
A third problem with licensing arises when the firm’s competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capabilities that produce those products. 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 pioneering the development of a new production process, known as lean production, that enables it to produce higher-quality automobiles at a lower cost than its global rivals.13 Although Toyota could license certain products, its real competitive advantage comes from its management and process capabilities. These kinds of skills are difficult to articulate or codify; they certainly cannot be written down in a simple licensing contract. They are organizationwide 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
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has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm’s skills and know-how are not amenable to licensing.
Advantages of Foreign Direct Investment It follows that a firm will favor foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favor foreign direct investment over licensing (or franchising) when it wishes to maintain control over its technological know-how, or over its operations and business strategy, or when the firm’s capabilities are simply not amenable to licensing, as may often be the case.
Beyond this, FDI has other “strategic” advantages that are difficult to achieve through licensing or exporting/importing. For example, the opening case describes how the Chinese automobile manufacturer Geely acquired the assets of Volvo from Ford in 2010 in order to gain access to Volvo’s design engineering skills and brand equity. In theory, Geely could have licensed in design know-how from Volvo, and/or produced Volvo cars in China under license. In practice, design knowledge might not be easy to license. As with Toyota’s lean production knowledge, such skills are difficult to articulate or codify and cannot be written down in a simple licensing contract. Thus, acquisition presents itself as a better option. Moreover, the acquisition gave Geely the tight operational control that it wanted over Volvo’s manufacturing activities, enabling it to relocate significant production to China, and using that as an export base to serve much of the world market outside of North America (North American demand is served from a production facility in South Carolina).
More generally, gaining technology, productive assets, market share, brand equity, distribution systems, and the like through FDI by purchasing the assets of an established company can all speed up market entry, improve production in the firm’s home base, and facilitate the transfer of technology from the acquired company to the acquiring company. We return to this topic in Chapter 13 when we discuss different entry strategies.
THE PATTERN OF FOREIGN DIRECT INVESTMENT
Observation suggests that firms in the same industry often undertake foreign direct investment at about the same time. Also, firms tend to direct their investment activities toward the same target markets. 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.14 An oligopoly is an industry composed of a limited number of large firms (e.g., an industry in which four firms control 80 percent of a domestic market would be defined as an oligopoly). A critical competitive feature of such industries is interdependence of the major players: What one firm does can have an immediate impact on the major competitors, forcing a response in kind. By cutting prices, one firm in an oligopoly can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share. 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.
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Page 222 Consider an oligopoly in the United States in which three firms—A, B, and C—dominate the market. Firm A establishes a subsidiary in France. Firms B and C decide that if successful, this new subsidiary may knock out their export business to France and give a first-mover advantage to firm A. Furthermore, firm A might discover some competitive asset in France that it could repatriate to the United States to torment firms B and C on their native soil. Given these possibilities, firms B and C decide to follow firm A and establish operations in France.
Studies that have looked at FDI by U.S. firms show that firms based in oligopolistic industries tended to imitate each other’s FDI.15 The same phenomenon has been observed with regard to FDI undertaken by Japanese firms.16 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by undertaking their own FDI in the United States and Europe. Research has also shown that models of strategic behavior in a global oligopoly can explain the pattern of FDI in the global tire industry.17
Knickerbocker’s theory can be extended to embrace the concept of multipoint competition. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.18 Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other’s moves in different markets to try to hold each other in check. 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 behavior by firms in oligopolistic industries, it does not explain why the first firm in an oligopoly decides to undertake FDI rather than to export or license. Internalization theory addresses this phenomenon. 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 late British economist John Dunning.19 Dunning argues that in addition to the various factors discussed earlier, location-specific advantages are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment. By location-specific advantages, Dunning means the advantages that arise from utilizing resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm’s technological, marketing, or management capabilities). Dunning accepts the argument of internalization theory that it is difficult for a firm to license its own unique capabilities and know-how. 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 requires the firm to establish production facilities where those foreign assets or resource endowments are located.
An obvious example of Dunning’s arguments are natural resources, such as oil and other minerals, which are—by their character—specific to certain locations. Dunning suggests that to exploit such foreign resources, a firm must undertake FDI. Clearly, this explains the FDI undertaken by many of the world’s oil companies, which have to invest where oil is located in order to combine their technological and managerial capabilities with this valuable location-
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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 production facilities in those countries where the cost and skills of local labor are most suited to its particular production processes.
However, Dunning’s theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semiconductor industry. Many of the world’s major computer and semiconductor companies— such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs there. According to Dunning’s arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is available nowhere else in the world. To be sure, that knowledge is commercialized as it diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning’s language, this means that Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part, it arises from a network of informal contacts that allows firms to benefit from each other’s knowledge generation. Economists refer to such knowledge “spillovers” as externalities, and there is a well-established theory suggesting that firms can benefit from such externalities by locating close to their source.20
Google Headquarters in Mountain View, California, USA.
©Phillip Bond/Alamy Stock Photo
Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, production facilities so they too can learn about and utilize valuable new knowledge before those based elsewhere, thereby giving them a competitive advantage in the global marketplace.21 Evidence suggests that European, Japanese, South Korean, and Taiwanese computer and semiconductor firms are investing in the Silicon Valley region precisely because they wish to benefit from the externalities that arise there.22 Others have argued that direct investment by foreign firms in the U.S. biotechnology industry has been motivated by desire to gain access to the unique location-specific technological knowledge of U.S. biotechnology firms.23 Dunning’s theory, therefore, seems to be a useful addition to those outlined previously because it helps explain how location factors affect the direction of FDI.24
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Political Ideology and Foreign Direct Investment
LO 8-3 Understand how political ideology shapes a government’s attitudes toward FDI.
Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance that is hostile to all inward FDI at one extreme to an adherence to the noninterventionist principle of free market economics at the other. Between these two extremes is an approach that might be called pragmatic nationalism.
THE RADICAL VIEW
The radical view traces its roots to Marxist political and economic theory. Radical writers argue that the multinational enterprise (MNE) is an instrument of imperialist domination. They see the MNE as a tool for exploiting host countries 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 corporations to undertake FDI because they can never be instruments of economic development, only of economic domination. Where MNEs already exist in a country, they should be immediately nationalized.25
Are 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 countries 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 being the Indo-Pakistani War of 1971, when the conflict started because of turmoil in East Pakistan (now called Bangladesh). However, in trying to improve the economic ties between the two nations, India recently announced that it will allow FDI from Pakistan, paving the way for industries from the neighboring country to set up businesses in the growing Indian market. While this is a prime example of how free markets are promoting trade between countries that have not traditionally enjoyed stable political relationships with each other, the question is also on what grounds cross-border interaction is founded. What do you think? Can countries that have been long-standing enemies normalize their relationship simply based on foreign direct investment opportunities?
Source: www.hindustantimes.com.
From 1945 until the 1980s, the radical view was very influential in the world economy. Until the collapse of communism between 1989 and 1991, the countries of eastern Europe were opposed to FDI. Similarly, communist countries elsewhere—such as China,
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Page 224Cambodia, 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 government, while rejecting Marxist theory, essentially embraced the radical view that FDI by MNEs is an instrument of imperialism.
By the early 1990s, the radical position was in retreat. 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, in addition to a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth; and (3) the strong economic performance of those developing countries that embraced capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan). Despite this, the radical view lingers on in some countries, such as Venezuela, where the government of Hugo Cha´vez and that of his successor Nicola´s Maduro have both viewed foreign multinationals as an instrument of domination.
THE FREE MARKET VIEW
The free market 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 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 dispersing the production of goods and services to the most efficient locations around the globe. Viewed this way, FDI by the MNE increases the overall efficiency of the world economy.
Imagine that Dell decided to move assembly operations for many of its personal computers from the United States to Mexico to take advantage of lower labor costs in Mexico. According to the free market view, moves such as this can be seen as increasing the overall efficiency of resource utilization in the world economy. Mexico, due to its lower labor costs, has a comparative advantage in the assembly of PCs. By moving the production of PCs from the United States to Mexico, Dell frees U.S. resources for use in activities in which the United States has a comparative advantage (e.g., the design of computer software, the manufacture of high value-added components such as microprocessors, or basic R&D). Also, consumers benefit because the PCs cost less than they would if they were produced domestically. In addition, Mexico gains from the technology, skills, and capital that the computer company transfers with its FDI. Contrary to the radical view, the free market view stresses that such resource transfers benefit the host country and stimulate its economic growth. 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 neither a radical policy nor a free market policy toward FDI but, instead, a policy that can best be described as pragmatic nationalism.26 The pragmatic nationalist view is that FDI has both benefits and costs. FDI can benefit a host country by
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bringing capital, skills, technology, and jobs, but those benefits come at a cost. When a foreign company rather than a domestic company produces products, the profits from that investment go abroad. Many countries are 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.27 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 investment in the automobile industry. Nissan, Toyota, and Honda now have major assembly plants in Britain and use the country as their base for serving the rest of Europe—with obvious employment and balance-of-payments benefits for Britain (what happens to these investments if and when Britian exits from the EU remains to be seen). Similarly, within the United States, individual states often compete with each other to attract FDI, offering generous financial incentives in the form of tax breaks to foreign companies looking to set up operations in the country.
SHIFTING IDEOLOGY
Recent years have seen a marked decline in the number of countries that adhere to a radical ideology. Although few countries have adopted a pure free market policy stance, an increasing number of countries are gravitating toward the free market end of the spectrum and have liberalized their foreign investment regime. This includes many countries that 30 years ago were firmly in the radical camp (e.g., the former communist countries of eastern Europe, many of the socialist countries of Africa, and India) and several countries that until recently could best be described as pragmatic nationalists with regard to FDI (e.g., Japan, South Korea, Italy, Spain, and most Latin American countries). One result has been the surge in the volume of FDI worldwide, which, as we noted earlier, has been growing faster than world trade. Another result has been an increase in the volume of FDI directed at countries that have liberalized their FDI regimes in the last 20 years, such as China, India, and Vietnam.
As a counterpoint, there is some evidence of a shift to a more hostile approach to foreign direct investment in some nations. Venezuela and Bolivia have become increasingly hostile to foreign direct investment. In 2005 and 2006, the governments of both nations unilaterally rewrote contracts for oil and gas exploration, raising the royalty rate that foreign enterprises had to pay the government for oil and gas extracted in their territories. Following his election victory
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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 developed nations, there is increasing evidence of hostile reactions to inward FDI as well. In Europe in 2006, there was a hostile political reaction to the attempted takeover of Europe’s largest steel company, Arcelor, by Mittal Steel, a global company controlled by the Indian entrepreneur Lakshmi Mittal. In mid-2005, China National Offshore Oil Company withdrew a takeover bid for Unocal of the United States after highly negative reaction in Congress about the proposed takeover of a “strategic asset” by a Chinese company.
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Benefits and Costs of FDI LO 8-4 Describe the benefits and costs of FDI to home and host countries.
To a greater or lesser degree, many governments can be considered pragmatic nationalists when it comes to FDI. Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI. Here, we explore the benefits and costs of FDI, first from the perspective of a host (receiving) country and then from the perspective of the home (source) country. In the next section, we look at the policy instruments governments use to manage FDI.
HOST-COUNTRY BENEFITS
The main benefits of inward FDI for a host country arise from resource-transfer effects, employment effects, balance-of-payments effects, and effects on competition and economic growth.
Resource-Transfer Effects Foreign direct investment can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available and thus boost that country’s economic growth rate.
With regard to capital, many MNEs, by virtue of their large size and financial strength, have access to financial resources not available to host-country firms. 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.
Does Foreign Direct Investment Promote Growth?
There are multiple reasons for companies to make foreign direct investments. Lowering the cost of production, increasing capacity (volume) of production, and strategically locating production facilities to serve world regions are some of the many reasons for FDI by a company. For the host countries that receive the investment by multinational corporations, the logic is that the influx of capital and increase in tax revenues will benefit the host country in the form of new infrastructure, increased knowledge, and
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general economic development. However, the evidence so far is very mixed on the value of FDI to the host, ranging from beneficial to detrimental. What do you think? Does FDI promote growth in the host country?
Source: L. Alfaro, A. Chanda, S. Kalemli-Ozcan, and S. Sayek, Does Foreign Direct Investment Promote Growth? Exploring the Role of Financial Markets on Linkages (Cambridge, MA: Harvard Business School, 2009), www.people.hbs.edu/lalfaro/fdiandlinkages.pdf.
As for technology, you will recall from Chapter 3 that technology can stimulate economic development and industrialization. Technology can take two forms, both of which are valuable. Technology can be incorporated in a production process (e.g., the technology for discovering, extracting, and refining oil), or it can be incorporated in a product (e.g., personal computers). However, many countries lack the research and development resources and skills required to develop their own indigenous product and process technology. 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.28 For example, a study of FDI in Sweden found that foreign firms increased both the labor and total factor productivity of Swedish firms that they acquired, suggesting that significant technology transfers had occurred (technology typically boosts productivity).29 Also, a study of FDI by the Organisation for Economic Co-operation and Development (OECD) found that foreign investors invested significant amounts of capital in R&D in the countries in which they had invested, suggesting that not only were they transferring technology to those countries but they may also have been upgrading existing technology or creating new technology in those countries.30
Foreign management skills acquired through FDI may also produce important benefits for the host country. Foreign managers trained in the latest management techniques can often help improve the efficiency of operations in the host country, whether those operations are acquired or greenfield developments. Beneficial spin-off effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help establish indigenous firms. Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own management skills.
An employee uses a robotic arm to fit a wheel onto a Volkswagen AG Vento automobile on the production line at the Volkswagen India Pvt. plant in Chakan, Maharashtra, India.
©Bloomberg/Getty Images
Employment Effects Another beneficial employment effect claimed for FDI is that it brings
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jobs to a host country that would otherwise not be created there. The effects of FDI on employment are both direct and indirect. Direct effects arise when a foreign MNE employs a number of host-country citizens. Indirect effects arise when jobs are created in local suppliers as a result of the investment and when jobs are created because of increased local spending by employees of the MNE. 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.31
Cynics argue that not all the “new jobs” created by FDI represent net additions in employment. In the case of FDI by Japanese auto companies in the United States, some argue that the jobs created by this investment have been more than offset by the jobs lost in U.S.-owned auto companies, which have lost market share to their Japanese competitors. As a consequence of such substitution effects, the net number of new jobs created by FDI may not be as great as initially claimed by an MNE. The issue of the likely net gain in employment may be a major negotiating point between an MNE wishing to undertake FDI and the host government.
When FDI takes the form of an acquisition of an established enterprise in the host economy as opposed to a greenfield investment, the immediate effect may be to reduce employment as the multinational tries to restructure the operations of the acquired unit to improve its operating efficiency. However, even in such cases, research suggests that once the initial period of restructuring is over, enterprises acquired by foreign firms tend to increase their employment base at a faster rate than domestic rivals. An OECD study found that foreign firms created new jobs at a faster rate than their domestic counterparts.32
Balance-of-Payments Effects FDI’s effect on a country’s balance-of-payments accounts is an important policy issue for most host governments. A country’s balance-of-payments accounts track both its payments to and its receipts from other countries. Governments normally are concerned when their country is running a deficit on the current account of their balance of payments. 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 rather 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.
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 payments has improved somewhat because many Japanese companies are now supplying the U.S. market from production facilities in the United States, as opposed to facilities in Japan. Insofar as this has reduced the need to finance a current account deficit by asset sales to foreigners, the United States has clearly benefited.
A second potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries. According to a UN report, inward FDI by foreign multinationals has been a major driver of export-led economic growth in a number of developing and
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developed nations.33 For example, in China exports increased from $26 billion in 1985 to around $3 trillion in 2017. Much of this dramatic export growth was due to the presence of foreign multinationals that invested heavily in China.
Effect on Competition and Economic Growth Economic theory tells us that the efficient functioning of markets depends on an adequate level of competition between producers. When FDI takes the form of a greenfield investment, the result is to establish a new enterprise, increasing the number of players in a market and thus consumer choice. In turn, this can increase the level of competition in a national market, thereby driving down prices and increasing the economic welfare of consumers. Increased competition tends to stimulate capital investments by firms in plant, equipment, and R&D as they struggle to gain an edge over their rivals. The long- term results may include increased productivity growth, product and process innovations, and greater economic growth.34 Such beneficial effects seem to have occurred in the South Korean retail sector following the liberalization of FDI regulations in 1996. FDI by large Western discount stores—including Walmart, Costco, Carrefour, and Tesco—seems to have encouraged indigenous discounters such as E-Mart to improve the efficiency of their own operations. The results have included more competition and lower prices, which benefit South Korean consumers. In a similar vein, the Indian government has been opening up that country’s retail sector to FDI, partly because it believes that inward investment by efficient global retailers such as Walmart, Carrefour, and IKEA will provide the competitive stimulus that is necessary to improve the efficiency of India’s fragmented retail system.
FDI’s impact on competition in domestic markets may be particularly important in the case of services, such as telecommunications, retailing, and many financial services, where exporting is often not an option because the service has to be produced where it is delivered.35 For example, under a 1997 agreement sponsored by the World Trade Organization, 68 countries accounting for more than 90 percent of world telecommunications revenues pledged to start opening their markets to foreign investment and competition and to abide by common rules for fair competition in telecommunications. Before this agreement, most of the world’s telecommunications markets were closed to foreign competitors, and in most countries, the market was monopolized by a single carrier, which was often a state-owned enterprise. The agreement has dramatically increased the level of competition in many national telecommunications markets, producing two major benefits. First, inward investment has increased competition and stimulated investment in the modernization of telephone networks around the world, leading to better service. Second, the increased competition has resulted in lower prices.
HOST-COUNTRY COSTS
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 competitors. If it is part of a larger international organization, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive indigenous companies out of business and allow the firm to monopolize the market. Once the market is monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harmful effects on the economic welfare of the host nation. This concern tends to be greater in countries that have few large firms of their own (generally, less developed
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countries). It tends to be a relatively minor concern in most advanced industrialized nations.
In general, while FDI in the form of greenfield investments should increase competition, it is less clear that this is the case when the FDI takes the form of acquisition of an established enterprise in the host nation. Because an acquisition does not result in a net increase in the number of players in a market, the effect on competition may be neutral. When a foreign investor acquires two or more firms in a host country and subsequently merges them, the effect may be to reduce the level of competition in that market, create monopoly power for the foreign firm, reduce consumer choice, and raise prices. For example, in India, Hindustan Lever Ltd., the Indian subsidiary of Unilever, acquired its main local rival, Tata Oil Mills, to assume a dominant position in the bath soap (75 percent) and detergents (30 percent) markets. Hindustan Lever also acquired several local companies in other markets, such as the ice cream makers Dollops, Kwality, and Milkfood. By combining these companies, Hindustan Lever’s share of the Indian ice cream market went from zero to 74 percent.36 However, although such cases are of obvious concern, there is little evidence that such developments are widespread. In many nations, domestic competition authorities have the right to review and block any mergers or acquisitions that they view as having a detrimental impact on competition. If such institutions are operating effectively, this should be sufficient to make sure that foreign entities do not monopolize a country’s markets.
Adverse Effects on the Balance of Payments 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 subsidiary’s home country. A second concern arises when a foreign subsidiary imports a substantial number of its inputs from abroad, which results in a debit on the current account of the host country’s balance of payments. One criticism leveled against Japanese-owned auto assembly operations in the United States, for example, is that they tend to import many component parts from Japan. Because of this, the favorable impact of this FDI on the current account of the U.S. balance-of-payments position may not be as great as initially supposed. The Japanese auto companies responded to these criticisms by pledging to purchase 75 percent of their component parts from U.S.-based manufacturers (but not necessarily U.S.-owned manufacturers). When the Japanese auto company Nissan invested in the United Kingdom, Nissan responded to concerns about local content by pledging to increase the proportion of local content to 60 percent and subsequently raising it to more than 80 percent.
Possible Effects on National Sovereignty and Autonomy Some host governments worry that FDI is accompanied by some loss of economic independence. 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 scientist Robert Reich has noted that such concerns are the product of outmoded thinking because they fail to account for the growing interdependence of the world economy.37 In a world in which firms from all advanced nations are increasingly investing in each other’s markets, it is not possible for one country to hold another to “economic ransom” without hurting itself.
HOME-COUNTRY BENEFITS
The benefits of FDI to the home (source) country arise from three sources. First, the home
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country’s balance of payments benefits from the inward flow of foreign earnings. FDI can also benefit the home country’s balance of payments if the foreign subsidiary creates demands for home-country exports of capital equipment, intermediate goods, complementary products, and the like.
Second, benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the foreign subsidiary creates demand for home-country exports. Thus, Toyota’s investment in auto assembly operations in Europe has benefited both the Japanese balance-of-payments position and employment in Japan, because Toyota imports some component parts for its European-based auto assembly operations directly from Japan.
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 country. 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.38
Is FDI a Form of Colonialism or Ethical Investing?
Some critics of globalization suggest that FDI is an advanced form of colonialism that destroys local cultures in developing countries. What these critics say may have some limited validity, but it isn’t the whole picture. Take Freeport McMoRan, a U.S.-based mining company with operations in West Papua (the former Irian Jaya), Indonesia, where the world’s largest gold, mineral, and copper reserves have been found. Freeport formed a joint venture with the Indonesian government to mine a concession, an isolated tract of land the size of Massachusetts on a remote island, half of which is the country of Papua New Guinea. Freeport has brought education, Internet connections, world-class health care, and the modern world to the isolated local tribes in West Papua, nomadic peoples who wear loincloths and hunt in the forest. 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 education, and from local employment opportunities with FCX. Is this colonialism or a kind of ethical investing?
Source: www.corpwatch.org.
HOME-COUNTRY COSTS
Against these benefits must be set the apparent costs of FDI for the home (source) country. The most important concerns center on the balance-of-payments and employment effects of outward FDI. The home country’s balance of payments may suffer in three ways. First, the balance of payments suffers from the initial capital outflow required to finance the FDI. This effect, however, is usually more than offset by the subsequent inflow of foreign earnings. Second, the current account of the balance of payments suffers if the purpose of the foreign investment is to serve the home market from a low-cost production location. 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 account position of Japan will deteriorate.
With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production. This was the case with Toyota’s investments in the United
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States and Europe. One obvious result of such FDI is reduced home-country employment. If the labor market in the home country is already tight, with little unemployment, this concern may not be that great. However, if the home country is suffering from unemployment, concern about the export of jobs may arise. For example, one objection frequently raised by U.S. labor leaders to the free trade pact among the United States, Mexico, and Canada (see Chapter 9) is that the United States would lose hundreds of thousands of jobs as U.S. firms invest in Mexico to take advantage of cheaper labor and then export back to the United States.39
INTERNATIONAL TRADE THEORY AND FDI
When assessing the costs and benefits of FDI to the home country, keep in mind the lessons of international trade theory (see Chapter 6). International trade theory tells us that home-country concerns about the negative economic effects of offshore production may be misplaced. The term offshore production refers to FDI undertaken to serve the home market. An example would be U.S. automobile companies investing in auto parts production facilities in Mexico. Far from reducing home-country employment, such FDI may actually stimulate economic growth (and hence employment) in the home country by freeing home-country resources to concentrate on activities where the home country has a comparative advantage. In addition, home-country consumers benefit if the price of the particular product falls as a result of the FDI. Also, if a company were prohibited from making such investments on the grounds of negative employment effects while its international competitors reaped the benefits of low-cost production locations, it would undoubtedly lose market share to its international competitors. Under such a scenario, the adverse long-run economic effects for a country would probably outweigh the relatively minor balance-of-payments and employment effects associated with offshore production.
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Government Policy Instruments and FDI LO 8-5 Explain the range of policy instruments that governments use to influence FDI.
We have reviewed the costs and benefits of FDI from the perspective of both home country and host country. We now turn our attention to the policy instruments that home (source) countries and host countries can use to regulate FDI.
HOME-COUNTRY POLICIES
Through their choice of policies, home countries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include foreign risk insurance, capital assistance, tax incentives, and political pressure. Then we look at policies designed to restrict outward FDI.
Encouraging Outward FDI Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. The types of risks insurable
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through these programs include the risks of expropriation (nationalization), war losses, and the inability to transfer profits back home. Such programs are particularly useful in encouraging firms to undertake investments in politically unstable countries.40 In addition, several advanced countries also have special funds or banks that make government loans to firms wishing to invest in developing countries. As a further incentive to encourage domestic firms to undertake FDI, many countries have eliminated double taxation of foreign income (i.e., taxation of income in both the host country and the home country). Last, and perhaps most significant, a number of investor countries (including the United States) have used their political influence to persuade host countries to relax their restrictions on inbound FDI. For example, in response to direct U.S. pressure, Japan relaxed many of its formal restrictions on inward FDI. In response to further U.S. pressure, Japan relaxed its informal barriers to inward FDI. One beneficiary of this trend was Toys “R” Us, which, after five years of intensive lobbying by company and U.S. government officials, opened its first retail stores in Japan in December 1991. By 2012, Toys “R” Us had more than 170 stores in Japan, and its Japanese operation, in which Toys “R” Us retained a controlling stake, had a listing on the Japanese stock market. Interestingly, although Toys “R” Us ceased operations in the United States in 2017 due to bankruptcy, it continues to operate in Japan.
Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One policy has been to limit capital outflows out of concern for the country’s balance of payments. From the early 1960s until 1979, for example, Britain had exchange-control regulations that limited the amount of capital a firm could take out of the country. Although the main intent of such policies was to improve the British balance of payments, an important secondary intent was to make it more difficult for British firms to undertake FDI.
In addition, countries have occasionally manipulated tax rules to try to encourage their firms to invest at home. 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.
Finally, countries sometimes prohibit national firms from investing in certain countries for political reasons. Such restrictions can be formal or informal. For example, formal U.S. rules prohibited U.S. firms from investing in countries such as Cuba and Iran, whose political ideology and actions are judged to be contrary to U.S. interests. Similarly, during the 1980s, informal pressure was applied to dissuade U.S. firms from investing in South Africa. In this case, the objective was to pressure South Africa to change its apartheid laws, which happened during the early 1990s.
HOST-COUNTRY POLICIES
Host countries adopt policies designed both to restrict and to encourage inward FDI. As noted earlier in this chapter, political ideology has determined the type and scope of these policies in the past. In the last decade of the twentieth century, many countries moved quickly away from adhering to some version of the radical stance and prohibiting much FDI toward a situation where a combination of free market objectives and pragmatic nationalism took hold.
Encouraging Inward FDI It is common for governments to offer incentives to foreign firms to invest in their countries. Such incentives take many forms, but the most common are tax concessions, low-interest loans, and grants or subsidies. Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI. They are also motivated by a
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desire to capture FDI away from other potential host countries. For example, in the mid-1990s, the governments of Britain and France competed with each other on the incentives they offered Toyota to invest in their respective countries. In the United States, state governments often compete with each other to attract FDI. For example, Kentucky offered Toyota an incentive package worth $147 million to persuade it to build its U.S. automobile assembly plants there. The package included tax breaks, new state spending on infrastructure, and low-interest loans.41
Restricting Inward FDI Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are ownership restraints and performance requirements. Ownership restraints can take several forms. In some countries, foreign companies are excluded from specific fields. 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 significant proportion of the equity of the subsidiary must be owned by local investors. Foreign ownership is restricted to 25 percent or less of an airline in the United States. In India, foreign firms were prohibited from owning media businesses until 2001, when the rules were relaxed, allowing foreign firms to purchase up to 26 percent of an Indian newspaper.
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 competition. Particularly in less developed countries, the feeling seems to be that local firms might not be able to develop unless foreign competition is restricted by a combination of import tariffs and controls on FDI. This is a variant of the infant industry argument discussed in Chapter 7.
Second, ownership restraints seem to be based on a belief that local owners can help maximize the resource-transfer and employment benefits of FDI for the host country. Until the 1980s, the Japanese government prohibited most FDI but allowed joint ventures between Japanese firms and foreign MNEs if the MNE had a valuable technology. 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 performance requirements are related to local content, exports, technology transfer, and local participation in top management. As with certain ownership restrictions, the logic underlying performance requirements is that such rules help maximize the benefits and minimize the costs of FDI for the host country. Many countries employ some form of performance requirements when it suits their objectives. However, performance requirements tend to be more common in less developed countries than in advanced industrialized nations.42
INTERNATIONAL INSTITUTIONS AND THE LIBERALIZATION OF FDI
Until the 1990s, there was no consistent involvement by multinational institutions in the governing of FDI. This changed with the formation of the World Trade Organization 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
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telecommunications and financial services. Both these agreements contained detailed clauses that require signatories to liberalize their regulations governing inward FDI, essentially opening their markets to foreign telecommunications and financial services companies. The WTO has had less success trying to initiate talks aimed at establishing a universal set of rules designed to promote the liberalization of FDI. Led by Malaysia and India, developing nations have so far rejected efforts by the WTO to start such discussions.
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Focus on Managerial Implications
FDI AND GOVERNMENT POLICY
LO 8-6 Identify the implications for managers of the theory and government policies associated with FDI.
Several implications for business are inherent in the material discussed in this chapter. In this section, we deal first with the implications of the theory and then turn our attention to the implications of government policy.
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 varies with circumstances. 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 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.
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8.4 FIGURE A decision framework.
Firms for which licensing is not a good option tend to be clustered in three types of industries:
1. High-technology industries in which protecting firm-specific expertise is of paramount importance and licensing is hazardous.
2. Global oligopolies, in which competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors.
3. Industries in which intense cost pressures require that multinational firms maintain tight control over foreign operations (so that they can disperse production to locations around the globe where factor costs are most favorable in order to minimize costs and maximize value).
Although empirical evidence is limited, the majority of studies seem to support these conjectures.43 In addition, licensing is not a good option if the competitive advantage of a firm is based upon managerial or marketing knowledge that is embedded in the routines of the firm or the skills of its managers and that is difficult to codify in a “book of blueprints.” This would seem to be the case for firms based in a fairly wide range of industries.
Firms for which licensing is a good option tend to be in industries whose conditions are opposite to those just specified. That is, licensing tends to be more common, and more profitable, in fragmented, low-technology industries in which globally dispersed manufacturing is not an option. A good example is the fast-food industry. McDonald’s has expanded globally by using a franchising strategy. Franchising is essentially the service-industry version of licensing, although it normally involves much longer-term commitments than licensing. With
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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 contract; (4) there is no compelling reason for McDonald’s to have tight control over franchisees; and (5) McDonald’s know-how, in terms of how to run a fast-food restaurant, is amenable to being specified in a written contract (e.g., the contract specifies the details of how to run a McDonald’s restaurant).
Finally, it should be noted that the product life-cycle theory and Knickerbocker’s theory of FDI tend to be less useful from a business perspective. 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 identifying the factors that influence the relative profitability of FDI, licensing, and exporting. Indeed, the issue of licensing as an alternative to FDI is ignored by both these theories.
Government Policy A host government’s attitude toward FDI should be an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment. Other things being equal, investing in countries that have permissive policies toward FDI is clearly preferable to investing in countries that restrict FDI.
However, often the issue is not this straightforward. Despite the move toward a free market stance in recent years, many countries still have a rather pragmatic stance toward FDI. In such cases, a firm considering FDI must often negotiate the specific terms of the investment with the country’s government. Such negotiations center on two broad issues. If the host government is trying to attract FDI, the central issue is likely to be the kind of incentives the host government is prepared to offer to the MNE and what the firm will commit in exchange. If the host government is uncertain about the benefits of FDI and might choose to restrict access, the central issue is likely to be the concessions that the firm must make to be allowed to go forward with a proposed investment.
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 negotiations. The converse also holds. The firm’s bargaining power is low when the host government places a low value on what the firm has to offer, the number of comparable alternatives open to the firm is fewer, and the firm has a short time in which to complete the negotiations.44
Key Terms
flow of FDI, p. 214 stock of FDI, p. 214
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outflows of FDI, p. 214 inflows of FDI, p. 214 greenfield investment, p. 217 eclectic paradigm, p. 218 exporting, p. 218 licensing, p. 218 internalization theory, p. 220 market imperfections, p. 220 oligopoly, p. 221 multipoint competition, p. 222 location-specific advantages, p. 222 externalities, p. 223 balance-of-payments accounts, p. 227 current account, p. 227 offshore production, p. 230
Summary
This chapter reviewed theories that attempt to explain the pattern of FDI between countries and to examine the influence of governments on firms’ decisions to invest in foreign countries. 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
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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 “Burberry Shifts Its Entry Strategy in Japan” and then answer the following questions:
a. Why did Burberry initially choose a licensing strategy to expand its presence in Japan? b. What limitations of licensing became apparent over time? Should Burberry
have expected these drawbacks to arise? c. Was terminating the Japanese licensing agreement and opening wholly owned stores the
correct strategy for Burberry? What are the risks here? 5. You are the international manager of a U.S. business that has just developed a
revolutionary new personal computer that can perform the same functions as existing PCs but costs only half as much to manufacture. Several patents protect the unique design of this computer. Your CEO has asked you to formulate a recommendation for how to expand into Western Europe. Your options are (a) to export from the United States, (b) to license a European firm to manufacture and market the computer in Europe, or (c) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative, and suggest a course of action to your CEO.
Research Task globalEDGE.msu.edu
Use the globalEDGETM website (globaledge.msu.edu) to complete the following exercises:
1. 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 on the top 20 companies, provide a summary of the countries and industries represented. Do you notice any common traits from your analysis? Did any industries or countries in the top 20 surprise you? Why?
2. An integral part of successful foreign direct investment is to understand the target market opportunities as well as the nature of the risk inherent in possible investment projects,
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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.
FDI in the Indian Reta i l Sector c los ing case
Historically, the structure of retailing in India was very fragmented with a large number of very small stores serving most of the market. Supply chains were also very poorly developed and fragmented. As recently as 2010, larger format big box stores, chain stores, and supermarkets only accounted for 4 percent of retail sales in the country (compared to 85 percent in the United States). This might sound like an ideal opportunity for efficient foreign retailers such as Walmart, IKEA, Tesco, and Carrefour. In theory, these multinational enterprises could enter the market and transform India’s retail space, making it more efficient and bringing modern retail formats, technology, and supply chains to the country. This would benefit consumers and producers from farmers to manufacturers. For example, it has been estimated that up to 40 percent of the food produced by Indian farmers is currently wasted because chronically underdeveloped supply chains mean that food rots before it reaches the market.
In practice, small store owners in India have a long history of using their political power to lobby the government to impose restrictions on direct investment by foreigners in the retail space. Like incumbents everywhere, their goal has been to limit competition and protect their businesses and jobs. Until 2011, foreign multi-brand retailers such as Costco, Tesco, and Walmart were forbidden from owning retail outlets in the country. Even single-brand retailers such as IKEA and Nike had to partner with a local retailer, were limited to a 51 percent ownership stake, and had to go through a lengthy bureaucratic approval process.
Chinese customers visit and exit a supermarket of Walmart in Hangzhou city, east China’s Zhejiang province
©Imaginechina/AP Images
By 2011, the Indian federal government had come to the conclusion that foreign investment in retailing was needed to improve India’s supply chain, increase consumer choice, and help farmers bring their products to market. This view was supported by much of Indian industry, which saw the modernization of the retailing sector as an important condition for continued economic development. Clearly, the government believed that greater foreign capital and technology would help India grow its economy.
In late 2011, the Indian government announced a plan to reform foreign direct investment regulations. The plan was to allow foreign multi-brand retailers such as Walmart and Tesco to open retail stores, although they would be limited to a 51 percent ownership stake. At the same time, the
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government stated its intention to allow single-brand retailers to set up wholly owned stores, although anything over a 49 percent foreign ownership stake would still require formal government approval. These plans were greeted with strong opposition from small retailers and rival political parties, and the government was forced to temporarily shelve them.
In early 2012, the Indian government managed to secure approval for plans to allow foreign single- brand retailers to open wholly owned stores, but imposed the requirement that a single-brand retailer had to source 30 percent of its inventory from India. One of the first retailers to respond to these changes was IKEA, which announced that it would invest $1.9 billion and set up 25 stores in the country. More generally though, many analysts viewed the 30 percent sourcing requirement as a major impediment to entering India. Both Apple and Nike, for example, would have to establish significant production facilities in the country in order to meet that requirement and set up their own brand stores.
In early 2018, the government modified the 30 percent requirement, giving single-brand retailers five years after their initial entry to reach the 30 percent figure. The government also allowed single-brand retailers to establish wholly owned subsidiaries without having to go through the cumbersome government approval process.
In late 2012, the federal Indian government allowed foreign investors to open multi-brand retail stores in India, but limited ownership to 51 percent. Moreover, in a nod to the strength of the political opposition, the federal government made this requirement subject to approval by individual states within the country, allowing some to opt out. Several states have done so, which reduces the attractiveness of India as a market for foreign retailers.
At the same time, India has allowed 100 percent ownership of online retail marketplaces in India. Amazon took advantage of this to enter the country in 2014 and has committed to invest $5 billion in India. Unlike in the United States, however, Amazon does not sell goods that it has taken ownership of because that would classify the company as a multi-brand retailer, limit its ownership stake in Indian operation to 51 percent, and require it to take an Indian partner. Instead, Amazon only sells goods offered through its marketplace platform by third parties. However, Amazon is investing heavily in fulfillment centers and logistics infrastructure to enable it to deliver goods efficiently to Indian customers. Its investment may help to boost the efficiency of supply chains in the country.
Sources: Greg Bensinger, “Amazon Plans $3 Billion Indian Investment,” The Wall Street Journal, June 7, 2016; Vibhuto Agarwal and Megha Bahree, “India Retreats on Retail,” The Wall Street Journal, December 8, 2011; “India Online,” The Economist, May 5, 2016; Newley Purnell, “Jeff Bezos Invests Billions to Make Amazon a Top E-Commerce Player in India,” The Wall Street Journal, November 19, 2016; and K.R. Srivats, “Cabinet Okays 100% FDI in Single Brand Retailing via Automatic Route,” Business Line, January 10, 2018.
CASE DISCUSSION QUESTIONS 1. What explains the fragmented nature of India’s retail sector? What are the benefits of
this system? What are the costs? 2. How might investment by foreign retailers change retailing in India? What are the
potential benefits of such FDI? 3. Who stands to lose from FDI into India’s retail sector? Who stands to gain? 4. Why has India been so slow to change its laws regarding foreign ownership of retailers?
What, if anything, can foreign retailers do to influence the laws in a way that benefits entry?
5. Given the political and economic realities in India, what is the best entry strategy for a foreign retailer?
Endnotes
1. United Nations, Conference on Trade and Development, Statistical Database, accessed July
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2018, http://unctadstat.unctad.org. 2. World Trade Organization, International Trade Statistics, 2017 (Geneva: WTO, 2017);
United Nations, World Investment Report, 2018. 3. United Nations, World Investment Report, 2018. 4. United Nations, World Investment Report, 2010 (New York and Geneva: United Nations,
2010). 5. United Nations, Conference on Trade and Development, Statistical Database. 6. United Nations, Conference on Trade and Development, Statistical Database. 7. United Nations, Conference on Trade and Development, Statistical Database. 8. United Nations, World Investment Report, 2018. 9. American Enterprise Institute, Chinese Investments in the United States, archived online
at http://www.aei.org/feature/china-tracker/ 10. United Nations, World Investment Report, 2018. 11. See D. J. Ravenscraft and F. M. Scherer, Mergers, Selloffs and Economic Efficiency
(Washington, DC: Brookings Institution, 1987); A. Seth, K. P. Song, and R. R. Pettit, “Value Creation and Destruction in Cross-Border Acquisitions,” Strategic Management Journal 23 (2002), pp. 921–40; B. Ayber and A. Ficici, “Cross-Border Acquisitions and Firm Value,” Journal of International Business Studies, 40 (2009), pp. 1317–38.
12. For example, see S. H. Hymer, 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, “Multinational Enterprise, Internal Governance, and Industrial Organization,” American Economic Review 75 (May 1983), pp. 233–38; C. W. L. Hill and W. C. Kim, “Searching for a Dynamic Theory of the Multinational Enterprise: A Transaction 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; J. H. Dunning, “Some Antecedents of Internalization Theory,” Journal of International Business Studies 34 (2003), pp. 108–28; A. H. Kirca, W. D. Fernandez, and S.K. Kundu, “An Empirical Analysis of Internalization Theory in Emerging Markets,” Journal of World Business 51 (2016), pp. 628–40.
13. J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).
14. The argument is most often associated with F. T. Knickerbocker, Oligopolistic Reaction and Multinational Enterprise (Boston: Harvard Business School Press, 1973). See also K. Head, T. Mayer, and J. Ries, “Revisiting Oligopolistic Reaction: Are Decisions on Foreign Direct Investment Strategic Complements?” Journal of Economics and Management Strategy 11 (2002), pp. 453–72.
15. The studies are summarized in R. E. Caves, Multinational Enterprise and Economic Analysis, 2nd ed. (Cambridge, UK: Cambridge University Press, 1996).
16. See R. E. Caves, “Japanese Investment in the US: Lessons for the Economic Analysis of Foreign Investment,” 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; J. Anand and B. Kogut, “Technological Capabilities of Countries, Firm Rivalry, and Foreign Direct Investment,” Journal of International Business Studies, 1997, pp. 445–65.
17. K. Ito and E. L. Rose, “Foreign Direct Investment Location Strategies in the Tire Industry,”
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Journal of International Business Studies 33 (2002), pp. 593–602. 18. H. Haveman and L. Nonnemaker, “Competition in Multiple Geographical Markets,”
Administrative Science Quarterly 45 (2000), pp. 232–67; L. Fuentelsaz and J. Gomez, “Multipoint Competition, Strategic Similarity and Entry into Geographic Markets,” Strategic Management Journal 27 (2006), pp. 447–57.
19. J. H. Dunning, Explaining International Production (London: Unwin Hyman, 1988); J. H. Dunning, “Reappraising the Eclectic Paradigm in an Age of Alliance Capital,” in J. H. Dunning, ed., The Eclectic Paradigm: A Framework for Synthesizing and Comparing Theories of International Business from Different Disciplines or Perspectives (London: Palgrave McMillian, 2015).
20. P. Krugman, “Increasing Returns and Economic Geography,” Journal of Political Economy 99, no. 3 (1991), pp. 483–99.
21. J. M. Shaver and F. Flyer, “Agglomeration Economies, Firm Heterogeneity, and Foreign Direct Investment in the United States,” Strategic Management Journal 21 (2000), pp. 1175–93.
22. J. H. Dunning and R. Narula, “Transpacific Foreign Direct Investment and the Investment Development Path,” South Carolina Essays in International Business, May 1995.
23. W. Shan and J. Song, “Foreign Direct Investment and the Sourcing of Technological Advantage: Evidence from the Biotechnology Industry,” Journal of International Business Studies, 1997, pp. 267–84.
24. For some additional evidence, see L. E. Brouthers, K. D. Brouthers, and S. Warner, “Is Dunning’s Eclectic Framework Descriptive or Normative?” Journal of International Business Studies 30 (1999), pp. 831–44.
25. For elaboration, see S. Hood and S. Young, The Economics of the Multinational Enterprise (London: Longman, 1979); P. M. Sweezy and H. Magdoff, “The Dynamics of U.S. Capitalism,” Monthly Review Press, 1972.
26. For an example of this policy as practiced in China, see L. G. Branstetter and R. C. Freenstra, “Trade and Foreign Direct Investment in China: A Political Economy Approach,” Journal of International Economics 58 (December 2002), pp. 335–58.
27. M. Itoh and K. Kiyono, “Foreign Trade and Direct Investment,” in Industrial Policy of Japan, R. Komiya, M. Okuno, and K. Suzumura, eds. (Tokyo: Academic Press, 1988).
28. E. Borensztein and J. De Gregorio, “How Does Foreign Direct Investment Affect Economic Growth?” Journal of International Economics 45 (June 1998), pp. 115–35; X. J. Zhan and T. Ozawa, Business Restructuring in Asia: Cross-Border M&As in Crisis Affected Countries (Copenhagen: Copenhagen Business School, 2000); I. Costa, S. Robles, and R. de Queiroz, “Foreign Direct Investment and Technological Capabilities,” Research Policy 31 (2002), pp. 1431–43; B. Potterie and F. Lichtenberg, “Does Foreign Direct Investment Transfer Technology across Borders?” Review of Economics and Statistics 83 (2001), pp. 490–97; K. Saggi, “Trade, Foreign Direct Investment and International Technology Transfer,” World Bank Research Observer 17 (2002), pp. 191–235; W. N. W. Azman-Saini, A. Z. Baharumshah and S. Hook Law, “Foreign Direct Investment, Economic Freedom and Economic Growth: International Evidence,” Economic Modelling 27 (2010), pp. 1079–89.
29. K. M. Moden, “Foreign Acquisitions of Swedish Companies: Effects on R&D and Productivity,” Research Institute of International Economics, 1998, mimeo.
30. “Foreign Friends,” The Economist, January 8, 2000, pp. 71–72. 31. A. Jack, “French Go into Overdrive to Win Investors,” Financial Times, December 10,
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1997, p. 6. 32. “Foreign Friends.” 33. United Nations, World Investment Report, 2014 (New York and Geneva: United Nations,
2014). 34. R. Ram and K. H. Zang, “Foreign Direct Investment and Economic Growth,” Economic
Development and Cultural Change 51 (2002), pp. 205–25. 35. United Nations, World Investment Report, 2014. 36. United Nations, World Investment Report, 2000 (New York and Geneva: United Nations,
2000). 37. R. B. Reich, The Work of Nations: Preparing Ourselves for the 21st Century (New York:
Knopf, 1991). 38. This idea has been articulated, although not quite in this form, by C. A. Bartlett and S.
Ghoshal, Managing across Borders: The Transnational Solution (Boston: Harvard Business School Press, 1989).
39. P. Magnusson, “The Mexico Pact: Worth the Price?” BusinessWeek, May 27, 1991, pp. 32– 35.
40. C. Johnston, “Political Risk Insurance,” in Assessing Corporate Political Risk, D. M. Raddock, ed. (Totowa, NJ: Rowman & Littlefield, 1986).
41. M. Tolchin and S. Tolchin, Buying into America: How Foreign Money Is Changing the Face of Our Nation (New York: Times Books, 1988).
42. L. D. Qiu and Z. Tao, “Export, Foreign Direct Investment and Local Content Requirements,” Journal of Development Economics 66 (October 2001), pp. 101–25.
43. See R. E. Caves, Multinational Enterprise and Economic Analysis (Cambridge, UK: Cambridge University Press, 1982); A. H. Kirca et al., “Firm-Specific Assets, Multinationality, and Financial Performance: A Meta-Analytic Review and Theoretical Integration,” Academy of Management Journal 54 (2011), pp. 47–72.
44. For a good general introduction to negotiation strategy, see M. H. Bazerman and M. A. Neale, Negotiating Rationally (New York: Free Press, 1992); A. Dixit and B. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: Norton, 1991); H. Raiffa, The Art and Science of Negotiation (Cambridge, MA: Harvard University Press, 1982).
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Part 3 The Global Trade and Investment Environment
Regional Economic Integration
Learning Object ives After reading this chapter, you will be able to:
LO9-1 Describe the different levels of regional economic integration.
LO9-2 Understand the economic and political arguments for regional economic integration.
LO9-3 Understand the economic and political arguments against regional economic integration.
LO9-4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.
LO9-5 Understand the implications for management practice that are inherent in regional economic integration agreements.
NAFTA 2.0: The USMCA
opening case In his 2016 presidential campaign, Donald Trump repeatedly criticized the North American Free Trade Agreement (NAFTA) as an unfair deal in which Americans had been taken to the cleaners by Mexico. Trump claimed that NAFTA had cost American manufacturers millions of jobs, even though there is
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scant evidence to suggest that this is the case. After becoming president, Trump stuck to his word and initiated a renegotiation of NAFTA.
Trump's anti-NAFTA stance sent shockwaves through industry on both sides of the border. Since NAFTA was signed in 1994, trade between the United States, Canada, and Mexico has tripled to $1.3 trillion. In 2017, the United States exported $342 billion of goods and services to Canada and $277 billion to Mexico, while importing $339 billion from Canada and $355 billion from Mexico. The U.S. ran a $2.8 billion surplus in trade with Canada, and a $69 billion deficit with Mexico. Canada and Mexico are now the largest export markets for the United States, accounting for a third of all U.S. exports, and the largest sources of imports behind China.
The renegotiation of NAFTA was complicated by the fact that multilayered supply chains now span both sides of the U.S.–Mexican border. Nowhere is this more the case than in the automobile industry. Auto parts manufactured in the United States may be shipped to plants in Mexico, where finished cars are assembled and then shipped back to the United States for final sale (the converse also occurs, with parts manufactured in Mexico being shipped to U.S. final assembly plants). In 2017, U.S. producers exported $21 billion of finished automobiles and automotive parts to Mexico but imported $84 billion in autos and parts from Mexico. Without that $63 billion trade deficit in autos and auto parts, the United States would be running only a $6 billion trade deficit with Mexico.
Perhaps because he recognizes the lopsided nature of trade in auto and auto parts between the United States and Mexico, President Trump has taken it upon himself to criticize auto producers that have moved production to Mexico or are planning to do so. Following criticism from Trump, Ford canceled plans to build a $1.6 billion auto assembly plant in Mexico. President Trump has also criticized General Motors, Toyota, and BMW for their plans to invest in Mexican assembly operations. Jawboning aside, as part of the NAFTA renegotiations, the Trump administration was looking at different options for restructuring trade with Mexico. These include placing tariffs on imports of autos from Mexico.
In the event, on September 30th, 2018, the Trump Administration reached agreement with Mexico and Canada on a revised version of NAFTA. Known as the United States-Mexico-Canada Agreement, or USMCA for short, this agreement must now be ratified by legislators in all three countries. The USMCA does make some changes to the 25-year-old NAFTA agreement. Most significantly, NAFTA required automakers to produce 62.5 percent of a vehicle’s content in North America to qualify for zero tariffs. The USMCA raises that threshold to 75%. That’s meant to force automakers to source fewer parts for a car assembled in North America from Germany, Japan, South Korea or China. The new agreement also mandates that by 2023, 40% of parts for any tariff-free vehicle must come from a so-called “high wage” factory. Those factories must pay a minimum of $16 an hour in average salaries for production workers, which is about triple the average wage in a Mexican factory right now.
The Trump Administration clearly hopes these provisions will increase the production of automobiles and component parts in the United States. That may occur, but critics also note that the consequences may include higher costs to North American automobile producers, and higher prices for consumers. • Sources: U.S. Census Bureau, www.census.gov/foreign-trade/index.html, accessed April 10, 2018; Robbie Whelan, “Gloom Descends on Mexico’s NAFTA Capital,” The Wall Street Journal, January 26, 2017; Dudley Althaus and Christina Rogers, “Donald Trump’s NAFTA Plan Would Confront Globalized Auto Industry,” The Wall Street Journal, November 10, 2016; William Mauldin and David Luhnow, “Donald Trump Posed to Pressure Mexico on Trade,” The Wall Street Journal, November 21, 2016; and Siobhan Hughes et al., “Trump Tariffs Spark GOP Rift,” The Wall Street Journal, March 5, 2018.
Introduction The past two decades have witnessed a proliferation of regional trade blocs that promote regional economic integration. World Trade Organization (WTO) members are required to notify the WTO of any regional trade agreements in which they participate. By 2018, all members had notified the WTO of participation in one or more regional trade agreements. As of
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early 2018, there were 284 regional trade agreements in force.1
Consistent with the predictions of international trade theory and particularly the theory of comparative advantage (see Chapter 6), agreements designed to promote freer trade within regions are believed by economists to produce gains from trade for all member countries. The General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization, also seek to reduce trade barriers. However, the WTO has a global perspective and 164 members, which can make reaching an agreement extremely difficult. By entering into regional agreements, groups of countries aim to reduce trade barriers more rapidly than can be achieved under the auspices of the WTO. 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, initiated in 2001 but currently in limbo (see Chapter 7). Given the failure of the Doha Round, national governments have felt that they can better advance their trade agenda through multilateral agreements than through the WTO.
Nowhere has the movement toward regional economic integration been more ambitious than in Europe. On January 1, 1993, the European Union formally removed many barriers to doing business across borders within the EU in an attempt to create a single market with 340 million consumers. Today, the EU has a population of more than 500 million and a gross domestic product of more than $17 trillion, making it slightly smaller than the United States in economic terms. That being said, the 2016 vote by the British to negotiate an exit from the EU (Brexit) has cast a cloud over the future of the European project (the British are set to exit the EU in March 2019).
Similar moves toward regional integration are being pursued elsewhere in the world. Canada, Mexico, and the United States entered into the NAFTA on January 1, 1994. Ultimately, NAFTA aimed to remove all barriers to the free flow of goods and services among the three countries. While the implementation of NAFTA has resulted in job losses in some sectors of the U.S. economy, in aggregate and consistent with the predictions of international trade theory, most economists argue that the benefits of greater regional trade outweigh any costs. As noted in the opening case, however, the administration of President Donald Trump criticized NAFTA, blaming it for significant job losses in the United States, and has negotiated a new agreement.
Regional economic integration is the focus of Chapter 9, and the value-added portion of globalEDGE™ that captures the ongoing development of major trade agreements worldwide is called “Regional Trade Agreements” (globaledge.msu.edu/global- resources/regional-trade-agreements). In this section of globalEDGE™, the most critical agreements of the some 300 that exist today are included, with direct access to the home pages for each agreement. The landing page for “Regional Trade Agreements” also includes globalEDGE’s own “Trade Bloc Insights,” which takes the user to a wealth of information and data (e.g., overview of each agreement, its history, countries included in the membership, related agreements, online resources, statistics, and an executive summary of what the agreement entails). In Chapter 9, we cover several of the trade agreements to provide an overview of the global marketplace. But which agreements are not covered in detail in the book, and which ones are covered on globalEDGE? What do you know, for example, about ECOWAS and SADC? How many members are in ECOWAS and SADC, respectively, and are any of these agreements overlapping? When were the treaties of ECOWAS and SADC started?
South America, too, has moved toward regional integration. For example, in 1991, Argentina, Brazil, Paraguay, and Uruguay implemented an agreement known as Mercosur to start reducing
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barriers to trade between each other, and although progress within Mercosur has been halting, the institution is still in place. There are also ongoing attempts at regional economic integration in Africa, where 26 countries signed an agreement to try and reduce tariffs and costly customs processes in order to stimulate economic growth in the region.
This chapter explores the economic and political debate surrounding regional economic integration, paying particular attention to the economic and political benefits and costs of integration; reviews progress toward regional economic integration around the world; and maps the important implications of regional economic integration for the practice of international business. We will discuss current developments that threatened the future of the EU and NAFTA. Before tackling these objectives, we first need to examine the levels of integration that are theoretically possible.
Levels of Economic Integration LO 9-1 Describe the different levels of regional economic integration.
Several levels of economic integration are possible in theory (see Figure 9.1). From least integrated to most integrated, they are a free trade area, a customs union, a common market, an economic union, and, finally, a full political union.
9.1 Figure Levels of economic integration
In a free trade area, all barriers to the trade of goods and services among member countries are removed. In the theoretically ideal free trade area, no discriminatory tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade between members. Each country, however, is allowed to determine its own trade policies with regard to nonmembers. 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—
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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 arrangement, each member being allowed to determine its own level of support. Members are also free to determine the level of protection applied to goods coming from outside the EFTA. Other free trade areas include the North American Free Trade Agreement, which we discuss in depth later in the chapter.
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 necessitates significant administrative machinery to oversee trade relations with nonmembers. Most countries that enter into a customs union desire even greater economic integration down the road. The EU began as a customs union, but it has now moved beyond this stage. Other customs unions include the current version of the Andean Community (formerly known as the Andean Pact) among Bolivia, Colombia, Ecuador, and Peru. The Andean Community established free trade between member countries 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 common market. Venezuela was accepted as a full member of Mercosur subject to ratification by the governments of the four existing members. As of early 2016, Paraguay has yet to ratify Venezuela’s membership.
Should Regional Economic Integration Be Based on Culture?
A free trade area is a group of countries committed to removing all barriers to the free flow of goods and services while at the same time pursuing independent external trade policies. A free trade area can be of the form of a customs union, common market, economic union, or political union. 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 members of the EU have adopted the common currency, the euro, and countries differ in a variety of economic measures (e.g., taxes, regulations). But the most obvious reason the EU is an imperfect market is that the cultures of the independent countries in many cases are very different, from the Nordic countries to the southern European countries to the former eastern bloc European countries, and so on. Do you think regional economic integration should be more based on similarity in culture of the nations involved, or are market-based economic indicators the most appropriate?
An economic union entails even closer economic integration and cooperation than a common market. Like the common market, an economic union involves the free flow of products and
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factors of production among member countries and the adoption of a common external trade policy, but it also requires a common currency, harmonization of members’ tax rates, and a common monetary and fiscal policy. Such a high degree of integration demands a coordinating bureaucracy and the sacrifice of significant amounts of national sovereignty to that bureaucracy. 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; differences 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 plays an important role in the EU, has been directly elected by citizens of the EU countries since the late 1970s. In addition, the Council of Ministers (the controlling, decision- making body of the EU) is composed of government ministers from each EU member. The United States provides an example of even closer political union; in the United States, independent states are effectively combined into a single nation.
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The Case for Regional Integration LO 9-2 Understand the economic and political arguments for regional economic integration.
The case for regional integration is both economic and political, and it is typically not accepted by many groups within a country, which explains why most attempts to achieve regional economic integration have been contentious and halting. In this section, we examine the economic and political cases for integration and two impediments to integration. In the next section, we look at the case against integration.
THE ECONOMIC CASE FOR INTEGRATION
The economic case for regional integration is straightforward. We saw in Chapter 6 how economic theories of international trade predict that unrestricted free trade will allow countries to specialize in the production of goods and services that they can produce most efficiently. 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 technological, marketing, and managerial know-how to host nations. Given the central role of knowledge in boosting economic growth, opening a country to FDI also is likely to stimulate economic growth. In sum, economic theories suggest that free trade and investment is a positive- sum game, in which all participating countries stand to gain.
Given this, the theoretical ideal is an absence of barriers to the free flow of goods, services, and factors of production among nations. However, as we saw in Chapters 7 and 8, a case can be made for government intervention in international trade and FDI. Because many governments
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have accepted part or all of the case for intervention, unrestricted free trade and FDI have proved to be only an ideal. Although international institutions such as the WTO have been moving the world toward a free trade regime, success has been less than total. In a world of many nations and many political ideologies, it is very difficult to get all countries to agree to a common set of rules.
Against this background, regional economic integration can be seen as an attempt to achieve additional gains from the free flow of trade and investment between countries beyond those attainable under global agreements such as the WTO. It is easier to establish a free trade and investment regime among a limited number of adjacent countries than among the world community. Coordination and policy harmonization problems are largely a function of the number of countries that seek agreement. 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 politically alien Soviet Union loomed large in the minds of many of the EC’s founders.4 A long-standing joke in Europe is that the European Commission should erect a statue to Joseph Stalin, for without the aggressive policies of the former dictator of the old Soviet Union, the countries of western Europe may have lacked the incentive to cooperate and form the EC.
The establishment of NAFTA also had a political aspect to it. Many NAFTA supporters felt that the trade agreement would help promote democracy and economic growth in Mexico. This, they argued, would be good for the United States, since it would reduce the flow of illegal immigration from Mexico. In fact, illegal immigration from Mexico rose from 2.9 million in 1995 to almost 7 million in 2007. However, since then, the strong Mexican economy has indeed led to a reduction in illegal immigration from Mexico. By 2017 the number Mexican illegal immigrants living in the United States had fallen to 5.8 million.5
IMPEDIMENTS TO INTEGRATION
Despite the strong economic and political arguments in support, integration has never been easy to achieve or sustain for two main reasons. First, although economic integration aids the majority, it has its costs. While a nation as a whole may benefit significantly from a regional free trade agreement, certain groups will lose, at least in the short to medium term. Moving to a free trade regime can involve painful adjustments. Due to the establishment of NAFTA, some Canadian and U.S. workers in such industries as textiles—which employ low-cost, low-skilled
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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 widening of the agreement.
A second impediment to integration arises from concerns over national sovereignty. For example, Mexico’s concerns about maintaining control of its oil interests resulted in an agreement with Canada and the United States to exempt the Mexican oil industry from any liberalization of foreign investment regulations achieved under NAFTA. Concerns about national sovereignty arise because close economic integration demands that countries give up some degree of control over such key issues as monetary policy, fiscal policy (e.g., tax policy), and trade policy. 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 remained an important holdout. A politically important segment of public opinion in that country opposed a common currency on the grounds that it would require relinquishing control of the country’s monetary policy to the EU, which many British perceive as a bureaucracy run by foreigners. In 1992, the British won the right to opt out of any single currency agreement. In 2016, the British held a referendum on their continuing membership of the EU and voted to leave the EU (discussed later in the chapter). Concerns over national sovereignty, particularly with regard to immigration policy, were the major factor persuading the British government that a referendum was necessary.
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The Case against Regional Integration LO 9-3 Understand the economic and political arguments against regional economic
integration.
Although the tide has been running in favor of regional free trade agreements, some economists have expressed concern that the benefits of regional integration have been oversold, while the costs have often been ignored.6 They point out that the benefits of regional integration are determined by the extent of trade creation, as opposed to trade diversion. Trade creation occurs when high-cost domestic producers are replaced by low-cost producers within the free trade area. It may also occur when higher-cost external producers are replaced by lower-cost external producers within the free trade area. Trade diversion occurs when lower-cost external suppliers are replaced by higher-cost suppliers within the free trade area. A regional free trade agreement will benefit the world only if the amount of trade it creates exceeds the amount it diverts.
Suppose the United States and Mexico imposed tariffs on imports from all countries and then set up a free trade area, scrapping all trade barriers between themselves but maintaining tariffs on imports from the rest of the world. If the United States began to import textiles from Mexico, would this change be for the better? If the United States previously produced all its own textiles at a higher cost than Mexico, then the free trade agreement has shifted production to the cheaper source. According to the theory of comparative advantage, trade has been created within the regional grouping, and there would be no decrease in trade with the rest of the world. Clearly, the change would be for the better. If, however, the United States previously imported textiles from Costa Rica, which produced them more cheaply than either
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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 nontariff barriers. As a result, regional trade blocs could emerge whose markets are protected from outside competition by high nontariff barriers. In such cases, the trade diversion effects might outweigh the trade creation effects. The only way to guard against this possibility, according to those concerned about this potential, is to increase the scope of the WTO so it covers nontariff barriers to trade. There is no sign that this is going to occur any time soon, however, so the risk remains that regional economic integration will result in trade diversion.
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Regional Economic Integration in Europe LO 9-4 Explain the history, current scope, and future prospects of the world’s most
important regional economic agreements.
Europe has two trade blocs—the European Union and the European Free Trade Association. Of the two, the EU is by far the more significant, not just in terms of membership (the EU currently has 28 members, although the British have voted to exit the union and is scheduled to do so on March 29, 2019; the EFTA has four), but also in terms of economic and political influence in the world economy. The EU has been viewed as an emerging economic and political superpower of the same order as the United States, although the exit of Britain may alter this perception. Accordingly, we will concentrate our attention on the EU.7
EVOLUTION OF THE EUROPEAN UNION
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 objective was to remove barriers to intragroup shipments of coal, iron, steel, and scrap metal. With the signing of the Treaty of Rome in 1957, the European Community (EC) was established. The name changed again in 1993 when the European Community became the European 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
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obstacles to the free movement of factors of production among the members. To facilitate the free movement of goods, services, and factors of production, the treaty provided for any necessary harmonization of the member states’ laws. Furthermore, the treaty committed the EC to establish common policies in agriculture and transportation.
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—eight of them from eastern Europe plus the small Mediterranean nations of Malta and Cyprus. Bulgaria and Romania joined in 2007 and Croatia in 2013, bringing the total number of member states to 28 (see Map 9.1). Through these enlargements, the EU has become a global economic power. Right now, it looks as if the the number of members will fall to 27 in 2019 when Britain exits the EU.
9.1 MAP Member states of the European Union in 2017.
Source: European Union, 1995-2017
POLITICAL STRUCTURE OF THE EUROPEAN UNION
The economic 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 Commission, the Council of the European Union, the European Parliament, and the Court of Justice.8
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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. Currently, there are 28 commissioners, one from each member state. A president of the commission is chosen by member states, and the president then chooses other members in consultation with the states. The entire commission has to be approved by the European Parliament before it can begin work. The commission has a monopoly in proposing 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 normally ask a state to comply with any EU laws that are being broken. If this persuasion is not sufficient, the commission can refer a case to the Court of Justice.
The European Commission’s role in competition policy has become increasingly important to business in recent years. Since 1990, when the office was formally assigned a role in competition policy, the EU’s competition commissioner has been steadily gaining influence as the chief regulator of competition policy in the member nations of the EU. As with antitrust authorities in the United States, which include the Federal Trade Commission and the Department of Justice, the role of the competition commissioner is to ensure that no one enterprise uses its market power to drive out competitors and monopolize markets. In 2009, for example, the commission fined Intel a record €1.06 billion for abusing its market power in the computer chip market. (See the accompanying Management Focus for details.) The previous record for a similar abuse was €497 million imposed on Microsoft in 2004 for blocking competition in markets for server computers and media software. The commissioner also reviews proposed mergers and acquisitions to make sure they do not create a dominant enterprise with substantial market power.9 For example, in 2000 a proposed merger between Time Warner of the United States and EMI of the United Kingdom, both music recording companies, was withdrawn after the commission expressed concerns that the merger would reduce the number of major record companies from five to four and create a dominant player in the $40 billion global music industry.
m a n a g e m e n t F O C U S
The European Commission and Intel
In May 2009, the European Commission announced that it had imposed a record €1.06 billion ($1.45 billion) fine on Intel for anticompetitive behavior. This fine was the result of an investigation into Intel’s competitive conduct during the period from October 2002 to December 2007. During this period, Intel’s market share of microprocessor sales to personal computer manufacturers consistently exceeded 70 percent. According to the commission, Intel illegally used its market power to ensure that its major rival, AMD, was at a competitive disadvantage, thereby harming “millions of European consumers.”
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,
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for selling only Intel-based computers in Germany, Belgium, and other countries.
Under the order, Intel had to change its practices immediately, pending any appeal. 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 insisted that it had never coerced computer makers and retailers with inducements and maintained that it had never paid to stop AMD products from reaching the market in Europe. Although Intel acknowledges that it did offer rebates, it claimed that they were never conditional on specific actions by manufacturers and retailers aimed to limit AMD. In June 2014, an EU court rejected Intel’s appeal and upheld the judgment against the company.
Sources: M. Hachman, “EU Hits Intel with $1.45 Billion Fine for Antitrust Violations,” PCMAG.com, May 13, 2009; J. Kanter, “Europe Fines Intel $1.45 Billion in Antitrust Case,” The New York Times, May 14, 2009; T. Fairless, “EU Court Upholds Record Fine against Intel,” The Wall Street Journal, June 12, 2014.
The European Council represents the interests of member states. It is clearly the ultimate controlling authority within the EU because draft legislation from the commission can become EU law only if the council agrees. 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 sessions and a failure to make progress or reach agreement on commission proposals. In an attempt to clear the resulting logjams, the Single European Act formalized the use of majority voting rules on issues “which have as their object the establishment and functioning of a single market.” Most other issues, however, such as tax regulations and immigration policy, still require unanimity among council members if they are to become law. The votes that a country gets in the council are related to the size of the country. For example, Germany, a large country, has 29 votes, whereas Denmark, a much smaller state, has seven votes.
As of 2016, the European Parliament has 751 members and is directly elected by the populations of the member states. 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 legislation, 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 governments, acting through the Council of the European Union.10 After significant debate, in December 2007, the member states signed a new treaty, the Treaty of Lisbon, under which the power of the European Parliament was increased. When it took effect in December 2009, for the first time in history the European Parliament was the co-equal legislator for almost all European laws.11 The Treaty of Lisbon also created a new position, a president of the European Council, who serves a 30-month
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term and represents the nation-states that make up the EU.
The Court of Justice, which is composed of one judge from each country, is the supreme appeals court for EU law. Like commissioners, the judges are required to act as independent officials, rather than as representatives of national interests. The commission or a member country can bring other members to the court for failing to meet treaty obligations. Similarly, member countries, member companies, or member institutions can bring the commission or council to the court for failure to act according to an EU treaty.
THE SINGLE EUROPEAN ACT
The Single European Act was born of a frustration among members that the community was not living up to its promise. By the early 1980s, it was clear that the EC had fallen short of its objectives to remove barriers to the free flow of trade and investment among member countries and to harmonize the wide range of technical and legal standards for doing business. Against this background, many of the EC’s prominent businesspeople mounted an energetic campaign in the early 1980s to end the EC’s economic divisions. The EC responded by creating the Delors Commission. Under the chairperson Jacques Delors, the commission proposed that all impediments to the formation of a single market be eliminated by December 31, 1992. 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:12
Remove all frontier controls among EC countries, thereby abolishing delays and reducing the resources required for complying with trade bureaucracy. Apply the principle of “mutual recognition” to product standards. A standard developed in one EC country should be accepted in another, provided it met basic requirements in such matters as health and safety. Institute open public procurement to nonnational suppliers, reducing costs directly by allowing lower-cost suppliers into national economies and indirectly by forcing national suppliers to compete. Lift barriers to competition in the retail banking and insurance businesses, which should drive down the costs of financial services, including borrowing, throughout the EC. Remove all restrictions on foreign exchange transactions between member countries by the end of 1992. Abolish restrictions on cabotage—the right of foreign truckers to pick up and deliver goods within another member state’s borders—by the end of 1992. Estimates suggested this would reduce the cost of haulage within the EC by 10 to 15 percent.
All those changes were expected to lower the costs of doing business in the EC, but the single-market program was also expected to have more complicated supply-side effects. For example, the expanded market was predicted to give EC firms greater opportunities to exploit economies of scale. In addition, it was thought that the increase in competitive intensity brought about by removing internal barriers to trade and investment would force EC firms to become more efficient. To signify the importance of the Single European Act, the European Community also decided to change its name to the European Union once the act took effect.
Impact The Single European Act has had an impact on the EU economy.13 The act provided the impetus for the restructuring of substantial sections of European industry. Many firms have shifted from national to pan-European production and distribution systems in an attempt to
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realize scale economies and better compete in a single market. The results have included faster economic growth than would otherwise have been the case. According to empirical research, the single market raised GDP by between 2 and 5 percent in its first 15 years (different empirical studies generated different results, although all pointed to a positive impact).14 However, 25 years after the formation of a single market, there is little doubt that the reality still falls short of the ideal. Although the EU is undoubtedly moving toward a single marketplace, long-established legal, cultural, and language differences among nations mean that implementation has been uneven.
Is Greece a Good Member of the European Union?
In April 2014, Greece held its first bond sale since 2010, raising about $4.2 billion as investors flocked to secure bonds from the hard-hit country. Greece stopped issuing bonds in 2010 amid the country’s economic crisis. The 2014 bond sale was hailed as a sign that Greece is recovering and heading in the right direction. As most observers agree, Greece has struggled to deal with its financial crisis, and has, among many measures, taken on more than $330 billion worth of bailouts and implemented various austerity measures to fix the country’s finances. The government’s bond sale is a return to international markets for Greece and a step toward the country reducing its dependence on foreign aid—a crucial step to regain confidence from investors and other countries. 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.
THE ESTABLISHMENT OF THE EURO
In February 1992, EC members signed the Maastricht Treaty, which committed them to adopting a common currency by January 1, 1999.15 The euro is now used by 19 of the 28 member states of the European Union; these 19 states are members of what is often referred to as the euro zone. It encompasses 330 million EU citizens and includes the powerful economies of Germany and France. Many of the countries that joined the EU on May 1, 2004, and the two that joined in 2007 originally planned to adopt the euro when they fulfilled certain economic criteria—a high degree of price stability, a sound fiscal situation, stable exchange rates, and converged long-term interest rates (the current members had to meet the same criteria). However, the events surrounding the EU sovereign debt crisis of 2010–2012 persuaded many of these countries to put their plans on hold, at least for the time being (further details provided later).
Establishment of the euro was a remarkable political feat with few historical precedents. It required participating national governments to give up their own currencies and national control over monetary policy. Governments do not routinely sacrifice national sovereignty for the greater good, indicating the importance that the Europeans attach to the euro. By adopting the euro, the EU has created the second most widely traded currency in the world after the U.S. dollar. Some believe that the euro could come to rival the dollar as the most important currency in the world.
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Three long-term EU members—Great Britain, Denmark, and Sweden—decided to sit 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 circulation. By mid-2002, all prices and routine economic transactions within the euro zone were in euros.
Benefits of the Euro Europeans decided to establish a single currency in the EU for a number of reasons. First, they believe that businesses and individuals realize significant savings from having to handle one currency, rather than many. 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 Commission, such savings amount to 0.5 percent of the European Union’s GDP.
Second, and perhaps more important, the adoption of a common currency makes it easier to compare prices across Europe. This has been increasing competition because it has become easier for consumers to shop around. For example, if a German finds that cars sell for less in France than Germany, he may be tempted to purchase from a French car dealer rather than his local car dealer. Alternatively, traders may engage in arbitrage to exploit such price differentials, buying cars in France and reselling them in Germany. The only way that German car dealers will be able to hold onto business in the face of such competitive pressures will be to reduce the prices they charge for cars. As a consequence of such pressures, the introduction of a common currency has led to lower prices, which translates into substantial gains for European consumers.
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 common currency, by increasing competition, has produced long-run gains in the economic efficiency of European companies.
Fourth, the introduction of a common currency has given a boost to the development of a highly liquid pan-European capital market. Over time, the development of such a capital market should lower the cost of capital and lead to an increase in both the level of investment and the efficiency with which investment funds are allocated. 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 money at a reasonable price. However, in theory, such companies can now tap a much more liquid pan-European capital market.
Finally, the development of a pan-European, euro-denominated capital market will increase the range of investment options open to both individuals and institutions. For example, it will now be much easier for individuals and institutions based in, let’s say, Holland to invest in Italian or French companies. 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.16
Costs of the Euro The drawback, for some, of a single currency is that national authorities have lost control 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 independent European Central Bank (ECB), similar in some respects to the U.S. Federal Reserve, with a clear mandate to manage monetary policy so as to ensure price stability. The ECB, based in Frankfurt,
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is meant to be independent from political pressure—although critics question this. Among other things, the ECB sets interest rates and determines monetary policy across the euro zone.
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.
Can the Euro Survive?
It seems like experts and interested observers are always debating the merits of the euro and its likelihood of survival. The answers lie in examining several interesting facts of the European Union. First, the lack of a European treasury is a missing piece of the puzzle. Without it, the ECB is limited in the assistance it can provide to euro zone member-states. In theory, the European Central Bank (ECB) could bail out those member-states burdened with excessive debt by printing more money. However, that would require the approval of all of the EU member countries (not just the countries that use the euro as their national currency). Germany is typically opposed to any measure that may light the fires of inflation. Some of the EU members also think it is unfair to bail out those states that have lived beyond their means for many years. It is difficult to compare the difficulties within the EU to those of other nations that have faced similar problems and survived. But the basic question remains, will the euro survive?
Source: http://seekingalpha.com.
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 independent 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 euro zone countries. 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. So far, the ECB has established a solid reputation for political independence.
According to critics, another drawback of the euro is that the EU is not what economists would call an optimal currency area. In an optimal currency area, similarities in the underlying structure of economic activity make it feasible to adopt a single currency and use a single exchange rate as an instrument of macroeconomic policy. Many of the European economies in the euro zone, however, are very dissimilar. For example, Finland and Portugal have different wage rates, tax regimes, and business cycles, and they may react very differently to external economic shocks. A change in the euro exchange rate that helps Finland may hurt Portugal. Obviously, such differences complicate macroeconomic policy. For example, when euro economies are not growing in unison, a common monetary policy may mean that interest rates are too high for depressed regions and too low for booming regions.
One way of dealing with such divergent effects within the euro zone is for the EU to engage in fiscal transfers, taking money from prosperous regions and pumping it into depressed regions. Such a move, however, opens a political can of worms. Would the citizens of Germany forgo their “fair share” of EU funds to create jobs for underemployed Greece workers? Not surprisingly, there is strong political opposition to such practices.
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The Euro Experience Since its establishment January 1, 1999, the euro has had a volatile trading history against the world’s major currency, the U.S. dollar. After starting life in 1999 at €1 = $1.17, the euro stood at a robust all-time high of €1 = $1.54 in early March 2008. One reason for the rise in the value of the euro was that the flow of capital into the United States stalled as the U.S. financial markets fell during 2007 and 2008. Many investors took money out of the United States, selling dollar-denominated assets such as U.S. stocks and bonds, and purchasing euro-denominated assets. Falling demand for U.S. dollars and rising demand for euros translated into a fall in the value of the dollar against the euro. Furthermore, in a vote of confidence in both the euro and the ability of the ECB to manage monetary policy within the euro zone, many foreign central banks added more euros to their supply of foreign currencies. In the first three years of its life, the euro never reached the 13 percent of global reserves made up by the deutsche mark and other former euro zone currencies. The euro didn’t jump that hurdle until early 2002 and hit 28 percent in 2009. By the end of 2017, the euro accounted for about 20 percent of global foreign exchange reserves.17
Euro sign sculpture.
©Bloomberg/Getty Images
Since 2008 however, the euro has weakened against a basket of currencies, reflecting persistent concerns over slow economic growth and large budget deficits among several EU member states, particularly Greece, Portugal, Ireland, Italy, and Spain. During the 2000s, all these governments had sharply increased their government debt to finance public spending. Government debt as a percentage of GDP hit record levels in many of these nations. By 2010, private investors became increasingly concerned that these nations would not be able to service their sovereign debt, particularly given the economic slowdown following the 2008–2009 global financial crisis. 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 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 to stave off such a sovereign debt crisis, in May 2010, the euro zone nations and the International Monetary Fund (IMF) agreed to a €110 billion bailout package to help rescue Greece. In November 2010, the EU and IMF agreed to a bailout package for Ireland of €85 billion; in May 2011, euro zone countries and the IMF instituted a €78 billion bailout plan for Portugal. In return for these loans, all three countries had to agree to sharp reductions in
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government spending, which meant slower economic growth and high unemployment until government debt was reduced to more sustainable levels. While Italy and Spain did not request bailout packages, both countries were forced by falling bond prices to institute austerity programs that required big reductions in government spending. 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 accompanying Country Focus, by 2012 Greece had been granted two more bailout packages in an attempt to forestall a full- blown default on payment of its sovereign debt. As might be expected, economic turmoil within the EU led to a decline in the value of the euro. By early 2018, the dollar-euro exchange rate stood at €1 = $1.23, below its 2008 value. The euro also declined by 20 to 30 percent against most of the world’s other major currencies between late 2008 and early 2017, but has staged a partial recovery since then largely on stronger economic growth in the EU.
Potentially troubling for the long-run success of the euro, many of the newer EU nations that had committed to adopting the euro put their plans on hold. Countries like Poland and the Czech Republic had no desire to join the euro zone and then have their taxpayers help bail out the profligate governments of countries like Italy and Greece. To compound matters, the sovereign debt crisis had exposed a deep flaw in the euro zone: 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 United Kingdom and Czech Republic abstained; Croatia joined in 2013).
ENLARGEMENT OF THE EUROPEAN UNION
Enlargement of the EU into eastern Europe has been discussed since the collapse of communism at the end of the 1980s. By the end of the 1990s, 13 countries had applied to become EU members. To qualify for EU membership, the applicants had to privatize state assets, deregulate markets, restructure industries, and tame inflation. They also had to enshrine complex EU laws into their own systems, establish stable democratic governments, and respect human rights.18 In December 2002, the EU formally agreed to accept the applications of 10 countries, and they joined May 1, 2004. The new members included the Baltic countries, the Czech Republic, and the larger nations of Hungary and Poland. The only new members 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.
c o u n t r y F O C U S
The Greek Sovereign Debt Crisis When the euro was established, some critics worried that free-spending countries in the euro zone (such
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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 extensive spending in the public sector. Much of the spending increase could be characterized as an attempt by the government to buy off powerful interest groups in Greek society, from teachers and farmers to public-sector employees, rewarding them with high pay and extensive benefits. To make matters worse, the government misled the international community about the level of its indebtedness. In October 2009, a new government took power and quickly announced that the 2009 public-sector deficit, which had been projected to be around 5 percent, would actually be 12.7 percent. 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 countries, led by Germany, along with the IMF agreed to lend Greece up to €110 billion. These loans were judged sufficient to cover Greece’s financing needs for three years. In exchange, the Greek government agreed to implement a series of strict austerity measures. These included tax increases, major cuts in public-sector pay, reductions in benefits enjoyed by public-sector employees (e.g., the retirement age was increased to 65 from 61, and limits were placed on pensions), and reductions in the number of public-sector enterprises from 6,000 to 2,000. However, the Greek economy contracted so fast in 2010 and 2011 that tax revenues plunged. By the end of 2011, the Greek economy was almost 29 percent smaller than it had been in 2005, while unemployment approached 20 percent. 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 below 8 percent, and the government was running a budget surplus before interest payments.
Unfortunately, things took a turn for the worse in 2014, when it became clear that despite economic progress, Greece did not have the funds to repay its creditors on time and would have to issue new bonds in order to do so. Following a decision to call a snap election, in January 2015, a radical left-wing “anti-bailout” party was swept into power. The financial minister of the new government suggested that Greece should default on its scheduled debt repayments to its largest creditor, Germany. This initiated a crisis in the euro zone and helped precipitate a sharp decline in the value of the euro against the U.S. dollar. Following further negotiations, Greece’s creditors agreed to a third bailout in late 2015—but only after Greece agreed to implement further austerity measures and economic reforms. Whether this will prove to be any more successful than the prior two bailouts remains to be seen.
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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; “Aegean Stables,” The Economist, January 11, 2014; Liz Alderman, “Greece’s Debt Crisis Explained,” The New York Times, November 8, 2015.
The new members were not able to adopt the euro for several years, and free movement of labor among the new and existing members was prohibited until then. Consistent with theories of free trade, the enlargement should create added benefits for all members. However, given the small size of the eastern European economies (together they amount to only 5 percent of the GDP of current EU members), the initial impact will probably be small. 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 lobbied 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, 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 in late 2016, the European Parliament voted to suspend negotiations following Turkish government purges of opposition groups and a belief that Turkey was tilting towards authoritarianism.
Welcome sign to Croatia when the country joined the European Union.
©FREDERICK FLORIN/AFP/Getty Images
BRITISH EXIT FROM THE EUROPEAN UNION (BREXIT)
On June 23, 2016, and by a narrow margin, the British electorate voted in a national referendum to leave the EU. In early 2017, the British government formally notified the EU of its intention to exit the EU. Under the Treaty of Lisbon, it had two years to negotiate the terms of exit with the EU, which was scheduled to occur on March 29, 2019. While the British have enjoyed the benefits of free trade within Europe, a segment of the population has never been comfortable with the loss of national sovereignty implied by membership within the EU. The British have
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often railed against regulations imposed by the EU bureaucracy in Brussels, and more recently, immigration has become a key issue. Immigration from within the EU hit record levels in 2015. Much of that immigration has been from eastern Europe. Many of the immigrants have been low skilled and work in restaurants, hotels, and retail stores. The campaign for leaving the EU claimed that exit would allow the British to “take back control” of immigration. In the referendum, London, Scotland, and Northern Ireland voted to stay in the EU, whereas most of the rest of the country voted for exit. The vote was also split by age and education. The younger and more educated voted to stay in the EU, while the older and less educated voted to leave.
The impending exit of Britain creates an existential problem for the EU. Britain is the EU’s second largest national economy. It is seen by many smaller member countries as an important counterweight to the economic power of Germany. In the aftermath of the British vote, right- wing politicians in Holland, Denmark, and France also called for referendums on continuing EU membership, raising fears that the British vote might trigger a “rush for the exits.” While this seems unlikely to occur, there is little doubt that an EU without Britain will lose some of its economic and political clout on the world stage, and the EU itself will be diminished. Given the importance of immigration in the British vote, further expansion of the EU now seems unlikely, particularly with regard to Turkey.
As for Britain, most experts predict that the country will bear short- to medium-term costs as a result of this decision.19 Britain is now less likely to attract inward investment from foreign multinationals, some multinationals may move operations to other EU countries to maintain access to the single market, exports to the EU may fall, London risks losing its position as the financial capital of Europe, and economic growth may be lower than it otherwise might have been. Furthermore, given that the Scots voted by a large margin to stay in the EU, this once again raises the possibility of Scottish independence from the United Kingdom. In the long run, whether Britain benefits from exit depends on its ability to negotiate trade deals with the EU and other major economic powers—including the United States, Japan, and China—to replace the benefits it will lose by exiting from the EU. In a world that is becoming increasingly resistant to free trade deals, there is no guarantee that the British will be able to do this. The British government would certainly like to extract favorable trade terms wth the EU as part of its exit negotiations, but the EU is likely to insist that in order to get full access to the single market, the British adopt EU regulations permitting the free movement of labor. This is something that the British are unlikely to accept given how important an issue immigration was in the referendum.
test PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.
Regional Economic Integration in the Americas No other attempt at regional economic integration comes close to the EU in its boldness or its potential implications for the world economy, but there have been significant attempts at regional economic integration in the Americas. The most notable is the North American Free Trade Agreement which at the time of writing is in the process of being superseded by the USMCA (see the Opening Case). In addition to NAFTA, several other trade blocs are in the offing in the Americas (see Map 9.2), the most significant of which appear to be the Andean
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Community and Mercosur.
9.2 MAP Economic integration in the Americas.
THE NORTH AMERICAN FREE TRADE AGREEMENT
The governments of the United States and Canada in 1988 agreed to enter into a free trade agreement, 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 (NAFTA) 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 governments of all three countries. The agreement became law January 1, 1994.20
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
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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 2015, the average hourly labor cost in Mexican automobile factories was $8–$10 an hour including benefits, compared to $42–$58 an hour in the United States.21) Movement of production to Mexico, they argued, was most likely to occur in lower-skilled, labor-intensive manufacturing industries in which Mexico might have a comparative advantage. Advocates of NAFTA argued that many would benefit from such a trend. Mexico would benefit from much- needed inward investment and employment. 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.
Did You Know? Did you know that NAFTA was thought to produce a “giant sucking sound”? Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.
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 environmental and labor laws. According to one extreme opponent, Ross Perot, up to 5.9 million U.S. jobs would be lost to Mexico after NAFTA in what he famously characterized as a “giant sucking sound.” Most economists, however, dismissed these numbers as being absurd and alarmist. 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 services) and an increase of $15 bill
