WHAT I LEARNED ESSAY

International Business Competing in the Global Marketplace

C h a r l e s W . L . H i l l U N I V E R S I T Y O F W A S H I N G T O N

G . To m a s M . H u l t M I C H I G A N S T A T E U N I V E R S I T Y

International Business Competing in the Global Marketplace

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INTERNATIONAL BUSINESS: COMPETING IN THE GLOBAL MARKETPLACE, TWELFTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2019 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2017, 2015, and 2013. 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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F o r m y m o t h e r J u n e H i l l , a n d t h e m e m o r y o f m y f a t h e r,

M i k e H i l l — C h a r l e s W . L . H i l l

F o r G e r t & M a r g a r e t a H u l t , m y p a r e n t s — G . To m a s M . H u l t

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about the AUTHORS C h a r l e s W . L . H i l l U n i v e r s i t y o f W a s h i n g t o n

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. The Foster School has a Center for International Business Education and Research (CIBER), one of only 17 funded by the U.S. Department of Education, and is con- sistently ranked as a Top-25 business school. Learn more about Professor Hill at 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 Busi- ness Today (McGraw-Hill). His work is among the most widely cited in the world in international business and strategic management. Beginning in 2014, Dr. Hill partnered with Dr. Tomas Hult in a formidable co-authorship of the IB franchise of textbooks (International Business, Global Business Today). This brought together two of the most cited international business scholars in history. 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. 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 . T o m a s M . H u l t M i c h i g a n S t a t e U n i v e r s i t y

G. Tomas M. Hult is the John W. Byington Endowed Chair, professor of marketing and international business, and director of the International Business Center in the Eli Broad College of Business at Michigan State University. The Broad College has a Center for International Business Education and Research (CIBER), one of only 17 funded by the U.S. Department of Education, and is consistently ranked as a Top-25 business school. Learn more about Professor Hult at broad.msu.edu/ facultystaff/hult A native of Sweden, Professor Hult received a mechanical engineer degree in Sweden before obtaining a PhD at The University of Memphis. In addition to Michigan State University, he has served on the faculties of Florida State University

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and the University of Arkansas at Little Rock. Dr. Hult holds visiting professorships in the International Business group of his native Uppsala University, Sweden (since 2013) and the International Business division of Leeds University, UK (since 2010). Michigan State, Uppsala, and Leeds are all ranked in the top 10 in the world in international business research. Several studies have ranked Professor Hult as one of the most cited scholars in the world in business and management. He served as editor of Journal of the Academy of Marketing Science, a Financial Times Top-50 business journal, and has published more than 70 articles in premier business journals, including Journal of International Business Studies, Academy of Management Journal, Strategic Management Journal, Journal of Management, Journal of Marketing, Journal of the Academy of Marketing Science, Journal of Retailing, Journal of Operations Management, Decision Sciences, and IEEE. He has also published several textbooks including International Business (McGraw-Hill) and Global Business Today (McGraw-Hill). Dr. Hult’s other books include Second Shift: The Inside Story of the Keep GM Movement, Global Supply Chain Management, Total Global Strategy, and Extending the Supply Chain. He is a regular contributor of op-ed and articles in the popular press (e.g., Time, Fortune, World Economic Forum, The Conversation). Professor Hult is a well-known keynote speaker on international business, interna- tional marketing, global supply chain management, global strategy, and marketing strat- egy. He teaches in doctoral, master’s, and undergraduate programs at Michigan State University. He also teaches frequently in executive development programs and has developed a large clientele of the world’s top multinational 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). Tomas Hult is an elected Fellow of the Academy of International Business (AIB), one of only about 90 scholars worldwide receiving this honor, and serves as the executive director and foundation president of AIB. He also serves on the U.S. District Export Council and holds board member positions on the International Trade Center of Mid-Michigan and the Sheth Foundation. Tomas enjoys tennis, golf, and traveling as his favorite recreational activities.

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brief CONTENTS

part one Introduction and Overview Chapter 1 Globalization 2

part two National Differences Chapter 2 National Differences in Political, Economic, and

Legal Systems 38

Chapter 3 National Differences in Economic Development 62

Chapter 4 Differences in Culture 90

Chapter 5 Ethics, Corporate Social Responsibility, and Sustainability 128

part three The Global Trade and Investment Environment Chapter 6 International Trade Theory 158

Chapter 7 Government Policy and International Trade 192

Chapter 8 Foreign Direct Investment 222

Chapter 9 Regional Economic Integration 252

part four The Global Monetary System Chapter 10 The Foreign Exchange Market 286

Chapter 11 The International Monetary System 312

Chapter 12 The Global Capital Market 340

part five The Strategy and Structure of International Business Chapter 13 The Strategy of International Business 362

Chapter 14 The Organization of International Business 392

Chapter 15 Entry Strategy and Strategic Alliances 430

part six International Business Functions Chapter 16 Exporting, Importing, and Countertrade 460

Chapter 17 Global Production and Supply Chain Management 486

Chapter 18 Global Marketing and R&D 516

Chapter 19 Global Human Resource Management 552

Chapter 20 Accounting and Finance in the International Business 582

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part seven Integrative Cases Global Medical Tourism 609

Venezuela under Hugo Chávez and Beyond 611

Political and Economic Reform in Myanmar 612

Will China Continue to Be a Growth Marketplace? 613

Lead in Toys and Drinking Water 614

Creating the World’s Biggest Free Trade Zone 616

Sugar Subsidies Drive Candy Makers Abroad 617

Volkswagen in Russia 618

The NAFTA Tomato Wars 619

Subaru’s Sales Boom Thanks to the Weaker Yen 620

The IMF and Ukraine’s Economic Crisis 621

The Global Financial Crisis and Its Aftermath: Declining Cross-Border Capital Flows 622

Ford’s Global Platform Strategy 624

Philips’ Global Restructuring 625

General Motors and Chinese Joint Ventures 626

Exporting Desserts by a Hispanic Entrepreneur 627

Apple: The Best Supply Chains in the World? 628

Domino’s Global Marketing 630

Siemens and Global Competitiveness 632

Microsoft and Its Foreign Cash Holdings 633

Glossary 635

Organization Index 645

Name Index 650

Subject Index 652

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THE PROVEN CHOICE FOR INTERNATIONAL BUSINESS

RELEVANT. PRACTICAL. INTEGRATED.

It is now more than a quarter of a century since work be- gan on the first edition of International Business: Compet- ing in the Global Marketplace. By the third edition the book was the most widely used international business text in the world. Since then its market share has only in- creased. The success of the book can be attributed to a number of unique features. Specifically, for the twelfth edition we have developed a learning program that

∙ Is comprehensive, state of the art, and timely. ∙ Is theoretically sound and practically relevant. ∙ Focuses on applications of international business

concepts. ∙ Tightly integrates the chapter topics throughout. ∙ Is fully integrated with results-driven technology. ∙ Takes full and integrative advantage of

globalEDGE.msu.edu—the Google-ranked #1 web resource for “international business resources.”

International Business, now in its twelfth edition, co- authored by Charles W. L. Hill and G. Tomas M. Hult, is a compre- hensive and case-oriented version of our text that lends itself to the core course in international business for those courses that want a deeper focus on the global monetary system, structure of international business, international accounting, and international finance. We cover more and integrated cases in International Business 12e and we provide a deeper treatment of the global capital market, the organization of an international business, interna- tional accounting, and international finance—topics that are allocated chapters in International Business 12e but are not attended to in the shorter treatment of IB in Global Business Today 10e. Like our shorter text, Global Business Today 10e (2017), International Business 12e, focuses on being current, rele- vant, application rich, accessible, and student focused. Our goal has always been to cover macro and micro is- sues 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 defi- ciency. Many of the students in these international busi- ness 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 mar- ketplace. We are proud and delighted to have put together this international business learning experience for the leaders of tomorrow. Over the years, and through now 12 editions, Dr. Charles Hill has worked hard to adhere to these goals. Since Global Business Today 9e (2015), and International Business 11e (2017), Charles’s co-author, Dr. Tomas Hult, follows the same approach. As a team, we have been guided not only by our own reading, teaching, and re- search but also by the invaluable feedback we received from professors and students around the world, from re- viewers, and from the editorial staff at McGraw-Hill Edu- cation. Our thanks go out to all of them.

RELEVANT AND COMPREHENSIVE

To be relevant and comprehensive, an international busi- ness package must

∙ Explain how and why the world’s cultures, coun- tries, and regions differ.

∙ Cover economics and politics of international trade and investment.

∙ Tackle international issues related to ethics, corpo- rate social responsibility, and sustainability.

∙ Explain the functions and form of the global mon- etary system.

∙ Examine the strategies and structures of interna- tional businesses.

∙ Assess the special roles of an international busi- ness’s various functions.

This text has always endeavored to be relevant, practical, and integrated. Too many other products have paid insuf- ficient attention to some portion of the topics mentioned, being skewed toward a particular portion of international business. Relevance and comprehensiveness also require cover- age 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,

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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 champi-

oned 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 advan- tage 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 transac- tion cost economics.

∙ Bartlett and Ghoshal’s research on the transna- tional 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 was as up-to-date as possible when it went to press. A significant amount has happened in the world since we began revisions of this book. By 2018, more than $4 trillion per day was f lowing across na- tional borders and, as we will see in Chapter 1, trade across borders has almost exponentially increased in the last 15 years. The size of such f lows fueled concern about the ability of short-term speculative shifts in global capital markets to destabilize the world economy.

What’s New in the Twelfth Edition

The world continued to become more global. Several Asian economies, most notably China and India, contin- ued to grow their economies at a rapid rate. New multina- tionals 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. And unfortunately, global terrorism and the attendant geopolitical risks keep emerging in various places glob- ally, many new and inconceivable just a decade ago. These represent a threat to global economic integration and activity. Plus, with the avenue of the United Kingdom opting to vote to leave the European Union, the election of President Donald Trump in the United States, and several elections around the world, the globe—in many ways—has paid more attention to nationalistic issues over trade. These topics and much more are integrated into this text for maximum learning opportunities. The success of the first eleven editions of International Business was based in part on the incorporation of leading- edge research into the text, the use of the up-to-date ex- amples 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 twelfth 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 events, statis- tics, and examples.

4. Add new and insightful opening and closing cases.

5. Incorporate value-added globalEDGE features in every chapter.

6. Connect every chapter to a focus on managerial implications.

7. Provide 20 new integrated cases that can be used as additional cases for specific chapters but, more importantly, as learning vehicles across multiple chapters.

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 are the only text in International Busi- ness that ensures that all material is up-to-date on virtu- ally a daily basis. The copyright for the book is 2019 but you are likely using the text in 2018, 2019, or 2020—we

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keep it updated to each semester you use the text in your course! We are able to do this by integrating globalEDGE features in every chapter. Specifically, the Google number-one-ranked globaledge.msu.edu site (for “interna- tional business resources”) is used in each chapter to add value to the chapter material and provide up-to-date data and information. This keeps chapter material constantly and dynamically updated for teachers who want to infuse globalEDGE material into the chapter topics, and it keeps students abreast of current developments in inter- national business. In addition to updating all statistics, figures, and maps to incorporate the most recently published data, a chapter-by-chapter selection of changes for the eleventh edition include the following:

Chapter 1: Globalization ∙ New opening case: Globalization of BMW,

Rolls-Royce, and the MINI ∙ New materials on international trade, trade agree-

ments, 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

∙ New closing case: Uber: Going Global from Day One

Chapter 2: National Differences in Political, Economic, and Legal Systems

∙ New opening case: The Decline of Zimbabwe ∙ Updated section on Pseudo-Democracies ∙ Updated data and figure on corruption ∙ New country focus: Corruption in Brazil ∙ New closing case: Economic Transformation in

Vietnam

Chapter 3: National Differences in Economic Development

∙ New opening case: Economic Development in Bangladesh

∙ Updated data, maps and discussion on Differences in Economic Development

∙ Updated data, maps and discussion on the spread of democracy and market-based economic systems.

∙ New closing case: The Political and Economic Evolution of Indonesia

Chapter 4: Differences in Culture ∙ New opening case: The Swatch Group and Cultural

Uniqueness ∙ New management focus: China and Its Guanxi ∙ Deeper treatment of culture, values, and norms ∙ Worked with the foundation that most religions are

now pro-business ∙ Updated the Hofstede culture framework with new

research ∙ New closing case: The Emirates Group and

Employee Diversity

Chapter 5: Ethics, Corporate Social Responsibility, and Sustainability

∙ New opening case: Woolworths Group’s Corporate Responsibility Strategy 2020

∙ New management focus: “Emissionsgate” at Volkswagen

∙ Deeper focus on corporate social responsibility and sustainability at the country, company, and customer levels

∙ New closing case: UNCTAD Sustainable Develop- ment Goals

Chapter 6: International Trade Theory ∙ New opening case: Donald Trump on Trade ∙ Added discussion of Donald Trump’s views on

trade at appropriate points in the chapter. ∙ Expanded discussion of David Autor’s important

research on trade and employment in U.S. counties impacted by trade with China.

∙ New closing case: The Trans Pacific Partnership (TPP)

Chapter 7: Government Policy and International Trade

∙ New opening case: Boeing and Airbus Are in a Dogfight over Illegal Subsidies

∙ New section, The World Trading System under Threat, discussing the possible implications of BREXIT and the election of Donald Trump (who appears to hold mercantilist views on trade).

∙ New closing case: Is China Dumping Excess Steel Production?

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Chapter 8: Foreign Direct Investment ∙ New opening case: Foreign Direct Investment in

Retailing in India ∙ Updated data and discussion on FDI trends on the

world economy. ∙ New closing case: Burberry Shifts Its Strategy in

Japan

Chapter 9: Regional Economic Integration ∙ New opening case: Renegotiating NAFTA ∙ New section discussing the implications of

BREXIT for Britain and the European Union ∙ New section on the future of NAFTA in light of

Donald Trump’s election as president ∙ New closing case: The Push toward Free Trade in

Africa

Chapter 10: The Foreign Exchange Market ∙ New opening case: The Mexican Peso, the Japanese

Yen, and Pokemon Go ∙ New closing case: Apple’s Earnings Hit by Strong

Dollar

Chapter 11: The International Monetary System

∙ New opening case: Egypt and the IMF ∙ Updated discussion of exchange rates since 1973 to

reflect recent exchange rate movements. ∙ New closing case: China’s Exchange Rate Regime

Chapter 12: The Global Capital Market ∙ New opening case: Saudi Aramco ∙ New closing case: Alibaba’s Record-Setting IPO

Chapter 13: The Strategy of International Business

∙ New opening case: Sony’s Global Strategy ∙ Deeper discussion of the rise of regionalism ∙ Integration of global strategy thoughts ∙ New closing case: IKEA’s Global Strategy

Chapter 14: The Organization of International Business

∙ Revised opening case: Unilever’s Global Organization

∙ Revised Management Focus: Walmart International

∙ Revised Management Focus: Lincoln Electric and Culture

∙ New closing case: Organizational Architecture at P&G

Chapter 15: Entry Strategy and Strategic Alliances

∙ New opening case: Gazprom and Global Strategic Alliances

∙ Deeper treatment of entry modes and global strategic alliances

∙ Revised closing case: Starbucks’ Foreign Entry Strategy

Chapter 16: Exporting, Importing, and Countertrade

∙ New opening case: Tata Motors and Exporting ∙ globalEDGE-related material on company readi-

ness to export and company readiness to import material

∙ Revised management focus: Ambient Technologies and the Panama Canal

∙ New and revised material on globalEDGE Diagnostic Tools; focusing on CORE-Company Readiness to Export

∙ New closing case: Embraer and Brazilian Importing

Chapter 17: Global Production and Supply Chain Management

∙ New opening case: Alibaba and Global Supply Chains

∙ Revised and new material on global logistics, global purchasing, and global operations.

∙ Revised sections on Strategic Roles for Production Facilities, Make-or-Buy Decisions, and Global Supply Chain Functions

∙ New text for the sections on Role of Information Technology, Coordination in Global Supply Chains, and Interorganizational Relationships

∙ New closing case: Amazon’s Global Supply Chains

Chapter 18: Global Marketing and R&D ∙ New opening case: ACSI and Satisfying Global

Customers

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∙ Revised sections on Globalization of Markets and Brands, Configuring the Marketing Mix (with a great summary table and sample measures), and International Market Research

∙ Revised positioning of the Product Development section

∙ New closing case: Global Branding, Marvel Studios, and Walt Disney Company

Chapter 19: Global Human Resource Management

∙ New opening case: Building a Global Diverse Workforce at Sodexo

∙ New section: Building a Diverse Global Workforce ∙ New closing case: AstraZeneca

Chapter 20: Accounting and Finance in the International Business

∙ Revised opening case: Shoprite—Financial Success of a Food Retailer in Africa

∙ Revised materials on global accounting standards and organizations

∙ Revised closing case: Tesla, Inc.—Subsidizing Tesla Automobiles Globally

Integrated Cases

All of the 20 integrated cases are new for International Business 12e. Many of these cases build on previous open- ing and closing chapter cases that have been revised, up- dated, and oftentimes adopted a new angle or focus. A unique feature of the opening and closing cases for the chapters as well as the integrated cases at the back-end of the text is that we cover all continents of the world and we do so with regional or country issues and large, me- dium, and small company scenarios. This makes the 60 total cases we have included in International Business 12e remarkable wealthy as a learning program. As a heads up for teachers (and students), the Domino’s case is the lengthiest and most in-depth in the twelfth edition.

∙ Global Medical Tourism ∙ Venezuela under Hugo Chávez and Beyond

∙ Political and Economic Reform in Myanmar ∙ Will China Continue to be a Growth Marketplace ∙ Lead in Toys and Drinking Water ∙ Creating the World’s Biggest Free Trade Zone ∙ Sugar Subsidies Drive Candy Makers Abroad ∙ Volkswagen in Russia ∙ The NAFTA Tomato Wars ∙ Subaru’s Sales Boom Thanks to the Weaker Yen ∙ The IMF and Ukraine’s Economic Crisis ∙ The Global Financial Crisis and Its Aftermath:

Declining Cross-Border Capital Flows ∙ Ford’s Global Platform Strategy ∙ Philips’ Global Restructuring ∙ General Motors and Chinese Joint Ventures ∙ Exporting Desserts by a Hispanic Entrepreneur ∙ Apple: The Best Supply Chains in the World? ∙ Domino’s Global Marketing ∙ Siemens and Global Competitiveness ∙ Microsoft and Its Foreign Cash Holdings

Beyond Uncritical Presentation and Shallow Explanation

Many issues in international business are complex and thus necessitate considerations of pros and cons. To dem- onstrate this to students, we have adopted a critical ap- proach that presents the arguments for and against economic theories, government policies, business strate- gies, organizational structures, and so on. Related to this, we have attempted to explain the com- plexities of the many theories and phenomena unique to international business so the student might fully compre- hend the statements of a theory or the reasons a phenom- enon 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.

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We have always believed that it is important to show students how the material covered in the text is rele- vant 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 ob- vious in the first half of the book, which considers many macroeconomic and political issues, from international trade theory and foreign direct investment flows to the IMF and the influence of inflation rates on foreign exchange quo- tations. 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.

Another tool that we have used to focus on managerial implica- tions is the Management Focus box. Most chapters have at least one Management Focus. Like the opening cases, the purpose of these boxes is

to illustrate the relevance of chapter material for the practice of international business.

Practical and Rich Applications

National Differences in Political, Economic, and Legal Systems Chapter 2 57

PRODUCT SAFETY AND PRODUCT LIABILITY

Product safety laws set certain safety standards to which a product must adhere. Prod- uct liability involves holding a firm and its officers responsible when a product causes in- jury, death, or damage. Product liability can be much greater if a product does not conform to required safety standards. Both civil and criminal product liability laws exist. Civil laws call for payment and monetary damages. Criminal liability laws result in fines or imprison- ment. 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 compre- hensive liability laws. Liability laws are typically the least extensive in less developed na- tions. 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.

In addition to the competitiveness issue, country differences in product safety and lia- bility 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.

F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

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 impor- tant 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 oper-

ate 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, eco- nomic, and legal systems. The overall attractiveness of a country as a market or investment site depends on balancing the likely long-term benefits of doing business in that country against the likely costs and risks. Because this chapter is the first of two dealing with issues of political economy, we will delay a detailed discussion of how political economy impacts the benefits, costs, and risks of doing business in different nation-states until the end of the next chapter, when we have a full grasp of all the relevant variables that are important for assessing benefits, costs, and risks. For now, other things being equal, a nation with democratic political institutions, a market- based economic system, and strong legal system that protects property rights and limits 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,

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

hiL29442_ch02_038-061.indd 57 12/29/17 11:48 AM

M A N A G E M E N T F O C U S

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 zon- ing 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, execu- tives 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 gen- eral 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

Did Walmart Violate the Foreign Corrupt Practices Act? populated neighborhoods without a construction license, an environmental permit, an urban impact assessment, or even a traffic permit. Similarly, thanks to nine bribe pay- ments 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 investiga- tion, and it had cost more than $612 million in fees. In addi- tion, the U.S. Department of Justice and the Securities and Exchange Commission both announced that they had started investigations into Walmart’s practices. In Novem- ber 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 alle- gations by the Times that top executives at Walmart, includ- ing former CEO Lee Scott Jr., had deliberately squashed earlier investigations. While the investigations are still on- going, in late 2016 people familiar with the matter stated that the federal investigation had not uncovered evidence of widespread bribery. Nevertheless, the company was ap- parently negotiating a settlement with the U.S. government that was estimated to be at least $600 million.

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.

international trade) to keep detailed records that would reveal whether a violation of the act has occurred. In 2012, evidence emerged that in its eagerness to expand in Mexico, Walmart may have run afoul of the FCPA (for details, see the Management Focus feature).

In 1997, trade and finance ministers from the member states of the Organisation for Economic Co-operation and Development (OECD), an association of 34 major econo- mies 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 pub- lic officials a criminal offense.

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),

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In addition, each chapter begins with an opening case that sets the stage for the chapter content and familiarizes students with how real international companies conduct business.

part two National Dif ferences

3National Differences in Economic Development L E A R N I N G O B J E C T I V E S Af ter 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.

©Shafiqul Alam/Corbis News/Getty Images©Shafiqul Alam/Corbis News/Getty Images

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part seven cases

Integrative Cases For International Business, 12e, we have again included a set of 20 cases as value- added materials at the end of the text in addition to the 40 cases—opening and clos- ing cases—that appear in the 20 chapters. We started this practice of including short but integrative cases in the 11th edition to provide instructors and students with a bet- ter platform for learning across chapters.

The end-of-the-book cases fill strategically aligned objectives for the core features of In- ternational Business 12e. Specifically, we are able to build on and enhance the worldwide market leadership of our text and its focus on current, application-rich, relevant, and

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Global Medical Tourism 1 4, 5 X X

Venezuela under Hugo Chávez and Beyond 2 3, 6 X X X

Political and Economic Reform in Myanmar 3 6, 7 X X X

Will China Continue to Be a Growth Marketplace? 4 7, 8 X X X

Lead in Toys and Drinking Water 5 4, 13 X X X

Creating the World’s Biggest Free Trade Zone 6 7, 8, 9 X X

Sugar Subsidies Drive Candy Makers Abroad 7 2, 3, 6 X X X

Volkswagen in Russia 8 7, 17 X X X

The NAFTA Tomato Wars 9 4, 6, 7 X X X

Subaru’s Sales Boom Thanks to the Weaker Yen 10 11, 12 X X

The IMF and Ukraine’s Economic Crisis 11 3, 12 X X X

The Global Financial Crisis and Its Aftermath: Declining Cross-Border Capital Flows

12 6, 8 X X X

Ford’s Global Platform Strategy 13 14, 17 X X X

Philips’ Global Restructuring 14 13 X X

General Motors and Chinese Joint Ventures 15 13, 14 X X

Exporting Desserts by a Hispanic Entrepreneur 16 15 X X X

Apple: The Best Supply Chains in the World? 17 13, 14, 15 X X X

Domino’s Global Marketing 18 16, 17 X X X

Siemens and Global Competitiveness 19 14 X X X

Microsoft and Its Foreign Cash Holdings 20 12, 14, 15 X X X X

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Globalization Chapter 1 35

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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

1. As the drivers of globalization continue to pres- sure 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, ana- lyzes these pressures and trends to identify op- portunities across markets and sectors through its trade forecasts. Visit the HSBC Global Con- nections site and use the trade forecast tool to identify which export routes are forecasted to see the greatest growth over the next 15 to 20 years. What patterns do you see? What types of coun- tries dominate these routes?

2. You are working for a company that is consider- ing investing in a foreign country. Investing in countries with different traditions is an impor- tant element of your company’s long-term strate- gic goals. As such, management has requested a report regarding the attractiveness of alternative countries based on the potential return of FDI. Accordingly, the ranking of the top 25 countries in terms of FDI attractiveness is a crucial ingre- dient 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 regard- ing how the index is constructed.

Uber, the controversial San Francisco–based ride-for-hire service, has made a virtue out of disrupting the estab- lished taxi business. From a standing start in 2009, the company has spread across the globe like wildfire. Uber’s strategy has been to focus on major metropolitan areas around the world. This strategy has so far taken Uber into about 600 cities in more than 80 countries. The privately held company is rumored to be generating annual reve- nues of around $10 billion. At the core of Uber’s business is a smartphone app that allows customers to hail a ride from the comfort of their own home, a restaurant, or a bar stool. The app shows cars in the area, notifies the rider when a car is on the way, and tracks the progress of the car on screen using GPS map- ping technology. The rider pays via the app using a credit card, so no cash changes hands. The driver takes 80 per- cent of the fee and Uber 20 percent. The price for the ride is determined by Uber using an algorithm that sets prices in order to match the demand for rides with the supply of cars on the road. Thus, if demand exceeds supply, the price for a ride will rise, inducing drivers to get on the road. Uber does not own any cars. Its drivers are independent contrac- tors with their own vehicles. The company is, in effect, a twenty-first-century version of an old-style radio taxi dis- patch company. Interestingly, Uber’s founders got their idea for the app-based service one snowy night in Paris when they were unable to find a taxi.

Historically, taxi markets around the globe have been tightly regulated by metropolitan authorities. The stated purpose of these regulations has often included (1) limit- ing the supply of taxis in order to boost demand for other forms of public transportation, (2) limiting the supply of taxis in order to reduce traffic congestion, (3) ensuring the safety of riders by only allowing licensed taxis to offer rides, (4) ensuring that the prices charged are “fair,” and (5) guaranteeing a reasonable rate of return to the owners of taxi licenses. In practice, widespread restrictions on the supply of taxi licenses have created shortages in many cities, making it dif- ficult to find a taxi, particularly at busy periods. In New York, the number of licenses barely increased from 11,787 in 1945 to 13,587 in 2017, even though the population ex- panded significantly. In Paris, the number of licenses was 14,000 in 1937 and had only increased to 17,137 by 2017, even though both the population and the number of visitors to the city had surged. The number of taxis in Milan was frozen between 1974 and 2014, despite Milan having a ratio of taxis to inhabitants that was one of the lowest for any major city. Whenever metropolitan authorities have tried to increase the number of taxis in a city, they have often been meet by strong resistance from established taxi companies. When the French tried to increase the number of taxis in Paris in 2007, a strike among transportation workers shut down the city and forced the government to back off.

C L O S I N G C A S E

Uber: Going Global from Day One

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The Part Seven Integrated Cases are somewhat longer, allowing a more in- depth study of international companies. These cases can be used as stand-alone cases, in conjunction with a specific chap- ter, and also as integrated cases covering relevant and practical material from several chapters. The introduction to the Part Seven section discusses and lays out topics covered in each case.

A closing case to each chapter is designed to illustrate the rele- vance of chapter material for the practice of international busi- ness and provide continued in- sight into how real companies handle those issues.

xvii

To help students go a step further in expanding their application-level understanding of international business, each chapter incorporates two globalEDGE research tasks designed and written by Tomas Hult, Tunga Kiyak, and the team at Michigan State University’s International Business Center and their globaledge.msu.edu site. The exercises dovetail with the content just covered.

INTEGRATED PROGRESSION OF TOPICS

A weakness of many texts is that they lack a tight, inte- grated 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. Globaliza- tion 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 busi- ness functions arise out of national differences in politi- cal 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 environ- ment in which international business occurs.

Part Four

Chapters 10 through 12 describe and explain the global monetary system, laying out in detail the monetary frame- work in which international business transactions are conducted.

Part Five

In Chapters 13 through 15 attention shifts from the envi- ronment 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 and structures that firms adopt to compete effectively in the international business environment.

Part Six

In Chapters 16 through 20 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; accounting; and finance—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 deliber- ately bring a management focus to the macro chapters (Chapters 1 through 12). We also integrate macro themes in covering the micro chapters (Chapters 13 through 20). Part Seven with its integrated cases also provides a great learning vehicle to better understand macro and micro issues.

ACCESSIBLE AND INTERESTING

The international business arena is fascinating and excit- ing, and we have tried to communicate our enthusiasm for it to the student. Learning is easier and better if the subject matter is communicated in an interesting, infor- mative, and accessible manner. One technique we have used to achieve this is weaving interesting anecdotes into the narrative of the text, that is, stories that illustrate theory. Most chapters also have a Country Focus box that pro- vides background on the political, economic, social, or cultural aspects of countries grappling with an interna- tional business issue.

McGRAW-HILL CONNECT INTERNATIONAL BUSINESS

Applied

Application Exercises A variety of interactive assignments within Connect re- quire students to apply what they have learned in a real- world scenario. These online exercises help students assess their understanding of the concepts at a higher level. Exer- cises include video cases, decision-making scenarios/cases from real-world companies, case analysis exercises, busi- ness models, processes, and problem-solving cases.

xviii

TEACHING SUPPORT

Within the Connect International Business’ Instructor Re- sources you can find a complete package to prepare you for your course.

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

∙ Test Bank. Approximately 100 true-false, multiple- choice, and essay questions per chapter are in- cluded in the test bank. We’ve aligned our test bank questions with Bloom’s Taxonomy and AACSB guidelines, tagging each question accord- ing to its knowledge and skill areas. Each test bank question also maps to a specific chapter learning objective listed in the text.

∙ PowerPoint Presentations. The PowerPoint pro- gram consists of one set of slides for every chapter, which include key text figures, tables, and maps. Quiz questions to keep students on their toes during classroom presentations are also included, along with instructor notes.

∙ International Business Video Program. McGraw-Hill offers the most comprehensive, diverse, and current video support for the International Business class- room. Updated monthly, our video program is the most current on the market. Additionally, video-based application exercises are assignable within Connect.

COURSE DESIGN AND DELIVERY

cesim GlobalChallenge Simulation

cesim is an international business simulation designed to develop student under-

standing of the interaction and complexity of various business disciplines and concepts in a rapidly evolving, competitive business environment. The simulation has a particular focus on creating long-term, sustainable, and profitable growth of a global technology company. Student teams make decisions about technology-based product roadmaps and global market and production strategies involving economics, finance, human re- sources, accounting, procurement, production, logistics, research and innovation, and marketing. cesim improves

the knowledge retention, business decision making, and teamwork skills of students.

CREATE

Instructors can now tailor their teaching resources to match the way they teach! With McGraw-Hill Create, www.mcgrawhillcreate.com, instructors can easily rearrange chapters, combine mate- rial from other content sources, and quickly upload and integrate their own content, such as course syllabi or teaching notes. Find the right content in Create by search- ing through thousands of leading McGraw-Hill textbooks. Arrange the material to fit your teaching style. Order a Create book and receive a complimentary print review copy in three to five business days or a complimentary electronic review copy via e-mail within one hour. Go to www.mcgrawhillcreate.com today and register.

TEGRITY CAMPUS

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

BLACKBOARD® PARTNERSHIP

McGraw-Hill Education and Blackboard have teamed up to simplify your life. Now you and your students can access Con- nect and Create right from within your Blackboard course— all with one single sign-on. The grade books are seamless, so when a student completes an integrated Connect as- signment, the grade for that assignment automatically (and instantly) feeds your Blackboard grade center. Learn more at http://www.mheducation.com/highered/services/ mhcampus.html.

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McGRAW-HILL CAMPUS™

McGraw-Hill Campus is a new one-stop teaching and learning experience available

to users of any learning management system. This institu- tional service allows faculty and students to enjoy single sign-on (SSO) access to all McGraw-Hill Higher Educa- tion materials, including the award-winning McGraw-Hill Connect platform, from directly within the institution’s website. With McGraw-Hill Campus, faculty receive in- stant access to teaching materials (e.g., eTextbooks, test

banks, PowerPoint slides, animations, learning objectives, etc.), allowing them to browse, search, and use any in- structor ancillary content in our vast library at no addi- tional cost to instructor or students. In addition, students enjoy SSO access to a variety of free content (e.g., quiz- zes, flash cards, narrated presentations, etc.) and sub- scription-based products (e.g., McGraw-Hill Connect). With McGraw-Hill Campus enabled, faculty and stu- dents will never need to create another account to access McGraw-Hill products and services. Learn more at www.mhcampus.com.

■ Connect content is authored by the world’s best subject matter experts, and is available to your class through a simple and intuitive interface.

■ The Connect eBook makes it easy for students to access their reading material on smartphones and tablets. They can study on the go and don’t need internet access to use the eBook as a reference, with full functionality.

■ Multimedia content such as videos, simulations, and games drive student engagement and critical thinking skills. ©McGraw-Hill Education

■ Connect’s assignments help students contextualize what they’ve learned through application, so they can better understand the material and think critically.

■ Connect will create a personalized study path customized to individual student needs through SmartBook®.

■ SmartBook helps students study more efficiently by delivering an interactive reading experience through adaptive highlighting and review.

McGraw-Hill Connect® is a highly reliable, easy-to- use homework and learning management solution that utilizes learning science and award-winning adaptive tools to improve student results.

73% of instructors who use Connect

require it; instructor satisfaction increases by 28% when Connect

is required.

Homework and Adaptive Learning

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Education products more intelligent, reliable, and precise.

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■ Connect Insight® generates easy-to-read reports on individual students, the class as a whole, and on specific assignments.

■ The Connect Insight dashboard delivers data on performance, study behavior, and effort. Instructors can quickly identify students who struggle and focus on material that the class has yet to master.

■ Connect automatically grades assignments and quizzes, providing easy-to-read reports on individual and class performance.

■ Connect integrates with your LMS to provide single sign-on and automatic syncing of grades. Integration with Blackboard®, D2L®, and Canvas also provides automatic syncing of the course calendar and assignment-level linking.

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■ If you’re looking for some guidance on how to use Connect, or want to learn tips and tricks from super users, you can find tutorials as you work. Our Digital Faculty Consultants and Student Ambassadors offer insight into how to achieve the results you want with Connect.

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CONTENTS

part one Introduction and Overview

C H A P T E R 1 Globalization 2 Opening Case Globalization of BMW, Rolls-Royce, and the MINI 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 10

Drivers of Globalization 11 Declining Trade and Investment Barriers 11 Role of Technological Change 15

The Changing Demographics of the Global Economy 17

The Changing World Output and World Trade Picture 17 The Changing Foreign Direct Investment Picture 18

Country Focus India’s Software Sector 19

The Changing Nature of the Multinational Enterprise 20

Management Focus Wanda Group 22

The Changing World Order 22 Global Economy of the Twenty-First Century 23

The Globalization Debate 24 Antiglobalization Protests 24 Globalization, Jobs, and Income 25

Country Focus Protesting Globalization in France 26

Globalization, Labor Policies, and the Environment 28 Globalization and National Sovereignty 29 Globalization and the World’s Poor 30

Managing in the Global Marketplace 31

Chapter Summary 33

Critical Thinking and Discussion Questions 34

Research Task 35

Closing Case Uber: Going Global from Day One 35

Endnotes 36

part two National Differences

C H A P T E R 2 National Differences in Political, Economic, and Legal Systems 38 Opening Case The Decline of Zimbabwe 39

Introduction 40

Political Systems 41 Collectivism and Individualism 41 Democracy and Totalitarianism 43

Country Focus Putin’s Russia 44

Economic Systems 46 Market Economy 46 Command Economy 47 Mixed Economy 48

Legal Systems 48 Different Legal Systems 49 Differences in Contract Law 50 Property Rights and Corruption 50

Country Focus Corruption in Brazil 53

Management Focus Did Walmart Violate the Foreign Corrupt Practices Act? 54

The Protection of Intellectual Property 55

Management Focus Starbucks Wins Key Trademark Case in China 56

Product Safety and Product Liability 57

Focus on Managerial Implications: The Macro Environment Influences Market Attractiveness 57

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Chapter Summary 58

Critical Thinking and Discussion Questions 59

Research Task 59

Closing Case Economic Transformation in Vietnam 59

Endnotes 61

C H A P T E R 3 National Differences in Economic Development 62 Opening Case Economic Development in Bangladesh 63

Introduction 64

Differences in Economic Development 64

Map 3.1 GNI per capita, 2016 65 Map 3.2 GNI PPP per capita, 2016 66 Map 3.3 Average annual growth rate in GDP (%),

2007–2016 67 Broader Conceptions of Development: Amartya Sen 68

Map 3.4 Human Development Index, 2015 69

Political Economy and Economic Progress 69 Innovation and Entrepreneurship Are the Engines of Growth 69 Innovation and Entrepreneurship Require a Market Economy 70 Innovation and Entrepreneurship Require Strong Property Rights 70 The Required Political System 71

Country Focus Emerging Property Rights in China 72

Economic Progress Begets Democracy 72 Geography, Education, and Economic Development 72

States in Transition 73 The Spread of Democracy 73

Map 3.5 Freedom in the world, 2017 74 The New World Order and Global Terrorism 76 The Spread of Market-Based Systems 77

Map 3.6 Index of economic freedom, 2017 78

The Nature of Economic Transformation 78 Deregulation 78 Privatization 79

Country Focus India’s Economic Transformation 80

Legal Systems 81

Implications of Changing Political Economy 81

Focus on Managerial Implications: Benefits, Costs, Risks, and Overall Attractiveness of Doing Business Internationally 82

Chapter Summary 86

Critical Thinking and Discussion Questions 86

Research Task 87

Closing Case The Political and Economic Evolution of Indonesia 87

Endnotes 89

C H A P T E R 4 Differences in Culture 90 Opening Case The Swatch Group and Cultural Uniqueness  91

Introduction 92

What Is Culture? 93 Values and Norms 93 Culture, Society, and the Nation-State 95 Determinants of Culture 96

Social Structure 96 Individuals and Groups 97 Social Stratification 99

Country Focus India and Its Caste System 100

Religious and Ethical Systems 102

Map 4.1 World Religions 103 Christianity 103 Islam 104

Country Focus Secularism in Turkey 107

Hinduism  108 Buddhism 109 Confusianism 110

Management Focus China and Its Guanxi 111

Language 112 Spoken Language 112 Unspoken Language 113

Education 113

Culture and Business 114

Cultural Change 117

Focus on Managerial Implications: Cultural Literacy and Competitive Advantage 119

Chapter Summary 121

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part three The Global Trade and Investment Environment

C H A P T E R 6 International Trade Theory 158 Opening Case Donald Trump on Trade 159

Introduction 160

An Overview of Trade Theory 160 The Benefits of Trade 161 The Pattern of International Trade 162 Trade Theory and Government Policy 162

Mercantilism 163

Country Focus Is China Manipulating Its Currency in Pursuit of a Neo-Mercantilist Policy? 164

Absolute Advantage 164

Comparative Advantage 166 The Gains from Trade 167 Qualifications and Assumptions 168 Extensions of the Ricardian Model 169

Country Focus Moving U.S. White-Collar Jobs Offshore 173

Heckscher–Ohlin Theory 174 The Leontief Paradox 175

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

New Trade Theory 177 Increasing Product Variety and Reducing Costs 177 Economies of Scale, First-Mover Advantages, and the Pattern of Trade 178 Implications of New Trade Theory 179

National Competitive Advantage: Porter’s Diamond 180

Factor Endowments 181 Demand Conditions 181 Related and Supporting Industries 181 Firm Strategy, Structure, and Rivalry 182 Evaluating Porter’s Theory 182

Focus on Managerial Implications: Location, First-Mover Advantages, and Government Policy 183

Critical Thinking and Discussion Questions 122

Research Task 123

Closing Case The Emirates Group and Employee Diversity 123

Endnotes 124

C H A P T E R 5 Ethics, Corporate Social Responsibility, and Sustainability 128 Opening Case Woolworths Group’s Corporate Responsibility Strategy 2020 129

Introduction 130

Ethics and International Business 131 Employment Practices 131

Management Focus “Emissionsgate” at Volkswagen 132

Human Rights 133 Environmental Pollution 134 Corruption 135

Ethical Dilemmas 136

Roots of Unethical Behavior 137 Personal Ethics 137 Decision-Making Processes 138 Organizational Culture 139 Unrealistic Performance Goals 139 Leadership 139 Societal Culture 140

Philosophical Approaches to Ethics 140 Straw Men 140 Utilitarian and Kantian Ethics 142 Rights Theories 143 Justice Theories 144

Focus on Managerial Implications: Making Ethical Decisions Internationally 145

Management Focus Corporate Social Responsibility at Stora Enso 150

Chapter Summary 152

Critical Thinking and Discussion Questions 153

Research Task 154

Closing Case UNCTAD Sustainable Development Goals 154

Endnotes 155

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The Future of the WTO: Unresolved Issues and the Doha Round 210

Country Focus Estimating the Gains from Trade for America 213

Multilateral and Bilateral Trade Agreements 214 The World Trading System under Threat 214

Focus on Managerial Implications: Trade Barriers, Firm Strategy, and Policy Implications 215

Chapter Summary 217

Critical Thinking and Discussion Questions 218

Research Task 218

Closing Case Is China Dumping Excess Steel Production? 219

Endnotes 220

C H A P T E R 8 Foreign Direct Investment 222 Opening Case Foreign Direct Investment in Retailing in India 223

Introduction 224

Foreign Direct Investment in the World Economy 224

Trends in FDI 224 The Direction of FDI 225 The Source of FDI 226

Country Focus Foreign Direct Investment in China 227

The Form of FDI: Acquisitions versus Greenfield Investments 228

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

Management Focus Foreign Direct Investment by Cemex 230

The Pattern of Foreign Direct Investment 232 The Eclectic Paradigm 233

Political Ideology and Foreign Direct Investment 234 The Radical View 234 The Free Market View 235 Pragmatic Nationalism 235 Shifting Ideology 236

Benefits and Costs of FDI 237 Host-Country Benefits 237 Host-Country Costs 239 Home-Country Benefits 240

Chapter Summary 184

Critical Thinking and Discussion Questions 185

Research Task 186

Closing Case The Trans Pacific Partnership (TPP) 186

Appendix

International Trade and the Balance of Payments 188

Endnotes 190

C H A P T E R 7 Government Policy and International Trade 192 Opening Case Boeing and Airbus Are in a Dogfight over Illegal Subsidies 193

Introduction 194

Instruments of Trade Policy 194 Tariffs 195 Subsidies 195

Country Focus Are the Chinese Illegally Subsidizing Auto Exports? 196

Import Quotas and Voluntary Export Restraints 197 Export Tariffs and Bans 198 Local Content Requirements 198 Administrative Policies 199 Antidumping Policies 199

The Case for Government Intervention 199

Management Focus Protecting U.S. Magnesium 200

Political Arguments for Intervention 201 Economic Arguments for Intervention 203

The Revised Case for Free Trade 205 Retaliation and Trade War 205 Domestic Policies 206

Development of the World Trading System 206 From Smith to the Great Depression 207 1947–1979: GATT, Trade Liberalization, and Economic Growth 207 1980–1993: Protectionist Trends 207 The Uruguay Round and the World Trade Organization 208 WTO: Experience to Date 209

xxvi

The North American Free Trade Agreement 271 The Andean Community 273 Mercosur 274 Central American Common Market, CAFTA, and CARICOM 275

Regional Economic Integration Elsewhere 275 Association of Southeast Asian Nations 275

Map 9.3 ASEAN countries 276 Regional Trade Blocs in Africa 277 Other Trade Agreements 277

Focus on Managerial Implications: Regional Economic Integration Threats 278

Chapter Summary 280

Critical Thinking and Discussion Questions 280

Research Task 281

Closing Case The Push toward Free Trade in Africa 281

Endnotes 283

part four The Global Monetary System

C H A P T E R 1 0 The Foreign Exchange Market 286 Opening Case The Mexican Peso, the Japanese Yen, and Pokemon Go 287

Introduction 288

The Functions of the Foreign Exchange Market 289 Currency Conversion 289 Insuring against Foreign Exchange Risk 291

Management Focus Embraer and the Gyrations of the Brazilian Real 293

The Nature of the Foreign Exchange Market 293

Economic Theories of Exchange Rate Determination 294

Prices and Exchange Rates 295

Country Focus Quantitative Easing, Inflation, and the Value of the U.S. Dollar 299

Interest Rates and Exchange Rates 300 Investor Psychology and Bandwagon Effects 301 Summary of Exchange Rate Theories 301

Home-Country Costs 241 International Trade Theory and FDI 241

Government Policy Instruments and FDI 242 Home-Country Policies 242 Host-Country Policies 243 International Institutions and the Liberalization of FDI 244

Focus on Managerial Implications: FDI and Government Policy 244

Chapter Summary 247

Critical Thinking and Discussion Questions 247

Research Task 248

Closing Case Burberry Shifts Its Strategy in Japan 248

Endnotes 249

C H A P T E R 9 Regional Economic Integration 252 Opening Case Renegotiating NAFTA 253

Introduction 254

Levels of Economic Integration 255

The Case for Regional Integration 257 The Economic Case for Integration 257 The Political Case for Integration 257 Impediments to Integration 258

The Case against Regional Integration 258

Regional Economic Integration in Europe 259 Evolution of the European Union 259

Map 9.1 Member states of the European Union in 2017 260

Political Structure of the European Union 260

Management Focus The European Commission and Intel 261

The Single European Act 262 The Establishment of the Euro 263

Country Focus The Greek Sovereign Debt Crisis 266

Enlargement of the European Union 268 British Exit from the European Union (BREXIT) 269

Regional Economic Integration in the Americas 270

Map 9.2 Economic integration in the Americas 270

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Focus on Managerial Implications: Currency Management, Business Strategy, and Government Relations 333

Management Focus Airbus and the Euro 335

Chapter Summary 336

Critical Thinking and Discussion Questions 337

Research Task 337

Closing Case China’s Exchange Rate Regime 338

Endnotes 339

C H A P T E R 1 2 The Global Capital Market 340 Opening Case Saudi Aramco  341

Introduction 342

Benefits of the Global Capital Market 342 Functions of a Generic Capital Market 342 Attractions of the Global Capital Market 343

Management Focus The Industrial and Commercial Bank of China Taps the Global Capital Market 345

Growth of the Global Capital Market 347 Global Capital Market Risks 349

Country Focus Did the Global Capital Markets Fail Mexico? 350

The Eurocurrency Market 351 Genesis and Growth of the Market 351 Attractions of the Eurocurrency Market 351 Drawbacks of the Eurocurrency Market 353

The Global Bond Market 353 Attractions of the Eurobond Market 354

The Global Equity Market 354

Foreign Exchange Risk and the Cost of Capital 356

Focus on Managerial Implications: Growth of the Global Capital Market 356

Chapter Summary 357

Critical Thinking and Discussion Questions 358

Research Task 358

Closing Case Alibaba’s Record-Setting IPO 359

Endnotes 360

Exchange Rate Forecasting 302 The Efficient Market School 302 The Inefficient Market School 302 Approaches to Forecasting 302

Currency Convertibility 303

Focus on Managerial Implications: Foreign Exchange Rate Risk 304

Chapter Summary 307

Critical Thinking and Discussion Questions 308

Research Task 309

Closing Case Apple’s Earnings Hit by Strong Dollar 309

Endnotes 310

C H A P T E R 1 1 The International Monetary System 312 Opening Case Egypt and the IMF 313

Introduction 314

The Gold Standard 315 Mechanics of the Gold Standard 315 Strength of the Gold Standard 315 The Period between the Wars: 1918–1939 316

The Bretton Woods System 317 The Role of the IMF 317 The Role of the World Bank 318

The Collapse of the Fixed Exchange Rate System 319

The Floating Exchange Rate Regime 320 The Jamaica Agreement 320 Exchange Rates since 1973 320

Country Focus The U.S. Dollar, Oil Prices, and Recycling Petrodollars 323

Fixed versus Floating Exchange Rates 324 The Case for Floating Exchange Rates 324 The Case for Fixed Exchange Rates 325 Who Is Right? 326

Exchange Rate Regimes in Practice 326 Pegged Exchange Rates 327 Currency Boards 327

Crisis Management by the IMF 328 Financial Crises in the Post–Bretton Woods Era 329

Country Focus The IMF and Iceland’s Economic Recovery 330

Evaluating the IMF’s Policy Prescriptions 331

xxviii

C H A P T E R 1 4 The Organization of International Business 392 Opening Case Unilever’s Global Organization 393

Introduction 394

Organizational Architecture 395

Organizational Structure 396 Vertical Differentiation: Centralization and Decentralization 396

Management Focus Walmart International 398

Horizontal Differentiation: The Design of Structure 399 Integrating Mechanisms 405

Management Focus Dow—(Failed) Early Global Matrix Adopter 406

Control Systems and Incentives 410 Types of Control Systems 410 Incentive Systems 412 Control Systems, Incentives, and Strategy in the International Business 413

Processes 415

Organizational Culture 415 Creating and Maintaining Organizational Culture 416 Organizational Culture and Performance in the International Business 417

Management Focus Lincoln Electric and Culture 419

Synthesis: Strategy and Architecture 420 Localization Strategy 420 International Strategy 420 Global Standardization Strategy 421 Transnational Strategy 421 Environment, Strategy, Architecture, and Performance 421

Organizational Change 422 Organizational Inertia 422 Implementing Organizational Change 423

Chapter Summary 425

Critical Thinking and Discussion Questions 425

Research Task 426

Closing Case Organizational Architecture at P&G 426

Endnotes 427

part five The Strategy and Structure of International Business

C H A P T E R 1 3 The Strategy of International Business 362 Opening Case Sony’s Global Strategy 363

Introduction 364

Strategy and the Firm 364 Value Creation 365 Strategic Positioning 366 The Firm as a Value Chain 368

Global Expansion, Profitability, and Profit Growth 370

Expanding the Market: Leveraging Products and Competencies 371 Location Economies 371 Experience Effects 373 Leveraging Subsidiary Skills 375 Profitability and Profit Growth Summary 376

Management Focus Leveraging Skills Worldwide at ArcelorMittal 377

Cost Pressures and Pressures for Local Responsiveness 377

Pressures for Cost Reductions 378 Pressures for Local Responsiveness 379

Management Focus Viacom International Media Networks 380

Choosing a Strategy 382 Global Standardization Strategy 383 Localization Strategy 384 Transnational Strategy 384 International Strategy 385

Management Focus Evolution of Strategy at Procter & Gamble 386

The Evolution of Strategy 387

Chapter Summary 388

Critical Thinking and Discussion Questions 388

Research Task 388

Closing Case IKEA’s Global Strategy 389

Endnotes 390

xxix

Opening Case Tata Motors and Exporting 461

Introduction 462

The Promise and Pitfalls of Exporting 463

Management Focus Ambient Technologies and the Panama Canal 465

Improving Export Performance 466 International Comparisons 466 Information Sources 466

Management Focus Exporting with Government Assistance 468

Service Providers 468 Export Strategy 469

Management Focus 3M’s Export Strategy 470

The globalEDGETM Exporting Tool 471

Export and Import Financing 472 Lack of Trust 473 Letter of Credit 474 Draft 475 Bill of Lading 475 A Typical International Trade Transaction 476

Export Assistance 477 Export-Import Bank 477 Export Credit Insurance 478

Countertrade 478 The Popularity of Countertrade 479 Types of Countertrade 479 Pros and Cons of Countertrade 480

Chapter Summary 481

Critical Thinking and Discussion Questions 482

Research Task 482

Closing Case Embraer and Brazilian Importing 483

Endnotes 484

C H A P T E R 1 7 Global Production and Supply Chain Management 486 Opening Case Alibaba and Global Supply Chains 487

Introduction 488

Strategy, Production, and Supply Chain Management 488

Where to Produce 491 Country Factors 491

C H A P T E R 1 5 Entry Strategy and Strategic Alliances 430 Opening Case Gazprom and Global Strategic Alliances 431

Introduction 432

Basic Entry Decisions 433 Which Foreign Markets? 433

Management Focus Tesco’s International Growth Strategy 434

Timing of Entry 434 Scale of Entry and Strategic Commitments 436 Market Entry Summary 437

Management Focus The Jollibee Phenomenon 438

Entry Modes 438 Exporting 439 Turnkey Projects 439 Licensing 440 Franchising 441 Joint Ventures 442 Wholly Owned Subsidiaries 444

Selecting an Entry Mode 444 Core Competencies and Entry Mode 445 Pressures for Cost Reductions and Entry Mode 446

Greenfield Venture or Acquisition? 446 Pros and Cons of Acquisitions 447 Pros and Cons of Greenfield Ventures 449 Which Choice? 450

Strategic Alliances 450 Advantages of Strategic Alliances 450 Disadvantages of Strategic Alliances 451 Making Alliances Work 451

Chapter Summary 454

Critical Thinking and Discussion Questions 455

Research Task 455

Closing Case Starbucks’ Foreign Entry Strategy 456

Endnotes 457

part six International Business Functions

C H A P T E R 1 6 Exporting, Importing, and Countertrade 460

xxx

Communication Strategy 528 Barriers to International Communication 528 Push versus Pull Strategies 529

Management Focus Unilever among India’s Poor 530

Global Advertising 531

Pricing Strategy 533 Price Discrimination 533 Strategic Pricing 534 Regulatory Influences on Prices 535

Configuring the Marketing Mix 536

International Market Research 538

Product Development 541 The Location of R&D 542 Integrating R&D, Marketing, and Production 543 Cross-Functional Teams 544 Building Global R&D Capabilities 544

Chapter Summary 546

Critical Thinking and Discussion Questions 547

Research Task 548

Closing Case Global Branding, Marvel Studios, and Walt Disney Company 548

Endnotes 549

C H A P T E R 1 9 Global Human Resource Management 552 Opening Case Building a Global Diverse Workforce at Sodexo 553

Introduction 554

Strategic Role of Global HRM: Managing a Global Workforce 555

Staffing Policy 556 Types of Staffing Policies 556 Expatriate Managers 560

Management Focus Expatriates at Royal Dutch Shell 562

Global Mindset 563

Training and Management Development 565 Training for Expatriate Managers 565 Repatriation of Expatriates 566

Management Focus Monsanto’s Repatriation Program 567

Management Development and Strategy 567

Management Focus IKEA Production in China 492

Technological Factors 493 Production Factors 496 The Hidden Costs of Foreign Locations 499

Management Focus H&M and Its Order Timing 500

Make-or-Buy Decisions 501

Global Supply Chain Functions 504 Global Logistics 504 Global Purchasing 506

Managing a Global Supply Chain 507 Role of Just-in-Time Inventory 508 Role of Information Technology 508 Coordination in Global Supply Chains 509 Interorganizational Relationships 510

Chapter Summary 511

Critical Thinking and Discussion Questions 512

Research Task 513

Closing Case Amazon’s Global Supply Chains 513

Endnotes 514

C H A P T E R 1 8 Global Marketing and R&D 516 Opening Case ACSI and Satisfying Global Customers 517

Introduction 518

Globalization of Markets and Brands 519

Market Segmentation 521

Management Focus Marketing to Afro-Brazilians 522

Product Attributes 523 Cultural Differences 523 Economic Development 523 Product and Technical Standards 524

Distribution Strategy 524 Differences between Countries 524 Choosing a Distribution Strategy 527

xxxi

Financial Management: Global Money Management 595 Minimizing Cash Balances 596 Reducing Transaction Costs 597 Managing the Tax Burden 598 Moving Money across Borders 599

Chapter Summary 603

Critical Thinking and Discussion Questions 604

Research Task 605

Closing Case Tesla, Inc.—Subsidizing Tesla Automobiles Globally 605

Endnotes 606

part seven Integrative Cases

Global Medical Tourism 609

Venezuela under Hugo Chávez and Beyond 611

Political and Economic Reform in Myanmar 612

Will China Continue to Be a Growth Marketplace? 613

Lead in Toys and Drinking Water 614

Creating the World’s Biggest Free Trade Zone 616

Sugar Subsidies Drive Candy Makers Abroad 617

Volkswagen in Russia 618

The NAFTA Tomato Wars 619

Subaru’s Sales Boom Thanks to the Weaker Yen 620

The IMF and Ukraine’s Economic Crisis 621

The Global Financial Crisis and Its Aftermath: Declining Cross-Border Capital Flows 622

Ford’s Global Platform Strategy 624

Philips’ Global Restructuring 625

General Motors and Chinese Joint Ventures 626

Exporting Desserts by a Hispanic Entrepreneur 627

Apple: The Best Supply Chains in the World? 628

Domino’s Global Marketing 630

Siemens and Global Competitiveness 632

Microsoft and Its Foreign Cash Holdings 633

Glossary 635

Organization Index 645

Name Index 650

Subject Index 652

Performance Appraisal 568 Performance Appraisal Problems 568 Guidelines for Performance Appraisal 569

Compensation 569 National Differences in Compensation 569

Management Focus McDonald’s Global Compensation Practices 570

Expatriate Pay 570

Building a Diverse Global Workforce 572

International Labor Relations 573 The Concerns of Organized Labor 574 The Strategy of Organized Labor 574 Approaches to Labor Relations 575

Chapter Summary 576

Critical Thinking and Discussion Questions 577

Research Task 577

Closing Case AstraZeneca 578

Endnotes 579

C H A P T E R 2 0 Accounting and Finance in the International Business 582 Opening Case Shoprite—Financial Success of a Food Retailer in Africa 583

Introduction 584

National Differences in Accounting Standards 585

International Accounting Standards 586

Management Focus Chinese Accounting 587

Accounting Aspects of Control Systems 588 Exchange Rate Changes and Control Systems 589 Transfer Pricing and Control Systems 590 Separation of Subsidiary and Manager Performance 591

Financial Management: The Investment Decision 591 Capital Budgeting 592 Project and Parent Cash Flows 592

Management Focus Black Sea Oil and Gas Ltd. 593

Adjusting for Political and Economic Risk 593 Risk and Capital Budgeting 594

Financial Management: The Financing Decision 595

xxxii

ACKNOWLEDGMENTS

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:

Bruce Gin, Content Project Manager (Assessment)

Jennifer Pickel, Senior Buyer

Egzon Shaqiri, Designer

Carrie Burger, Content Licensing Specialist

Susan Gouijnstook, Managing Director

Michael Ablassmeir, Director

Anke Braun Weekes, Executive Portfolio Manager

Katie Benson Eddy, Product Developer

Harvey Yep, Content Project Manager (Core)

Anthony C. Koh, University of Toledo

Laura Kozloski Hart, Barry University

Katarina Lagerstrom, Uppsala University

Steve Lawton, Oregon State University

Ruby Lee, Florida State University

Joseph W. Leonard, Miami University

Vishakha Maskey, West Liberty University

David N. McArthur, Utah Valley University

Shelly McCallum, Saint Mary’s University of Minnesota

Emily A. Morad, Reading Area Community College

Tim Muth, Florida Institute of Technology

Sunder Narayanan, New York University

Eydis Olsen, Drexel University

Daria Panina, Texas A&M University

Hoon Park, University of Central Florida

Dr. Mahesh Raisinghani, Texas Women’s University

Brian Satterlee, Liberty University

Dwight Shook, Catawba Valley Community College

Brenda Sternquist, Michigan State University

Michael Volpe, University of Maryland

James Whelan, Manhattan College

Man Zhang, Bowling Green State University

Yeqing Bao, University of Alabama, Huntsville

Jacobus F. Boers, Georgia State University

Peter Buckley, Leeds University

Ken Chinen, California State University, Sacramento

Macgorine A. Cassell, Fairmont State University

David Closs, Michigan State University

Ping Deng, Maryville University of St. Louis

Betty J. Diener, Barry University

Abiola O. Fanimokun, Pennsylvania State University, Fayette

John Finley, Columbus State University

Pat Fox, Marion Technical College

David Frayer, Michigan State University

Connie Golden, Lakeland Community College

Martin Grossman, Bridgewater State University

Sanjay Gupta, Michigan State University

Michael Harris, East Carolina University

Kathy Hastings, Greenville Technical College

Chip Izard, Richland College

Jan Johanson, Uppsala University

Candida Johnson, Holyoke Community College

Sara B. Kimmel, Mississippi College

Tunga Kiyak, Michigan State University

Second, our thanks go to the reviewers who provided good feedback that helped shape this book through the last few editions:

A special thanks to David Closs and David Frayer for allowing us to borrow elements of the sections titled Strategic Roles for Production Facilities; Make-or-Buy Decisions; Global Supply Chain Functions; Coordination in Global Sup- ply Chains; and Interorganizational Relationships for Chapter 17 of this text from Tomas Hult, David Closs, and David Frayer, Global Supply Chain Management, New York: McGraw Hill (2014).

International Business Competing in the Global Marketplace

Globalization L E A R N I N G O B J E C T I V E S Af ter 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. 

part one Introduc tion and Over view

1

©jvdwolf/123RF

Globalization of BMW, Rolls-Royce, and the MINI

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 es- calate 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 perfec- tion drives the supreme quality, exquisite hand craftsman- ship, 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 that is 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 cus- tomers’ 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 en- gineering 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! 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 ge- nius.” 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: Bavar- ian 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; Hannah Elliott, “The Best Luxury Sedan Is Still a BMW,” Bloomberg BusinessWeek, June 6, 2016.

O P E N I N G C A S E Bayerische Motoren Werke, which is German for Bavarian Motor Works, is better known globally for its acronym BMW (bmwgroup.com). BMW was created as a combination of three German manufacturing companies: Rapp Motoren- werke and Bayerische Flugzeugwerke in Bavaria and Fahrzeugfabrik Eisenach in Thuringia. Aircraft engine manufacturer Rapp Motorenwerke became Bayerische Motorenwerke in 1916, and the company added motorcy- cles 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, incred- ible 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, 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 perfor- mance; 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 au- tomobile brand in the world. This reputation is rooted in the brand’s long history and rich tradition. Rolls-Royce

3

4 Part 1 Introduction and Overview

Introduction

Over the past five decades, a fundamental shift has been occurring in the world econ- omy. We have been moving away from a world in which national economies were rela- tively 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. And, as we will see later on in this chapter as well as 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 tele- communications 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, United Kingdom voting to leave the European Union, and the elections around the globe of nationalistic politicians) create tension and uncertainty regarding the future of global trade activities.

Interestingly, as the opening case outlines, BMW’s focus on the future is an impor- tant part of the company’s identity, its day-to-day work, and the reason for its global success. The futuristic perspective of BMW manifests itself in innovation, striving for improvement, positive change, and improved performance at all times to make cus- tomers satisfied and feel that they receive value for the money they spend on BMW products. Innovation is one of the main success factors for the BMW Group, and in- novation is infused into all of BMW’s product lines. Likewise, proponents of increased trade argue that cross-cultural engagement and trade across country borders is the fu- ture and that returning back to a nationalistic perspective is the past. Meanwhile, 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 arguments and sides have merit. We will ex- plore all aspects of today’s global marketplace in this text through 20 integrated and topical chapters.

Focusing on the increase in globalization, the rise of Uber, which we discuss in the clos- ing case in this chapter, is an illustration of the trend toward the unique opportunities that globalization can present to a company. From a standing start in 2009, Uber has built a global ride-for-hire taxi service that by 2018 could be found in more than 600 cities in more than 70 countries. Uber customers visiting London, New York, Athens, Paris, or Hong Kong can now quickly find rides by using the Uber app on their smartphone. Uber has rapidly built a global brand. Its strategy was to be “born global” virtually from day one of the company’s founding. In doing so, it is similar to many other modern technology busi- nesses such as Facebook, Google, and Amazon that have also rapidly built a global presence.

At the same time, it has not always been smooth sailing for Uber. Local authorities have banned or placed tight restrictions on Uber’s service in many cities around the world. Uber’s brash American ways have not always endeared them to local regulators, drivers, and customers. It is perhaps true, as critics have noted, that Uber might have done even better internationally if it had adapted its entry strategy to take local differences in regula- tions, culture, and political realities into account. With the rise in nationalism in many countries, companies like Uber face potential barriers to entry and operations that were hard to foresee just a few years ago.

That said, globalization now does have an impact on almost everything we do. For example, the average American—let’s call the person Isabelle—might drive to work in a car that was designed in Germany and assembled in Mexico by Ford from components made in the United States and Japan, which were fabricated from Korean steel and

Globalization Chapter 1 5

Malaysian rubber. Isabelle may have filled the car with gasoline at a Shell service sta- tion 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, Isabelle 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. She could 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. And, interestingly, in many cases we simply do not know or perhaps even care to know where the product was deigned and where it was made. This is a change in attitude and interest. Just a couple of decades ago, “Made in the USA” or “Made in Germany” had strong meaning and referred to something (e.g., U.S. often stood for quality and Germany often stood for sophisticated engineering). The country of origin for a product has now given way to “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 relationships a customer has developed with a rep- resentative of a company—here we focus on what has become know as CRM (customer relationship management).

Whether it is still quality associated with the country of a product’s origin or the assur- ance given by a specific company regardless of where they manufacture the 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 where more than $5 trillion in foreign exchange transactions are made every day, where $19 trillion of goods and $5 trillion of services are sold across national borders every year.1 It is a world in which international institutions such as the World Trade Organiza- tion and gatherings of leaders from the world’s most powerful economies continue to work for even lower barriers to cross-border trade and investment. It is a world where the symbols of material and popular culture are increasingly global: from Coca-Cola and Starbucks to Sony PlayStations, Facebook, Netflix video streaming service, IKEA stores, and Apple iPads and iPhones. It is also a world in which vigorous and vocal groups pro- test against globalization, which they blame for a list of ills from unemployment in devel- oped nations to environmental degradation and the Westernization or Americanization of local culture. These protesters now come from environmental groups, which have been around for some time, and more recently also from nationalistic groups focused on countries being more sovereign.

For businesses, the globalization process has produced 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 enter- prises has been facilitated by generally favorable political and economic trends. Since the collapse of communism over a quarter of a century ago, the pendulum of public policy in many nations has swung toward the free market end of the economic spectrum. Regula- tory and administrative barriers to doing business in foreign nations have been reduced, while those nations have often transformed their economies, privatizing state-owned enter- prises, deregulating markets, increasing competition, and welcoming investment by foreign businesses. This has allowed businesses both large and small, from both advanced nations and developing nations, to expand internationally.

As globalization unfolds, it is transforming industries and creating anxiety among those who believed their jobs were protected from foreign competition. Historically, while many workers in manufacturing industries worried about the impact foreign competition might have on their jobs, workers in service industries felt more secure. Now, this too is chang- ing. Advances in technology, lower transportation costs, and the rise of skilled workers in

6 Part 1 Introduction and Overview

developing countries imply that many services no longer need to be performed where they are delivered. Today, many individual U.S. tax returns are compiled in India. Indian ac- countants, trained in U.S. tax rules, perform work for U.S. accounting firms.2 They access individual tax returns stored on computers in the United States, perform routine calcula- tions, and save their work so that it can be inspected by a U.S. accountant, who then bills clients. As the best-selling author Thomas Friedman has argued, the world is becoming flat.3 People living in developed nations no longer have the playing field tilted in their fa- vor. Increasingly, enterprising individuals based in India, China, or Brazil have the same opportunities to better themselves as those living in western Europe, the United States, or Canada.

In this text, we will take a close look at the issues introduced here and many more. We will explore how changes in regulations governing international trade and invest- ment, when coupled with changes in political systems and technology, have dramati- cally 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 also to entire economies. First, though, we need to get a better overview of the nature and process of globalization, and that is the func- tion of this first chapter.

What Is Globalization?

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

THE GLOBALIZATION OF MARKETS

The globalization of markets 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.4 Consumer products such as Citigroup credit cards, Coca-Cola soft drinks, video games, McDonald’s hamburgers, Starbucks coffee, IKEA furniture, and Apple iPhones are frequently held up as prototypical examples of this trend. The firms that produce these products are more than just benefactors of this trend; they are also facilitators of it. By offering the same basic product worldwide, they help create a global market.

A company does not have to be the size of these multinational giants to facilitate, and benefit from, the globalization of markets. In the United States, for example, ac- cording to the International Trade Administration, more than 300,000 small and medium-size firms with fewer than 500 employees exported in 2017, accounting for 98 percent of the companies that exported that year. More generally, exports from small and medium-sized companies accounted for 33 percent of the value of U.S. exports of manufactured goods.5 Typical of these is B&S Aircraft Alloys, a New York company whose exports account for 40 percent of its $8 million annual revenues.6 The situation is similar in several other nations. For example, in Germany, 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 from its country to the rest of the world.

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

Globalization Chapter 1 7

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 rele- vant 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 en- try strategy in many foreign cities in order to take differences in the regulatory regime into account. These differences frequently require companies to customize marketing strategies, product features, and operating practices to best match conditions in a par- ticular 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.

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 Micro- soft 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.7 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.

I N T E R N A T I O N A L B U S I N E S S R E S O U R C E S

globalEDGETM 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 interna- tional 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 con- tent 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!

8 Part 1 Introduction and Overview

THE GLOBALIZATION OF PRODUCTION

The globalization of production refers to the sourcing of goods and services from loca- tions 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.8 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.

Early outsourcing efforts were primarily confined to manufacturing activities, such as those undertaken by Boeing and Apple. Increasingly, however, companies are taking ad- vantage 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. engi- neers sleep, transmitting the corrected code back to the United States over secure Internet connections so it is ready for U.S. engineers to work on the following day. Dispersing value-creation activities in this way can compress the time and lower the costs required to develop new software programs. Other companies, from computer makers to banks, are outsourcing customer service functions, such as customer call centers, to developing na- tions 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 irrele- vant to talk about American products, Japanese products, German products, or Korean products. Increasingly, according to Reich, the outsourcing of productive activities to dif- ferent suppliers results in the creation of products that are global in nature, that is, “global products.”9 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 pro- ductive activities to locations around the globe. These impediments include formal and informal barriers to trade between countries, barriers to foreign direct investment, trans- portation costs, issues associated with economic and political risk, and the sheer manage- rial 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 PRE P 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.

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.

9

M A N A G E M E N T F O C U S

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. Forty-five years ago, when the early models of Boeing’s venerable 737 and 747 jets were rolling off the company’s Seattle-area production lines, foreign suppliers accounted for only 5 percent of those parts on average. Boeing was vertically integrated and manufactured many of the major components that went into the planes. The largest parts produced by out- side suppliers were the jet engines, where two of the three suppliers were American companies. The lone foreign en- gine manufacturer was the British company Rolls-Royce. Fast-forward to the modern era, and things look very different. In the case of its latest aircraft, the super-efficient 787 Dreamliner, 50 outside suppliers spread around the world account for 65 percent of the value of the aircraft. Italian firm Alenia Aeronautica makes the center fuselage and horizontal stabilizer. Kawasaki of Japan makes part of the forward fuselage and the fixed trailing edge of the wing. French firm Messier-Dowty makes the aircraft’s land- ing 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. Mitsubi- shi 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 compo- nent part production to those suppliers who are the best in the world at their particular activity. Over the years, for ex- ample, 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

Boeing’s Global Production System and costs onto suppliers, who had to undertake major in- vestments in capacity to ramp up to produce for the 787. So what did Boeing retain for itself? Engineering de- sign, 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 fair- ing (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 ex- tensive 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 prob- lems 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: Sim- ply Inevitable?” CNN Money, January 22, 2013; 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.

10 Part 1 Introduction and Overview

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

The Emergence of Global Institutions

As markets globalize and an increasing proportion of business activity transcends national borders, institutions are needed to help manage, regulate, and police the global market- place and to promote the establishment of multinational treaties to govern the global busi- ness 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 respon- sible 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 busi- ness system unencumbered by barriers to trade and investment between countries. With- out 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 na- tional sovereignty of individual nation-states.

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 in- frastructure 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 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 re- quirements have sparked controversy. Some critics charge that the IMF’s policy recom- mendations are often inappropriate; others maintain that by telling national governments what economic policies they must adopt, the IMF, like the WTO, is usurping the sover- eignty 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 commit- ted 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

Globalization Chapter 1 11

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 prog- ress and development—all issues that are central to the creation of a vibrant global econ- omy. 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.10

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 re- sponse 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.

Drivers of Globalization

Two macro factors underlie the trend toward greater globalization.11 The first is the decline in barriers to the free flow of goods, services, and capital that has occurred in recent de- cades. 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 manu- factured goods. The typical aim of such tariffs was to protect domestic industries from for- eign 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 com- mitted themselves after World War II to progressively reducing barriers to the free flow of goods, services, and capital among nations.12 This goal was enshrined in the General Agreement on Tariffs and Trade. Under the umbrella of GATT, eight rounds of negotia- tions among member states worked to lower barriers to the free flow of goods and ser- vices. 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 copy- rights; and established the World Trade Organization to police the international trading system.13 Table 1.1 summarizes the impact of GATT agreements on average tariff rates for manufactured goods. As can be seen, average tariff rates have fallen significantly since 1950 and now stand at about 1.6 percent. Comparable tariff rates in 2017 for China and India were 3.4 and 7.1 percent, respectively.

LO 1 -2 Recognize the main drivers of globalization.

12 Part 1 Introduction and Overview

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 four years being forecast data). Trade and production are indexed to 100 in 1960. 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 growth rate in the world economy since 1950, and the chart shows that this growth has been markedly higher since the turn of the century.

TA B L E 1 .1

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 (between 2014 and 2017, each country in the table raised their rates by .1 percent)

1913 1950 1990 2017 France 21% 18% 5.9% 1.6%

Germany 20 26 5.9 1.6

Italy 18 25 5.9 1.6

Japan 30 — 5.3 1.4

Netherlands 5 11 5.9 1.6

Sweden 20 9 4.4 1.6

United Kingdom — 23 5.9 1.6

United States 44 14 4.8 1.6

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Globalization Chapter 1 13

As a consequence, by 2020 the value of world trade is expected to be 167 times larger than it was in 1960, whereas the world economy will be 65 times larger. This trend has continued into the modern era. Between 2000 and 2020, the value of world trade increased 3.3 times whereas the world economy has increased 2.6 times. Perhaps the most obvious difference is between world trade and world production. Trade across country borders is 2.6 times higher than world production, a figure that has gone up drastically since 2000. The forecast is also 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 be- ing produced worldwide. From a customer perspective, this is driving demand for interna- tionally traded goods. Thus, the larger the difference between the growth rates of world trade and world production, the greater the extent of globalization and the more important it becomes to understand international business.

Additionally, despite the recent wave of nationalism around the world (e.g., Brexit, 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 coun- try, 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 re- gional 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 be- come 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 prosper- ity for all countries by 2030 as part of a new sustainability agenda.14 The urgency of deliv- ering on UN’s Sustainable Development Goals can be traced to the difference between the world production and population data. As world production approaches the total popula- tion 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.

The chart in Figure 1.1 also indicates that our needs worldwide are still rather “spiky” and not flat as Tom Friedman projected in 2004. Trading across country borders is significantly

14 Part 1 Introduction and Overview

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 im- plies 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 out- flow of FDI increased from $14 billion in 1970 to $1.45 trillion in the most recent year, 2016, audited by the United Nations Conference on Trade and Development (UNCTAD).15 As a result of the strong FDI flow, by 2016 the global stock of FDI was about $27 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

F I G U R E 1 . 2

Comparisons of world trade and world population; world trade and number of regional trade agreements; world population and world production; and world population and world trade (index 1960 = 100). Sources: World Bank, 2017; World Trade Organization, 2017; United Nations, 2017.

Five business executives from various parts of the world ready to board a plane. The efficiency of commercial airline travel has shrunk the world to a more manageable global marketplace. ©Glow Images

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0 1,000

2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000

10,000 11,000

12,000 13,000 14,000 15,000 16,000 17,000 18,000

0

50

100

150

200

250

300

350

World trade Regional trade agreements

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

World populationWorld production

0 1,000

2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000

10,000 11,000

12,000 13,000 14,000 15,000 16,000 17,000 18,000

World trade World population

Globalization Chapter 1 15

$36 trillion in global sales, higher than the value of global exports of goods and services, which stood at close to $23.4 trillion.16

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 inten- sity 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 un- likely, 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 as- sociated 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 develop- ment 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 individu- als and firms. The microprocessor also underlies many recent advances in telecommunica- tions 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 vast amount of information that flows along these electronic highways. The cost of micropro- cessors 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).17

Internet of Things The explosive growth of the Internet since 1994, when the first web browser was intro- duced, is the latest expression of the development of the so-called Internet of Things. Trac- ing back about three decades to 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.18 As such, 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 2017.19 Viewed globally, the Internet has emerged as an equalizer. It rolls back some of the constraints of location, scale, and time zones.20 The Internet makes it much easier for buyers and sellers to find each other, wherever they may be located and whatever

16 Part 1 Introduction and Overview

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 indus- try is responsible for carrying about 90 percent of the volume of world trade in goods, this has been an extremely important development.21 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 work- ers 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).22 Today, the typical cost of trans- porting 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, disper- sal of production to geographically separate locations has become more economical. As a result of the technological innovations discussed earlier, the real costs of information pro- cessing and communication have fallen dramatically in the past two decades. These develop- ments make it possible for a firm to create and then manage a globally dispersed production system, further facilitating the globalization of production. A worldwide communications network has become essential for many international businesses. For example, Dell uses the Internet to coordinate and control a globally dispersed production system to such an extent that it holds only three days’ worth of inventory at its assembly locations. Dell’s Internet- based system records orders for computer equipment as they are submitted by customers via the company’s website and then immediately transmits the resulting orders for components to various suppliers around the world, which have a real-time look at Dell’s order flow and can adjust their production schedules accordingly. Given the low cost of airfreight, Dell can use air transportation to speed up the delivery of critical components to meet unanticipated demand shifts without delaying the shipment of final product to consumers. Dell has also used modern communications technology to outsource its customer service operations to India. When U.S. customers call Dell with a service inquiry, they are routed to Bangalore in India, where English-speaking service personnel handle the call.

Implications for the Globalization of Markets In addition to the globalization of production, technological innovations have facilitated the globalization of markets. Low-cost global communications networks, including those built on top of the Internet, are helping create electronic global marketplaces. As noted earlier, low-cost transportation has made it more economical to ship products around the world, thereby helping create global markets. In addition, low-cost jet travel has resulted in

Globalization Chapter 1 17

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 prefer- ences. 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.

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

The Changing Demographics of the Global Economy

Hand in hand with the trend toward globalization has been a fairly dramatic change in the demographics of the global economy over the past 30 years. As late as the 1960s, four styl- ized facts described the demographics of the global economy. The first was U.S. domi- nance 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 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 do- mestic product (GDP). By 2018, the United States accounted for 15.8 percent of world out- put, with China now at 17.1 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 stand- ing 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.

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 17.1 percent, making it the world’s 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 be- ing 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 had slipped to 8.2 percent by 2017, 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

TEST PRE P 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.

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

18 Part 1 Introduction and Overview

world exports accounted for by the United States and other long-established developed nations seems likely. By itself, this is not bad. The relative decline of the United States re- flects 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 importantly, if current trends continue, the Chinese econ- omy 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 2030.23

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 de- veloping nations of the world, and many of tomorrow’s most capable competitors will prob- ably 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.

THE CHANGING FOREIGN DIRECT INVESTMENT PICTURE

Reflecting the dominance of the United States in the global economy, U.S. firms ac- counted 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.24 Several European gov- ernments, 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 in- vest 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

Share of Share of Share of World Output World Output World Exports Country in 1960 (%) Today (%) Today (%) United States 38.3%  15.8%    8.2%

Germany 8.7  3.4   7.1

France 4.6  2.3   2.8

Italy  3.0  1.9   2.4

United Kingdom  5.3  2.4   2.3

Canada  3.0  1.4   2.2

Japan  3.3  4.3   3.6

China   NA 17.1  11.1

TA B L E 1 . 2

Changing Demographics of World Output and World Exports

Sources: Output data from World Bank database, 2017. Trade data from WTO Statistical Database, 2017.

C O U N T R Y F O C U S

Some 30 years ago, a number of small software enterprises were established in Bangalore, India. Typical of these enter- prises 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 com- panies clustered around Bangalore, which has become the epicenter of India’s fast-growing information technology sec- tor. 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 universi- ties 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 gradu- ate was roughly 12 percent of the cost of hiring an Ameri- can 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 effi- ciencies 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, busi- ness process outsourcing contracts, and information technology consulting services. Over the past 15 years, these markets have boomed, with Indian enterprises cap- turing a large slice of the pie. One response of Western firms to this emerging competitive threat has been to in- vest in India to garner the same kind of economic advan- tages that Indian firms enjoy. IBM, for example, has invested $2 billion in its Indian operations and now has 150,000 employees located there, more than in any other country. Microsoft, too, has made major investments in India, including a research and development (R&D) cen- ter in Hyderabad that employs 4,000 people and was lo- cated 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 Econo- mist, 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; “India’s Outsourcing Business: On the Turn,” The Economist, January 19, 2013.

India’s Software Sector

19

Japanese firms invested in North America and Europe—often as a hedge against unfavor- able 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, Euro- pean Union countries, Developed Economies, and the World changed between 1995 and to- day. (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 1.2, we invest more today outside of our own country than we did in 1995. For example, U.S. firms invested 17.8 percent of the nation’s GDP outside the country in 1995 and now that figure is 34.4 percent. Collectively, the 196 countries in the world today invest 34.6 percent of their GDP outside its country borders, an increase from 12.8 percent in 1995. Bottom line, the world is becoming more globalized in investment mentality and opportunities are no lon- ger as restricted to the home country of a firm as they used to be even as recent as in 1995.

20 Part 1 Introduction and Overview

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 impor- tance of developing nations as the destination of foreign direct investment. Throughout the 1990s, the amount of investment directed at both developed and developing nations in- creased 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 time period, the growth of foreign direct invest- ment into developing nations remained robust. Among developing nations, the largest re- cipient has been China, which in 2016 received a record $249.8 billion in inflows. 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.

THE CHANGING NATURE OF THE MULTINATIONAL ENTERPRISE

A multinational enterprise (MNE) is any business that has productive activities in two or more countries. In the last half a century, two notable trends in the demographics of the multinational enterprise have been (1) the rise of non-U.S. multinationals and (2) the growth of mini-multinationals.

F I G U R E 1 . 3

Share of FDI stock outward as a percentage of GDP. Sources: OECD data 2017, FDI stocks.

Today1995

45 50

40 35 30 25 20 15 10 5 0

United States

China Japan United Kingdom

European Union

Developed Economies

World

F I G U R E 1 . 4

FDI inflows (in millions of dollars). Source: United Nations Conference on Trade and Development, World Investment Report 2017. (Data for 2018–2020 are forecast.)

2,500,000

2,000,000

1,500,000

1,000,000

500,000

0

19 9

0

2 0

2 0

Developed Countries Developing Countries

19 9

2

19 9

4

19 9

6

19 9

8

2 0

0 0

2 0

0 2

2 0

0 4

2 0

0 6

2 0

0 8

2 0

10

2 0

12

2 0

16

2 0

14

2 0

18

Globalization Chapter 1 21

Non-U.S. Multinationals In the 1960s, global business activity was dominated by large U.S. multinational corpora- tions. 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.

By 2017, things had 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 ex- pected to continue. Specifically, we expect that firms from developing nations will emerge as even important competitors in global markets, further shifting the axis of the world economy away from North America and western Europe and challenging the long domi- nance of companies from the so-called developed world. One such rising competitor, the Dalian Wanda Group, is profiled in the Management Focus.

The Rise of Mini-Multinationals Another trend in international business has been the growth of small and medium-sized multinationals (mini-multinationals).25 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 are still conducted by large firms, many medium-size and small businesses are becoming increasingly involved in international trade and investment. The rise of the Internet is lowering the barriers that small firms face in building international sales.

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.26

F I G U R E 1 . 5

National share of largest multinational corporations. Source: Forbes Global 2000 in 2003 and 2017.

100

80

60

40

20

0 United States

Japan United Kingdom

Other

2003 Today

M A N A G E M E N T F O C U S

22

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’s movie theaters with Hoyts and its already extensive movie prop- erties in China, Dalian Wanda has become the largest cin- ema operator in the world with more than 500 cinemas. This puts Wanda in a strong position when negotiating dis- tribution terms with movie studios. Wanda is also expanding its international real estate op- erations. 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, “Chi- na’s Wanda to Buy AMC Cinema Chain for $2.6 Billion,” Bloomberg Businessweek, May 21, 2012; Wanda Group Corporate,  http://www. wanda-group.com/

Wanda Group The Dalian Wanda Group is perhaps the world’s largest real estate company, although as yet it is little known out- side of China. Established in 1988, Dalian Wanda Group is the largest owner of five-star hotels in the world. The com- pany’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 en- tertainment. 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 is theaters to show more IMAX and 3D movies. 

Consider also Lixi Inc., a small U.S. manufacturer of industrial X-ray equipment; 70 percent of Lixi’s $4.5 million in revenues comes from exports to Japan.27 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 mar- ket for cocoa-bean roasting machines.28 International business is conducted not just by large firms but also by medium-size and small enterprises.

THE CHANGING WORLD ORDER

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

Many of the former communist nations of Europe and Asia seem to share a commitment to democratic politics and free market economics. For half a century, these countries were essentially closed to Western international businesses. Now, they present a host of export and investment opportunities. Two decades later, the economies of many of the former com- munist states are still relatively undeveloped, and their continued commitment to democracy and market-based economic systems cannot be taken for granted. Disturbing signs of grow- ing unrest and totalitarian tendencies continue to be seen in several eastern European and central Asian states, including Russia, which has shown signs of shifting back toward greater

Globalization Chapter 1 23

state involvement in economic activity and authoritarian government.29 Thus, the risks in- volved in doing business in such countries are high, but so may be the returns.

In addition to these changes, quieter revolutions have been occurring in China, other states in Southeast Asia, and Latin America. Their implications for international businesses may be just as profound as the collapse of communism in eastern Europe. China suppressed its pro- democracy movement in the bloody Tiananmen Square massacre of 1989. Despite this, China continues to move progressively toward greater free market reforms. If what is occurring in China continues for two more decades, China may move from third world to industrial super- power status even more rapidly than Japan did. If China’s GDP per capita grows by an aver- age 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 represents a huge and largely untapped market. Reflecting this, between 1983 and 2017, annual foreign direct investment in China increased from less than $2 billion to $249.8 billion annually. On the other hand, China’s new firms are proving to be very capa- ble competitors, and they could take global market share away from Western and Japanese enterprises (e.g., 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, Mex- ico, 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 inves- tors 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 re- treat 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

24 Part 1 Introduction and Overview

on free market principles might not occur as quickly as many hope. Clearly, this would be a tougher world for international businesses.

Also, greater globalization brings with it risks of its own. This was starkly demonstrated in 1997 and 1998, when a financial crisis in Thailand spread first to other East Asian nations and then to Russia and Brazil. Ultimately, the crisis threatened to plunge the economies of the developed world, including the United States, into a recession. We explore the causes and consequences of this and other similar global financial crises in Chapter 11. Even from a purely economic perspective, globalization is not all good. The opportunities for doing busi- ness 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 nation- alistic tendencies by some countries (e.g., United States, United Kingdom).

The Globalization Debate

Is the shift toward a more integrated and interdependent global economy a good thing? Many influential economists, politicians, and business leaders seem to think so.30 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 global- ization 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 in- vestment 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, global- ization has its critics.31 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 impov- erished” interests and values of the United States. All of these ills, the demonstrators claimed, could be laid at the feet of globalization. The World Trade Organization was meeting to try to launch a new round of talks to cut barriers to cross-border trade and in- vestment. As such, it was seen as a promoter of globalization and a target for the protest- ers. 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 ba- tons 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

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

TEST PRE P 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.

Globalization Chapter 1 25

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.

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 globaliza- tion 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 inter- national 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.32 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 work- ers received 48 cents per hour.33 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 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.34 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 Har- wood 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

C O U N T R Y F O C U S

26

opponents, and the protests started. In May 2001, the so- cialist 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 de- signed to enrich wealthy U.S. shareholders at the cost of his villagers and the environment. Following Diaz’s victory, Mondavi announced he would pull out of the project. A spokesperson noted, “It’s a huge waste, but there are clearly personal and political interests at play here that go way beyond us.” So, are the French opposed to foreign investment? 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 em- ploys 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 in- vestment, receiving more than $700 billion of foreign invest- ment 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 percent- age of this investment. French enterprises have also been significant foreign investors; some 1,100 French multination- als 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); Rob Wile, “The True Story of How McDonald’s Conquered France,” Business Insider, August 22, 2014.

It all started one night in August 1999, but it might as well have been today. Back to 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 Mc- Donald’s restaurant under construction, causing an esti- mated $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 no- ble aims, or so it was claimed. The attack was initially pre- sented 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 sci- entists 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 cer- tain 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 de- cided 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 agree- ment with the mayor and council of the village of Aniane and regional authorities to turn 125 acres of wooded hill- side 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 environmen- talists objected to the plan, which they claimed would de- stroy the area’s unique ecological heritage. José Bové, basking in sudden fame, offered his support to the

Protesting Globalization in France

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 coun- tries. By outsourcing its customer service call centers to India, Dell can reduce its cost struc- ture 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 ser- vices. 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.

Globalization Chapter 1 27

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 capi- tal (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 eco- nomic 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 de- cline 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.35 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, sug- gesting that the fall in labor’s share has been due to a fall in the share taken by unskilled labor. A study by the IMF suggested the earnings gap between workers in skilled and un- skilled sectors has widened by 25 percent over the past two decades.36 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.37 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. Evidence suggests that real labor compensation has expanded in most devel- oped nations since the 1980s, including the United States. Several studies by the Organisa- tion 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 popula- tion 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.38

As noted earlier, globalization critics argue that the decline in unskilled wage rates is due to the migration of low-wage manufacturing jobs offshore and a corresponding reduction in de- mand for unskilled workers. However, supporters of globalization see a more complex picture. They maintain that the weak growth rate in real wage rates for unskilled workers owes far more to a technology-induced shift within advanced economies away from jobs where the only qualification was a willingness to turn up for work every day and toward jobs that require sig- nificant 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.39 This suggests that a solution to the problem of slow real income growth among the unskilled is to be found not in limiting free trade and globalization but in increas- ing society’s investment in education to reduce the supply of unskilled workers.40

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

28 Part 1 Introduction and Overview

estimate suggests that wages in China will approach Western levels in two decades.41 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.42 Globalization critics often argue that adhering to labor and environmental regulations significantly increases the costs of manufacturing enterprises and puts them at a competitive disadvantage in the global marketplace vis-à-vis firms based in developing nations that do not have to comply with such regulations. Firms deal with this cost disadvantage, the theory goes, by moving their production facilities to nations that do not have such burdensome regulations or that fail to enforce the regulations they have.

If this were the case, we might expect free trade to lead to an increase in pollution and result in firms from advanced nations exploiting the labor of less developed nations.43 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 work- place safety and health issues, all in the name of higher profits.44

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.45 In general, as countries get richer, they enact tougher en- vironmental and labor regulations.46 Because free trade enables developing countries to increase their economic growth rates and become richer, this should lead to tougher envi- ronmental and labor laws. In this view, the critics of free trade have got it backward: Free trade does not lead to more pollution and labor exploitation; it leads to less. By creating wealth and incentives for enterprises to produce technological innovations, the free market system and free trade could make it easier for the world to cope with pollution and popula- tion growth. Indeed, while pollution levels are rising in the world’s poorer countries, they have been falling in developed nations. In the United States, for example, the concentra- tion of carbon monoxide and sulfur dioxide pollutants in the atmosphere decreased by 60 percent since 1978, while lead concentrations decreased by 98 percent—and these re- ductions have occurred against a background of sustained economic expansion.47

A number of econometric studies have found consistent evidence of a hump-shaped relationship between income levels and pollution levels (see Figure 1.6.).48 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 $8,000.49

While the hump-shaped relationship depicted in Figure 1.6 seems to hold across a wide range of pollutants—from sulfur dioxide to lead concentrations and water quality—carbon dioxide emissions are an important 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 in- creases in carbon taxes offset by reductions in income or consumption taxes.50

Although UN-sponsored talks have had reduction in carbon dioxide emissions as a cen- tral aim since the 1992 Earth Summit in Rio de Janeiro, until recently there has been little

Globalization Chapter 1 29

success in moving toward the ambitious goals for reducing carbon emissions laid down in the Earth Summit and subsequent talks in Kyoto, Japan, in 1997 and in Copenhagen in 2009. In part, this is because the largest emitters of carbon dioxide, the United States and China, 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 America 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 agree- ment reached in Paris in 2015 that has committed the nations of the world to carbon reduc- tion 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 protec- tion 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.51

They also argue that business firms are not the amoral organizations that critics sug- gest. While there may be some rotten apples, most business enterprises are staffed by managers who are committed to behave in an ethical manner and would be unlikely to move production offshore just so they could pump more pollution into the atmosphere or exploit labor. Furthermore, the relationship between pollution, labor exploitation, and pro- duction 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 coun- tries to exploit their labor force may be misplaced.

GLOBALIZATION AND NATIONAL SOVEREIGNTY

Another concern voiced by critics of globalization is that today’s increasingly interdepen- dent 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 poli- cies 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.52

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

F I G U R E 1 . 6

Income levels and environmental pollution. Source: C. W. L. Hill and G. T. M. Hult, Global Business Today (New York: McGraw-Hill Education, 2018).

P o

llu ti

o n

L ev

el s

$8,000 Income per Capita

Other Pollutants

Carbon Dioxide Emissions

30 Part 1 Introduction and Overview

trade disputes between its 162 member states. The arbitration panel can issue a ruling instruct- ing a member state to change trade policies that violate GATT regulations. If the violator re- fuses 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. environmen- talist, 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.53

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 su- pranational 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 2017, 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 av- erage 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.54

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.55 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.56 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 pro- longed civil war. A combination of such factors helps explain why countries such as Afghani- stan, 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 gov- ernment, 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.57

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

Globalization Chapter 1 31

high as 85 percent of the value of the economy, as measured by gross domestic product, and the annual costs of serving government debt consumed 15 percent of the country’s export earn- ings.58 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 eco- nomic 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 econo- mies 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 es- tablishment in the world’s richer nations.59 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 move- ment 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 pro- grams, 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 Organiza- tion 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.60

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 Sus- tainable Development Goals. These were 17 economic and human development goals for the world. We address these goals more in Chapter 5. Overall, it is hard to escape the con- clusion that globalization and lower barriers to cross-border trade and investment were major factors behind this remarkable achievement.

Managing in the Global Marketplace

Much of this text is concerned with the challenges of managing in an international busi- ness. An international business is any firm that engages in international trade or invest- ment. 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?

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

TEST PRE P 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.

32 Part 1 Introduction and Overview

As their organizations increasingly engage in cross-border trade and investment, manag- ers 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 devel- opment. 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 differ- ences 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 gov- ernment 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 inter- national business must not only be sensitive to these differences but also adopt the appropri- ate 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 ac- tivities 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 na- tions. Then they must decide how best to coordinate and control globally dispersed produc- tion 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 interna- tional business must also deal with government restrictions on international trade and in- vestment. They must find ways to work within the limits imposed by specific governmental interventions. As this text explains, even though many governments are nominally commit- ted to free trade, they often intervene to regulate cross-border trade and investment. Man- agers 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 domes- tic 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 them- selves 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 trans- actions 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

Globalization Chapter 1 33

when a firm becomes an international business. Chapters 2, 3, and 4 explore how coun- tries differ from each other with regard to their political, economic, legal, and cultural in- stitutions. 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, 11, and 12 review the global monetary system. These chapters focus on the nature of the foreign exchange market and the emerging global monetary system. Chapters 12, 13, and 14 explore the strategy, organization, and market entry choices of an international business. Chapters 15, 16, 17, 18, 19, and 20 look at the management of various functional operations within an international business, including exporting, importing, countertrade, production, supply chain management, marketing, R&D, and human resources. By the time you complete this text, you should have a good grasp of the issues that managers working in international business have to grapple with on a daily basis, and you should be familiar with the range of strategies and operating policies available to compete more effectively in today’s rapidly emerging global economy.

TEST PRE P 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.

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. 10 World Trade Organization

(WTO), p. 10

International Monetary Fund (IMF), p. 10

World Bank, p. 10 United Nations (UN), p. 10 Group of Twenty (G20), p. 11 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. 31

Key Terms

C H A P T E R S U M M A R Y

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

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

 2. The globalization of markets implies that na- tional markets are merging into one huge market- place. However, it is important not to push this view too far.

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

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

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

 6. As a consequence of the globalization of produc- tion and markets, in the last decade, world trade has grown faster than world output, foreign direct investment has surged, imports have penetrated more deeply into the world’s industrial nations, and competitive pressures have increased in in- dustry 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 so- phisticated information networks. Jet air travel,

34 Part 1 Introduction and Overview

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 multina- tionals, and roughly half the world—the centrally planned economies of the communist world—was closed to Western businesses.

 9. By the 2000s, the U.S. share of world output had been cut in half, with major shares now being ac- counted for by western European and Southeast Asian economies. The U.S. share of worldwide foreign direct investment had also fallen by about two-thirds. U.S. multinationals were now facing competition from a large number of Japanese and European multinationals. In addition, the emergence of mini-multinationals was noted.

10. One of the most dramatic developments of the past 30 years has been the collapse of communism in eastern Europe, which has created enormous op-

portunities 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 busi- nesspeople, 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 invest- ment system, and (d) international transactions in- volve converting money into different currencies.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

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

 2. “The study of international business is fine if you are going to work in a large multinational enterprise, but it has no relevance for individu- als 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 mar- kets have been possible without these technolog- ical 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 busi- ness activity and the globalization of the world economy?

 6. If current trends continue, China may be the world’s largest economy by 2030. 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 on Boeing and

answer the following questions: a. What are the benefits to Boeing of out-

sourcing 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 de- cision to outsource component part manu- facturing 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 em- ployees, 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.

Globalization Chapter 1 35

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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

1. As the drivers of globalization continue to pres- sure 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, ana- lyzes these pressures and trends to identify op- portunities across markets and sectors through its trade forecasts. Visit the HSBC Global Con- nections site and use the trade forecast tool to identify which export routes are forecasted to see the greatest growth over the next 15 to 20 years. What patterns do you see? What types of coun- tries dominate these routes?

2. You are working for a company that is consider- ing investing in a foreign country. Investing in countries with different traditions is an impor- tant element of your company’s long-term strate- gic goals. As such, management has requested a report regarding the attractiveness of alternative countries based on the potential return of FDI. Accordingly, the ranking of the top 25 countries in terms of FDI attractiveness is a crucial ingre- dient 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 regard- ing how the index is constructed.

Uber, the controversial San Francisco–based ride-for-hire service, has made a virtue out of disrupting the estab- lished taxi business. From a standing start in 2009, the company has spread across the globe like wildfire. Uber’s strategy has been to focus on major metropolitan areas around the world. This strategy has so far taken Uber into about 600 cities in more than 80 countries. The privately held company is rumored to be generating annual reve- nues of around $10 billion. At the core of Uber’s business is a smartphone app that allows customers to hail a ride from the comfort of their own home, a restaurant, or a bar stool. The app shows cars in the area, notifies the rider when a car is on the way, and tracks the progress of the car on screen using GPS map- ping technology. The rider pays via the app using a credit card, so no cash changes hands. The driver takes 80 per- cent of the fee and Uber 20 percent. The price for the ride is determined by Uber using an algorithm that sets prices in order to match the demand for rides with the supply of cars on the road. Thus, if demand exceeds supply, the price for a ride will rise, inducing drivers to get on the road. Uber does not own any cars. Its drivers are independent contrac- tors with their own vehicles. The company is, in effect, a twenty-first-century version of an old-style radio taxi dis- patch company. Interestingly, Uber’s founders got their idea for the app-based service one snowy night in Paris when they were unable to find a taxi.

Historically, taxi markets around the globe have been tightly regulated by metropolitan authorities. The stated purpose of these regulations has often included (1) limit- ing the supply of taxis in order to boost demand for other forms of public transportation, (2) limiting the supply of taxis in order to reduce traffic congestion, (3) ensuring the safety of riders by only allowing licensed taxis to offer rides, (4) ensuring that the prices charged are “fair,” and (5) guaranteeing a reasonable rate of return to the owners of taxi licenses. In practice, widespread restrictions on the supply of taxi licenses have created shortages in many cities, making it dif- ficult to find a taxi, particularly at busy periods. In New York, the number of licenses barely increased from 11,787 in 1945 to 13,587 in 2017, even though the population ex- panded significantly. In Paris, the number of licenses was 14,000 in 1937 and had only increased to 17,137 by 2017, even though both the population and the number of visitors to the city had surged. The number of taxis in Milan was frozen between 1974 and 2014, despite Milan having a ratio of taxis to inhabitants that was one of the lowest for any major city. Whenever metropolitan authorities have tried to increase the number of taxis in a city, they have often been meet by strong resistance from established taxi companies. When the French tried to increase the number of taxis in Paris in 2007, a strike among transportation workers shut down the city and forced the government to back off.

C L O S I N G C A S E

Uber: Going Global from Day One

36 Part 1 Introduction and Overview

Uber’s strategy has been to break these regulations, estab- lishing its service first and then fighting attempts by regula- tors to shut the service down. In pursuing this strategy, Uber has often used social networks to enlist the support of its riders, getting them to pressure local governments to change their regulations and allow Uber to continue offering its ser- vice. In many cities, the strategy has worked, even in the face of protests from established taxi companies and their driv- ers. In London, for example, when taxi drivers went on strike to pressure the government to restrict Uber, Uber reported a surge in downloads for its app and thousands of new riders. However, this confrontational strategy has not always worked well. The government of Vancouver, Canada, re- acted to the unauthorized entry of Uber by banning it out- right. So did the local authorities in Brussels in Belgium, Delhi in India, and a host of other cities around the globe. In Paris, the government has tried to limit Uber by impos- ing several restrictions that make it harder for Uber to do business there. To complicate matters, Uber drivers in Paris have unionized—something that they cannot do in the United States due to their status as independent con- tractors. They went on strike when Uber tried to lower fares. Similar protests by Uber drivers have occurred in other cities. Overall, there is a sense that Uber’s abrasive strategy has not always worked well, particularly outside of the United States where locals see Uber as a brash American startup that pays scant attention to local laws, customs, and culture. Uber is also witnessing the emergence of local rivals in some countries, such as India and China, where startups using a smartphone app and a business model similar to Uber are gaining traction. In China, local rival Didi Kuaidi has raised $4 billion in venture capital and claims that soon it will be operating in more than 400 cities in China. Didi

already has a 90 percent market share in Beijing, where the company fields more than 1 million daily ride requests.

Sources: Brad Stone, “The $99 Billion Idea: How Uber and Airbnb Fought City Hall, Won Over the People, Outlasted Rivals, and Figured Out the Shar- ing Economy,” Bloomberg BusinessWeek, January 26, 2017; Adi Gaskell, “Study Explores the Impact of Uber on the Taxi Industry,” Forbes, January 26, 2017; Alyson Shontel, “Uber Is Generating a Staggering Amount of Reve- nue,” Business Insider, November 15, 2014; Carmel DeAmicic, “Leaked Doc: Uber Nears $2 Billion in Revenue,” Recode, August 21, 2015; Kara Swisher, “Uber and Uber Man,” Vanity Fair, December 2014; Nitish Kulkarni, “Uber Hits Roadblock in India after Being Denied Permission to Operate in Delhi,” Tech Crunch, September 16, 2015; Brian Solomon, “Uber Seems to Be Getting Its Butt Kicked in China,” Forbes, December 1, 2015.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Companies like Uber, Lyft (one of Uber’s main com-

petitors), and Airbnb (an online marketplace that enables people to lease or rent short-term lodging) are innovating in fields that traditionally have been very complex and regulated. Can Uber’s business model be applied in other industries globally?

2. Are cities around the world doing a disservice to their citizens or their visitors, or both, by banning Uber outright from operating in their community?

3. Uber’s strategy has been to break these regula- tions, establishing its service first, and then fight- ing attempts by regulators to shut the service down. This goes along with the old saying that “do first, ask questions later.” Is this business approach viable globally in the long run?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

E n d n o t e s

 1. Figures from World Trade Organization, Statistics Database, 2015.

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

 3. Ibid.

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

 5. U.S. Department of Commerce, Internal Trade Administration, “Profile of U.S. Exporting and Importing Companies, 2012–2013,” April 2015.

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

 7. 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.

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

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

10. United Nations, “About the United Nations,” http://www.un. org/en/about-un/

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

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

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

14. United Nations Sustainable Development Goals, 2015. http://www. un.org/sustainabledevelopment/sustainable-development-goals/

Globalization Chapter 1 37

15. United Nations Conference on Trade and Investment, June 22, 2017.

16. United Nations, World Investment Report, 2015.

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

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

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

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

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

22. Frankel, “Globalization of the Economy.”

23. Raj Kumar Ray, “India’s Economy to Become 3rd Largest, Sur- pass Japan, Germany by 2030,” Hindustan Times, April 28, 2017.

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

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

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

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

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

29. 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.

30. 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.

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

32. 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).

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

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

35. For example, see B. Milanovic and L. Squire, “Does Tariff Liber- alization Increase Wage Inequality?” National Bureau of Eco- nomic 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).

36. See Piketty, “The Globalization of Labor.”

37. 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.

38. 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.

39. See Piketty, “The Globalization of Labor.”

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

41. R. B. Freeman (2006), “Labor Market Imbalances: Shortages, Surpluses, or What?” Volume 51, Conference Series, Federal Reserve Bank of Boston.

42. 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).

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

44. Ibid.

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

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

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

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

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

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

51. Krugman, Pop Internationalism.

52. 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).

53. 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.

54. 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.

55. Ibid.

56. 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).

57. 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).

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

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

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

National Differences in Political, Economic, and Legal Systems L E A R N I N G O B J E C T I V E S Af ter 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.

part two National Dif ferences

2

©Philimon Bulawayo/Reuters

The Decline of Zimbabwe

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 or had never farmed at all. In the wake of the land reform program, agricultural productivity slumped, and the coun- try is now a net importer of food.  The country’s mining sector remains potentially lucra- tive, 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 dec- imated by poaching and deforestation. As economic activ- ity 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 gov- ernment 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 endow- ment of natural resources, its existing stock of public infra- structure, and its comparatively skilled human resources. However, attaining that potential will require a change in leadership and policies. Mugabe showed no signs of giv- ing up the reins of power. However, in late 2017 he was forced to resign after a military coup.

Sources: “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.

O P E N I N G C A S E In 1980, the southern African state of Zimbabwe gained independence from its colonial master, Great Britain. Speaking at the time, the late Tanzanian president, Julius Nyerere, described Zimbabwe as “the jewel of Africa.” It was a country that boasted a strong economy, abundant natural resources, and a vibrant agricultural sector. As part of the independence process, the British bequeathed Zimbabwe with democratic political institutions. Zimbabwe’s birth as an independent nation was a diffi- cult 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 inde- pendence was an illegal rebellion, and imposed sanctions on Rhodesia. Other nations that followed suit included the United States. An armed conflict followed with two guerrilla movements waging war against Rhodesia’s white govern- ment. 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 interna- tional 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 indepen- dence. Robert Mugabe was elected as the country’s first prime minister. For most of 2017 Mugabe was still in power, then as president. His ZANU-PF party won every election since independence. Once a largely ceremonial position, Mugabe systematically consolidated power in the presidency and restricted his political opponents. He was reelected as president in 2013 in a general election that, like many in the Mugabe era, was widely seen as rigged. The country is also 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 econ- omy maintained a positive economic growth rate through the 1980s and 1990s, things have 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 per annum in GDP. The de- cline occurred after Mugabe launched a “fast-track” land reform program that encouraged the seizure without com- pensation of land owned by white farmers. At the time, white farmers were the backbone of the country’s strong

39

40 Part 2 National Differences

Introduction

International business is much more complicated than domestic business because coun- tries 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 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 dif- fer. Collectively, we refer to these systems as constituting the political economy of a coun- try. 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. Zimbabwe gained its independence from the British in 1980. Although the British left the country with democratic institutions, the country has effectively become a one-party state with limited political freedom and was led by one man, Robert Mugabe, for 37 years. Under Mugabe’s economic mismanagement, the once-thriving economy has collapsed. Property rights have been violated; corruption has become endemic; private enterprise has been discouraged by regulations, taxes, and corruption; inflation surged out of control; more than 80 percent of the population is now unemployed; and life expectancy has declined. Poor economic policies have effectively transformed an economy that once held out great promise into one that cur- rently offers few opportunities for international businesses. In many respects, Zimbabwe is a case study in how not to run a country. That being said, a change in economic policies could still unlock the substantial potential over the country.

G E T I N S I G H T S B Y C O U N T R Y

The “Get Insights by Country” section of globalEDGETM (globaledge.msu.edu/global- insights/by/country) is your source for information and statistical data for nearly every coun- try around the world (more than 200 countries). As related to Chapter 2 of the text, glo- balEDGETM 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?

National Differences in Political, Economic, and Legal Systems Chapter 2 41

Political Systems

The political system of a country shapes its economic and legal systems.1 As such, we need to understand the nature of different political systems before discussing economic and le- gal 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 empha- size 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 individu- alism. 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 circum- stances, 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 so- cialist 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 re- turn. 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 compen- sated for their labor. Thus, the idea is to manage state-owned enterprise to benefit society as a whole, rather than individual capitalists.3

In the early twentieth century, the socialist ideology split into two broad camps. The communists believed that socialism could be achieved only through violent revolution and totalitarian dictatorship, whereas the social democrats committed themselves to achieving socialism by democratic means, turning their backs on violent revolution and dictatorship. Both versions of socialism waxed and waned during the twentieth century.

The communist version of socialism reached its high point in the late 1970s, when the majority of the world’s population lived in communist states. The countries under Communist Party rule at that time included the former Soviet Union; its eastern European client nations (e.g., Poland, Czechoslovakia, Hungary); China; the Southeast Asian nations of Cambodia, Laos, and Vietnam; various African nations (e.g., Angola and Mozambique); and the Latin American nations of Cuba and Nicaragua. By the mid-1990s, however, communism was in retreat worldwide. The Soviet Union had collapsed and had been replaced by a collection of 15 republics, many of which were at least nominally structured as democracies. Communism was swept out of eastern Europe by the largely

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

42 Part 2 National Differences

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 inf luence 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 national- ized 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 telecommu- nications, 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 govern- ment 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 commit- ted to free market economics. These parties sold state-owned enterprises to private inves- tors (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 collectiv- ism, 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 indepen- dence 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.

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

National Differences in Political, Economic, and Legal Systems Chapter 2 43

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 politi- cal freedoms are the ground rules on which a society should be based. This puts individual- ism 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 indi- vidualism, championed by the United States. From the late 1980s until about 2005, the waning of collectivism was matched by the ascendancy of individualism. Democratic ide- als 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 sev- eral 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 towards 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 pro- hibits opposing political parties. The democratic–totalitarian dimension is not indepen- dent of the individualism–collectivism dimension. Democracy and individualism go hand in hand, as do the communist version of collectivism and totalitarianism. However, gray areas exist; it is possible to have a democratic state in which collective values predominate, and it is possible to have a totalitarian state that is hostile to collectivism and in which some degree of individualism—particularly in the economic sphere—is encouraged. For example, China and Vietnam have seen a move toward greater individual freedom in the economic sphere, but those countries are stilled ruled by parties that have a monopoly on political power and constrain political freedom.

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

C O U N T R Y F O C U S

44

Putin’s Russia The modern Russian state was born in 1991 after the dra- matic 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 im- perfectly 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 econ- omy went through a financial crisis that nearly bought the country to its knees. Fast-forward to 2017, and Russia still has a long way to go before it resembles a modern democracy with a func- tioning free market–based economic system. On the posi- tive 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 ac- counted 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 pur- chasing 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 2016 (in the United States, by com- parison, public debt amounts to 70 percent of GDP). In- deed, 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 around $27 before rebounding to $50. This drove a freight train through Russia’s public finances. Much of Russia’s oil and gas pro- duction remains in the hands of enterprises in which the state still has a significant ownership stake. The govern- ment has a controlling ownership position in Gazprom and Rosneft, two of the country’s largest oil and gas compa- nies. The government used the rise in oil and gas reve- nues 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 enter- prises that collectively still account for about half of the Russian economy. Now with lower oil prices, Russia is hav- ing to issue more debt to finance public spending. 

Totalitarianism In a totalitarian country, all the constitutional guarantees on which representative democ- racies 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, politi- cal repression is widespread, free and fair elections are lacking, media are heavily cen- sored, basic civil liberties are denied, and those who question the right of the rulers to rule find themselves imprisoned or worse.

Four major forms of totalitarianism exist in the world today. Until recently, the most widespread was communist totalitarianism. Communism, however, is in decline world- wide, and most of the Communist Party dictatorships have collapsed since 1989. Excep- tions 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

Russian private enterprises are also hamstrung by bu- reaucratic red tape and endemic corruption. The World Bank ranks Russia 92nd in the world in terms of the ease of doing business and 88th when it comes to starting a business (for comparison, the United States is ranked 4th and 20th, respectively). Transparency International, which ranks countries by the extent of corruption, ranked Russia 131 out of 176 nations in 2016. The state and state-owned enterprises are famous for pushing work to private enter- prises that are owned by political allies, which further sub- verts market-based processes. On the political front, Russia is becoming less demo- cratic 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 govern- ment passed laws increasing its control over the Internet, dramatically raising fines for participating in “unsanctioned” street protests, and expanded the definition of treason to further limit opposition activities. Vocal opponents of the régime—from business executives who do not tow the state line to protest groups such as the punk rock protest band Pussy Riot—have found themselves jailed on dubi- ous 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 support- ers, 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 Gen- nadiy Zyuganove, with 17.2 percent of the vote. Under a Putin-inspired 2008 constitutional amendment, the term of the presidency was expanded from four years to six. Putin will be eligible for another six-year term in 2018. In 2014, Putin burnished his growing reputation for authori- tarianism when he took advantage of unrest in the neighbor- ing country of Ukraine to annex the Crimea region and to support armed revolt by Russian-speaking separatists in east- ern 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 3.7 percent in 2015 and another 0.6 percent in 2016. Despite economic weaknesses, however, there is no sign that Putin’s hold on power has been dimin- ished; 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 2015: Russia, www.freedomhouse.org; K. Hille, “Putin Tightens Grip on Legal Sys- tem,” Financial Times, November 27, 2013.

45

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

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

46 Part 2 National Differences

A fourth major form of totalitarianism might be described as right-wing totalitarianism. Right-wing totalitarianism generally permits some individual economic freedom but re- stricts individual political freedom, frequently on the grounds that it would lead to the rise of communism. A common feature of many right-wing dictatorships is an overt hostility to socialist or communist ideas. Many right-wing totalitarian governments are backed by the military, and in some cases, the government may be made up of military officers. The fas- cist regimes that ruled Germany and Italy in the 1930s and 1940s were right-wing totalitar- ian 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 mili- tary dictatorship between 1964 and 1985). They were also found in several Asian coun- tries, particularly South Korea, Taiwan, Singapore, Indonesia, and the Philippines. Since the early 1980s, however, this form of government has been in retreat. Most Latin American countries are now genuine multiparty democracies. Similarly, South Korea, Taiwan, and the Philippines have all become functioning democracies, as has Indonesia.

Pseudo-Democracies Many of the world’s nations are neither pure democracies nor iron-clad totalitarian states. Rather they lie between pure democracies and complete totalitarian systems of government. They might be described as imperfect or pseudo-democracies, where authoritarian elements have captured some or much of the machinery of state and use this in an attempt to deny basic political and civil liberties. In the Russia of Vladimir Putin, for example, elections are still held, people compete through the ballot box for political office, and the independent press does not always tow the official line. However, Putin has used his position to system- atically 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 has systematically extended its political, legal, and economic power over the past 15 years (see the Country Focus). Zimbabwe too, is nominally a democratic state, but democratic institutions have been subverted by Robert Mugabe and his ZANU-PF party, which has had a near monopoly on political power since 1980 (see the opening case).

Economic Systems

It should be clear from the previous section that political ideology and economic systems are connected. In countries where individual goals are given primacy over collective goals, we are more likely to find market-based economic systems. In contrast, in countries where collective goals are given preeminence, the state may have taken control over many enter- prises; markets in such countries are likely to be restricted rather than free. We can iden- tify 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 sup- ply, 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.

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 in- crease 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.

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.

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

National Differences in Political, Economic, and Legal Systems Chapter 2 47

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 com- petitors, 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. Govern- ments 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 own- ership 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 pro- cesses, by pursuing better marketing and after-sale service, or simply through managing their businesses more efficiently than their competitors. In turn, the constant improve- ment 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 coun- try 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

North Korean leader Kim Jong-un visiting a factory. ©AFP/Getty Images

48 Part 2 National Differences

economies has fallen dramatically. Some elements of a command economy were also evi- dent 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 in- centive for individuals to look for better ways to serve consumer needs; hence, dynamism and innovation are absent from command economies. Instead of growing and becoming more prosperous, such economies tend to stagnate.

MIXED ECONOMY

Mixed economies can be found between market and command economies. In a mixed economy, certain sectors of the economy are left to private ownership and free market mechanisms, while other sectors have significant state ownership and government plan- ning. Mixed economies were once common throughout much of the developed world, al- though they are becoming less so. Until the 1980s, Great Britain, France, and Sweden were mixed economies, but extensive privatization has reduced state ownership of busi- nesses 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, typi- cally by first winning power through democratic means and then subverting those same structures to maintain their grip on power.

In mixed economies, governments also tend to take into state ownership troubled firms whose continued operation is thought to be vital to national interests. For example, in 2008 the U.S. government took an 80 percent stake in AIG to stop that financial institu- tion 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 noth- ing 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.

Legal Systems

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

Like the economic system of a country, the legal system is influenced by the prevailing political system (although it is also strongly influenced by historical tradition). The gov- ernment of a country defines the legal framework within which firms do business, and

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.

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

National Differences in Political, Economic, and Legal Systems Chapter 2 49

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 prop- erty rights with particular reference to patents, copyrights, and trademarks. Then we dis- cuss 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 inter- pret 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 un- der 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.

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 us- age of both Hindu and Jewish law persisted into the twentieth century. Islamic law is pri- marily 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 Sun- nah, 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 founda- tions 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.

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

50 Part 2 National Differences

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 de- manded 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 addi- tion 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 ap- proach of each to contract law (remember, most theocratic legal systems also have ele- ments 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 re- sort to contract law when one party feels the other has violated either the letter or the spirit of an agreement.

Because common law tends to be relatively ill specified, contracts drafted under a com- mon law framework tend to be very detailed with all contingencies spelled out. In civil law systems, however, contracts tend to be much shorter and less specific because many of the issues are already covered in a civil code. Thus, it is more expensive to draw up contracts in a common law jurisdiction, and resolving contract disputes can be very adversarial in com- mon 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 Inter- national 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 dif- ferent 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 rati- fied the CISG.

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

PROPERTY RIGHTS AND CORRUPTION

In a legal sense, the term 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, equip- ment, capital, mineral rights, businesses, and intellectual property (ideas, which are pro- tected 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

National Differences in Political, Economic, and Legal Systems Chapter 2 51

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 le- gal system allows a much higher level of criminal action. For example, in the chaotic pe- riod 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, in- cluding bombings and assassinations (about 500 contract killings of businessmen occurred per year in the 1990s).14

Russia is not alone in having organized crime problems (and the situation in Russia has improved since the 1990s). 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 prop- erty holders. This can be done through legal mechanisms such as levying excessive taxa- tion, requiring expensive licenses or permits from property holders, taking assets into state ownership without compensating the owners, or redistributing assets without compensat- ing the prior owners. It can also be done through illegal means, or corruption, by demand- ing 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 bank- ers, 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 demand- ing 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 ex- tent 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 poli- ticians 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 dedi- cated to exposing and fighting corruption, businesses and individuals spend some $400 billion a year worldwide on bribes related to government procurement contracts alone.17

52 Part 2 National Differences

Transparency International has also measured the level of corruption among public offi- cials in different countries.18 As can be seen in Figure 2.1, the organization rated countries such as Denmark and Sweden as clean; it rated others, such as Russia, India, Zimbabwe and Venezuela, as corrupt. Somalia ranked last out of all 176 countries in the survey (the country is often described as a “failed state”).

Economic evidence suggests that high levels of corruption significantly reduce the for- eign direct investment, level of international trade, and economic growth rate in a coun- try.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 busi- nesses 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 eco- nomic development is given in the accompanying Country Focus, which looks at the im- pact of corruption on economic growth in Brazil.

Foreign Corrupt Practices Act In the 1970s, the United States passed the Foreign Corrupt Practices Act (FCPA) follow- ing 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 govern- ment 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

F I G U R E 2 .1

Rankings of corruption by country, 2016. Source: Constructed by the author from raw data from Transparency International, Corruption Perceptions Index 2016.

0 10 20

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

Venezuela

Vietnam

Nigeria

Russia

China

Colombia

India

Brazil

South Korea

Poland

Italy

South Africa

Turkey

France

United States

United Kingdom

Germany

Canada

Sweden

Denmark

Somalia

C O U N T R Y F O C U S

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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 larg- est oil producer (Petrobras) and one of its top banks (Banco do Brazil) are both state owned. Many econo- mists, 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 con- nections and discourages investment by more ethical businesses.  Transparency International, a nongovernmental organi- zation that evaluates countries based on perceptions of how corrupt they are, ranked Brazil 79th out of the 176 countries it looked at in its 2016 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 coun- tries in the proper use of public funds. Over the last decade, several corruption scandals have come to light that serve to emphasize Brazil’s cor- ruption problem. In 2005, a scandal known as the mensalao (the monthly payoff scandal) broke. The scan- dal 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 con- tracts. 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 laun- dering, and corruption. The public uproar surrounding the mensalao scandal was just starting to die down when in March 2014 an- other corruption scandal captured the attention of Brazil- ians. 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 con- struction 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 mem- bers of Congress, including the former Brazilian Presi- dent 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; Romero, “Dilma Rousseff Is Ousted as Brazil’s President in Impeachment Vote,” The New York Times, August 31, 2016.

M A N A G E M E N T F O C U S

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 zon- ing 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, execu- tives 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 gen- eral 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

Did Walmart Violate the Foreign Corrupt Practices Act? populated neighborhoods without a construction license, an environmental permit, an urban impact assessment, or even a traffic permit. Similarly, thanks to nine bribe pay- ments 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 investiga- tion, and it had cost more than $612 million in fees. In addi- tion, the U.S. Department of Justice and the Securities and Exchange Commission both announced that they had started investigations into Walmart’s practices. In Novem- ber 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 alle- gations by the Times that top executives at Walmart, includ- ing former CEO Lee Scott Jr., had deliberately squashed earlier investigations. While the investigations are still on- going, in late 2016 people familiar with the matter stated that the federal investigation had not uncovered evidence of widespread bribery. Nevertheless, the company was ap- parently negotiating a settlement with the U.S. government that was estimated to be at least $600 million.

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.

international trade) to keep detailed records that would reveal whether a violation of the act has occurred. In 2012, evidence emerged that in its eagerness to expand in Mexico, Walmart may have run afoul of the FCPA (for details, see the Management Focus feature).

In 1997, trade and finance ministers from the member states of the Organisation for Economic Co-operation and Development (OECD), an association of 34 major econo- mies 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 pub- lic officials a criminal offense.

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),

54

National Differences in Political, Economic, and Legal Systems Chapter 2 55

the purpose of which is to expedite or to secure the performance of a routine governmen- tal 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 facili- tate 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 le- gal rights of authors, composers, playwrights, artists, and publishers to publish and dis- perse 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 prob- lematic, 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 in- centive 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 in- ventor of a new drug a 20-year monopoly in production of that drug. This gives pharma- ceutical firms an incentive to undertake the expensive, difficult, and time-consuming basic research required to generate new drugs (it can cost $1 billion in R&D and take 12 years to get a new drug on the market). Without the guarantees provided by patents, companies would be unlikely to commit themselves to extensive basic research.23

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 Prop- erty Organization, all of which have signed international treaties designed to protect in- tellectual 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 com- puter software.

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

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

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’ ubiqui- tous 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 regis- tered its Chinese name in 1998. The court stated that Xing Ba Ke’s use of the name and similar logo was “clearly mali- cious” 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 in- volved here may be small, the precedent is not. In a coun- try where violation of trademarks has been common, the courts seem to be signaling a shift toward greater protec- tion of intellectual property rights. This is perhaps not sur- prising 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 Jour- nal, January 2, 2006, p. A11; “Starbucks Calls China Its Top Growth Focus,” The Wall Street Journal, February 14, 2006, p. 1.

56

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

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 copy- cat that signaled a change in the approach in China (see the accompanying Manage- ment 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 en- trepreneurs. 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.

National Differences in Political, Economic, and Legal Systems Chapter 2 57

PRODUCT SAFETY AND PRODUCT LIABILITY

Product safety laws set certain safety standards to which a product must adhere. Prod- uct liability involves holding a firm and its officers responsible when a product causes in- jury, death, or damage. Product liability can be much greater if a product does not conform to required safety standards. Both civil and criminal product liability laws exist. Civil laws call for payment and monetary damages. Criminal liability laws result in fines or imprison- ment. 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 compre- hensive liability laws. Liability laws are typically the least extensive in less developed na- tions. 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.

In addition to the competitiveness issue, country differences in product safety and lia- bility 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.

F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

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 impor- tant 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 oper-

ate 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, eco- nomic, and legal systems. The overall attractiveness of a country as a market or investment site depends on balancing the likely long-term benefits of doing business in that country against the likely costs and risks. Because this chapter is the first of two dealing with issues of political economy, we will delay a detailed discussion of how political economy impacts the benefits, costs, and risks of doing business in different nation-states until the end of the next chapter, when we have a full grasp of all the relevant variables that are important for assessing benefits, costs, and risks. For now, other things being equal, a nation with democratic political institutions, a market- based economic system, and strong legal system that protects property rights and limits 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,

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

58 Part 2 National Differences

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 nu- anced and complex. For example, China lacks democratic institutions; corruption is wide- spread; 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.

political economy, p. 40 political system, p. 41 collectivism, p. 41 socialists, p. 41 communists, p. 41 social democrats, p. 41 privatization, p. 42 individualism, p. 42 democracy, p. 43 totalitarianism, p. 43 representative democracy, p. 43 communist totalitarianism, p. 44 theocratic totalitarianism, p. 45 tribal totalitarianism, p. 45

right-wing totalitarianism, p. 46 market economy, p. 46 command economy, p. 47 legal system, p. 48 common law, p. 48 civil law system, p. 49 theocratic law system, p. 49 contract, p. 50 contract law, p. 50 United Nations Convention on

Contracts for the International Sale of Goods (CISG), p. 50

property rights, p. 50 private action, p. 51

public action, p. 51 Foreign Corrupt Practices

Act (FCPA), p. 52 intellectual property, p. 55 patent, p. 55 copyrights, p. 55 trademarks, p. 55 World Intellectual Property

Organization, p. 55 Paris Convention for the Protection

of Industrial Property, p. 55 product safety laws, p. 57 product liability, p. 57

Key Terms

C H A P T E R S U M M A R Y

This chapter has reviewed how the political, economic, and legal systems of countries vary. The potential bene- fits, 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 empha- size 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 eco- nomic 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 representa- tive democracy, citizens periodically elect indi- viduals 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 sys- tems: a market economy, a command economy,

National Differences in Political, Economic, and Legal Systems Chapter 2 59

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 for- bidden. 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.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

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

2. A democratic political system is an essential con- dition for sustained economic progress. Discuss.

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

4. You are the CEO of a company that has to choose between making a $100 million

investment in Russia or Poland. Both invest- ments 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 feature titled 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?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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.

Vietnam is a country undergoing transformation from a centrally planned socialist economy to a system that is more market orientated. The transformation dates back to 1986, a decade after the end of the Vietnam War that reunited the north and south of the country under

communist rule. At that time, Vietnam was one of the poorest countries in the world. Per capita income stood at just $100 per person, poverty was endemic, price infla- tion exceeded 700 percent, and the Communist Party ex- ercised tight control over most forms of economic and

C L O S I N G C A S E

Economic Transformation in Vietnam

60 Part 2 National Differences

political life. To compound matters, Vietnam struggled under a trade embargo imposed by the United States after the end of the Vietnam War. Recognizing that central planning and government ownership of the means of production were not raising the living standards of the population, in 1986 the Com- munist Party embarked upon the first of a series of re- forms that, over the next two decades, transformed much of the economy. Agricultural land was privatized and state farm collectives were dismantled. As a result, farm productivity surged. Following this, rules restricting the establishment of private enterprises were relaxed. Many price controls were removed. State-owned enterprises were privatized. Barriers to foreign direct investment were lowered, and Vietnam entered into trade agreements with its neighbors and its old enemy the United States, culminating in the country joining the World Trade Orga- nization in 2007. The impact of these reforms has been dramatic. Vietnam achieved annual economic growth rates of around 7 percent for the first 20 years of its reform pro- gram. Although growth rates fell to 5 percent in the after- math of the 2008–2009 global financial crisis, by 2015 Vietnam was once again achieving growth rates of around 6–7 percent. Living standards have surged, with GDP per capita on a purchasing parity basis reaching $6,400 in 2016. The country is now a major exporter of textiles and agricultural products, with an expanding electronics sector. State-owned enterprises now only account for 40 percent of total output, down from a near monopoly in 1985. Moreover, with a population approaching 100 mil- lion and an average age of just 30, Vietnam is emerging as a potentially significant market for consumer goods. For all of this progress, significant problems still re- main. The country is too dependent upon exports of com- modities, the prices of which can be very volatile. Vietnam’s remaining state-owned enterprises are ineffi- cient and burdened with high levels of debt. Rather than let prices be set by market forces, the government has re- cently reintroduced some price controls. On the political front, the Communist Party has maintained a tight grip on power, even as the economy has transitioned to a mar- ket-based system. Vietnam bans all independent political parties, labor unions, and human rights organizations. Government critics are routinely harassed and can be

arrested and detained for long periods without trial. The courts lack independence and are used as a political tool by the Communist Party to punish critics. There is no freedom of assembly or freedom of the press. To compound matters, corruption is rampant in Vietnam. Transparency International, a nongovernmental organization that evaluates countries based on percep- tions of how corrupt they are, ranks Vietnam 113th out of the 176 countries it ranks. Corruption is not a new prob- lem in Vietnam. There is a well-established tradition of public officials selling their influence and favoring their families. However, critics say that the problem was exac- erbated by privatization processes that provided opportu- nities for government officials to appoint themselves and family members as executives of formerly state-owned companies. Although the ruling Communist Party has launched anticorruption initiatives, these seem to be largely symbolic efforts. Many observers believe that widespread corruption has a negative impact on new busi- ness formation and is hamstringing economic growth.

Sources: “Crying over Cheap Milk,” The Economist, November 21, 2015; “Gold Stars,” The Economist, January 23, 2016; Nick Davis, “Vietnam 40 Years On,” The Guardian, April 22, 2015; Vietnam, CIA Fact Book, 2016; Human Rights Watch, “Vietnam,” World Report 2015.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Why did Vietnam experience a low economic

growth rate in the decade after the end of the Vietnam War in 1976?

2. Vietnam now has an economy that is growing strongly with low unemployment and rising living standards. What changes in economic pol- icy have been responsible for this economic transformation?

3. The level of public corruption in Vietnam is high. Why is this the case? How do you think this affects Vietnam’s economic performance? What should the government do about this?

4. How do you think a shift toward more demo- cratic institutions will affect economic progress in Vietnam?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

National Differences in Political, Economic, and Legal Systems Chapter 2 61

E n d n o t e s

 1. As we shall see, there is not a strict one-to-one correspondence be- tween 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 Authoritarian- ism, 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.

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

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

14. P. Klebnikov, “Russia’s Robber Barons,” Forbes, November 21, 1994, pp. 74–84; C. Mellow, “Russia: Making Cash from Chaos,” Fortune, April 17, 1995, pp. 145–51; “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. Palif ka, 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. Ibid.

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

part two National Dif ferences

3National Differences in Economic Development L E A R N I N G O B J E C T I V E S Af ter 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.

©Shafiqul Alam/Corbis News/Getty Images©Shafiqul Alam/Corbis News/Getty Images

Economic Development in Bangladesh

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 ac- count for 80 percent of Bangladesh’s exports. The devel- opment of the textile industry has been helped by the availability of low-cost labor, managerial skills, favorable trade agreements, and government policies that elimi- nated import duties on inputs for the textile business, such as raw materials. The Bangladesh economy has also ben- efited from its productive agricultural sector and remit- tences from more than 10 million Bangladesh citizens who work in other nations. Bangladesh is also home of the mi- crofinance 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 re- mains poor; corruption continues to be a major problem; and the political system is, at best, an imperfect democ- racy where opposition is stifled. The country is too depen- dent 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 po- tential for damaging floods in much of the remainder. Nevertheless, according to the U.S. investment bank Gold- man Sachs, Bangladesh is one of the 11 lower-middle- income nations posed 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; Qimiao Fan, “Bangladesh: Setting a Global Standard in Ending Poverty,” World Bank blog, October 5, 2016.

O P E N I N G C A S E When Bangladesh gained independence from Pakistan in 1971 after a brutal civil war that may have left as many as 3 million dead, the U.S. National Security Adviser, Henry Kissinger, referred to the country as a “basket case.” Kiss- inger’s assessment was accurate enough. At the time, Bangladesh was one of the world’s poorest nations. Al- though most of the country is dominated by the fertile Ganges-Brahmaputra delta, a lack of other natural re- sources, coupled with poor infrastructure, political instabil- ity, and high levels of corruption, long held the country back. To compound matters, Bangladesh is prone to natu- ral disasters. Most of Bangladesh is less than 12 meters above sea level. The extensive low-lying areas are vulner- able to tropical cyclones, floods, and tidal bores.   Beginning in the mid 1990s, however, Bangladesh be- gan 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 re- duction 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. Yes, it has a considerable way to go, but it is no longer one of the world’s poorest countries. Several reasons underlie Bangladesh’s relative eco- nomic success. In its initial post-independence period, Bangladesh adopted socialist policies, nationalizing many companies and subsidizing the costs of agricultural pro- duction 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 agricul- tural subsidies, the privatization of state-owned compa- nies, 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

63

64 Part 2 National Differences

Introduction

In Chapter 2, we described how countries differ with regard to their political systems, eco- nomic systems, and legal systems. In this chapter, we build on this material to explain how these differences influence the level of economic development of a nation and, thus, how attractive it is as a place for doing business. We also look at how economic, political, and legal systems are changing around the world and what the implications of this are for the future rate of economic development of nations and regions. The past three decades have seen a general move toward more democratic forms of government, market-based eco- nomic reforms, and adoption of legal systems that better enforce property rights. Taken 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 sec- tion of this chapter, we pull all this material together to explore how differences in politi- cal, economic, and legal institutions affect the benefits, costs, and risks of doing business in different nations.

The opening case, which looks at changes in the economy of Bangladesh since it gained independence in 1971, highlights many of the issues that we discuss here. Bangladesh ini- tially embraced socialist policies, including the nationalization of private enterprises and extensive agricultural and food subsidies. These policies failed. Starting in the 1980s, Bangladesh adopted a series of market-based reforms that were aimed at making the econ- omy work more efficiently. These included the privatization of state-owned enterprises, removal of subsidies, lowering of import barriers, removal of restrictions on foreign capital flows, and ultimately, adoption of a fully convertible free-floating currency. These policies laid the ground work for the emergence of Bangladesh as the second-largest exporter of ready-made garments in the world after China. Developments such as these have helped to dramatically reduce poverty levels in Bangladesh. Once one of the poorest countries in the world, Bangladesh is now a rapidly growing lower-middle-income country that offers opportunities for international businesses, both as a supplier of goods and services and as a country in which to invest.

Differences in Economic Development

Different countries have dramatically different levels of economic development. One com- mon measure of economic development is a country’s gross national income (GNI) per head of population. GNI is regarded as a yardstick for the economic activity of a country; it measures the total annual income received by residents of a nation. Map 3.1 summarizes the GNI per capita of the world’s nations in 2016. As can be seen, countries such as Japan, Sweden, Switzerland, the United States, and Australia are among the richest on this mea- sure, whereas the large developing countries of China and India are significantly poorer. Japan, for example, had a 2016 GNI per capita of $38,000, but China achieved only $8,260 and India just $1,680.1

GNI per person figures can be misleading because they don’t consider differences in the cost of living. For example, although the 2016 GNI per capita of Switzerland at $81,240 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 2016 the GNI per capita for China was $8,260, 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 $15,500 in the United States. Table 3.1 gives the GNI per capita

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

65

PACIFIC OCEAN

ARCTIC OCEAN

PACIFIC OCEAN

ATLANTIC OCEAN

INDIAN OCEAN

Low Income: $765 or less

Upper Middle Income: $3,035–$9,385

Lower High Income: $9,385–$20,000 Upper High Income: $20,001 or more No data

The values for the class intervals above are taken from the World Bank’s cuto� figures for high-income, upper-middle-income, lower-middle- income, and low-income economies.

GNI per Capita in U.S. Dollars

Lower Middle Income: $765–$3,035

1000

0

0

1000 2000 Miles

2000 3000 Kilometers Scale: 1 to 174,385,000

M A P 3 .1

GNI per capita, 2016.

TA B L E 3 .1

Economic Data for Select Countries

Source: World Development Indicators Online, 2017.

Annual Size of GNI per GNI PPP GDP Growth Economy Capita, per Capita, Rate, 2007– GDP, 2016 Country 2016 ($) 2016 ($) 2016 (%) ($ billions) Brazil $ 8,840 $14,810 2.1 $ 1,796

China 8,260 15,500 9.0 11,199

Germany 43,660 49,530 1.3 3,467

India 1,680 6,490 7.4 2,263

Japan 38,000 42,870 0.5 4,939

Nigeria 2,450 5,740 5.0 405

Poland 12,680 26,770 3.6 470

Russia 9,720 22,540 1.7 1,283

Switzerland 81,240 63,660 1.6 660

United Kingdom 42,390 42,100 1.1 2,618

United States 56,180 58,030 1.3 18,569

66 Part 2 National Differences

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INDIAN OCEAN

Low Income: $1,990 or less

Upper Middle Income: $4,581–$9,170 Lower High Income: $9,171–$20,000 Upper High Income: $20,001 or more No data

Purchasing Power Parity in U.S Dollars

Lower Middle Income: $1,991–$4,580

1000

0

0

1000 2000 Miles

2000 3000 Kilometers Scale: 1 to 174,385,000

M A P 3 . 2

GNI PPP per capita, 2016.

measured at PPP in 2016 for a selection of countries, along with their GNI per capita and their growth rate in gross domestic product (GDP) from 2007 to 2016. Map 3.2 summarizes the GNI PPP per capita in 2016 for the nations of the world.

As can be seen, there are striking differences in the standards of living among coun- tries. Table 3.1 suggests the average Indian citizen can afford to consume only about 11 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 un- likely 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 transac- tions 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

Did You Know? Did you know that the United States has an economy that is 70 percent larger than that of China and has four times the standard of living?

Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.

National Differences in Economic Development Chapter 3 67

implies that the Indian economy is half as big again as the figures reported in Table 3.1. Estimates produced by the European Union suggest that in 2012 the shadow economy ac- counted for around 10 percent of GDP in the United Kingdom and France but 24 percent in Greece and as much as 32 percent in Bulgaria.2

The GNI and PPP data give a static picture of development. They tell us, for example, that China is much poorer than the United States, but they do not tell us if China is clos- ing 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 2007 and 2016. Map 3.3 summarizes the an- nual average percentage growth rate in GDP from 2007 to 2016. 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 eco- nomic growth rates, China will become the world’s largest economy sometime during the next decade. On current trends, India too will be among the largest economies in the

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ATLANTIC OCEAN

INDIAN OCEAN

Less than 0.0% 0.0%–0.9% 1.0%–1.9% 2.0%–2.9% 3.0%–3.9% More than 4.0% No data

Average Annual Growth Rate, GDP: 2007–2016

1000

0

0

1000 2000 Miles

2000 3000 Kilometers Scale: 1 to 174,385,000

M A P 3 . 3

Average annual growth rate in GDP (%), 2007–2016.

68 Part 2 National Differences

C O U N T R Y C O M P A R A T O R

The “Country Comparator” tool on globalEDGETM (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 eco- nomic changes occurring in countries. As related to Chapter 3, the globalEDGETM Coun- try 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 clas- sify 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?

world. Given that potential, many international businesses are trying to establish a strong presence in these markets.

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 and opportunities that people enjoy.3 According to Sen, develop- ment should be seen as a process of expanding the real freedoms that people experi- ence. 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 per- spective leads Sen to emphasize basic health care, especially for children, and basic education, especially for women. Not only are these factors desirable for their instru- mental 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 inf luential thesis has been picked up by the United Nations, which has devel- oped 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 ba- sic 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 sug- gests 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.

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National Differences in Economic Development Chapter 3 69

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 organiza- tions, 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

PACIFIC OCEAN

ARCTIC OCEAN

PACIFIC OCEAN

ATLANTIC OCEAN

INDIAN OCEAN

Very High Human Development: 0.800–1.00 High Human Development: 0.700–0.799 Medium Human Development: 0.550– 0.699 Low Human Development: less than 0.550 No data

Levels of Human Development

1000

0

0

1000 2000 Miles

2000 3000 Kilometers Scale: 1 to 174,385,000

M A P 3 . 4

Human Development Index, 2015.

70 Part 2 National Differences

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 in- crease 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 ben- efited greatly from a high level of entrepreneurial activity, which has resulted in rapid in- novation 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 consid- ered this issue highlight the advantages of a market economy.6 It has been argued that the economic freedom associated with a market economy creates greater incentives for innova- tion and entrepreneurship than either a planned or a mixed economy. In a market economy, any individual who has an innovative idea is free to try to make money out of that idea by starting a business (by engaging in entrepreneurial activity). Similarly, existing businesses are free to improve their operations through innovation. To the extent that they are successful, both individual entrepreneurs and established businesses can reap rewards in the form of high profits. Thus, market economies contain enormous incentives to develop innovations.

In a planned economy, the state owns all means of production. Consequently, entrepre- neurial individuals have few economic incentives to develop valuable new innovations be- cause it is the state, rather than the individual, that captures most of the gains. The lack of economic freedom and incentives for innovation was probably a main factor in the eco- nomic stagnation of many former communist states and led ultimately to their collapse at the end of the 1980s. Similar stagnation occurred in many mixed economies in those sec- tors 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 relation- ship 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 persis- tently 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.

INNOVATION AND ENTREPRENEURSHIP REQUIRE STRONG PROPERTY RIGHTS

Strong legal protection of property rights is another requirement for a business environ- ment 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

National Differences in Economic Development Chapter 3 71

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 econo- mist 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 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 as- sets 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 cal- culations, the total value of real estate held by the poor in third world and former commu- nist 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 boot- strap their way out of poverty. Interestingly enough, the Chinese seem to have taken de Soto’s arguments to heart. Despite still being nominally a communist country, in October 2007 the government passed a law that gave private property owners the same rights as the state, which significantly improved the rights of urban and rural landowners to the land that they use (see the accompanying Country Focus).

THE REQUIRED POLITICAL SYSTEM

Much debate surrounds which kind of political system best achieves a functioning market economy with strong protection for property rights.11 People in the West tend to associate a representative democracy with a market economic system, strong property rights protec- tion, 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 30 years—China, South Korea, Taiwan, Singapore, and Hong Kong—had one thing in common at the start of their economic growth: undemo- cratic 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 nec- essarily leads to development. I believe that a country needs to develop discipline more than democracy. The exuberance of democracy leads to undisciplined and disorderly con- duct 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 re- gime 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 free- dom, also suppress human development and therefore are detrimental to progress.

C O U N T R Y F O C U S

72

Emerging Property Rights in China On October 1, 2007, a new property law took effect in China, granting rural and urban landholders far more secure prop- erty 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 dy- namic market-based economy where two-thirds of eco- nomic activity is in the hands of private enterprises. Although all land in China still technically belongs to the state—an ideological necessity in a country where the gov- ernment still claims to be guided by Marxism—urban land- holders 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 compensa- tion, 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 land- holdings as security against which they could borrow funds for investments to boost productivity.

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

ECONOMIC PROGRESS BEGETS DEMOCRACY

While it is possible to argue that democracy is not a necessary precondition for a free mar- ket economy in which property rights are protected, subsequent economic growth often leads to establishment of a democratic regime. Several of the fastest-growing Asian econo- mies 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.

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 criti- cize 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 indi- vidual 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 at- tention is geography.14 But the belief that geography can influence economic policy, and

National Differences in Economic Development Chapter 3 73

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 re- duced 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 produc- tive population. Anecdotal comparisons suggest this is true. In 1960, Pakistanis and South Koreans were on equal footing economically. However, just 30 percent of Pakistani children were enrolled in primary schools, while 94 percent of South Koreans were. By the mid- 1980s, South Korea’s GNP per person was three times that of Pakistan.16 A survey of 14 statistical studies that looked at the relationship between a country’s investment in educa- tion 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.

States in Transition

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

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 2017, 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” coun- tries, the political process is tightly controlled and basic freedoms are denied.

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74 Part 2 National Differences

Freedom House classified some 87 countries as free in 2017, accounting for about 45 percent of the world’s nations. These countries respect a broad range of political rights. Another 59 countries accounting for 30 percent of the world’s nations were classified as

partly free, while 49 countries representing approximately 25 per- cent 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 2017. 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 nomi- nally 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.

Voters wait in a queue in front of the election center in the city of Lagos, Nigeria. ©Anadolu Agency/Getty Images

M A P 3 . 5

Freedom in the world, 2017.

Source: The Freedom House Survey Team, “Freedom in the World 2017,” www.freedomhouse.org.

Free Partly free Not free

Free Partly free Not free

Status Countries

87 59 49

Total 195

Freedom in the World 2017

National Differences in Economic Development Chapter 3 75

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 an election and there was a peaceful transfer of power.

Three main reasons account for the spread of democracy.20 First, many totalitarian re- gimes failed to deliver economic progress to the vast bulk of their populations. The col- lapse 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 econo- mies 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 commu- nist bloc, the Philippines and Taiwan in Asia, and Chile in Latin America—has strength- ened the case for democracy as a key component of successful economic advancement.

Second, new information and communication technologies—including satellite televi- sion, 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 informa- tion 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 2016, only 9 countries were considered free, 20 were partly free, and 20 were not free. Among the post-communist countries in eastern and central Europe and the former Soviet Union, only 13 are classified as free (primarily in eastern Europe). And there 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, there are disturbing signs that authoritarianism is gaining ground in several countries where political and civil liberties have been progressively limited in recent years, including Russia, Ukraine, Indonesia, Ecuador, and Venezuela. An increasingly autocratic Russia annexed the Crimea region from the Ukraine in 2014 and has actively supported pro-Russian rebels in eastern Ukraine. Libya, where there was hope that a democracy might be 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, sug- gesting that the shift toward greater democracy that occurred during the 1985–2005 pe- riod has peaked for the time being and that there have been some notable reversals in states such as Russia and Venezuela.

76 Part 2 National Differences

THE NEW WORLD ORDER AND GLOBAL TERRORISM

The end of the Cold War and the “new world order” that followed the collapse of commu- nism 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 uni- versal civilization characterized by democratic regimes and free market capitalism. In a controversial book, the late influential political scientist Samuel Huntington argued there is no “universal” civilization based on widespread acceptance of Western liberal demo- cratic ideals.23 Huntington maintained that while many societies may be modernizing— they are adopting the material paraphernalia of the modern world, from automobiles and Facebook to Coca-Cola and smartphones—they are not becoming more Western. On the contrary, Huntington theorized that modernization in non-Western societies can result in a retreat toward the traditional, such as the resurgence of Islam in many traditionally Muslim societies. He wrote,

The Islamic resurgence is both a product of and an effort to come to grips with moderniza- tion. 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 psy- chological 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 has drawn further attention to Huntington’s thesis, as has the growing penchant for ISIS to engage is terrorist acts outside of the Middle East, most notably in Paris in 2015.

If Huntington’s views are even partly correct, they have important implications for in- ternational 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 be- tween civilizations and the clash of value systems and ideology. The terror attacks under- taken 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 ter- rorism 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

National Differences in Economic Development Chapter 3 77

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

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 coun- tries 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 occur- ring also would include Asian states such as China and Vietnam, as well as African coun- tries 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 econo- mies to promote greater competition.

The rationale for economic transformation has been the same the world over. In gen- eral, command and mixed economies failed to deliver the kind of sustained economic performance that was achieved by countries adopting market-based systems, such as the United States, Switzerland, Hong Kong, and Taiwan. As a consequence, even more states have gravitated toward the market-based model.

Map 3.6, based on data from the 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 (given that the Heritage Foundation has an overt political agenda and generally supports the “Tea Party” wing of the Republican Party, its work should be viewed with caution). The Heritage Foundation’s index of economic freedom is based on 10 indicators, including the extent to which the government intervenes in the economy, trade policy, the degree to which property rights are protected, foreign investment regulations, taxa- tion 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.

Chinese construction workers build the new African Union Buildings in Addis Ababa, Ethiopia. ©Per-Anders Pettersson/Getty Images

78 Part 2 National Differences

According to the 2017 index, which is summarized in Map 3.6, the world’s freest econo- mies are (in rank order) Hong Kong, Singapore, New Zealand, Switzerland, Australia, Estonia, Canada, United Arab Emirates, Ireland, and Chile. The United Kingdom was ranked 12, the United States 17, Germany came in at 26, Japan at 40, Mexico at 62, France at 75, Brazil at 122, India at 123, China at 144, and Russia at 153. The economies of Zim- babwe, 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.

The Nature of Economic Transformation

The shift toward a market-based economic system often entails a number of steps: deregu- lation, privatization, and creation of a legal system to safeguard property rights.28

DEREGULATION

Deregulation involves removing legal restrictions to the free play of markets, the establish- ment of private enterprises, and the manner in which private enterprises operate. Before the collapse of communism, the governments in most command economies exercised tight

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.

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

NIGERIA

80%–100% Free 70%–79.9% Mostly Free 60%–69.9% Moderately Free 50%–59.9% Mostly Unfree 0%–49.9% Repressed Not ranked

Economic Freedom Scores

PACIFIC OCEAN

ATLANTIC OCEAN PACIFIC

OCEAN

INDIAN OCEAN

UNITED KINGDOM

IRELAND

SWEDEN

NORWAY

GERMANY

SPAIN

BOTSWANA

VENEZUELA

URUGUAY

ARGENTINA

COLOMBIA

CHILE

FRANCE

UKRAINE

FINLAND

TURKEY

IR A

Q

SAUDI ARABIA

SOUTH AFRICA

EG YPT

ALGERIA

MALI

BRAZIL

M EXICO

PERU BOLIVIA

NIGER SUDAN

KENYA

IRAN

KAZAKHSTAN MONGOLIA

JAPAN

TAIWAN

AFGHANISTAN

SOUTH KOREA

INDIA

U N I T E D S T A T E S

R U S S I A

C H I N A

C A N A D A

GREENLAND (DENMARK)

A U S T R A L I A

NEW ZEALAND

LIBYA

M A P 3 . 6

Index of economic freedom, 2017.

Source: The Freedom House Survey Team, “Freedom in the World 2016.” www.freedomhouse.org

National Differences in Economic Development Chapter 3 79

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 re- stricted direct investment by foreign enterprises, and limited international trade. Deregula- tion 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 invest- ment by foreign enterprises and international trade.

In mixed economies, the role of the state was more limited; but here, too, in certain sec- tors the state set prices, owned businesses, limited private enterprise, restricted investment by foreigners, and restricted international trade. For these countries, deregulation has in- volved the same kind of initiatives that we have seen in former command economies, al- though 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 econ- omy over the past two decades (see the Country Focus on India).

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 pri- vate 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 indus- try. By allowing other firms to compete head to head with BT, deregulation ensured that privatization did not simply replace a state-owned monopoly with a private monopoly. Since the 1980s, privatization has become a worldwide phenomenon. More than 8,000 acts of privatization were completed around the world between 1995 and 1999.31 Some of the most dramatic privatization programs occurred in the economies of the former Soviet Union and its eastern European satellite states. In the Czech Republic, for example, three- quarters of all state-owned enterprises were privatized between 1989 and 1996, helping push the share of gross domestic product accounted for by the private sector up from 11 percent in 1989 to 60 percent in 1995.32

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 com- panies still dominate the banking, energy, telecommunications, health care, and technol- ogy sectors. Overall, they account for about 40 percent of the country’s GDP. In a report released in early 2012, the World Bank cautioned China that unless it reformed these sectors—liberalizing them and privatizing many state-owned enterprises—the country runs the risk of experiencing a serious economic crisis.33

As privatization has proceeded, it has become clear that simply selling state-owned as- sets to private investors is not enough to guarantee economic growth. Studies of privatiza- tion in central Europe have shown that the process often fails to deliver predicted benefits if the newly privatized firms continue to receive subsidies from the state and if they are protected from foreign competition by barriers to international trade and foreign direct investment.34 In such cases, the newly privatized firms are sheltered from competition and continue acting like state monopolies. When these circumstances prevail, the newly priva- tized entities often have little incentive to restructure their operations to become more ef- ficient. 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

C O U N T R Y F O C U S

80

India’s Economic Transformation After gaining independence from Britain in 1947, India ad- opted 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 sys- tem constrained the growth of the private sector. Private companies could expand only with government permis- sion. It could take years to get permission to diversify into a new product. Much of heavy industry, such as auto, chemi- cal, 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 incapa- ble 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 an- nual 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, and several areas once closed to the private sector were opened, including electricity generation, parts of the oil in- dustry, steelmaking, air transport, and some areas of the telecommunications industry. Investment by foreign enter- prises, formerly allowed only grudgingly and subject to ar- bitrary ceilings, was suddenly welcomed. Approval was made automatic for foreign equity stakes of up to 51 per- cent in an Indian enterprise, and 100 percent foreign own- ership was allowed under certain circumstances. Raw materials and many industrial goods could be freely im- ported, and the maximum tariff that could be levied on im- ports was reduced from 400 percent to 65 percent. The top income tax rate was also reduced, and corporate tax fell from 57.5 percent to 46 percent in 1994, and then to 35 percent in 1997. The government also announced plans to start privatizing India’s state-owned businesses, some 40 percent of which were losing money in the early 1990s. Judged by some measures, the response to these eco- nomic reforms has been impressive. The Indian economy expanded at an annual rate of about 6.3 percent from 1994

to 2004 and then accelerated to 7 to 8 percent annually dur- ing 2005–2014. Foreign investment, a key indicator of how attractive foreign companies thought the Indian economy was, jumped from $150 million in 1991 to a record $34.4 bil- lion in 2014. In the first half of 2015, India overtook both China and the United States to become the top destination for for- eign investment, with $31 billion invested in just six months. In the information technology sector, India has emerged as a vibrant global center for software development with sales of $147 billion and exports of $99 billion in 2015, 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. At- tempts to further reduce import tariffs have been stalled by political opposition from employers, employees, and politi- cians who fear that if barriers come down, a flood of inex- pensive 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 parlia- ment. State-owned firms still account for 38 percent of na- tional output in the non-farm sector, yet India’s private firms are 30 to 40 percent more productive than state-owned enterprises. There has also been strong resistance to re- forming 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 em- ployees to fire workers, creating a disincentive for entre- preneurs 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, Septem- ber 20, 2003, pp. 39–40; Joanna Slater, “Indian Pirates Turned Part- ners,” 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.

National Differences in Economic Development Chapter 3 81

newly privatized entities would face significant competition and thus would have to im- prove their operating efficiency to survive.

LEGAL SYSTEMS

As noted in Chapter 2, a well-functioning market economy requires laws protecting private property rights and providing mechanisms for contract enforcement. Without a legal sys- tem 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 insti- tuting 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 de- mands for restitution from owners in the pre-communist era. Also, although most coun- tries 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.35 Nevertheless, prog- ress 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 on China’s emerging property rights).36

Implications of Changing Political Economy

The global changes in political and economic systems discussed earlier have several impli- cations for international business. The long-standing ideological conflict between collectiv- ism 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 re- mains to be seen, however, whether the global financial crisis of 2008–2009 and the reces- sion 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 enor- mous implications for business. For nearly 50 years, half of the world was off-limits to Western businesses. Now much of that has changed. Many of the national markets of eastern Europe, Latin America, Africa, and Asia may still be underdeveloped, but they are potentially enormous. With a population of more than 1.3 billion, the Chinese market alone is potentially bigger than that of the United States, the European Union, and Japan combined. Similarly, India, with about 1.2 billion people, is a potentially huge market. Latin America has another 600 million potential consumers. It is unlikely that China, Russia, Vietnam, or any of the other states now moving toward a market system will attain the living standards of the West soon. Nevertheless, the upside potential is so large that companies need to consider making inroads now. For example, if China and the United States continue to grow at the rates they did during 1996–2016, 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 democ- racy will thrive in many of the world’s newer democratic states, particularly if these states have to grapple with severe economic setbacks. Totalitarian dictatorships could return, al- though they are unlikely to be of the communist variety. Although the bipolar world of the

TEST PRE P 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.

82 Part 2 National Differences

Cold War era has vanished, it may be replaced by a multipolar world dominated by a num- ber of civilizations. In such a world, much of the economic promise inherent in the global shift toward market-based economic systems may stall in the face of conflicts between civi- lizations. While the long-term potential for economic gain from investment in the world’s new market economies is large, the risks associated with any such investment are also sub- stantial. It would be foolish to ignore these. The financial system in China, for example, is not transparent, and many suspect that Chinese banks hold a high proportion of nonper- forming loans on their books. If true, these bad debts could trigger a significant financial crisis during the next decade in China, which would dramatically lower growth rates.

TEST PRE P 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.

F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

BENEFITS, COSTS, RISKS, AND OVERALL ATTRACTIVENESS OF DOING BUSINESS INTERNATIONALLY

As noted in Chapter 2, the political, economic, and legal environments of a coun- try clearly influence the attractiveness of that country as a market or investment site. In this chapter, we argued that countries with democratic regimes, market-

based economic policies, and strong protection of property rights are more likely to attain high and sustained 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., China and India), low living standards may imply limited purchasing power and, therefore, a relatively small market when measured in economic terms. International businesses need to be aware of this distinction, but they also need to keep in mind the likely future prospects of a country. In 1960, South Korea was viewed as just 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 nec- essary 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.37 (First- mover advantages are the advantages that accrue to early entrants into a market. Late-mover disadvantages are the handicaps that late entrants might suffer.) This kind of reasoning has been driving significant inward investment into China, which may become the world’s 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 estab- lish a sustainable advantage in this nation.

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

National Differences in Economic Development Chapter 3 83

A country’s economic system and property rights regime are reasonably good predictors of economic prospects. Countries with free market economies in which property rights are protected tend to achieve greater economic growth rates than command economies or economies where property rights are poorly protected. It follows that a country’s economic system, property rights regime, and market size (in terms of population) probably constitute reasonably good indicators of the potential long-run benefits of doing business in a country. In contrast, countries where property rights are not well respected and where corruption is rampant tend to have lower levels of economic growth. We must be careful about general- izing too much from this, however, because both China and India have achieved high growth rates despite relatively weak property rights regimes and high levels of corruption. In both countries, the shift toward a market-based economic system has produced large gains de- spite weak property rights and endemic corruption.

Costs A number of political, economic, and legal factors determine the costs of doing business in a country. With regard to political factors, a company may 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 unde- veloped 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 restau- rant 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

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

84 Part 2 National Differences

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.38 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 typi- cally finds expression in strikes, demonstrations, terrorism, and violent conflict. Such unrest is more likely to be found in countries that contain more than one ethnic nationality, in coun- tries where competing ideologies are battling for political control, in countries where eco- nomic mismanagement has created high inflation and falling living standards, or in countries that straddle the “fault lines” between civilizations. Social unrest can result in abrupt changes in government and government policy or, in some cases, in protracted civil strife. Such strife tends to have negative economic implica- tions for the profit goals of business enterprises. For example, in the aftermath of the 1979 Islamic revolution in Iran, the Iranian assets of numerous U.S. companies were seized by the new Iranian government without compensation. Similarly, the violent disintegration of the  Yugoslavian federation into warring states, including Bosnia, Croatia, and Serbia, precipitated a collapse in the local economies and in the profitability of investments in those countries. More generally, a change in political regime can result in the enactment of laws that are less favorable to international business. In Venezuela, for example, the populist socialist politician Hugo Chávez held power from 1998 until his death in 2013. Chávez declared him- self 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 particu- lar business enterprise. Economic risks are not independent of political risk. Economic mis- management 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 visi- ble 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 mismanage- ment 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,

National Differences in Economic Development Chapter 3 85

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 cre- ating 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 safe- guards 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 likeli- hood 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 enter- ing into a long-term contract or joint-venture agreement with a firm in that country. For ex- ample, 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 in- vestment 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 politi- cally 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 but also on likely future economic growth rates. Economic growth appears

Overall Attractiveness

Risks Political Risks: Social Unrest/Antibusiness Trends

Economic Risks: Economic Mismanagement Legal Risks: Failure to Safeguard Property Rights

Benefits Size of Economy

Likely Economic Growth

Costs Corruption

Lack of Infrastructure Legal Costs

F I G U R E 3 .1

Country attractiveness.

86 Part 2 National Differences

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.

gross national income (GNI), p. 64 purchasing power parity

(PPP), p. 64 Human Development Index

(HDI), p. 68

innovation, p. 69 entrepreneurs, p. 70 deregulation, p. 78 first-mover advantages, p. 82 late-mover disadvantages, p. 82

political risk, p. 84 economic risk, p. 84 legal risk, p. 85

Key Terms

C H A P T E R S U M M A R Y

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 func- tion of its political, economic, and legal systems. The chapter made the following points:

1. The rate of economic progress in a country seems to depend on the extent to which that country has a well-functioning market economy in which property rights are protected.

2. Many countries are now in a state of transition. There is a marked shift away from totalitarian governments and command or mixed economic systems and toward democratic political institu- tions 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 never- theless 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 infrastruc- ture 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.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. What is the relationship among property rights, corruption, and economic progress? How impor- tant 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 coun- try seems the most attractive target for foreign direct investment? Why?

3. Reread the Country Focus on India, and answer the following questions:

a.  What kind of economic system did India op- erate under during 1947–1990? What kind of

National Differences in Economic Development Chapter 3 87

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 regula- tions have affected (i) the efficiency of state and private businesses and (ii) the rate of new business formation in India during the 1947–1990 time frame? How do you think these factors affected the rate of economic growth in India during this time frame?

c.  How would privatization, deregulation, and the removal of barriers to foreign direct investment affect the efficiency of business, new business formation, and the rate of

economic growth in India during the post- 1990 time period?

d.  India now has pockets of strengths in key high-technology industries such as software and pharmaceuticals. Why do you think India is developing strength in these areas? How might success in these industries help generate growth in the other sectors of the Indian economy?

e.  Given what is now occurring in the Indian economy, do you think the country repre- sents an attractive target for inward invest- ment by foreign multinationals selling consumer products? Why?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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. As such, your company must evalu- ate these commercial transaction risks for its for- eign 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 simultane- ously. Provide a commercial transaction risk over- view 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 strat- egy. 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 recom- mendations on which countries in each continent would serve as a good candidate for your com- pany to further analyze.

Indonesia is a vast country. Its 260 million people are spread out over some 17,000 islands that span an arc 3,200 miles long from Sumatra in the west to Irian Jaya in the east. It is the most populous Muslim nation—some 86 percent of the population count themselves as Muslims—but it is also one of the most ethnically diverse. More than 500 languages are spoken in the country, and separatists are active in a number of provinces. For 30 years, the strong arm of President Suharto held this sprawling nation together. Suharto was a vir- tual dictator who was backed by the military establish- ment. Under his rule, the Indonesian economy grew

steadily, but there was a cost. Suharto brutally repressed internal dissent. He was also famous for “crony capital- ism,” using his command of the political system to favor the business enterprises of his supporters and family. In the end, Suharto was overtaken by massive debts that Indonesia had accumulated during the 1990s. In 1997, the Indonesian economy went into a tailspin. The Inter- national Monetary Fund stepped in with a $43 billion rescue package. When it was revealed that much of this money found its way into the personal coffers of Suharto and his cronies, people took to the streets in protest, and he was forced to resign.

C L O S I N G C A S E

The Political and Economic Evolution of Indonesia

88 Part 2 National Differences

After Suharto, Indonesia moved rapidly toward a vig- orous democracy. In 2004, the country’s first directly elected president, Susilo Bambang Yudhoyono, took power. Yudhoyono was elected to a second term in 2009. In 2014, he was succeeded by the current president, Joko Widodo. Freedom House, which tracks the state of politi- cal freedom around the world, notes that Indonesia has “free and fair elections,” although they criticize the coun- try for restrictions on civil liberties, freedom of move- ment, and freedom of the press. Freedom House also notes that Indonesia has high levels of public corruption. Transparency International, which ranks countries ac- cording to their level of corruption, has given Indonesia a poor score. It ranked Indonesia 88th out of the 168 na- tions in 2015 with a score of just 36 out of a possible 100. On the economic front, progress has been somewhat halting. Although Indonesia has consistently grown its economy, growth has been at a lower rate than in other large developing nations such as India and China. Eco- nomic liberalism has never really taken hold in Indonesia. Many industries are sheltered from foreign competition by protectionist policies. These policies have their roots in the widespread belief that foreigners have long plun- dered Indonesia’s resources while leaving the country im- poverished. In 2014, the list of industries protected from foreign competition was expanded to include onshore oil extraction and e-commerce. To compound matters, the government has frequently imposed price controls and heavily subsidized certain goods, most notably gasoline, all of which distorts the market mechanism. Moreover, several sectors are still dominated by ineffi- cient state-run enterprises. There are more than 140 state- run enterprises in Indonesia accounting for about 20 percent of the country’s gross domestic product. State- owned enterprises are widespread in energy, power produc- tion, transportation, aviation, agriculture, banking, and telecommunications. The country also suffers from chroni- cally poor infrastructure, much of which is managed by state-owned enterprises. There are simply not enough power stations, roads, ports, and so forth. Indonesia has five times the population of the United Kingdom but only half the power- generating capacity. Due to poor transportation in- frastructure, logistics costs in Indonesia are 50 percent more than in Thailand and twice as much as in Malaysia. In 2014, Indonesia’s new president, Joko Widodo, pledged to liberalize the economy and improve infrastruc- ture. In early 2015, Widodo abolished the state subsidy on gasoline, allowing the market to set prices. The sub-

sidy was costing the government almost $20 billion a year, or 15 percent of total government outlays. Widodo also announced plans to boost public infrastructure, in- vesting in 5 deep-sea and 24 feeder ports, 10 airports, 25 hydroelectric dams, 2,000 kilometers of roads, and 10 industrial parks. These acts were followed by a number of measures designed to deregulate the economy. Import restrictions on some goods were removed, the time required to process investment permits was reduced substantially, and some onerous business regulations were abolished. Widodo has also repeatedly signaled that Indonesia will be more welcoming to foreign investment than hitherto. Despite these measures, Indonesia still faces signifi- cant economic headwinds. One major problem: The economy is overly dependent upon commodities, the prices of which have fallen sharply in the wake of eco- nomic slowdown in China. Then there is the persistently high level of corruption, which continues to burden and distort business activity in the country. There is also no move to reduce the number of state-owned enterprises. Many critics feel that for Indonesia to unleash its full po- tential, it must do more to reduce corruption, privatize inefficient state-owned companies, further deregulate its economy, continue to improve its infrastructure, and do more to attract long-term foreign investors.

Sources: Freedom House, “Freedom in the World 2015”; “A Survey of Indonesia: Time to Deliver,” The Economist, December 11, 2004; “Spicing Up Growth,” The Economist, May 9, 2015; “The Unstimulating Stimulus,” The Economist, October 17, 2015; CIA World Factbook, 2015; Mukul Raheja, “The Dire Need for Reform of Indonesian SOEs,” Jakarta Post, February 26, 2014.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Under the leadership of Suharto, the Indonesian

economy grew at a steady pace. Why was this ultimately not sustainable?

2. Since Suharto was removed, Indonesia has grown its economy at a slower pace than two other large developing nations, India and China. Why do you think this has been the case?

3. What actions could Indonesia take to improve its economic performance? What impediments might make it difficult for the Government to take these actions?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

National Differences in Economic Development Chapter 3 89

E n d n o t e s

 1. World Bank, World Development Indicators Online, 2017.

 2. P. Sinha and N. Singh, “The Economy’s Black Hole,” The Times of India, March 22, 2010. EU estimates for 2012 can be found at http://ec.europa.eu/europe2020/pdf/themes/07_shadow_ economy.pdf.

 3. A. Sen, Development as Freedom (New York: 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).

 8. D. North, Institutions, Institutional Change, and Economic Perfor- mance (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 Prop- erty 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.”

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 2017,” 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, vol. 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., 2017 Index of Economic Freedom (Washington, DC: Heritage Foundation, 2017).

28. International Monetary Fund, World Economic Outlook: Focus on Transition Economies (Geneva: IMF, October 2000).

29. J. C. Brada, “Privatization Is Transition—Is It?” Journal of Economic Perspectives, Spring 1996, pp. 67–86.

30. See S. Zahra et al., “Privatization and Entrepreneurial 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. “China 2030,” World Bank, 2012.

34. 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).

35. M. S. Borish and M. Noel, “Private Sector Development in the Visegrad Countries,” World Bank, March 1997.

36. “Caught between Right and Left,” The Economist, March 8, 2007.

37. For a discussion of first-mover advantages, see M. Liberman and D. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 (Summer Special Issue, 1988), pp. 41–58.

38. S. H. Robock, “Political Risk: Identification and Assessment,” Columbia Journal of World Business, July–August 1971, pp. 6–20.

Differences in Culture L E A R N I N G O B J E C T I V E S Af ter 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.

part two National Dif ferences

4

©PSL Images/Alamy Stock Photo

The Swatch Group and Cultural Uniqueness 

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 al- most always emphasized upfront in the company’s annual report and something the Swatch Group nurtures in vari- ous 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 min- imalist 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 descrip- tion of its brand captures this 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 any- thing. 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 di- verse, or as a company marketing products globally to customers of different cultures. In many respects the com- pany 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 cus- tomer 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 (reuters.com/article/us-swatch- results-idUSKBN16N15B); “The Amazing Adventures of the Second Watch,” Swatch History 2017 (swatch.com/en_us/explore/history); “Swatch Is Challenging Google and Apple with Its Own Operating System,” Fortune, March 16, 2017.

O P E N I N G C A S E The Swatch Group (swatchgroup.com) with its headquar- ters 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 Allge- meine Gesellschaft der Schweizerischen Uhrenindustrie and Société Suisse pour l’Industrie Horlogère. It is now the world’s biggest watchmaker. 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 di- verse. In fact, everything that Swatch engages in is based on diversity and culture. This cultural diversity is embed- ded 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 like Patek Philippe, Rolex, Jaeger-LeCoultre, e.g.) 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 defi- nition, “swatch” means a sample of material or color, often- times 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 inte- grated 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

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92 Part 2 National Differences

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 compa- ny’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 under- standing 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 deals with precisely this point. 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 up country- specific cultures that make people different from each other as well as personal character- istics that people draw from to showcase his or her individualized Swatch use. They even encourage the sharing of this individuality via the tag #MySwatch and #YourMove. In this Chapter 4, we make a case that it is important for foreign businesses to gain an under- standing of the culture that prevails in countries where they do business and that success requires a foreign enterprise to adapt, at least to some degree for most products and ser- vices, to the macro (overall) culture of its host country as well as dominant subcultures within the country.3

Another theme developed in this chapter is that a relationship may exist between cul- ture 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 selling to customers (i.e., where supply and demand set the prices for products and services). For example, some observers have argued that cultural factors lowered the costs of doing busi- ness in Japan and helped explain Japan’s rapid economic ascent during when they became 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 Great Britain found it difficult to achieve cooperation between management and labor. Class di- visions led to a high level of industrial disputes in that country during the same time pe- riod that Japan was developing into a global force. This raised the costs of doing business relative to the costs in countries such as Germany, Japan, Norway, Sweden, and Switzerland, where class conflict was historically less prevalent.

The examples of Japan and Great Britain bring us to another theme we explore in this chapter. Culture is not static. Culture is rooted in the values and norms 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 way. Culture can and does evolve, although the rate at which culture can change is the subject of some dispute (e.g., how easy or often do we change habits?). Generally, culture evolves as behaviors of people become ingrained in their values and norms. This means that after some time, when a person has behaved a certain way for a while, that person (and perhaps people around that person) adopts a cultural mindset consistent with the type of behavior illustrated by the person’s actions.

Your own personal cultural values and norms are one thing; they are definitely hard to change. The same goes for culture in society, which evolves when large population seg- ments in a country or region adopt cultural values based on common ways of behaving. Finally, it is not enough to think about your own personal cultural values and norms or

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.

Differences in Culture Chapter 4 93

those macro issues in a country’s society (or of its subcultures); multinational corpora- tions can themselves be the structure for cultural values and norms. Many people operate a certain way in their personal lives, a different way at work, and yet a different way in so- ciety. This is not to say that there are not overlaps—some people use the same values and norms across the personal–company–society boundaries—but many people also act differ- ently in each place.

What Is Culture?

As people, we have a hard time even agreeing on on a simple definition of culture. This makes it tough to study and understand culture and build it into companies’ global opera- tions. In the 1870s, anthropologist Edward Tylor defined culture as “that complex whole which includes knowledge, belief, art, morals, law, custom, and other capabilities acquired by man as a member of society.”5 Since then, thousands of other definitions have been offered by diverse sets of people—but that draws from the general notion that culture actually affects how different people define culture itself!

Florence Kluckhohn and Fred Strodtbeck’s values orientation theory of culture illus- trates that all culture definitions must answer a limited number of universal problems, that the value-based solutions are limited in number and universally known, and that different cultures have different preferences among them.6 Following their work, other prominent culture specialists have supported the idea of a universal set of human values serving as the basis for culture, such as Milton Rokeach with his work on “the nature of human values” and Shalom Schwartz with his work on the “theory of basic human values.”7

Also supportive of this 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, in this sense, 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 dif- ferently, values are shared assumptions about how things ought to be.11 By norms, we mean the social rules and guidelines that pre- scribe 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 (i.e., they sup- port multiple 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 cultur- ally being one society for the purpose of a multinational corpora- tion 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.

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

LO 4 -1 Explain what is meant by the culture of a society.

Geert Hofstede. Often viewed as the foremost expert on cross-cultural differences in international busi- ness, presents his work in Istanbul, Turkey at the Academy of International Business conference. Courtesy of Academy of International Business

94 Part 2 National Differences

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 con- siderable 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 soci- ety. As we saw in Chapter 2, democratic free market capitalism is a reflection of a philo- sophical value system that emphasizes individual freedom.12

Norms are the social rules that govern people’s actions toward one another. 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 signifi- cance. 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, vio- lation 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. How- ever, traveling managers are increasingly expected to know about specific dress codes, so- cial and professional manners, eating with the correct utensils, and business etiquette. The evolution of norms now demand that business partners at least try to behave according to the folkways norms in the country in which they are doing business.

An example of folkways that perhaps is not immediately thought of as a culture issue is people’s attitudes toward time. People are very aware of what time it is, the passage of time, and the importance of time in, for example, the United States and northern Euro- pean cultures such as Germany, Netherlands, and the Scandinavian countries (Denmark, Finland, Iceland, Norway, and Sweden). In these cultures, businesspeople are very con- scious 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.

In 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 inter- action 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 some- where “tomorrow” might mean next week. Like Latin Americans, many Saudis are un- likely to understand Westerners’ obsession with precise times and schedules.

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 rit- ual 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 soci- ety 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 ex- pected 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

Differences in Culture Chapter 4 95

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 is a term that refers to norms that are more widely observed, have greater moral significance than other norms, and are central to the functioning of a society and to its social life. This means that mores have a much greater significance than folkways. Violat- ing mores can bring serious retribution, ill will, and the collapse of any business deal. Mores include such drastic factors as indictments against theft, adultery, incest, and can- nibalism. In many societies, certain mores are so drastic that they have been enacted into law. For example, all advanced societies have laws against theft, incest, and cannibalism. However, there are also many mores that 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). 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 in if they do not flaunt it. In some way, mores are being implemented differently depending on where you are and who you are.

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 these nation-states are often studied for their “national identity,” “na- tional character,” and even “competitive advantage of nations,” in reality they may contain a single culture or several subcultures.14 Representative of a single culture setting, the French nation can be thought of as the political embodiment of French culture. However, the nation of Canada has at least three cultures—an Anglo culture, a French-speaking “Quebecois” culture, and a Native American culture. Similarly, many of the 55 African nations have important cultural differences among tribal groups, as 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, and Tamils).

Cultures can also embrace several nations, as our discussion about the Scandinavian countries of Denmark, Finland, Iceland, Norway, and Sweden indicated. Additionally, many people make a strong case that we can consider an Islamic society as a culture that is shared by the citizens of many different nations in the Middle East, Asia, and Africa. In today’s world, though, we have begun to see nuances to the Islamic world—those who ad- here to various degrees, or 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 abide by these cultural nuances, businesspeople need to be aware of the delicate issues that pertain

96 Part 2 National Differences

to folkways, and they also need to make sure not to violate mores in the country in which they intend to do business. Increased globalization has meant an increased number of busi- ness relationships across countries and cultures but not necessarily an increased cultural understanding. Culture is still a complex phenomenon with multiple dimensions and multiple levels.16

DETERMINANTS OF CULTURE

The values and norms of a culture do not emerge fully formed. They evolve over time in response to a number of factors, 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 philoso- phies 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 accord- ing 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 in- fluence the values and norms of a society, the values and norms of a society can influence social structure and religion.

Social Structure

A society’s social structure refers to its basic social organization. In essence, we are talk- ing 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 treats each other as people, groups, companies, and so on, is both emergent from and a determinant of the behaviors of individuals in the specific society. Although the social structure consists of many differ- ent aspects, two dimensions are particularly important when explaining differences among cultures. The first is the degree to which the basic unit of a social organization is the indi- vidual, 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 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

LO 4 -2 Identify the forces that lead to differences in social culture.

F I G U R E 4 .1

Determinants of culture.

Social St ructure

Culture Norms and Value Systems

Language

Political Philosophy

Economic Philosophy

Education

Religion

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Differences in Culture Chapter 4 97

(e.g., India); other societies are characterized by a low degree of social stratification and high mobility between strata (e.g., 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 ex- pectations 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. In a way, social media have expanded the boundaries and what is included in group life and placed an added emphasis on what we can call the 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 ex- ample, consumers are significantly more likely to buy from the brands they follow on Instagram, Twitter, Facebook, or LinkedIn, or that they get exposed to via Snapchat, due to group influences. However, while groups are found in all societies, some societies differ according to the degree to which the group is viewed as the primary means of social orga- nization.18 In some societies, individual attributes and achievements are viewed as being more important than group membership; in others, the reverse is true.

The Individual In Chapter 2, we discussed individualism as a political philosophy. However, individualism is more than just an abstract political philosophy. In many Western societies, the individ- ual is the basic building block of social organization. This is reflected not just in the politi- cal 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 individu- als 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 “indepen- dent 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 sci- ence, the label “star scientist” has become synonymous with these individualistic 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 admira- tion 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 (e.g., personal computers, photocopiers, computer software, biotechnology, supermarkets, and discount retail stores). One can argue that the dynamism of the U.S. economy owes much to the philosophy of individualism. Highly individualistic societies are often synonymous with people who are capable and have the capacity to constantly innovate by their creative ideas for products and services.

Individualism also finds expression in a high degree of managerial mobility between companies, as our “personal brand” example illustrated earlier, and this is not always a good thing. Although moving from company to company may be good for individual man- agers who are trying to build impressive résumés and increase their salaries, it is not neces- sarily 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

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98 Part 2 National Differences

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 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.

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 every- day 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, for example, is the impor- tance 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 achieve- ments 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, to move from company to company. Lifetime employment in a particular company was long the norm in certain sectors of the Japanese economy (esti- mates 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 the recent decade, 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 char- acterized 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

Differences in Culture Chapter 4 99

consequences are unclear, one implication is that the United States could continue to cre- ate 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 exists 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 In fact, 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 (i.e., taking the idea to the market).

SOCIAL STRATIFICATION

All societies are stratified on a hierarchical basis into social categories—that is, into social strata. These strata are typically defined on the basis of socioeconomic characteristics such as family background, occupation, and income. Individuals are born into a particular stratum. They become a member of the social category to which their parents belong. In- dividuals 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 sys- tem of stratification in which social position is determined by the family into which a per- son 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 occupa- tions are embedded in the caste and passed down through the family to succeeding genera- tions. Although the number of societies with caste systems diminished rapidly during the twentieth century, one partial example still remains. India has four main castes and several thousand subcastes. Even though the caste system was officially abolished in 1949, two years after India became independent, it is still a force in rural Indian society where occu- pation 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

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C O U N T R Y F O C U S

100

Modern India is a country of dramatic contrasts. The coun- try’s information technology (IT) sector is among the most vibrant in the world, with companies such as Tata Consul- tancy Services, Cognizant Technology Solutions, Infosys, and Wipro as powerful global players. Cognizant is an in- teresting company in that it was founded as a technology arm of Dun & Bradstreet (USA), but it is typically consid- ered an Indian IT company because a majority of its em- ployees are based in India. In fact, many IT companies locate or operate in India because of its strong IT knowl- edge, 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 discrim- ination against lower castes is illegal. India has also en- acted 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 socioeco- nomic 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 econ- omy. 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 en- tered 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 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 historic 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. Pri- vate employers are resisting attempts to impose quotas, arguing with some justification that people who are guar- anteed 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 un- less 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 Confeder- ation 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 Democ- racy,” Bloomberg View, January 8, 2017; “Why Some of India’s Castes Demand to Be Reclassified,” The Economist, February 16, 2016.

India and Its Caste System

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, mana- gerial, 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

Differences in Culture Chapter 4 101

class, whose members were involved in important managerial occupations and the prestigious professions (e.g., lawyers, accountants, doctors), and the lower-middle class, whose members were involved in clerical work (e.g., bank tellers) and the less prestigious professions (e.g., schoolteachers).

The British class system exhibited significant divergence between the life chances of members of different classes. The upper and upper-middle classes typically sent their 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 be- hind this class structure and moving toward a classless society. However, sociologists con- tinue 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 presti- gious 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 registra- tion that restricted most Chinese to the place of their birth for their lifetime. Bound to collective farming, peasants were cut off from many urban privileges—compulsory educa- tion, 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 peas- ant laborers have flooded into China’s cities looking for work. Sociologists now hypothe- size 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 ori- gins are highly respected in American society.

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 mobil- ity 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

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102 Part 2 National Differences

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 man- agement 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 conscious- ness 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 pro- duction 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.

Religious and Ethical Systems

Religion may be defined as a system of shared beliefs and rituals that are concerned with the realm of the sacred.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 dom- inant 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.

Some scholars have theorized that the most important business implications of re- ligion center on the extent to which different religions shape attitudes toward work and entrepreneurship and the degree to which the religious ethics affects the costs of doing business in a country. However, it is hazardous to make sweeping generaliza- tions about the nature of the relationship between religion and ethical systems and business practice. While some professionals argue that there is a relationship between religious and ethical systems and business practice in a society, in a world where na- tions with Catholic, Protestant, Muslim, Hindu, and Buddhist majorities all show evi- dence of entrepreneurial activity and sustainable economic growth, it is important to view such proposed relationships with a degree of skepticism. The proposed relation- ships 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

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Differences in Culture Chapter 4 103

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 stimu- late 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 fol- lowers. 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 impor- tance in several countries (e.g., Greece and Russia). In the sixteenth century, the Reforma- tion led to a further split with Rome; the result was Protestantism. The nonconformist nature of Protestantism has facilitated the emergence of numerous denominations under the Protestant umbrella (e.g., Baptist, Methodist, Calvinist).

PACIFIC OCEAN

ARCTIC OCEAN

ARCTIC OCEAN

PACIFIC OCEAN

ATLANTIC OCEAN

INDIAN OCEAN

M C

C

C

J H

C

M

J

J

M

J

M

M

M C

B

MH

C C

C

J

J

HM H

J J

1000

0

0

1000 2000 Miles

2000 3000 Kilometers Scale: 1 to 190,080,000

PA

C

IFICPA

CIFIC

ACIFICOCCEAN

AR

CTICOCEANARCCTI

C

OCEEANCIFICCIFICPA

C

CCE

AN

OOCCCCTLANNTICTLANTLANNTICNAAAOCEOOEANNOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOODINDDIIANOCEANEANEEANNMMCCCCCCCCCCCCJHCMMMMMMMMMMMMMMMMMMMJJJJJJJJMJJJJJJJJJJJJJMMMMMMMMMMMMMCBMMMMMMMHHHCCCCCCCCCCCCCCCCCCCCCCCCCJJHHHHHHHHHHHHHHHHHMMMMMMMMMMMMMMMMMMMMMMMMMHHHHHHHJJJ10000010002000

Miles

20003000

Kilometer

sSc

a

le:

1

to 190,080,000Christianity (C)*

Predominant Religions

Islam (M) Sunni

Shi’a

Buddhism (B) Hinayanistic

Lamaistic

Hinduism (H)

Judaism (J)

Sikhism

Animism (tribal)

Chinese complex (Confucianism, Taoism, and Buddhism) Korean complex (Buddhism, Confucianism, Christianity, and Chondogyo) Japanese complex (Shinto and Buddhism) Vietnamese complex (Buddhism, Taoism, Confucianism, and Cao Dai)

* Capital letters indicate the presence of locally important minority adherents of nonpredominant faiths.

Unpopulated regions

Roman Catholic

Protestant

Mormon (LDS)

Eastern churches

Mixed sects

M A P 4 .1

World religions.

Source: “Map 14,” Allen, John L., Student Atlas of World Politics, 10th ed. McGraw-Hill Education.

104 Part 2 National Differences

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 emer- gence 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 enter- prises. 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 capi- talism in western Europe and subsequently in the United States. In contrast, Weber argued that the Catholic promise of salvation in the next world, rather than this world, did not foster the same kind of work ethic.

Protestantism also may have encouraged capitalism’s development in another way. By breaking away from the hierarchical domination of religious and social life that character- ized the Catholic Church for much of its history, Protestantism gave individuals signifi- cantly more freedom to develop their own relationship with God. The right to freedom of form of worship was central to the nonconformist nature of early Protestantism. This emphasis on individual religious freedom may have paved the way for the subsequent emphasis on individual economic and political freedoms and the development of indi- vidualism as an economic and political philosophy. As we saw in Chapter 2, such a phi- losophy forms the bedrock on which entrepreneurial free market capitalism is based. Building on this, some scholars claim there is a connection between individualism, as in- spired by Protestantism, and the extent of entrepreneurial activity in a nation.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

With about 1.60 billion adherents, Islam is the second largest of the world’s major reli- gions. Islam dates to a.d. 610 when the Prophet Muhammad began spreading the word, although the Muslim calendar begins in a.d. 622 when, to escape growing opposition, Muhammad left Mecca for the oasis settlement of Yathrib, later known as Medina. Adher- ents 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

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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) respect- ing the rights of others, (3) being generous but not a squanderer, (4) avoiding killing ex- cept 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 or- phans, 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 eco- nomic activities. Religion is paramount in all areas of life. The Muslim lives in a social structure that is shaped by Islamic values and norms of moral conduct. The ritual nature of everyday life in a Muslim country is striking to a Western visitor. Among other things, orthodox Muslim ritual requires prayer five times a day (business meetings may be put on hold while the Muslim participants engage in their daily prayer ritual), demands that women should be dressed in a certain manner, and forbids the consumption of pork and alcohol.

Islamic Fundamentalism The past three decades have witnessed the growth of a social movement often referred to as Islamic fundamentalism.39 In the West, Islamic fundamentalism is associated in the media with militants, terrorists, and violent upheavals, such as the bloody conflict occur- ring 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 characteriza- tion 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 fur- ther their own political and violent ends perpetrates the violence that the Western me- dia 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 fundamental- ists 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 tradi- tional 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 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 funda- mentalists’ actions are directed against Western governments, cultural symbols, businesses, and even individuals.

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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 the Islam doctrine. Islam makes no distinction between church and state. It is not just a religion; Islam is also the source of law, a guide to state- craft, and an arbiter of social behavior. Muslims believe that every human endeavor is within the purview of the faith—and this includes political activity—because the only pur- pose 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 coun- tries, such as Afghanistan, Algeria, Egypt, Pakistan, Saudi Arabia, and the Sudan.

Economic Implications of Islam The Koran establishes some explicit economic principles, many of which are pro–free enterprise.42 The Koran speaks approvingly of free 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 own- ers 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 ref lects 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 obliga- tions 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 about the region around Kayseri in central Turkey.

Given the Islamic proclivity to favor market-based systems, Muslim countries are likely to be receptive to international businesses as long as those businesses behave in a manner that is consistent with Islamic ethics, customs, and business practices. Businesses that are perceived as making an unjust profit through the exploitation of others, by deception, or by breaking contractual obligations are unlikely to be welcomed in an Islamic country. In addition, in Islamic countries where fundamentalism is on the rise, hostility toward Western- owned businesses is likely to increase.

One economic principle of Islam prohibits the payment or receipt of interest, which is considered usury. This is not just a matter of theology; in several Islamic states, it is also a matter of law. The Koran clearly condemns interest, which is called riba in Arabic, as ex- ploitative and unjust. For many years, banks operating in Islamic countries conveniently 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 the Sudan enforce Islamic banking conventions, in an increasing number of countries, customers can choose between conventional banks and Islamic banks.

Conventional banks make a profit on the spread between the interest rate they have to pay to depositors and the higher interest rate they charge borrowers. Because Islamic banks cannot pay or charge interest, they must find a different way of making money. Islamic banks have experimented with two different banking methods—the mudarabah and the murabaha.44

LO 4 -3 Identify the business and economic implications of differences in culture.

C O U N T R Y F O C U S

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 conse- quence, allowing Turkey into the EU would be a mistake. However, a close look at what is going on in Turkey sug- gests this view may be misplaced. Consider the area around the city of Kayseri in central Turkey. Many dismiss this poor, largely agricultural region of Turkey as a non- European backwater, far removed from the secular bustle of Istanbul. It is a region where traditional Islamic values hold sway. And yet it is a region that has produced so many thriving Muslim enterprises that it is sometimes called the “Anatolian Tiger.” Businesses based here in- clude large food manufacturers, textile companies, furni- ture manufacturers, and engineering enterprises, many of which export a substantial percentage of their production. Local business leaders attribute the success of compa- nies 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 observ- ers 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 asso- ciated 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 man- aging director of Ipek, the largest furniture producer in the region (which exports to more than 30 countries), says an- other force is at work: globalization! According to Arslan, over the past three decades, local Muslims who once es- chewed 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 Sta- bility Initiative, the same group that holds up the Kayseri region as an example of Islamic Calvinism, the low partici- pation 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.

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A mudarabah contract is similar to a profit-sharing scheme. Under mudarabah, when an Islamic bank lends money to a busi- ness, 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 Is- lamic 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 invest- ment (as opposed to interest payments) according to an agreed- upon ratio. Some Muslims claim this is a more efficient system than the Western banking system because it encourages both 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.

An Islamic bank in Baghdad, Iraq. ©ALI AL-SAADI/Getty Images

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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 func- tionally equivalent to an interest payment, and it is the similarity between this method and conventional banking that makes it so much easier to adopt.

HINDUISM 

Hinduism has approximately 1.10 billion adherents, most of them on the Indian subconti- nent. 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 lon- ger necessary. Many Hindus believe that the way to achieve nirvana is to lead a severe ascetic lifestyle of material and physical self-denial, devoting life to a spiritual rather than material quest.

Economic Implications of Hinduism Max Weber, famous for expounding on the Protestant work ethic, also argued that the as- cetic principles embedded in Hinduism do not encourage the kind of entrepreneurial activ- ity 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 entre- preneurial activity than devout Protestants.

LO 4 -2 Identify the forces that lead to differences in social culture.

LO 4 -3 Identify the business and economic implications of differences in culture.

C U LT U R E O N G L O B A L E D G E

The “Culture” section of globalEDGETM (globaledge.msu.edu/global-resources/culture) of- fers a variety of sources, information, and data on culture and international business. In ad- dition, the “Insights by Country” section (globaledge.msu.edu/global-insights/by/country), with coverage of more than 200 countries, has country-specific culture issues (e.g., what to do and not to do when visiting a country). These globalEDGE culture resources are great complements to the material in Chapter 4. In this chapter, we cover a lot of material on cul- ture, and Geert Hofstede’s research has been the most influential on culture and business. globalEDGE has “The Hofstede Centre” as one of its cultural reference sources. This refer- ence 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.

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Mahatma Gandhi, the famous Indian nationalist and spiritual leader, was certainly the embodiment of Hindu asceticism. It has been argued that the values of Hindu asceticism and self-reliance that Gandhi advocated had a negative impact on the economic develop- ment of 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 earlier in the chapter, it still casts a long shadow over Indian life.

BUDDHISM

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 empha- sizes right seeing, thinking, speech, action, living, effort, mindfulness, and meditation. Unlike Hinduism, Buddhism does not support the caste system. Nor does Buddhism advo- cate the kind of extreme ascetic behavior that is encouraged by Hinduism. Nevertheless, like Hindus, Buddhists stress the afterlife and spiritual achievement rather than involve- ment in this world.

Economic Implications of Buddhism The emphasis on wealth creation that is embedded in Protestantism is historically not found in Buddhism. Thus, in Buddhist 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 sug- gests that a Buddhist society may represent a more fertile ground for entrepreneurial activ- ity 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

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LO 4 -3 Identify the business and economic implications of differences in culture.

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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 f lash—perhaps while you’re plugged into the earphones of your ZEN MP3 player, available from Creative.”50

CONFUSIANISM

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, Confucian- ism 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 reli- gions, Confucianism is not concerned with the supernatural and has little to say about the concept of a supreme being or an afterlife.

Economic Implications of Confucianism Some scholars maintain that 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 abso- lute obligation. In modern organizations based in Confucian cultures, the loyalty that binds employees to the heads of their organization can reduce the conflict between man- agement and labor that we find in more class-conscious societies. Cooperation between management and labor can be achieved at a lower cost in a culture where the virtue of loyalty is emphasized in the value systems.

However, in a Confucian culture, loyalty to one’s superiors, such as a worker’s loyalty to management, is not blind loyalty. The concept of reciprocal obligations is important. Con- fucian ethics stresses that superiors are obliged to reward the loyalty of their subordinates by bestowing blessings on them. If these “blessings” are not forthcoming, then neither will be the loyalty. This Confucian ethic is central to the Chinese concept of guanxi, which re- fers to relationship networks supported by reciprocal obligations.53 Guanxi means relation- ships, although in business settings it can be better understood as connections. Today, Chinese will often cultivate a guanxiwang, or “relationship network,” for help. Reciprocal obligations are the glue that holds such networks together. If those obligations are not met—if favors done are not paid back or reciprocated—the reputation of the transgressor is tarnished, and the person will be less able to draw on his or her guanxiwang for help in the future. Thus, the implicit threat of social sanctions is often sufficient to ensure that favors are repaid, obligations are met, and relationships are honored. In a society that lacks a rule-based legal tradition, and thus legal ways of redressing wrongs such as violations of business agreements, guanxi is an important mechanism for building long-term business relationships and getting business done in China. For an example of the importance of guanxi, read the Management Focus on China.

A third concept found in Confucian ethics is the importance attached to honesty. Con- fucian thinkers emphasize that although dishonest behavior may yield short-term benefits

LO 4 -2 Identify the forces that lead to differences in social culture.

LO 4 -3 Identify the business and economic implications of differences in culture.

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By 2009, DMG had emerged as one of China’s fastest- growing advertising agencies with a client list that includes Budweiser, Unilever, Sony, Nabisco, Audi, Volkswagen, China Mobile, and dozens of other Chinese brands. 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

China and Its Guanxi revolution in favor of simplified versions. To get permission to use the characters in film and print ads—a first in mod- ern 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 dis- tributing 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 in 2009. This is 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.

*Source: 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; Simon Montlake, “Hollywood’s Mr China: Dan Mintz, DMG,” Forbes, August 29, 2012.

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 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

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other not to violate the terms of cooperative agreements. Thus, the costs of achieving co- operation 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 de- sign. 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 obliga- tions is central to the workings and persistence of guanxi networks in China.

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 defin- ing 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 na- ture 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 cul- ture. 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 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 continuously engage in some level of conf lict. 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 (e.g., witness the har- mony in Switzerland, where four languages are spoken), there certainly seems to be a tendency in this direction.56

Mandarin (Chinese) is the mother tongue of the largest number of people, followed by English and Hindi, which is spoken in India. However, the most widely spoken language in the world is English, followed by French, Spanish, and Mandarin (i.e., many people speak English as a second language). And, importantly, English is increasingly becoming the language of international business throughout the world, as it has been in much of the de- veloped 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

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can build rapport and goodwill, which may be very important for a business deal. Interna- tional 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 China took it literally to mean “bring your ancestors back from the grave.”

UNSPOKEN LANGUAGE

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 recog- nition 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 indi- cate that “it’s all right,” in Greece the gesture is obscene.

Another aspect of nonverbal communication is personal space, which is the comfort- able 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 back- ing away as aloofness. The result can be a regrettable lack of rapport between two business- people from different cultures.

Education

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 cur- riculum” 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

LO 4 -2 Identify the forces that lead to differences in social culture.

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114 Part 2 National Differences

School Professor Michael Porter notes that after the last World War, Japan had almost nothing except for a pool of skilled and educated human resources:

With a long tradition of respect for education that borders on reverence, Japan possessed a large pool of literate, educated, and increasingly skilled human resources. . . . Japan has ben- efited from a large pool of trained engineers. Japanese universities graduate many more engi- neers 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. Pri- mary 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 explain- ing the country’s postwar economic success. Not only is a good education system a deter- minant of national competitive advantage, but it is also an important factor guiding the 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, promo- tional 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.

Culture and Business

Of considerable importance for a multinational corporation, or any company—small, me- dium 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 ac- cording 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 both 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 under- taken 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. Re- spondents 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 dimen- sions that he claimed summarized the different cultures62—power distance, uncertainty avoidance, individualism versus collectivism, and masculinity versus femininity—and then, later on, he added a fifth dimension inspired by Confucianism that he called long-term versus short-term orientation.63

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 re- search, 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.

LO 4 - 4 Recognize how differences in social culture influence values in business.

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Differences in Culture Chapter 4 115

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 individu- als were loose, and individual achievement and freedom were highly valued. In societies where collectivism was emphasized, the ties between individuals were tight. In such societ- ies, people were born into collectives, such as extended families, and everyone was sup- posed 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 un- certainty. Members of high uncertainty avoidance cultures placed a premium on job secu- rity, 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 character- ized by a greater readiness to take risks and less emotional resistance to change.

Hofstede’s masculinity versus femininity dimension looked at the relationship be- tween 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 distin- guished, and little differentiation was made between men and women in the same job.

The long-term versus short-term orientation dimension refers to the extent to which a culture programs its citizens to accept delayed gratification of their material, social, and emotional needs. It captures attitudes toward time, persistence, ordering by status, protec- tion of face, respect for tradition, and reciprocation of gifts and favors. The label refers to these “values” being derived from Confucian teachings.

Hofstede created an index score for each of these five dimensions that ranged from 0 to 100 and scored high for 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.

Recently, there has been a strong scholarly movement to add a sixth dimension to Hofstede’s work. Geert Hofstede, working with Michael Minkov’s analysis of the World Values Survey, added a promising new dimension called indulgence versus restraint (IND) in 2010.66 On January 17, 2011, Hofstede delivered a webinar for SIETAR Europe called “New Software of the Mind” to introduce the third edition of Cultures and Organizations, in which the results of Minkov’s analysis were included to support this sixth dimension. In addition, in a keynote delivered at the annual meeting of the Academy of International Business (http://aib.msu.edu) in Istanbul, Turkey, on July 6, 2013, Hofstede again pre- sented results and theoretical rationale to support the indulgence versus restraint dimen- sion. 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 col- lected 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

116 Part 2 National Differences

Japan’s culture has strong uncertainty avoidance and high masculinity. This characteriza- tion 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 mascu- linity (high emphasis on “feminine” values).

Hofstede’s results are interesting for what they tell us in a very general way about differ- ences between cultures. Many of Hofstede’s findings are consistent with standard stereo- types 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 cor- respondence between culture and the nation-state, but as we discussed earlier, many coun- tries 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 con- firm 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

Power Distance

Uncertainty Avoidance

Individualism

Masculinity

Long-Term Orientation

Australia 36 51 90 61 31

Brazil 69 76 38 49 65

Canada 39 48 80 52 23

Germany (F.R.) 35 65 67 66 31

United Kingdom 35 35 89 66 25

India 77 40 48 56 61

Japan 54 92 46 95 80

Netherlands 38 53 80 14 44

New Zealand 22 49 79 58 30

Pakistan 55 70 14 50 00

Philippines 94 44 32 64 19

Singapore 74 8 20 48 48

Sweden 31 29 71 5 33

Thailand 64 64 20 34 56

United States 40 46 91 62 29

TA B L E 4 .1

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.

Differences in Culture Chapter 4 117

and employee selection procedures, making it possible that the employees’ values were dif- ferent in important respects from the values of the cultures from which those employees came, as we also pointed out earlier.

Still, Hofstede’s work is the leading research the world has seen on culture. As such, 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 individu- als 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 busi- ness-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 or- ganizations build on findings by Hofstede and other culture researchers. The GLOBE research established nine cultural dimensions: power distance, uncertainty avoidance, hu- mane 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 reli- gion 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 cul- ture 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 addi- tional validation and connection to work-related values, business, and marketplace issues. At the same time, the factors discussed in Chapters 2 and 3—economic, political, and legal systems—are probably more important than culture in explaining differential economic growth rates over time.

Cultural Change

An important point we want to make in this chapter on culture is that culture is not a con- stant; it evolves over time.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 corpora- tions 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 2015, 23 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.

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118 Part 2 National Differences

For another illustration of cultural change, consider Japan. Some business profes- sionals 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 character- ized 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 genera- tion 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 richer, the cultural emphasis on collectiv- ism 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 col- lectivism declines, while greater economic freedoms lead to an increase in opportunities for expressing individualism.

The culture of societies may also change as they become richer because economic prog- ress affects a number of other factors, which in turn influence culture. For example, in- creased urbanization and improvements in the quality and availability of education are both a function of economic progress, and both can lead to declining emphasis on the traditional values associated with poor rural societies. The World Values Survey, which we mentioned earlier, has documented how values change. The study linked these changes in values to changes in a country’s level of economic development.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 inter- national 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 ubiq- uitous 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 uni- versally 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 to- ward Islamic fundamentalism in several countries; the continual separatist movement in Quebec, Canada; ethnic strains and separatist movements in Russia; nationalist move- ments in the United Kingdom (e.g., Brexit); and the election of a populist, nationally ori- ented 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 materi- alistic 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.

General Motors Chair and CEO, Mary Barra, making an announcement about the Chevrolet Bolt autonomous vehicles at a news conference in Detroit, Michigan. ©Rebecca Cook/Reuters

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Differences in Culture Chapter 4 119

F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

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 differ- ences exist but also to appreciate what such differences mean for international busi-

ness. 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 re- quires 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, structure of the organization, name of a product, tenor of relations between management and labor, 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 differ- ences in culture affect the practice of business. Transferring executives globally at regu- lar 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 dan- gers 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 prob- lems in Germany, where a cultural tendency toward correcting strangers can shock and of- fend 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 execu- tives 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 pres- sure. 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

120 Part 2 National Differences

shows up late to a meeting because he met a friend in the street and stopped to talk. The American, of course, is very concerned about time and scheduling. But for the Arab, finish- ing 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 relation- ship 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 advan- tage. 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 reli- gion. 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. Also, 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 en- courages 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 entre- preneurship and innovation are highly valued, such as computer software and biotechnol- ogy. 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 pro- duce the most viable competitors. For example, we might argue that U.S. enterprises are likely to see continued growth in aggressive, cost-efficient competitors from those Pacific Rim nations where a combination of free market economics, Confucian ideology, group- oriented social structures, and advanced education systems can all be found (e.g., South Korea, Taiwan, Japan, and, increasingly, China). Second, the connection between culture and competitive advantage has important implications for the choice of countries in which to locate production facilities and do business. Consider a hypothetical case where a company has to choose between two countries, A and B, for locating a production facility. Both countries are characterized by low labor costs and good access to world markets. Both countries are of roughly the same size (in terms of population), and both are at a similar stage of economic development. In country A, the edu- cation system is underdeveloped, the society is characterized by a marked stratification

Differences in Culture Chapter 4 121

between the upper and lower classes, and there are six major linguistic groups. In country B, the education system is well developed, social stratification is lacking, group identification is valued by the culture, and there is only one linguistic group. Which country makes the best investment site? Country B probably does. In country A, conflict between management and labor, and between different language groups, can be expected to lead to social and industrial disrup- tion, thereby raising the costs of doing business.84 The lack of a good education system also can be expected to work against the attainment of business goals. The same kind of com- parison could be made for an international business trying to decide where to push its prod- ucts, 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 overem- phasize their importance in the economic sphere. For example, earlier we noted that Max Weber argued that the ascetic principles embedded in Hinduism do not encourage en- trepreneurial activity. While this is an interesting academic thesis, recent years have seen an increase in entrepreneurial activity in India, particularly in the information technology sector, where India is rapidly becoming an important global player. The ascetic principles of Hinduism and caste-based social stratification have apparently not held back entrepre- neurial activity in this sector.

cross-cultural literacy, p. 92 culture, p. 93 values, p. 93 norms, p. 93 society, p. 93 folkways, p. 94 mores, p. 95 social structure, p. 96

group, p. 97 social strata, p. 99 social mobility, p. 99 caste system, p. 99 class system, p. 99 class consciousness, p. 102 religion, p. 102 ethical system, p. 102

power distance, p. 115 individualism versus

collectivism, p. 115 uncertainty avoidance, p. 115 masculinity versus femininity, p. 115 long-term versus short-term

orientation, p. 115 ethnocentrism, p. 119

Key Terms

C H A P T E R S U M M A R Y

This chapter 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, re- ligion, 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

122 Part 2 National Differences

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 so- cieties 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 character- ized 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 reli- gions are Christianity, Islam, Hinduism, and Buddhism. The value systems of different reli- gious and ethical systems have different implica- tions 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 dimen- sions 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 nation- als, build a cadre of cosmopolitan executives, and guard against the dangers of ethnocentric behavior.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

 1. Outline why the culture of a country might influ- ence the costs of doing business in that country. Illustrate your answer with examples.

 2. Do you think that business practices in an Is- lamic country are likely to differ from business practices in a Christian country? If so, how?

 3. Choose two countries that appear to be cultur- ally diverse. Compare the cultures of those coun- tries, and then indicate how cultural differences influence (a) the costs of doing business in each country, (b) the likely future economic develop- ment of that country, and (c) business practices.

 4. Reread the Country Focus about Secularism in Turkey. 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 on China and Its Guanxi and answer the follow questions:

 a. Why do you think it is so important to culti- vate 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 draw- ing on guanxiwang to get things done in China? What does this suggest about the lim- its of using guanxiwang for a Western busi- ness committed to high ethical standards?

Differences in Culture Chapter 4 123

The Emirates Group is an international aviation holding company that is headquartered in Dubai in the United Arab Emirates (UAE). The Emirates Group is primarily made up of Dnata (one of the world’s largest suppliers of air services such as flight catering and aircraft ground handling, with a global footprint in 37 countries) and Emirates Airline (the largest airline in the Middle East). Emirates flies to more than 125 destinations across six continents, operating a fleet of more than 180 wide-bodied aircraft. The airline also has 170 aircraft on order worth AED 213 billion (about $58 billion in U.S. dollars; the dirham, AED, currency used in the UAE has been pegged to the U.S. dollar at a rate of 3.6725 since 1997). Sales turnover for The Emirates Group is AED 67.4 billion ($18.4 billion in U.S. dollars) and the company employs more than 85,000 people who represent more than 160 countries. The Emirates Group views its employee diversity of more than 160 nationalities as a unique strength given its prominent role as a truly global organization. Emirates’ opinion is that talent is not nationality exclusive, and di- versity of nationalities, cultures, religious and ethnic backgrounds enriches the workforce. These come in the form of a constant flow of new ideas, innovations, and thinking styles that are then implemented and lead to business success. The company’s employee diversity also complements Emirates’ headquarter city of Dubai as a

cosmopolitan multicultural population, where about 85 percent of the 3 million residents are expatriates. Dubai is the most populous city in the UAE; it is the capital of the Emirate of Dubai, one of seven emirates that make up the country. In Dubai, the core ethic groups living and working in the city are Indian (53 percent), Emirati (15 percent), Pakistani (13 percent), and Bangladeshi (8 percent). The remaining inhabitants, each with less than 3 percent, include Filipinos, Sri Lankans, and Ameri- cans. On average, the people in Dubai are young (27 years), and they mainly come from a background of four cultures: Arabian, Arabic, Emirati, and Islamic. The official language is Arabic, but English is widely spoken and has become both the preferred business language as well as the choice in social settings. Islam is the official state religion, although, as with the myriad of people with different backgrounds, there are varied religious beliefs among the population. Dubai has large expatriate commu- nities of Hindus, Christians, Buddhists, Sikhs, and others With “people” as one of The Emirates Group’s core values, the company offers a range of generous benefits to assist expatriate employees who are recruited globally to live in Dubai. Through detailed research and analysis, the remuneration policy focuses on developing compensation and benefits policies that are globally competitive. In fact, the main focus for the company is to ensure that The Emirates Group remains competitive within the market it

C L O S I N G C A S E

The Emirates Group and Employee Diversity

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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 col- league 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 interna- tional business travel. In fact, Middle Eastern cultures exhibit significant differences in busi- ness etiquette when compared to Western cul- tures. 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 busi- ness etiquette in the Middle Eastern country of your choice.

124 Part 2 National Differences

operates. This, by extension, will ensure that Emirates at- tract and retain the right talent. Employment of high- quality people who benefit from working and living in Dubai are important. This places extra emphasis on work- related conditions and cultural integration in the commu- nity, as best as expatriate employees from around the world can be assimilated into the Dubai environment. One of the ugly sides of expatriates in Dubai is the army of migrant workers. These workers, who are largely from South East Asia, are paid a minuscule salary com- pared with developed-nation expatriates and significantly below what they need to be able to earn to afford prod- ucts or services at Dubai’s fashionable boutiques and glamorous world-leading hotels. Technically, human rights in Dubai are protected and equal based on the Constitution of the United Arab Emirates. That includes the promise of equitable treatment of all people, regard- less of race, nationality, or social status. The actual employment practices, though, have been criticized by a number of human rights organizations, albeit more recently the country has made strides to improve.

Sources: Rob Britton, “Emirates Finally Hits Turbulence,” The Huffington Post, January 24, 2017; “The Middle East’s Once Fast-Expanding Airlines Are Coming Under Pressure,” The Economist, March 14, 2017; Dominic Dudley, “Is The Emirates Airline Growth Story at an End?” Forbes, November 11, 2016; Natalie Robehmed, “How Dubai Became One of the Most Important Aviation Hubs in the World,” Forbes, June 4, 2016; “Emirates Group Announces 26th Consecutive Year of Profit,” Forbes Middle East, May 7, 2014; “Super-Connecting the World,” The Economist, April 25, 2015.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Is it sustainable to think that Emiratis, which

make up only about 15 percent of the people in Dubai, can be leading the city as they have been for so long?

2. Integrating 160 different nationalities into one corporation, such as The Emirates Group, has challenges and opportunities. What challenges do you see? What opportunities come from this diverse workforce?

3. If you lived in a city with such diversity of people as Dubai, would you assimilate yourself with the people who are like you, or would you try to integrate into the overall community of all people?

4. Compared with 10 years ago, expatriate employees stay twice as long in Dubai, about five years, before they return to their home coun- try or another foreign location. Do you think more expatriates will stay longer in Dubai as the city continues to develop into a world-class location?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

E n d n o t e s

 1. D. Barry, Exporters! The Wit and Wisdom of Small Businesspeople Who Sell Globally (Washington, DC: International Trade Admin- istration, 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 Interna- tional Business: Recent Advances and Their Implications for Future Research,” Journal of International Business Studies, 2005, pp. 357–78. Several research articles and books also support the notion that significant cultural differences still exist

in the world; for example, T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill, 2014).

 3. M. Y. Brannen, “When Micky Loses Face: 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. Source: Tylor, E.B., Primitive Culture, London: Murray, 1871.

 6. F. Kluckhohn and F. Strodtbeck, Variations in Value Orienta- tions (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).

Differences in Culture Chapter 4 125

 7. M. Rokeach, The Nature of Human Values (New York: Free Press, 1973); S. Schwartz, “Universals in the Content and Struc- ture 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. Source: Hofstede, G., Culture’s Consequences: International Differences in Work-Related Values Beverly Hills, CA: Sage, 1984. 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 Iden- tity: 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 Institu- tional Differences Affecting Competitive Advantage,” Interna- tional Journal of Biotechnology, 1999, pp. 119–31.

20. C. Nakane, Japanese Society (Berkeley: University of California Press, 1970).

21. Source: Nakane, C., Japanese Society, Berkeley: University of California Press, 1970.

22. For details, see M. Aoki, Information, Incentives, and Bargaining in the Japanese Economy (Cambridge, UK: Cambridge Univer- sity Press, 1988); M. L. Dertouzos, R. K. Lester, and R. M. Solow, Made in America (Cambridge, MA: MIT Press, 1989).

23. Global Innovation Barometer 2013 is a product by Ideas Lab and supported by General Electric (GE). The GE Global Inno- vation Barometer explores how business leaders around the world view innovation and how those perceptions are influenc- ing business strategies in an increasingly complex and global- ized environment. It is the largest global survey of business executives dedicated to innovation. GE expanded the global study in 2013, surveying more than 3,000 executives in 25 countries, www.ideaslaboratory.com/projects/innovation- barometer-2013/.

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 Col- lins, 1997); T. Davenport and L. Prusak, Working Knowledge: How Organizations Manage What They Know (Boston, MA: Harvard Business School Press, 1998).

25. Source: Macionis, G. and John, L., Sociology, Toronto, Ontario: Pearson Canada, Inc., 2010, 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 Econ- omy,” 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 excel- lent review of Weber’s work, see A. Giddens, Capitalism and Modern Social Theory (Cambridge, UK: Cambridge University Press, 1971).

35. Source: Weber, M., The Protestant Ethic and the Spirit of Capitalism, 1905. 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.

37. See S. M. Abbasi, K. W. Hollman, and J. H. Murrey, “Islamic Economics: Foundations and Practices,” International Journal of

126 Part 2 National Differences

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: Intercul- tural 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,” Inter- national 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. Source: Clark, P., “Zen and the Art of Startup Naming,” Bloom- berg 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. Source: Porter, M.E., The Competitive Advantage of Nations, New York: Free Press, 1990. 395–97

61. G. Hofstede, “The Cultural Relativity of Organizational Prac- tices 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 orienta- tion, 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 Hofst- ede 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 Manage- ment, 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 Na- tional Culture and Economic Ideology on Managerial Work Values,” Journal of International Business Studies 28, no. 1 (1997), pp. 177–208; P. B. Smith, M. F. Peterson, and Z. Ming Wang, “The Manager as a Mediator of Alternative 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 Postmod- ern 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.”

Differences in Culture Chapter 4 127

75. G. Hofstede, “National Cultures in Four Dimensions,” Interna- tional 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, go to http://wvs.isr.umich.edu/index.html.

77. Hofstede, “National Cultures in Four Dimensions.”

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.”

Ethics, Corporate Social Responsibility, and Sustainability L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO5 -1 Understand the ethical issues faced by international businesses.

LO5-2 Recognize an ethical dilemma.

LO5-3 Identify the causes of unethical behavior by managers.

LO5-4 Describe the different philosophical approaches to ethics.

LO5-5 Explain how managers can incorporate ethical considerations into their decision making.

part two National Dif ferences

5

©Takatoshi Kurikawa/Alamy Stock Photo

Woolworths Group’s Corporate Responsibility Strategy 2020

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 emis- sions 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 traps heat in the atmosphere, which according to most scientists contributes to disruptive climate change. The focus on Prosperity is founded on trusted relation- ships. 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 custom- ers 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 Sustainabil- ity,” Inside Retail (Australia), February 14, 2017; Justin  Smith, “How Wool- worths 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” (woolworthsgroup.com.au/page/community-and-responsibility/ group-responsibility/).

O P E N I N G C A S E The Woolworths Group (woolworthsgroup.com.au) is an Australian conglomerate founded in 1924; it has its head- quarters in Bella Vista in New South Wales. Colloquially known as “Woolies,” the company has extensive retail in- terests in the Oceania region, particularly in Australia and New Zealand, but it also has a foothold in India. The Wool- worths Group consists of three core businesses (Wool- worths 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 re- sponsibility 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 Responsi- bility 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 tar- geting at least 40 percent of executive and senior man- ager 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 com- pany 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 waste going to

129

130 Part 2 National Differences

Introduction

Ethics, corporate social responsibility, and sustainability are intertwined issues facing countries, companies, and societies. 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. Ultimately, differences 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.

O N L I N E C O U R S E M O D U L E S

globalEDGETM has a series of interactive educational modules for businesspeople, policy officials, and students. These modules focus on issues pertinent to international business and include a case study or anecdotes, a glossary of terms, quiz questions, and a list of ref- erences, when applicable. See more at globaledge.msu.edu/reference-desk/online- course-modules. The combination of our textbook on international business and the free globalEDGE online course modules serves as an excellent resource that you can use to prepare for NASBITE’s Certified Global Business Professional Credential (the CGBP includes a testing focus on management, marketing, supply chain management, and finance). Achiev- ing 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 quick test on your understanding of the main issues in international ethics and your readiness to achieve the CGBP credential.

For example, we know that some toy manufacturers have been violating safety regulations for almost 30 years, and many will continue to do so in the future. Time will tell, assuming we can track the ingredients in the materials being used to make toys. What we do know is that about a third of the toys that are exported out of China currently are tainted with heavy met- als 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, Woolworths Group’s Corporate Responsi- bility Strategy 2020 identifies 20 corporate responsibility and sustainability goals that the company plans to implement by the year 2020. Woolworths’ Corporate Responsibility Strategy is based on a framework of People, Planet, and Prosperity. And the goals that stem from this strategy cover a broad range of Woolworths’ stakeholders (e.g., customers, team members, suppliers, and local communities in which Woolworths operates).

The core starting point for the chapter is ethics. Ethics serves as the foundation for what people do or do not, and ultimately what companies engage in globally. As such, companies’ involvement in corporate social responsibility practices and sustainability ini- tiatives 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 or wrong governing the conduct of businesspeople, and an ethical strategy is a strategy, or course of action, that does not violate these accepted principles.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 131

Broadly, we look at how ethical issues should be incorporated into decision making in an international business in this chapter. We also review the reasons for poor ethical deci- sion making and discuss different philosophical approaches to business ethics. Then, using the ethical decision-making process as platform, we include 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

Many of the ethical issues in international business are rooted in differences in political systems, laws, economic development, and culture across countries. What is considered normal practice in one nation may be considered unethical in another. Managers in a mul- tinational firm need to be particularly sensitive to these differences. In the international business setting, the most common ethical issues involve employment practices, human rights, environmental regulations, corruption, and the moral obligation of multinational corporations.

EMPLOYMENT PRACTICES

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

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 re- port 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 being 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. Consequently, 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 appropri- ate 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 stan- dards 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 de- bacle regarding software used by VW to unethically lower the output data for air polluting emissions.

LO 5 -1 Understand the ethical issues faced by international businesses.

132

M A N A G E M E N T F O C U S

Volkswagen, often abbreviated as VW, is a German auto- maker founded by the German Labor Front. The com- pany 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 early 2017 when the sales numbers for 2016 were released. Volkswagen said it delivered 10.3 million vehicles world- wide, while the nearest competitor Toyota announced global sales of 10.2 million cars. To go along with its car numbers, Toyota had sales of about €106 billion ($113 billion in U.S. dollars) and an employee workforce at 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 big- gest challenge in its 80-year history (the company was founded in 1937). Sometimes referred to as “emissionsgate” or “diesel- gate,” 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 regu- lations based on laws passed by the U.S. Congress. The EPA has been around since 1970, although the Trump ad- ministration 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 soft- ware in the cars sensed when the car was being tested in a regulatory lab, and then the software automatically acti- vated equipment in the vehicle that reduced emissions. Think about that in terms of the decision making that had

“Emissionsgate” at Volkswagen

to go in to 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. reg- ulators. 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 in- teresting because it at least implies that the top-level man- agers were not aware of the software installation and unethical use.

Sources: Nathan Bomey, “Volkswagen Passes Toyota as World’s Larg- est 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.

A Volkswagen factory, including its heating plant with four chimneys, in Wolfsburg, Germany. ©Sean Gallup/Getty Images News/Getty Images

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 133

HUMAN RIGHTS

Basic human rights still are not respected in a large number of nations, and several histori- cal and current examples exist to illustrate this point. Rights taken for granted in devel- oped nations, such as freedom of association, freedom of speech, freedom of assembly, freedom of movement, and freedom from political repression, for example, are not univer- sally accepted worldwide (see Chapter 2 for details). One of the most obvious historic ex- amples 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—despite it ending in 1994—still linger to this day.

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 hap- pening. 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 econ- omy. 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, 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 busi- ness in South Africa, which helped persuade several companies to divest their South Afri- can 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). Ultimately, adopting an ethical stance by these large multinational corporations was argued to have helped im- prove 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 Freedom House, more than 1.6 billion people—23 percent of the world’s population—have no say in how they are governed. These people also face se- vere 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

134 Part 2 National Differences

live. This begs the question: Is it ethical for multinational corporations to do business in these repressive countries? 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. Invest- ment 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 ex- treme that doing business there could not be justified on ethical grounds. However, a cynic might note that Myanmar has a small economy and that divestment carries no great eco- nomic penalty for firms, unlike, for example, divestment from China. Interestingly, after decades of pressure from the international community, in 2012 the military government of Myanmar finally acquiesced and allowed limited democratic elections to be held.

ENVIRONMENTAL POLLUTION

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

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 produc- tion 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 lo- cal 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 com- mon standards regarding pollution controls?

These questions take on added importance because some parts of the environment are a public good that no one owns but anyone can despoil. 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 pos- sible, 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 appli- cable. The tragedy of the commons occurs when a resource held in common by all but owned by no one is overused by individuals,

People wearing breathing masks walk at Tian‘anmen Square in China’s capital city, Beijing. ©VCG/Visual China Group/Getty Images

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 135

resulting in its degradation. The phenomenon was first named by Garrett Hardin when describing a particular problem in sixteenth-century England. Large open areas, called commons, were free for all to use as pasture. The poor put out livestock on these commons and supplemented their meager incomes. It was advantageous for each to put out more and more livestock, but the social consequence was far more livestock than the commons could handle. The result was overgrazing, degradation of the commons, and the loss of this much-needed supplement.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, given that doing so will contribute to global warming? Again, many would argue that doing so violates basic ethical principles.

CORRUPTION

As noted in Chapter 2, corruption has been a problem in almost every society in history, and it continues to be one today.8 There always have been and always will be corrupt government officials. International businesses can and have gained economic advantages by making pay- ments to those officials. A classic example concerns a well-publicized incident in the 1970s. Carl Kotchian, the president of Lockheed, made a $12.6 million payment to Japanese agents and government officials to secure a large order for Lockheed’s TriStar jet from Nippon Air. When the payments were discovered, U.S. officials charged Lockheed with falsification of its records and tax violations. Although such payments were supposed to be an accepted busi- ness 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 crim- inally 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 busi- ness in Japan! The payment was nothing more than a bribe, paid to corrupt officials, to se- cure a large order that might otherwise have gone to another manufacturer, such as Boeing. Kotchian clearly engaged in unethical behavior—and to argue that the payment was an “acceptable form of doing business in Japan” was self-serving and incorrect.

The Lockheed case was the impetus for the 1977 passage of the Foreign Corrupt Practices Act (FCPA) in the United States, discussed in Chapter 2. The act outlawed the 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 pay- ments 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.

In 1997, the trade and finance ministers from the member states of the Organisation for Economic Co-operation and Development (OECD) followed the U.S. lead and adopted

136 Part 2 National Differences

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 of- fense. The convention excludes facilitating payments made to expedite routine government action from the convention.

While facilitating payments, or speed money, are excluded from both the Foreign 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 ef- ficiency 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 busi- ness investment and leads to low economic growth.12 In a country where corruption is common, unproductive bureaucrats who demand side payments for granting the enter- prise permission to operate may siphon off the profits from a business activity. This re- duces 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 An- other 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

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 dic- tates such [facilitating] payments and there is no alternative, facilitating payments are to be for the minimum amount necessary and must be accurately documented and re- corded.”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 sec- tion on “international business guidelines” altogether, so our assumption has to be that the company is taking a stronger zero-tolerance approach at this time.

At the same time, as many companies Dow Corning may have realized that the nuances between a bribe and a facilitating payment are very unclear in interpretation. Many U.S. companies have sustained FCPA violations due to facilitating payments that were made but did not fall within the general rules allowing such payments. For example, 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

Ethical Dilemmas

The ethical obligations of a multinational corporation toward employment conditions, hu- man 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

TEST PRE P 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.

LO 5 -2 Recognize an ethical dilemma.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 137

about what constitutes accepted ethical principles. From an inter- national business perspective, some argue that what is ethical de- pends 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 consid- ered 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 dilem- mas where the appropriate course of action is not clear. For exam- ple, 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 man- ager 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 prosti- tution. Two years later, she dies of AIDS. Had the visiting American understood the grav- ity of the girl’s situation, would he still have requested her replacement? Would it have been better to stick with the status quo and allow the girl to continue working? Probably not, because that would have violated the reasonable prohibition against child labor found in the company’s own ethical code. What then would have been the right thing to do? What was the obligation of the executive given this ethical dilemma?

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 out- line 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

Roots of Unethical Behavior

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 un- ethical manner? There is no simple answer to this question because the causes are com- plex, 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

PERSONAL ETHICS

Societal business ethics are not divorced from personal ethics, which are the generally ac- cepted principles of right and wrong governing the conduct of individuals. As individuals, we are typically taught that it is wrong to lie and cheat—it is unethical—and that it is right to behave with integrity and honor and to stand up for what we believe to be right and true. This is generally true across societies. The personal ethical code that guides our behavior

TEST PRE P 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.

LO 5 -3 Identify the causes of unethical behavior by managers.

A young girl making cigarettes in Bagan, Myanmar. ©Angela N Perryman/Shutterstock

138 Part 2 National Differences

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 psy- chologically 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 unrealis- tic 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 do- ing so, allowing such behavior to flourish and persist.

DECISION-MAKING PROCESSES

Several studies of unethical behavior in a business setting have concluded that businesspeo- ple 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 busi- ness 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.

Ethical Behavior

Unrealistic Performance

Goals

Leadership

Decision-Making Processes

Organizational Culture

Societal Culture

Personal Ethics

F I G U R E 5 .1

Determinants of ethical behavior.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 139

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 un- ethical 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 de- cide 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 pro- cess 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 organiza- tional factors (Japan), while others stress individual personal factors (United States), yet some may base it 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 con- sequences of business decisions. This brings us to the third cause of unethical behavior in businesses: an organizational culture that deemphasizes business ethics, reducing all deci- sions 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 par- ticular situations. Just as societies have cultures, so do business organizations, as we dis- cussed 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 accept- able 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 orga- nization, 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 per- sisted 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 chal- lenging performance goals. The combination of an organizational culture that legitimizes unethical behavior, or at least turns a blind eye to such behavior, and unrealistic perfor- mance goals may be particularly toxic. In such circumstances, there is a greater than aver- age probability that managers will violate their own personal ethics and engage in unethical behavior. Conversely, an organization culture can do just the opposite and reinforce the need for ethical behavior. At Hewlett-Packard, for example, Bill Hewlett and David Packard, the company’s founders, propagated a set of values known as The HP Way. These values, which shape the way business is conducted both within and by the corporation, have an important ethical component. Among other things, they stress the need for confidence in and respect for people, open communication, and concern for the individual employee.

LEADERSHIP

The Hewlett-Packard example suggests a fifth root cause of unethical behavior: leadership. Leaders help 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

140 Part 2 National Differences

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 cor- ruption is endemic, are more likely to engage in unethical behavior than enterprises head- quartered in Scandinavia.

Philosophical Approaches to Ethics

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 be- havior 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 re- sponsibility 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 expendi- tures beyond those mandated by the law and required for the efficient running of a busi- ness. For example, his arguments suggest that improving working conditions beyond the level required by the law and necessary to maximize employee productivity will reduce profits and are therefore not appropriate. His belief is that a firm should maximize its

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LO 5 - 4 Describe the different philosophical approaches to ethics.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 141

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. How- ever, 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 profit- ability 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 par- ticularly true in international business, where the “rules of the game” are not well estab- lished and differ from country to county. Consider again the case of sweatshop labor. Child labor may not be against the law in a developing nation, and maximizing productiv- ity may not require that a multinational firm stop using child labor in that country, but it is still immoral to use child labor because the practice conflicts with widely held views about what is the right and proper thing to do. Similarly, there may be no rules against pol- lution 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 un- ethical 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. 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 ethi- cally acceptable.

The Righteous Moralist A righteous moralist claims that a multinational’s home-country standards of ethics are the appropriate ones for companies to follow in foreign countries. This approach is typi- cally associated with managers from developed nations. While this seems reasonable at first blush, the approach can create problems. Consider the following example: An

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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 in- come tax 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 hear- ing, he was told the firm owed three times as much tax as it had paid, reflecting the depart- ment’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 busi- ness. 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 ex- ample, 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 in- vesting 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 be- cause 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 prac- tice 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 incum- bent 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 utilitar- ian 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 consequences over bad consequences. Utilitarianism is committed to the

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maximization of good and the minimization of harm. Utilitarianism recognizes that ac- tions 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 as- sessment that are firmly rooted in a utilitarian philosophy. Managers often weigh the ben- efits 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 degra- dation in a fragile ecosystem. An agricultural biotechnology company such as Monsanto must decide whether the benefits of genetically modified crops that produce natural pesti- cides 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 in- terests of keeping down health insurance costs, the government decides to screen people for the HIV virus and deny insurance coverage to those who are HIV positive. By reducing health costs, such action might produce significant benefits for a large number of people, but the action is unjust because it discriminates unfairly against a minority.

Kantian ethics is based on the philosophy of Immanuel Kant (1724–1804). Kantian ethics holds that people should be treated as ends and never purely as means to the ends of others. People are not instruments, like a machine. People have dignity and need to be 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 phi- losophy as incomplete—for example, his system has no place for moral emotions or senti- ments 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 col- lective 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 ex- ample, the interest of the state in civil harmony or moral consensus.31 Moral theorists ar- gue that fundamental human rights form the basis for the moral compass that managers should navigate by when making decisions that have an ethical component. More pre- cisely, they should not pursue actions that violate these rights.

The notion that there are fundamental rights that transcend national borders and cul- tures was the underlying motivation for the United Nations Universal Declaration of Human Rights, adopted in 1948, which has been ratified by almost every country on the

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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 declara- tion states:

All human beings are born free and equal in dignity and rights. They are endowed with rea- son 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 favor- able 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 Arti- cle 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 develop- ment 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 ca- pable 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.

JUSTICE THEORIES

Justice theories focus on the attainment of a just distribution of economic goods and ser- vices. 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.

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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 ex- ample, race, sex, intelligence, nationality, family background, and special talents. Rawls then asks what system people would design under a veil of ignorance. Under these condi- tions, people would unanimously agree on two fundamental principles of justice.

The first principle is that each person be permitted the maximum amount of basic lib- erty 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 free- dom of thought, the freedom and right to hold personal property, and freedom from arbi- trary 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 distri- bution also benefits the least-advantaged members of society. One can argue that a well- regulated, market-based economy and free trade, by promoting economic growth, benefit the least-advantaged members of society. In principle at least, the inequalities inherent in such systems are therefore just (in other words, the rising tide of wealth created by a market- based economy and free trade lifts all boats, even those of the most disadvantaged).

In the context of international business ethics, Rawls’s theory creates an interesting per- spective. Managers could ask themselves whether the policies they adopt in foreign 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 operat- ing under a veil of ignorance would design a system where foreign employees were paid subsis- tence 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 compa- nies 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 man- agers can use to help them navigate through difficult ethical dilemmas.

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F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

MAKING ETHICAL DECISIONS INTERNATIONALLY What, then, is the best way for managers in a multinational firm to make sure that

ethical considerations figure into international business decisions? How do managers decide on an ethical course of action when confronted with

decisions pertaining to working conditions, human rights, corruption, and environ- mental 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

LO 5 -5 Explain how managers can incorporate ethical considerations into their decision making.

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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 promot- ing people with a well-grounded sense of personal ethics; (2) build an organizational culture and exemplify leadership behaviors that place a high value on ethical behavior; (3) put deci- sion-making processes in place that require people to consider the ethical dimension of business decisions; (4) institute ethical officers in the organization; (5) develop moral cour- age; (6) make corporate social responsibility a cornerstone of enterprise policy; and (7) pur- sue strategies that are sustainable.

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 be- havior. Similarly, you would expect a business to not promote people, and perhaps to fire people, whose behavior does not match generally accepted ethical standards. How- ever, 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 sub- sequently turn out to have poor personal ethics, particularly given that people have an incen- tive to hide this from public view (indeed, the unethical person may lie about his or her nature)? Businesses can give potential employees psychological tests to try to discern their ethical predispositions, and they can check with prior employees regarding someone’s repu- tation (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. Promot- ing people who have displayed poor ethics should not occur in a company where the orga- nizational culture values the need for ethical behavior and where leaders act accordingly. Not only should businesses strive to identify and hire people with a strong sense of per- sonal ethics, but it also is in the interests of prospective employees to find out as much as they can about the ethical climate in an organization. Who wants to work at a multinational such as Enron, which ultimately entered bankruptcy because unethical executives had es- tablished 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 busi- ness 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 Interna- tional Business (the top professional organization in international business) has a Code of Ethics for its leadership:39

AIB’s Motivation for the Code of Ethics: The leadership of an organization is ulti- mately 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.

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Having articulated values in a code of ethics or some other document, leaders in the busi- ness must give life and meaning to those words by repeatedly emphasizing their impor- tance 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. Finally, building an organizational culture that places a high value on ethical behavior re- quires incentive and reward systems, including promotions that reward people who engage in ethical behavior and sanction those who do not. At General Electric, for example, the for- mer CEO Jack Welch has described how he reviewed the performance of managers, divid- ing 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 theo- ries, 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 cor- porate 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 an- other 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 in- direct claim on the firm. Typically, this group comprises primary stakeholders such as custom- ers, 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 pro- vide 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. Com- munities 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.

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Stakeholder analysis involves a certain amount of what has been called moral imagina- tion.47 This means standing in the shoes of a stakeholder and asking how a proposed deci- sion might impact that stakeholder. For example, when considering outsourcing to subcontractors, managers might need to ask themselves how it might feel to be working under substandard health conditions for long hours. Step 2 involves judging the ethics of the proposed strategic decision, given the infor- mation gained in step 1. Managers need to determine whether a proposed decision would violate the fundamental rights of any stakeholders. For example, we might argue that the right to information about health risks in the workplace is a fundamental entitle- ment of employees. Similarly, the right to know about potentially dangerous features of a product is a fundamental entitlement of customers (something tobacco companies vio- lated 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 igno- rance. 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 mem- bers of society—for instance, the prohibition on stealing—should not be violated. The judg- ment 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 prin- ciples are violated—that the business behaves in an ethical manner. Step 3 requires managers to establish moral intent. This means the business must re- solve to place moral concerns ahead of other concerns in cases where either the funda- mental 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 erro- neous) 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 princi- ples, 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 responsi- ble 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 pro- grams 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

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ombudsperson with responsibility for handling confidential inquiries from employees, investigating complaints from employees or others, reporting findings, and making rec- ommendations for change. For example, United Technologies, a multinational aerospace company with worldwide revenues of more than $30 billion, has had a formal code of ethics since 1990.49  United Technologies has some 450 business practice officers (the company’s name for ethics offi- cers), 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 supe- riors, or otherwise complain about unethical actions. For example, consider the following excerpt from Academy of International Business Code of Ethics:

AIB Statement of Commitment: In establishing policy for and on behalf of the Acad- emy 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 com- mit that I will observe a high standard of ethics and conduct as I devote my best ef- forts, 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 en- hanced. 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. 

Corporate Social Responsibility Multinational corporations have power that comes from their control over resources and their ability to move production from country to country. Although that power is constrained not only by laws and regulations but also by the discipline of the market and the competitive process, it is substantial. Some moral philosophers argue that with power comes the social responsibility for multinationals to give something back to the societies that enable them to prosper and grow. The concept of corporate social responsibility (CSR) refers to the idea that business- people should consider the social consequences of economic actions when making busi- ness 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

Did You Know? Did you know corporate social responsibility is not as new as it seems?

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M A N A G E M E N T F O C U S

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 head- quartered in Helsinki, the capital of Finland, and it has ap- proximately 29,000 employees. In 2000, the company bought Consolidated Papers in North America. Stora Enso also expanded into South America, Asia, and Russia. By 2005, Stora Enso had become the world’s largest pulp and paper manufacturer as measured by production ca- pacity. 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 Re- sponsibility means realizing concrete actions that will help us fulfil [sic] our Purpose, which is to do good for the peo- ple 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, buy- ing 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 pur- pose boldly in writing. At the same time, Stora Enso posi- tions 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.

Corporate Social Responsibility at Stora Enso Tracing to its past and reflecting on its future, Stora Enso has adopted three lead areas for its global respon- sibility strategy: people and ethics, forests and land use, and environment and efficiency. For people and ethics, the company focuses on conducting business in a so- cially responsible manner throughout its global value chain. For forests and land use, it focuses on an innova- tive and responsible approach on forestry and land use to make it a preferred partner and a good local commu- nity citizen. For the environment and efficiency, the focus is on resource-efficient operations that help the com- pany achieve superior environmental performance re- lated to its products. While a number of companies have corporate social responsibility statements incorporated as part of their websites, annual reports, and talking points, Stora Enso also presents clear targets and performance goals that are assessed by established metrics. Its overall opera- tions are guided by corporate-level targets for environ- mental 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 catego- ries 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 Perfor- mance” document also lists performance in the prior year, targets in the current year, and strategic objectives re- lated 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.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 151

can be supported for its own sake simply because it is the right way for a business to be- have. Advocates of this approach argue that businesses, particularly large successful busi- nesses, 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 hon- orable 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, result- ing 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. 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 busi- ness.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 Management Focus feature on the Finnish com- pany Stora Enso.

Sustainability As managers in international businesses strive to translate ideas about corpo- rate 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 envi- ronment 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 organiza- tion—through its actions—does not exert a negative impact on the ability of future genera- tions 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 de- plete 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 strat- egies try to ensure that they do not precipitate or participate in a situation that results in a tragedy of the commons Thus, for example, a company pursuing a sustainable strategy would try to reduce its carbon footprint (CO2 emissions) so that it does not contribute to global warming. Nor would a company pursuing a sustainable strategy adopt policies that negatively af- fect the well-being of key stakeholders such as employees and suppliers because manag- ers 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 up- grading 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

152 Part 2 National Differences

C H A P T E R S U M M A R Y

This chapter discussed the source and nature of ethical issues in international businesses, the different philosoph- ical approaches to business ethics, the steps managers can take to ensure that ethical issues are respected in in- ternational 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 per- son, the members of a profession, or the actions of an organization. Business ethics are the ac- cepted principles of right or wrong governing the conduct of businesspeople. An ethical strat- egy is one that does not violate these accepted principles.

 2. Ethical issues and dilemmas in international business are rooted in the variations among po- litical systems, law, economic development, and culture from country to country.

 3. The most common ethical issues in interna- tional business involve employment practices, human rights, environmental regulations, cor- ruption, 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 dys- functional 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

business ethics, p. 130 ethical strategy, p. 130 Foreign Corrupt Practices Act

(FCPA), p. 135 Convention on Combating Bribery

of Foreign Public Officials in International Business Transactions, p. 136

ethical dilemma, p. 137

organizational culture, p. 139 cultural relativism, p. 141 righteous moralist, p. 141 naive immoralist, p. 142 utilitarian approach to ethics, p. 142 Kantian ethics, p. 143 rights theories, p. 143 Universal Declaration of Human

Rights, p. 143

just distribution, p. 144 code of ethics, p. 146 stakeholders, p. 147 internal stakeholders, p. 147 external stakeholders, p. 147 corporate social responsibility

(CSR), p. 149 sustainable strategies, p. 151

Key Terms

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 produc- tion 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.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 153

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 great- est 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 sys- tem under a veil of ignorance.

12. To make sure that ethical issues are considered in international business decisions, managers should (a) favor hiring and promoting people with a well-grounded sense of personal ethics, (b) build an organizational culture and exemplify leadership behaviors that place a high value on ethical behavior, (c) put decision-making pro- cesses 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 respon- sibility 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.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. A visiting American executive finds that a for- eign 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 multina- tional toward environmental protection and (b) inf luence the policies of a clothing company in their potential decision of outsourcing its manufacturing operations.

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

4. Do you think facilitating payments (speed payments) should be ethical? Does it matter in which country, or part of the world, such payments are made?

5. A manager from a developing country is oversee- ing 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 re- sponsibility of business is to increase profits.”57 Do you agree? If not, do you prefer that multina- tional corporations adopt a focus on corporate social responsibility or sustainability practices?

7. Can a company be good at corporate social re- sponsibility but not be sustainability oriented? Is it possible to focus on sustainability but not corpo- rate social responsibility? Based on reading the section on Focus On Managerial Implications, dis- cuss how much CSR and sustainability are related and how much the concepts differ from each other.

154 Part 2 National Differences

The United Nations Conference on Trade and Develop- ment (UNCTAD) was established in 1964 to promote development-friendly integration of countries into the world economy. UNCTAD has progressively evolved into an authoritative, knowledge-based institution work- ing on helping to shape policy debates and thinking on development. A core of this focus is on ensuring that countries’ domestic policies and international actions are mutually supportive in bringing about sustainable development. As a consequence, in 2000 the United Nations estab- lished the Millennium Development Goals to reduce the number of people who live in extreme poverty by 2015. Subsequently, in September 2015, the United Nations re- leased the new set of Sustainable Development Goals that set targets to end poverty, protect the planet, and en- sure prosperity for all countries by 2030. Seventeen goals were created to replace the Millennium Development Goals. As such, in parallel with the sustainability efforts that companies have undertaken in the last couple of decades, countries have developed policy to engage in sustainability as a direct result of the UN’s efforts.

Specifically, on September 15, 2015, the UN’s 193 mem- ber countries adopted the “2030 Agenda for Sustainable Development” and its 17 “Sustainable Development Goals” (SDGs) to end poverty, protect the planet, and en- sure prosperity for all. Each goal has a set of specific tar- gets to be achieved in the 15 years that follow. Importantly, the idea is that for the 17 goals to be achieved in this time frame, everyone needs to participate and do their part, in- cluding governments, the private sector of businesses, civil society, and all people. The 17 SDGs include (1) no poverty; (2) zero hunger; (3) good health and well-being; (4) quality education; (5) gender equality; (6) clean water and sanitation; (7) affordable and clean energy; (8) decent work and eco- nomic growth; (9) industry, innovation, and infrastruc- ture; (10) reduced inequalities; (11) sustainable cities and communities; (12) responsible consumption and produc- tion; (13) climate action; (14) life below water; (15) life on land; (16) peace, justice, and strong institutions; and (17) partnerships for the goals. These SDGs are described in detail by UNCTAD (un.org/sustainabledevelopment) A brief overview of the

C L O S I N G C A S E

UNCTAD Sustainable Development Goals

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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 organiza- tions 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 Coun- try 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 in- dustries 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?

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 155

current status of certain SDGs can serve as a precursor to what has to be done to achieve each SDG by 2030. For example, with respect to SGD 1, while extreme poverty rates have been reduced by more than half in the last 25 years, more than 800 million people still live in extreme poverty. For SDG 2, globally one in every nine people (some 800 million people) are undernourished. Quality education (SDG 4)—a driver of global competitiveness—is a major goal. Currently, there are 103 million youth worldwide who lack basic literacy skills. These three Sustainable Development Goals that were highlighted in the previous paragraph illustrate the task at hand for the world and its countries to end poverty, pro- tect the planet, and ensure prosperity for all. Plus, SGD 17 makes it very clear that revitalizing global partnerships is critical for sustainable development to reach the aspira- tions that have been set forth in the UNCTAD “2030 Agenda for Sustainable Development.” These partner- ships should include governments, the private business sector, and civil society. UNCTAD has said that these in- clusive partnerships also have to build on principles and values, a shared vision, and shared goals that place people and the planet at the center.

Sources: United Nations, “Sustainable Development Goals—17 Goals to Transform Our World,” www.un.org; James Zhan, “Investing in Sustain- able Development Goals,” CFI.co, October 9, 2014; Yves Flückiger and Nikhil Seth, “Sustainable Development Goals: SDG Indicators Need Crowdsourcing,” Nature 531 (March 2016), p. 448; David Griggs, Mark Stafford-Smith, Owen Gaffney, Johan Rockström, Marcus C. Öhman, Priya Shyamsundar, Will Steffen, Gisbert Glaser, Norichika Kanie, and Ian Noble, “Policy: Sustainable Development Goals for People and Planet,” Nature 495 (March 2013), pp. 305–7; Mans Nilsson, David Griggs, and Martin Visbeck, “Map the Interactions between Sustainable Development Goals,” Nature 153 (June 2016), pp. 320–22.

C a s e D i s c u s s i o n Q u e s t i o n s 1. In the most recent ranking of how countries are

doing in implementing the UN’s Sustainable Development Goals, Sweden ranked first in the world, followed by several other countries in Scandinavia. However, even Sweden had only achieved an 85 percent success rate, meaning the country has another 15 percent remaining to be fully compliant with the SDG initiative. What is the chance that all countries will achieve 100 per- cent compliance by the year 2030?

2. Some would argue that the Sustainable Develop- ment Goals is not something that should be man- dated on countries to achieve by 2030 or any other year. Countries should be free to set their own sustainability goals. What do you think?

3. Seventeen Sustainable Development Goals is a large set of goals for the world’s 260 countries and territories to achieve. Would it be better to focus on a smaller set of goals, or are the Sustainable Development Goals integrated enough that countries can tackle all of them at the same time?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

E n d n o t e s

 1. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!” Journal of the Academy of Marketing Science 39, pp. 1–6, 2011; T. Hult, J. Mena, O. C. Ferrell, and L. Ferrell, “Stake- holder 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 influ- ence 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.

156 Part 2 National Differences

25. Friedman, “The Social Responsibility of Business Is to Increase Profits.”

26. M. Friedman, “The Social Responsibility of Business Is to Increase Profits,” The New York Times Magazine, September 13, 1970

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 Interna- tional 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 Revolution- ary,” Harvard Business School Case 9-394-065, April 1994.

41. For example, see R. E. Freeman and D. Gilbert, Corporate Strat- egy 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).

42. Freeman and Gilbert, Corporate Strategy and the Search for Eth- ics; Jones, “Ethical Decision Making by Individuals in Organi- zations”; 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, Organiza- tions (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.

 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.

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, no. 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, no. 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. 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.

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 In- crease Profits,” The New York Times Magazine, September 13, 1970. Reprinted in T. L. Beauchamp and N. E. Bowie, Ethical Theory and Business, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 157

54. J. Smith, “The World’s Most Sustainable Companies,” Forbes, January 24, 2014.

55. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!”

56. M. Clarkson, “A Stakeholder Framework for Analyzing and Evaluating Corporate Social Performance,” Academy of Manage- ment Review 20 (1995), pp. 92–117; R. Freeman, Strategic Man- agement: 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.

57. M. Friedman, “The Social Responsibility of Business Is to Increase Profits,” The New York Times Magazine, September 13, 1970.

48. “Our Principles,” Unilever, www.unilever.com.

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

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 Manage- ment 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.

International Trade Theory L E A R N I N G O B J E C T I V E S Af ter 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.

part three The Global Trade and Investment Environment

6

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Donald Trump on Trade

current American trade negotiators as “stupid people,” “political hacks and diplomats,” and “saps” and suggested that he should become “negotiator in chief.” In direct 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 eco- nomic 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 cre- ated elsewhere in the economy will more than compen- sate 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. 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 may change. Pro–free traders argue that if Trump does indeed push for more protection- ist trade policies—and his rhetoric and cabinet picks sug- gest 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 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, http://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.

O P E N I N G C A S E On November 8, 2016, Donald Trump was elected the President of the United States. In contrast to all U.S. presi- dents since World War II, Donald Trump has 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. He has called the North American Free Trade Agreement (NAFTA) “the worst trade deal maybe ever signed anywhere.” 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 adminis- tration. In his first week in office, he signed an executive order formally withdrawing the United States from the TPP. Trump has also floated various ideas for imposing higher tariffs on imports and punitive taxes on American compa- nies that move production out of the country. At one point, he threatened to impose a 45 percent tariff on imports of goods from China. His transition team was reportedly con- sidering imposing a 5 percent general tariff on all imports into the United States. 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 penalties on companies that move American production offshore. 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 weak- ness. In his words, “you only have to look at our trade defi- cit 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 fre- quent targets of his criticisms. He has argued that China’s trade surplus with the United States is a result of that coun- try’s currency manipulation, which has made Chinese ex- ports 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

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* Source: “Donald Trump on Free Trade”, On The Issues, http://www.ontheissues.org/2016/Donald_Trump_Free_Trade.htm.

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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 that suggest he may be the most antitrade president in modern history. If Trump follows through on his threats, he could upend 70 years of American-led policy designed to lower barriers to the free flow of goods and services be- tween 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 intellec- tual foundations for trade policy; at the impact of trade policy on jobs, income, and eco- nomic 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 ex- ample, 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 deals with the global trade and investment environ- ment. 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 sys- tem, 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 in- vestment 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 of 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 understand- ing of the international trade and investment environment, and you should be able to ana- lyze in depth and critique the policy positions taken both by free traders and by people like Donald Trump. 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 en- courage exports and discourage imports. Although mercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the trade poli- cies of many countries. Indeed, one could argue that Donald Trump espouses mercantil- ist 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 inf luence 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 ad- ditional theories that we review. One is the theory of comparative advantage, advanced by the nineteenth-century English economist David Ricardo. This theory is the intellec- tual 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.

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THE BENEFITS OF TRADE

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

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

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

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

LO 6 -1 Understand why nations trade with each other.

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.

T R A D E T U T O R I A L S

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 econ- omy. 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 prod- ucts. 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 globalEDGETM’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 globalEDGETM glossary can help.

162 Part 3 The Global Trade and Investment Environment

THE PATTERN OF INTERNATIONAL TRADE

The theories of Smith, Ricardo, and Heckscher–Ohlin help explain the pattern of international trade that we observe in the world economy. Some aspects of the pattern are easy to understand. Climate and natural resource endow- ments explain why Ghana exports cocoa, Brazil exports coffee, Saudi Arabia exports oil, and China exports craw- fish. However, much of the observed pattern of interna- tional trade is more difficult to explain. For example, why does Japan export automobiles, consumer electronics, and machine tools? Why does Switzerland export chemi- cals, 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 in- terplay 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 particu- lar goods. This explanation rests on the assumption that countries have varying endow- ments 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 be- comes widely accepted internationally, however, production starts in other countries. As a result, the theory suggests, the product may ultimately be exported back to the country of its original innovation.

In a similar vein, during the 1980s, economists such as Paul Krugman developed what has come to be known as the new trade theory. New trade theory (for which Krugman won the Nobel Prize in economics in 2008) stresses that in some cases, countries special- ize in the production and export of particular products not because of underlying differ- ences 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 competi- tive 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 indus- tries. 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 (and Donald Trump seems to advocate such policies). The theories of Smith, Ricardo,

A Rolex Group logo sits on display above a luxury wristwatch store in Vienna, Austria. ©Bloomberg/Bloomberg/Getty Images

International Trade Theory Chapter 6 163

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.

Mercantilism

The first theory of international trade, mercantilism, emerged in England in the mid- sixteenth century. The principle assertion of mercantilism was that gold and silver were the mainstays of national wealth and essential to vigorous commerce. At that time, gold and silver were the currency of trade between countries; a country could earn gold and silver by exporting goods. Conversely, importing goods from other countries would result in an 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 inf lation 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 dem- onstrate 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 ap- pears 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 devel- oped nations, and thus amass a trade surplus and foreign exchange reserves (see the accompanying Country Focus).

TEST PRE P 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.

TEST PRE P 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.

LO 6 -2 Summarize the different theories explaining trade flows between nations.

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 lead 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. The trade deficit with America has been a particular cause for concern. In 2015, this reached a record $366 bil- lion. At the same time, China 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, hardly 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 sell- ing yuan and buying U.S. dollars. To stop the yuan from de- clining 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 pol- icy by artificially depressing the value of its currency.

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, “US 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.

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Absolute Advantage

In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their abil- ity to produce goods efficiently. In his time, the English, by virtue of their superior manu- facturing 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. Simi- larly, France could get all the textiles it needed by selling wine to England and buying tex- tiles 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

LO 6 -2 Summarize the different theories explaining trade flows between nations.

International Trade Theory Chapter 6 165

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 pro- duction 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 re- sources 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.

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 pro- duce 20 tons of cocoa, and South Korea could produce 20 tons of rice. Thus, by special- izing, the production of both goods could be increased. Production of cocoa would increase from 12.5 tons to 20 tons, while production of rice would increase from 15 tons to 20 tons. The increase in production that would result from specialization is therefore 7.5 tons of cocoa and 5 tons of rice. Table 6.1 summarizes these figures.

By engaging in trade and swapping 1 ton of cocoa for 1 ton of rice, producers in both countries could consume more of both cocoa and rice. Imagine that Ghana and South Korea swap cocoa and rice on a one-to-one basis; that is, the price of 1 ton of cocoa is equal to the price of 1 ton of rice. If Ghana decided to export 6 tons of cocoa to South

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166 Part 3 The Global Trade and Investment Environment

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

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 interna- tional 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

LO 6 -2 Summarize the different theories explaining trade flows between nations.

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa Rice Ghana 10 20

South Korea 40 10

Production and Consumption without Trade

Ghana 10.0 5.0

South Korea 2.5 10.0

Total production 12.5 15.0

Production with Specialization

Ghana 20.0 0.0

South Korea 0.0 20.0

Total production 20.0 20.0

Consumption after Ghana Trades 6 Tons of Cocoa for 6 Tons of South Korean Rice

Ghana 14.0 6.0

South Korea 6.0 14.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 4.0 1.0

South Korea 3.5 4.0

TA B L E 6 .1

Absolute Advantage and the Gains from Trade

International Trade Theory Chapter 6 167

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

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

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

THE GAINS FROM TRADE

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

Not only is output higher, but both countries also can now benefit from trade. If Ghana and South Korea swap cocoa and rice on a one-to-one basis, with both countries choosing to exchange 4 tons of their export for 4 tons of the import, both countries are able to consume more cocoa and rice than they could before specialization and trade (see Table 6.2). Thus, if Ghana exchanges 4 tons of cocoa with South Korea for 4 tons of rice, it is still left with 11 tons of cocoa, which is 1 ton more than it had before trade. The 4 tons of rice it gets from South Korea in exchange for its 4 tons of cocoa, when added to the 3.75 tons it now produces

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168 Part 3 The Global Trade and Investment Environment

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

QUALIFICATIONS AND ASSUMPTIONS

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

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

2. We have assumed away transportation costs between countries.

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa Rice Ghana 10 13.33

South Korea 40 20

Production and Consumption without Trade

Ghana 10.0 7.5

South Korea 2.5 5.0

Total production 12.5 12.5

Production with Specialization

Ghana 15.0 3.75

South Korea 0.0 10.0

Total production 15.0 13.75

Consumption after Ghana Trades 4 Tons of Cocoa for 4 Tons of South Korean Rice

Ghana 11.0 7.75

South Korea 4.0 6.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 1.0 0.25

South Korea 1.5 1.0

TA B L E 6 . 2

Comparative Advantage and the Gains from Trade

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.

International Trade Theory Chapter 6 169

3. We have assumed away differences in the prices of resources in different coun- tries. 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 spe- cialization exist. The amount of resources required to produce a good might de- crease 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 specializa- tion, 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, re- search 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 in- terpretation, 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 sim- ple 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 effi- ciency with which those resources are utilized.

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

170 Part 3 The Global Trade and Investment Environment

Resources do not always move easily from one economic activity to another. The pro- cess 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 transi- tion 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 spe- cialization. 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 as- sume 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 re- sources 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 re- sources 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.

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

A second reason for diminishing returns is that different goods use resources in differ- ent 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,

G

G'

C o

co a

Rice 0

F I G U R E 6 . 3

Ghana’s PPF under diminishing returns.

International Trade Theory Chapter 6 171

the cocoa industry will have to shift toward more labor-intensive methods of production. The effect is that the efficiency with which the cocoa industry uses labor will decline, and returns will diminish.

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

Dynamic Effects and Economic Growth The simple comparative advantage model assumed that trade does not change a country’s stock of resources or the efficiency with which it utilizes those resources. This static assump- tion 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 re- sources. Gains in the efficiency of resource utilization could arise from a number of fac- tors. 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 compe- tition 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. As a consequence of this outward shift, the country in Figure 6.4 can

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.

C o

co a

Rice 0

PPF2

PPF1

F I G U R E 6 . 4

The influence of free trade on the PPF.

172 Part 3 The Global Trade and Investment Environment

produce more of both goods than it did before introduction of free trade. The theory sug- gests that opening an economy to free trade not only results in static gains of the type dis- cussed 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 out- come that is not so beneficial.

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 sug- gests 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 tradi- tionally were not internationally mobile, such as software debugging, call-center jobs, ac- counting 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.

Having said this, it should be noted that Samuelson concedes that free trade has his- torically benefited rich counties (as data discussed later seem to confirm). Moreover, he notes that introducing protectionist measures (e.g., trade barriers) to guard against the theoretical possibility that free trade may harm the United States in the future may pro- duce a situation that is worse than the disease they are trying to prevent. To quote Samuel- son: “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 evi- dence 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 analy- sis, they note that as a practical matter, developing nations are unlikely to be able to up- grade the skill level of their workforce rapidly enough to give rise to the situation in Samuelson’s model. In other words, they will quickly run into diminishing returns. How- ever, such rebuttals are at odds with data suggesting that Asian countries are rapidly

C O U N T R Y F O C U S

173

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 glo- balization 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 “hollow- ing 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 pro- grammers 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 work- force. 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 in- terpret 30 CT scans a day for Massachusetts General Hospital that are sent over the Internet. At yet another Bangalore busi- ness, 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 sim- ple. 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 in- ception. For example, Zoho Corporation, a California- based start-up offering online web applications for small businesses, has about 20 employees in the United States and more than 1,000 in India!

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

Employees walk below the Infosys Ltd. logo at the company’s campus in Electronics City in Bangalore, India. ©Bloomberg/Getty Images

174 Part 3 The Global Trade and Investment Environment

upgrading their educational systems. For example, about 56 percent of the world’s engineer- ing 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 com- parative 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 sam- ple 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 devel- oping 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 per- cent 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 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 be- tween 1967 and 2009 concluded: “The macroeconomic evidence provides dominant sup- port 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 in- come 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 ad- justment 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

Heckscher–Ohlin Theory

Ricardo’s theory stresses that comparative advantage arises from differences in productiv- ity. 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 en- dowments 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 econ- omy. Like Ricardo’s theory, the Heckscher–Ohlin theory argues that free trade is benefi- cial. 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 dif- ferences in productivity.

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LO 6 -2 Summarize the different theories explaining trade flows between nations.

International Trade Theory Chapter 6 175

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 impor- tant; a country may have larger absolute amounts of land and labor than another country but be relatively abundant in one of them.

THE LEONTIEF PARADOX

The Heckscher–Ohlin theory has been one of the most influential theoretical ideas in in- ternational economics. Most economists prefer the Heckscher–Ohlin theory to Ricardo’s theory because it makes fewer simplifying assumptions. Because of its influence, the the- ory 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 rela- tively abundant in capital compared to other nations, the United States would be an ex- porter 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 en- trepreneurship, 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

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 interna- tional trade patterns. On the other hand, the theory they regard as being too limited, Ricardo’s theory of comparative advantage, actually predicts trade patterns with greater accuracy. The best solution to this dilemma may be to return to the Ricardian idea that trade patterns are largely driven by international differences in productivity. Thus, one might argue that the United States exports commercial aircraft and imports textiles not because its factor endowments are especially suited to aircraft manufacture and not suited to textile manufacture, but because the United States is relatively more efficient at producing aircraft than textiles. A key assumption in the Heckscher–Ohlin theory is that technologies are the same across countries. This may not be the case. Differences in technology may lead to differences in productivity, which in turn, drives interna- tional 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 abun- dant capital. More recent empirical work suggests that this theoretical explanation may be correct.28 The new research shows that once differences in technology across coun- tries 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 tech- nology on productivity is controlled for, the Heckscher–Ohlin theory seems to gain predictive power.

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176 Part 3 The Global Trade and Investment Environment

The Product Life-Cycle Theory

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, photocopi- ers, personal computers, and semiconductor chips). To explain this, Vernon argued that the wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new 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 pro- duced abroad at some low-cost location and then exported back into the United States. However, Vernon argued that most new products were initially produced in America. Ap- parently, 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 de- mand is starting to grow rapidly in the United States, demand in other advanced countries is limited to high-income groups. The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to start producing the new prod- uct, but it does necessitate some exports from the United States to those countries.

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

As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon. As this oc- curs, 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 be- come 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 coun- tries. 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 prod- uct 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 interna- tional 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 ex- ported 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 addi- tion, 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, ex- ports from the United States declined, and U.S. users began to buy some photocopiers from

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International Trade Theory Chapter 6 177

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 produc- tion 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 photo- copiers is consistent with the predictions of the product life-cycle theory that mature indus- tries tend to go out of the United States and into low-cost assembly locations.

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

New Trade Theory

The new trade theory began to emerge in the 1970s when a number of economists pointed out that the ability of firms to attain economies of scale might have important 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 em- ployees and equipment. Economies of scale are a major source of cost reductions in many industries, from computer software to automobiles and from pharmaceuticals to aero- space. 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 in- stalled. 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 econo- mies of scale represents a significant proportion of total world demand, the global market may be able to support only a small number of enterprises. Thus, world trade in certain products may be dominated by countries whose firms were first movers in their production.

INCREASING PRODUCT VARIETY AND REDUCING COSTS

Imagine first a world without trade. In industries where economies of scale are important, both the variety of goods that a country can produce and the scale of production are limited by the size of the market. If a national market is small, there may not be enough demand to enable producers to realize economies of scale for certain products. Accordingly, those products may not be produced, thereby limiting the variety of products available to consum- ers. 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.

TEST PRE P 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.

LO 6 -2 Summarize the different theories explaining trade flows between nations.

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.

178 Part 3 The Global Trade and Investment Environment

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

Suppose there are two countries, each with an annual market for 1 million automobiles. By trading with each other, these countries can create a combined market for 2 million cars. In this combined market, due to the ability to better realize economies of scale, more variet- ies (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. Con- sumers in this case benefit from having access to a product (sports cars) that was not avail- able 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 econo- mies, the production of a greater variety of products, and lower prices.

ECONOMIES OF SCALE, FIRST-MOVER ADVANTAGES, AND THE PATTERN OF TRADE

A second theme in new trade theory is that the 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 ben- efit from a lower cost structure, is an important first-mover advantage. New trade theory argues that for those products where economies of scale are significant and represent a substantial proportion of world demand, the first movers in an industry can gain a scale- based cost advantage that later entrants find almost impossible to match. Thus, the pattern of trade that we observe for such products may reflect first-mover advantages. Countries may dominate in the export of certain goods because economies of scale are important in their production and because firms located in those countries were the first to capture scale economies, giving them a first-mover advantage.

For example, consider the commercial aerospace industry. In aerospace, there are sub- stantial 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 de- velop 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 prob- ably 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 super- jumbo 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

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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 bene- fit 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 econo- mies 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 in- creased, 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 indus- try, 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 en- dowed with the factors of production required to manufacture aircraft, but because one of the first movers in the industry, Boeing, was a U.S. firm. The new trade theory is not at variance with the theory of comparative advantage. Economies of scale increase productiv- ity. 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 sup- port 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 na- tions in specific industries.33 The number of firms is very limited in many global indus- tries, 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 innova- tive. 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

180 Part 3 The Global Trade and Investment Environment

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 sophisti- cated and judicious use of subsidies, could a government increase the chances of its domestic firms becoming first movers in newly emerging industries, as the U.S. government appar- ently did with Boeing (and the European Union did with Airbus)? If this is possible, and the new trade theory suggests it might be, we have an economic rationale for a proactive trade policy that is at variance with the free trade prescriptions of the trade theories we have re- viewed so far. We consider the policy implications of this issue in Chapter 7.

National Competitive Advantage: Porter’s Diamond

Michael Porter, the famous Harvard strategy professor, has also written extensively on inter- national 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 interna- tional 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 preci- sion 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

∙ Factor endowments—a nation’s position in factors of production, such as skilled la- bor 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.

LO 6 -2 Summarize the different theories explaining trade flows between nations.

TEST PRE P 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.

Demand Conditions

Factor Endowments

Related and Supporting Industries

Firm Strategy, Structure, and Rivalry

F I G U R E 6 . 5

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.

International Trade Theory Chapter 6 181

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 ad- vantage. For example, regulation can alter home demand conditions, antitrust policies can influence the intensity of rivalry within an industry, and government investments in educa- tion can change factor endowments.

FACTOR ENDOWMENTS

Factor endowments lie at the center of the Heckscher–Ohlin theory. While Porter does not propose anything radically new, he does analyze the characteristics of factors of produc- tion. He recognizes hierarchies among factors, distinguishing between basic factors (e.g., natural resources, climate, location, and demographics) and advanced factors (e.g., com- munication infrastructure, sophisticated and skilled labor, research facilities, and techno- logical 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 up- grade a nation’s advanced factors.

The relationship between advanced and basic factors is complex. Basic factors can pro- vide an initial advantage that is subsequently reinforced and extended by investment in 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 (reflect- ing 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 characteris- tics 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 sophis- ticated and knowledgeable buyers of cameras helped stimulate the Japanese camera indus- try 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. semi- conductor industry provided the basis for U.S. success in personal computers and several

182 Part 3 The Global Trade and Investment Environment

other technically advanced electronic products. Similarly, Switzerland’s success in phar- maceuticals is closely related to its previous international success in the technologically related dye industry.

One consequence of this process is that successful industries within a country tend to be grouped into clusters of related industries. This was one of the most pervasive findings of Porter’s study. One such cluster Porter identified was in the German textile and apparel sector, which included high-quality cotton, wool, synthetic fibers, sewing machine needles, and a wide range of textile machinery. Such clusters are important because valuable knowl- edge 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 strat- egy, 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 back- grounds leading many U.S. firms. He linked this to U.S. firms’ lack of attention to improv- ing 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. com- petitiveness in those engineering-based industries where manufacturing processes and product design issues are all-important (e.g., the automobile industry).

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 im- prove quality, to reduce costs, and to invest in upgrading advanced factors. All this helps create world-class competitors. Porter cites the case of Japan:

Nowhere is the role of domestic rivalry more evident than in Japan, where it is all-out warfare in which many companies fail to achieve profitability. With goals that stress market share, Japanese companies engage in a continuing struggle to outdo each other. Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings measure which companies are most popular with university graduates. The rate of new product and process development is breathtaking.37

EVALUATING PORTER’S THEORY

Porter contends that the degree to which a nation is likely to achieve international suc- cess 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 inf luence buyer needs. Government policy can influence supporting and related industries through regu- lation and influence firm rivalry through such devices as capital market regulation, tax policy, and antitrust laws.

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.

International Trade Theory Chapter 6 183

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 interna- tional trade.

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F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

LOCATION, FIRST-MOVER ADVANTAGES, AND GOVERNMENT POLICY

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

Location Underlying most of the theories we have discussed is the notion that dif- ferent 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 facili- ties should be located; if the manufacture of basic components can be performed most ef- ficiently 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 advan- tage, factor endowments, and the like. If the firm does not do this, it may find itself at a com- petitive 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 publi- cations offer strategies for exploiting first-mover advantages and for avoiding the traps as- sociated with pioneering a market (first-mover disadvantages).38

Government Policy The theories of international trade also matter to international busi- nesses 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 interna- tional trade claim that promoting free trade is generally in the best interests of a country,

LO 6 -5 Understand the important implications that international trade theory holds for business practice.

184 Part 3 The Global Trade and Investment Environment

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 pro- posed tariff, by increasing the cost of LCD screens, would increase the cost of laptop com- puters produced by IBM and Apple, thus making them less competitive in the world market. In other words, the tariff, designed to protect U.S. firms, would be self-defeating. In response to these pressures, the U.S. government reversed its posture. Unlike IBM and Apple, however, businesses do not always lobby for free trade. In the United States, for example, restrictions on imports of steel have periodically been put into place in response to direct pressure by U.S. firms on the government. In some cases, the government has responded to pressure by getting foreign companies to agree to “volun- tary” 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 “antidump- ing” actions to justify tariffs on imports from other nations (these mechanisms will be dis- cussed 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 ad- vanced 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. 160 new trade theory, p. 162 mercantilism, p. 163 zero-sum game, p. 163 absolute advantage, p. 164

constant returns to specialization, p. 170 factor endowments, p. 174 economies of scale, p. 177 first-mover advantages, p. 178 balance-of-payments accounts, p. 188

current account, p. 189 current account deficit, p. 189 current account surplus, p. 189 capital account, p. 189 financial account, p. 189

C H A P T E R S U M M A R Y

This chapter reviewed a number of theories that explain why it is beneficial for a country to engage in interna- tional 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 mercan- tilist doctrine and, to a lesser extent, the new trade theory can be interpreted to support government intervention to promote exports through subsidies and to limit imports through tariffs and quotas.

In explaining the pattern of international trade, this chapter shows that, with the exception of mercantilism, which is si- lent on this issue, the different theories offer largely comple- mentary 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 advan- tage 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 prod- uct is introduced is important; the new trade theory tells us that increasing returns to specialization and first-mover ad- vantages 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 effi- ciently. 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 produc- ing those goods that it can produce most effi- ciently, 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 in- creased world production—that is, that trade is a positive-sum game.

 5. The theory of comparative advantage also sug- gests that opening a country to free trade stimu- lates 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 in- tensive 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 indus- tries where substantial economies of scale imply that the world market will profitably support only a few firms, countries may predominate in the ex- port of certain products simply because they had a firm that was a first mover in that industry.

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

11. Porter’s theory of national competitive advantage suggests that the pattern of trade is influenced by four attributes of a nation: (a) factor endow- ments, (b) domestic demand conditions, (c) re- lated 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.

International Trade Theory Chapter 6 185

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

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 competi- tion “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?

186 Part 3 The Global Trade and Investment Environment

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

5. Reread the Country Focus “Is China Manipulat- ing 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 on 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 transfer- ence 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 competi- tive disadvantage in every sector of their econo- mies. They have little to export. They have no capital; their land is of poor quality; they often have too many people given available work op- portunities; and they are poorly educated. Free trade cannot possibly be in the interests of such nations. Discuss.

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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 compre- hensive, 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 ser- vice categories. Using the most recent statistics available, identify the top 10 countries that lead in the export and import of merchandise trade, re- spectively. Which countries appear in the top 10 in both exports and imports? Can you explain why these countries appear at the top of both lists?

2. Food in an integral part of understanding differ- ent 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 search- ing through the Australian supplier directory, identify three to four companies that can be po- tential suppliers. Then develop a list of criteria you would need to ask these companies to select which one to work with.

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, South Korea, Chile, Canada, Mexico, and Vietnam. China was not part of the deal.

Together, these countries account 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 op- position. Donald Trump, now president of the United States, said that the “TPP is a terrible deal.” Bernie Sanders,

C L O S I N G C A S E

The Trans Pacific Partnership (TPP)

International Trade Theory Chapter 6 187

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. On the other hand, the administration of Barack Obama heralded the TPP as a historic deal of major importance. Editorials in influen- tial publications such as The Wall Street Journal and The Economist urged the U.S. Congress to ratify the deal. So what does the deal try to do? If enacted, the TPP will eliminate or reduce about 18,000 tariffs, taxes, and nontar- iff barriers such as quotas on trade between and among the 12 member countries. By expanding market access and low- ering prices for consumers, economists claim that the deal will 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 will occur in other countries. U.S. agriculture would be 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 com- parative 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. manufac- turers also came out in support of the deal, which eliminates 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. On the other hand, 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 agree- ment, those tariffs would be phased down over 30 years. Labor unions were quick to oppose 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 com- panies 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 pro- tected new biotechnology products from generic competi- tion 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 bil- lion, 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 dur- ing the 2010–2015 period. At the time of writing, it seems that the TPP is effec- tively dead. President Trump remains opposed to the deal and pulled the United States out of the agreement. He claimed that the TPP would hurt American workers and undercut U.S. companies. China, a country that was not part of the TPP, responded to Trump’s election by pushing its own regional free trade deal. Known as the Regional Comprehensive Economic Partnership (RCEP), this agree- ment will cover 16 nations, including China, Vietnam, Ma- laysia, Indonesia, Japan, South Korea, India, Australia, and New Zealand, but it excludes the United States. Like the TPP, the RCEP will cut tariffs between member nations, but unlike the TPP, it will not restrict subsidies to ineffi- cient state-owned enterprises. The Council of Economic Advisors assessed that if the RCEP passes in place of the TPP, at least 35 U.S. industries that annually export $5.3 billion in goods to Japan “would see an erosion of their market access to Japan relative to Chinese firms.” This would affect 162,000 U.S. businesses that employ 5 million U.S. workers—and that’s only counting exports to Japan, one of seven TPP countries also involved in RCEP. 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.

C a s e D i s c u s s i o n Q u e s t i o n s 1. What are the benefits of the TPP? 2. Can you think of any drawbacks associated with

the TPP? 3. Why do you think that Donald Trump is so ada-

mantly opposed to the TPP? 4. Is the RCEP a threat to American economic

interests? 5. What is the opportunity cost to the United States

of withdrawing from the TPP?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

188 Part 3 The Global Trade and Investment Environment

A p p e n d i x : I n t e r n a t i o n a l Tr a d e a n d t h e B a l a n c e o f P a y m e n t s

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 pay- ments to foreigners for imports of goods and services, and receipts from foreigners for goods and services ex- ported to them. A summary copy of the U.S. balance-of- payments accounts for 2015 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.

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

Current Account $ Millions

Exports of goods, services, and income receipts (credits) $3,172,693

Goods 1,510,303

Services 750,860

Primary income receipts 782,915

Secondary income receipts 128,614

Imports of goods, services, and income (debits) 3,635,658

Goods 2,272,868

Services 488,657

Primary income payments 600,531

Secondary income payments 273,602

Capital Account Capital transfer receipts 0

Capital transfer debits 42

Financial Account

Net U.S. acquisition of financial assets 225,398

Net U.S. incurrence of liabilities 395,234

Net financial derivatives –25,392

Statistical discrepancy 267,780

Balances

Balance on current account −462,965

Balance on capital account −42

Balance on financial account −195,227

TA B L E A .1

U.S. Balance-of- Payments Accounts, 2015

Source: Bureau of Economic Analysis

International Trade Theory Chapter 6 189

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 transac- tions 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 food- stuffs, autos, computers, chemicals). The second category is the export or import of services (e.g., intangible products such as banking and insurance services). The third cate- gory, primary income receipts or payments, refers to in- come 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, ser- vice, or asset to the U.S. government or U.S. private enti- ties, or the transfer to a foreign government or entity in the case of payments (this includes tax payments, foreign pen- sion payments, cash transfers, etc.).

A current account deficit occurs when a country im- ports 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 2015 the United States ran a current account deficit of $462.97 billion. This is often a headline-grabbing figure and is widely reported in the news media. In recent years, the U.S. current account deficit has been fairly sig- nificant, primarily because America imports far more phys- ical 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 per- cent of the country’s GDP. The deficit has shrunk since then, and the 2015 current account deficit represented just 2.6 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 $42 million in 2015.

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 coun- try. 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 2015 there was a $225 billion 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 as- sets than they were selling. The net U.S. incurrence of liabilities refers to the change in U.S. assets owned by foreigners. In 2015 foreigners increased their holdings of U.S. assets by $395 billion, 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 transac- tion 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 an- other country for goods, it will enter the balance of pay- ments as a debit on the current account. Toyota now has the $20,000 and must do something with it. If Toyota de- posits the money at a U.S. bank, Toyota has purchased a U.S. asset—a bank deposit worth $20,000—and the trans- action 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. bal- ance 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 ac- count. 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 fi- nancial account.

Thus, any international transaction automatically gives rise to two offsetting entries in the balance of payments. Because of this, the sum of the current account balance, the capital account, and the financial account balance should always add up to zero. In practice, this does not always occur due to the existence of “statistical discrepan- cies,” the source of which need not concern us here (note that in 2015, the statistical discrepancy amounted to $267.8 billion).

190 Part 3 The Global Trade and Investment Environment

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 persis- tent 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. as- sets 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 ac- count deficit is being financed by a steady sale of U.S. as- sets (stocks, bonds, real estate, and whole corporations) to other countries. In short, countries that run current ac- count deficits become net debtors.

For example, as a result of financing its current ac- count deficit through asset sales, the United States must deliver a stream of interest payments to foreign bondhold- ers, rents to foreign landowners, and dividends to foreign stockholders. One might argue that such payments to for- eigners drain resources from a country and limit the funds available for investment within the country. Be- cause investment within a country is necessary to stimu- late 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 in-

vestments 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 reces- sion, the U.S. economy has grown substantially over the past 30 years, despite running a persistent current ac- count deficit and despite financing that deficit by selling U.S. assets to foreigners. This is precisely because foreign- ers 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 cur- rent 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 in- vestment in the United States back into the country, they would sell those dollars for another currency, European eu- ros, 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 ex- change 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 persis- tent 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 con- trolled decline in the value of the dollar, the dollar might suddenly lose a significant amount of its value in a very short time, precipitating a “dollar crisis.”42 Because the U.S. dollar is the world’s major reserve currency and is held by many foreign governments and banks, any dollar crisis could deliver a body blow to the world economy and at the very least trigger a global economic slowdown. That would not be a good thing.

E n d n o t e s

 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: Univer- sity 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 Argu- ments of Mainstream Economists Supporting Globalization,” Jour- nal 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. Paul A. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting

International Trade Theory Chapter 6 191

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 Pov- erty,” working paper, Development Research Group, World Bank, June 2001. Also, for an accessible discussion of the relationship between free trade and economic growth, see T. Taylor, “The Truth about Globalization,” Public Interest, Spring 2002, pp. 24–44; D. Acemoglu, S. Johnson, and J. Robinson, “The Rise of Europe: Atlantic Trade, Institutional Change and Economic Growth,” American Economic Review 95, no. 3 (2005), pp. 547–79; 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,” Brookings Papers on Economic Activity 1 (1995), 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 relation- ship 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, “Multi- country, 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 Econ- omy 15, no. 4 (1992), pp. 423–41.

31. M. B. Lieberman and D. B. Montgomery, “First-Mover Advan- tages,” 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: 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 Assess- ment,” Strategic Management Journal 12 (1991), pp. 535–48.

36. B. Kogut, ed., Country Competitiveness: Technology and the Orga- nizing of Work (New York: Oxford University Press, 1993).

37. M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990), 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 Cor- rection or Abrupt Adjustment?” National Bureau of Economic Research Working Paper Series, working paper no. 12154, April 2006.

Government Policy and International Trade L E A R N I N G O B J E C T I V E S Af ter 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.

part three The Global Trade and Investment Environment

7

©Bloomberg/Bloomberg/Getty Images

Boeing and Airbus Are in a Dogfight over Illegal Subsidies

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 rea- son 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 facili- ties 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. It remains to be seen what the final outcome will be. The WTO has yet to rule on how much damage Boeing’s tax breaks might impose upon Airbus. For its part, Boeing claims that the benefits from the subsidies to the 777X pro- gram only amount to $50 million a year, an assessment that Airbus vigorously disagrees with. The EU appealed this decision. 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.

O P E N I N G C A S E Boeing and Airbus 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’ 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. 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. In September 2016, the WTO issued another ruling criti- cizing the Europeans for failing to comply with its 2010 rul- ing 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

193

194 Part 3 The Global Trade and Investment Environment

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 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 sup- ports 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 domes- tic producers. For example, the opening case suggests that both Airbus and Boeing have been the recipients of illegal subsidies from various government agencies in Europe and the United States. The purpose of these subsidies has been to give each company an edge in global competition against its primary rival. In large part, the subsidies have been given because aircraft manufacturing employs significant numbers of highly skilled and well-paid labor, and as such has an important impact on the local economies where production operations are based. As described in the case, the World Trade Organization has been called on to rule on disputes between Airbus, Boeing, and the various governments in- volved. The WTO seems to believe that both Airbus and Boeing have been the recipients of illegal subsidies.

This chapter explores the political and economic reasons that governments have for intervening in international trade. When governments intervene, they often do so by re- stricting imports of goods and services into their nation while adopting policies that pro- mote domestic production and exports. Normally, their motives are to protect domestic producers. In recent years, social issues have intruded into the decision-making calculus. In the United States, for example, a movement is growing to ban imports of goods from 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 govern- ment intervention in international trade. Then we look at the emergence of the modern international trading system, which is based on the General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization. The GATT and WTO are the creations of a series of multinational treaties. The final section of this chapter dis- cusses the implications of this material for management practice.

Instruments of Trade Policy

Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary ex- port restraints, local content requirements, administrative policies, and antidumping du- ties. 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 suc- cessful 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 anti- dumping duties.

LO 7-1 Identify the policy instruments used by governments to influence international trade flows.

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TARIFFS

A tariff is a tax levied on imports (or exports). Tariffs fall into two categories. Specific tariffs are levied as a fixed charge for each unit of a good imported (e.g., $3 per barrel of oil). Ad valorem tariffs are levied as a proportion of the value of the imported good. In most cases, tariffs are placed on imports to protect domestic producers from foreign com- petition 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.

The important thing to understand about an import tariff is who suffers and who gains. The government gains because the tariff increases government revenues. Domestic produc- ers gain because the tariff affords them some protection against foreign competitors by 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 do- mestic 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 vio- lation of the WTO treaty, and the United States removed them in December of that year.

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 produc- ers from foreign competitors, this restriction of supply also raises domestic prices. For exam- ple, 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 encour- ages domestic firms to produce products at home that could be produced more efficiently abroad. The consequence is an inefficient utilization of resources.2

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 mod- erate the growth in exports of textiles from China, thereby alleviating tensions with other trad- ing 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. As noted in the opening case, both Boeing and Airbus have received substantial subsidies from government bodies over the last 40 years. By lowering produc- tion 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 benefi- ciaries 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

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.

C O U N T R Y F O C U S

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Are the Chinese Illegally Subsidizing Auto Exports? In late 2012, during that year’s presidential election cam- paign, 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 com- plaint also pointed out that in the years 2002 through 2011, the value of China’s exports of autos and auto parts in- creased more than ninefold from $7.4 billion to $69.1 bil- lion. The United States was China’s largest market for exports of auto parts during this period. The United States asserted 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 proba- bility, 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 addi- tion, 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 any event, the WTO does not move rapidly, and the case is still under consideration. Indeed, in February 2014, the United States expanded its complaint with the WTO against China, arguing that the country had an illegal ex- port subsidy program that includes not only autos and auto parts, but also textile, apparel and footwear, ad- vanced materials and metals, specialty chemicals, medical products, and agriculture.

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.

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 advan- tage 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 ex- ports of autos and auto parts. Details are given in the Country Focus feature.

The main gains from subsidies accrue to domestic producers, whose international com- petitiveness is increased as a result. Advocates of strategic trade policy (which, as you will recall from Chapter 6, is an outgrowth of the new trade theory) favor subsidies to help 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 (just as U.S. government subsidies, in the form of substantial R&D grants, alleg- edly helped Boeing). If this is achieved, further gains to the domestic economy arise from the employment and tax revenues that a major global company can generate. However, government subsidies must be paid for, typically by taxing individuals and corporations.

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Whether subsidies generate national benefits that exceed their national costs is debat- able. In practice, many subsidies are not that successful at increasing the international com- petitiveness 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

An import quota is a direct restriction on the quantity of some good that may be im- ported 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 im- ports. 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.

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.

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 situa- tion by appeasing protectionist pressures in a country.

80%

10%

Tari� Rate % Quota Limit

In quota

Out of quota

2 million1 million Tons of Rice Imported0

F I G U R E 7.1

Hypothetical tariff rate quota.

198 Part 3 The Global Trade and Investment Environment

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 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 infra- structure 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, 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 a 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 con- tent regulations have been widely used by developing countries to shift their manufactur- ing 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

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the prices of imported components. In turn, higher prices for imported components are passed on to consumers of the final product in the form of higher final prices. So as with all trade policies, local content regulations tend to benefit producers and not consumers.

ADMINISTRATIVE POLICIES

In addition to the formal instruments of trade policy, governments of all types sometimes use informal or administrative policies to restrict imports and boost exports. Administra- tive 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 re- cent 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 for- eign, 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.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 competi- tors 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 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 agen- cies, 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. Magne- sium, used antidumping legislation to gain protection from unfair foreign competitors.

The Case for Government Intervention

Now that we have reviewed the various instruments of trade policy that governments can use, it is time to look at the case for government intervention in international trade. Argu- ments for government intervention take two paths: political and economic. Political argu- ments for intervention are concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consum- ers), 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).

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.

LO 7-2 Understand why governments sometimes intervene in international trade.

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 Com- mission 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. Magne- sium, 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.”9

During a yearlong investigation, the ITC solicited input from various sides in the dispute. Foreign producers and consumers of magnesium in the United States argued that falling prices for magnesium during 2002 and 2003 simply reflected an imbalance between supply and de- mand due to additional capacity coming on stream not from Russia or China but from a new Canadian plant that opened in 2001 and from a planned Australian plant. The Canadian plant shut down in 2003, the Australian plant never came on stream, and prices for magnesium rose again in 2004. Magnesium consumers in the United States also argued to the ITC that imposing antidumping duties on foreign imports of magnesium would raise prices in the United States significantly above world levels. A spokes- person for Alcoa, which mixes magnesium with alumi- num to make alloys for cans, predicted that if antidumping duties were imposed, high magnesium prices in the United States would force Alcoa to move some produc- tion 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 automo- biles 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 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 im- ports of magnesium from China. Russian producers faced duties ranging from 19 percent to 22 percent. The duties were to be levied for five years, after which the ITC would revisit the situation. The ITC revoked the antidumping order on Russia in February 2011 but decided to continue placing them on Chinese producers. 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 per- cent 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.”10  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 pro- tect 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; Dan Ikenson, “Death by Antidumping,” Forbes, January 3, 2011.

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POLITICAL ARGUMENTS FOR INTERVENTION

Political arguments for government intervention cover a range of issues, including pre- serving 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. Competi- tion is most often viewed as unfair when producers in an exporting country are subsidized in some way by their government. For example, it has been repeatedly claimed that Chinese enterprises in several industries, including aluminum, steel, and auto parts, have benefited from extensive government subsidies. Such logic was behind the complaint that the Obama administration filed with the WTO against Chinese auto parts producers in 2012 (see the Country Focus 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, in- cluding direct subsidies to Chinese producers and currency manipulations. Scott esti- mated that as many as 3.4 million U.S. jobs were lost as a consequence.11 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 estab- lishment 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 atten- tion (e.g., aerospace, advanced electronics, and semiconductors). Although not as com- mon as it used to be, this argument is still made. Those in favor of protecting the U.S. semiconductor industry from foreign competition, for example, argue that semiconductors are now such important components of defense products that it would be dangerous to rely primarily on foreign producers for them. In 1986, this argument helped persuade the fed- eral government to support Sematech, a consortium of 14 U.S. semiconductor companies that accounted for 90 percent of the U.S. industry’s revenues. Sematech’s mission was to conduct joint research into manufacturing techniques that could be parceled out to mem- bers. The government saw the venture as so critical that Sematech was specially protected from antitrust laws. Initially, the U.S. government provided Sematech with $100 million per year in subsidies. By the mid-1990s, however, the U.S. semiconductor industry had re- gained its leading market position, largely through the personal computer boom and de- mand for microprocessor chips made by Intel. In 1994, the consortium’s board voted to seek an end to federal funding, and since 1996, the consortium has been funded entirely by private money.12

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Retaliating Some argue that governments should use the threat to intervene in trade policy as a bar- gaining 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 cost- ing 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.13

If it works, such a politically motivated rationale for government intervention may liber- alize trade and bring with it resulting economic gains. It is a risky strategy, however. A country that is being pressured may not back down and instead may respond to the imposi- tion 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 bar- riers 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, de- cided 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.14 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

T R A D E L A W

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 govern- ment level and moving all the way to what organizations and even individuals can and cannot do globally when trading. The globalEDGETM section “Trade Law” (globaledge.msu.edu/ global-resources/trade-law) is a unique compilation of globalEDGETM partner-designed “compendiums of trade laws,” country- and region-specific trade law, free online learning modules created for globalEDGETM 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 globalEDGETM and especially the A-CAPPP site to become more famil- iar with the topic. (Is China really as bad as many in the international community think?)

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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 gov- ernment 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 weap- ons 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 weap- ons. The U.S. government responded by relaxing those sanctions. Similarly, the U.S. gov- ernment used trade sanctions to pressure the Iranian government to halt its alleged nuclear weapons program. Following a 2015 agreement to limit Iran’s nuclear program, it relaxed some of those sanctions.

Other countries can undermine unilateral trade sanctions. 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 na- tions, such as Canada and Germany, have stepped.

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 re- sponse 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 re- cent years. Until the early 1980s, most economists saw little benefit in government inter- vention 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 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) un- til they have grown strong enough to meet international competition.

This argument has had substantial appeal for the governments of developing nations during the past 50 years, and the GATT has recognized the infant industry argument as a legitimate reason for protectionism. Nevertheless, many economists remain critical of this argument for two main reasons. First, protection of manufacturing from foreign competi- tion does no good unless the protection helps make the industry efficient. In case after

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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.15

Second, the infant industry argument relies on an assumption that firms are unable to make efficient long-term investments by borrowing money from the domestic or interna- tional capital market. Consequently, governments have been required to subsidize long- term investments. Given the development of global capital markets over the past 20 years, this assumption no longer looks as valid as it once did. Today, if a developing country has a potential comparative advantage in a manufacturing industry, firms in that country should be able to borrow money from the capital markets to finance the required invest- ments. Given financial support, firms based in countries with a potential comparative ad- vantage 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 govern- ment protection would be those that are not worthwhile.

Strategic Trade Policy Some new trade theorists have proposed the strategic trade policy argument.16 We re- viewed 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 famous cigar maker Jose Castelar Cairo, better known as El Cueto, about to roll a cigar, in Havana, Cuba. ©Esben Hansen/123RF

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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 en- sure 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 argu- ments 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 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 argu- ment 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 mar- ket when it began production in the mid-1970s. By 2016, 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.17 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 domes- tic 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.

The Revised Case for Free Trade

The strategic trade policy arguments of the new trade theorists suggest an economic justi- fication 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.18

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

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.

LO 7-3 Summarize and explain the arguments against strategic trade policy.

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be that the subsidies would cancel each other out. In the process, both European and U.S. taxpayers would end up supporting an expensive and pointless trade war, and both Europe and the United States would be worse off.

Krugman may be right about the danger of a strategic trade policy leading to a trade war. The problem, however, is how to respond when one’s competitors are already being 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 sup- ported 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 econ- omy; 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 farm- ers 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 accord- ing to the theory but may be the best policy that the country is likely to get.19

Development of the World Trading System

Strong economic arguments support unrestricted free trade. While many governments have recognized the value of these arguments, they have been unwilling to unilaterally lower their trade barriers for fear that other nations might not follow suit. Consider the problem that two neighboring countries, say, Brazil and Argentina, face when deciding whether to lower trade barriers between them. In principle, the government of Brazil might favor lowering trade bar- riers, but it might be unwilling to do so for fear that Argentina will not do the same. Instead, the government might fear that the Argentineans will take advantage of Brazil’s low barriers to enter the Brazilian market while continuing to shut Brazilian products out of their market through high trade barriers. The Argentinean government might believe that it faces the same dilemma. The essence of the problem is a lack of trust. Both governments recognize that their respective nations will benefit from lower trade barriers between them, but neither government is willing to lower barriers for fear that the other might not follow.20

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 govern- ment 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.

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.

LO 7- 4 Describe the development of the world trading system and the current trade issue.

Government Policy and International Trade Chapter 7 207

FROM SMITH TO THE GREAT DEPRESSION

As noted in Chapter 5, the theoretical case for free trade dates to the late eighteenth cen- tury 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 re- pealed 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 with- drawn 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 consid- erable hardship and suffering among the populace, Parliament narrowly reversed its long- held position.

During the next 80 years or so, Great Britain, as one of the world’s dominant trading powers, pushed the case for trade liberalization, but the British government was a voice in the wilderness. Its major trading partners did not reciprocate the British policy of unilateral free trade. The only reason Britain kept this policy for so long was that as the world’s largest exporting nation, it had far more to lose from a trade war than did any other country.

By the 1930s, the British attempt to stimulate free trade was buried under the eco- nomic 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 unem- ployment by protecting domestic industries and diverting consumer demand away from foreign products, the Smoot–Hawley Act erected an enormous wall of tariff barriers. Almost every industry was rewarded with its “made-to-order” tariff. The Smoot–Hawley Act had a damaging effect on employment abroad. Other countries reacted by raising their own tariff barriers. U.S. exports tumbled in response, and the world slid further into the Great Depression.21

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 argu- ments 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

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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 competi- tors. 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) circumvent GATT agreements, because neither the importing country nor the exporting country complains to the GATT bureaucracy in Geneva—and without a complaint, the GATT bureaucracy can do nothing. Exporting countries agreed to VERs to avoid more damaging punitive tariffs. One of the best-known examples is the automobile VER between Japan and the United States, under which Japanese producers promised to limit their auto imports into the United States as a way of defusing growing trade tensions. According to a World Bank study, 16 percent of the imports of industrialized countries in 1986 were sub- jected to nontariff trade barriers such as VERs.22

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 negotia- tions yet. Until then, GATT rules had applied only to trade in manufactured goods and commodities. In the Uruguay Round, member countries sought to extend GATT rules to cover trade in services. They also sought to write rules governing the protection of intel- lectual property, to reduce agricultural subsidies, and to strengthen the GATT’s monitor- ing 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 Gen- eral Agreement on Trade in Services (GATS) has taken the lead to extending free trade agreements to services. The WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) is an attempt to narrow the gaps in the way intellectual property rights are protected around the world and to bring them under common international rules. WTO has taken over responsibility for arbitrating trade disputes and monitoring the trade policies of member countries. While the WTO operates on the basis of consensus as

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the GATT did, in the area of dispute settlement, member countries are no longer able to block adoption of arbitration reports. Arbitration panel reports on trade disputes between member countries are automatically adopted by the WTO unless there is a consensus to reject them. Countries that have been found by the arbitration panel to violate GATT rules may appeal to a permanent appellate body, but its verdict is binding. If offenders fail to comply with the recommendations of the arbitration panel, trading partners have the right to compensation or, in the last resort, to impose (commensurate) trade sanctions. Every stage of the procedure is subject to strict time limits. Thus, the WTO has something that the GATT never had—teeth.23

WTO: EXPERIENCE TO DATE

By 2016, 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 pro- mote 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 protec- tionism. 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.24 Between 1995 and 2015, more than 500 trade disputes between member countries were brought to the WTO.25 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 agree- ments 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 telecommu- nication and financial services industries.

In February 1997, the WTO brokered a deal to get countries to agree to open their tele- communication 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 tele- phone, data, and satellite and radio communications. Many telecommunication compa- nies responded positively to the deal, pointing out that it would give them a much greater

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ability to offer their business customers one-stop shopping—a global, seamless service for all their corporate needs and a single bill.

This was followed in December 1997 with an agreement to liberalize cross-border trade in financial services. The deal covered more than 95 percent of the world’s financial ser- vices 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 fi- nancial services sector. The United States and the European Union (with minor excep- tions) 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 grow- ing in many nations. As the public face of globalization, some politicians and nongovern- mental 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 poli- cies, the high level of protectionism in agriculture, the lack of strong protection for intel- lectual property rights in many nations, and continued high tariff rates on nonagricultural goods and services in many nations. We shall look at each in turn before discussing the latest round of talks between WTO members aimed at reducing trade barriers, the Doha Round, which began in 2001 and now seem to be stalled.

Antidumping Actions Antidumping actions proliferated during the 1990s and 2000s. WTO rules allow countries to impose antidumping duties on foreign goods that are being sold cheaper than at home or below their cost of production when domestic producers can show that they are being harmed. Unfortunately, the rather vague definition of what constitutes “dumping” has proved to be a loophole that many countries are exploiting to pursue protectionism.

Between 1995 and mid-2016, WTO members had reported implementation of some 5,132 antidumping actions to the WTO. India initiated the largest number of antidumping actions, some 818; the EU initiated 485 over the same period, and the United States, 593. China accounted for 1,170 complaints, South Korea for 384, the United States for 273, Taipei for 279, and Japan for 202. Antidumping actions seem to be concentrated in certain sectors of the economy, such as basic metal industries (e.g., aluminum and steel), chemi- cals, plastics, and machinery and electrical equipment.26 These sectors account for ap- proximately 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 produc- tive capacity, which have led to low prices and profits (or losses) for firms in those indus- tries. 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

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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 agricul- tural 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 21.2 percent for Canada, 15.9 percent for the European Union, 18.6 percent for Japan, and 10.3 percent for the United States.27 The implication is that consumers in these countries are paying signifi- cantly higher prices than necessary for agricultural products imported from abroad, which leaves them with less money to spend on other goods and services.

The historically high tariff rates on agricultural products reflect a desire to protect 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 Develop- ment (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.28 OECD countries spend more than $300 bil- lion a year in agricultural subsidies.

Not surprisingly, the combination of high tariff barriers and subsidies introduces sig- nificant 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 agricul- tural trade, and encourage the overproduction of products that are heavily subsidized (with the government typically buying the surplus). Because global trade in agriculture

Production operations at J.M. Larson Dairy. ©Bloomberg/Getty Images

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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 Interna- tional Monetary Fund, removal of tariffs and subsidies on agricultural products would raise global economic welfare by $128 billion annually.29 Others suggest gains as high as $182 billion.30

The biggest defenders of the existing system have been the advanced nations of the world, which want to protect their agricultural sectors from competition by low-cost pro- ducers in developing nations. In contrast, developing nations have been pushing hard for reforms that would allow their producers greater access to the protected markets of the developed nations. Estimates suggest that removing all subsidies on agricultural produc- tion 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.31 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 poor- est 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 cen- tral 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 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 eco- nomic 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.

C O U N T R Y F O C U S

213

Estimating the Gains from Trade for America A study published by the Institute for International Eco- nomics tried to estimate the gains to the American econ- omy from free trade. According to the study, due to reductions in tariff barriers under the GATT and WTO since 1947, by 2003 the gross domestic product (GDP) of the United States was 7.3 percent higher than would otherwise be the case. The benefits of that amounted to roughly $1 trillion a year, or $9,000 extra income for each American household per year. The same study tried to estimate what would happen if America concluded free trade deals with all its trading partners, reducing tariff barriers on all goods and services to zero. Using several methods to estimate the impact, the study concluded that additional annual gains of between $450 billion and $1.3 trillion could be realized. This final march to free trade, according to the authors of the study, could safely be expected to raise incomes of the average American household by an additional $4,500 per year. The authors also tried to estimate the scale and cost of 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 barri- ers. 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 an- other $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 asso- ciated 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).

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.32 Given the ris- ing 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.33 Another estimate from the OECD suggests a figure closer to $300 billion annually.34 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 non- agricultural goods into developing nations. Many of these nations use the infant industry argument to justify the continued imposition of high tariff rates; however, ultimately these rates need to come down for these nations to reap the full benefits of international trade. For example, the bound tariff rates of 53.9 percent on imports of transportation equip- ment 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 in- come of consumers who must pay more for transportation equipment and related services.

214 Part 3 The Global Trade and Investment Environment

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 limit- ing the use of antidumping laws. The talks are currently ongoing. They have been charac- terized 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 sub- sidies 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 disagree- ments over how deep the cuts in subsidies to agricultural producers should be. As of early 2017, the goal was to reduce tariffs for manufactured and agricultural goods by 60 to 70 percent and to cut subsidies to half of their current level—but getting nations to agree to these goals was proving exceedingly difficult.

MULTILATERAL AND BILATERAL TRADE AGREEMENTS

In response to the apparent failure of the Doha Round to progress, many nations have pushed forward with multilateral or bilateral trade agreements, which are reciprocal trade agreements between two or more partners. For example, in 2014 Australia and China entered into a bilateral free trade agreement. Similarly, in March 2012 the United States entered into a bilateral free trade agreement with South Korea. Under this agree- ment, 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. 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 TPP was abandoned, and the future of the trade agreement being negotiated with the EU is now in doubt.

Multilateral and bilateral trade agreements are designed to capture gain from trade be- yond those agreements currently attainable under WTO treaties. Multilateral and bilateral trade agreements are allowed under WTO rules, and countries entering into these agree- ments are required to notify the WTO. As of 2016, some 432 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 f low 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

Government Policy and International Trade Chapter 7 215

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. He has also ex- pressed hostility toward NAFTA and the WTO. Both Britain and America have been leaders in the the global push toward greater free trade. If these two countries are now turning their backs on free trade deals, and dismantling existing ones, 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 unem- ployment 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.

F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

TRADE BARRIERS, FIRM STRATEGY, AND POLICY IMPLICATIONS What are the implications for business practice? Why should the international man-

ager 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 ques- tion. 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 pro- duction 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 automak- ing capacity in the United States during the 1980s and 1990s. This followed the establish- ment 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.35  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 produc- tion 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

LO 7-5 Explain the implications for managers of developments in the world trading system.

216 Part 3 The Global Trade and Investment Environment

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, irre- spective 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 coun- tries whose exports are not targeted by the specific trade barrier. Finally, the threat of antidumping action limits the ability of a firm to use aggressive pricing to gain market share in a country. Firms in a country also can make strategic use of antidump- ing 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 for- eign 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 pro- ducers 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).36

Policy Implications As noted in Chapter 6, business firms are major players on the interna- tional 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 protec- tionism, 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 argu- ments 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 ineffi- cient 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 ex- ecuted, 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 for- eign 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 increas- ing integration of the world economy and internationalization of production that has oc- curred 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 advan- tage. 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 en- gage 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 produc- tion system. By encouraging their governments to engage in protectionism, their own activi- ties 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.

Government Policy and International Trade Chapter 7 217

free trade, p. 194 General Agreement on Tariffs and

Trade (GATT), p. 194 tariff, p. 195 specific tariff, p. 195 ad valorem tariff, p. 195 subsidy, p. 195 import quota, p. 197 tariff rate quota, p. 197

voluntary export restraint (VER), p. 197

quota rent, p. 198 export tariff, p. 198 export ban, p. 198 local content requirement

(LCR), p. 198 administrative trade

policies, p. 199

dumping, p. 199 antidumping policies, p. 199 countervailing duties, p. 199 infant industry argument, p. 203 strategic trade policy, p. 206 Smoot-Hawley Act, p. 207 multilateral or bilateral trade

agreements, p. 214

Key Terms

C H A P T E R S U M M A R Y

This chapter described how the reality of international trade deviates from the theoretical ideal of unrestricted free trade reviewed in Chapter 6. In this chapter, we re- ported the various instruments of trade policy, reviewed the political and economic arguments for government intervention in international trade, reexamined the eco- nomic 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 busi- ness and consumers may be best served by strengthen- ing 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 domes- tic industries from foreign competition. The chapter made the following points:

 1. Trade policies such as tariffs, subsidies, anti- dumping regulations, and local content require- ments 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 govern- ment intervention in international trade: politi- cal 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 re- gard 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, po- litical intervention often hurts consumers, and it can be self-defeating. Countries sometimes argue that it is important to protect certain industries for reasons of national security. Some argue that government should use the threat to intervene in trade policy as a bargaining tool to open foreign markets. This can be a risky policy; if it fails, the result can be higher trade barriers.

 4. The infant industry argument for government in- tervention contends that to let manufacturing get a toehold, governments should temporarily sup- port new industries. In practice, however, govern- ments often end up protecting the inefficient.

 5. Strategic trade policy suggests that with subsi- dies, 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 two- fold: (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 eco- nomic growth.

218 Part 3 The Global Trade and Investment Environment

 8. The completion of the Uruguay Round of GATT talks and the establishment of the World Trade Organization have strengthened the world trad- ing system by extending GATT rules to services, increasing protection for intellectual property, re- ducing agricultural subsidies, and enhancing monitoring and enforcement mechanisms.

 9. Trade barriers act as a constraint on a firm’s abil- ity 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 govern- ment efforts to open protected markets to imports and foreign direct investment than from government efforts to protect domestic industries from foreign competition.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Do you think governments should consider hu- man 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 con- cern 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 gov- ernment 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 rela- tively low labor costs and a skilled workforce. Other possible locations considered at the time were Malaysia and Hong Kong. The U.S. govern- ment decides to impose punitive 100 percent ad valorem tariffs on imports of computers from Thailand to punish the country for administra- tive 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 anti- dumping 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?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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 lim- ited. 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 pharma- ceutical 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?

Government Policy and International Trade Chapter 7 219

In the 15 years up to 2015, China increased its steel production fivefold as it forged the steel products demanded by its huge boom in construction and infrastructure spending. By 2015, the country produced 800 million tons of steel a year, half of the world’s annual output. However, in 2015 the bottom fell out of the Chinese domestic market for steel. The economy slowed down, and the government shifted its priorities away from massive infrastructure investments and to- ward boosting consumer spending. By the end of 2015, Chinese steelmakers were estimated to be producing 300 million more tons of steel a year than required for domestic consumption. With prices for steel slumping, China’s largest 101 steel firms lost more than $12 billion in 2015, roughly twice what they made in profits during 2014. Not sur- prisingly, the Chinese are seeking to export this un- wanted product, even if it is at a loss. China exported more than 100 million tons of steel for the first time in 2015, making its steel exports alone larger than the pro- duction of any other country in the world except for Japan. The prices for Chinese steel products appear to be at least 10 percent lower outside of China than within the country. Those low-priced exports are having a devastating im- pact on steelmakers around the globe. American produc- ers have responded by clamoring for action from the U.S. Commerce Department to stop what they perceive to be the illegal dumping of steel products below the costs of production. Moreover, they have argued that cheap steel from China has also persuaded producers in India, Italy, South Korea, and Taiwan to dump their excess produc- tion on the world market, further harming U.S. produc- ers. In November 2015, the Commerce Department ruled that all of these countries except Taiwan were dumping steel and placed duties as high as 236 percent on some imports of foreign steel. In late December, the Commerce Department ruled that China was also selling corrosion- resistant steel at unfairly low prices and placed an addi- tional 256 percent tariff on such imports. This erected a huge barrier to certain Chinese steel imports into the United States. The European Union also took similar steps. The United Kingdom has been particularly hard hit by Chinese imports. Chinese imports now take 45 percent of

the UK market for steel rebar, up from nothing in 2010. Overall, steel imports from China doubled between 2014 and 2015. The United Kingdom lost some 4,000 steelmaking jobs in the second half of 2015 as the Chinese grabbed market share. Elsewhere in Europe, the Luxembourg- based steel giant ArcelorMittal blamed dumping by Chinese firms for a $8 billion loss in 2015. In response, in January 2016, the EU placed a 13 percent tariff on imports of Chinese steel. EU steel- makers called this totally inadequate, particularly given the much large tariffs levied in the United States. In mid-2016, the EU responded by placing tariffs as high as 22 percent on imports of non–stainless steel prod- ucts from China. For its part, the Chinese government remained unmoved. In fact, it may have added fuel to the fire in December 2015 when it cut export taxes on several types of steel, signaling perhaps that it was dou- bling down on a strategy to encourage domestic pro- ducers to export their surplus production rather than close mills.

Sources: Sonja Elmquist, “U.S. Calls for 256% Tariff on Imports of Steel from China,” Bloomberg News, December 22, 2015; “China’s Soaring Steel Exports May Presage a Trade War,” The Economist, December 9, 2015; “Steel Imports from China Investigated by the European Commission,” BBC News, February 12, 2016; Ivana Kottasova, “Europe Tries to Protect Steel Jobs with Tariffs on Chinese Imports,” CNN Money, January 29, 2016; Jones Hayden, “China-Russia Steel Hit with 5-Year Anti-Dumping Tariffs,” Bloomberg, August 4, 2016.

C a s e D i s c u s s i o n Q u e s t i o n s

1. Does the evidence suggest to you that China is dumping excess steel production on world markets?

2. Absent of any response from other nations, how long can China pursue this policy?

3. Who is harmed by this action? Who might benefit? 4. What alternative policy might China pursue? What

are the costs and benefits of this alternative policy to China?

5. Are the EU and the United States correct to im- pose significant antidumping duties on imports of Chinese steel? What will the benefits of such policy be? Are there any drawbacks?

C L O S I N G C A S E

Is China Dumping Excess Steel Production?

220 Part 3 The Global Trade and Investment Environment

6. Can you think of any unintended consequences that might occur as the result of the imposition of antidumping duties on Chinese steel imports by the United States and the EU?

7. What other steps could be taken in the long run to reduce the probability that producers in China

and elsewhere will dump their excess production at a loss on world markets?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

E n d n o t e s

 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, “Distor- tions 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. Huf bauer and Z. A. Elliott, Measuring the Costs of Protection- ism in the United States (Washington, DC: Institute for Interna- tional Economics, 1993).

 8. Sean McLain, “American Cars in Japan: Lost in Translation,” The Wall Street Journal, January 26, 2017.

 9. D. Anderton, “U.S. Magnesium Lands Ruling on Unfair Imports,” Deseret News, October 1, 2004, p. D10.

10. S. Oberbeck, “U.S. Magnesium Plans Big Utah Production Expansion,” Salt Lake Tribune, March 30, 2006.

11. Robert E. Scott. “Growth in US–China Trade Deficit Between 2001–2015 Cost 3.4 Million Jobs,” Economic Policy Institute, January 31, 2017.

12. 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.

13. N. Dunne and R. Waters, “U.S. Waves a Big Stick at Chinese Pirates,” Financial Times, January 6, 1995, p. 4.

14. 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.

15. “Brazil’s Auto Industry Struggles to Boost Global Competitive- ness,” Journal of Commerce, October 10, 1991, p. 6A.

16. 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.

17. “Airbus and Boeing: The Jumbo War,” The Economist, June 15, 1991, pp. 65–66.

18. For details, see Krugman, “Is Free Trade Passé?”; Brander, “Rationales for Strategic Trade and Industrial Policy.”

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

20. This dilemma is a variant of the famous prisoner’s dilemma, which has become a classic metaphor for the difficulty of achieving cooperation between self-interested and mutually suspicious entities. For a good general introduction, see A. Dixit and B. Nalebuff, Thinking Strategically: The Competi- tive Edge in Business, Politics, and Everyday Life (New York: Norton, 1991).

21. Note that the Smoot–Hawley Act did not cause the Great De- pression. However, the beggar-thy-neighbor trade policies that it ushered in certainly made things worse. See J. Bhagwati, Protec- tionism (Cambridge, MA: MIT Press, 1988).

22. World Bank, World Development Report (New York: Oxford University Press, 1987).

23. 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.

24. 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 https://www. wto.org/english/res_e/publications_e/anrep16_e.htm.

25. Information provided on WTO website, www.wto.org/english/ tratop_e/dispu_e/dispu_status_e.htm.

26. Data at www.wto.org/english/tratop_e/adp_e/adp_e.htm.

27. World Trade Organization, Annual Report by the Director General 2003 (Geneva: WTO, 2003).

Government Policy and International Trade Chapter 7 221

28. World Trade Organization, Annual Report by the Director General 2003 (Geneva: WTO, 2003).

29. World Trade Organization, Annual Report by the Director General 2003 (Geneva: WTO, 2003).

30. Anderson et al., “Distortions to World Trade.”

31. World Trade Organization, Annual Report 2002 (Geneva: WTO, 2002).

32. S. C. Bradford, P. L. E. Grieco, and G. C. Huf bauer, “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).

33. World Bank, Global Economic Prospects 2005 (Washington, DC: World Bank, 2005).

34. “Doha Development Agenda,” OECD Observer, September 2006, pp. 64–67.

35. Peter Nicholas, “Trump Warns Auto Executive on Moving Business Overseas,” The Wall Street Journal, January 24, 2017.

36. “Punitive Tariffs Are Approved on Imports of Japanese Steel,” The New York Times, June 12, 1999, p. A3.

Foreign Direct Investment L E A R N I N G O B J E C T I V E S Af ter 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.

part three The Global Trade and Investment Environment

8

©Imaginechina via AP Images

Foreign Direct Investment in Retailing in India

retailers set up wholly owned stores. These plans were greeted with strong opposition from small retailers and ri- val political parties, and the government was forced to temporarily shelve them.  In early 2012, the Indian government managed to se- cure approval for plans to allow foreign single-brand retail- ers 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 retail- ers to respond to these changes was IKEA, which an- nounced that it would invest $1.9 billion and set up 25 stores in the country. More generally though, many an- alysts 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 late 2012, the federal Indian government allowed for- eign 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 owner- ship 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 com- pany as a multi-brand retailer, limit its ownership stake in Indian operation to 51 percent, and require it to take an In- dian partner. Instead, Amazon only sells goods offered through its marketplace platform by third parties. However, Amazon, is investing heavily in fulfillment centers and lo- gistics infrastructure to enable it to deliver goods efficiently to Indian customers. As such, its investment may help to boost the efficiency of supply chains in the country.

Sources: Greg Bensinger, “Amazon Plans $3 Billion Indian Invest- ment,” 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.

O P E N I N G C A S E Historically, the structure of retailing in India was very frag- mented 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 (com- pared 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 trans- form India’s retail space, making it more efficient and bring- ing modern retail formats, technology, and supply chains to the country. This would benefit consumers and produc- ers from farmers to manufacturers. For example, it has been estimated that up to 40 percent of the food pro- duced 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 his- tory 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.  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 con- dition for continued economic development. Clearly, the government believed that greater foreign capital and tech- nology 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 government stated its intention to allow single-brand

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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 investments by IKEA and Amazon in India that were discussed in the opening case are examples of FDI.

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. The chapter then moves on to look at government policy toward foreign direct investment. As illustrated by the opening case on FDI in India’s retail sector, govern- ment policy can have a dramatic impact on a firm’s ability to invest directly in a foreign nation. Retailers from Nike and IKEA to Walmart and Tesco have long wanted to open retail stores in India, but have been kept at bay by regulations that either banned outright foreign ownership of retail outlets or made it costly to enter the market. This has not been good for India, which has a grossly inefficient retail sector and a poor logistic infrastruc- ture. Recent changes in the laws governing FDI have now made it somewhat easier for foreigner retailers to enter India, but barriers still exist, which is not good for the Indian economy, consumers, or many producers within the country. Those barriers, however, do protect small retailers, who are politically powerful. 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

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 accumu- lated value of foreign-owned assets at a given time. We also talk of outflows of FDI, mean- ing 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 $1.59 trillion in 2016 (see Figure 8.1).1 Over the past 25 years, the flow of FDI has acceler- ated faster than the growth in world trade and world output. For example, between 1990 and 2016, 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 2016 the global stock of FDI was about $26 trillion. The foreign af- filiates of multinationals had more than $36 trillion in global sales in 2016, compared to $21 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 phenome- non in the global economy.

FDI has grown more rapidly than world trade and world output for several reasons. First, despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Given the rising pressures for protectionism associated with the election of Donald Trump as president in the United States and the decision by the British to leave the European Union, this seems likely to continue for some time. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world’s developing nations. The general shift toward democratic political institu- tions 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

LO 8 -1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.

Foreign Direct Investment Chapter 8 225

many restrictions on FDI have made these countries more attractive to foreign multina- tionals. 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 custom- ers. 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

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United States has been an attractive target for FDI because of its large and wealthy domes- tic 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 $391 billion in 2016. The developed nations of Europe have also been recipients of significant FDI inflows, principally from the United States and other European nations. In 2016, inward investment into Europe was $532 billion. The United Kingdom and France have historically been the largest recipients of inward FDI.5

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 na- tions 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 at- tracted about $60 billion of FDI in 2004 and rose steadily to hit a record $134 billion in 2016.6 The reasons for the strong flow of investment into China are discussed in the ac- companying Country Focus. Latin America is the next most important region in the devel- oping world for FDI inflows. In 2016, total inward investments into this region reached $142 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 the NAFTA. In 2016, 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, $59 billion in 2016. 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 in- ability 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 1998–2016 (see Figure 8.3). As might be expected, these countries also predominate in rankings of the world’s largest multinationals.8 These nations domi- nate primarily because they were the most developed nations with the largest economies

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.

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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 35 years of sustained high economic growth rates of around 8–10 percent, compounded annually, although they have recently dropped down to 6–7 percent. This growth attracted substantial foreign investment. Starting from a tiny base, foreign investment increased to an an- nual average rate of $2.7 billion between 1985 and 1990 and then surged to $40 billion annually in the late 1990s, making China the second-biggest recipient of FDI inflows in the world after the United States. The growth has continued, with inward investments into China hitting a record $136 bil- lion in 2015 (with another $103 billion going into Hong Kong). Over the past 20 years, this inflow has resulted in the establishment of more than 300,000 foreign-funded enter- prises in China. The total stock of FDI in mainland China grew from almost nothing in 1978 to $1.2 trillion in 2015 (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 repre- sents 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 coun- try’s huge potential. China joined the World Trade Organi- zation 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 pres- ence in the country to build guanxi, the crucial relation- ship networks (see Chapter 4 for details). Furthermore, a combination of relatively inexpensive labor and tax incen- tives, 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 mak- ing 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 be- hind 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 work- force, 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 environ- ment, which can make it problematic to conduct business transactions, and shifting tax and regulatory regimes. Then there are problems with local joint-venture partners that are inexperienced, opportunistic, or simply operate ac- cording 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 part- ner, 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, 2016; Linda Ng and C. Tuan, “Building a Fa- vorable 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 Eco- nomic 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 http://www.mckinsey.com/ business-functions/strategy-and-corporate-finance/our-insights/ a-pocket-guide-to-doing-business-in-china.

during much of the postwar period and therefore home to many of the largest and best- capitalized enterprises. Many of these countries also had a long history as trading nations and naturally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises based there have been at the forefront of foreign investment trends.

That being said, it is noteworthy that Chinese firms have started to emerge as major foreign investors. In 2005, Chinese firms invested some $12 billion internationally. Since

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then, the figure has risen steadily, reaching a record $134 billion in 2016. Firms based in Hong Kong accounted for another $108 billion of outward FDI in 2016. Much of the out- ward investment by Chinese firms has been directed at extractive industries in less devel- oped 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 2015, Chinese firms invested $16 billion in the United States, up from $146 million in 2003. Perhaps even more striking, in the first six weeks of 2016, Chinese firms announced takeover bids of Western firms valued at $81.5 billion, with half of this value involving takeovers of U.S. enterprises.9

THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS

FDI takes on two main forms. The first is a greenfield investment, which involves the estab- lishment 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 2016.10 However, FDI flows into developed nations differ markedly from those into developing na- tions. 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.

When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments? We consider this question in depth in Chapter 15. For now, we can make a few basic observations. First, mergers and acquisitions are quicker to execute than greenfield investments. 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 loy- alty, customer relationships, trademarks or patents, distribution systems, production sys- tems, and the like. It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through a greenfield investment. Third, firms make ac- quisitions because they believe they can increase the efficiency of the acquired unit by transferring capital, technology, or management skills (see the Management Focus on Ce- mex for an example). However, as we discuss in Chapter 15, there is evidence that many mergers and acquisitions fail to realize their anticipated gains.11

Theories of Foreign Direct Investment

In this section, we review several theories of foreign direct investment. These theories ap- proach 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 of- ten undertake foreign direct investment at the same time and why they favor certain loca- tions 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 theo- retical 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

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LO 8 -2 Explain the different theories of FDI.

Foreign Direct Investment Chapter 8 229

goods at home and then shipping them to the receiving country for sale. Licensing in- volves granting a foreign entity (the licensee) the right to produce and sell the firm’s prod- uct 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 ex- pensive 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 indig- enous firms, there is a greater probability that a foreign firm undertaking FDI in a country for the first time will make costly mistakes due to its ignorance. When a firm exports, it need not bear the costs associated with FDI, and it can reduce the risks associated with selling abroad by using a native sales agent. Similarly, when a firm allows another enter- prise to produce its products under license, the licensee bears the costs or risks (e.g., fash- ion retailer Burberry originally entered Japan via a licensing contract with a Japanese retailer). So why do so many firms apparently prefer FDI over either exporting or licens- ing? The answer can be found by examining the limitations of exporting and licensing as means for capitalizing on foreign market opportunities.

R A N K I N G S

Cross-border investments have been ramped up to a relatively large degree in the last de- cade. 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 compa- nies. On globalEDGETM, there are myriad opportunities to gain more knowledge about for- eign direct investment (FDI). The “Rankings” section is a great starting point (globaledge. msu.edu/global-resources/rankings). In this section, globalEDGETM 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 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 prod- ucts 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 (see the accompanying Management Focus). For products with a high value-to-weight ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software, etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI.

Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods, governments can increase the cost of exporting relative to foreign direct in- vestment 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 com- panies in the United States that started in the mid 1980s and continues to this day has been

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M A N A G E M E N T F O C U S

Foreign Direct Investment by Cemex Over the last two decades, Mexico’s largest cement man- ufacturer, Cemex, has transformed itself from a primarily Mexican operation into the second-largest cement company in the world behind Lafarge Group of France. Cemex has long been a powerhouse in Mexico and cur- rently controls more than 60 percent of the market for cement in that country. Cemex’s domestic success has been based in large part on an obsession with efficient manufacturing and a focus on customer service that is tops in the industry. Cemex is a leader in using information technology to match production with consumer demand. The company sells ready-mixed cement that can survive for only about 90 minutes before solidifying, so precise delivery is im- portant. But Cemex can never predict with total certainty what demand will be on any given day, week, or month. To better manage unpredictable demand patterns, Cemex developed a system of seamless information technology—including truck-mounted global positioning systems, radio transmitters, satellites, and computer hardware—that allows it to control the production and distribution of cement like no other company can, re- sponding quickly to unanticipated changes in demand and reducing waste. The results are lower costs and superior customer service, both differentiating factors for Cemex. Cemex’s international expansion strategy was driven by a number of factors. First, the company wished to reduce its reliance on the Mexican construction market, which was characterized by very volatile demand. Second, the com- pany realized there was tremendous demand for cement in many developing countries, where significant construc- tion was being undertaken or needed. Third, the company believed that it understood the needs of construction busi- nesses in developing nations better than the established multinational cement companies, all of which were from developed nations. Fourth, Cemex believed that it could create significant value by acquiring inefficient cement companies in other markets and transferring its skills in customer service, marketing, information technology, and production management to those units. The company embarked in earnest on its international expansion strategy in the 1990s. Initially, Cemex targeted

other developing nations, acquiring established cement makers in Venezuela, Colombia, Indonesia, the Philip- pines, Egypt, and several other countries. It also pur- chased two stagnant companies in Spain and turned them around. Bolstered by the success of its Spanish ventures, Cemex began to look for expansion opportuni- ties in developed nations. In 2000, Cemex purchased Houston-based Southland, one of the largest cement companies in the United States, for $2.5 billion. Following the Southland acquisition, Cemex had 56 cement plants in 30 countries, most of which were gained through acquisitions. In all cases, Cemex devoted great attention to transferring its technological, management, and mar- keting know-how to acquired units, thereby improving their performance. In 2004, Cemex made another major foreign invest- ment move, purchasing RMC of Great Britain for $5.8 bil- lion. RMC was a huge multinational cement firm with sales of $8 billion, only 22 percent of which were in the United Kingdom, and operations in more than 20 other nations, including many European nations where Cemex had no presence. Finalized in March 2005, the RMC acquisition transformed Cemex into a global powerhouse in the cement industry. Today it generates more than $16 billion in annual sales and operations in 50 countries. Only about a third of the company’s sales are now generated in Mexico. Ironically, President Trump’s plan to build a wall along the Mexican–U.S. border could benefit Cemex, which has six cement plants on the U.S. side of the border within delivery distance of the pro- posed wall.

Sources: C. Piggott, “Cemex’s Stratospheric Rise,” Latin Finance, March 2001, p. 76; J. F. Smith, “Making Cement a Household Word,” Los Angeles Times, January 16, 2000, p. C1; D. Helft, “Cemex Attempts to Cement Its Future,” The Industry Standard, November 6, 2000; Diane Lindquist, “From Cement to Services,” Chief Executive, November 2002, pp. 48–50; “Cementing Global Success,” Strategic Direct Investor, March 2003, p. 1; M. T. Derham, “The Cemex Surprise,” Latin Finance, November 2004, pp. 1–2; “Holcim Seeks to Acquire Aggregate,” The Wall Street Journal, January 13, 2005, p. 1; J. Lyons, “Cemex Prowls for Deals in Both China and India,” The Wall Street Journal, January 27, 2006, p. C4; S. Donnan, “Cemex Sells 25 Percent Stake in Semen Gresik,” FT.com, May 4, 2006, p. 1; J. Berr, “Trump’s Wall Could Benefit This Mexican Company,” CBS Money Watch, January 26, 2017.

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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.

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 mar- kets (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 compa- nies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market without the costs and risks associated with foreign direct investment. However, Matsushita and Sony quickly as- similated 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 opera- tional 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 pri- mary 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 closing case in this chapter 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 pro- duced 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 capa- bilities 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 pro- cess 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

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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 cer- tainly cannot be written down in a simple licensing contract. They are organization-wide 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 op- posed to allowing foreign automobile companies to produce its cars under license.

All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has valuable know-how that cannot be adequately protected by a licens- ing 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 main- tain 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.

THE PATTERN OF FOREIGN DIRECT INVESTMENT

Observation suggests that firms in the same industry often undertake foreign direct invest- ment 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 in- dustries.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 competi- tors, 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 imita- tive behavior; rivals often quickly imitate what a firm does in an oligopoly.

Imitative behavior can take many forms in an oligopoly. One firm raises prices, and the others follow; one expands capacity, and the rivals imitate lest they be left at a disadvantage in the future. Knickerbocker argued that the same kind of imitative behavior characterizes FDI. Consider an oligopoly in the United States in which three firms—A, B, and C—dominate the market. Firm A establishes a subsidiary in France. Firms B and C decide that if successful, this new subsidiary may knock out their export business to France and give a first-mover ad- vantage 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

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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 competi- tion. 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 gener- ated there to subsidize competitive attacks in other markets.

Although Knickerbocker’s theory and its extensions can help explain imitative FDI be- havior by firms in oligopolistic industries, it does not explain why the first firm in an oli- gopoly decides to undertake FDI rather than to export or license. Internalization theory addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, internalization theory addresses the efficiency issue. For these reasons, many economists favor internalization theory as an explanation for FDI, although most would agree that the imitative explanation tells an important part of the story.

THE ECLECTIC PARADIGM

The eclectic paradigm has been championed by the 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 ad- vantages, Dunning means the advantages that arise from utilizing resource endow- ments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm’s technological, mar- keting, or management capabilities). Dunning accepts the argument of internalization 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 capa- bilities with this valuable location-specific resource. Another obvious example is valuable human resources, such as low-cost, highly skilled labor. The cost and skill of labor varies from country to country. Because labor is not internationally mobile, according to Dunning it makes sense for a firm to locate production facilities in those countries where the cost and skills of local labor are most suited to its particular pro- duction 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

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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 semicon- ductor 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 ex- ternalities by locating close to their source.20

Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, pro- duction 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 re- gion 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 desires 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

Political Ideology and Foreign Direct Investment

Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance that is hostile to all inward FDI at one extreme to an adherence to the non- interventionist principle of free market economics at the other. Between these two ex- tremes 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 writ- ers argue that the multinational enterprise (MNE) is an instrument of imperialist domi- nation. 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 con- trolled 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 ad- vanced capitalist nations for investment, jobs, and technology. Thus, according to the extreme version of this view, no country should ever permit foreign corporations to un- dertake FDI because they can never be instruments of economic development, only of economic domination. Where MNEs already exist in a country, they should be immedi- ately nationalized.25

From 1945 until the 1980s, the radical view was very influential in the world economy. Until the collapse of communism between 1989 and 1991, the countries of eastern Europe were opposed to FDI. Similarly, communist countries elsewhere—such as China, Cambodia, and Cuba—were all opposed in principle to FDI (although, in practice, the Chinese started

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LO 8 -3 Understand how political ideology shapes a government’s attitudes toward FDI.

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Foreign Direct Investment Chapter 8 235

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 rea- sons for this: (1) the collapse of communism in eastern Europe; (2) the generally abys- mal 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 radi- cal view lingers on in some countries, such as Venezuela, where the government of Hugo Chávez and his successor, Nicolás Maduro, 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 accord- ing 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 over- all efficiency of the world economy.

Imagine that Dell decided to move assembly operations for many of its personal com- puters 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 soft- ware, 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 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.

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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 manage- rial 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 auto- mobile 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 radi- cal 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 for- eign 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 for- eign enterprises had to pay the government for oil and gas extracted in their territories. Following his election victory in 2006, Bolivian president Evo Morales nationalized the nation’s gas fields and stated that he would evict foreign firms unless they 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 reac- tion in Congress about the proposed takeover of a “strategic asset” by a Chinese company.

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Foreign Direct Investment Chapter 8 237

Benefits and Costs of FDI

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 per- spective 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 man- age 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 eco- nomic growth.

Resource-Transfer Effects Foreign direct investment can make a positive contribution to a host economy by supply- ing 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.

As for technology, you will recall from Chapter 3 that technology can stimulate eco- nomic 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 re- sources and skills required to develop their own indigenous product and process technol- ogy. This is particularly true in less developed nations. Such countries must rely on advanced industrialized nations for much of the technology required to stimulate eco- nomic growth, and FDI can provide it.

Research supports the view that multinational firms often transfer significant technol- ogy 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 (technol- ogy typically boosts productivity).29 Also, a study of FDI by the Organisation for Economic Co-operation and Development (OECD) found that foreign inves- tors invested significant amounts of capital in R&D in the coun- tries 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 pro- duce important benefits for the host country. Foreign managers trained in the latest management techniques can often help im- prove the efficiency of operations in the host country, whether those operations are acquired or greenfield developments. Benefi- cial 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 in- digenous firms. Similar benefits may arise if the superior manage- ment skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own management skills.

LO 8 - 4 Describe the benefits and costs of FDI to home and host countries.

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/Bloomberg/Getty Images

238 Part 3 The Global Trade and Investment Environment

Employment Effects Another beneficial employment effect claimed for FDI is that it brings jobs to a host coun- try 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 em- ployees 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 em- ployment. In the case of FDI by Japanese auto companies in the United States, some argue that the jobs created by this investment have been more than offset by the jobs lost in U.S.- owned auto companies, which have lost market share to their Japanese competitors. As a consequence of such substitution effects, the net number of new jobs created by FDI may not be as great as initially claimed by an MNE. The issue of the likely net gain in employ- ment may be a major negotiating point between an MNE wishing to undertake FDI and the host government.

When FDI takes the form of an acquisition of an established enterprise in the host economy as opposed to a greenfield investment, the immediate effect may be to reduce employment as the multinational tries to restructure the operations of the acquired unit to improve its operating efficiency. However, even in such cases, research suggests that once the initial period of restructuring is over, enterprises acquired by foreign firms tend to increase their employment base at a faster rate than domestic rivals. An OECD study found that foreign firms created new jobs at a faster rate than their domestic counterparts.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 pay- ments 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 pay- ments. The current account tracks the export and import of goods and services. A cur- rent 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 gov- ernments 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 im- prove 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

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developing and developed nations.33 For example, in China exports increased from $26 billion in 1985 to $2.3 trillion in 2014. 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 invest- ment, 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 con- sumers. 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 competi- tive stimulus that is necessary to improve the efficiency of India’s fragmented retail system (see the opening case in this chapter).

FDI’s impact on competition in domestic markets may be particularly important in the case of services, such as telecommunications, retailing, and many financial services, where exporting is often not an option because the service has to be produced where it is deliv- ered.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 interna- tional 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 mar- kets, 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 countries). It tends to be a relatively minor concern in most advanced indus- trialized nations.

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In general, while FDI in the form of greenfield investments should increase competi- tion, it is less clear that this is the case when the FDI takes the form of acquisition of an established enterprise in the host nation, as was the case when Cemex acquired RMC in Britain (see the Management Focus earlier in this chapter). 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, ac- quired 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 obvi- ous concern, there is little evidence that such developments are widespread. In many na- tions, 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 institu- tions 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 subse- quent outflow of earnings from the foreign subsidiary to its parent company. Such out- flows 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 repatri- ated to a foreign subsidiary’s home country. A second concern arises when a foreign sub- sidiary 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 im- pact 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 criti- cisms by pledging to purchase 75 percent of their component parts from U.S.-based manu- facturers (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 inde- pendence. 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 grow- ing 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 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

Foreign Direct Investment Chapter 8 241

creates demands for home-country exports of capital equipment, intermediate goods, com- plementary products, and the like.

Second, benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the for- eign subsidiary creates demand for home-country exports. Thus, Toyota’s investment in auto assembly operations in Europe has benefited both the Japanese balance-of-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 expo- sure 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 mar- ket, 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

HOME-COUNTRY COSTS

Against these benefits must be set the apparent costs of FDI for the home (source) coun- try. 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 for- eign earnings. Second, the current account of the balance of payments suffers if the pur- pose 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 posi- tion of Japan will deteriorate.

With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production. This was the case with Toyota’s investments in the United States and Europe. One obvious result of such FDI is reduced home-country em- ployment. If the labor market in the home country is already tight, with little unemploy- ment, 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 les- sons 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 produc- tion facilities in Mexico. Far from reducing home-country employment, such FDI may ac- tually 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 com- parative advantage. In addition, home-country consumers benefit if the price of the par- ticular 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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242 Part 3 The Global Trade and Investment Environment

Government Policy Instruments and FDI

We have reviewed the costs and benefits of FDI from the perspective of both home coun- try 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 through these programs in- clude the risks of expropriation (nationalization), war losses, and the inability to transfer profits back home. Such programs are particularly useful in encouraging firms to under- take 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 signifi- cant, 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 in- tensive lobbying by company and U.S. government officials, opened its first retail stores in Japan in December 1991. By 2012, Toys “R” Us had more than 170 stores in Japan, and its Japanese operation, in which Toys “R” Us retained a controlling stake, had a listing on the Japanese stock market.

Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One policy has been to limit capital outflows out of concern for the country’s balance of payments. From the early 1960s until 1979, for ex- ample, 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 diffi- cult 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 po- litical 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.

LO 8 -5 Explain the range of policy instruments that governments use to influence FDI.

Foreign Direct Investment Chapter 8 243

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 coun- tries. 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 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 govern- ments often compete with each other to attract FDI. For example, Kentucky offered Toy- ota 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 infrastruc- ture, 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 devel- opment 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 own- ing 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 tar- iffs 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. Un- til 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 perfor- mance requirements are related to local content, exports, technology transfer, and local participation in top management. As with certain ownership restrictions, the logic un- derlying 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 require- ments tend to be more common in less developed countries than in advanced industrial- ized nations.42

244 Part 3 The Global Trade and Investment Environment

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 can- not export McDonald’s hamburgers or consumer banking services). Given this, the WTO has become involved in regulations governing FDI. As might be expected for an institution created to promote free trade, the thrust of the WTO’s efforts has been to push for the liberalization of regulations governing FDI, particularly in services. Under the auspices of the WTO, two extensive multinational agreements were reached in 1997 to liberalize trade in telecommunications and financial services. Both these agreements contained detailed clauses that require signatories to liberalize their regulations governing inward FDI, essen- tially opening their markets to foreign telecommunications and financial services compa- nies. 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, de- veloping nations have so far rejected efforts by the WTO to start such discussions.

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F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

FDI AND GOVERNMENT POLICY Several implications for business are inherent in the material discussed in this chap-

ter. 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 ex- porting. 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 preci- sion how the relative profitability of foreign direct investment, exporting, and licensing var- ies 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 be- tween 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 can- not 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. 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 para- mount importance and licensing is hazardous.

2. Global oligopolies, in which competitive interdependence requires that multina- tional firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors.

LO 8 - 6 Identify the implications for managers of the theory and government policies associated with FDI.

Foreign Direct Investment Chapter 8 245

3. Industries in which intense cost pressures require that multinational firms maintain tight control over foreign operations (so that they can disperse production to loca- tions 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 rou- tines 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 prof- itable, in fragmented, low-technology industries in which globally dispersed manufacturing is not an option. A good example is the fast-food industry. McDonald’s has expanded globally by using a franchising strategy. Franchising is essentially the service-industry version of licensing, although it normally involves much longer-term commitments than licensing. With franchising, the firm licenses its brand name to a foreign firm in return for a percentage of the franchisee’s profits. 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

F I G U R E 8 . 4

A decision framework. Export

FDI

FDI

FDI

Then License

Low

High

Yes

No

Yes

No

Yes

No

Is Tight Control over Foreign Operation Required?

How High Are Transportation Costs and Tari�s?

Is Know-how Amenable to Licensing?

Can Know-how Be Protected by Licensing Contract?

246 Part 3 The Global Trade and Investment Environment

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 techno- logical 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 his- torical evolution of FDI, but they do a relatively poor job of identifying the factors that influ- ence 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 mar- ket 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 govern- ment, 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

flow of FDI, p. 224 stock of FDI, p. 224 outflows of FDI, p. 224 inflows of FDI, p. 224 greenfield investment, p. 228 eclectic paradigm, p. 228

exporting, p. 228 licensing, p. 229 internalization theory, p. 231 market imperfections, p. 231 oligopoly, p. 232 multipoint competition, p. 233

location-specific advantages, p. 233 externalities, p. 234 balance-of-payments

accounts, p. 238 current account, p. 238 offshore production, p. 241

Key Terms

Foreign Direct Investment Chapter 8 247

C H A P T E R S U M M A R Y

This chapter reviewed theories that attempt to explain the pattern of FDI between countries and to examine the in- fluence of governments on firms’ decisions to invest in 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 estab- lishing 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 ade- quately 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 capa- bilities 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) coun- try include improvement in the balance of pay- ments 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 re- source-transfer effect. A reverse resource-transfer effect arises when the foreign subsidiary learns valuable skills abroad that can be transferred back to the home country.

10. The costs of FDI to the home country include adverse balance-of-payments effects that arise from the initial capital outflow and from the export substitution effects of FDI. Costs also arise when FDI exports jobs abroad.

11. Home countries can adopt policies designed to both encourage and restrict FDI. Host countries try to attract FDI by offering incentives and try to restrict FDI by dictating ownership restraints and requiring that foreign MNEs meet specific performance requirements.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

 1. In 2008, inward FDI accounted for some 63.7 per- cent of gross fixed capital formation in Ireland but only 4.1 percent in Japan (gross fixed capital for- mation 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 Knickerbock- er’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 inf luence man- agement practice?

 4. Read the Management Focus on Cemex, and then answer the following questions: a. Which theoretical explanation, or explana-

tions, of FDI best explains Cemex’s FDI? b. What is the value that Cemex brings to a

host economy? Can you see any potential drawbacks of inward investment by Cemex in an economy?

c. Cemex has a strong preference for acquisi- tions over greenfield ventures as an entry mode. Why?

248 Part 3 The Global Trade and Investment Environment

 5. You are the international manager of a U.S. business that has just developed a revolution- ary new personal computer that can perform the same functions as existing PCs but costs only half as much to manufacture. Several pat- ents protect the unique design of this com- puter. 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.

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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 compre- hensive 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 sum- mary 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, par- ticularly in developing countries. You work for a company that builds wastewater and sanitation infrastructure in such countries. The Multilat- eral 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.

Burberry, the icon British luxury apparel company best known for its high-fashion outwear, 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 prod- ucts in its own stores. “In luxury,” Ahrendts once re- marked, “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 Burb- erry to tightly control its global brand image. Ahrendts was determined to rein in licensees and re- gain control of Burberry’s sales in foreign markets, even if it mean taking a short-term hit to sales. She started off

C L O S I N G C A S E

Burberry Shifts Its Strategy in Japan

*Angela Ahrendts, “Burberry’s CEO on Turning an Aging British Icon into a Global Luxury Brand,” Harvard Business Review, January–February 2013.

Foreign Direct Investment Chapter 8 249

the process of terminating licensees before leaving Burb- erry 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 Burb- erry 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 prod- ucts 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, 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 neces- sary 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 Hrendts, “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 Mag- azine, June 18, 2015; G. Fasol, G., “Burberry Solves Its ‘Japan Problem,’ at Least for Now,” Japan Strategy, August 19, 2015.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Why did Burberry initially chose a licensing

strategy to expand its presence in Japan? 2. What limitations of the licensing strategy be-

came apparent over time? Should Burberry have expected these drawbacks to arise?

3. Was terminating the Japanese licensing agreement and opening wholly owned stores the correct stra- tegic move for Burberry? What are the risks here?

4. To what extent does internalization theory ex- plain Burberry’s experience in Japan?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

E n d n o t e s

 1. United Nations Conference on Trade and Development, Statisti- cal Database, accessed July 2017, http://unctadstat.unctad.org.

 2. World Trade Organization, International Trade Statistics, 2015 (Geneva: WTO, 2015); United Nations, World Investment Report, 2016.

 3. United Nations, World Investment Report, 2017.

 4. United Nations, World Investment Report, 2010 (New York and Geneva: United Nations, 2010).

 5. United Nations, Conference on Trade and Development, Statistical Database, accessed July 2017.

 6. United Nations, Conference on Trade and Development, Statistical Database, accessed July 2017.

 7. United Nations, Conference on Trade and Development, Statistical Database, accessed January 27, 2017.

 8. United Nations, World Investment Report, 2016.

 9. M. Caruso-Cabrera, “Chinese Investment in US May Break Record in 2015,” CNBC, January 4, 2015; Shayndi Raice and William Mauldin, “Chinese Deals Draw Scrutiny in Washington,” The Wall Street Journal, February 19, 2016.

10. United Nations, World Investment Report, 2017.

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 Man- agement Journal 23 (2002), pp. 921–40; B. Ayber and A. Ficici, “Cross-Border Acquisitions and Firm Value,” Journal of Interna- tional 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).

250 Part 3 The Global Trade and Investment Environment

14. The argument is most often associated with F. T. Knicker- bocker, 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,” 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 Inter- national Economics, 1998, mimeo.

30. “Foreign Friends,” The Economist, January 8, 2000, pp. 71–72.

31. A. Jack, “French Go into Overdrive to Win Investors,” Finan- cial Times, December 10, 1997, p. 6.

32. “Foreign Friends.”

33. United Nations, World Investment Report, 2014 (New York and Geneva: United Nations, 2014).

34. R. Ram and K. H. Zang, “Foreign Direct Investment and Eco- nomic Growth,” Economic Development and Cultural Change 51 (2002), pp. 205–25.

35. United Nations, World Investment Report, 2014 (New York and Geneva: United Nations, 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?” Business- Week, 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).

Foreign Direct Investment Chapter 8 251

42. L. D. Qiu and Z. Tao, “Export, Foreign Direct Investment and Local Content Requirements,” Journal of Development Econom- ics 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).

Regional Economic Integration L E A R N I N G O B J E C T I V E S Af ter 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.

part three The Global Trade and Investment Environment

9

©MANDEL NGAN/AFP/Getty Images

Renegotiating NAFTA

Motors, Toyota, and BMW for their plans to invest in Mexican assembly operations. Jawboning aside, the Trump administration is looking at different options for restructuring trade with Mexico. These include placing tariffs on imports of autos from Mexico. The CEO of Fiat Chrysler has stated that if the Trump administration does impose tariffs on Mexican imports, his firm could pull out of Mexico entirely.  One thing is certain, if the Trump administration does place tariffs on imports from Mexico, the costs will be born in part by American auto producers, who will have to pay more for auto parts, and in part by American consumers, who probably end up paying more for their automobiles. Whether such import tariffs will create new jobs in the United States is an open question. Many U.S. firms may respond by accelerating their adoption of labor-saving au- tomation to expand output from U.S. plants rather than hir- ing additional U.S. workers. There is also the possibility that Mexico will respond by placing its own retaliatory tar- iffs on U.S. imports, which would probably result in U.S. job losses. If the outcome is a trade war, everybody loses. For Mexico, the consequences of a change in NAFTA are potentially very serious. NAFTA has been a boon to Mexico—particularly those cities and states located near the U.S. border. The city of Monterrey, for example, has been booming thanks to significant investment by foreign companies. The economy of Nuevo Leon, the state where Monterrey is located, grew by 67 percent between 2004 and 2016, a yearly average of more than 4 percent. Some 84,000 jobs in the state are now dependent on the auto industry. Likewise, the economies of the 12 Mexican states that rely most on export industries governed by NAFTA have grown by 3.7 percent per annum since 2004, compared to the 20 states that do not rely on NAFTA, where growth was only 2.8 percent per annum. Since Trump won the election, however, foreign invest- ment into the region has dried up, which does not bode well for the future.

Sources: U.S. Census Bureau, https://www.census.gov/foreign-trade/ index.html, accessed February 2, 2017; Robbie Whelan, “Gloom De- scends 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 Luh- now, “Donald Trump Posed to Pressure Mexico on Trade,” The Wall Street Journal, November 21, 2016.

O P E N I N G C A S E In his 2016 presidential campaign, Donald Trump repeat- edly 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. Now that he is president, Trump shows every intention of sticking to his promise to renegotiate the NAFTA deal.  This has sent shockwaves through industry on both sides of the border. Since NAFTA was signed in 1994, trade between America and Mexico has surged. In 2015, the United States imported $322.4 billion in goods and services from Mexico and exported $267.2 billion, result- ing in a $55 billion trade deficit. When Canada, the third NAFTA member, is included in the mix, the total value of cross-border trade among the three members of the trade bloc is $1.1 trillion. Canada and Mexico are the two top des- tinations for U.S. exports, and Canada and Mexico are the second and third largest source of U.S. imports after China. Canada has been spared from attacks by Trump, probably because trade between the two countries is relatively balanced. The impact of any change in the terms of NAFTA, or exit from NAFTA, is 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 automo- bile 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 manufac- tured in Mexico being shipped to U.S. final assembly plants). In 2015, U.S. producers exported $34 billion of fin- ished automobiles and automotive parts to Mexico but im- ported $106 billion in autos and parts from Mexico. Without that $72 billion trade deficit in autos and auto parts with Mexico, the United States would be running a trade sur- plus with the country.   Perhaps because he recognizes the lopsided nature of trade in auto and auto parts between the two nations, 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

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254 Part 3 The Global Trade and Investment Environment

Introduction

The past two decades have witnessed a proliferation of regional trade blocs that promote regional economic integration. World Trade Organization (WTO) members are re- quired to notify the WTO of any regional trade agreements in which they participate. By 2017, nearly all members had notified the WTO of participation in one or more regional trade agreements. As of early 2017, there were 432 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 be- come 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, na- tional governments have felt that they can better advance their trade agenda through mul- tilateral 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 dark cloud over the future of the European project.

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. Ulti- mately, NAFTA aims to remove all barriers to the free flow of goods and services among the three countries. While the implementation of NAFTA has resulted in job losses in some sectors of the U.S. economy, in aggregate and consistent with the predictions of in- ternational 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 is overtly hostile to NAFTA in its present form, blaming it for significant job losses in the United States. As with Brexit and the EU, Trump’s 2016 victory in the U.S. presidential election means that the future of NAFTA is now in doubt.

South America, too, has moved toward regional integration. For example, in 1991, Argentina, Brazil, Paraguay, and Uruguay implemented an agreement known as Mercosur to start reducing barriers to trade between each other, and although progress within Mercosur has been halting, the institution is still in place. There are also ongoing attempts at regional economic integration in Africa, where 26 countries recently signed an agreement to try and reduce tariffs and costly customs processes in order to stimulate economic growth in the region.

R E G I O N A L T R A D E A G R E E M E N T S

Regional economic integration is the focus of Chapter 9, and the value-added portion of globalEDGETM that captures the ongoing development of major trade agreements world- wide is called “Regional Trade Agreements” (globaledge.msu.edu/global-resources/ regional-trade-agreements). In this section of globalEDGETM, 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

Regional Economic Integration Chapter 9 255

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? (Hint: African trade agreements.) 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 (trade agreements) of ECOWAS and SADC started?

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 inter- national business. We will discuss current developments that are threatening 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

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 mar- ket, an economic union, and, finally, a full political union.

In a free trade area, all barriers to the trade of goods and services among member countries are removed. In the theoretically ideal free trade area, no discriminatory tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade between mem- bers. 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 coun- tries 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

LO 9 -1 Describe the different levels of regional economic integration.

F I G U R E 9 .1

Levels of economic integration.

Customs Union

Common Market

Economic Union

Political Union

NAFTA

X Level of Integration

X

Free Trade Area

EU 2003

256 Part 3 The Global Trade and Investment Environment

The most enduring free trade area in the world is the European Free Trade Associa- tion (EFTA). Established in January 1960, the EFTA currently joins four countries— Norway, Iceland, Liechtenstein, and Switzerland—down from seven in 1995 (three EFTA members—Austria, Finland, and Sweden—joined the EU on January 1, 1996). The EFTA was founded by those western European countries that initially decided not to be part of the European Community (the forerunner of the EU). Its original members included Aus- tria, 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 sup- port. 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 rela- tions 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, Co- lombia, Ecuador, and Peru. The Andean Community established free trade between member countries and imposes a common tariff, of 5 to 20 percent, on products im- ported 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 es- tablish 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.

An economic union entails even closer economic integration and cooperation than a common market. Like the common market, an economic union involves the free flow of products and factors of production among member countries and the adoption of a com- mon external trade policy, but it also requires a common currency, harmonization of mem- bers’ 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; differ- ences in tax rates and regulations across countries still remain; and some markets, such as the market for energy, are still not fully deregulated.

The move toward economic union raises the issue of how to make a coordinating bu- reaucracy 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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Regional Economic Integration Chapter 9 257

The Case for Regional Integration

The case for regional integration is both economic and political, and it is typically not ac- cepted by many groups within a country, which explains why most attempts to achieve re- gional economic integration have been contentious and halting. In this section, we examine the economic and political cases for integration and two impediments to integration. In the next section, we look at the case against integration.

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 restric- tions. 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 sug- gest that free trade and investment is a positive-sum game, in which all participating coun- tries stand to gain.

Given this, the theoretical ideal is an absence of barriers to the free flow of goods, ser- vices, and factors of production among nations. However, as we saw in Chapters 7 and 8, a case can be made for government intervention in international trade and FDI. Because many governments have accepted part or all of the case for intervention, unrestricted free trade and FDI have proved to be only an ideal. Although international institutions such as the WTO have been moving the world toward a free trade regime, success has been less than total. In a world of many nations and many political ideologies, it is very difficult to get all countries to agree to a common set of rules.

Against this background, regional economic integration can be seen as an attempt to achieve additional gains from the free flow of trade and investment between countries be- yond those attainable under global agreements such as the WTO. It is easier to establish a free trade and investment regime among a limited number of adjacent countries than among the world community. Coordination and policy harmonization problems are largely a 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 at- tempts 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 politi- cal 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

LO 9 -2 Understand the economic and political arguments for regional economic integration.

258 Part 3 The Global Trade and Investment Environment

without the aggressive policies of the former dictator of the old Soviet Union, the coun- tries 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 support- ers 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, and by 2015, the number Mexican illegal immigrants 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 establish- ment of NAFTA, some Canadian and U.S. workers in such industries as textiles—which employ low-cost, low-skilled labor—lost their jobs as Canadian and U.S. firms moved pro- duction to Mexico. The promise of significant net benefits to the Canadian and U.S. econ- omies as a whole is little comfort to those who lose as a result of NAFTA. Such groups have been at the forefront of opposition to NAFTA and will continue to oppose any widen- ing of the agreement.

A second impediment to integration arises from concerns over national sovereignty. For example, Mexico’s concerns about maintaining control of its oil interests resulted in an agreement with Canada and the United States to exempt the Mexican oil industry from any liberalization of foreign investment regulations achieved under NAFTA. Concerns about national sovereignty arise because close economic integration demands that coun- tries 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 re- mained 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 bu- reaucracy 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 member- ship 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.

The Case against Regional Integration

Although the tide has been running in favor of regional free trade agreements, some econ- omists 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 inte- gration 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 pro- ducers 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

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LO 9 -3 Understand the economic and political arguments against regional economic integration.

Regional Economic Integration Chapter 9 259

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 pre- viously produced all its own textiles at a higher cost than Mexico, then the free trade agree- ment has shifted production to the cheaper source. According to the theory of comparative advantage, trade has been created within the regional grouping, and there would be no decrease in trade with the rest of the world. Clearly, the change would be for the better. If, however, the United States previously imported textiles from Costa Rica, which produced them more cheaply than either Mexico or the United States, then trade has been diverted from a low-cost source—a change for the worse.

In theory, WTO rules should ensure that a free trade agreement does not result in trade diversion. These rules allow free trade areas to be formed only if the members set tariffs that are not higher or more restrictive to outsiders than the ones previously in effect. How- ever, 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 com- petition by high nontariff barriers. In such cases, the trade diversion effects might out- weigh 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, how- ever, so the risk remains that regional economic integration will result in trade diversion.

Regional Economic Integration in Europe

Europe has two trade blocs—the European Union and the European Free Trade Associa- tion. Of the two, the EU is by far the more significant, not just in terms of membership (the EU currently has 28 members, although the British have voted to exit the union and may do so by 2019; the EFTA has four), but also in terms of economic and political influ- ence in the world economy. The EU has been viewed as an emerging economic and politi- cal 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 Euro- pean nations’ desire to hold their own on the world’s political and economic stage. In ad- dition, many Europeans were aware of the potential economic benefits of closer economic integration of the countries.

The forerunner of the EU, the European Coal and Steel Community, was formed in 1951 by Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands. Its ob- jective was to remove barriers to intragroup shipments of coal, iron, steel, and scrap metal. With the signing of the Treaty of Rome in 1957, the European Community (EC) was es- tablished. 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 obstacles to the free movement of factors of production among the members. To fa- cilitate the free movement of goods, services, and factors of production, the treaty provided for any necessary harmonization of the member states’ laws. Furthermore, the treaty com- mitted the EC to establish common policies in agriculture and transportation.

The community grew in 1973, when Great Britain, Ireland, and Denmark joined. These three were followed in 1981 by Greece; in 1986 by Spain and Portugal; and in 1995 by Austria, Finland, and Sweden—bringing the total membership to 15 (East Germany be- came 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

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.

LO 9 - 4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

260 Part 3 The Global Trade and Investment Environment

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.

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

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

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M A N A G E M E N T F O C U S

261

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 re- bates 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. In- tel also apparently made payments to Media Saturn Hold- ings, the owner of Media Markt chain of superstores, for

The European Commission and Intel selling only Intel-based computers in Germany, Belgium, and other countries. Under the order, Intel had to change its practices immedi- ately, 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 mak- ers 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 re- bates, 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 Anti- trust 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.

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 moni- tor 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 impor- tant to business in recent years. Since 1990, when the office was formally assigned a role in competition policy, the EU’s competition commissioner has been steadily gaining influ- ence 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 Management Focus for details.) The previous record for a similar abuse was €497 billion imposed on Microsoft in 2004 for blocking competition in markets for server computers and media software. The commis- sioner 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.

262 Part 3 The Global Trade and Investment Environment

The European Council represents the interests of member states. It is clearly the ulti- mate controlling authority within the EU because draft legislation from the commission can become EU law only if the council agrees. The council is composed of one representa- tive from the government of each member state. The membership, however, varies depend- ing on the topic being discussed. When agricultural issues are being discussed, the agriculture ministers from each state attend council meetings; when transportation is be- ing 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 mara- thon 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 formal- ized the use of majority voting rules on issues “which have as their object the establish- ment 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 legisla- tion, which the commission and ultimately the council are not obliged to take up but often will. The power of the parliament recently has been increasing, although not by as much as parliamentarians would like. The European Parliament now has the right to vote on the appointment of commissioners as well as veto some laws (such as the EU budget and single-market legislation).

One major debate waged in Europe during the past few years is whether the council or the parliament should ultimately be the most powerful body in the EU. Some in Europe expressed concern over the democratic accountability of the EU bureaucracy. One side argued that the answer to this apparent democratic deficit lay in increasing the power of the parliament, while others think that true democratic legitimacy lies with elected govern- ments, acting through the Council of the European Union.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 term and represents the nation-states that make up the EU.

The Court of Justice, which is comprised of one judge from each country, is the su- preme appeals court for EU law. Like commissioners, the judges are required to act as in- dependent 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 obli- gations. 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 coun- tries 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.

Regional Economic Integration Chapter 9 263

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 de- liver 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 ex- ploit economies of scale. In addition, it was thought that the increase in competitive inten- sity 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 at- tempt to realize scale economies and better compete in a single market. The results have included faster economic growth than would otherwise have been the case. 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.

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 pow- erful 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 situ- ation, 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

264 Part 3 The Global Trade and Investment Environment

crisis of 2010–2012 persuaded many of these countries to put their plans on hold, at least for the time being (further details provided later).

Establishment of the euro was an remarkable political feat with few historical prece- dents. 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 cur- rency in the world after that of the U.S. dollar. Some believe that the euro could come to rival the dollar as the most important currency in the world.

Three long-term EU members—Great Britain, Denmark, and Sweden—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 cir- culation. 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 han- dle 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 eco- nomic 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 in- crease the range of investment options open to both individuals and institutions. For ex- ample, 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

Regional Economic Integration Chapter 9 265

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, 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.

In theory, the design of the ECB should ensure that it remains free of political pressure. The ECB is modeled on the German Bundesbank, which historically has been the most in- dependent and successful central bank in Europe. The Maastricht Treaty prohibits the ECB from taking orders from politicians. The executive board of the bank, which consists of a president, vice president, and four other members, carries out policy by issuing instructions to national central banks. The policy itself is determined by the governing council, which consists of the executive board plus the central bank governors from the 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 econo- mists would call an optimal currency area. In an optimal currency area, similarities in the underlying structure of economic activity make it feasible to adopt a single currency and use a single exchange rate as an instrument of macroeconomic policy. Many of the European economies in the euro zone, however, are very dissimilar. For example, Finland and Portugal have different wage rates, tax regimes, and business cycles, and they may re- act 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 mone- tary policy may mean that interest rates are too high for depressed regions and too low for booming regions.

One way of dealing with such divergent effects within the euro zone is for the EU to engage in fiscal transfers, taking money from prosperous regions and pumping it into de- pressed regions. Such a move, however, opens a political can of worms. Would the citizens of Germany forgo their “fair share” of EU funds to create jobs for underemployed Greece workers? Not surprisingly, there is strong political opposition to such practices.

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 for- eign currencies. In the first three years of its life, the euro never reached the 13 percent of global reserves made up by the deutsche mark and other former euro zone currencies. The euro didn’t jump that hurdle until early 2002, but by 2011, it stood at 26.3 percent.17

C O U N T R Y F O C U S

When the euro was established, some critics worried that free-spending countries in the euro zone (such as Italy and Greece) might borrow excessively, running up large public- sector deficits that they could not finance. This would then rock the value of the euro, requiring their more sober brethren, such as Germany or France, to step in and bail out the profligate nation. In 2010, this worry became a real- ity 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 character- ized 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 gov- ernment 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 gov- ernment had apparently been cooking the books. This shattered any faith that international investors might have had in the Greek economy. Interest rates on Greek gov-

ernment debt quickly surged to 7.1 percent, about 4 percent- age 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 gov- ernment debt, pushing the EU and the euro into a major

The Greek Sovereign Debt Crisis

266

Since 2008 however, the euro has weakened, ref lecting persistent concerns over slow economic growth and large budget deficits among several EU member states, particu- larly Greece, Portugal, Ireland, Italy, and Spain. During the 2000s, all these govern- ments 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 follow- ing 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 na- tional governments, particularly Greece, might default on their sovereign debt, plung- ing the euro zone into an economic crisis.

To try and stave off such a sovereign debt crisis, in May 2010, the euro zone nations and the International Monetary Fund (IMF) agreed to a €110 billion bailout package to help rescue Greece. In November 2010, the EU and IMF agreed to a bailout pack- age for Ireland of €85 billion; in May 2011, euro zone countries and the IMF instituted a €78 billion bailout plan for Portugal. In return for these loans, all three countries had to agree to sharp reductions in government spending, which meant slower economic

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 in- creased to 65 from 61, and limits were placed on pen- sions), 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 rev- enues 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 con- tracting 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 govern- ment bonds to agree to the biggest sovereign debt re- structuring in history, In effect, bondholders agreed to write off 53.5 percent of the debt they held.  While the Greek government did not technically default on its sovereign debt, to many it seemed as if the EU and

IMF had orchestrated an orderly partial default. By early 2014, it looked as if the Greek economy had finally turned a corner and was on the way to recovery. Yields on 10-year bonds had fallen blow 8 percent, and the government was running a budget surplus before interest 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 Janu- ary 2015, a radical left-wing “anti-bailout” party was swept into power. The financial minister of the new gov- ernment suggested that Greece should default on its scheduled debt repayments to its largest creditor, Ger- many. 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 aus- terity measures and economic reforms. Whether this will prove to be any more successful than the prior two bail- outs remains to be seen. 

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.

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growth and high unemployment until government debt was reduced to more sustain- able 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 re- ductions 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 at- tempt 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 2017, the dollar-euro exchange rate stood at €1 = $1.08, significantly 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.

More troubling perhaps for the long-run success of the euro, many of the newer EU nations that had committed to adopting the euro put their plans on hold. Countries like Poland and the Czech Republic had no desire to join the euro zone and then have their taxpayers help bail out the prof ligate governments of countries like Italy and Greece. To compound matters, the sovereign debt crisis had exposed a deep f law in the euro zone: It was difficult for fiscally more conservative nations like Germany to limit

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prof ligate 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 gov- ernments of Greece, Portugal, and Ireland. This started to erode support for the euro in the stronger EU states. To try to correct this f law, 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). Whether such actions will be sufficient to get the euro back on track remains to be seen.

ENLARGEMENT OF THE EUROPEAN UNION

Enlargement of the EU into eastern Europe has been discussed since the collapse of com- munism at the end of the 1980s. By the end of the 1990s, 13 countries had applied to be- come 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 en- shrine 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 ap- plications 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 member- ship to 28 nations.

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. How- ever, given the small size of the eastern European economies (together they amount to

Euro sign sculpture. ©Bloomberg/Getty Images

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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 bud- get negotiations among 28 nations are bound to prove more prob- lematic 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 con- cerns over human rights issues (particularly Turkish policies to- ward 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 al- low the Turkish application to proceed with no further delay in December 2004 if the country improved its human rights record to the satisfaction of the EU. In December 2004, the EU agreed to allow Turkey to start accession talks in October 2005, but those talks are stalled, and at this point, it is unclear when the na- tion will join.

BRITISH EXIT FROM THE EUROPEAN UNION (BREXIT)

On June 23, 2016, and by a narrow margin, the British electorate voted in a national refer- endum 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 now has two years to negotiate the terms of exit with the EU. 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 often railed against regulations imposed by the EU bureaucracy in Brussels, and more recently, immi- gration 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 Island 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 coun- tries as an important counterweight to the economic power of Germany. In the after- math 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 significant 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 will probably 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

Welcome sign to Croatia when the country joined the European Union. ©FREDERICK FLORIN/Getty Images

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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 eco- nomic 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 gov- ernment 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 mar- ket, the British adopt EU regulations permitting the free movement of labor. This is some- thing that the British are unlikely to accept given how important an issue immigration was in the referendum.

Regional Economic Integration in the Americas

No other attempt at regional economic integration comes close to the EU in its boldness or its potential implications for the world economy, but regional economic integration is on the rise in the Americas. The most significant attempt is the North American Free Trade Agreement. In addition to NAFTA, several other trade blocs are in the offing in the Americas (see Map 9.2), the most significant of which appear to be the Andean Commu- nity and Mercosur.

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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 fol- lowed in 1991 by talks among the United States, Canada, and Mexico aimed at establish- ing 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 railway industries, American airline and radio communica- tions 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 oppor- tunity to create an enlarged and more efficient productive base for the entire region. Advo- cates 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 manufac- turing 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 competi- tiveness of U.S. and Canadian firms that moved production to Mexico to take advantage of lower labor costs would be enhanced, enabling them to better compete with Asian and European rivals.

The Case against NAFTA Those who opposed NAFTA claimed that ratification would be followed by a mass exodus of jobs from the United States and Canada into Mexico as employers sought to profit from Mexico’s lower wages and less strict environmental and labor laws. According to one ex- treme opponent, Ross Perot, up to 5.9 million U.S. jobs would be lost to Mexico after

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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 billion per year to the joint U.S. and Mexican GDP to a net loss of 490,000 U.S. jobs. To put these numbers in perspective, employment in the U.S. economy was predicted to grow by 18 million from 1993 to 2003. As most economists repeatedly stressed, NAFTA would have a small impact on both Canada and the United States. It could hardly be any other way, because the Mexican economy was only 5 percent of the size of the U.S. economy. Signing NAFTA required the largest leap of economic faith from Mexico rather than Canada or the United States. Falling trade barriers would expose Mexican firms to highly efficient U.S. and Canadian competitors that, when compared to the average Mexican firm, had far greater capital resources, access to highly educated and skilled workforces, and much greater technological sophistication. The short-run outcome was likely to be painful economic restructuring and unemployment in Mexico. But advo- cates of NAFTA claimed there would be long-run dynamic gains in the efficiency of Mexican firms as they adjusted to the rigors of a more competitive marketplace. To the extent that this occurred, they argued, Mexico’s economic growth rate would accelerate, and Mexico might become a major market for Canadian and U.S. firms.22

Environmentalists also voiced concerns about NAFTA. They pointed to the sludge in the Rio Grande and the smog in the air over Mexico City and warned that Mexico could degrade clean air and toxic waste standards across the continent. They pointed out that the lower Rio Grande was the most polluted river in the United States and that, with NAFTA, chemical waste and sewage would increase along its course from El Paso, Texas, to the Gulf of Mexico.

There was also opposition in Mexico to NAFTA from those who feared a loss of na- tional sovereignty. Mexican critics argued that their country would be dominated by U.S. firms that would not really contribute to Mexico’s economic growth but instead would use Mexico as a low-cost assembly site while keeping their high-paying, high-skilled jobs north of the border.

NAFTA: The Results Studies of NAFTA’s impact suggest its initial effects muted, and both advocates and de- tractors may have been guilty of exaggeration.23 On average, studies indicate that NAFTA’s overall impact has been small but positive.24 NAFTA was meant to increase trade among the three member states, and it appears to have done so.

In 1990, U.S. trade with Canada and Mexico accounted for about 25 percent of total U.S. trade. By 2015, the figure was 43 percent. Canada and Mexico are now among the top three trading partners of the United States (the other is China), accounting for $1.1 trillion in cross-border trade in goods and service in 2015, up from $290 billion in 1993.25 All three countries also experienced strong productivity growth in the first 10 years NAFTA was in place. In Mexico, labor productivity has increased by 50 percent. The passage of NAFTA may well have contributed to this.

Estimates suggest that employment effects of NAFTA have been moderate to small. The most pessimistic estimate of job losses comes from a study published by the left-leaning Economic Policy Institute. This study suggests that the United States lost about 850,000 jobs between 1993 and 2013 due to NAFTA, or 42,500 jobs a year on average. To put this loss in context, between 1992 and 2000, the U.S. economy created 2.86 million jobs every year on average. Other studies suggest that NAFTA had a far more moderate job impact in the United States. One recent study concluded that at most, 5 percent of U.S. job losses per year can be traced to NAFTA, and most of those who lose jobs find work elsewhere.

Did You Know? Did you know that NAFTA was thought to produce a “giant sucking sound?”

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Regional Economic Integration Chapter 9 273

Similarly, a review of empirical studies by the OECD concluded that “the net employment effects were relatively small, although there were adjustments across sectors displacing workers.”26

A study of the welfare effects of NAFTA, which take into account its impact on national income, suggest that Mexico and the United States saw small welfare gains of 1.31 percent and 0.08 percent, respectively, while Canada suffered a welfare loss of 0.06 percent. The same study noted that real wages increased for all NAFTA members, with Mexico registering the largest gain. Similarly, a study by the Peterson Institute for International Economics concluded that the United States was $127 billion richer every year thanks to NAFTA. These studies support the general conclusion that contrary to po- litical rhetoric, the impact of NAFTA has been quite small.27

The Future of NAFTA Despite data suggesting that NAFTA has had a small positive impact on U.S. national in- come and, at worse, a small negative impact on employment, the trade deal continues to be the target of politically motivated criticism. Politicians on both the right (Donald Trump) and the left (Bernie Sanders) have taken aim at NAFTA, claiming that the free trade area is responsible for significant job losses in the United States. While the economic data does not offer much support for these assertions, anecdotal evidence of job layoffs due to NAFTA can be found in some sectors, such as the automobile industry where Mexico has made major gains in recent years (see the opening case in this chapter).

Despite the muted impact of NAFTA, following the accession of Donald Trump to the U.S. presidency, NAFTA is being renegotiated. The outcome might include higher tariffs on the exports of certain goods from Mexico, such as finished automobiles or automobile parts. One idea currently making the rounds is that products manufactured in Mexico should have increased levels of North American components. Some auto makers, such as Japan’s Mazda, import components directly from Japan and then assemble cars in Mexico. Under revised rules, those cars might be subject to a tariff unless the components were made in the region. These tighter rules of origin would likely prompt a shift to greater U.S. content but would also raises costs.

The worst-case scenario would be if NAFTA collapsed, which is possible if a trade war betweens the United States and Mexico breaks out. Absent of NAFTA, trade between the United States and Mexico would be governed by WTO rules, which would suggest tariffs of around 5 percent. That in itself is probably manageable. However, the Trump adminis- tration has floated the idea of imposing much higher tariffs on Mexican imports (figures as high as 20 percent have been mentioned). Not only would such tariffs raise prices to U.S. consumers, but if such tariffs were imposed, Mexico would probably respond with tariffs of its own on U.S. imports. Since Mexico is the second largest export market for the United States, purchasing $212 billion of U.S. goods and services in 2015, such retaliatory tariffs would have negative consequences for many U.S. producers and their employees and would almost certainly have a harmful impact on the U.S. economy. In short, a trade war between the United States and Mexico that results in the collapse of NAFTA would not be in the economic interests of the United States, or Mexico.

THE ANDEAN COMMUNITY

Bolivia, Chile, Ecuador, Colombia, and Peru signed an agreement in 1969 to create the Andean Pact. The Andean Community was largely based on the EU model but was far less successful at achieving its stated goals. The integration steps begun in 1969 included an internal tariff reduction program, a common external tariff, a transportation policy, a common industrial policy, and special concessions for the smallest members, Bolivia and Ecuador.

By the mid-1980s, the Andean Pact had all but collapsed and had failed to achieve any of its stated objectives. There was no tariff-free trade among member countries, no com- mon external tariff, and no harmonization of economic policies. Political and economic

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problems seem to have hindered cooperation among member countries. The countries of the Andean Pact have had to deal with low economic growth, hyperinflation, high unem- ployment, political unrest, and crushing debt burdens. In addition, the dominant political ideology in many of the Andean countries during this period tended toward the radical- socialist end of the political spectrum. Because such an ideology is hostile to the free market economic principles on which the Andean Pact was based, progress toward closer integration could not be expected.

The tide began to turn in the late 1980s when, after years of economic decline, the gov- ernments of Latin America began to adopt free market economic policies. In 1990, the heads of the five current members of the Andean Community—Bolivia, Ecuador, Peru, Colombia, and Venezuela—met in the Galápagos Islands. The resulting Galápagos Decla- ration effectively relaunched the Andean Pact, which was renamed the Andean Commu- nity in 1997. The declaration’s objectives included the establishment of a free trade area by 1992, a customs union by 1994, and a common market by 1995. This last milestone has not been reached. A customs union was implemented in 1995—although Peru opted out and Bolivia received preferential treatment until 2003. The Andean Community now oper- ates as a customs union. In December 2005, it signed an agreement with Mercosur to re- start stalled negotiations on the creation of a free trade area between the two trading blocs. Those negotiations are proceeding at a slow pace. In late 2006, Venezuela withdrew from the Andean Community as part of that country’s attempts to join Mercosur.

MERCOSUR

Mercosur originated in 1988 as a free trade pact between Brazil and Argentina. The mod- est reductions in tariffs and quotas accompanying this pact reportedly helped bring about an 80 percent increase in trade between the two countries in the late 1980s.28 This success encouraged the expansion of the pact in March 1990 to include Paraguay and Uruguay as full members. In 2012, the pact was further expanded when Venezuela joined Mercosur. However, in 2016 Venezuela was suspended from Mercosur for violating the pact’s demo- cratic principles and engaging in widespread human rights violations.

The initial aim of Mercosur was to establish a full free trade area by the end of 1994 and a common market sometime thereafter. In December 1995, Mercosur’s members agreed to a five-year program under which they hoped to perfect their free trade area and move toward a full customs union—something that has yet to be achieved.29 For its first eight years or so, Mercosur seemed to be making a positive contribution to the economic growth rates of its member states. Trade among the four core members quadrupled between 1990 and 1998. The combined GDP of the four member states grew at an annual average rate of 3.5 percent between 1990 and 1996, a performance that is significantly better than the four attained during the 1980s.30

However, Mercosur had its critics, including Alexander Yeats, a senior economist at the World Bank, who wrote a stinging critique.31 According to Yeats, the trade diversion ef- fects of Mercosur outweigh its trade creation effects. Yeats pointed out that the fastest- growing items in intra-Mercosur trade were cars, buses, agricultural equipment, and other capital-intensive goods that are produced relatively inefficiently in the four member coun- tries. In other words, Mercosur countries, insulated from outside competition by tariffs that run as high as 70 percent of value on motor vehicles, are investing in factories that build products that are too expensive to sell to anyone but themselves. The result, accord- ing to Yeats, is that Mercosur countries might not be able to compete globally once the group’s external trade barriers come down. In the meantime, capital is being drawn away from more efficient enterprises. In the near term, countries with more efficient manufac- turing enterprises lose because Mercosur’s external trade barriers keep them out of the market.

Mercosur hit a significant roadblock in 1998, when its member states slipped into reces- sion and intrabloc trade slumped. Trade fell further in 1999, following a financial crisis in Brazil that led to the devaluation of the Brazilian real, which immediately made the goods

Regional Economic Integration Chapter 9 275

of other Mercosur members 40 percent more expensive in Brazil, their largest export mar- ket. At this point, progress toward establishing a full customs union all but stopped. Things deteriorated further in 2001, when Argentina, beset by economic stresses, suggested the customs union be temporarily suspended. Argentina wanted to suspend Mercosur’s tariff so that it could abolish duties on imports of capital equipment, while raising those on consumer goods to 35 percent (Mercosur had established a 14 percent import tariff on both sets of goods). Brazil agreed to this request, effectively halting Mercosur’s quest to become a fully functioning customs union.32 Hope for a revival arose in 2003, when new Brazilian President Lula da Silva announced his support for a revitalized and expanded Mercosur modeled after the EU with a larger membership, a common currency, and a democratically elected Mercosur parliament.33 In 2010, the members of Mercosur did agree on a common customs code to avoid outside goods having to pay tariffs more than once, an important step toward achieving a full customs union. Since 2010, however, Mer- cosur has made little forward progress, and the jury is still out on whether it will become a fully functioning customs union.

CENTRAL AMERICAN COMMON MARKET, CAFTA, AND CARICOM

Two other trade pacts in the Americas have not made much progress. In the early 1960s, Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua attempted to set up a Cen- tral American Common Market. It collapsed in 1969, when war broke out between Hondu- ras and El Salvador after a riot at a soccer match between teams from the two countries. Since then, the member countries have made some progress toward reviving their agreement (the five founding members were joined by the Dominican Republic). The proposed com- mon market was given a boost in 2003, when the United States signaled its intention to enter into bilateral free trade negotiations with the group. These culminated in a 2004 agreement to establish a free trade agreement between the six countries and the United States. Known as the Central America Free Trade Agreement (CAFTA), the aim is to lower trade barriers between the United States and the six countries for most goods and services.

A customs union was to have been created in 1991 among the English-speaking Caribbean countries under the auspices of the Caribbean Community. Referred to as CARICOM, it was established in 1973. However, it repeatedly failed to progress toward economic integration. A formal commitment to economic and monetary union was adopted by CARICOM’s mem- ber states in 1984, but since then, little progress has been made. In October 1991, the CARI- COM governments failed, for the third consecutive time, to meet a deadline for establishing a common external tariff. Despite this, CARICOM expanded to 15 members by 2005. In early 2006, six CARICOM members established the Caribbean Single Market and Econ- omy (CSME). Modeled on the EU’s single market, CSME’s goal is to lower trade barriers and harmonize macroeconomic and monetary policy between member states.34

Regional Economic Integration Elsewhere

Numerous attempts at regional economic integration have been tried throughout Asia, Africa, and elsewhere. One of the most significant is the Association of Southeast Asian Nations (ASEAN), although there have been numerous attempts to establish free trade agreements in Africa (see the closing case in this chapter), and there are ongoing efforts to establish free trade agreements between the United States and 11 other nations bordering the Pacific (the Trans Pacific Partnership, or TPP) and the United States and the European Union (the Transatlantic Trade and Investment Partnership, or TTIP).

ASSOCIATION OF SOUTHEAST ASIAN NATIONS

Formed in 1967, the Association of Southeast Asian Nations (ASEAN) includes Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam. Laos, Myanmar, Vietnam, and Cambodia have all joined recently, creating a regional

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276 Part 3 The Global Trade and Investment Environment

grouping of 600 million people with a combined GDP of some $2 trillion (see Map 9.3). The basic objective of ASEAN is to foster freer trade among member countries and to achieve co- operation in their industrial policies. Progress so far has been limited, however.

Until recently, only 5 percent of intra-ASEAN trade consisted of goods whose tariffs had been reduced through an ASEAN preferential trade arrangement. This may be chang- ing. In 2003, an ASEAN Free Trade Area (AFTA) among the six original members of ASEAN came into full effect. The AFTA has cut tariffs on manufacturing and agricultural products to less than 5 percent. However, there are some significant exceptions to this tariff reduction. Malaysia, for example, refused to bring down tariffs on imported cars until 2005 and then agreed to lower the tariff only to 20 percent, not the 5 percent called for under the AFTA. Malaysia wanted to protect Proton, an inefficient local carmaker, from foreign competition. Similarly, the Philippines has refused to lower tariff rates on petro- chemicals, and rice, the largest agricultural product in the region, will remain subject to higher tariff rates until at least 2020.35

Notwithstanding such issues, ASEAN and AFTA are at least progressing toward estab- lishing a free trade zone. Vietnam joined the AFTA in 2006, Laos and Myanmar in 2008,

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and Cambodia in 2010. The goal was to reduce import tariffs among the six original mem- bers to zero by 2010 and to do so by 2015 for the newer members (although important exceptions to that goal, such as tariffs on rice, will persist).

ASEAN signed a free trade agreement with China that removes tariffs on 90 percent of traded goods. This went into effect January 1, 2010. Trade between China and ASEAN members more than tripled during the first decade of the twenty-first century, and this agreement should spur further growth.36

REGIONAL TRADE BLOCS IN AFRICA

African countries have been experimenting with regional trade blocs for half a century. Nominally there are now 17 trade blocs on the African continent. Many countries are members of more than one group. Although the number of trade groups is impressive, progress toward the establishment of meaningful trade blocs has been slow.

Many of these groups have been dormant for years. Significant political turmoil in sev- eral African nations has persistently impeded any meaningful progress. Also, deep suspi- cion of free trade exists in several African countries. The argument most frequently heard is that because these countries have less developed and less diversified economies, they need to be “protected” by tariff barriers from unfair foreign competition. Given the preva- lence of this argument, it has been hard to establish free trade areas or customs unions.

A meaningful attempt to reenergize the free trade movement in Africa occurred in early 2001, when Kenya, Uganda, and Tanzania, member states of the East African Community (EAC), committed themselves to relaunching their bloc, 24 years after it collapsed. The three countries, with 80 million inhabitants, intend to establish a customs union, regional court, legislative assembly, and, eventually, a political federation.

Their program includes cooperation on immigration, road and telecommunication net- works, investment, and capital markets. However, while local business leaders welcomed the relaunch as a positive step, they were critical of the EAC’s failure in practice to make progress on free trade. At the EAC treaty’s signing in November 1999, members gave themselves four years to negotiate a customs union, with a draft slated for the end of 2001. But that fell far short of earlier plans for an immediate free trade zone, shelved after Tan- zania and Uganda, fearful of Kenyan competition, expressed concerns that the zone could create imbalances similar to those that contributed to the breakup of the first commu- nity.37 Nevertheless, in 2005 the EAC did start to implement a customs union. In 2007, Burundi and Rwanda joined the EAC. The EAC established a common market in 2010 and is now striving toward an eventual goal of monetary union.

In 2015, in what is a promising sign, representatives from 26 African nations signed an agreement pledging to work together to establish a free trade area that would remove or re- duce many tariffs and eliminate time-consuming customs procedures between them. Known as the Tripartite Free Trade Area (TFTA), this common market would encompass more than 630 million people and link together three existing regional trading blocks in Southern and Eastern Africa with a combined gross domestic product of $1.2 trillion and more than $102 billion in trade among member states (see this chapter’s closing case for further details).

OTHER TRADE AGREEMENTS

As noted in Chapter 7, following the failure of the Doha Round of talks to extend the WTO, the United States and many other nations have placed renewed emphasis on bilat- eral and multilateral trade agreements. Under President Obama, the United States was pursuing two major multilateral trade agreements: the Trans Pacific Partnership (TPP) with 11 other Pacific Rim countries (including Australia, New Zealand, Japan, South Korea, Malaysia, and Chile) and the Transatlantic Trade and Investment Partnership (TTIP) with the European Union. However, President Trump, who appears to be op- posed to free trade, pulled the United States out of the TPP. In theory, the TTIP is still in negotiation. However, given the tenor of the Trump administration, it seems unlikely that this will progress.

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F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

REGIONAL ECONOMIC INTEGRATION THREATS Currently, the most significant developments in regional economic integration are

occurring in the EU and NAFTA. Although some of the Latin American trade blocs and ASEAN may have economic significance in the future, developments in the EU and NAFTA currently have more profound implications for business practice. Accordingly, in this section, we concentrate on the business implications of those

two groups. Similar conclusions, however, could be drawn with regard to the cre- ation of a single market anywhere in the world.

Opportunities Regional economic integration has created significant opportunities for busi- nesses to grow the market for their goods and services and lower their factor costs. Mar- kets that were formerly protected from foreign competition have become more open, and the costs of doing business have fallen. The latter is particularly true in the case of the EU’s single market and, to a lesser extent, NAFTA. In these zones, free movement of goods and services across borders, harmonized product standards, and simplified tax regimes have made it increasingly possible for businesses to realize potentially significant cost econo- mies by centralizing production of products, or component parts, in those EU and NAFTA locations where the mix of factor costs and skills is optimal. Rather than producing a prod- uct in each of the 28 EU countries or the three NAFTA countries, a firm may be able to serve the whole EU or North American market from a single location. This location must be chosen carefully, of course, with an eye on local factor costs and skills. That being said, it is important to recognize that even after the removal of barriers to trade and investment, enduring differences in culture and competitive practices often limit the ability of companies to realize cost economies by centralizing production in key locations and producing a standardized product for a single multiple-country market. Consider the case of Atag Holdings NV, a Dutch maker of kitchen appliances.38 Atag thought it was well placed to benefit from the single market but found it tough going. Atag’s plant is just one mile from the German border and near the center of the EU’s population. The company thought it could cater to both the “potato” and “spaghetti” belts—marketers’ terms for consumers in northern and southern Europe—by producing two main product lines and selling these standardized “euro-products” to “euro- consumers.” The main benefit of doing so is the economy of scale derived from mass production of a standardized range of products. Atag quickly discovered that the “euro- consumer” was a myth. Consumer preferences vary much more across nations than Atag had thought. Consider ceramic cooktops: Atag planned to market just two varieties throughout the EU but found it needed 11. Belgians, who cook in huge pots, require extra- large burners. Germans like oval pots and burners to fit. The French need small burners and very low temperatures for simmering sauces and broths. Germans like oven knobs on the top; the French want them on the front. Most Germans and French prefer black and white ranges; the British demand a range of colors, including peach, pigeon blue, and mint green.

Threats Just as the emergence of single markets creates opportunities for business, it also presents a number of threats. For one thing, the business environment within each grouping has become more competitive. The lowering of barriers to trade and investment among countries has led to increased price competition throughout the EU and NAFTA. Over time, price differentials across nations will decline in a single market. This is a direct threat to any firm doing business in EU or NAFTA countries. To survive in the tougher

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single-market environment, firms must take advantage of the opportunities offered by the creation of a single market to rationalize their production and reduce their costs. Otherwise, they will be at a severe disadvantage. A further threat to firms outside these trading blocs arises from the likely long-term im- provement in the competitive position of many firms within the areas. This is particularly rel- evant in the EU, where many firms have historically been limited by a high-cost structure in their ability to compete globally with North American and Asian firms. The creation of a sin- gle market and the resulting increased competition in the EU produced serious attempts by many EU firms to reduce their cost structure by rationalizing production. This transformed many EU companies into more efficient global competitors. The message for non-EU busi- nesses is that they need to respond to the emergence of more capable European competi- tors by reducing their own cost structures. Another threat to firms outside of trading areas is the threat of being shut out of the single market by the creation of a “trade fortress.” The charge that regional economic integration might lead to a fortress mentality is most often leveled at the EU. Although the free trade philosophy underpinning the EU theoretically argues against the creation of any fortress in Europe, occasional signs indicate the EU may raise barriers to imports and investment in certain “politically sensitive” areas, such as autos. Non-EU firms might be well advised, therefore, to set up their own EU operations. This could also occur in the NAFTA countries, but it seems less likely. The emerging role of the European Commission in competition policy suggests the EU is increasingly willing and able to intervene and impose conditions on companies proposing mergers and acquisitions. This is a threat insofar as it limits the ability of firms to pursue the corporate strategy of their choice. The commission may require significant concessions from businesses as a precondition for allowing proposed mergers and acquisitions to proceed. While this constrains the strategic options for firms, it should be remembered that in taking such action, the commission is trying to maintain the level of competition in Europe’s single market, which should benefit consumers. Finally, there is a clear threat to business that is explicit in the growing opposition to free trade areas, both within the United States, where President Trump has vowed to renegotiate NAFTA, and the EU, where the impending exit of the British (Brexit), along with opposition to the EU from populist politicians within several countries, might result in the weakening of the EU. If the EU and NAFTA are diminished, some of the the gains from trade will be lost, and many of the benefits that businesses enjoyed will disappear as well. 

regional economic integration, p. 254

free trade area, p. 255 European Free Trade

Association (EFTA), p. 256 customs union, p. 256 common market, p. 256 economic union, p. 256 political union, p. 256 trade creation, p. 258 trade diversion, p. 258

European Union, p. 259 Treaty of Rome, p. 259 European Commission, p. 260 European Council, p. 262 European Parliament, p. 262 Treaty of Lisbon, p. 262 Court of Justice, p. 262 Maastricht Treaty, p. 263 optimal currency area, p. 265 North American Free Trade

Agreement (NAFTA), p. 271

Andean Community, p. 273 Mercosur, p. 274 Central American Common

Market, p. 275 Central America Free Trade

Agreement (CAFTA), p. 275 CARICOM, p. 275 Caribbean Single Market and

Economy (CSME), p. 275 Association of Southeast Asian

Nations (ASEAN), p. 275

Key Terms

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C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. NAFTA has produced significant net benefits for the Canadian, Mexican, and U.S. economies. Discuss.

2. What are the economic and political arguments for regional economic integration? Given these arguments, why don’t we see more substantial examples of integration in the world economy?

3. What in general was the effect of the creation of a single market and a single currency within the EU on competition within the EU? Why?

4. Do you think it is correct for the European Commission to restrict mergers between American companies that do business in

C H A P T E R S U M M A R Y

This chapter pursued three main objectives: to examine the economic and political debate surrounding regional economic integration; to review the progress toward re- gional economic integration in Europe, the Americas, and elsewhere; and to distinguish the important implications of regional economic integration for the practice of inter- national business. The chapter made the following points:

 1. A number of levels of economic integration are possible in theory. In order of increasing integra- tion, they include a free trade area, a customs union, a common market, an economic union, and full political union.

 2. In a free trade area, barriers to trade among member countries are removed, but each country determines its own external trade policy. In a customs union, internal barriers to trade are re- moved, and a common external trade policy is adopted. A common market is similar to a cus- toms union, except that a common market also allows factors of production to move freely among countries. An economic union involves even closer integration, including the establish- ment of a common currency and the harmoniza- tion of tax rates. A political union is the logical culmination of attempts to achieve ever-closer economic integration.

 3. Regional economic integration is an attempt to achieve economic gains from the free flow of trade and investment between neighboring countries.

 4. Integration is not easily achieved or sustained. Although integration brings benefits to the major- ity, it is never without costs for the minority. Concerns over national sovereignty often slow or stop integration attempts. In 2016, these concerns resulted in Britain voting for exit from the EU.

 5. Regional integration will not increase economic welfare if the trade creation effects in the free trade area are outweighed by the trade diversion effects.

 6. The Single European Act sought to create a true single market by abolishing administrative barri- ers to the free flow of trade and investment among EU countries.

 7. Seventeen EU members now use a common cur- rency, the euro. The economic gains from a com- mon currency come from reduced exchange costs, reduced risk associated with currency fluc- tuations, and increased price competition within the EU.

 8. Increasingly, the European Commission is tak- ing an activist stance with regard to competition policy, intervening to restrict mergers and acqui- sitions that it believes will reduce competition in the EU.

 9. Although no other attempt at regional economic integration comes close to the EU in terms of po- tential economic and political significance, vari- ous other attempts are being made in the world. The most notable include NAFTA in North America, the Andean Community and Mercosur in Latin America, and ASEAN in Southeast Asia.

10. The creation of single markets in the EU and North America means that many markets that were formerly protected from foreign competi- tion are now more open. This creates major in- vestment and export opportunities for firms within and outside these regions.

11. The free movement of goods across borders, the harmonization of product standards, and the simplification of tax regimes make it possible for firms based in a free trade area to realize poten- tially enormous cost economies by centralizing production in those locations within the area where the mix of factor costs and skills is optimal.

12. The lowering of barriers to trade and investment among countries within a trade group will proba- bly be followed by increased price competition.

Europe? (For example, the European Commis- sion vetoed the proposed merger between World- Com and Sprint, both U.S. companies, and it carefully reviewed the merger between AOL and Time Warner, again both U.S. companies.)

5. What were the causes of the 2010–2012 sovereign debt crisis in the EU? What does this crisis tell us about the weaknesses of the euro? Do you think the euro will survive the sovereign debt crisis?

6. How should a U.S. firm that currently exports only to ASEAN countries respond to the creation of a single market in this regional grouping?

7. How should a firm with self-sufficient production facilities in several ASEAN countries respond to the creation of a single market? What are the constraints on its ability to respond in a manner that minimizes production costs?

8. After a promising start, Mercosur, the major Latin American trade agreement, has faltered and made little progress since 2000. What prob- lems are hurting Mercosur? What can be done to solve these problems?

9. Read the second Management Focus feature in this chapter, “NAFTA’s Tomato Wars,” then answer the following questions:

•  Was the establishment of a minimum floor price for tomatoes consistent with the free trade prin- ciples enshrined in the NAFTA agreement?

•  Why, despite the establishment of a minimum floor price, have imports from Mexico grown over the years?

•  Who benefits from the importation of toma- toes grown in Mexico? Who suffers?

•  Do you think that Mexican producers were dumping tomatoes in the United States?

•  Was the Commerce Department right to es- tablish a new minimum floor price, rather than scrap the agreement and file an anti- dumping suit? Who would have benefited from an antidumping suit against Mexican to- mato producers? Who would have suffered?

•  What do you think will be the impact of the new higher floor price? Who benefits from the higher floor price? Who suffers?

•  What do you think is the optimal government policy response here? Explain your answer.

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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

1. The World Trade Organization maintains a data- base of regional trade agreements. You can search this database to identify all agreements that a spe- cific country participates in. Search the database to identify the trade agreements that Japan cur- rently participates in. What patterns do you see? Which region (or regions) of the world does Japan seem to be focusing on in its trade endeavors?

2. Your company has assigned you the task of inves- tigating the various trade blocs in Africa to see if your company can benefit from these trade agreements while expanding into African mar- kets. The first trade bloc you come across is COMESA. Prepare a short executive summary for your company, explaining the level of integration the bloc has currently achieved, the level it as- pires to accomplish, and the relationships it has with other African trade blocs.

On June 10, 2015, representatives from 26 African nations signed an agreement pledging to work together to establish a free trade area that would remove or reduce many tariffs and eliminate time-consuming customs procedures between them. Known as the Tripartite Free Trade Area (TFTA), this

common market would encompass more than 630 million people and link together three existing regional trading blocks in Southern and Eastern Africa with a combined gross domestic product of $1.2 trillion and more than $102 billion in trade between member states.

C L O S I N G C A S E

The Push toward Free Trade in Africa

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The existing regional trading blocks are the East African Community, created in 2000; the Southern African Development Community, created in 1980; and an overlapping Common Market for Eastern and South- ern Africa, which also took shape in the 1980s. The East Africa Community has made some progress fostering trade between its member countries, which include Kenya, Tanzania, and Uganda. Countries in the Southern African Development Community have a common set of external tariffs, and several member states use the South African rand, the most liquid and widely traded currency on the continent. However, the existing patchwork of African trading blocks—there are some 17 in all, with many countries be- ing members of more than one—has made it difficult to realize the gains from trade that could flow from an ex- panded single market. An African firm selling goods on the continent still faces an average tariff of 8.7 percent, compared with a 2.5 percent tariff on goods sold over- seas. Other costs of intra-African trade include often- lengthy stops at borders for customs inspection, excessive customs-related bureaucracy and red tape, and a lack of adequate physical infrastructure, including roads and rail- ways. As a consequence of such factors, it can take three weeks for a shipping container to travel the 700 miles from the Kenyan port of Mombasa to Kampala, the capi- tal of Uganda. There are also some vexing local content requirements. The South African Development Commu- nity, for example, requires that clothes traded within the region are both manufactured and sourced there to qual- ify for lower tariffs. However, because few textiles are pro- duced in the region, the rules have stif led trade in garments. For all these reasons, African countries are more likely to trade with Europe and America than they are with each other. Only 19 percent of Africa’s $930 billion in trade is with other countries on the continent. By com- parison, some 60 percent of Europe’s trade is within its own continent, as is 40 percent of North American trade. Other factors contributing to the lack of intra-African trade include low industrialization levels, restricted move- ment of labor, poor infrastructure, and a high dependence on exporting unprocessed commodities in many countries. The thinking behind the TFTA is that harmonizing rules, reducing tariffs, and streamlining or removing cus- toms procedures will allow African firms to sell more

goods and services to their neighbors, enabling them to achieve greater economies of scale and lower costs, which would benefit all parties to the agreement. On the other hand, such agreements may prove difficult to reach and, if the past is any guide, even more difficult to implement, given political realities on the ground. Some observers think that the TFTA is too ambitious an undertaking and that focusing effort on improving the three existing re- gional groups would yield more gains. It’s easier, they ar- gue, to reach an agreement between five adjacent member states, as in the case of the East African Community, than 26 very different countries scattered over the entire continent. Despite the skepticism surrounding TFTA, Africa na- tions have even bigger ambitions. In 2016, African leaders committed themselves to establishing a Continental Free Trade Area (CFTA) that encompasses all African coun- tries. If established, the CFTA would be the largest free trade area in the world measured by population, spanning 54 countries with more than 1 billion people (and an esti- mated 2 billion by 2050), and a gross domestic product of more than $3 trillion.

Sources: “Intra -African Trade: The Road Less Travelled,” The Economist, April 17, 2013; Martin Stevis and Patrick McGroarty, “African Leaders Pledge to Create a Free Trade Zone,” The Wall Street Journal, June 10, 2015; “Trade Within Africa: Tear Down These Walls,” The Economist, February 27, 2016; John Aglionby, “Africa Looks to Boost Growth and Jobs with Free Trade Area,” Financial Times, December 1, 2016.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Why are African countries more likely to trade

with Europe and America than they are with each other?

2. What are the likely gains from trade to be had from TFTA if it is fully implemented as a com- mon market?

3. Why do you think free trade areas established so far in Africa have not lived up to their expectations?

4. What will African countries need to do to make the TFTA a success? What are the likely impedi- ments to doing this?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

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E n d n o t e s

 1. Information taken from World Trade Organization website and current as of April 2016, www.wto.org.

 2. Information taken from World Trade Organization website and current as of April 2016, www.wto.org.

 3. The Andean Community has been through a number of changes since its inception. The latest version was established in 1991. See “Free-Trade Free for All,” The Economist, January 4, 1991, p. 63.

 4. D. Swann, The Economics of the Common Market, 6th ed. (London: Penguin Books, 1990).

 5. Pew Research Center, “Unauthorized Immigration Population Trends for States, Birth Countries and Regions,” November 3, 2016.

 6. See J. Bhagwati, “Regionalism and Multilateralism: An Over- view,” Columbia University Discussion Paper 603, Department of Economics, Columbia University, New York; A. de la Torre and M. Kelly, “Regional Trade Arrangements,” International Monetary Fund Occasional Paper 93, March 1992; J. Bhagwati, “Fast Track to Nowhere,” The Economist, October 18, 1997, pp. 21–24; Jagdish Bhagwati, Free Trade Today (Princeton and Oxford: Princeton University Press, 2002); B. K. Gordon, “A High Risk Trade Policy,” Foreign Affairs 82 no. 4 (July–August 2003), pp. 105–15; M. Dai, Y. Votov, and T. Zylkin, “On the Trade Diversion Effects of Free Trade Agreements,” Economic Letters 122 (2014), pp. 321–25.

 7. N. Colchester and D. Buchan, Europower: The Essential Guide to Europe’s Economic Transformation in 1992 (London: The Econo- mist Books, 1990); Swann, Economics of the Common Market.

 8. Swann, Economics of the Common Market; Colchester and Buchan, Europower; “The European Union: A Survey,” The Econ- omist, October 22, 1994; “The European Community: A Survey,” The Economist, July 3, 1993; European Union website at http://europa.eu.int.

 9. E. J. Morgan, “A Decade of EC Merger Control,” International Journal of Economics and Business, November 2001, pp. 451–73.

10. “The European Community: A Survey,” 1993.

11. Tony Barber, “The Lisbon Reform Treaty,” FT.com, December 13, 2007.

12. “One Europe, One Economy,” The Economist, November 30, 1991, pp. 53–54; “Market Failure: A Survey of Business in Europe,” The Economist, June 8, 1991, pp. 6–10.

13. Alan Riley, “The Single Market Ten Years On,” European Policy Analyst, December 2002, pp. 65–72.

14. Deutsche Bank, “The Single European Market 20 Years On,” EU Monitor, October 31, 2013.

15. See C. Wyploze, “EMU: Why and How It Might Happen,” Journal of Economic Perspectives 11 (1997), pp. 3–22; M. Feldstein, “The Political Economy of the European

Economic and Monetary Union,” Journal of Economic Perspec- tives 11 (1997), pp. 23–42.

16. “One Europe, One Economy”; Feldstein, “The Political Economy of the European Economic and Monetary Union.”

17. “Euro Still the World’s Second Reserve Currency,” The Economic Times, July 22, 2011.

18. Details regarding conditions of membership and the progression of enlargement negotiations can be found at http://europa.eu/ pol/enlarg/index_en.htm.

19. Chris Giles, “Brexit in Seven Charts—The Economic Impact,” Financial Times, June 27, 2016.

20. “What Is NAFTA?” Financial Times, November 17, 1993, p. 6; S. Garland, “Sweet Victory,” BusinessWeek, November 29, 1993, pp. 30–31.

21. Bernie Woodall, “U.S. Autoworkers Face Threat as Car Makers Drawn to Mexico,” Reuters, March 26, 2015.

22. “NAFTA: The Showdown,” The Economist, November 13, 1993, pp. 23–36.

23. N. C. Lustog, “NAFTA: Setting the Record Straight,” The World Economy, 1997, pp. 605–14; G. C. Huf bauer and J. J. Schott, NAFTA Revisited: Achievements and Challenges (Washington, DC: Institute for International Economics, 2005).

24. W. Thorbecke and C. Eigen-Zucchi, “Did NAFTA Cause a Giant Sucking Sound?” Journal of Labor Research, Fall 2002, pp. 647–58; G. Gagne, “North American Free Trade, Canada, and U.S. Trade Remedies: An Assessment after Ten Years,” The World Economy, 2000, pp. 77–91; Hufbauer and Schott, NAFTA Revisited; J. Romalis, “NAFTA’s and Custfa’s Impact on International Trade,” Review of Economics and Statistics 98, no. 3 (2007), pp. 416–35; “NAFTA at 20: Ready to Take Off Again?” The Economist, January 4, 2014. G. C. Hufbauer, C. Cimno, and T. Moran, “NAFTA at 20: Mis- leading Charges and Positive Achievements,” Peterson Institute for International Economics, May 2014.

25. Data from the U.S. Census Bureau.

26. C. J. O’Leary, R. W. Eberts, and B. M. Pittelko, “Effects of NAFTA on US Employment and Policy Responses: A Product of the International Collaborative Initiative on Trade and Em- ployment (ICITE),” OECD Trade Policy Papers, no. 131 (Paris: OECD Publishing, 2012); Huf bauer, Cimno, and Moran, “NAFTA at 20: Misleading Charges and Positive Achievements.”

27. L. Caliendo and F. Parro, “Estimates of the Trade and Welfare Effects of NAFTA,” Review of Economic Studies, July 2014; Huf bauer, Cimno and Moran, “NAFTA at 20: Misleading Charges and Positive Achievements.”

28. “The Business of the American Hemisphere,” The Economist, August 24, 1991, pp. 37–38.

29. “NAFTA Is Not Alone,” The Economist, June 18, 1994, pp. 47–48.

284 Part 3 The Global Trade and Investment Environment

30. “Murky Mercosur,” The Economist, July 26, 1997, pp. 66–67.

31. See M. Philips, “South American Trade Pact under Fire,” The Wall Street Journal, October 23, 1996, p. A2; A. J. Yeats, Does Mercosur’s Trade Performance Justify Concerns about the Global Welfare-Reducing Effects of Free Trade Arrangements? Yes! (Washington, DC: World Bank, 1996); D. M. Leipziger et al., “Mercosur: Integration and Industrial Policy,” The World Economy, 1997, pp. 585–604.

32. “Another Blow to Mercosur,” The Economist, March 31, 2001, pp. 33–34.

33. “Lula Lays Out Mercosur Rescue Mission,” Latin America News- letters, February 4, 2003, p. 7.

34. “CARICOM Single Market Begins,” EIU Views, February 3, 2006.

35. “Every Man for Himself: Trade in Asia,” The Economist, November 2, 2002, pp. 43–44.

36. L. Gooch, “Asian Free-Trade Zone Raises Hopes,” The New York Times, January 1, 2010, p. B3.

37. M. Turner, “Trio Revives East African Union,” Financial Times, January 16, 2001, p. 4.

38. T. Horwitz, “Europe’s Borders Fade,” The Wall Street Journal, May 18, 1993, pp. A1, A12; “A Singular Market,” The Economist, October 22, 1994, pp. 10–16; “Something Dodgy in Europe’s Single Market,” The Economist, May 21, 1994, pp. 69–70.

39. E. Malkin, “Mexico Finds Unlikely Allies in Trade Fight,” The New York Times, December 25, 2012, p. B1.

40. Malkin, “Mexico Finds Unlikely Allies in Trade Fight.”

part four The Global Monetar y System

10The Foreign Exchange Market L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO10 -1 Describe the functions of the foreign exchange market.

LO10-2 Understand what is meant by spot exchange rates.

LO10-3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

LO10-4 Understand the different theories explaining how currency exchange rates are determined and their relative merits.

LO10-5 Identify the merits of different approaches toward exchange rate forecasting.

LO10-6 Compare and contrast the differences among translation, transaction, and economic exposure, and explain the implications for management practice.

©Bloomberg/Getty Images

The Mexican Peso, the Japanese Yen, and Pokemon Go

about the health of the Mexican economy following the election of Donald Trump to the U.S. presidency put further pressure on the peso. The Mexican peso hit a record low against the U.S. dollar following the election of Mr. Trump. In addition to Nintendo, the fall in the value of the peso against the yen has created problems for other Japanese firms. Japanese auto makers have significant assembly op- erations in Mexico. Companies such as Toyota and Mazda import a large number of specialty electronic components from suppliers in Japan. The price of these components has gone up when translated into pesos, raising costs for their Mexican operations and making them less profitable. On the other hand, the weak peso has boosted demand for some Mexican products in Japan. For example, Japan imports a large quantity of frozen Mexican pork. The price has fallen when translated into yen and demand has surged. Mexico dices up the pork and exports it to Japanese convenience stores, where it is sold in bento boxes. The dicing process is labor intensive—and one less step they have to perform in Japan. Mexico can do it cheaper, and the currency moves have only added to the cost savings, which is good for Japanese consumers.

Sources: Julie Wernau, “Pokeman Go Illustrates a Currency Prob- lem,” The Wall Street Journal, August 11, 2016; Elena Holodny and Portia Crowe, “Mexican Peso Crashes to Record Low,” Business Insider, November 8, 2016; “Peso Falls to Session Lows after Meet- ing between US and Mexico Presidents Falls Through,” Reuters, January 26, 2017.

O P E N I N G C A S E Nintendo’s hit game Pokemon Go is looking a lot less lucrative in Mexico nowadays. This is because Mexicans purchase the “Pokecoins” they need to navigate the game in Mexican pesos, and the peso has been falling in value against the Japanese yen. Back in early 2015, 1 Mexican peso bought 8 Japanese yen. By mid-2016, 1 peso was only worth about 5.5 Japanese yen. This meant that when pesos spent on Pokemon Go were translated back into Japanese yen, they were worth less in yen, which nega- tively affected Nintendo’s profits from Mexico. The diverging values on the yen and peso are a function of their exchange rates against the U.S. dollar. Most trades between the yen and the peso are converted through the U.S. dollar, rather than traded directly. This is because the U.S. dollar is the world’s most widely traded and liquid cur- rency. It’s easier to trade dollars for yen, and dollars for pe- sos, than it is to trade yen for pesos. In the first half of 2016, the yen gained against the dollar, while the Mexican peso fell, leading to a fall in the peso/yen exchange rate. The strength of the yen reflected the belief that Japan is a safe haven in which to park cash. Although the Japanese economy has been stagnant for decades, inflation is low and the yen has been a strong currency. The Mexican peso is the most liquid emerging market currency, which makes it an easy one to sell when investors worry about the economic strength of developing economies, which they did in 2015 and 2016. To compound matters, worries

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288 Part 4 The Global Monetary System

Introduction

Like many enterprises in the global economy, Nintendo is affected by changes in the value of currencies on the foreign exchange market. As described in the opening case, Nintendo’s revenues and profits from Mexico were reduced in 2016 as a result of an increase in the value of the yen against the Mexican peso on foreign exchange markets. The case illus- trates that what happens in the foreign exchange market can have a fundamental impact on the sales, profits, and strategy of an enterprise. Accordingly, it is very important for manag- ers to understand how the foreign exchange works and what the impact of changes in cur- rency exchange rates might be for their enterprise.

This chapter has three main objectives. The first is to explain how the foreign exchange market works. The second is to examine the forces that determine exchange rates and to discuss the degree to which it is possible to predict future exchange rate movements. The third objective is to map the implications for international business of exchange rate move- ments. This chapter is the first of three that deal with the international monetary system and its relationship to international business. Chapter 11 explores the institutional struc- ture of the international monetary system. The institutional structure is the context within which the foreign exchange market functions. As we shall see, changes in the institutional structure of the international monetary system can exert a profound influence on the de- velopment of foreign exchange markets.

The foreign exchange market is a market for converting the currency of one country into that of another country. An exchange rate is simply the rate at which one currency is converted into another. For example, Toyota uses the foreign exchange market to convert the dollars it earns from selling cars in the United States into Japanese yen. Without the foreign exchange market, international trade and international investment on the scale that we see today would be impossible; companies would have to resort to barter. The foreign exchange market is the lubricant that enables companies based in countries that use differ- ent currencies to trade with each other.

We know from earlier chapters that international trade and investment have their risks. Some of these risks exist because future exchange rates cannot be perfectly predicted. The rate at which one currency is converted into another can change over time. For example, at the start of 2001, 1 U.S. dollar bought 1.065 euros, but by early 2014, 1 U.S. dollar bought only 0.74 euro. The dollar had fallen sharply in value against the euro. This made American goods cheaper in Europe, boosting export sales. At the same time, it made European goods more expensive in the United States, which hurt the sales and profits of European companies that sold goods and services to the United States. The pricing advantage en- joyed by U.S. companies, however, disappeared during 2015 and 2016 as economic weak- ness in Europe and a stronger U.S. economy resulted in a sharp fall in the value of the euro. By early 2017, 1 U.S. dollar bought 0.93 euro, meaning that American exports to the euro zone had become more expensive. Rapid changes in currency values such as these often take managers by surprise, and if they have not hedged against the possible risk, sales and profits can be significantly affected.

One function of the foreign exchange market is to provide some insurance against the risks that arise from such volatile changes in exchange rates, commonly referred to as for- eign exchange risk. Although the foreign exchange market offers some insurance against foreign exchange risk, it cannot provide complete insurance. It is not unusual for interna- tional businesses to suffer losses (or gains) because of unpredicted changes in exchange rates. Currency fluctuations can make seemingly profitable trade and investment deals unprofitable, and vice versa.

We begin this chapter by looking at the functions and the form of the foreign exchange market. This includes distinguishing among spot exchanges, forward exchanges, and cur- rency swaps. Then we consider the factors that determine exchange rates. We also look at how foreign trade is conducted when a country’s currency cannot be exchanged for other currencies, that is, when its currency is not convertible. The chapter closes with a discus- sion of these things in terms of their implications for business.

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The Functions of the Foreign Exchange Market

The foreign exchange market serves two main functions. The first is to convert the cur- rency of one country into the currency of another. The second is to provide some insur- ance against foreign exchange risk, or the adverse consequences of unpredictable changes in exchange rates.1

CURRENCY CONVERSION

Each country has a currency in which the prices of goods and services are quoted. In the United States, it is the dollar ($); in Great Britain, the pound (£); in France, Germany, and the other 17 members of the euro zone, it is the euro (€); in Japan, the yen (¥); and so on. In general, within the borders of a particular country, one must use the national currency. A U.S. tourist cannot walk into a store in Edinburgh, Scotland, and use U.S. dollars to buy a bottle of Scotch whisky. Dollars are not recognized as legal tender in Scotland; the tour- ist must use British pounds. Fortunately, the tourist can go to a bank and exchange her dollars for pounds. Then she can buy the whisky.

When a tourist changes one currency into another, she is participating in the foreign exchange market. The exchange rate is the rate at which the market converts one currency into another. For example, an exchange rate of €1 = $1.07 specifies that 1 euro buys 1.07 U.S. dollars. The exchange rate allows us to compare the relative prices of goods and services in different countries. A U.S. tourist wishing to buy a bottle of Scotch whisky in Edinburgh may find that she must pay £30 for the bottle, knowing that the same bottle costs $35 in the United States. Is this a good deal? Imagine the current pound/dollar exchange rate is £1.00 = $1.25 (i.e., 1 British pound buys $1.25). Our intrepid tourist takes out her calcula- tor and converts £30 into dollars. (The calculation is 30 × 1.25.) She finds that the bottle of Scotch costs the equivalent of $37.50. She is surprised that a bottle of Scotch whisky could cost less in the United States than in Scotland despite shipping costs (alcohol is taxed heavily in Great Britain).

Tourists are minor participants in the foreign exchange market; companies engaged in international trade and investment are major ones. International businesses have four main uses of foreign exchange markets. First, the payments a company receives for its exports, the income it receives from foreign investments, or the income it receives from licensing agreements with foreign firms may be in foreign currencies. To use those funds in its home country, the company must convert them to its home country’s currency.

LO 10 -1 Describe the functions of the foreign exchange market.

D ATA B A S E O F I N T E R N AT I O N A L B U S I N E S S S TAT I S T I C S

The “global money system” can have a significant effect on how companies operate glob- ally. Often companies have to deal with exchange rates, monetary systems, and the capital market on both country and regional levels. But the influences of countries on the regional and global money system are significant (i.e., countries set the tone for the parameters of the foreign exchange market and the international monetary system). The globalEDGETM Data- base of International Business Statistics (DIBS) includes time-series data beginning in the 1990s until today and covers more than 200 countries and more than 5,000 data variables. Countries, regions, and the world use these types of data points to drive the global money system, and everyone who is interested in better understanding the global capital market needs to know about them! Register free on globalEDGETM to gain access to the DIBS database right now; students have free access to DIBS, and DIBS can be found at globaledge.msu.edu/tools-and-data/dibs.

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Consider the Scotch distillery that exports its whisky to the United States. The distillery is paid in dollars, but because those dollars can- not be spent in Great Britain, they must be converted into British pounds. Similarly, Toyota sells its cars in the United States for dollars; it must convert the U.S. dollars it receives into Japanese yen to use them in Japan.

Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its coun- try’s currency. For example, Dell buys many of the components for its computers from Malaysian firms. The Malaysian companies must be paid in Malaysia’s currency, the ringgit, so Dell must convert money from dollars into ringgit to pay them.

Third, international businesses also use foreign exchange markets when they have spare cash that they wish to invest for short terms in money mar- kets. For example, consider a U.S. company that has $10 million it wants to invest for three months. The best interest rate it can earn on these funds in the United States may be 2 percent. Investing in a South Korean money market account, however, may earn 6 percent. Thus, the company may change its $10 million into Korean won and invest it in South Korea. Note, however, that the rate of return it earns on this investment depends not only on the Korean interest rate but also on the changes in the value of the Korean won against the dollar in the intervening period.

Currency speculation is the fourth use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. Consider again a U.S. company with $10 million to invest for three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company expects the

value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/ yen exchange rate is $1 = ¥120. The company exchanges its $10 million into yen, receiving ¥1.2 billion ($10 million × 120 = ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 = ¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds that it has $12 million. The company has made a $2 million profit on currency speculation in three months on an initial investment of $10 million! In general, however, companies should beware, for speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. While a speculator may profit handsomely if his speculation about future currency movements turns out to be correct, he can also lose vast amounts of money if it turns out to be wrong.

A kind of speculation that has become more common in recent years is known as the carry trade. The carry trade involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high.2 For example, if the interest rate on borrowings in Japan is 1 percent but the interest rate on deposits in American banks is 6 percent, it can make sense to borrow in Japanese yen, con- vert the money into U.S. dollars, and deposit it in an American bank. The trader can make a 5 percent margin by doing so, minus the transaction costs associated with changing one currency into another. The speculative element of this trade is that its success is based on a belief that there will be no adverse movement in exchange rates (or interest rates for that matter) that will make the trade unprofitable. However, if the yen were to rapidly increase in value against the dollar, then it would take more U.S. dollars to repay the original loan, and the trade could fast become unprofitable. The dollar/yen carry trade was actually very significant during the mid-2000s, peaking at more than $1 trillion in 2007, when some 30 percent of trade on the Tokyo foreign exchange market was related to the carry trade.3 This carry trade declined in importance during 2008–2009 because interest rate differen- tials were falling as U.S. rates came down, making the trade less profitable. By late 2016,

Tourists exchanging currency in Istanbul, Turkey. ©muratart/Shutterstock

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there were signs that the dollar/yen carry trade was becoming important again as negative interest rates in Japan, coupled with rising interest rates in the United States, were making it profitable to borrow in yen again and convert the money into U.S. dollars.4

INSURING AGAINST FOREIGN EXCHANGE RISK

A second function of the foreign exchange market is to provide insurance against foreign exchange risk, which is the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm. When a firm insures itself against foreign exchange risk, it is engaging in hedging. To explain how the market performs this function, we must first distinguish among spot exchange rates, forward exchange rates, and currency swaps.

Spot Exchange Rates When two parties agree to exchange currency and execute the deal immediately, the trans- action is referred to as a spot exchange. Exchange rates governing such “on the spot” trades are referred to as spot exchange rates. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Thus, when our U.S. tourist in Edinburgh goes to a bank to convert her dollars into pounds, the exchange rate is the spot rate for that day.

Spot exchange rates are reported on a real-time basis on many financial websites. An ex- change rate can be quoted in two ways: as the amount of foreign currency one U.S. dollar will buy or as the value of a dollar for one unit of foreign currency. Thus, on February 6, 2016, at 12:30 p.m., Eastern Standard Time, 1 U.S. dollar bought €0.93, and 1 euro bought $1.08.

Spot rates change continually, often on a minute-by-minute basis (although the magni- tude of changes over such short periods is usually small). The value of a currency is deter- mined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies. For example, if lots of people want U.S. dollars and dollars are in short supply, and few people want British pounds and pounds are in plentiful supply, the spot exchange rate for converting dollars into pounds will change. The dollar is likely to appreciate against the pound (or the pound will depreciate against the dollar). Imagine the spot exchange rate is £1 = $1.25 when the market opens. As the day progresses, dealers demand more dollars and fewer pounds. By the end of the day, the spot exchange rate might be £1 = $1.23. Each pound now buys fewer dollars than at the start of the day. The dollar has appreciated, and the pound has depreciated.

Forward Exchange Rates Changes in spot exchange rates can be problematic for an international business. For ex- ample, a U.S. company that imports high-end cameras from Japan knows that in 30 days it must pay yen to a Japanese supplier when a shipment arrives. The company will pay the Japanese supplier ¥200,000 for each camera, and the current dollar/yen spot exchange rate is $1 = ¥120. At this rate, each camera costs the importer $1,667 (i.e., 1,667 = 200,000/120). The importer knows she can sell the camera the day they arrive for $2,000 each, which yields a gross profit of $333 on each ($2,000 − $1,667). However, the im- porter will not have the funds to pay the Japanese supplier until the cameras are sold. If, over the next 30 days, the dollar unexpectedly depreciates against the yen, say, to $1 = ¥95, the importer will still have to pay the Japanese company ¥200,000 per camera but in dollar terms that would be equivalent to $2,105 per camera, which is more than she can sell the cameras for. A depreciation in the value of the dollar against the yen from $1 = ¥120 to $1 = ¥95 would transform a profitable deal into an unprofitable one.

To insure or hedge against this risk, the U.S. importer might want to engage in a forward exchange. A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Exchange rates governing such future transactions are referred to as forward exchange rates. For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future. In some cases, it is possible to get forward exchange rates for several years into the future.

LO 10 -2 Understand what is meant by spot exchange rates.

LO 10 -3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

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Returning to our camera importer example, let us assume the 30-day forward exchange rate for converting dollars into yen is $1 = ¥110. The importer enters into a 30-day for- ward exchange transaction with a foreign exchange dealer at this rate and is guaranteed that she will have to pay no more than $1,818 for each camera (1,818 = 200,000/110). This guarantees her a profit of $182 per camera ($2,000 − $1,818). She also insures herself against the possibility that an unanticipated change in the dollar/yen exchange rate will turn a profitable deal into an unprofitable one.

In this example, the spot exchange rate ($1 = ¥120) and the 30-day forward rate ($1 = ¥110) differ. Such differences are normal; they reflect the expectations of the foreign e xchange market about future currency movements. In our example, the fact that $1 bought more yen with a spot exchange than with a 30-day forward exchange indicates for- eign exchange dealers expected the dollar to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a discount on the 30-day forward market (i.e., it is worth less than on the spot market). Of course, the opposite can also occur. If the 30-day forward exchange rate were $1 = ¥130, for example, $1 would buy more yen with a forward exchange than with a spot exchange. In such a case, we say the dollar is selling at a premium on the 30-day forward market. This reflects the foreign exchange dealers’ expec- tations that the dollar will appreciate against the yen over the next 30 days.

In sum, when a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprof- itable by the time that transaction has been executed. Although many firms routinely enter into forward exchange contracts to hedge their foreign exchange risk, sometimes this can work against the company. An example is given in the accompanying Management Focus, which explains how the hedging strategy adopted by the Brazilian regional jet manufac- turer, Embraer, backfired.

Currency Swaps The preceding discussion of spot and forward exchange rates might lead you to conclude that the option to buy forward is very important to companies engaged in international trade—and you would be right. According to the most recent data, forward instruments account for almost two-thirds of all foreign exchange transactions, while spot exchanges account for about one-third.5 However, the vast majority of these forward exchanges are not forward exchanges of the type we have been discussing but rather a more sophisticated instrument known as currency swaps.

A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Swaps are transacted between international busi- nesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign ex- change risk. A common kind of swap is spot against forward. Consider a company such as Apple. Imagine Apple assembles laptop computers in the United States, but the screens are made in Japan. Apple also sells some of the finished laptops in Japan. So, like many companies, Apple both buys from and sells to Japan. Imagine Apple needs to change $1 million into yen to pay its supplier of laptop screens today. Apple knows that in 90 days it will be paid ¥120 million by the Japanese importer that buys its finished laptops. It will want to convert these yen into dollars for use in the United States. Let us say today’s spot exchange rate is $1 = ¥120 and the 90-day forward exchange rate is $1 = ¥110. Apple sells $1 million to its bank in return for ¥120 million. Now Apple can pay its Japanese supplier. At the same time, Apple enters into a 90-day forward exchange deal with its bank for con- verting ¥120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (¥120 million/110 = $1.09 million). Because the yen is trading at a premium on the 90-day forward market, Apple ends up with more dollars than it started with (although the oppo- site could also occur). The swap deal is just like a conventional forward deal in one impor- tant respect: It enables Apple to insure itself against foreign exchange risk. By engaging in a swap, Apple knows today that the ¥120 million payment it will receive in 90 days will yield $1.09 million.

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M A N A G E M E N T F O C U S

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Embraer and the Gyrations of the Brazilian Real For many years, Brazil was a country battered by persis- tently high inflation. As a result, the value of its currency, the real, depreciated steadily against the U.S. dollar. This changed in the early 2000s, when the Brazilian govern- ment was successful in bringing down annual inflation rates into the single digits. Lower inflation, coupled with policies that paved the way for the expansion of the Brazilian economy, resulted in a steady appreciation of the real against the U.S. dollar. In May 2004, 1 real bought $0.3121; by August 2008, 1 real bought $0.65, an apprecia- tion of more than 100 percent. The appreciation of the real against the dollar was a mixed bag for Embraer, the world’s largest manufacturer of regional jets of up to 110 seats and one of Brazil’s most prominent industrial companies. Embraer purchases many of the parts that go into its jets, including the engines and electronics, from U.S. manufacturers. As the real appreci- ated against the dollar, these parts cost less when trans- lated into reals, which benefited Embraer’s profit margins. However, the company also prices its aircraft in U.S. dol- lars, as do all manufacturers in the global market for com- mercial jet aircraft. So, as the real appreciated against the dollar, Embraer’s dollar revenues were compressed when exchanged back into reals. To try to deal with the impact of currency appreciation on its revenues, in the mid-2000s, Embraer started to hedge against future appreciation of the real by buying forward contracts (forward contracts give the holder the right to ex- change one currency—in this case, dollars—for another—in this case, reals—at some point in the future at a predeter- mined exchange rate). If the real had continued to appreci- ate, this would have been a great strategy for Embraer

because the company could have locked in the rate at which sales made in dollars were exchanged back into re- als. Unfortunately for Embraer, as the global financial crisis unfolded in 2008, investors fled to the dollar, which they viewed as a safe haven, and the real depreciated against the dollar. Between August 2008 and November 2008, the value of the real fell by almost 40 percent against the dollar. But for the hedging, this depreciation would have actually increased Embraer’s revenues in reals. Embraer, however, had locked itself into a much higher real/dollar exchange rate, and the company was forced to take a $121 million loss on what was essentially a bad currency bet. Since the shock of 2008, Embraer has cut back on cur- rency hedging, and most of its dollar sales and purchases are not hedged. This makes Embraer’s sales revenues very sensitive to the real/dollar exchange rate. By 2010, the Brazilian real was once more appreciating against the U.S. dollar, which pressured Embraer’s revenues. By 2012, however, the Brazilian economy was stagnating, while in- flation was starting to increase again. This led to a sus- tained fall in the value of the real, which fell from 1 real = $0.644 in July 2011 to 1 real = $0.32 by February 2017, a depreciation of 50 percent. What was bad for the Brazilian currency, however, was good for Embraer, whose stock price surged to the highest price since February 2008 on speculation that the decline on the real would lead to a boost in Embraer’s revenues when expressed in reals.

Sources: D. Godoy, “Embraer Rallies as Brazilian Currency Weakens,” Bloomberg, May 31, 2013; K. Kroll, “Embraer Fourth Quarter Profits Plunge 44% on Currency Woes,” Cleveland.com, March 27, 2009; “A Fall from Grace: Brazil’s Mediocre Economy,” The Economist, June 8, 2013; “Brazil’s Economy: The Deterioration,” The Economist, December 7, 2013.

The Nature of the Foreign Exchange Market

The foreign exchange market is not located in any one place. It is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. When companies wish to convert currencies, they typically go through their own banks rather than entering the market directly. The foreign exchange market has been growing at a rapid pace, reflecting a general growth in the volume of cross-border trade and investment (see Chapter 1). In March 1986, the average total value of global foreign exchange trading was about $200 billion per day. By April 2016, the last date for which we have solid data, it had hit $5.1 trillion a day.6 The most important trading centers are London (37 percent of activity); New York (18 percent of activity); and Zurich, Tokyo,

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and Singapore (all with around 5 to 6 percent of activity).7 Major secondary trading centers include Frankfurt, Paris, Hong Kong, and Sydney.

London’s dominance in the foreign exchange market is due to both history and geogra- phy. As the capital of the world’s first major industrial trading nation, London had become the world’s largest center for international banking by the end of the nineteenth century, a position it has retained. Today, London’s central position between Tokyo and Singapore to the east and New York to the west has made it the critical link between the East Asian and New York markets. Due to the particular differences in time zones, London opens soon after Tokyo closes for the night and is still open for the first few hours of trading in New York. It is an open question, however, as to how the decision to exit from the EU (Brexit) will affect London’s position as a global trading center.8

Two features of the foreign exchange market are of particular note. The first is that the market never sleeps. Tokyo, London, and New York are all shut for only three hours out of every 24. During these three hours, trading continues in a number of minor centers, particu- larly San Francisco and Sydney, Australia. The second feature of the market is the integration of the various trading centers. High-speed computer linkages among trading centers around the globe have effectively created a single market. The integration of financial centers implies there can be no significant difference in exchange rates quoted in the trading centers. For ex- ample, if the yen/dollar exchange rate quoted in London at 3 p.m. is ¥120 = $1, the yen/dollar exchange rate quoted in New York at the same time (10 a.m. New York time) will be identical. If the New York yen/dollar exchange rate were ¥125 = $1, a dealer could make a profit through arbitrage, buying a currency low and selling it high. For example, if the prices dif- fered in London and New York as given, a dealer in New York could take $1 million and use that to purchase ¥125 million. She could then immediately sell the ¥125 million for dollars in London, where the transaction would yield $1.041666 million, allowing the trader to book a profit of $41,666 on the transaction. If all dealers tried to cash in on the opportunity, however, the demand for yen in New York would rise, resulting in an appreciation of the yen against the dollar such that the price differential between New York and London would quickly disap- pear. Because foreign exchange dealers are always watching their computer screens for arbi- trage opportunities, the few that arise tend to be small, and they disappear in minutes.

Another feature of the foreign exchange market is the important role played by the U.S. dollar. Although a foreign exchange transaction can involve any two currencies, most transactions involve dollars on one side. This is true even when a dealer wants to sell a non-dollar currency and buy another. A dealer wishing to sell Mexican pesos for Japanese yen, for example, will usually sell the pesos for dollars and then use the dollars to buy yen (see the opening case for an example). Although this may seem a roundabout way of doing things, it is actually cheaper than trying to find a holder of pesos who wants to buy yen. Because the volume of international transactions involving dollars is so great, it is not hard to find dealers who wish to trade dollars for pesos or yen.

Due to its central role in so many foreign exchange deals, the dollar is a vehicle cur- rency. In 2013, 87 percent of all foreign exchange transactions involved dollars on one side of the transaction. After the dollar, the most important vehicle currencies were the euro (33 percent), the Japanese yen (23 percent), and the British pound (12 percent)—reflecting the historical importance of these trading entities in the world economy.

Economic Theories of Exchange Rate Determination

At the most basic level, exchange rates are determined by the demand and supply of one cur- rency relative to the demand and supply of another. For example, if the demand for dollars outstrips the supply of them and if the supply of Japanese yen is greater than the demand for them, the dollar/yen exchange rate will change. The dollar will appreciate against the yen (the yen will depreciate against the dollar). However, while differences in relative demand and sup- ply explain the determination of exchange rates, they do so only in a superficial sense. This simple explanation does not reveal what factors underlie the demand for and supply of a

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LO 10 - 4 Understand the different theories explaining how currency exchange rates are determined and their relative merits.

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currency. Nor does it tell us when the demand for dollars will exceed the supply (and vice versa) or when the supply of Japanese yen will exceed demand for them (and vice versa). Neither does it show under what conditions a currency is in demand or under what conditions it is not demanded. In this section, we will review economic theory’s answers to these ques- tions. This will give us a deeper understanding of how exchange rates are determined.

If we understand how exchange rates are determined, we may be able to forecast exchange rate movements. Because future exchange rate movements influence export opportunities, the profitability of international trade and investment deals, and the price competitiveness of foreign imports, this is valuable information for an international business. Unfortunately, there is no simple explanation. The forces that determine exchange rates are complex, and no theoretical consensus exists, even among academic economists who study the phenomenon every day. Nonetheless, most economic theories of exchange rate movements seem to agree that three factors have an important impact on future exchange rate movements in a coun- try’s currency: the country’s price inflation, its interest rate, and market psychology.9

PRICES AND EXCHANGE RATES

To understand how prices are related to exchange rate movements, we first need to discuss an economic proposition known as the law of one price. Then we will discuss the theory of purchasing power parity (PPP), which links changes in the exchange rate between two countries’ currencies to changes in the countries’ price levels.

The Law of One Price The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.10 For ex- ample, if the exchange rate between the British pound and the dollar is £1 = $2, a jacket that retails for $80 in New York should sell for £40 in London (because $80/$2 = £40). Consider what would happen if the jacket cost £30 in London ($60 in U.S. currency). At this price, it would pay a trader to buy jackets in London and sell them in New York (an example of arbitrage). The company initially could make a profit of $20 on each jacket by purchasing it for £30 ($60) in London and selling it for $80 in New York (we are assuming away transportation costs and trade barriers). However, the increased demand for jackets in London would raise their price in London, and the increased supply of jackets in New York would lower their price there. This would continue until prices were equalized. Thus, prices might equalize when the jacket cost £35 ($70) in London and $70 in New York (as- suming no change in the exchange rate of £1 = $2).

Purchasing Power Parity If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products in different currencies, it would be possible to determine the “real” or PPP exchange rate that would exist if markets were efficient. (An efficient market has no impediments to the free flow of goods and services, such as trade barriers.)

A less extreme version of the PPP theory states that given relatively efficient markets— that is, markets in which few impediments to international trade exist—the price of a “bas- ket of goods” should be roughly equivalent in each country. To express the PPP theory in symbols, let P$ be the U.S. dollar price of a basket of particular goods and P¥ be the price of the same basket of goods in Japanese yen. The PPP theory predicts that the dollar/yen exchange rate, E$/¥, should be equivalent to

E$/¥ = P$/P¥ Thus, if a basket of goods costs $200 in the United States and ¥20,000 in Japan, PPP theory predicts that the dollar/yen exchange rate should be $200/¥20,000 or $0.01 per Japanese yen (i.e., $1 = ¥100).

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Every year, the news magazine The Economist publishes its own version of the PPP theo- rem, which it refers to as the “Big Mac Index.” The Economist has selected McDonald’s Big Mac as a proxy for a “basket of goods” because it is produced according to more or less the same recipe in about 120 countries. The Big Mac PPP is the exchange rate that would have hamburgers costing the same in each country. According to The Economist, comparing a coun- try’s actual exchange rate with the one predicted by the PPP theorem based on relative prices of Big Macs is a test of whether a currency is undervalued or not. This is not a totally serious exercise, as The Economist admits, but it does provide a useful illustration of the PPP theorem.

To calculate the index, The Economist converts the price of a Big Mac in a country into dollars at current exchange rates and divides that by the average price of a Big Mac in America. According to the PPP theorem, the prices should be the same. If they are not, it implies that the currency is either overvalued against the dollar or undervalued. For ex- ample, in January 2017, the average price of a Big Mac in the United States was $5.06, while it was $2.83 in China, and $5.67 in Norway. This suggests that the Chinese yuan is undervalued by 44 percent, while the Norwegian krona is overvalued by 12 percent!

The next step in the PPP theory is to argue that the exchange rate will change if relative prices change. For example, imagine there is no price inflation in the United States, while prices in Japan are increasing by 10 percent a year. At the beginning of the year, a basket of goods costs $200 in the United States and ¥20,000 in Japan, so the dollar/yen exchange rate, according to PPP theory, should be $1 = ¥100. At the end of the year, the basket of goods still costs $200 in the United States, but it costs ¥22,000 in Japan. PPP theory predicts that the exchange rate should change as a result. More precisely, by the end of the year

E$/¥ = $200/¥22,000

Thus, ¥1 = $0.0091 (or $1 = ¥110). Because of 10 percent price inflation, the Japanese yen has depreciated by 10 percent against the dollar. One dollar will buy 10 percent more yen at the end of the year than at the beginning.

Money Supply and Price Inflation In essence, PPP theory predicts that changes in relative prices will result in a change in exchange rates. Theoretically, a country in which price inflation is running wild should expect to see its currency depreciate against that of countries in which inflation rates are lower. If we can predict what a country’s future inflation rate is likely to be, we can also predict how the value of its currency relative to other currencies—its exchange rate—is likely to change. The growth rate of a country’s money supply determines its likely future inflation rate.11 Thus, in theory at least, we can use information about the growth in money supply to forecast exchange rate movements.

Inflation is a monetary phenomenon. It occurs when the quantity of money in circula- tion rises faster than the stock of goods and services—that is, when the money supply in- creases faster than output increases. Imagine what would happen if everyone in the country was suddenly given $10,000 by the government. Many people would rush out to spend their extra money on those things they had always wanted—new cars, new furniture, better clothes, and so on. There would be a surge in demand for goods and services. Car dealers, department stores, and other providers of goods and services would respond to this upsurge in demand by raising prices. The result would be price inflation.

A government increasing the money supply is analogous to giving people more money. An increase in the money supply makes it easier for banks to borrow from the government and for individuals and companies to borrow from banks. The resulting increase in credit causes increases in demand for goods and services. Unless the output of goods and ser- vices is growing at a rate similar to that of the money supply, the result will be inflation. This relationship has been observed time after time in country after country.

So now we have a connection between the growth in a country’s money supply, price inflation, and exchange rate movements. Put simply, when the growth in a country’s money supply is faster than the growth in its output, price inflation is fueled. The PPP theory tells us that a country with a high inflation rate will see depreciation in its currency exchange rate. In one of the clearest historical examples, in the mid-1980s, Bolivia experienced

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hyperinflation—an explosive and seemingly uncontrollable price inflation in which money loses value very rapidly. Table 10.1 presents data on Bolivia’s money supply, inflation rate, and its peso’s exchange rate with the U.S. dollar during the period of hyperinflation. The exchange rate is actually the “black market” exchange rate because the Bolivian government prohibited converting the peso to other currencies during the period. The data show that the growth in money supply, the rate of price inflation, and the de- preciation of the peso against the dollar all moved in step with each other. This is just what PPP theory and monetary economics pre- dict. Between April 1984 and July 1985, Bolivia’s money supply in- creased by 17,433 percent, prices increased by 22,908 percent, and the value of the peso against the dollar fell by 24,662 percent! In October 1985, the Bolivian government instituted a dramatic stabi- lization plan—which included the introduction of a new currency and tight control of the money supply—and by 1987, the country’s annual inflation rate was down to 16 percent.12

Another way of looking at the same phenomenon is that an in- crease in a country’s money supply, which increases the amount of currency available, changes the relative demand-and-supply condi- tions in the foreign exchange market. If the U.S. money supply is growing more rapidly than U.S. output, dollars will be relatively more

TA B L E 1 0 .1

Macroeconomic Data for Bolivia, April 1984 to October 1985

Source: Juan-Antonio Morales, “Inflation Stabilization in Bolivia,” Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge, MA: MIT Press, 1988).

Price Level Exchange Money Supply Relative to 1982 Rate (pesos Month (billions of pesos) (average = 1) per dollar)

1984

April 270 21.1 3,576

May 330 31.1 3,512

June 440 32.3 3,342

July 599 34.0 3,570

August 718 39.1 7,038

September 889 53.7 13,685

October 1,194 85.5 15,205

November 1,495 112.4 18,469

December 3,296 180.9 24,515

1985

January 4,630 305.3 73,016

February 6,455 863.3 141,101

March 9,089 1,078.6 128,137

April 12,885 1,205.7 167,428

May 21,309 1,635.7 272,375

June 27,778 2,919.1 481,756

July 47,341 4,854.6 885,476

August 74,306 8,081.0 1,182,300

September 103,272 12,647.6 1,087,440

October 132,550 12,411.8 1,120,210

An outdoor market in Bolivia. ©Bloomberg/Getty Images

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plentiful than the currencies of countries where monetary growth is closer to output growth. As a result of this relative increase in the supply of dollars, the dollar will depreciate on the foreign exchange market against the currencies of countries with slower monetary growth.

Government policy determines whether the rate of growth in a country’s money supply is greater than the rate of growth in output. A government can increase the money supply simply by telling the country’s central bank to issue more money. Governments tend to do this to finance public expenditure (building roads, paying government workers, paying for defense, etc.). A government could finance public expenditure by raising taxes, but because nobody likes paying more taxes and because politicians do not like to be unpopular, they have a natural preference for expanding the money supply. Unfortunately, there is no magic money tree. The result of excessive growth in money supply is typically price inflation. How- ever, this has not stopped governments around the world from expanding the money supply, with predictable results. If an international business is attempting to predict future move- ments in the value of a country’s currency on the foreign exchange market, it should exam- ine that country’s policy toward monetary growth. If the government seems committed to controlling the rate of growth in money supply, the country’s future inflation rate may be low (even if the current rate is high) and its currency should not depreciate too much on the foreign exchange market. If the government seems to lack the political will to control the rate of growth in money supply, the future inflation rate may be high, which is likely to cause its currency to depreciate. Historically, many Latin American governments have fallen into this latter category, including Argentina, Bolivia, and Brazil. More recently, many of the newly democratic states of eastern Europe made the same mistake. In late 2010, when the U.S. Federal Reserve decided to promote growth by expanding the U.S. money supply using a technique known as quantitative easing, critics charged that this too would lead to inflation and a decline in the value of the U.S. dollar on foreign exchange markets, but are they right? For a discussion of this, see the accompanying Country Focus.

Empirical Tests of PPP Theory PPP theory predicts that exchange rates are determined by relative prices and that changes in relative prices will result in a change in exchange rates. A country in which price inflation is running wild should expect to see its currency depreciate against that of countries with lower inflation rates. This is intuitively appealing, but is it true in practice? There are several good examples of the connection between a country’s price inflation and exchange rate position (such as Bolivia). However, extensive empirical testing of PPP theory has yielded mixed re- sults.13 While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less.14 In addition, the theory seems to best predict exchange rate changes for countries with high rates of inflation and underdeveloped capital markets. The theory is less useful for predicting short-term exchange rate movements between the currencies of ad- vanced industrialized nations that have relatively small differentials in inflation rates.

The failure to find a strong link between relative inflation rates and exchange rate move- ments has been referred to as the purchasing power parity puzzle. Several factors may explain the failure of PPP theory to predict exchange rates more accurately.15 PPP theory assumes away transportation costs and barriers to trade. In practice, these factors are significant, and they tend to create significant price differentials between countries. Transportation costs are certainly not trivial for many goods. Moreover, as we saw in Chapter 7, governments routinely intervene in international trade, creating tariff and nontariff barriers to cross-border trade. Barriers to trade limit the ability of traders to use arbitrage to equalize prices for the same product in different countries, which is required for the law of one price to hold. Government intervention in cross-border trade, by violating the assumption of efficient markets, weakens the link between relative price changes and changes in exchange rates predicted by PPP theory.

PPP theory may not hold if many national markets are dominated by a handful of multi- national enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels, and differentiate their product offerings between nations.16 In fact, this situation seems to prevail in a number of industries. In such cases,

C O U N T R Y F O C U S

Quantitative Easing, Inflation, and the Value of the U.S. Dollar In fall 2010, the U.S. Federal Reserve (the Fed) decided to expand the U.S. money supply by entering the open market and purchasing $600 billion in U.S. government bonds from bondholders, a technique known as quantitative easing. Where did the $600 billion come from? The Fed simply cre- ated new bank reserves and used this cash to pay for the bonds. It had, in effect, printed money. The Fed took this action in an attempt to stimulate the U.S. economy, which, in the aftermath of the 2008–2009 global financial crisis, was struggling with low economic growth and high unemploy- ment rates. The Fed had already tried to stimulate the econ- omy by lowering short-term interest rates, but these were already close to zero, so it decided to lower medium- to longer-term rates; its tool for doing this was to pump $600 billion into the economy, increasing the supply of money and lowering its price, the interest rate. The Fed pursued further rounds of quantitative easing in 2011 through to 2013. In 2014, with the U.S. economy getting stronger and unem- ployment falling below 6 percent, the Fed progressively re- duced its bond buying program. It ended the program in October 2014. By that time, the Fed had effectively pumped more than $3.5 trillion into the U.S. economy. Critics were quick to attack the Fed’s moves. Many claimed that the policy of expanding the money supply would fuel inflation and lead to a decline in the value of the U.S. dollar on the foreign exchange market. Some even called the policy a deliberate attempt by the Fed to de- base the value of the U.S. currency, thereby driving down its value and promoting U.S. exports, which, if true, would be a form of mercantilism. However, these charges may be unfounded for two rea- sons. First, at the time, the core U.S. inflation rate was the lowest in 50 years. In fact, the Fed actually feared the risk of deflation (a persistent fall in prices), which is a very damag- ing phenomenon. When prices are falling, people hold off

their purchases because they know that goods will be cheaper tomorrow than they are today. This can result in a collapse in aggregate demand and high unemployment. The Fed felt that a little inflation—say, 2 percent per year— might be a good thing. Second, U.S. economic growth had been weak, unemployment was high, and there was excess productive capacity in the economy. Consequently, if the in- jection of money into the economy did stimulate demand, this would not translate into price inflation because the first response of businesses would be to expand output to uti- lize their excess capacity. Defenders of the Fed argued that the important point, which the critics seemed to be missing, was that expanding the money supply leads to only higher price inflation when unemployment is relatively low and there is not much excess capacity in the economy, a situa- tion that did not exist in fall 2010. As for the currency market, its reaction was muted. At the beginning of November 2010, just before the Fed announced its policy, a trade-weighted index of the value of the dollar against a basket of other major currencies stood at 72. At the end of January 2014, it stood at 78—a slight appreciation. In short, currency traders did not seem to be selling off the dollar or reflecting worries about high inflation rates. By March 2016, with the program over, there was no sign of a surge in price inflation in the U.S. economy. In- deed, inflation rates remained near historic lows. More- over, far from weakening, the U.S. dollar had increased in value against most currencies, and the index value stood at 92. The Fed, it would seem, had been right and the crit- ics were wrong.

Sources: P. Wallsten and S. Reddy, “Fed’s Bond Buying Plan Ignites Growing Criticism,” The Wall Street Journal, November 15, 2010; S. Chan, “Under Attack, the Fed Defends Policy of Buying Bonds,” Inter- national Herald Tribune, November 17, 2010; “What QE Means for the World; Positive Sum Currency Wars,” The Economist, February 14, 2013.

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dominant enterprises may be able to exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions. This is referred to as price discrimination. For price discrimination to work, arbitrage must be limited. According to this argument, enterprises with some market power may be able to control distribution channels and therefore limit the unauthorized resale (arbitrage) of products purchased in another national market. They may also be able to limit resale (arbitrage) by differentiating otherwise identical products among nations along some line, such as design or packaging.

For example, even though the version of Microsoft Office sold in China may be less expensive than the version sold in the United States, the use of arbitrage to equalize prices

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may be limited because few Americans would want a version that was based on Chinese characters. The design differentiation between Microsoft Office for China and for the United States means that the law of one price would not work for Microsoft Office, even if transportation costs were trivial and tariff barriers between the United States and China did not exist. If the inability to practice arbitrage were widespread enough, it would break the connection between changes in relative prices and exchange rates predicted by the PPP theorem and help explain the limited empirical support for this theory.

Another factor of some importance is that governments also intervene in the foreign exchange market in attempting to influence the value of their currencies. We look at why and how they do this in Chapter 11. For now, the important thing to note is that govern- ments regularly intervene in the foreign exchange market, and this further weakens the link between price changes and changes in exchange rates. One more factor explaining the failure of PPP theory to predict short-term movements in foreign exchange rates is the im- pact of investor psychology and other factors on currency purchasing decisions and ex- change rate movements. We discuss this issue in more detail later in this chapter.

INTEREST RATES AND EXCHANGE RATES

Economic theory tells us that interest rates reflect expectations about likely future infla- tion rates. In countries where inflation is expected to be high, interest rates also will be high, because investors want compensation for the decline in the value of their money. This relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher effect. The Fisher effect states that a country’s “nominal” interest rate (i) is the sum of the required “real” rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). More formally,

i = r + I

For example, if the real rate of interest in a country is 5 percent and annual inflation is expected to be 10 percent, the nominal interest rate will be 15 percent. As predicted by the Fisher effect, a strong relationship seems to exist between inflation rates and interest rates.17

We can take this one step further and consider how it applies in a world of many coun- tries and unrestricted capital flows. When investors are free to transfer capital between countries, real interest rates will be the same in every country. If differences in real interest rates did emerge between countries, arbitrage would soon equalize them. For example, if the real interest rate in Japan was 10 percent and only 6 percent in the United States, it would pay investors to borrow money in the United States and invest it in Japan. The resulting in- crease in the demand for money in the United States would raise the real interest rate there, while the increase in the supply of foreign money in Japan would lower the real interest rate there. This would continue until the two sets of real interest rates were equalized.

It follows from the Fisher effect that if the real interest rate is the same worldwide, any difference in interest rates between countries reflects differing expectations about inflation rates. Thus, if the expected rate of inflation in the United States is greater than that in Japan, U.S. nominal interest rates will be greater than Japanese nominal interest rates.

Because we know from PPP theory that there is a link (in theory, at least) between infla- tion and exchange rates and because interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and exchange rates. This link is known as the international Fisher effect. The international Fisher effect (IFE) states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two coun- tries. Stated more formally, the change in the spot exchange rate between the United States and Japan, for example, can be modeled as follows:

S1 − S2 × 100 = i$ − i¥S2 where i$ and i¥ are the respective nominal interest rates in the United States and Japan, S1 is the spot exchange rate at the beginning of the period, and S2 is the spot exchange rate at the end of the period. If the U.S. nominal interest rate is higher than Japan’s, reflecting

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greater expected inflation rates, the value of the dollar against the yen should fall by that interest rate differential in the future. So if the interest rate in the United States is 10 per- cent and in Japan it is 6 percent, we would expect the value of the dollar to depreciate by 4 percent against the Japanese yen.

Do interest rate differentials help predict future currency movements? The evidence is mixed; as in the case of PPP theory, in the long run, there seems to be a relationship be- tween interest rate differentials and subsequent changes in spot exchange rates. However, considerable short-run deviations occur. Like PPP, the international Fisher effect is not a good predictor of short-run changes in spot exchange rates.18

INVESTOR PSYCHOLOGY AND BANDWAGON EFFECTS

Empirical evidence suggests that neither PPP theory nor the international Fisher effect is particularly good at explaining short-term movements in exchange rates. One reason may be the impact of investor psychology on short-run exchange rate movements. Evidence re- veals that various psychological factors play an important role in determining the expecta- tions of market traders as to likely future exchange rates.19 In turn, expectations have a tendency to become self-fulfilling prophecies.

A particularly famous example of this mechanism occurred in September 1992, when the international financier George Soros made a huge bet against the British pound. Soros borrowed billions of pounds, using the assets of his investment funds as collateral, and im- mediately sold those pounds for German deutsche marks (this was before the advent of the euro). This technique, known as short selling, can earn the speculator enormous prof- its if he can subsequently buy back the pounds he sold at a much better exchange rate and then use those pounds, purchased cheaply, to repay his loan. By selling pounds and buying deutsche marks, Soros helped start pushing down the value of the pound on the foreign exchange markets. More importantly, when Soros started shorting the British pound, many foreign exchange traders, knowing Soros’s reputation, jumped on the bandwagon and did likewise. This triggered a classic bandwagon effect with traders moving as a herd in the same direction at the same time. As the bandwagon effect gained momentum, with more traders selling British pounds and purchasing deutsche marks in expectation of a decline in the pound, their expectations became a self-fulfilling prophecy. Massive selling forced down the value of the pound against the deutsche mark. In other words, the pound declined in value not so much because of any major shift in macroeconomic fundamentals but because investors followed a bet placed by a major speculator, George Soros.

According to a number of studies, investor psychology and bandwagon effects play an important role in determining short-run exchange rate movements.20 However, these effects can be hard to predict. Investor psychology can be influenced by political factors and by microeconomic events, such as the investment decisions of individual firms, many of which are only loosely linked to macroeconomic fundamentals, such as relative inflation rates. Also, bandwagon effects can be both triggered and exacerbated by the idiosyncratic behav- ior of politicians. Something like this seems to have occurred in Southeast Asia during 1997 when, one after another, the currencies of Thailand, Malaysia, South Korea, and Indonesia lost between 50 and 70 percent of their value against the U.S. dollar in a few months.

SUMMARY OF EXCHANGE RATE THEORIES

Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates. They are poor predic- tors of short-run changes in exchange rates, however, perhaps because of the impact of psycho- logical factors, investor expectations, and bandwagon effects on short-term currency movements. This information is useful for an international business. Insofar as the long-term profitability of foreign investments, export opportunities, and the price competitiveness of foreign imports are all influenced by long-term movements in exchange rates, international businesses would be advised to pay attention to countries’ differing monetary growth, infla- tion, and interest rates. International businesses that engage in foreign exchange transactions on a day-to-day basis could benefit by knowing some predictors of short-term foreign exchange rate movements. Unfortunately, short-term exchange rate movements are difficult to predict.

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Exchange Rate Forecasting

A company’s need to predict future exchange rate variations raises the issue of whether it is worthwhile for the company to invest in exchange rate forecasting services to aid deci- sion making. Two schools of thought address this issue. The efficient market school ar- gues that forward exchange rates do the best possible job of forecasting future spot exchange rates and, therefore, investing in forecasting services would be a waste of money. The other school of thought, the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services. In other words, this school of thought does not believe the forward exchange rates are the best possible predictors of future spot exchange rates.

THE EFFICIENT MARKET SCHOOL

Forward exchange rates represent market participants’ collective predictions of likely spot exchange rates at specified future dates. If forward exchange rates are the best possible predictor of future spot rates, it would make no sense for companies to spend additional money trying to forecast short-run exchange rate movements. Many economists believe the foreign exchange market is efficient at setting forward rates.21 An efficient market is one in which prices reflect all available public information. (If forward rates reflect all available information about likely future changes in exchange rates, a company cannot beat the mar- ket by investing in forecasting services.)

If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of future spot rates. This does not mean the predictions will be accurate in any specific situation. It means inaccuracies will not be consistently above or below future spot rates; they will be random. Many empirical tests have addressed the efficient market hy- pothesis. Although most of the early work seems to confirm the hypothesis (suggesting that companies should not waste their money on forecasting services), some studies have challenged it.22 There is some evidence that forward rates are not unbiased predictors of future spot rates and that more accurate predictions of future spot rates can be calculated from publicly available information.23

THE INEFFICIENT MARKET SCHOOL

Citing evidence against the efficient market hypothesis, some economists believe the for- eign exchange market is inefficient. An inefficient market is one in which prices do not reflect all available information. In an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates.

If this is true, it may be worthwhile for international businesses to invest in forecast- ing services (as many do). The belief is that professional exchange rate forecasts might provide better predictions of future spot rates than forward exchange rates do. However, the track record of professional forecasting services is not that good.24 For example, forecasting services did not predict the 1997 currency crisis that swept through South- east Asia, nor did they predict the rise in the value of the dollar that occurred during late 2008, a period when the United States fell into a deep financial crisis that some thought would lead to a decline in the value of the dollar (it appears that the dollar rose because it was seen as a relatively safe currency in a time when many nations were experiencing economic trouble).

APPROACHES TO FORECASTING

Assuming the inefficient market school is correct that the foreign exchange market’s esti- mate of future spot rates can be improved, on what basis should forecasts be prepared? Here again, there are two schools of thought. One adheres to fundamental analysis, while the other uses technical analysis.

LO 10 -5 Identify the merits of different approaches toward exchange rate forecasting.

Did You Know? Did you know that the U.S. dollar has been one of the strongest currencies in the world since the great recession of 2008–2009?

Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.

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Fundamental Analysis Fundamental analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. The variables contained in these models typically include those we have discussed, such as relative money supply growth rates, in- flation rates, and interest rates. In addition, they may include variables related to balance- of-payments positions.

Running a deficit on a balance-of-payments current account (a country is importing more goods and services than it is exporting) creates pressures that may result in the de- preciation of the country’s currency on the foreign exchange market.25 Consider what might happen if the United States were running a persistent current account balance-of- payments deficit (as it has been). Because the United States would be importing more than it was exporting, people in other countries would be increasing their holdings of U.S. dollars. If these people were willing to hold their dollars, the dollar’s exchange rate would not be influenced. However, if these people converted their dollars into other currencies, the supply of dollars in the foreign exchange market would increase (as would demand for the other currencies). This shift in demand and supply would create pressures that could lead to the depreciation of the dollar against other currencies.

This argument hinges on whether people in other countries are willing to hold dollars. This depends on such factors as U.S. interest rates, the return on holding other dollar- denominated assets such as stocks in U.S. companies, and, most important, inflation rates. So, in a sense, the balance-of-payments situation is not a fundamental predictor of future exchange rate movements. But what makes financial assets such as stocks and bonds attractive? The answer is prevailing interest rates and inflation rates, both of which affect underlying economic growth and the real return to holding U.S. financial assets. Given this, we are back to the argument that the fundamental determinants of exchange rates are monetary growth, inflation rates, and interest rates.

Technical Analysis Technical analysis uses price and volume data to determine past trends, which are ex- pected to continue into the future. This approach does not rely on a consideration of eco- nomic fundamentals. Technical analysis is based on the premise that there are analyzable market trends and waves and that previous trends and waves can be used to predict future trends and waves. Since there is no theoretical rationale for this assumption of predictabil- ity, many economists compare technical analysis to fortune-telling. Despite this skepticism, technical analysis has gained favor in recent years.26

Currency Convertibility

Until this point, we have assumed that the currencies of various countries are freely con- vertible into other currencies. Due to government restrictions, a significant number of currencies are not freely convertible into other currencies. A country’s currency is said to be freely convertible when the country’s government allows both residents and nonresi- dents to purchase unlimited amounts of a foreign currency with it. A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations. A currency is nonconvertible when neither residents nor non- residents are allowed to convert it into a foreign currency.

Free convertibility is not universal. Many countries place some restrictions on their resi- dents’ ability to convert the domestic currency into a foreign currency (a policy of external convertibility). Restrictions range from the relatively minor (such as restricting the amount of foreign currency they may take with them out of the country on trips) to the major (such as restricting domestic businesses’ ability to take foreign currency out of the country). Ex- ternal convertibility restrictions can limit domestic companies’ ability to invest abroad, but they present few problems for foreign companies wishing to do business in that country. For example, even if the Japanese government tightly controlled the ability of its residents to

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convert the yen into U.S. dollars, all U.S. businesses with deposits in Japanese banks may at any time convert all their yen into dollars and take them out of the country. Thus, a U.S. company with a subsidiary in Japan is assured that it will be able to convert the profits from its Japanese operation into dollars and take them out of the country.

Serious problems arise, however, under a policy of nonconvertibility. This was the prac- tice of the former Soviet Union, and it continued to be the practice in Russia for several years after the collapse of the Soviet Union. When strictly applied, nonconvertibility means that although a U.S. company doing business in a country such as Russia may be able to generate significant ruble profits, it may not convert those rubles into dollars and take them out of the country. Obviously, this is not desirable for international business.

Governments limit convertibility to preserve their foreign exchange reserves. A country needs an adequate supply of these reserves to service its international debt commitments and to purchase imports. Governments typically impose convertibility restrictions on their currency when they fear that free convertibility will lead to a run on their foreign exchange reserves. This occurs when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency—a phenomenon generally referred to as capital flight. Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country’s economic prospects are shaky in other respects. Under such circumstances, both residents and nonresidents tend to believe that their money is more likely to hold its value if it is converted into a foreign currency and invested abroad. Not only will a run on foreign exchange reserves limit the country’s ability to service its international debt and pay for imports, but it will also lead to a precipitous depreciation in the exchange rate as resi- dents and nonresidents unload their holdings of domestic currency on the foreign exchange markets (thereby increasing the market supply of the country’s currency). Governments fear that the rise in import prices resulting from currency depreciation will lead to further increases in inflation. This fear provides another rationale for limiting convertibility.

Companies can deal with the nonconvertibility problem by engaging in countertrade. Countertrade refers to a range of barter-like agreements by which goods and services can be traded for other goods and services. Countertrade can make sense when a country’s cur- rency is nonconvertible. For example, consider the deal that General Electric struck with the Romanian government when that country’s currency was nonconvertible. When General Electric won a contract for a $150 million generator project in Romania, it agreed to take payment in the form of Romanian goods that could be sold for $150 million on international markets. In a similar case, the Venezuelan government negotiated a contract with Caterpillar under which Venezuela would trade 350,000 tons of iron ore for Caterpillar heavy construc- tion equipment. Caterpillar subsequently traded the iron ore to Romania in exchange for Romanian farm products, which it then sold on international markets for dollars.27

How important is countertrade? Twenty years ago, a large number of nonconvertible currencies existed in the world, and countertrade was quite significant. However, in recent years, many governments have made their currencies freely convertible, and the percent- age of world trade that involves countertrade is probably significantly below 5 percent.28

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F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

FOREIGN EXCHANGE RATE RISK This chapter contains a number of clear implications for business. First, it is critical

that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Adverse changes in exchange rates can make apparently profitable deals unprofitable. As noted, the risk introduced into international business transactions by changes in exchange rates is referred

to as foreign exchange risk. Foreign exchange risk is usually divided into three main categories: transaction exposure, translation exposure, and economic exposure.

LO 10 - 6 Compare and contrast the differences among translation, transaction, and economic exposure, and explain the implications for management practice.

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Transaction Exposure Transaction exposure is the extent to which the income from indi- vidual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies. For example, suppose in 2004, an American airline agreed to purchase 10 Airbus 330 aircraft for €120 million each for a total price of €1.20 billion, with delivery scheduled for 2008 and payment due then. When the contract was signed in 2004, the dollar/euro exchange rate stood at $1 = €1.10, so the American airline anticipated paying $1.09 billion for the 10 aircraft when they were delivered (€1.2 billion/1.1 = $1.09 billion). However, imagine that the value of the dollar depreciates against the euro over the intervening period, so that a dollar buys only €0.80 in 2008 when payment is due ($1 = €0.80). Now the total cost in U.S. dollars is $1.5 billion (€1.2 billion/0.80 = $1.5 billion), an increase of $0.41 billion! The transaction exposure here is $0.41 billion, which is the money lost due to an adverse movement in exchange rates between the time when the deal was signed and when the aircraft were paid for.

Translation Exposure Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Translation exposure is concerned with the present measurement of past events. The resulting accounting gains or losses are said to be unrealized—they are “paper” gains and losses—but they are still important. Consider a U.S. firm with a subsidiary in Mexico. If the value of the Mexican peso depreciates significantly against the dollar, this would substantially reduce the dollar value of the Mexican subsidiary’s equity. In turn, this would reduce the total dollar value of the firm’s equity reported in its con- solidated balance sheet. This would raise the apparent leverage of the firm (its debt ratio), which could increase the firm’s cost of borrowing and potentially limit its access to the capital market. Similarly, if an American firm has a subsidiary in the European Union and the value of the euro depreciates rapidly against that of the dollar over a year, this will reduce the dollar value of the euro profit made by the European subsidiary, resulting in negative translation exposure. In fact, many U.S. firms suffered from significant negative translation exposure in Europe during 2000, precisely because the euro did depreciate rapidly against the dollar. In 2002–2007, the euro rose in value against the dollar. This positive translation exposure boosted the dollar profits of American multinationals with significant operations in Europe. Between mid-2014 and early 2015, the euro slumped in value against the dollar, compressing the dollar profits of American multinationals with significant European exposure.

Economic Exposure Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs. This is distinct from transaction exposure, which is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months. Consider the effect of wide swings in the value of the dollar on many U.S. firms’ international competitiveness. The rapid rise in the value of the dollar on the foreign exchange market in the 1990s hurt the price competitiveness of many U.S. pro- ducers in world markets. U.S. manufacturers that relied heavily on exports saw their export volume and world market share decline. The reverse phenomenon occurred in 2000–2009, when the dollar declined against most major currencies. The fall in the value of the dollar helped increase the price competitiveness of U.S. manufacturers in world markets. Between mid-2014 and early 2015, the dollar increased significantly in value against most major cur- rencies, decreasing the price competitiveness of U.S. exporters.

REDUCING TRANSLATION AND TRANSACTION EXPOSURE A number of tactics can help firms minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. We have already discussed two of these tactics at length in the chapter, entering into forward exchange rate contracts and buying swaps. In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure through leading and lagging

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payables and receivables—that is, paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables (payments from customers) early when a foreign currency is expected to depreciate and paying foreign currency payables (to suppli- ers) before they are due when a currency is expected to appreciate. A lag strategy in- volves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Leading and lagging involve accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries. Lead and lag strategies can be difficult to implement, however. The firm must be in a posi- tion to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly when they are dealing with important customers who are in a position to dictate payment terms. Also, because lead and lag strategies can put pressure on a weak currency, many governments limit leads and lags. For example, some countries set 180 days as a limit for receiving payments for exports or making payments for imports.

REDUCING ECONOMIC EXPOSURE Reducing economic exposure requires strategic choices that go beyond the realm of finan- cial management. The key to reducing economic exposure is to distribute the firm’s produc- tive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates. This is a strategy that firms both large and small sometimes pursue. For example, during the 2000s, fearing that the euro would con- tinue to strengthen against the U.S. dollar, some European firms that did significant business in the United States set up local production facilities in that market to ensure that a rising euro does not put them at a competitive disadvantage relative to their local rivals. Similarly, Toyota has production plants distributed around the world in part to make sure that a rising yen does not price Toyota cars out of local markets. Caterpillar has also pursued this strat- egy, setting up factories around the world that can act as a hedge against the possibility that a strong dollar will price Caterpillar’s exports out of foreign markets. In 2008, 2009, and 2014–2015, all periods of dollar strength, this real hedge proved to be very useful.

OTHER STEPS FOR MANAGING FOREIGN EXCHANGE RISK A firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure. Although there is no universal agreement as to the components of this mechanism, a number of common themes stand out.29 First, central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers. Although such centers may not be able to execute all foreign exchange deals—particularly in large, complex multinationals where myriad trans- actions may be pursued simultaneously—they should at least set guidelines for the firm’s subsidiaries to follow. Second, firms should distinguish between, on one hand, transaction and translation expo- sure and, on the other, economic exposure. Many companies seem to focus on reducing their transaction and translation exposure and pay scant attention to economic exposure, which may have more profound long-term implications.30 Firms need to develop strategies for dealing with economic exposure. For example, Stanley Black & Decker, the maker of power tools, has a strategy for actively managing its economic risk. The key to Stanley Black & Decker’s strategy is flexible sourcing. In response to foreign exchange movements, Stanley Black & Decker can move production from one location to another to offer the most competi- tive pricing. Stanley Black & Decker manufactures in more than a dozen locations around the world—in Europe, Australia, Brazil, Mexico, and Japan. More than 50 percent of the compa- ny’s productive assets are based outside North America. Although each of Stanley Black & Decker’s factories focuses on one or two products to achieve economies of scale, there is considerable overlap. On average, the company runs its factories at no more than 80 percent capacity, so most are able to switch rapidly from producing one product to producing another

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or to add a product. This allows a factory’s production to be changed in response to foreign exchange movements. For example, if the dollar depreciates against other currencies, the amount of imports into the United States from overseas subsidiaries can be reduced and the amount of exports from U.S. subsidiaries to other locations can be increased.31

Third, the need to forecast future exchange rate movements cannot be overstated, though, as we saw earlier in the chapter, this is a tricky business. No model comes close to perfectly predicting future movements in foreign exchange rates. The best that can be said is that in the short run, forward exchange rates provide the best predictors of exchange rate movements, and in the long run, fundamental economic factors—particularly relative inflation rates—should be watched because they influence exchange rate movements. Some firms attempt to forecast exchange rate movements in-house; others rely on outside forecasters. However, all such forecasts are imperfect attempts to predict the future. Fourth, firms need to establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm’s exposure positions. Such reporting systems should enable the firm to identify any exposed accounts, the exposed position by currency of each account, and the time periods covered. Finally, on the basis of the information it receives from exchange rate forecasts and its own regular reporting systems, the firm should produce monthly foreign exchange exposure re- ports. These reports should identify how cash flows and balance sheet elements might be af- fected by forecasted changes in exchange rates. The reports can then be used by management as a basis for adopting tactics and strategies to hedge against undue foreign exchange risks. Surprisingly, some of the largest and most sophisticated firms don’t take such precaution- ary steps, exposing themselves to very large foreign exchange risks.

foreign exchange market, p. 288 exchange rate, p. 288 foreign exchange risk, p. 289 currency speculation, p. 290 carry trade, p. 290 spot exchange rate, p. 291 forward exchange, p. 291 forward exchange rate, p. 291 currency swap, p. 292

Key Terms

arbitrage, p. 294 law of one price, p. 295 efficient market, p. 295 Fisher effect, p. 300 international Fisher effect

(IFE), p. 300 bandwagon effect, p. 301 inefficient market, p. 302 freely convertible currency, p. 303

externally convertible currency, p. 303 nonconvertible currency, p. 303 capital flight, p. 304 countertrade, p. 304 transaction exposure, p. 305 translation exposure, p. 305 economic exposure, p. 305 lead strategy, p. 306 lag strategy, p. 306

C H A P T E R S U M M A R Y

This chapter explained how the foreign exchange market works, examined the forces that determine exchange rates, and then discussed the implications of these factors for international business. Given that changes in ex- change rates can dramatically alter the profitability of for- eign trade and investment deals, this is an area of major interest to international business. The chapter made the following points:

 1. One function of the foreign exchange market is to convert the currency of one country into the currency of another. A second function of the

foreign exchange market is to provide insurance against foreign exchange risk.

 2. The spot exchange rate is the exchange rate at which a dealer converts one currency into an- other currency on a particular day.

 3. Foreign exchange risk can be reduced by using forward exchange rates. A forward exchange rate is an exchange rate governing future transactions. Foreign exchange risk can also be reduced by en- gaging in currency swaps. A swap is the simultaneous purchase and sale of a given

amount of foreign exchange for two different value dates.

 4. The law of one price holds that in competitive markets that are free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in the same currency.

 5. Purchasing power parity (PPP) theory states the price of a basket of particular goods should be roughly equivalent in each country. PPP theory predicts that the exchange rate will change if relative prices change.

 6. The rate of change in countries’ relative prices depends on their relative inflation rates. A coun- try’s inflation rate seems to be a function of the growth in its money supply.

 7. The PPP theory of exchange rate changes yields relatively accurate predictions of long-term trends in exchange rates but not of short-term move- ments. The failure of PPP theory to predict ex- change rate changes more accurately may be due to transportation costs, barriers to trade and in- vestment, and the impact of psychological factors such as bandwagon effects on market movements and short-run exchange rates.

 8. Interest rates reflect expectations about inflation. In countries where inflation is expected to be high, interest rates also will be high.

 9. The international Fisher effect states that for any two countries, the spot exchange rate should

change in an equal amount but in the opposite direction to the difference in nominal interest rates.

10. The most common approach to exchange rate forecasting is fundamental analysis. This relies on variables such as money supply growth, inflation rates, nominal interest rates, and balance-of-pay- ments positions to predict future changes in ex- change rates.

11. In many countries, the ability of residents and nonresidents to convert local currency into a for- eign currency is restricted by government policy. A government restricts the convertibility of its currency to protect the country’s foreign ex- change reserves and to halt any capital flight.

12. Nonconvertibility of a currency makes it very dif- ficult to engage in international trade and invest- ment in the country. One way of coping with the nonconvertibility problem is to engage in coun- tertrade—to trade goods and services for other goods and services.

13. The three types of exposure to foreign exchange risk are transaction exposure, translation expo- sure, and economic exposure.

14. Tactics that insure against transaction and trans- lation exposure include buying forward, using currency swaps, and leading and lagging payables and receivables.

15. Reducing a firm’s economic exposure requires strategic choices about how the firm’s productive assets are distributed around the globe.

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C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. The interest rate on South Korean government se- curities with one-year maturity is 4 percent, and the expected inflation rate for the coming year is 2 per- cent. The interest rate on U.S. government securi- ties with one-year maturity is 7 percent, and the expected rate of inflation is 5 percent. The current spot exchange rate for Korean won is $1 = W1,200. Forecast the spot exchange rate one year from to- day. Explain the logic of your answer.

2. Two countries, Great Britain and the United States, produce just one good: beef. Suppose the price of beef in the United States is $2.80 per pound and in Britain it is £3.70 per pound. a. According to PPP theory, what should the

dollar/pound spot exchange rate be? b. Suppose the price of beef is expected to rise

to $3.10 in the United States and to £4.65 in Britain. What should the one-year forward dollar/pound exchange rate be?

c. Given your answers to parts a and b, and given that the current interest rate in the United States is 10 percent, what would you expect the current interest rate to be in Britain?

3. Reread the Management Focus on Embraer, then answer the following questions: a. What does the recent economic history of

Brazil tell you about the relationship be- tween price inflation and exchange rates? What other factors might determine ex- change rates for the Brazilian real?

b. Is a decline in value of the real against the U.S. dollar good for Embraer, bad for Embraer, or a mixed bag? Explain your answer.

c. What kind of foreign exchange rate risks is Embraer exposed to? Can Embraer reduce these risks? How?

The Foreign Exchange Market Chapter 10 309

d. Do you think Embraer’s decision to try and hedge against further appreciation of the real in the early 2000s was a good decision? What was the alternative?

e. Since 2008, Embraer has significantly reduced its dollar hedging operations. Is this wise?

f. Between mid-2014 and early 2015, the real depreciated significantly against the U.S. dollar. What do you think the impact was on Embraer?

4. You manufacture wine goblets. In mid-June, you receive an order for 10,000 goblets from Japan.

Payment of ¥400,000 is due in mid-December. You expect the yen to rise from its present rate of $1 = ¥130 to $1 = ¥100 by December. You can borrow yen at 6 percent a year. What should you do?

5. You are the CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures com- ponent parts for your U.S. assembly operations. The subsidiary has been financed by bank bor- rowings in the United States. One of your ana- lysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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

1. One of your company’s essential suppliers is lo- cated in Japan. Your company needs to make a 1 million Japanese yen payment in six months. Considering that your company primarily oper- ates in U.S. dollars, you are assigned the task of deciding on a strategy to minimize your transac- tion exposure. Identify the spot and forward ex- change rates between the two currencies. What factors influence your decision to use each? Which one would you choose? How many dollars

must you spend to acquire the amount of yen required?

2. Sometimes analysts use the price of specific prod- ucts in different locations to compare currency val- uation and purchasing power. For example, The Economist’s Big Mac Index compares the purchas- ing power parity of many countries based on the price of a Big Mac. Using Google, locate the latest edition of this index that is accessible. Identify the five countries (and their currencies) with the lowest purchasing power parity according to this classifi- cation. Which currencies, if any, are overvalued?

When Apple reported its fourth quarter earnings in January 2016, they contained a nasty surprise. According to CEO Tim Cook, the strong U.S. dollar had cost Apple nearly $5 billion in revenue. If currency moves were ex- cluded, Apple would have generated $80.8 billion in rev- enue in the quarter ending December 31, 2015. Instead, it reported $75.9 billion in revenue, knocking down what would have been an 8 percent increase to just 2 percent. Although the U.S. dollar has been trending higher against most currencies since 2012, the appreciation has accelerated since September 2014. For a company like Apple, which gets 66 percent of its revenues from outside of the United States, this can have a major impact. Since September 2014, according to Cook, the appreciation

in the value of the dollar against most of the world’s currencies has meant that $100 of Apple’s revenues outside of the United States translated into just $85 by January 2016. With regard to specific currencies, between September 1, 2014, and March 21, 2016, the U.S. dollar appreciated by 17 percent against the euro, 15 percent against the British pound, 5 percent against the Chinese yuan, 21 per- cent against the Canadian dollar, 33 percent against the Mexican peso, 62 percent against the Brazilian real, and 82 percent against the Russian ruble. Cook referred to these moves, and others like them, as constituting “extreme conditions unlike anything we have seen before just about everywhere we look.”

C L O S I N G C A S E

Apple’s Earnings Hit by Strong Dollar

310 Part 4 The Global Monetary System

Apple has tried to protect the dollar value of its over- seas sales by buying currency forward to hedge against future increases, but the appreciation of the dollar has been faster than forecasted, and Apple’s hedging activity has been insufficient to protect the value of its overseas earnings. To shore up its revenues and protect profit mar- gins, in some markets the company has turned to price increases. But there is only so far that Apple can push this strategy before people stop buying its phones. Nor is Apple alone is feeling the pain from a sustained increase in the value of the dollar on foreign exchange markets. Numerous other major technology enterprises— including Microsoft, Google, IBM, and Oracle—have also reported lower revenues and earnings due to the transla- tion effects of the strong dollar. Large technology compa- nies are particularly hard hit by the appreciating dollar because they generate 59 percent of their revenue outside of the United States on average, compared to 48 percent for companies within the broader S&P 500 index. So why is the dollar so strong? There are several rea- sons. First, the U.S. economy has performed better than most since the great recession of 2008–2009, making it a more attractive destination for foreign capital. The U.S. economy, for example, has consistently outperformed the economies of all major European nations, Japan, Australia, and Canada. Foreigners have responded by investing more in the United States, and the inflow of capital has driven up the value of the dollar. Second, governments in Europe and Japan have responded to slow growth by low- ering interest rates and expanding their domestic money supply. The purpose of such “quantitative easing” is to try to encourage consumption and investment. At the same time, interest rates in the United States have started to inch up as the economy continues to expand. Investors have responded by moving money to the United States to take advantage of favorable interest rate differentials. Third, several developing nations have seen their econ- omies hammered by adverse developments, which has put downward pressure on their currencies. The rapid fall in the price of oil since mid-2015, for example, has hit major oil exporting nations such as Russia hard. In Brazil, a serious corruption scandal coupled with economic mismanagement has translated into a lack of consumer confidence, slow economic growth, and a weak currency.

In China, a slowdown in the rate of economic growth from 10 percent per annum to around 6 percent per annum is exposing structural f laws in the economy, including excessive debt and too many poorly managed state-owned enterprises, resulting in an outflow of capital. The Chinese reportedly spent $500 billion trying to prop up the value of the yuan against the U.S. dollar in 2015 and another $500 billion in 2016. Despite this aggressive action, the yuan has depreciated against the dollar, al- though by less than most other major currencies. The conditions that have led to an increase in the value of the dollar are unlikely to change in the near fu- ture. For companies like Apple, this means that they must adopt strategies to hedge against further increases. At the same time, too much hedging can expose the company to significant financial risks if the dollar does not move in the predicted direction. It is crucial, therefore, for Apple to get its hedging strategy right.

Sources: B. White, “Here Is Why the Dollar Is So Strong and What It Means for Investors,” Business Insider, January 30, 2015; D. Clark, “Strong Dollar Batters Earnings for U.S. Tech Firms,” The Wall Street Journal, January 31, 2016; Mark DeCambre, “Apple Chief Tim Cook: We’re Seeing Extreme Conditions Everywhere We Look,” Market Watch, January 27, 2016.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Why did the strong U.S. dollar during 2015 have

a negative impact on Apple’s earnings? 2. Why did Apple not fully hedge its foreign ex-

change exposure to avoid a hit on earnings? 3. Why was the U.S. dollar so strong during the

2014–2016 period? Was the strength in the dollar a rational response to economic fundamentals?

4. Under what conditions do you think the U.S. dol- lar might weaken against other major currencies (e.g., the euro, yen and yuan?

5. How would a fall in the value of the U.S. dollar against other major currencies impact Apple?

6. Some companies do not hedge their foreign ex- change exposure? Do you think Apple is correct to hedge? Why?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

E n d n o t e s

 1. For a good general introduction to the foreign exchange market, see R. Weisweiller, How the Foreign Exchange Market Works (New York: New York Institute of Finance, 1990). A detailed

description of the economics of foreign exchange markets can be found in P. R. Krugman and M. Obstfeld, International Eco- nomics: Theory and Policy (New York: HarperCollins, 1994).

The Foreign Exchange Market Chapter 10 311

 2. Oscar Jorda and Alan Taylor, “The Carry Trade and Fundamen- tals: Nothing to Fear but FEER Itself,” Journal of International Economics 88 (2012), pp. 74–90.

 3. “The Domino Effect,” The Economist, July 5, 2008, p. 85.

 4. Leo Lewis, “Speculations of a Yen Carry Trade Revival Grow,” Financial Times, December 22, 2016.

 5. Bank for International Settlements, Tri-annual Central Bank Survey of Foreign Exchange and Derivatives Market Activity, April 2016 (Basel, Switzerland: BIS, December 11, 2016).

 6. Bank for International Settlements, Tri-annual Central Bank Survey of Foreign Exchange and Derivatives Market Activity, April 2016 (Basel, Switzerland: BIS, December 11, 2016).

 7. Bank for International Settlements, Tri-annual Central Bank Survey of Foreign Exchange and Derivatives Market Activity, April 2016 (Basel, Switzerland: BIS, December 11, 2016).

 8. M. Dickson, “Capital Gain: How London Is Thriving as It Takes on the Global Competition,” Financial Times, March 27, 2006, p. 11; Patrick Jenkins, “The City of London Faces the Future Beyond Brexit,” Financial Times, October 3, 2016.

 9. For a comprehensive review, see M. Taylor, “The Economics of Ex- change Rates,” Journal of Economic Literature 33 (1995), pp. 13–47.

10. Krugman and Obstfeld, International Economics.

11. M. Friedman, Studies in the Quantity Theory of Money (Chicago: University of Chicago Press, 1956). For an accessible explanation, see M. Friedman and R. Friedman, Free to Choose (London: Penguin Books, 1979), chap. 9.

12. Juan-Antonio Morales, “Inflation Stabilization in Bolivia,” in Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge, MA: MIT Press, 1988); The Economist, World Book of Vital Statistics (New York: Random House, 1990).

13. For reviews and various articles, see H. J. Edison, J. E. Gagnon, and W. R. Melick, “Understanding the Empirical Literature on Purchasing Power Parity,” Journal of International Money and Finance 16 (February 1997), pp. 1–18; J. R. Edison, “Multi-country Evidence on the Behavior of Purchasing Power Parity under the Current Float,” Journal of International Money and Finance 16 (February 1997), pp. 19–36; K. Rogoff, “The Purchasing Power Parity Puzzle,” Journal of Economic Literature 34 (1996), pp. 647–68; D. R. Rapach and M. E. Wohar, “Testing the Monetary Model of Exchange Rate Determination: New Evidence from a Century of Data,” Journal of International Economics, December 2002, pp. 359–85; M. P. Taylor, “Purchasing Power Parity,” Review of International Economics, August 2003, pp. 436–56; H. Kim and YK Moh, “A Century of Purchasing Power Parity Confirmed,” Journal of International Money and Finance 29 (2010), pp. 1398–1405.

14. M. Obstfeld and K. Rogoff, “The Six Major Puzzles in Interna- tional Economics,” National Bureau of Economic Research Working Paper Series, paper no. 7777, July 2000.

15. M. Obstfeld and K. Rogoff, “The Six Major Puzzles in Interna- tional Economics,” National Bureau of Economic Research Work- ing Paper Series, paper no. 7777, July 2000.

16. See M. Devereux and C. Engel, “Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibil- ity,” National Bureau of Economic Research Working Paper Series, paper no. 7665, April 2000. See also P. Krugman, “Pricing to Market When the Exchange Rate Changes,” in Real Financial

Economics, ed. S. Arndt and J. Richardson (Cambridge, MA: MIT Press, 1987).

17. For a summary of the evidence, see the survey by Taylor, “The Economics of Exchange Rates.”

18. R. E. Cumby and M. Obstfeld, “A Note on Exchange Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis,” Journal of Finance, June 1981, pp. 697–703; L. Coppock and M. Poitras, “Evaluating the Fisher Effect in Long-Term Cross-Country Averages,” International Review of Economics and Finance 9 (2000), pp. 181–203.

19. Taylor, “The Economics of Exchange Rates.” See also R. K. Lyons, The Microstructure Approach to Exchange Rates (Cambridge, MA: MIT Press, 2002); P. De Grauwe and M. Grimaldi, The Exchange Rate in a Behavioral Finance Framework (Princeton, NJ: Princeton University Press, 2006).

20. See H. L. Allen and M. P. Taylor, “Charts, Noise, and Funda- mentals in the Foreign Exchange Market,” Economic Journal 100 (1990), pp. 49–59; T. Ito, “Foreign Exchange Rate Expecta- tions: Micro Survey Data,” American Economic Review 80 (1990), pp. 434–49; T. F. Rotheli, “Bandwagon Effects and Run Patterns in Exchange Rates,” Journal of International Financial Markets, Money and Institutions 12, no. 2 (2002), pp. 157–66.

21. For example, see E. Fama, “Forward Rates as Predictors of Future Spot Rates,” Journal of Financial Economics, October 1976, pp. 361–77.

22. L. Kilian and M. P. Taylor, “Why Is It So Difficult to Beat the Random Walk Forecast of Exchange Rates?” Journal of Interna- tional Economics 20 (May 2003), pp. 85–103; R. M. Levich, “The Efficiency of Markets for Foreign Exchange,” in International Fi- nance, ed. G. D. Gay and R. W. Kold (Richmond, VA: Robert F. Dane, 1983).

23. J. Williamson, The Exchange Rate System (Washington, DC: Institute for International Economics, 1983); R. H. Clarida, L. Sarno, M. P. Taylor, and G. Valente, “The Out of Sample Success of Term Structure Models as Exchange Rate Predictors,” Journal of International Economics 60 (May 2003), pp. 61–84.

24. Kilian and Taylor, “Why Is It So Difficult to Beat the Random Walk Forecast of Exchange Rates?”

25. Rogoff, “The Purchasing Power Parity Puzzle.”

26. C. Engel and J. D. Hamilton, “Long Swings in the Dollar: Are They in the Data and Do Markets Know It?” American Economic Review, September 1990, pp. 689–713.

27. J. R. Carter and J. Gagne, “The Do’s and Don’ts of International Countertrade,” Sloan Management Review, Spring 1988, pp. 31–37.

28. D. S. Levine, “Got a Spare Destroyer Lying Around?” World Trade 10 (June 1997), pp. 34–35; Dan West, “Countertrade,” Business Credit, April 2001, pp. 64–67.

29. For details on how various firms manage their foreign exchange exposure, see the articles contained in the special foreign ex- change issue of Business International Money Report, December 18, 1989, pp. 401–12.

30. For details on how various firms manage their foreign exchange exposure, see the articles contained in the special foreign exchange issue of Business International Money Report, December 18, 1989, pp. 401–12.

31. S. Arterian, “How Black & Decker Defines Exposure,” Business International Money Report, December 18, 1989, pp. 404, 405, 409.

The International Monetary System L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO11 -1 Describe the historical development of the modern global monetary system.

LO11-2 Explain the role played by the World Bank and the IMF in the international monetary system.

LO11-3 Compare and contrast the differences between a fixed and a floating exchange rate system.

LO11-4 Identify exchange rate regimes used in the world today and why countries adopt different exchange rate regimes.

LO11-5 Understand the debate surrounding the role of the IMF in the management of financial crises.

LO11-6 Explain the implications of the global monetary system for management practice.

11

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part four The Global Monetar y System

Egypt and the IMF

U.S. dollar and the euro, making Egyptian exports cheaper and its imports more expensive. This should help the country to improve its trade deficit and earn more foreign currency. At the same time, the IMF required the Egyptian government to implement an austerity program that in- cluded an immediate end to energy subsidies, which had kept energy prices artificially low; reforms to public enter- prises to make them more efficient; tighter monetary policy to rein in inflation; and the imposition of a value-added tax to raise government revenues. In November 2016, Egypt let the pound float freely. It immediately lost 50 percent of its value against the U.S. dollar, trading at around 13 pounds to the dollar. The de- preciation continued into the new year, with the pound fall- ing to 19 pounds to the dollar by mid-January 2017, bringing the official exchange rate and the black market rate into equality. Egypt also moved rapidly to impose the value- added tax. In return, the IMF released the first $2.75 billion of its loan to Egypt. Further tranches of the loan will be re- leased as Egypt makes progress on the economic reforms advocated by the IMF. Only time will tell if these policies will work. In addition to a fall in the value of the pound, the immediate impact included a surge in the annual inflation rate to around 20 percent. The IMF envisages the inflation rate falling to 7 percent within three years, while there should be sharp improvements in both the trade deficit and the budget def- icit. However, the planned austerity measures carry signifi- cant political risks for the Egyptian government. If protests materialize over short-term hardships, the government might cave in to political pressure and pull back from the IMF-mandated reforms. If that happens, the IMF might with- hold further installments under the loan program, and the Egyptian economy could continue to deteriorate.

Sources: Heba Mahfouz and Paul Schemm, “Struggling Egypt Deval- ues Currency by Almost 50% Ahead of IMF Loan,” The Washington Post, November 3, 2016; Lin Noueihed and Ahmed Aboulenein, “Egypt on Track to Receive IMF Loan’s Second Tranche,” Reuters, January 18, 2017; “State of Denial,” The Economist, August 6, 2016; CIA World Fact Book, Egypt, accessed February 2017.

O P E N I N G C A S E When President Abdel Fatah al-Sissi came to power in a 2013 military coup, he promised to fix Egypt’s mounting economic problems. Three years later, those problems had only intensified. The country was struggling with low economic growth; 13 percent unemployment; a 12 percent inflation rate; a large trade deficit, amounting to 7 percent of GDP; a persisted budget deficit of around 12 percent of GDP; and public debt, which, by 2016, stood at 92 percent of GDP. The tourism trade, a major source of foreign cur- rency, had collapsed in the wake of concerns about terror- ism, which included an Islamic State–linked insurgency in the Sinai Peninsula that claimed the bombing of a Russian passenger jet in 2016. Foreign direct investment, another source of foreign currency, had also slumped in the wake of Egypt’s economic and political problems. One major issue was a lack of foreign currency in the country, which made it difficult to pay for imports and re- sulted in shortages of key commodities. For example, Egypt imports one-third of its sugar. By mid-2016, this commodity was in short supply due to the inability of Egyptian traders to get the foreign currency required to pay for imported sugar. Historically, in times of trouble, the oil-rich Arab states of the Persian Gulf had loaned foreign currency to Egypt at low interest rates, but a collapse in oil prices had left those states financially strained, and loans were not forthcoming. In an indication of the depth of Egypt’s problems, while the official exchange rate of the Egyptian pound was pegged at 9 pounds to the U.S. dollar, the black market rate had soared to 18 pounds to the dollar. In mid-2016, with its foreign exchange reserves being rapidly depleted, the Egyptian government applied to the IMF for a loan. The IMF agreed to loan Egypt up to $12 bil- lion, but only if the government undertook a number of economic reforms. These included liberalizing the ex- change rate, letting the Egyptian pound float against other currencies. The thinking was that the pound would imme- diately depreciate against major currencies such as the

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Introduction

In this chapter, we look at the international monetary system and its role in determining exchange rates. The international monetary system refers to the institutional arrange- ments that govern exchange rates. In Chapter 10, we assumed the foreign exchange market was the primary institution for determining exchange rates and the impersonal market forces of demand and supply determined the relative value of any two currencies (i.e., their exchange rate). Furthermore, we explained that the demand and supply of currencies is influenced by their respective countries’ relative inflation rates and interest rates. When the foreign exchange market determines the relative value of a currency, we say that the country is adhering to a floating exchange rate regime. Four of the world’s major trading currencies—the U.S. dollar, the European Union’s euro, the Japanese yen, and the British pound—are all free to float against each other. Thus, their exchange rates are determined by market forces and fluctuate against each other day to day, if not minute to minute. How- ever, the exchange rates of many currencies are not determined by the free play of market forces; other institutional arrangements are adopted.

Many of the world’s developing nations peg their currencies, primarily to the dollar or the euro. A pegged exchange rate means the value of the currency is fixed relative to a refer- ence currency, such as the U.S. dollar, and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate. As noted in the opening case, Egypt pegged the value of its currency to the U.S. dollar until November 2016.

Other countries, while not adopting a formal pegged rate, try to hold the value of their currency within some range against an important reference currency such as the U.S. dol- lar or a “basket” of currencies. This is often referred to as a managed float system or a dirty-float system. It is a float because, in theory, the value of the currency is determined by market forces, but it is a managed (or dirty) float (as opposed to a clean float) because the central bank of a country will intervene in the foreign exchange market to try to main- tain the value of its currency if it depreciates too rapidly against an important reference currency. This has been the policy adopted by the Chinese since July 2005. The value of the Chinese currency, the yuan, has been linked to a basket of other currencies—including the dollar, yen, and euro—and it is allowed to vary in value against individual currencies, but only within limits.

Still other countries have operated with a fixed exchange rate, in which the values of a set of currencies are fixed against each other at some mutually agreed-on exchange rate.

G L O B A L E D G E B L O G

The international monetary system captures our attention because here we are talking about the institutional arrangements that govern exchange rates, and this is a tricky business in which countries have leverage to influence their country’s currency value but do not nec- essarily always use it. The options for how the value, or “rate,” is set for a currency are many: floating exchange rate, pegged exchange rate, dirty float, and fixed exchange rate are the ones covered in this Chapter 11. We start the chapter by some history related to the “gold standard,” a practice that takes us back to ancient times. Technically, no country uses the gold standard any longer but many, including the United States, hold substantial gold reserves. The international monetary system depends on a lot of variables (see the globalEDGETM Database of International Business Statistics, which we covered in Chapter 10); today, these variables also include “behavioral” (perception) issues in addition to hard, concrete data. The globalEDGETM Blog has been a favored “international business” vehicle to stay current on important topics, often related to monetary issues. Check out the globalEDGETM Blog (globaledge.msu.edu/blog), see what is covered on monetary issues, and engage with people from around the world on issues that are of interest to you.

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Before the introduction of the euro in 1999, several member states of the European Union operated with fixed exchange rates within the context of the European Monetary System (EMS). For a quarter of a century after World War II, the world’s major industrial nations participated in a fixed exchange rate system. Although this system collapsed in 1973, some still argue that the world should attempt to reestablish it.

This chapter explains how the international monetary system works and points out its implications for international business. To understand how the system works, we must re- view its evolution. We begin with a discussion of the gold standard and its breakup during the 1930s. Then we discuss the 1944 Bretton Woods conference. The Bretton Woods con- ference also created two major international institutions that play a role in the interna- tional monetary system—the International Monetary Fund (IMF) and the World Bank. The IMF was given the task of maintaining order in the international monetary system; the World Bank’s role was to promote development. Today, both these institutions continue to play major roles in the world economy and in the international monetary system. As dis- cussed in the opening case, the IMF has stepped in to help Egypt navigate its way through a currency crisis caused by poor economic policies, terrorism, and political turmoil. The Bretton Woods system of fixed exchange rates collapsed in 1973. Since then, the world has operated with a mixed system in which some currencies are allowed to float freely, but many are either managed by government intervention or pegged to another currency.

Finally, we discuss the implications of all this material for international business. We will see how the exchange rate policy adopted by a government can have an important impact on the outlook for business operations in a given country. We also look at how the policies adopted by the IMF can have an impact on the economic outlook for a country and, accordingly, on the costs and benefits of doing business in that country.

The Gold Standard

The gold standard had its origin in the use of gold coins as a medium of exchange, unit of account, and store of value—a practice that dates to ancient times. When international trade was limited in volume, payment for goods purchased from another country was typi- cally made in gold or silver. However, as the volume of international trade expanded in the wake of the Industrial Revolution, a more convenient means of financing international trade was needed. Shipping large quantities of gold and silver around the world to finance international trade seemed impractical. The solution adopted was to arrange for payment in paper currency and for governments to agree to convert the paper currency into gold on demand at a fixed rate.

MECHANICS OF THE GOLD STANDARD

Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. By 1880, most of the world’s major trading nations, including Great Britain, Germany, Japan, and the United States, had adopted the gold standard. Given a common gold standard, the value of any currency in units of any other currency (the exchange rate) was easy to determine.

For example, under the gold standard, 1 U.S. dollar was defined as equivalent to 23.22 grains of “fine” (pure) gold. Thus, one could, in theory, demand that the U.S. government convert that one dollar into 23.22 grains of gold. Because there are 480 grains in an ounce, one ounce of gold cost $20.67 (480/23.22). The amount of a currency needed to purchase one ounce of gold was referred to as the gold par value. The British pound was valued at 113 grains of fine gold. In other words, one ounce of gold cost £4.25 (480/113). From the gold par values of pounds and dollars, we can calculate what the exchange rate was for converting pounds into dollars; it was £1 = $4.87 (i.e., $20.67/£4.25).

STRENGTH OF THE GOLD STANDARD

The great strength claimed for the gold standard was that it contained a powerful mechanism for achieving balance-of-trade equilibrium by all countries.1 A country is said to be in

LO 11 -1 Describe the historical development of the modern global monetary system.

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balance-of-trade equilibrium when the income its residents earn from exports is equal to the money its residents pay to other countries for imports (the current account of its balance of payments is in balance). Suppose there are only two countries in the world, Japan and the United States. Imagine Japan’s trade balance is in surplus because it exports more to the United States than it imports from the United States. Japanese exporters are paid in U.S. dollars, which they exchange for Japanese yen at a Japanese bank. The Japanese bank submits the dollars to the U.S. government and demands payment of gold in return. (This is a simplification of what would occur, but it will make our point.)

Under the gold standard, when Japan has a trade surplus, there is a net flow of gold from the United States to Japan. These gold flows automatically reduce the U.S. money supply and swell Japan’s money supply. As we saw in Chapter 10, there is a close connec- tion between money supply growth and price inflation. An increase in money supply will raise prices in Japan, while a decrease in the U.S. money supply will push U.S. prices downward. The rise in the price of Japanese goods will decrease demand for these goods, while the fall in the price of U.S. goods will increase demand for these goods. Thus, Japan will start to buy more from the United States, and the United States will buy less from Japan, until a balance-of-trade equilibrium is achieved.

This adjustment mechanism seems so simple and attractive that even today, nearly 80 years after the final collapse of the gold standard, some people believe the world should return to a gold standard.

THE PERIOD BETWEEN THE WARS: 1918–1939

The gold standard worked reasonably well from the 1870s until the start of World War I in 1914, when it was abandoned. During the war, several governments financed part of their massive military expenditures by printing money. This resulted in inflation, and by the war’s end in 1918, price levels were higher everywhere. The United States returned to the gold standard in 1919, Great Britain in 1925, and France in 1928.

Great Britain returned to the gold standard by pegging the pound to gold at the prewar gold parity level of £4.25 per ounce, despite substantial inflation between 1914 and 1925. This priced British goods out of foreign markets, which pushed the country into a deep depression. When foreign holders of pounds lost confidence in Great Britain’s commit- ment to maintaining its currency’s value, they began converting their holdings of pounds into gold. The British government saw that it could not satisfy the demand for gold with- out seriously depleting its gold reserves, so it suspended convertibility in 1931.

The United States followed suit and left the gold standard in 1933 but returned to it in 1934, raising the dollar price of gold from $20.67 per ounce to $35.00 per ounce. Because more dollars were needed to buy an ounce of gold than before, the implication was that the dollar was worth less. This effectively amounted to a devaluation of the dollar relative to other currencies. Thus, before the devaluation, the pound/dollar ex- change rate was £1 = $4.87, but after the devaluation it was £1 = $8.24. By reducing the price of U.S. exports and increasing the price of imports, the government was try- ing to create employment in the United States by boosting output (the U.S. government was basically using the exchange rate as an instrument of trade policy—something it now accuses China of doing). However, a number of other countries adopted a similar tactic, and in the cycle of competitive devaluations that soon emerged, no country could win.

The net result was the shattering of any remaining confidence in the system. With countries devaluing their currencies at will, one could no longer be certain how much gold a currency could buy. Instead of holding onto another country’s currency, people often tried to change it into gold immediately, lest the country devalue its currency in the intervening period. This put pressure on the gold reserves of various countries, forc- ing them to suspend gold convertibility. By the start of World War II in 1939, the gold standard was dead.

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The Bretton Woods System

In 1944, at the height of World War II, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system. With the col- lapse of the gold standard and the Great Depression of the 1930s fresh in their minds, these statesmen were determined to build an enduring economic order that would facili- tate postwar economic growth. There was consensus that fixed exchange rates were desir- able. In addition, the conference participants wanted to avoid the senseless competitive devaluations of the 1930s, and they recognized that the gold standard would not ensure this. The major problem with the gold standard as previously constituted was that no mul- tinational institution could stop countries from engaging in competitive devaluations.

The agreement reached at Bretton Woods established two multinational institutions— the International Monetary Fund (IMF) and the World Bank. The task of the IMF would be to maintain order in the international monetary system and that of the World Bank would be to promote general economic development. The Bretton Woods agreement also called for a system of fixed exchange rates that would be policed by the IMF. Under the agreement, all countries were to fix the value of their currency in terms of gold but were not required to exchange their currencies for gold. Only the dollar remained convert- ible into gold—at a price of $35 per ounce. Each country decided what it wanted its exchange rate to be vis-à-vis the dollar and then calculated the gold par value of the currency based on that selected dollar exchange rate. All participating countries agreed to try to maintain the value of their currencies within 1 percent of the par value by buying or selling currencies (or gold) as needed. For example, if foreign exchange dealers were selling more of a country’s currency than demanded, that country’s government would intervene in the foreign exchange markets, buying its currency in an attempt to increase demand and maintain its gold par value.

Another aspect of the Bretton Woods agreement was a commitment not to use devalu- ation as a weapon of competitive trade policy. However, if a currency became too weak to defend, a devaluation of up to 10 percent would be allowed without any formal approval by the IMF. Larger devaluations required IMF approval.

THE ROLE OF THE IMF

The IMF Articles of Agreement were heavily inf luenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinf lation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars. The aim of the Bretton Woods agreement, of which the IMF was the main custodian, was to try to avoid a repetition of that chaos through a combination of disci- pline and flexibility.

Discipline A fixed exchange rate regime imposes discipline in two ways. First, the need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment. Second, a fixed exchange rate regime imposes monetary disci- pline on countries, thereby curtailing price inflation. For example, consider what would happen under a fixed exchange rate regime if Great Britain rapidly increased its money supply by printing pounds. As explained in Chapter 10, the increase in money supply would lead to price inflation. Given fixed exchange rates, inflation would make British goods uncompetitive in world markets, while the prices of imports would become more attractive in Great Britain. The result would be a widening trade deficit in Great Britain, with the country importing more than it exports. To correct this trade imbalance under a fixed exchange rate regime, Great Britain would be required to restrict the rate of growth in its money supply to bring price inflation back under control. Thus, fixed exchange rates are seen as a mechanism for controlling inflation and imposing economic discipline on countries.

LO 11 -2 Explain the role played by the World Bank and the IMF in the international monetary system.

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Flexibility Although monetary discipline was a central objective of the Bretton Woods agreement, it was recognized that a rigid policy of fixed exchange rates would be too inflexible. It would probably break down just as the gold standard had. In some cases, a country’s attempts to reduce its money supply growth and correct a persistent balance-of-payments deficit could force the country into recession and create high unemployment. The architects of the Bretton Woods agreement wanted to avoid high unemployment, so they built limited flex- ibility into the system. Two major features of the IMF Articles of Agreement fostered this flexibility: IMF lending facilities and adjustable parities.

The IMF stood ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficits, when a rapid tightening of monetary or fis- cal policy would hurt domestic employment. A pool of gold and currencies contributed by IMF members provided the resources for these lending operations. A persistent balance- of-payments deficit can lead to a depletion of a country’s reserves of foreign currency, forcing it to devalue its currency. By providing deficit-laden countries with short-term foreign currency loans, IMF funds would buy time for countries to bring down their inflation rates and reduce their balance-of-payments deficits. The belief was that such loans would reduce pressures for devaluation and allow for a more orderly and less painful adjustment.

Countries were to be allowed to borrow a limited amount from the IMF without adher- ing to any specific agreements. However, extensive drawings from IMF funds would re- quire a country to agree to increasingly stringent IMF supervision of its macroeconomic policies. Heavy borrowers from the IMF must agree to monetary and fiscal conditions set down by the IMF, which typically included IMF-mandated targets on domestic money sup- ply growth, exchange rate policy, tax policy, government spending, and so on.

The system of adjustable parities allowed for the devaluation of a country’s currency by more than 10 percent if the IMF agreed that a country’s balance of payments was in “funda- mental disequilibrium.” The term fundamental disequilibrium was not defined in the IMF’s Articles of Agreement, but it was intended to apply to countries that had suffered permanent adverse shifts in the demand for their products. Without devaluation, such a country would experience high unemployment and a persistent trade deficit until the domestic price level had fallen far enough to restore a balance-of-payments equilibrium. The belief was that de- valuation could help sidestep a painful adjustment process in such circumstances.

THE ROLE OF THE WORLD BANK

The official name for the World Bank is the International Bank for Reconstruction and Development (IBRD). When the Bretton Woods participants established the World Bank, the need to reconstruct the war-torn economies of Europe was foremost in their minds. The bank’s initial mission was to help finance the building of Europe’s economy by provid- ing low-interest loans. As it turned out, the World Bank was overshadowed in this role by the Marshall Plan, under which the United States lent money directly to European nations to help them rebuild. So the bank turned its attention to development and began lending money to third-world nations. In the 1950s, the bank concentrated on public-sector projects. Power stations, road building, and other transportation investments were much in favor. During the 1960s, the bank also began to lend heavily in support of agriculture, education, population control, and urban development.

The bank lends money under two schemes. Under the IBRD scheme, money is raised through bond sales in the international capital market. Borrowers pay what the bank calls a market rate of interest—the bank’s cost of funds plus a margin for expenses. This “market” rate is lower than commercial banks’ market rate. Under the IBRD scheme, the bank offers low-interest loans to risky customers whose credit rating is often poor, such as the governments of underdeveloped nations.

A second scheme is overseen by the International Development Association (IDA), an arm of the bank created in 1960. Resources to fund IDA loans are raised through subscriptions from wealthy members such as the United States, Japan, and Germany.

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IDA loans go only to the poorest countries. Borrowers have up to 50 years to repay at an interest rate of less than 1 percent a year. The world’s poorest nations receive grants and interest-free loans.

The Collapse of the Fixed Exchange Rate System

The system of fixed exchange rates established at Bretton Woods worked well until the late 1960s, when it began to show signs of strain. The system finally collapsed in 1973, and since then, we have had a managed-float system. To understand why the system collapsed, one must appreciate the special role of the U.S. dollar in the system. As the only currency that could be converted into gold and as the currency that served as the reference point for all others, the dollar occupied a central place in the system. Any pressure on the dollar to devalue could wreak havoc with the system, and that is what occurred.

Most economists trace the breakup of the fixed exchange rate system to the U.S. mac- roeconomic policy package of 1965–1968.2 To finance both the Vietnam conflict and his welfare programs, President Lyndon Johnson backed an increase in U.S. government spending that was not financed by an increase in taxes. Instead, it was financed by an in- crease in the money supply, which led to a rise in price inflation from less than 4 percent in 1966 to close to 9 percent by 1968. At the same time, the rise in government spending had stimulated the economy. With more money in their pockets, people spent more— particularly on imports—and the U.S. trade balance began to deteriorate.

The increase in inflation and the worsening of the U.S. foreign trade position gave rise to speculation in the foreign exchange market that the dollar would be devalued. Things came to a head in spring 1971, when U.S. trade figures showed that for the first time since 1945, the United States was importing more than it was exporting. This set off massive purchases of German deutsche marks in the foreign exchange market by speculators who guessed that the mark would be revalued against the dollar. On a single day, May 4, 1971, the Bundesbank (Germany’s central bank) had to buy $1 billion to hold the dollar/ deutsche mark exchange rate at its fixed exchange rate, given the great demand for deutsche marks. On the morning of May 5, the Bundesbank purchased another $1 billion during the first hour of foreign exchange trading! At that point, the Bundesbank faced the inevitable and allowed its currency to float.

In the weeks following the decision to float the deutsche mark, the foreign exchange mar- ket became increasingly convinced that the dollar would have to be devalued. However, de- valuation of the dollar was no easy matter. Under the Bretton Woods provisions, any other country could change its exchange rates against all currencies simply by fixing its dollar rate at a new level. But as the key currency in the system, the dollar could be devalued only if all countries agreed to simultaneously revalue against the dollar. Many countries did not want this, because it would make their products more expensive relative to U.S. products.

To force the issue, President Richard Nixon announced in August 1971 that the dollar was no longer convertible into gold. He also announced that a new 10 percent tax on im- ports would remain in effect until U.S. trading partners agreed to revalue their currencies against the dollar. This brought the trading partners to the bargaining table, and in Decem- ber 1971, an agreement was reached to devalue the dollar by about 8 percent against foreign currencies. The import tax was then removed. The problem was not solved, however. The U.S. balance-of-payments position continued to deteriorate throughout 1973, while the nation’s money supply continued to expand at an inflationary rate. Speculation continued to grow that the dollar was still overvalued and that a second devaluation would be necessary. In anticipation, foreign exchange dealers began converting dollars to deutsche marks and other currencies. After a massive wave of speculation in February 1973, which culminated with European central banks spending $3.6 billion on March 1 to try to prevent their currencies from appreciating against the dollar, the foreign exchange market was closed. When the foreign exchange market reopened March 19, the currencies of Japan and most European countries were floating against the dollar, although many developing countries

LO 11 -3 Compare and contrast the differences between a fixed and a floating exchange rate system.

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continued to peg their currency to the dollar, and many do to this day. At that time, the switch to a floating system was viewed as a temporary response to unmanageable speculation in the foreign exchange market. But it is now more than 40 years since the Bretton Woods system of fixed exchange rates collapsed, and the temporary solution looks permanent.

The Bretton Woods system had an Achilles’ heel: The system could not work if its key currency, the U.S. dollar, was under speculative attack. The Bretton Woods system could work only as long as the U.S. inflation rate remained low and the United States did not run a balance-of-payments deficit. Once these things occurred, the system soon became strained to the breaking point.

The Floating Exchange Rate Regime

The floating exchange rate regime that followed the collapse of the fixed exchange rate system was formalized in January 1976, when IMF members met in Jamaica and agreed to the rules for the international monetary system that are in place today.

THE JAMAICA AGREEMENT

The Jamaica meeting revised the IMF’s Articles of Agreement to reflect the new reality of floating exchange rates. The main elements of the Jamaica agreement include the following:

∙ Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange market to even out “unwarranted” speculative fluctuations.

∙ Gold was abandoned as a reserve asset. The IMF returned its gold reserves to mem- bers at the current market price, placing the proceeds in a trust fund to help poor na- tions. IMF members were permitted to sell their own gold reserves at the market price.

∙ Total annual IMF quotas—the amount member countries contribute to the IMF—were increased to $41 billion. (Since then, they have been increased to $767 billion, while the membership of the IMF has been expanded to include 188 countries. Non-oil-exporting, less developed countries were given greater access to IMF funds.)

EXCHANGE RATES SINCE 1973

Since March 1973, exchange rates have become much more volatile and less predictable than they were between 1945 and 1973.3 This volatility has been partly due to a number of unexpected shocks to the world monetary system, including:

∙ The oil crisis in 1971, when the Organization of the Petroleum Exporting Countries (OPEC) quadrupled the price of oil. The harmful effect of this on the U.S. inflation rate and trade position resulted in a further decline in the value of the dollar.

∙ The loss of confidence in the dollar that followed a sharp rise in the U.S. inflation rate in 1977–1978.

∙ The oil crisis of 1979, when OPEC once again increased the price of oil dramati- cally: this time, it was doubled.

∙ The unexpected rise in the dollar between 1980 and 1985, despite a deteriorating balance-of-payments picture.

∙ The rapid fall of the U.S. dollar against the Japanese yen and German deutsche mark between 1985 and 1987, and against the yen between 1993 and 1995.

∙ The partial collapse of the European Monetary System in 1992. ∙ The 1997 Asian currency crisis, when the Asian currencies of several countries—

including South Korea, Indonesia, Malaysia, and Thailand—lost between 50 and 80 percent of their value against the U.S. dollar in a few months.

∙ The global financial crisis of 2008–2010 and the sovereign debt crisis in the European Union during 2010–2011.

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Figure 11.1 summarizes how the value of the U.S. dollar has f luctuated against an index of trading currencies between January 1973 and January 2017. (The index, which was set equal to 100 in March 1973, is a weighted average of the foreign exchange values of the U.S. dollar against a basket of other currencies.) An interesting phenomenon in Figure 11.1 is the rapid rise in the value of the dollar between 1980 and 1985 and its subsequent fall between 1985 and 1988. A similar, though less pronounced, rise and fall in the value of the dollar occurred between 1995 and 2012. You will also notice a sharp uptick in the value of the dollar between mid-2014 and early 2017. We briefly discuss the rise and fall of the dollar during these periods, because this tells us something about how the international monetary system has operated in recent years.4

The rise in the value of the dollar between 1980 and 1985 occurred when the United States was running a large and growing trade deficit, importing substantially more than it exported. Conventional wisdom would suggest that the increased supply of dollars in the foreign exchange market as a result of the trade deficit should lead to a reduction in the value of the dollar, but as shown in Figure 11.1, it increased in value. Why?

A number of favorable factors overcame the unfavorable effect of a trade deficit. Strong economic growth in the United States attracted heavy inf lows of capital from foreign investors seeking high returns on capital assets. High real interest rates attracted foreign investors seeking high returns on financial assets. At the same time, political tur- moil in other parts of the world, along with relatively slow economic growth in the devel- oped countries of Europe, helped create the view that the United States was a good place to invest. These inf lows of capital increased the demand for dollars in the foreign exchange market, which pushed the value of the dollar upward against other currencies.

The fall in the value of the dollar between 1985 and 1988 was caused by a combination of government intervention and market forces. The rise in the dollar, which priced U.S. goods out of foreign markets and made imports relatively cheap, had contributed to a dis- mal trade picture. In 1985, the United States posted a then-record-high trade deficit of more than $160 billion. This led to growth in demands for protectionism in the United States. In September 1985, the finance ministers and central bank governors of the

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Major currencies dollar index, 1973–2017. Source: Data from www.federalreserve.gov.

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so-called Group of Five major industrial countries (Great Britain, France, Japan, Germany, and the United States) met at the Plaza Hotel in New York City and reached what was later referred to as the Plaza Accord. They announced that it would be desirable for most major currencies to appreciate vis-à-vis the U.S. dollar and pledged to intervene in the foreign ex- change markets, selling dollars, to encourage this objective. The dollar had already begun to weaken during summer 1985, and this announcement further accelerated the decline.

The dollar continued to decline until 1987. The governments of the Group of Five be- gan to worry that the dollar might decline too far, so the finance ministers of the Group of Five met in Paris in February 1987 and reached a new agreement known as the Louvre Accord. They agreed that exchange rates had been realigned sufficiently and pledged to support the stability of exchange rates around their current levels by intervening in the foreign exchange markets when necessary to buy and sell currency. Although the dollar continued to decline for a few months after the Louvre Accord, the rate of decline slowed, and by early 1988, the decline had ended.

Except for a brief speculative flurry around the time of the Persian Gulf War in 1991, the dollar was relatively stable for the first half of the 1990s. However, in the late 1990s, the dollar again began to appreciate against most major currencies, including the euro after its introduction, even though the United States was still running a significant balance- of-payments deficit. Once again, the driving force for the appreciation in the value of the dollar was that foreigners continued to invest in U.S. financial assets, primarily stocks and bonds, and the inflow of money drove up the value of the dollar on foreign exchange markets. The inward investment was due to a belief that U.S. financial assets offered a favorable rate of return.

By 2002, foreigners had started to lose their appetite for U.S. stocks and bonds, and the inflow of money into the United States slowed. Instead of reinvesting dollars earned from exports to the United States in U.S. financial assets, they exchanged those dollars for other currencies, particularly euros, to invest them in non-dollar-denominated assets. One reason for this was the continued growth in the U.S. trade deficit, which hit a record $791 billion in 2005 (by 2016, it had fallen to $502 billion). Although the U.S. trade deficits had been setting records for decades, this deficit was the largest ever when measured as a percentage of the country’s GDP (6.3 percent of GDP in 2005).

The record deficit meant that even more dollars were flowing out of the United States into foreign hands, and those foreigners were less inclined to reinvest those dollars in the United States at a rate required to keep the dollar stable. This growing reluctance of foreign- ers to invest in the United States was in turn due to several factors. First, there was a slow- down in U.S. economic activity during 2001–2002. Second, the U.S. government’s budget deficit expanded rapidly after 2001. This led to fears that ultimately the budget deficit would be financed by an expansionary monetary policy that could lead to higher price inflation. Third, from 2003 onward, U.S. government officials began to “talk down” the value of the dollar, in part because the administration believed that a cheaper dollar would increase ex- ports and reduce imports, thereby improving the U.S. balance-of-trade position.5 Foreigners saw this as a signal that the U.S. government would not intervene in the foreign exchange markets to prop up the value of the dollar, which increased their reluctance to reinvest dol- lars earned from export sales in U.S. financial assets. As a result of these factors, demand for dollars weakened, and the value of the dollar slid on the foreign exchange markets— hitting an index value of 80.5 in June 2011, the lowest value since the index began in 1973. Some believed that the dollar would have fallen even further had not oil-producing states recycled the dollars they were earning from sales of crude oil back into the U.S. economy. At the time, these states were benefiting from high oil prices (oil is priced in U.S. dollars), and they chose to invest the dollars they earned back into the United States, rather than selling them for another currency (see the Country Focus for details).

Interestingly, from mid-2008 through early 2009, the dollar staged a moderate rally against major currencies, despite the fact that the American economy was suffering from a serious financial crisis. The reason seems to be that despite America’s problems, things were even worse in many other countries, and foreign investors saw the dollar as a safe

C O U N T R Y F O C U S

Between 2004 and 2008, global oil prices surged. They peaked at $147 a barrel in July 2008, up from about $20 in 2001, before falling sharply back to a $34 to $48 range by early 2009. From 2010 onward, they increased again, ris- ing to more than $100 a barrel in early 2014, before falling back to around $30 a barrel by early 2016. The rise was due to a combination of greater-than-expected demand for oil, particularly from rapidly developing giants such as China and India; tight supplies; and perceived geopolitical risks in the Middle East, the world’s largest oil-producing region. The fall since mid-2014 was due to the combination of a weak global economy and rapidly increasing produc- tion from shale oil fields in the United States. The surge in oil prices between 2004 and 2009 was a windfall for oil-producing countries. Collectively, they earned around $700 billion in oil revenues in 2005 and well over $1 trillion in 2007 and 2008—some 64 percent of which went to members of OPEC. Saudi Arabia, the world’s largest oil producer, reaped a major share. Because oil is priced in U.S. dollars, the rise in oil prices translated into a substantial increase in the dollar holdings of oil producers (the dollars earned from the sale of oil are often referred to as petrodollars). In essence, rising oil prices represent a net transfer of dollars from oil consumers in countries such as the United States to oil producers in Russia, Saudi Arabia, and Venezuela. What did they do with these dollars? One option for producing countries was to spend their petrodollars on public-sector infrastructure, such as health services, education, roads, and telecommunications sys- tems. Among other things, this could boost economic growth in those countries and pull in foreign imports, which would help counterbalance the trade surpluses enjoyed by oil producers and support global economic growth. Spending did indeed pick up in many oil-producing coun- tries. However, according to the IMF, OPEC members spent only about 40 percent of their windfall profits

from  higher oil prices in 2002–2007 (an exception was Venezuela, whose leader, Hugo Chávez, was on a spend- ing spree until his death in early 2013). The last time oil prices increased sharply in 1979, oil producers significantly ramped up spending on infrastructure, only to find them- selves saddled with excessive debt when oil prices col- lapsed a few years later. This time they were more cautious—an approach that seems wise given the rapid fall in oil prices during late 2008 and again in late 2014. Another option was for oil producers to invest a good chunk of the dollars they earned from oil sales in dollar- denominated assets, such as U.S. bonds, stocks, and real estate. This did happen. OPEC members in particular fun- neled dollars back into U.S. assets, mostly low-risk govern- ment bonds. The implication is that by recycling their petrodollars, oil producers helped finance the large and growing current account deficit of the United States, en- abling it to pay its large oil import bill. A third possibility for oil producers was to invest in non-dollar-denominated assets, including European and Japanese bonds and stocks. This, too, happened. Also, some OPEC investors had purchased not just small equity positions but entire companies. In 2005, for example, Dubai International Capital purchased the Tussauds Group, a British theme-park firm, and DP World of Dubai purchased P&O, Britain’s biggest port and ferries group. Despite examples such as these, the bulk of petrodollars appear to have been recycled into dollar-denominated assets. In part, this was because U.S. interest rates increased throughout 2004–2007 and in part because the United States was viewed as a safe haven in economically troubled times.

Sources: “Recycling the Petrodollars; Oil Producers’ Surpluses,” The Economist, November 12, 2005, 101–02; S. Johnson, “Dollar’s Rise Aided by OPEC Holdings,” Financial Times, December 5, 2005, p. 17; “The Petrodollar Puzzle,” The Economist, June 9, 2007, p. 86.

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haven and put their money in low-risk U.S. assets, particularly low-yielding U.S. govern- ment bonds. This rally faltered in mid-2009 as investors became worried about the level of U.S. indebtedness. However, between 2014 and early 2017, the dollar yet again increased significantly in value, primarily because of the strength of the U.S. economy, which had emerged from the great financial crisis of 2008–2009 in better shape than any other major developed nation, with higher economic growth rates and lower levels of unemployment.

This review tells us that in recent history, both market forces and government interven- tion have determined the value of the dollar. Under a floating exchange rate regime, market

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forces have produced a volatile dollar exchange rate. Governments have sometimes re- sponded by intervening in the market—buying and selling dollars—in an attempt to limit the market’s volatility and to correct what they see as overvaluation (in 1985) or potential un- dervaluation (in 1987) of the dollar. In addition to direct intervention, statements from government officials have frequently influenced the value of the dollar. The dollar may not have declined by as much as it did in 2004, for example, had not U.S. government officials publicly ruled out any action to stop the decline. Paradoxically, a signal not to intervene can affect the market. The frequency of government intervention in the foreign exchange market explains why the current system is sometimes thought of as a managed-float system or a dirty-float system.

Fixed versus Floating Exchange Rates

The breakdown of the Bretton Woods system has not stopped the debate about the relative merits of fixed versus floating exchange rate regimes. Disappointment with the system of floating rates in recent years has led to renewed debate about the merits of fixed exchange rates. This section reviews the arguments for fixed and floating exchange rate regimes.6 We discuss the case for floating rates before studying why many critics are disappointed with the experience under floating exchange rates and yearn for a system of fixed rates.

THE CASE FOR FLOATING EXCHANGE RATES

The case in support of floating exchange rates has three main elements: monetary policy autonomy, automatic trade balance adjustments, and economic recovery following a severe economic crisis.

Monetary Policy Autonomy It is argued that under a fixed system, a country’s ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity. Monetary ex- pansion can lead to inflation, which puts downward pressure on a fixed exchange rate (as predicted by the PPP theory; see Chapter 10). Similarly, monetary contraction requires high interest rates (to reduce the demand for money). Higher interest rates lead to an in- flow of money from abroad, which puts upward pressure on a fixed exchange rate. Thus, to maintain exchange rate parity under a fixed system, countries were limited in their ability to use monetary policy to expand or contract their economies.

Advocates of a floating exchange rate regime argue that removal of the obligation to maintain exchange rate parity would restore monetary control to a government. If a government faced with unemployment wanted to increase its money supply to stimulate domestic demand and reduce unemployment, it could do so unencumbered by the need to maintain its exchange rate. While monetary expansion might lead to inflation, this would lead to a depreciation in the country’s currency. If PPP theory is correct, the resulting cur- rency depreciation on the foreign exchange markets should offset the effects of inflation. Although under a floating exchange rate regime, domestic inflation would have an impact on the exchange rate, it should have no impact on businesses’ international cost competi- tiveness due to exchange rate depreciation. The rise in domestic costs should be exactly offset by the fall in the value of the country’s currency on the foreign exchange markets. Similarly, a government could use monetary policy to contract the economy without wor- rying about the need to maintain parity.

Trade Balance Adjustments Under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade (importing more than it exported) that could not be corrected by domestic policy, this would require the IMF to agree to currency devaluation. Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate

Did You Know? Did you know that China has recently been trying to stop its currency from falling in value on foreign exchange markets?

Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.

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The International Monetary System Chapter 11 325

regime. They argue that if a country is running a trade deficit, the imbalance between the supply and demand of that country’s currency in the foreign exchange markets (supply exceeding demand) will lead to depreciation in its exchange rate. In turn, by making its exports cheaper and its imports more expensive, exchange rate depreciation should correct the trade deficit.

Crisis Recovery Advocates of floating exchange rates also argue that exchange rate adjustments can help a country to deal with economic crises. When a country is hit by a severe economic cri- sis, its currency typically declines on foreign exchange markets. The reason for this is that investors respond to the crisis by taking their money out of the country, selling the local currency, and driving down its value. At some point, however, the currency be- comes so cheap that it starts to stimulate exports. This is what occurred in Iceland after the krona lost 50 percent of its value against the U.S. dollar and euro following a bank- ing crisis in 2008. By 2009, exports of fish and aluminum from Iceland were booming, which helped pull the Icelandic economy out of a recession. A similar process occurred in South Korean after the 1997 Asian banking crisis. The value of the South Korean won plunged to 1,700 per dollar from around 800. In turn, the cheap won helped South Korea increase its exports and resulted in an export-led economic recovery. On the other hand, in both countries, the declining value of the currency did raise import prices and led to an increase in inf lation, so there is a price that has to be paid for an export-led recovery due to falling currency values.

A contrast can be drawn with the recent situation in Greece, where the economy im- ploded following the 2008–2009 global financial crisis and has struggled to recover. Part of the problem in Greece is that it gave up its own currency to adopt the euro in 2001, and the euro has remained quite strong; thus, Greece cannot rely on a falling local currency to boost exports and stimulate economic recovery.

THE CASE FOR FIXED EXCHANGE RATES

The case for fixed exchange rates rests on arguments about monetary discipline, specula- tion, uncertainty, and the lack of connection between the trade balance and exchange rates.

Monetary Discipline We have already discussed the nature of monetary discipline inherent in a fixed exchange rate system when we discussed the Bretton Woods system. The need to maintain fixed ex- change rate parity ensures that governments do not expand their money supplies at infla- tionary rates. While advocates of floating rates argue that each country should be allowed to choose its own inflation rate (the monetary autonomy argument), advocates of fixed rates argue that governments all too often give in to political pressures and expand the monetary supply far too rapidly, causing unacceptably high price inflation. A fixed ex- change rate regime would ensure that this does not occur.

Speculation Critics of a floating exchange rate regime also argue that speculation can cause fluctua- tions in exchange rates. They point to the dollar’s rapid rise and fall during the 1980s, which they claim had nothing to do with comparative inflation rates and the U.S. trade deficit but everything to do with speculation. They argue that when foreign exchange dealers see a currency depreciating, they tend to sell the currency in the expectation of future depreciation, regardless of the currency’s longer-term prospects. As more traders jump on the bandwagon, the expectations of depreciation are realized. Such destabiliz- ing speculation tends to accentuate the fluctuations around the exchange rate’s long-run value. It can damage a country’s economy by distorting export and import prices. Thus, advocates of a fixed exchange rate regime argue that such a system will limit the destabi- lizing effects of speculation.

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Uncertainty Speculation also adds to the uncertainty surrounding future currency movements that characterizes floating exchange rate regimes. The unpredictability of exchange rate move- ments in the post–Bretton Woods era has made business planning difficult, and it adds risk to exporting, importing, and foreign investment activities. Given a volatile exchange rate, international businesses do not know how to react to the changes—and often they do not react. Why change plans for exporting, importing, or foreign investment after a 6 per- cent fall in the dollar this month, when the dollar may rise 6 percent next month? This uncertainty, according to the critics, dampens the growth of international trade and invest- ment. They argue that a fixed exchange rate, by eliminating such uncertainty, promotes the growth of international trade and investment. Advocates of a floating system reply that the forward exchange market ensures against the risks associated with exchange rate fluctua- tions (see Chapter 10), so the adverse impact of uncertainty on the growth of international trade and investment has been overstated.

Trade Balance Adjustments and Economic Recovery Those in favor of floating exchange rates argue that floating rates help adjust trade imbal- ances and can assist with economic recovery after a crisis. Critics question the closeness of the link between the exchange rate, the trade balance, and economic growth. They claim trade deficits are determined by the balance between savings and investment in a country, not by the external value of its currency.7 They argue that depreciation in a currency will lead to inflation (due to the resulting increase in import prices). This inflation, they state, will wipe out any apparent gains in cost competitiveness that arise from currency deprecia- tion. In other words, a depreciating exchange rate will not boost exports and reduce im- ports, as advocates of floating rates claim; it will simply boost price inflation. In support of this argument, those who favor fixed rates point out that the 40 percent drop in the value of the dollar between 1985 and 1988 did not correct the U.S. trade deficit. In reply, advocates of a floating exchange rate regime argue that between 1985 and 1992, the U.S. trade deficit fell from more than $160 billion to about $70 billion, and they attribute this in part to the decline in the value of the dollar. Moreover, the experience of countries like South Korea and Iceland seems to suggest that floating rates can help a country recover from a severe economic crisis.

WHO IS RIGHT?

Which side is right in the vigorous debate between those who favor a fixed exchange rate and those who favor a floating exchange rate? Economists cannot agree. Business, as a major player on the international trade and investment scene, has a large stake in the reso- lution of the debate. Would international business be better off under a fixed regime, or are flexible rates better? The evidence is not clear.

However, a fixed exchange rate regime modeled along the lines of the Bretton Woods system probably will not work. Speculation ultimately broke the system, a phenomenon that advocates of fixed rate regimes claim is associated with floating exchange rates! Nev- ertheless, a different kind of fixed exchange rate system might be more enduring and might foster the stability that would facilitate more rapid growth in international trade and invest- ment. In the next section, we look at potential models for such a system and the problems with such systems.

Exchange Rate Regimes in Practice

Governments around the world pursue a number of different exchange rate policies. These range from a pure “free float” in which the exchange rate is determined by market forces to a pegged system that has some aspects of the pre-1973 Bretton Woods system of fixed ex- change rates. Some 21 percent of the IMF’s members allow their currency to float freely.

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Another 23 percent intervene in only a limited way (the so-called managed float as prac- ticed by China, among other nations). A further 5 percent of IMF members now have no separate legal tender of their own (this figure excludes the European Union countries that have adopted the euro). These are typically smaller states, mostly in Africa or the Caribbean, that have no domestic currency and have adopted a foreign currency as legal tender within their borders, typically the U.S. dollar or the euro. The remaining countries use more inflexible systems, including a fixed peg arrangement (43 percent) under which they peg their currencies to other currencies, such as the U.S. dollar or the euro, or to a basket of currencies. Other countries have adopted a system under which their exchange rate is allowed to fluctuate against other currencies within a target zone (an adjustable peg system). In this section, we look more closely at the mechanics and implications of exchange rate regimes that rely on a currency peg or target zone.

PEGGED EXCHANGE RATES

Under a pegged exchange rate regime, a country will peg the value of its currency to that of a major currency so that, for example, as the U.S. dollar rises in value, its own currency rises too. Pegged exchange rates are popular among many of the world’s smaller nations. As with a full fixed exchange rate regime, the great virtue claimed for a pegged exchange rate is that it imposes monetary discipline on a country and leads to low inflation. For example, if Belize pegs the value of the Belizean dollar to that of the U.S. dollar so that US$1 = B$1.97, then the Belizean government must make sure the inflation rate in Belize is similar to that in the United States. If the Belizean inflation rate is greater than the U.S. inflation rate, this will lead to pressure to devalue the Belizean dollar (i.e., to alter the peg). To maintain the peg, the Belizean government would be required to rein in inflation. Of course, for a pegged exchange rate to impose monetary discipline on a country, the country whose currency is chosen for the peg must also pursue sound monetary policy.

Evidence shows that adopting a pegged exchange rate regime moderates inflationary pressures in a country. An IMF study concluded that countries with pegged exchange rates had an average annual inflation rate of 8 percent, compared with 14 percent for intermedi- ate regimes and 16 percent for floating regimes.8 However, many countries operate with only a nominal peg and in practice are willing to devalue their currency rather than pursue a tight monetary policy. It can be very difficult for a smaller country to maintain a peg against another currency if capital is flowing out of the country and foreign exchange traders are speculating against the currency. Something like this occurred in 1997, when a combination of adverse capital flows and currency speculation forced several Asian coun- tries, including Thailand and Malaysia, to abandon pegs against the U.S. dollar and let their currencies float freely. Malaysia and Thailand would not have been in this position had they dealt with a number of problems that began to arise in their economies during the 1990s, including excessive private-sector debt and expanding current account trade deficits.

CURRENCY BOARDS

Hong Kong’s experience during the 1997 Asian currency crisis added a new dimension to the debate over how to manage a pegged exchange rate. During late 1997, when other Asian currencies were collapsing, Hong Kong maintained the value of its currency against the U.S. dollar at about $1 = HK$7.80 despite several concerted speculative attacks. Hong Kong’s currency board has been given credit for this success. A country that intro- duces a currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate. To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100 percent of the domestic currency issued. The system used in Hong Kong means its currency must be fully backed by the U.S. dollar at the specified exchange rate. This is still not a true fixed exchange rate regime because the U.S. dollar—and, by extension, the Hong Kong dollar—floats against other currencies, but it has some features of a fixed exchange rate regime.

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Under this arrangement, the currency board can issue additional domestic notes and coins only when there are foreign exchange reserves to back it. This limits the ability of the government to print money and, thereby, create inflationary pressures. Under a strict cur- rency board system, interest rates adjust automatically. If investors want to switch out of domestic currency into, for example, U.S. dollars, the supply of domestic currency will shrink. This will cause interest rates to rise until it eventually becomes attractive for inves- tors to hold the local currency again. In the case of Hong Kong, the interest rate on three- month deposits climbed as high as 20 percent in late 1997, as investors switched out of Hong Kong dollars and into U.S. dollars. The dollar peg held, however, and interest rates declined again.

Since its establishment in 1983, the Hong Kong currency board has weathered sev- eral storms. This success persuaded several other countries in the developing world to consider a similar system. Argentina introduced a currency board in 1991 (but aban- doned it in 2002), and Bulgaria, Estonia, and Lithuania have all gone down this road in recent years. Despite interest in the arrangement, however, critics are quick to point out that currency boards have their drawbacks.9 If local inf lation rates remain higher than the inf lation rate in the country to which the currency is pegged, the currencies of countries with currency boards can become noncompetitive and overvalued (this is what happened in the case of Argentina, which had a currency board). Also, under a currency board system, government lacks the ability to set interest rates. Interest rates in Hong Kong, for example, are effectively set by the U.S. Federal Reserve. In addition, economic collapse in Argentina in 2001 and the subsequent decision to abandon its currency board dampened much of the enthusiasm for this mechanism of managing exchange rates.

Crisis Management by the IMF

Many observers initially believed that the collapse of the Bretton Woods system in 1973 would diminish the role of the IMF within the international monetary system. The IMF’s original function was to provide a pool of money from which members could borrow, short term, to adjust their balance-of-payments position and maintain their exchange rate. Some believed the demand for short-term loans would be considerably diminished under a f loating exchange rate regime. A trade deficit would presumably lead to a decline in a country’s exchange rate, which would help reduce imports and boost exports. No temporary IMF adjustment loan would be needed. Consistent with this, after 1973, most industrialized countries tended to let the foreign exchange market determine exchange rates in response to demand and supply. Since the early 1970s, the rapid development of global capital markets has generally allowed developed countries such as Great Britain and the United States to finance their deficits by borrowing private money, as opposed to drawing on IMF funds.

Despite these developments, the activities of the IMF have expanded over the past 30 years. By 2017, the IMF had 189 members, more than 40 of which had some kind of IMF program in place. In 1997, the institution implemented its largest rescue packages until that date, committing more than $110 billion in short-term loans to three troubled Asian countries—South Korea, Indonesia, and Thailand. This was followed by additional IMF rescue packages in Turkey, Russia, Argentina, and Brazil. IMF loans increased again in late 2008 as the global financial crisis took hold. Between 2008 and 2010, the IMF made more than $100 billion in loans to troubled economies such as Latvia, Greece, and Ireland. In April 2009, in response to the growing financial crisis, major IMF members agreed to triple the institution’s resources from $250 billion to $750 bil- lion, thereby giving the IMF the financial leverage to act aggressively in times of global financial crisis.

The IMF’s activities have expanded because periodic financial crises have continued to hit many economies in the post–Bretton Woods era. The IMF has repeatedly lent

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money to nations experiencing financial crises, requesting in return that the govern- ments enact certain macroeconomic policies. Critics of the IMF claim these policies have not always been as beneficial as the IMF might have hoped and, in some cases, may have made things worse. Following the IMF loans to several Asian economies, these criticisms reached new levels, and a vigorous debate was waged as to the appro- priate role of the IMF. In this section, we discuss some of the main challenges the IMF has had to deal with over the past three decades and review the ongoing debate over the role of the IMF.

FINANCIAL CRISES IN THE POST–BRETTON WOODS ERA

A number of broad types of financial crises have occurred over the past 30 years, many of which have required IMF involvement. A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the cur- rency or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates to defend the prevailing exchange rate. This happened in Brazil in 2002, and the IMF stepped in to help stabilize the value of the Brazilian currency on foreign exchange markets by lending it foreign currency. A banking crisis refers to a loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits. This is what happened in Iceland in 2008. The experi- ence of Iceland with the IMF is discussed in depth in the next Country Focus feature. A foreign debt crisis is a situation in which a country cannot service its foreign debt obliga- tions, whether private-sector or government debt. This happened to Greece, Ireland, and Portugal in 2010.

These crises tend to have common underlying macroeconomic causes: high relative price inflation rates, a widening current account deficit, excessive expansion of domestic borrowing, high government deficits, and asset price inflation (such as sharp increases in stock and property prices).10 At times, elements of currency, banking, and debt crises may be present simultaneously, as in the 1997 Asian crisis, the 2000–2002 Argentinean crisis, and the 2010 crisis in Ireland.

To assess the frequency of financial crises, the IMF looked at the macroeconomic per- formance of a group of 53 countries from 1975 to 1997 (22 of these countries were devel- oped nations, and 31 were developing countries).11 The IMF found there had been 158 currency crises, including 55 episodes in which a country’s currency declined by more than 25 percent. There were also 54 banking crises. The IMF’s data suggest that develop- ing nations were more than twice as likely to experience currency and banking crises as developed nations. It is not surprising, therefore, that most of the IMF’s loan activities since the mid-1970s have been targeted toward developing nations.

In 1997, several Asian currencies started to fall sharply as international investors came to the realization that there was a speculative investment bubble in the region. They took their money out of local currencies, changing it into U.S. dollars, and those currencies started to fall precipitously. The currency declines started in Thailand and then, in a process of contagion, quickly spread to other countries in the region. Stabiliz- ing those currencies required massive help from the IMF. In the case of South Korea, local enterprises had built up huge debt loads as they invested heavily in new industrial capacity. By 1997, they found they had too much industrial capacity and could not gen- erate the income required to service their debt. South Korean banks and companies had also made the mistake of borrowing in dollars, much of it in the form of short-term loans that would come due within a year. Thus, when the Korean won started to decline in fall 1997 in sympathy with the problems elsewhere in Asia, South Korean companies saw their debt obligations balloon. Several large companies were forced to file for bankruptcy. This triggered a decline in the South Korean currency and stock market that was difficult to halt.

With its economy on the verge of collapse, the South Korean government requested $20 billion in standby loans from the IMF on November 21. As the negotiations

The IMF and Iceland’s Economic Recovery When the global financial crisis hit in 2008, tiny Iceland suffered more than most. The country’s three biggest banks had been expanding at a breakneck pace since 2000, when the government privatized the banking sec- tor. With a population of around 320,000, Iceland was too small for the banking sector’s ambitions, so the banks started to expand into other Scandinavian countries and the United Kingdom. They entered local mortgage mar- kets, purchased foreign financial institutions, and opened foreign branches—attracting depositors by offering high interest rates. The expansion was financed by debt, much of it structured as short-term loans that had to be regularly refinanced. By early 2008, the three banks held debts that amounted to almost six times the value of the entire economy of Iceland! So long as they could periodi- cally refinance this debt, it was not a problem. However, in 2008, global financial markets imploded following the bankruptcy of Lehman Brothers and the collapse of the U.S. housing market. In the aftermath, financial markets froze. The Icelandic banks found that they could not refi- nance their debt, and they faced bankruptcy. The Icelandic government lacked the funds to bail out the banks, so it decided to let the big three fail. In quick suc- cession, the local stock market plunged 90 percent, and unemployment increased ninefold. The krona, Iceland’s cur- rency, plunged on foreign exchange markets, pushing up the price of imports, and inflation soared to 18 percent. Iceland appeared to be in free fall. The economy shrank by almost 7 percent in 2009 and another 4 percent in 2010. To stem the decline, the government secured $10 bil- lion in loans from the International Monetary Fund (IMF)

and other countries. The Icelandic government stepped in to help local depositors, seizing the domestic assets of the Icelandic banks and using IMF and other loans to backstop deposit guarantees. Far from implementing austerity mea- sures to solve the crisis, the Icelandic government looked for ways to shore up consumer spending. For example, the government provided means-tested subsidies to reduce the mortgage interest expenses of borrowers. The idea was to stop domestic consumer spending from imploding and further depressing the economy. With the financial system stabilized, thanks to the IMF and other foreign loans, what happened next is an object lesson in the value of having a floating currency. The fall in the value of the krona helped boost Iceland’s exports, such as fish and aluminum, while depressing demand for costly imports, such as automobiles. By 2009, the krona was worth half as much against the U.S. dollar and euro as it was in 2007 before the crisis. Iceland’s exports surged and imports slumped. While the high cost of imports did stoke inflation, booming exports started to pump money back into the Icelandic economy. In 2011, the economy grew again at a 3.1 percent annual rate. This was followed by 2.7 percent growth in 2012 and 4 percent growth in 2013, while unemployment fell from a high of nearly 10 per- cent to 4.4 percent at the end of 2013.

Sources: Charles Forelle, “In European Crisis, Iceland Emerges as an Island of Recovery,” The Wall Street Journal, May 19, 2012, pp. A1, A10; “Coming in from the Cold,” The Economist, December 16, 2010; Charles Duxbury, “Europe Gets Cold Shoulder in Iceland,” The Wall Street Journal, April 26, 2012; “Iceland,” The World Factbook 2013 (Washington, DC: Central Intelligence Agency, 2013).

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progressed, it became apparent that South Korea was going to need far more than $20 billion. On December 3, 1997, the IMF and South Korean government reached a deal to lend $55 billion to the country. The agreement with the IMF called for the South Koreans to open their economy and banking system to foreign investors. South Korea also pledged to restrain Korea’s largest enterprises, the chaebol, by reducing their share of bank financing and requiring them to publish consolidated financial statements and undergo annual independent external audits. On trade liberalization, the IMF said South Korea would comply with its commitments to the World Trade Organization to elimi- nate trade-related subsidies and restrictive import licensing and would streamline its import certification procedures, all of which should open the South Korean economy to greater foreign competition.12

The International Monetary System Chapter 11 331

EVALUATING THE IMF’S POLICY PRESCRIPTIONS

By 2017, the IMF had programs in more than 40 countries that were struggling with eco- nomic and/or currency crises. All IMF loan packages come with conditions attached. Until very recently, the IMF has always insisted on a combination of tight macroeconomic policies, including cuts in public spending, higher interest rates, and tight monetary policy. It has also often pushed for the deregulation of sectors formerly protected from domestic and foreign competition, privatization of state-owned assets, and better financial reporting from the banking sector. These policies are designed to cool overheated economies by rein- ing in inflation and reducing government spending and debt. This set of policy prescrip- tions has come in for tough criticisms from many observers, and the IMF itself has started to modify its approach.13

Inappropriate Policies One criticism is that the IMF’s traditional policy prescriptions represent a “one-size-fits-all” approach to macroeconomic policy that is inappropriate for many countries. In the case of the 1997 Asian crisis, critics argue that the tight macroeconomic policies imposed by the IMF were not well suited to countries that are suffering not from excessive government spending and inflation but from a private-sector debt crisis with deflationary undertones.14

In South Korea, for example, the government had been running a budget surplus for years (it was 4 percent of South Korea’s GDP in 1994–1996), and inflation was low at about 5 percent. South Korea had the second-strongest financial position of any country in the Organisation for Economic Co-operation and Development. Despite this, critics say, the IMF insisted on applying the same policies that it applies to countries suffering from high inflation. The IMF required South Korea to maintain an inflation rate of 5 percent. However, given the collapse in the value of its currency and the subsequent rise in price for imports such as oil, critics claimed inflationary pressures would inevitably increase in South Korea. So to hit a 5 percent inflation rate, the South Koreans would be forced to apply an unnecessarily tight monetary policy. Short-term interest rates in South Korea did

The IMF Managing Director Christine Lagarde addresses the Development Committee at the World Bank Headquarters in Washington, DC. ©Stephen Jaffe/IMF/Handout/Getty Images News/Getty Images

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jump from 12.5 to 21 percent immediately after the country signed its initial deal with the IMF. Increasing interest rates made it even more difficult for companies to service their already excessive short-term debt obligations, and critics used this as evidence to argue that the cure prescribed by the IMF may actually increase the probability of widespread corporate defaults, not reduce them.

At the time, the IMF rejected this criticism. According to the IMF, the central task was to rebuild confidence in the won. Once this was achieved, the won would recover from its over- sold levels, reducing the size of South Korea’s dollar-denominated debt burden when ex- pressed in won and making it easier for companies to service their debt. The IMF also argued that by requiring South Korea to remove restrictions on foreign direct investment, foreign capital would flow into the country to take advantage of cheap assets. This, too, would in- crease demand for the Korean currency and help improve the dollar/won exchange rate.

South Korea did recover fairly quickly from the crisis, supporting the position of the IMF. While the economy contracted by 7 percent in 1998, by 2000, it had rebounded and grew at a 9 percent rate (measured by growth in GDP). Inflation, which peaked at 8 per- cent in 1998, fell to 2 percent by 2000, and unemployment fell from 7 to 4 percent over the same period. The won hit a low of $1 = W1,812 in early 1998 but by 2000 was back to an exchange rate of around $1 = W1,200, at which it seems to have stabilized.

Moral Hazard A second criticism of the IMF is that its rescue efforts are exacerbating a problem known to economists as moral hazard. Moral hazard arises when people behave recklessly because they know they will be saved if things go wrong. Critics point out that many Japanese and Western banks were far too willing to lend large amounts of capital to over- leveraged Asian companies during the boom years of the 1990s. These critics argue that the banks should now be forced to pay the price for their rash lending policies, even if that means some banks must close.15 Only by taking such drastic action, the argument goes, will banks learn the error of their ways and not engage in rash lending in the future. By providing support to these countries, the IMF is reducing the probability of debt default and in effect bailing out the banks whose loans gave rise to this situation.

This argument ignores two critical points. First, if some Japanese or Western banks with heavy exposure to the troubled Asian economies were forced to write off their loans due to widespread debt default, the impact would have been difficult to contain. The fail- ure of large Japanese banks, for example, could have triggered a meltdown in the Japanese financial markets. That would almost inevitably lead to a serious decline in stock markets around the world, which was the very risk the IMF was trying to avoid by stepping in with financial support. Second, it is incorrect to imply that some banks have not had to pay the price for rash lending policies. The IMF insisted on the closure of banks in South Korea, Thailand, and Indonesia after the 1997 Asian financial crisis. Foreign banks with short- term loans outstanding to South Korean enterprises have been forced by circumstances to reschedule those loans at interest rates that do not compensate for the extension of the loan maturity.

Lack of Accountability The final criticism of the IMF is that it has become too powerful for an institution that lacks any real mechanism for accountability.16 The IMF has determined macroeconomic policies in those countries, yet according to critics such as noted economist Jeffrey Sachs, the IMF, with a staff of less than 1,000, lacks the expertise required to do a good job. Evi- dence of this, according to Sachs, can be found in the fact that the IMF was singing the praises of the Thai and South Korean governments only months before both countries lurched into crisis. Then the IMF put together a draconian program for South Korea with- out having deep knowledge of the country. Sachs’s solution to this problem is to reform the IMF so it makes greater use of outside experts and its operations are open to greater outside scrutiny.

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Observations As with many debates about international economics, it is not clear which side is correct about the appropriateness of IMF policies. There are cases where one can argue that IMF policies had been counterproductive or only had limited success. For example, one might question the success of the IMF’s involvement in Turkey given that the country has had to implement some 18 IMF programs since 1958! But the IMF can also point to some nota- ble accomplishments, including its success in containing the Asian crisis, which could have rocked the global international monetary system to its core, and its actions in 2008–2010 to contain the global financial crisis, quickly stepping in to rescue Iceland, Ireland, Greece, and Latvia. Similarly, many observers give the IMF credit for its deft handling of politically difficult situations, such as the Mexican peso crisis, and for successfully promoting a free market philosophy.

Several years after the IMF’s intervention, the economy of Asia recovered. Certainly, the kind of catastrophic implosion that might have occurred had the IMF not stepped in had been averted, and although some countries still faced considerable problems, it is not clear that the IMF should take much blame for this. The IMF cannot force countries to adopt the policies required to correct economic mismanagement. While a government may commit to taking corrective action in return for an IMF loan, internal political problems may make it difficult for a government to act on that commitment. In such cases, the IMF is caught between a rock and a hard place, because if it decided to withhold money, it might trigger financial collapse and the kind of contagion that it seeks to avoid.

Finally, it is notable that in recent years the IMF has started to change its policies. In re- sponse to the global financial crisis of 2008–2009, the IMF began to urge countries to adopt policies that included fiscal stimulus and monetary easing—the direct opposite of what the fund traditionally advocated. Some economists in the fund are also now arguing that higher inflation rates might be a good thing, if the consequence is greater growth in aggregate de- mand, which would help pull nations out of recessionary conditions. The IMF, in other words, is starting to display the very flexibility in policy responses that its critics claim it lacks. While the traditional policy of tight controls on fiscal policy and tight monetary policy targets might be appropriate for countries suffering from high inflation rates, the Asian eco- nomic crisis and the 2008–2009 global financial crisis were caused not by high inflation rates but by excessive debt, and the IMF’s “new approach” seems tailored to deal with this.17

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.

F O C U S O N M A N A G E R I A L I M P L I C AT I O N S

CURRENCY MANAGEMENT, BUSINESS STRATEGY, AND GOVERNMENT RELATIONS

The implications for international businesses of the material discussed in this chapter fall into three main areas: currency management, business strategy, and corporate–government relations.

Currency Management An obvious implication with regard to currency manage- ment is that companies must recognize that the foreign exchange market does not work

quite as depicted in Chapter 10. The current system is a mixed system in which a combina- tion of government intervention and speculative activity can drive the foreign exchange market. Companies engaged in significant foreign exchange activities need to be aware of this and to adjust their foreign exchange transactions accordingly. For example, the currency management unit of Caterpillar claims it made millions of dollars in the hours following the announcement of the Plaza Accord by selling dollars and buying currencies that it expected to appreciate on the foreign exchange market following government intervention.

LO 11 - 6 Explain the implications of the global monetary system for management practice.

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Under the present system, speculative buying and selling of currencies can create very volatile movements in exchange rates (as exhibited by the rise and fall of the dollar during the 1980s and the Asian currency crisis of the late 1990s). Contrary to the predictions of the purchasing power parity theory (see Chapter 10), exchange rate movements during the 1980s and 1990s often did not seem to be strongly influenced by relative inflation rates. In- sofar as volatile exchange rates increase foreign exchange risk, this is not good news for business. On the other hand, as we saw in Chapter 10, the foreign exchange market has developed a number of instruments, such as the forward market and swaps, that can help ensure against foreign exchange risk. Not surprisingly, use of these instruments has in- creased markedly since the breakdown of the Bretton Woods system in 1973.

Business Strategy The volatility of the current global exchange rate regime presents a co- nundrum for international businesses. Exchange rate movements are difficult to predict, and yet their movement can have a major impact on a business’s competitive position. For a detailed example, see the accompanying Management Focus on Airbus. Faced with uncer- tainty about the future value of currencies, firms can utilize the forward exchange market, which Airbus has done. However, the forward exchange market is far from perfect as a pre- dictor of future exchange rates (see Chapter 10). It is also difficult, if not impossible, to get adequate insurance coverage for exchange rate changes that might occur several years in the future. The forward market tends to offer coverage for exchange rate changes a few months—not years—ahead. Given this, it makes sense to pursue strategies that will increase the company’s strategic flexibility in the face of unpredictable exchange rate movements— that is, to pursue strategies that reduce the economic exposure of the firm (which we first discussed in Chapter 10). Maintaining strategic flexibility can take the form of dispersing production to different locations around the globe as a real hedge against currency fluctuations (this seems to be what Airbus has considered). Consider the case of Daimler-Benz, Germany’s export- oriented automobile and aerospace company. In June 1995, the company stunned the German business community when it announced it expected to post a severe loss in 1995 of about $720 million. The cause was Germany’s strong currency, which had appreciated by 4 percent against a basket of major currencies since the beginning of 1995 and had risen by more than 30 percent against the U.S. dollar since late 1994. By mid-1995, the exchange rate against the dollar stood at $1 = DM1.38. Daimler’s management believed it could not make money with an exchange rate under $1 = DM1.60. Daimler’s senior manag- ers concluded the appreciation of the mark against the dollar was probably permanent, so they decided to move substantial production outside of Germany and increase purchasing of foreign components. The idea was to reduce the vulnerability of the company to future exchange rate movements. Even before the company’s acquisition of Chrysler Corporation in 1998, the Mercedes-Benz division planned to produce 10 percent of its cars outside Germany by 2000, mostly in the United States. Similarly, the move by Japanese automobile companies to expand their productive capacity in the United States and Europe can be  seen in the context of the increase in the value of the yen between 1985 and 1995, which raised the price of Japanese exports. For the Japanese companies, building produc- tion capacity overseas was a hedge against continued appreciation of the yen (as well as against trade barriers). Another way of building strategic flexibility and reducing economic exposure involves contracting out manufacturing. This allows a company to shift suppliers from country to country in response to changes in relative costs brought about by exchange rate move- ments. However, this kind of strategy may work only for low-value-added manufacturing (e.g., textiles), in which the individual manufacturers have few if any firm-specific skills that contribute to the value of the product. It may be less appropriate for high-value-added man- ufacturing, in which firm-specific technology and skills add significant value to the product (e.g., the heavy equipment industry) and in which switching costs are correspondingly high. For high-value-added manufacturing, switching suppliers will lead to a reduction in the value that is added, which may offset any cost gains arising from exchange rate fluctuations.

M A N A G E M E N T F O C U S

Airbus and the Euro Airbus had reason to celebrate in 2003; for the first time in the company’s history, it delivered more commercial jet air- craft than long-time rival Boeing. Airbus delivered 305 planes in 2003, compared to Boeing’s 281. The celebra- tion, however, was muted because the strength of the euro against the U.S. dollar was casting a cloud over the company’s future. Airbus, which is based in Toulouse, France, prices planes in dollars, just as Boeing has always done. But more than half of Airbus’s costs are in euros. So as the dollar drops in value against the euro—and it dropped by more than 50 percent between 2002 and the end of 2009—Airbus’s costs rise in proportion to its reve- nue, squeezing profits in the process. In the short run, the fall in the value of the dollar against the euro did not hurt Airbus. The company fully hedged its dollar exposure in 2005 and was mostly hedged for 2006. However, anticipating that the dollar would stay weak against the euro, Airbus started to take other steps to re- duce its economic exposure to a strong European cur- rency. Recognizing that raising prices is not an option given the strong competition from Boeing, Airbus decided to focus on reducing its costs. As a step toward doing this, Airbus gave U.S. suppliers a greater share of work on new aircraft models, such as the A380 superjumbo and the A350. It also shifted supply work on some of its older mod- els from European to American-based suppliers. This in- creased the proportion of its costs that were in dollars, making profits less vulnerable to a rise in the value of the euro and reducing the costs of building an aircraft when they were converted back into euros. In addition, Airbus pushed its European-based suppli- ers to start pricing in U.S. dollars. Because the costs of many suppliers were in euros, the suppliers found that to comply with Airbus’s wishes, they too had to move more work to the United States or to countries whose currency is pegged to the U.S. dollar. Thus, one large French-based

supplier, Zodiac, announced that it was considering acqui- sitions in the United States. Not only was Airbus pushing suppliers to price components for commercial jet aircraft in dollars, but the company was also requiring suppliers to its A400M program, a military aircraft that will be sold to European governments and priced in euros, to price com- ponents in U.S. dollars. Beyond these steps, the CEO of EADS, Airbus’s parent company, publicly stated it might be prepared to assemble aircraft in the United States if that would help win important U.S. contracts. While this strat- egy made good sense for years, it worked against Airbus between mid-2014 and 2015 as the dollar rose rapidly against the euro.

Sources: D. Michaels, “Airbus Deliveries Top Boeing’s; But Several Obstacles Remain,” The Wall Street Journal, January 16, 2004, p. A9; J. L. Gerondeau, “Airbus Eyes U.S. Suppliers as Euro Gains,” Seattle Times, February 21, 2004, p. C4; “Euro’s Gains Create Worries in Europe,” HoustonChronicle.com, January 13, 2004, 3; K. Done, “Soft Dollar and A380 Hitches Lead to EADS Losses,” Financial Times, November 9, 2006, p. 32.

Aircraft factory assembly line. ©xenotar/Getty Images

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The roles of the IMF and the World Bank in the current international monetary system also have implications for business strategy. Increasingly, the IMF has been acting as the macro- economic police of the world economy, insisting that countries seeking significant borrow- ings adopt IMF-mandated macroeconomic policies. These policies typically include anti-inflationary monetary policies and reductions in government spending. In the short run, such policies usually result in a sharp contraction of demand. International businesses sell- ing or producing in such countries need to be aware of this and plan accordingly. In the long run, the kind of policies imposed by the IMF can promote economic growth and an expansion of demand, which create opportunities for international business.

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Corporate-Government Relations As major players in the international trade and investment environment, businesses can influence government policy toward the international mone- tary system. For example, intense government lobbying by U.S. exporters helped convince the U.S. government that intervention in the foreign exchange market was necessary. With this in mind, business can and should use its influence to promote an international monetary system that facilitates the growth of international trade and investment. Whether a fixed or floating regime is optimal is a subject for debate. However, exchange rate volatility such as the world experienced during the 1980s and 1990s creates an environment less conducive to international trade and investment than one with more stable exchange rates. Therefore, it would seem to be in the interests of international business to promote an international monetary system that minimizes volatile exchange rate movements, particularly when those movements are unrelated to long-run economic fundamentals.

international monetary system, p. 314

floating exchange rate, p. 314 pegged exchange rate, p. 314 managed-float system, p. 314 dirty-float system, p. 314

fixed exchange rate, p. 314 European Monetary System

(EMS), p. 315 gold standard, p. 315 gold par value, p. 315 balance-of-trade equilibrium, p. 316

currency board, p. 327 currency crisis, p. 329 banking crisis, p. 329 foreign debt crisis, p. 329 moral hazard, p. 332

Key Terms

C H A P T E R S U M M A R Y

This chapter explained the workings of the international monetary system and pointed out its implications for inter- national business. The chapter made the following points:

 1. The gold standard is a monetary standard that pegs currencies to gold and guarantees convert- ibility to gold. It was thought that the gold stan- dard contained an automatic mechanism that contributed to the simultaneous achievement of a balance-of-payments equilibrium by all countries. The gold standard broke down during the 1930s as countries engaged in competitive devaluations.

 2. The Bretton Woods system of fixed exchange rates was established in 1944. The U.S. dollar was the central currency of this system; the value of every other currency was pegged to its value. Significant exchange rate devaluations were allowed only with the permission of the International Monetary Fund (IMF). The role of the IMF was to maintain order in the interna- tional monetary system (a) to avoid a repetition of the competitive devaluations of the 1930s and (b) to control price inflation by imposing mone- tary discipline on countries.

 3. The fixed exchange rate system collapsed in 1973, primarily due to speculative pressure on

the dollar following a rise in U.S. inflation and a growing U.S. balance-of-trade deficit.

 4. Since 1973, the world has operated with a float- ing exchange rate regime, and exchange rates have become more volatile and far less predict- able. Volatile exchange rate movements have helped reopen the debate over the merits of fixed and floating systems.

 5. The case for a f loating exchange rate regime claims (a) such a system gives countries auton- omy regarding their monetary policy and (b) f loating exchange rates facilitate smooth adjustment of trade imbalances.

 6. The case for a fixed exchange rate regime claims (a) the need to maintain a fixed exchange rate imposes monetary discipline on a country; (b) floating exchange rate regimes are vulnerable to speculative pressure; (c) the uncertainty that accompanies floating exchange rates dampens the growth of international trade and investment; and (d) far from correcting trade imbalances, depreciating a currency on the foreign exchange market tends to cause price inflation.

 7. In today’s international monetary system, some countries have adopted floating exchange rates;

The International Monetary System Chapter 11 337

some have pegged their currency to another currency, such as the U.S. dollar; and some have pegged their currency to a basket of other currencies, allowing their currency to fluctuate within a zone around the basket.

 8. In the post–Bretton Woods era, the IMF has continued to play an important role in helping countries navigate their way through financial crises by lending significant capital to embattled governments and by requiring them to adopt certain macroeconomic policies.

 9. An important debate is occurring over the ap- propriateness of IMF-mandated macroeconomic policies. Critics charge that the IMF often

imposes inappropriate conditions on developing nations that are the recipients of its loans.

10. The current managed-float system of exchange rate determination has increased the importance of currency management in international businesses.

11. The volatility of exchange rates under the current managed-float system creates both opportunities and threats. One way of responding to this volatil- ity is for companies to build strategic flexibility and limit their economic exposure by dispersing production to different locations around the globe by contracting out manufacturing (in the case of low-value-added manufacturing) and other means.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Why did the gold standard collapse? Is there a case for returning to some type of gold standard? What is it?

2. What opportunities might current IMF lending policies to developing nations create for interna- tional businesses? What threats might they create?

3. Do you think the standard IMF policy prescriptions of tight monetary policy and reduced government spending are always appropriate for developing na- tions experiencing a currency crisis? How might the IMF change its approach? What would the implica- tions be for international businesses?

4. Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most im- portant criteria in a choice between the systems? Which system is the more desirable for an inter- national business?

5. Imagine that Canada, the United States, and Mexico decide to adopt a fixed exchange rate system. What would be the likely consequences of such a system for (a) international businesses and (b) the flow of trade and investment among the three countries?

6. Reread the Country Focus on the U.S. dollar, oil prices, and recycling petrodollars, then answer the following questions:

a.  What will happen to the value of the U.S. dollar if oil producers decide to invest most of their earnings from oil sales in domestic infrastructure projects?

b.  What factors determine the relative attractive- ness of dollar-, euro-, and yen-denominated as- sets to oil producers flush with petrodollars? What might lead them to direct more funds toward non-dollar-denominated assets?

c.  What will happen to the value of the U.S. dollar if OPEC members decide to invest more of their petrodollars toward non-dollar- denominated assets, such as euro-denominated stocks and bonds?

d.  In addition to oil producers, China is also ac- cumulating a large stock of dollars, currently estimated to total $3.3 trillion. What would happen to the value of the dollar if China and oil-producing nations all shifted out of dollar- denominated assets at the same time? What would be the consequence for the U.S. economy?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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

1. The Global Financial Stability Report is a semian- nual report published by the International Capital Markets division of the International Monetary Fund. The report includes an assess- ment of the risks facing the global financial markets. Locate and download the latest report

to get an overview of the most important issues currently under discussion. Also, download a report from five years ago. How do issues from five years ago compare with financial issues identified in the current report?

2. An important element to understanding the in- ternational monetary system is keeping updated on current growth trends worldwide. A German

C L O S I N G C A S E

China’s Exchange Rate Regime

338 Part 4 The Global Monetary System

For years, there have been claims from politicians in the United States that the Chinese actively manipulate their currency, the yuan, keeping its value low against the dol- lar and other major currencies in order to boost Chinese exports. In November 2015, for example, presidential hopeful Donald Trump claimed that “the wanton ma- nipulation of China’s currency” is “robbing Americans of billions of dollars in capital and millions of jobs.”18 But is this claim true? Would it even be possible for China to manipulate the foreign exchange markets to ar- tificially depress the value of their currency? To answer these questions, one needs to look at the history of ex- change rate determination for China and understand something about how the international monetary sys- tem actually works. For most of its history, the Chinese yuan was pegged to the U.S. dollar at a fixed exchange rate. When China started to open up its economy to foreign trade and in- vestment in the 1980s, the yuan was devalued by the Chinese government in order to improve the competi- tiveness of Chinese exports. Thus, the official yuan/ USD pegged exchange rate was increased from 1.50 yuan per U.S. dollar in 1980 to 8.62 yuan per U.S. dollar in 1994. With China’s exports growing and the country running a growing current account trade surplus, pres- sure began to increase for China to let its currency appreciate. In response, between 1997 and 2005, the exchange rate was fixed at 8.27 yuan per U.S. dollar, which represented a small appreciation. One could argue that during this period, China’s currency was indeed undervalued and that this was the result of government policy. By the 2000s, China’s growing importance in the global economy and the rise of its export-led economy led to calls for the country to reevaluate its fixed exchange rate policy. In response, in July 2005, the country ad- opted a managed floating exchange rate system. Under this system, the exchange rate for the yuan was set with

reference to a basket of foreign currencies that included the U.S. dollar, the euro, the Japanese yen, and the British pound. The daily exchange rate was allowed to f loat within a narrow band of 0.3 percent around the central parity. The daily band was extended to 0.5 percent in 2007, 1 percent in 2012, and 2 percent in 2014. Over time, this managed-float system allowed for the appreciation of the Chinese yuan. For example, against the U.S. dollar, the exchange rate changed from 8.27 yuan per dollar in mid-2005 to 6.0875 yuan per U.S. dollar on July 20, 2015, representing an appreciation of 26 percent. More generally, the effective exchange rate index of the yuan against a basket of more than 60 other currencies increased from 86.3 in July 2005 to 123.8 by early 2016, representing as appreciation of 43 percent. The yuan has appreciated by less than this against the U.S. dollar pri- marily because the U.S. dollar has also been relatively strong and appreciated against many other currencies over the same time period. These data suggest that rather than artificially try- ing to keep its currency undervalued, since July 2005, the Chinese have allowed the yuan to increase in value against other currencies, albeit within the constraints imposed by the managed f loat. In late 2015, this com- mitment was put to the test when a slowdown in the rate of growth of the Chinese economy led to an outf low of capital from China, which put downward pressure on the yuan. The Chinese responded by trying to maintain the value of the yuan, using its foreign exchange reserves, which are primarily held in U.S. dollars, to buy yuan on the open market and shore up its value. Reports suggest that China spent $500 bil- lion in 2015 to shore up the value of the yuan and more than $1 trillion in 2016. These actions reduced China’s foreign exchange reserves to $3.011 trillion by January 2017, the lowest level since 2012. China appears to be trying to keep the yuan from depreciating below 7 yuan to the U.S. dollar.

colleague told you yesterday that Deutsche Bank Research provides an effective way to stay informed on important topics in international finance from a European perspective. One area of focus for the site is emerging markets and

economic and financial challenges faced by these markets. Find an emerging market research report for analysis. On which emerging market region did you choose to focus? What are the key takeaways from your chosen report?

The International Monetary System Chapter 11 339

One reason for China to protect the value of the yuan against the dollar: A large number of Chinese companies have dollar-denominated debt. If the yuan falls against the dollar, the price of serving that debt goes up when translated into yuan. This could stress the financials of those companies (possibly pushing some into bank- ruptcy) and make it more difficult for China to hit the government’s economic growth targets. Another reason: China might want to head off charges from the Trump administration that it continues to keep the value of its currency artificially low.

Sources: T. Hult, “The U.S. Shouldn’t Fret over Cheaper Yuan,” Time, August 14, 2015; “The Yuan and the Markets,” The Economist, January 16, 2016; Madison Gesiotto, “The Negative Effects of China’s Currency Manipulation Explained,” Washington Times, November 13, 2015; Matthew Slaughter, “The Myths of China’s Currency Manipulation,” The Wall Street Journal, January 8, 2016; “The Curious Case of China's Currency,” The Economist, August 11, 2015; L. Wei, “China Foreign Exchange Reserves Keep Dropping,” The Wall Street Journal, January 8, 2017.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Why do you think that the Chinese historically

pegged the value of the yuan to the U.S. dollar? 2. Why did the Chinese move to a managed-float

system in 2005? 3. What are the benefits that China might gain by

allowing the yuan to float freely against other major currencies such as the U.S. dollar and the euro? What are the risks? What do you think they should do?

4. Is there any evidence that the Chinese kept the level of its currency artificially low in the past to boost exports? Is China keeping it artificially low today?

5. What policy stance should the United States and the EU adopt toward China with regard to how it manages the value of its currency?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

E n d n o t e s

 1. The argument goes back to eighteenth-century philosopher David Hume. See D. Hume, “On the Balance of Trade,” reprinted in The Gold Standard in Theory and in History, ed. B. Eichengreen (London: Methuen, 1985).

 2. R. Solomon, The International Monetary System, 1945–1981 (New York: Harper & Row, 1982).

 3. International Monetary Fund, World Economic Outlook, 2005 (Washington, DC: IMF, May 2005).

 4. For an extended discussion of the dollar exchange rate in the 1980s, see B. D. Pauls, “US Exchange Rate Policy: Bretton Woods to the Present,” Federal Reserve Bulletin, November 1990, pp. 891–908.

 5. R. Miller, “Why the Dollar Is Giving Way,” BusinessWeek, December 6, 2004, pp. 36–37.

 6. For a feel for the issues contained in this debate, see P. Krugman, Has the Adjustment Process Worked? (Washington, DC: Institute for International Economics, 1991); “Time to Tether Curren- cies,” The Economist, January 6, 1990, pp. 15–16; P. R. Krugman and M. Obstfeld, International Economics: Theory and Policy (New York: HarperCollins, 1994); J. Shelton, Money Meltdown (New York: Free Press, 1994); S. Edwards, “Exchange Rates and the Political Economy of Macroeconomic Discipline,” American Economic Review 86, no. 2 (May 1996), pp. 159–63.

 7. The argument is made by several prominent economists, particu- larly Stanford University’s Robert McKinnon. See R. McKinnon, “An International Standard for Monetary Stabilization,” Policy Analyses in International Economics 8 (1984). The details of this

argument are beyond the scope of this book. For a relatively accessible exposition, see P. Krugman, The Age of Diminished Expectations (Cambridge, MA: MIT Press, 1990).

 8. A. R. Ghosh and A. M. Gulde, “Does the Exchange Rate Regime Matter for Inflation and Growth?” Economic Issues, no. 2 (1997).

 9. “The ABC of Currency Boards,” The Economist, November 1, 1997, p. 80.

10. International Monetary Fund, World Economic Outlook, 1998 (Washington, DC: IMF, 1998).

11. International Monetary Fund, World Economic Outlook, 1998 (Washington, DC: IMF, 1998).

12. T. S. Shorrock, “Korea Starts Overhaul; IMF Aid Hits $55 Billion,” Journal of Commerce, December 8, 1997, p. 3A.

13. See J. Sachs, “Economic Transition and Exchange Rate Regime,” American Economic Review 86, no. 92 (May 1996), pp. 147–52; J. Sachs, “Power unto Itself,” Financial Times, December 11, 1997, p. 11.

14. Sachs, “Power unto Itself.”

15. Martin Wolf, “Same Old IMF Medicine,” Financial Times, December 9, 1997, p. 12.

16. Sachs, “Power unto Itself.”

17. “New Fund, Old Fundamentals,” The Economist, May 2, 2009, p. 78.

18. Matthew Slaughter, “The Myths of China’s Currency Manipulation,” The Wall Street Journal, January 8, 2016.

The Global Capital Market L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO12-1 Describe the benefits of the global capital market.

LO12-2 Identify why the global capital market has grown so rapidly.

LO12-3 Understand the risks associated with the globalization of capital markets.

LO12-4 Compare and contrast the benefits and risks associated with the Eurocurrency market, the global bond market, and the global equity market.

LO12-5 Understand how foreign exchange risks affect the cost of capital.

12

©Hassan Ammar/AFP/Getty Images

part four The Global Monetar y System

Saudi Aramco 

lists 170 companies and has a total market capitalization of around $350 billion. Offering 5 percent of Saudi Aramco through the Tadawul will not result in a high price for the stock; there is simply not enough local demand to support that. The only way to raise $100 billion is to offer stock of Saudi Aramco for sale not just on the Tadawul, but also on one or more additional large and highly liquid stock mar- kets. The exchanges being considered include New York, London, and Singapore. For example, with a market capi- talization of more than $20 trillion, the New York Stock Ex- change is far more able to absorb the offering than the Tadawul. Listing on multiple exchanges will make the IPO available to a much wider pool of investors, thus poten- tially increasing demand and driving up the price, making it more likely that the Saudi government will hit its target of raising $100 billion. If Saudi Aramco does list on larger exchanges, which seems highly likely, it will have to abide by the strict ac- counting regulations and reporting requirements of those markets. Regular financial reporting will increase the transparency of Saudi Aramco, which in turn will in- crease investor confidence in the IPO and thus increase demand and drive up the market price of the stock. An- other benefit of listing on multiple exchanges is that it will make it easier for Saudi Aramco to undertake addi- tional stock offerings down the road and to issue debt securities in those markets. Right now, the IPO is being planned for 2018.

Sources: J. Blas and W. Mahdi, “Saudi Arabia's Oil Wealth Is about to Get a Reality Check,” Bloomberg, February 23, 2017; M. Farrell and N. Parasie, “Saudi Aramco IPO: The Biggest Fee Event in Wall Street History,” The Wall Street Journal, June 9, 2016; J. Everington, “Saudi Aims to Double the Size of the Stock Market,” The National, April 5, 2016.

O P E N I N G C A S E In 2015, the government of Saudi Arabia announced an ambitious plan, known as Vision 2030, to diversify the economy beyond oil. Saudi’s plans to modernize its econ- omy will require copious funding, something that will strain the finances of the desert kingdom. The country relies heavily on oil, with 87 percent of the budget, 42 percent of GDP, and 90 percent of export earnings being derived from oil revenues. As a consequence of lower oil prices and higher government outlays, the Saudi government has recently been running large budget deficits. In 2016, the deficit hit $90 billion, or 13 percent of GDP. To raise the funds for Vision 2030, therefore, the government decided to sell off shares in Saudi Aramco, the state-run oil com- pany that has exclusive control over Saudi Arabia’s oil reserves. Saudi Aramco is one of the largest enterprises on earth. Saudi Arabia possesses about 16 percent of the world’s oil reserves, including some of the lowest cost reserves on the planet. This gives Saudi Aramco 10 times the reserves of the largest private oil company, ExxonMobil. Saudi gov- ernment estimates suggest that Saudi Aramco is worth $2 trillion. Based on this valuation, the government is pro- posing to sell 5 percent of the shares of Saudi Aramco to private investors, which would raise $100 billion in capital for the government—enough to fund aggressive invest- ments in non-oil ventures to support Vision 2030. If this comes to pass, the initial public offering (IPO) of Saudi Aramco will be the largest in history by a wide margin. Raising $100 billion in capital has its challenges, not least of which is that the Saudi stock exchange, or Tadawul, is far too small and illiquid to absorb such a massive stock offering. As it stands, the entire Saudi stock market only

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342 Part 4 The Global Monetary System

Introduction

Over the last 30 years, we have moved from a world in which national capital markets were segmented from each other by regulatory barriers to capital flows toward a world in which the capital market is becoming increasingly global. This has clear benefits for corporations, but as we shall see, it also comes with some risks. The opening case touches on some of the issues here. Nowadays, it is fairly routine for large stock offerings to be sold simultaneously on multiple markets. The opening case illustrates why. The ability of Saudi Aramco to offer 5 percent of its stock for sale to private investors in multiple markets—including, possibly, through stock exchanges in Saudi Arabia, New York, London, and (perhaps) Singapore— will increase demand for the stock and make it easier for the company to raise the required capital from the sale of its equity. Listing on foreign exchanges will also pave the way for Saudi Aramco to raise additional capital in the future, whether that be from further equity offerings or from debt offerings.

This chapter looks at the global market for capital. We begin by studying the benefits associated with the globalization of capital markets. This is followed by a more detailed look at the growth of the international capital market and the macroeconomic risks associ- ated with such growth. Next, we review three important segments of the global capital market: the Eurocurrency market, the international bond market, and the international equity market. As usual, we close the chapter by pointing out some of the implications for the practice of international business.

Benefits of the Global Capital Market

Although this section is about the global capital market, it opens by discussing the functions of a generic capital market. Then we look at the limitations of domestic capital markets and discuss the benefits of using global capital markets.

FUNCTIONS OF A GENERIC CAPITAL MARKET

Capital markets bring together those who want to invest money and those who want to borrow money (see Figure 12.1). Those who want to invest money include corporations with surplus cash, individuals, and nonbank financial institutions (e.g., pension funds, in- surance companies). Those who want to borrow money include individuals, companies, and governments. Between these two groups are the market makers. Market makers are the financial service companies that connect investors and borrowers, either directly or indi- rectly. They include commercial banks (e.g., Citi, Bank of America) and investment banks (e.g., Goldman Sachs, J.P.Morgan).

Commercial banks perform an indirect connection function. They take cash deposits from corporations and individuals and pay them a rate of interest in return. They then lend that money to borrowers at a higher rate of interest, making a profit from the difference in interest rates (commonly referred to as the interest rate spread). Investment banks perform a direct connection function. They bring investors and borrowers together and charge com- missions for doing so. For example, Goldman Sachs may act as a stockbroker for an indi- vidual who wants to invest some money. Its personnel will advise her as to the most attractive purchases and buy stock on her behalf, charging a fee for the service.

LO 12-1 Describe the benefits of the global capital market.

F I G U R E 1 2 .1

The main players in the generic capital market.

Investors: Companies Individuals Institutions

Market Makers: Commercial Bankers Investment Bankers

Borrowers: Individuals Companies Governments

The Global Capital Market Chapter 12 343

Capital market loans to corporations are either equity loans or debt loans. An equity loan is made when a corporation sells stock to investors (as Saudi Aramco is planning to do in 2018; see the opening case). The money the corporation receives in return for its stock can be used to purchase plants and equipment, fund R&D projects, pay wages, and so on. A share of stock gives its holder a claim to a firm’s profit stream. Ultimately, the corporation honors this claim by paying dividends to the stockholders (although many fast-growing young corporations do not start to issue dividends until the business has ma- tured and growth rate slows). The amount of the dividends is not fixed in advance. Rather, it is determined by management based on how much profit the corporation is making. In- vestors purchase stock both for its dividend yield and in anticipation of gains in the price of the stock, which in theory reflects future dividend yields. Stock prices increase when a corporation is projected to have greater earnings in the future, which increases the probability that it will raise future dividend payments.

A debt loan requires the corporation to repay a predetermined portion of the loan amount (the sum of the principal plus the specified interest) at regular intervals regardless of how much profit it is making. Management has no discretion as to the amount it will pay investors. Debt loans include cash loans from banks and funds raised from the sale of corporate bonds to investors. When an investor purchases a corporate bond, he purchases the right to receive a specified fixed stream of income from the corporation for a specified number of years (i.e., until the bond maturity date). The maturity period of debt loans vary from the very long term, such as 20 years, to extremely short-term loans, including those with a maturity of just one day.

G L O S S A R Y

Our International Business textbook covers what is commonly referred to as a “survey” of topics in international business. As such, the book includes a lot of terms, definitions, and technical language associated with international business and worldwide trade. One such chapter topic that covers a lot of important details is this chapter on global capital markets. While our goal is to provide readers of the textbook with state-of-the-art knowledge, every possible term and definition that may be important when conducting international business around the world cannot be covered in our textbook (due to space and volume of terms). Instead, globalEDGE provides several hundred relevant terms and definitions. They may become valuable to better understand certain scenarios in our book as well as, most impor- tantly, to better understand practical scenarios that you may encounter in the workplace. As related to this Chapter 12 (and also all other chapters), check out globalEDGE’s glossary sec- tion at globaledge.msu.edu/reference-desk/glossary. View the glossary, definitions, and breadth of terminology as a quick examination of your understanding of the main issues in international business.

ATTRACTIONS OF THE GLOBAL CAPITAL MARKET

A global capital market benefits both borrowers and investors. It benefits borrowers by increasing the supply of funds available for borrowing and by lowering the cost of capital. It benefits investors by providing a wider range of investment opportunities, thereby allow- ing them to build portfolios of international investments that diversify their risks.

The Borrower’s Perspective: Lower Cost of Capital In a purely domestic capital market, the pool of investors is limited to residents of the country. This places an upper limit on the supply of funds available to borrowers. In other

344 Part 4 The Global Monetary System

words, the liquidity of the market is limited. A global capital market, with its much larger pool of investors, provides a larger supply of funds for borrowers to draw on.

Perhaps the most important drawback of the limited liquidity of a purely domestic capital market is that the cost of capital tends to be higher than it is in a global market. The cost of capital is the price of borrowing money, which is the rate of return that borrowers must pay investors. This is the interest rate on debt loans and the dividend yield and ex- pected capital gains on equity loans. In a purely domestic market, the limited pool of inves- tors implies that borrowers must pay more to persuade investors to lend them their money. The larger pool of investors in an international market implies that borrowers will be able to pay less.

The argument is illustrated in Figure 12.2, using Deutsche Telekom, the German tele- communications company, as an example. In 1996, in what was one of the first major global offerings, Deutsche Telekom raised more than $13 billion by simultaneously offer- ing shares for sales in Frankfurt, New York, London, and Tokyo. The vertical axis in Fig- ure 12.2 is the cost of capital (the price of borrowing money), and the horizontal axis is the amount of money available at varying interest rates. The Deutsche Telekom demand curve for borrowings is DD. Note that the Deutsche Telekom demand for funds varies with the cost of capital; the lower the cost of capital, the more money Deutsche Telekom will borrow. (Money is just like anything else; the lower its price, the more of it people can af- ford.) The supply curve of funds available in the German capital market is SSG, and the funds available in the global capital market is represented by SSI. Note that Deutsche Telekom can borrow more funds more cheaply on the global capital market. As Figure 12.2 illustrates, the greater pool of resources in the global capital market—the greater liquidity—both lowers the cost of capital and increases the amount Deutsche Telekom can borrow. Thus, the advantage of a global capital market to borrowers is that it lowers the cost of capital.

Problems of limited liquidity are not restricted to less developed nations, which nat- urally tend to have smaller domestic capital markets. In recent decades, even very large enterprises based in some of the world’s largest economies have tapped the interna- tional capital markets in their search for greater liquidity and a lower cost of capital. One of the largest offerings of the global capital market era was that of the Industrial and Commercial Bank of Japan, which is discussed below in the next Management Focus.1

F I G U R E 1 2 . 2

Market liquidity and the cost of capital.

D

C o

st o

f C

ap it

al

D2D1

SSG SSI

D

10%

Dollars

9

0

M A N A G E M E N T F O C U S

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The Industrial and Commercial Bank of China Taps the Global Capital Market In October 2006, the Industrial and Commercial Bank of China, or ICBC, successfully completed what was then the world’s largest ever initial public offering (IPO), raising some $21 billion. It beat Japan’s 1998 IPO of NTT DoCoMo by a wide margin to earn a place in the record books (NTT raised $18.4 billion in its IPO).  The ICBC offering followed the IPOs of a number of other Chinese banks and corporations. Indeed, Chinese enterprises had been regularly tapping global capital mar- kets for the prior decade as the Chinese have sought to fortify the balance sheets of the country’s largest compa- nies, to improve corporate governance and transparency, and to give China’s industry leaders global recognition. Between 2000 and 2006, Chinese companies raised more than $100 billion from the equity markets. About half of that came in 2005 and 2006, largely from the country’s biggest banks. Shares sold by Chinese companies are also accounting for a greater share of global equity sales— about 10 percent in 2006 compared to 2.8 percent in 2001, surpassing the total amount raised by companies in the world’s then-second-largest economy, Japan. To raise this amount of capital, Chinese corporations have been aggressively courting international investors. In the case of ICBC, it simultaneously listed its IPO shares on the Shanghai stock exchange and the Hong Kong ex- change. The rationale for the Hong Kong listing was that regulations in Hong Kong are in accordance with inter- national standards, while those in Shanghai have some

way  to go. By listing in Hong Kong, ICBC signaled to potential investors that it would adhere to the strict report- ing and governance standards expected of the top global companies. The ICBC listing attracted considerable interest from foreign investors, who saw it as a way to invest in the Chinese economy. ICBC has a nationwide bank network of more than 18,000 branches, the largest in the nation. It claims 2.5 million corporate customers and 150 million per- sonal accounts. Some 1,000 institutions from across the globe reportedly bid for shares in the IPO. Total orders from these institutions were equivalent to 40 times the amount of stock offered for sale. In other words, the offer- ing was massively oversubscribed. Indeed, the issue gen- erated a total demand of some $430 billion, almost twice the value of Citi, the world’s largest bank by market capital- ization. The listing on Hong Kong attracted some $350 bil- lion in orders from global investors, more than any other offering in Hong Kong’s history. The domestic portion of the stock sales, through the Shanghai exchange, attracted some $80 billion in orders. This massive oversubscription enabled ICBC to raise the issuing price for its shares and reap some $2 billion more than planned.

Sources: K. Linebaugh, “Record IPO Could Have Been Even Bigger,” The Wall Street Journal, October 21, 2006, p. B3; “Deals That Changed the Market in 2006: ICBC’s Initial Public Offering,” Euro- money, February 7, 2007, p. 1; T. Mitchell, “ICBC Discovers That Good Things Come to Those Who Wait,” Financial Times, October 26, 2006, p. 40.

The Investor’s Perspective: Portfolio Diversification By using the global capital market, investors have a much wider range of investment op- portunities than in a purely domestic capital market. The most significant consequence of this choice is that investors can diversify their portfolios internationally, thereby reducing their risk to less than what could be achieved in a purely domestic capital market. We con- sider how this works in the case of stock holdings, although the same argument could be made for bond holdings.

Consider an investor who buys stock in a biotech firm that has not yet produced a new product. Imagine the price of the stock is very volatile—investors are buying and selling the stock in large numbers in response to information about the firm’s prospects. Such stocks are risky investments; investors may win big if the firm produces a marketable product; but investors may also lose all their money if the firm fails to come up with a product that sells. Investors can guard against the risk associated with holding this stock by buying other firms’ stocks, particularly those weakly or negatively correlated with the biotech stock. By holding a variety of stocks in a diversified portfolio, the losses incurred when some stocks fail to live up to their promise are offset by the gains enjoyed when other stocks exceed their promise.

346 Part 4 The Global Monetary System

As an investor increases the number of stocks in her portfolio, the portfolio’s risk de- clines. At first, this decline is rapid. Soon, however, the rate of decline falls off and asymp- totically approaches the systematic risk of the market. Systematic risk refers to movements in a stock portfolio’s value that are attributable to macroeconomic forces affecting all firms in an economy, rather than factors specific to an individual firm. The systematic risk is the level of nondiversifiable risk in an economy. Data from a classic study by Solnik2 sug- gested that a fully diversified U.S. portfolio is only about 27 percent as risky as a typical individual stock.

By diversifying a portfolio internationally, an investor can reduce the level of risk even further because the movements of stock market prices across countries are not perfectly correlated. For example, one study looked at the correlation among three stock market in- dexes. The Standard & Poor’s 500 (S&P 500) summarized the movement of large U.S. stocks. The Morgan Stanley Capital International Europe, Australia, and Far East Index (EAFE) summarized stock market movements in other developed nations. The third index, the International Finance Corporation Global Emerging Markets Index (IFC), summarized stock market movements in less developed “emerging economies.” From 1981 to 1994, the correlation between the S&P 500 and EAFE indexes was 0.45, suggesting they moved to- gether only about 20 percent of the time (i.e., 0.45 × 0.45 = 0.2025). The correlation be- tween the S&P 500 and IFC indexes was even lower at 0.32, suggesting they moved together only a little more than 10 percent of the time.3 Other studies have confirmed that despite casual observations, different national stock markets appear to be only moderately corre- lated. One study found that between 1972 and 2000 the average pair-wise correlation be- tween the world’s four largest equity markets in the United States, United Kingdom, Germany, and Japan was 0.475, suggesting that these markets moved in tandem only about 22 percent of the time (0.475 × 0.472 = 0.22 or 22 percent of shared variance).4

The relatively low correlation between the movement of stock markets in different coun- tries reflects two basic factors. First, countries pursue different macroeconomic policies and face different economic conditions, so their stock markets respond to different forces and can move in different ways. For example, in 1997, the stock markets of several Asian countries, including South Korea, Malaysia, Indonesia, and Thailand, lost more than 50 percent of their value in response to the Asian financial crisis, while at the same time the S&P 500 increased in value by more than 20 percent. Second, some stock markets are still somewhat segmented from each other by capital controls—that is, by restrictions on cross-border capital flows (although as noted earlier, such restrictions are declining rap- idly). The most common restrictions include limits on the amount of a firm’s stock that a foreigner can own and limits on the ability of a country’s citizens to invest their money outside that country. For example, until recently it was difficult for foreigners to own more than 30 percent of the equity of South Korean enterprises. Such barriers to cross-border capital flows limit the ability of capital to roam the world freely in search of the highest risk-adjusted return. Consequently, at any one time there may be too much capital invested in some markets and too little in others. This will tend to produce differences in rates of return across stock markets.5 The implication is that by diversifying a portfolio to include foreign stocks, an investor can reduce the level of risk below that incurred by holding only domestic stocks.

According to the classic study by Bruno Solnik,6 a fully diversified portfolio that con- tains stocks from many countries is less than half as risky as a fully diversified portfolio that contains only U.S. stocks. Solnik found that a fully diversified portfolio of interna- tional stocks is only about 12 percent as risky as a typical individual stock, whereas a fully diversified portfolio of U.S. stocks is about 27 percent as risky as a typical individual stock.

There is a perception, increasingly common among investment professionals, that the growing integration of the global economy and the emergence of the global capital market have increased the correlation between different stock markets, reducing the benefits of international diversification.7 Today, it is argued, if the U.S. economy enters a recession, and the U.S. stock market declines rapidly, other markets follow suit. Indeed, this is what seems to have occurred in 2008 and 2009 as the financial crisis that started in the United

The Global Capital Market Chapter 12 347

States swept around the world. Another study by Solnik suggests there may be some truth to this assertion, but the rate of integration is not occurring as rapidly as the popular per- ception would lead one to believe. Solnik and his associate looked at the correlation be- tween 15 major stock markets in developed countries between 1971 and 1998. They found that on average, the correlation of monthly stock market returns increased from 0.66 in 1971 to 0.75 in 1998, indicating some convergence over time, but that “the regression re- sults were weak,” which suggests that this “average” relationship was not strong and that there was considerable variation among countries.8 Similarly, a more recent study con- firmed this basic finding, suggesting that even today, most of the time a portfolio equally diversified across all available markets can reduce portfolio risk to about 35 percent of the volatility associated with a single market (i.e., a 65 percent reduction in risk).9

The implication here is that international portfolio diversification can still reduce risk. Moreover, the correlation between stock market movements in developed and emerging markets seems to be lower, and the rise of stock markets in developing nations, such as China, has given international investors many more opportunities for international portfo- lio diversification.10

The risk-reducing effects of international portfolio diversification would be greater were it not for the volatile exchange rates associated with the current floating exchange rate re- gime. Floating exchange rates introduce an additional element of risk into investing in foreign assets. As we have said repeatedly, adverse exchange rate movements can trans- form otherwise profitable investments into unprofitable investments. The uncertainty en- gendered by volatile exchange rates may be acting as a brake on the otherwise rapid growth of the international capital market.

GROWTH OF THE GLOBAL CAPITAL MARKET

According to data from the Bank for International Settlements, the global capital mar- ket is growing at a rapid pace. Stocks, bonds, and bank loans currently total around $300 trillion, more than three times the size of the world economy.11 There seem to be two factors driving this growth—advances in information technology and deregulation by governments.

Information Technology Financial services is an information-intensive industry. It draws on large volumes of infor- mation about markets, risks, exchange rates, interest rates, creditworthiness, and so on. It uses this information to make decisions about what to invest where, how much to charge borrowers, how much interest to pay to depositors, and the value and riskiness of a range of financial assets including corporate bonds, stocks, government securities, and currencies.

Because of this information intensity, the financial services industry has been revolu- tionized more than any other industry by advances in information technology since the 1970s. The growth of international communications technology has facilitated instanta- neous communication between any two points on the globe. At the same time, rapid ad- vances in data processing capabilities have allowed market makers to absorb and process large volumes of information from around the world. According to one study, because of these technological developments, the real cost of recording, transmitting, and processing information fell by 95 percent between 1964 and 1990.12 With the rapid rise of the Internet and the massive increase in computing power that we have seen since 1990, it seems likely that the cost of recording, transmitting, and processing information has fallen by a similar amount since 1990 and is now trivial.

Such developments have facilitated the emergence of an integrated international capital market. It is now technologically possible for financial services companies to engage in 24-hour-a-day trading, whether it is in stocks, bonds, foreign exchange, or any other finan- cial asset. Due to advances in communications and data processing technology, the inter- national capital market never sleeps. San Francisco closes one hour before Tokyo opens, but during this period trading continues in New Zealand.

LO 12-2 Identify why the global capital market has grown so rapidly.

348 Part 4 The Global Monetary System

The integration facilitated by technology has a dark side.13 “Shocks” that occur in one financial center now spread around the globe very quickly. For example, the financial cri- sis that began in the United States in 2008 quickly spread around the globe. However, most market participants would argue that the benefits of an integrated global capital market far outweigh any potential costs. Moreover, despite the fact that shocks in national financial markets do seem to spill over into other markets, on average the correlation between move- ments in national equity markets remains relatively low, suggesting that such shocks may have a relatively moderate long-term impact outside their home market.14

Deregulation In country after country, financial services has historically been the most tightly regulated of all industries. Governments around the world have traditionally kept other countries’ financial service firms from entering their capital markets. In some cases, they have also restricted the overseas expansion of their domestic financial services firms. In many coun- tries, the law has also segmented the domestic financial services industry. In the United States, for example, until the late 1990s commercial banks were prohibited from perform- ing the functions of investment banks, and vice versa. Historically, many countries have limited the ability of foreign investors to purchase significant equity positions in domestic companies. They have also limited the amount of foreign investment that their citizens could undertake. In the 1970s, for example, capital controls made it very difficult for a British investor to purchase American stocks and bonds.

Many of these restrictions have been crumbling since the early 1980s. In part, this has been a response to the development of the Eurocurrency market, which from the begin- ning was outside national control. (This is explained later in the chapter.) It has also been a response to pressure from financial services companies, which have long wanted to oper- ate in a less regulated environment. Increasing acceptance of the free market ideology as- sociated with an individualistic political philosophy also has a lot to do with the global trend toward the deregulation of financial markets (see Chapter 2). Whatever the reason, deregulation in a number of key countries has undoubtedly facilitated the growth of the international capital market.

The trend began in the United States in the late 1970s and early 1980s with a series of changes that allowed foreign banks to enter the U.S. capital market and domestic banks to expand their operations overseas. In Great Britain, the so-called Big Bang of October 1986 removed barriers that had existed between banks and stockbrokers and allowed foreign fi- nancial service companies to enter the British stock market. Restrictions on the entry of foreign securities houses have been relaxed in Japan, and Japanese banks are now allowed to open international banking facilities. In France, the “Little Bang” of 1987 opened the French stock market to outsiders and to foreign and domestic banks. In Germany, foreign banks are now allowed to lend and manage foreign euro issues, subject to reciprocity agree- ments.15 All of this has enabled financial services companies to transform themselves from primarily domestic companies into global operations with major offices around the world— a prerequisite for the development of a truly international capital market. As we saw in Chapter 8, in late 1997 the World Trade Organization brokered a deal that removed many of the restrictions on cross-border trade in financial services. This deal facilitated further growth in the size of the global capital market.

In addition to the deregulation of the financial services industry, many countries beginning in the 1970s started to dismantle capital controls, loosening both restrictions on inward investment by foreigners and outward investment by their own citizens and corpo- rations. By the 1980s, this trend spread from developed nations to the emerging econo- mies of the world as countries across Latin America, Asia, and eastern Europe started to dismantle decades-old restrictions on capital flows.

The trends toward deregulation of financial services and removal of capital controls were still firmly in place until 2008. However, the global financial crisis of 2008–2009 prompted many to wonder if deregulation had gone too far, and it focused attention on the need for new regulations to govern certain sectors of the financial services industry,

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including the hedge funds, which operate largely outside of existing regulatory boundaries. (Hedge funds are private investment funds that position themselves to make “long bets” on assets that they think will increase in value and “short bets” on assets that they think will decline in value.) Given the benefits associated with the globalization of capital, not- withstanding the current contraction, over the long term the growth of the global capital market can be expected to continue. While most commentators see this as a positive devel- opment, some believe the globalization of capital holds inherent serious risks.

GLOBAL CAPITAL MARKET RISKS

Some analysts are concerned that due to deregulation and reduced controls on cross-border capital flows, individual nations are becoming more vulnerable to speculative capital flows. They see this as having a destabilizing effect on national economies.16 Harvard economist Martin Feldstein, for example, has argued that most of the capital that moves internation- ally is pursuing temporary gains, and it shifts in and out of countries as quickly as condi- tions change.17 He distinguishes between this short-term capital, or “hot money,” and “patient money” that would support long-term cross-border capital flows. To Feldstein, pa- tient money is still relatively rare, primarily because although capital is free to move interna- tionally, its owners and managers still prefer to keep most of it at home. Feldstein supports his arguments with statistics that demonstrate that although vast amounts of money flows through the foreign exchange markets every day, “when the dust settles, most of the savings done in each country stays in that country.”18 Feldstein argues that the lack of patient money is due to the relative paucity of information that investors have about foreign invest- ments. In his view, if investors had better information about foreign assets, the global capital market would work more efficiently and be less subject to short-term speculative capital flows. Feldstein claims that Mexico’s economic problems in the mid-1990s were the result of too much hot money flowing in and out of the country and too little patient money. This example is reviewed in detail in the accompanying Country Focus.

A lack of information about the fundamental quality of foreign investments may en- courage speculative flows in the global capital market. Faced with a lack of quality infor- mation, investors may react to dramatic news events in foreign nations and pull their money out too quickly. Despite advances in information technology, it is still difficult for investors to get access to the same quantity and quality of information about foreign invest- ment opportunities that they can get about domestic investment opportunities. This infor- mation gap is exacerbated by different accounting conventions in different countries, which makes the direct comparison of cross-border investment opportunities difficult for all but the most sophisticated investor (see Chapter 19 for details). For example, histori- cally German accounting principles have been different from those found in the United States and presented quite a different picture of the health of a company. Thus, when the Germany company Daimler-Benz translated its German financial accounts into U.S.-style accounts in 1993, as it had to do to be listed on the New York Stock Exchange, it found that while it had made a profit of $97 million under German rules, under U.S. rules it had lost $548 million!19 However, in the 2000s there has been rapid movement toward harmo- nization of different national accounting standards, which is certainly improving the qual- ity of information available to investors (see Chapter 20 for details).

Given the problems created by differences in the quantity and quality of information, many investors have yet to venture into the world of cross-border investing, and those who do are prone to reverse their decision on the basis of limited (and perhaps inaccurate) in- formation. However, if the international capital market continues to grow, financial inter- mediaries likely will increasingly provide quality information about foreign investment opportunities. Better information should increase the sophistication of investment deci- sions and reduce the frequency and size of speculative capital flows. Although concerns about the volume of “hot money” sloshing around in the global capital market increased as a result of the Asian financial crisis, IMF research suggests there has not been an increase in the volatility of financial markets since the 1970s.20

LO 12-3 Understand the risks associated with the globalization of capital markets.

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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In early 1994, soon after passage of the North American Free Trade Agreement (NAFTA), Mexico was widely ad- mired among the international community as a shining ex- ample of a developing country with a bright economic future. Since the late 1980s, the Mexican government had pursued sound monetary, budget, tax, and trade policies. By historical standards, inflation was low, the country was experiencing solid economic growth, and exports were booming. This robust picture attracted capital from foreign investors; between 1991 and 1993, foreigners invested more than $75 billion in the Mexican economy, more than in any other developing nation. If there was a blot on Mexico’s economic report card, it was the country’s growing current account (trade) deficit. Mexican exports were booming but so were its imports. In the 1989–1990 period, the current account deficit was equivalent to about 3 percent of Mexico’s gross domestic product. In 1991, it increased to 5 percent, and by 1994, it was running at an annual rate of more than 6 percent. Bad as this might seem, it is not unsustainable and should not bring an economy crashing down. The United States has been running a current account deficit for decades with apparently little in the way of ill effects. A current account deficit will not be a problem for a country as long as for- eign investors take the money they earn from trade with that country and reinvest it within the country. This has been the case in the United States for years, and during the early 1990s, it was occurring in Mexico too. Thus, com- panies such as Ford took the pesos they earned from ex- ports to Mexico and reinvested those funds in productive capacity in Mexico, building auto plants to serve the future needs of the Mexican market and to export elsewhere. Unfortunately for Mexico, much of the $25 billion an- nual inflow of capital it received during the early 1990s was not the kind of patient long-term money that Ford was put- ting into Mexico. Rather, according to economist Martin Feldstein, much of the inflow was short-term capital that could flee if economic conditions changed for the worse. This is what seems to have occurred. In February 1994, the U.S. Federal Reserve began to increase U.S. interest rates. This led to a rapid fall in U.S. bond prices. At the same time, the yen began to appreciate sharply against the U.S. dollar. These events resulted in large losses for many man- agers of short-term capital, such as hedge fund managers and banks, which had been betting on exactly the oppo- site happening. Many hedge funds had been betting that

interest rates would fall, bond prices would rise, and the dollar would appreciate against the yen. Faced with large losses, money managers tried to reduce the riskiness of their portfolios by pulling out of risky situa- tions. About the same time, events took a turn for the worse in Mexico. An armed uprising in the southern state of Chiapas, the assassination of the leading candidate in the pres- idential election campaign, and an accelerating inflation rate all helped produce a feeling that Mexican investments were risk- ier than had been assumed. Money managers began to pull many of their short-term investments out of the country. As hot money flowed out, the Mexican government real- ized it could not continue to count on capital inflows to finance its current account deficit. The government had assumed the inflow was mainly composed of patient, long-term money. In reality, much of it appeared to be short-term money. As money flowed out of Mexico, the Mexican government had to commit more foreign reserves to defending the value of the peso against the U.S. dollar, which was pegged at 3.5 pesos to the dollar. Currency speculators entered the picture and began to bet against the Mexican government by selling pesos short. Events came to a head in December 1994 when the Mexican government was essentially forced by capital flows to aban- don its support for the peso. Over the next month, the peso lost 40 percent of its value against the dollar, the government was forced to introduce an economic austerity program, and the Mexican economic boom came to an abrupt end. According to Martin Feldstein, the Mexican economy was brought down not by currency speculation on the foreign exchange market, but by a lack of long-term patient money. He argued that Mexico offered, and still offers, many attrac- tive long-term investment opportunities, but because of the lack of information on long-term investment opportunities in Mexico, most of the capital flowing into the country from 1991 to 1993 was short-term, speculative money, the flow of which could quickly be reversed. If foreign investors had better in- formation, Feldstein argued, Mexico should have been able to finance its current account deficit from inward capital flows because patient capital would naturally gravitate toward at- tractive Mexican investment opportunities.

Sources: Martin Feldstein, “Global Capital Flows: Too Little, Not Too Much,”  The Economist,  June 24, 1995, pp. 72–73; R. Dornbusch, “We Have Salinas to Thank for the Peso Debacle,” BusinessWeek, January 16, 1995, p. 20; P. Carroll and C. Torres, “Mexico Unveils Program of Harsh Fiscal Medicine,” The Wall Street Journal, March 10, 1995, pp. A1, A6. See also Martin Feldstein and Charles Horioka, “Domestic Savings and Inter- national Capital Flows,” Economic Journal 90 (1980), pp. 314–29.

Did the Global Capital Markets Fail Mexico?

The Global Capital Market Chapter 12 351

The Eurocurrency Market

A Eurocurrency is any currency banked outside its country of origin. Eurodollars, which account for about two-thirds of all Eurocurrencies, are dollars banked outside the United States. Other important Eurocurrencies include the Euro-yen, the Euro-pound, and the Euro-euro! The term Eurocurrency is actually a misnomer because a Eurocurrency can be created anywhere in the world; the persistent Euro- prefix reflects the European origin of the market. The Eurocurrency market has been an important and relatively low-cost source of funds for international businesses.

GENESIS AND GROWTH OF THE MARKET

The Eurocurrency market was born in the mid-1950s when eastern European holders of dollars, including the former Soviet Union, were afraid to deposit their holdings of dollars in the United States lest they be seized by the U.S. government to settle U.S. residents’ claims against business losses resulting from the communist takeover of eastern Europe.21 These countries deposited many of their dollar holdings in Europe, particularly in London. Additional dollar deposits came from various western European central banks and from companies that earned dollars by exporting to the United States. These two groups depos- ited their dollars in London banks, rather than U.S. banks, because they were able to earn a higher rate of interest (which will be explained).

The Eurocurrency market received a major push in 1957 when the British government prohibited British banks from lending British pounds to finance non-British trade, a busi- ness that had been very profitable for British banks. British banks began financing the same trade by attracting dollar deposits and lending dollars to companies engaged in inter- national trade and investment. Because of this historical event, London became, and has remained, the leading center of Eurocurrency trading.

The Eurocurrency market received another push in the 1960s when the U.S. govern- ment enacted regulations that discouraged U.S. banks from lending to non-U.S. residents. Would-be dollar borrowers outside the United States found it increasingly difficult to borrow dollars in the United States to finance international trade, so they turned to the Eurodollar market to obtain the necessary dollar funds.

The U.S. government changed its policies after the 1973 collapse of the Bretton Woods system (see Chapter 11), removing an important impetus to the growth of the Eurocur- rency market. However, another political event, the oil price increases engineered by OPEC in the 1973–1974 and 1979–1980 periods, gave the market another big shove. As a result of the oil price increases, the Arab members of OPEC accumulated huge amounts of dollars. They were afraid to place their money in U.S. banks or their European branches, lest the U.S. government attempt to confiscate them. (Iranian assets in U.S. banks and their European branches were frozen by President Carter in 1979 after Americans were taken hostage at the U.S. embassy in Tehran; their fear was not unfounded.) Instead, these countries deposited their dollars with banks in London, further increasing the supply of Eurodollars.

Although these various political events contributed to the growth of the Eurocurrency market, they alone were not responsible for it. The market grew because it offered real fi- nancial advantages—initially to those who wanted to deposit dollars or borrow dollars and later to those who wanted to deposit and borrow other currencies. We now look at the source of these financial advantages.

ATTRACTIONS OF THE EUROCURRENCY MARKET

The main factor that makes the Eurocurrency market attractive to both depositors and bor- rowers is its lack of government regulation. This allows banks to offer higher interest rates on Eurocurrency deposits than on deposits made in the home currency, making Eurocur- rency deposits attractive to those who have cash to deposit. The lack of regulation also al- lows banks to charge borrowers a lower interest rate for Eurocurrency borrowings than for

LO 12- 4 Compare and contrast the benefits and risks associated with the Eurocurrency market, the global bond market, and the global equity market.

352 Part 4 The Global Monetary System

borrowings in the home currency, making Eurocurrency loans attractive for those who want to borrow money. In other words, the spread between the Eurocurrency deposit rate and the Eurocurrency lending rate is less than the spread between the domestic deposit and lending rates (see Figure 12.3). To understand why this is so, we must examine how government regulations raise the costs of domestic banking.

Domestic currency deposits are regulated in all industrialized countries. Such regula- tions ensure that banks have enough liquid funds to satisfy demand if large numbers of domestic depositors should suddenly decide to withdraw their money. All countries oper- ate with certain reserve requirements. For example, each time a U.S. bank accepts a deposit in dollars, it must place some fraction of that deposit in a non-interest-bearing account at a Federal Reserve Bank as part of its required reserves. Similarly, each time a British bank accepts a deposit in pounds sterling, it must place a certain fraction of that deposit with the Bank of England.

Banks are given much more freedom in their dealings in foreign currencies, however. For example, the British government does not impose reserve requirement restrictions on deposits of foreign currencies within its borders. Nor are the London branches of U.S. banks subject to U.S. reserve requirement regulations, provided those deposits are payable only outside the United States. This gives Eurobanks a competitive advantage.

For example, suppose a bank based in New York faces a 10 percent reserve require- ment. According to this requirement, if the bank receives a $100 deposit, it can lend out no more than $90 of that, and it must place the remaining $10 in a non-interest-bearing account at a Federal Reserve bank. Suppose the bank has annual operating costs of $1 per $100 of deposits and that it charges 10 percent interest on loans. The highest interest the New York bank can offer its depositors and still cover its costs is 8 percent per year. Thus, the bank pays the owner of the $100 deposit (0.08 × $100 =) $8, earns (0.10 × $90 =) $9 on the fraction of the deposit it is allowed to lend, and just covers its operating costs.

In contrast, a Eurobank can offer a higher interest rate on dollar deposits and still cover its costs. The Eurobank, with no reserve requirements regarding dollar deposits, can lend out all of a $100 deposit. Therefore, it can earn 0.10 × $100 = $10 at a loan rate of 10 percent. If the Eurobank has the same operating costs as the New York bank ($1 per $100 deposit), it can pay its depositors an interest rate of 9 percent, a full per- centage point higher than that paid by the New York bank, and still cover its costs. That is, it can pay out 0.09 × $100 = $9 to its depositor, receive $10 from the borrower, and be left with $1 to cover operating costs. Alternatively, the Eurobank might pay the de- positor 8.5 percent (which is still above the rate paid by the New York bank), charge borrowers 9.5 percent (still less than the New York bank charges), and cover its operating

F I G U R E 1 2 . 3

Interest rate spreads in domestic and Eurocurrency markets.

Domestic Lending Rate

Domestic Deposit Rate

Eurocurrency Lending Rate

Eurocurrency Deposit Rate

0%

Rate of Interest

The Global Capital Market Chapter 12 353

costs. Thus, the Eurobank has a competitive advantage vis-à-vis the New York bank in both its deposit rate and its loan rate.

Clearly, there are strong financial motivations for companies to use the Eurocurrency market. By doing so, they receive a higher interest rate on deposits and pay less for loans. Given this, the surprising thing is not that the Euromarket has grown rapidly but that it hasn’t grown even faster. Why do any depositors hold deposits in their home currency when they could get better yields in the Eurocurrency market?

DRAWBACKS OF THE EUROCURRENCY MARKET

The Eurocurrency market has two drawbacks. First, when depositors use a regulated bank- ing system, they know that the probability of a bank failure that would cause them to lose their deposits is very low. Regulation maintains the liquidity of the banking system. In an unregulated system such as the Eurocurrency market, the probability of a bank failure that would cause depositors to lose their money is greater (although, in absolute terms, still low). Thus, the lower interest rate received on home-country deposits reflects the costs of insuring against bank failure. Some depositors are more comfortable with the security of such a system and are willing to pay the price.

Second, borrowing funds internationally can expose a company to foreign exchange risk. For example, consider a U.S. company that uses the Eurocurrency market to borrow Euro-pounds—perhaps because it can pay a lower interest rate on Euro-pound loans than on dollar loans. Imagine, however, that the British pound subsequently appreciates against the dollar. This would increase the dollar cost of repaying the Euro-pound loan and thus the company’s cost of capital. This possibility can be insured against by using the forward exchange market (as we saw in Chapter 10), but the forward exchange market does not of- fer perfect insurance. Consequently, many companies borrow funds in their domestic cur- rency to avoid foreign exchange risk, even though the Eurocurrency markets may offer more attractive interest rates.

The Global Bond Market

The global bond market has grown rapidly over the last four decades. Bonds are an impor- tant means of financing for many companies. The most common kind of bond is a fixed- rate bond. The investor who purchases a fixed-rate bond receives a fixed set of cash payoffs. Each year until the bond matures, the investor gets an interest payment, and then at matu- rity he gets back the face value of the bond.

International bonds are of two types: foreign bonds and Eurobonds. Foreign bonds are sold outside the borrower’s country and are denominated in the currency of the country in which they are issued. Thus, when Dow Chemical issues bonds in Japanese yen and sells them in Japan, it is issuing foreign bonds. Many foreign bonds have nicknames; foreign bonds sold in the United States are called Yankee bonds, foreign bonds sold in Japan are Samurai bonds, and foreign bonds sold in Great Britain are bulldogs. Companies will issue international bonds if they believe that it will lower their cost of capital. For example, dur- ing the late 1990s and early 2000s, many companies issued Samurai bonds in Japan to take advantage of the very low interest rates in Japan. In early 2001, 10-year Japanese govern- ment bonds yielded 1.24 percent, compared with 5 percent for comparable U.S. govern- ment bonds. Against this background, companies found that they could raise debt at a cheaper rate in Japan than the United States.

Eurobonds are normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated. For example, a bond may be issued by a German corporation, denominated in U.S. dollars, and sold to investors outside the United States by an international syndicate of banks. Eurobonds are routinely issued by multinational corporations, large domestic corpora- tions, sovereign governments, and international institutions. They are usually offered

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354 Part 4 The Global Monetary System

simultaneously in several national capital markets, but not in the capital market of the country, nor to residents of the country, in whose currency they are denominated. Histori- cally, Eurobonds accounted for the lion’s share of international bond issues, but increas- ingly they are being eclipsed by foreign bonds.

ATTRACTIONS OF THE EUROBOND MARKET

Three features of the Eurobond market make it an appealing alternative to most major domestic bond markets, specifically:

∙ An absence of regulatory interference. ∙ Less stringent disclosure requirements than in most domestic bond markets. ∙ A favorable tax status.

Regulatory Interference National governments often impose controls on domestic and foreign issuers of bonds denominated in the local currency and sold within their national boundaries. These con- trols tend to raise the cost of issuing bonds. However, government limitations are generally less stringent for securities denominated in foreign currencies and sold to holders of those foreign currencies. Eurobonds fall outside the regulatory domain of any single nation. As such, they can often be issued at a lower cost to the issuer.

Disclosure Requirements Eurobond market disclosure requirements tend to be less stringent than those of several national governments. For example, if a firm wishes to issue dollar-denominated bonds within the United States, it must first comply with SEC disclosure requirements. The firm must disclose detailed information about its activities, the salaries and other compensation of its senior executives, stock trades by its senior executives, and the like. In addition, the issuing firm must submit financial accounts that conform to U.S. accounting standards. For non-U.S. firms, redoing their accounts to make them consistent with U.S. standards can be very time-consuming and expensive. Therefore, many firms have found it cheaper to issue Eurobonds, including those denominated in dollars, than to issue dollar-denominated bonds within the United States.

Favorable Tax Status Before 1984, U.S. corporations issuing Eurobonds were required to withhold for U.S. in- come tax up to 30 percent of each interest payment to foreigners. This did not encourage foreigners to hold bonds issued by U.S. corporations. Similar tax laws were operational in many countries at that time, and they limited market demand for Eurobonds. U.S. laws were revised in 1984 to exempt from any withholding tax foreign holders of bonds issued by U.S. corporations. As a result, U.S. corporations found it feasible for the first time to sell Eurobonds directly to foreigners. Repeal of the U.S. laws caused other governments— including those of France, Germany, and Japan—to liberalize their tax laws likewise to avoid outflows of capital from their markets. The consequence was an upsurge in demand for Eurobonds from investors who wanted to take advantage of their tax benefits.

The Global Equity Market

Historically, substantial regulatory barriers separated national equity markets from each other. Not only was it often difficult to take capital out of a country and invest it elsewhere, but corporations also frequently lacked the ability to list their shares on stock markets outside their home nations. These regulatory barriers made it difficult

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The Global Capital Market Chapter 12 355

for a corporation to attract significant equity capital from foreign investors. These bar- riers tumbled fast during the 1980s and 1990s. The global equity market enabled firms to attract capital from international investors, to list their stock on multiple exchanges, and to raise funds by issuing equity or debt around the world. For example, in 1994 Daimler-Benz, Germany’s largest industrial company, raised $300 million by issuing new shares not in Germany, but in Singapore.22 Similarly, in 1996 the German telecom- munications provider Deutsche Telekom raised some $13.3 billion by simultaneously listing its shares for sale on stock exchanges in Frankfurt, London, New York, and Tokyo. These German companies elected to raise equity through foreign markets because they reasoned that their domestic capital market was too small to supply the requisite funds at a reasonable cost. To lower their cost of capital, they tapped into the large and highly liquid global capital market.

More recently, many Chinese companies have been raising equity capital through foreign stock issues. In 2010, a record 39 Chinese companies issued stock through the New York Stock Exchange, giving them access to more capital at a lower cost than would have been possible if they had just issued stock in China.23 In 2014, in what was the largest IPO ever, the Chinese Internet company Alibaba raised equity capital in the New York Stock Exchange. Of course, the other side of the coin is that if foreign entities are going to issue stock in New York, London, or another major foreign mar- ket, they also have to adhere to the stringent requirements for financial reporting that are common in those markets.

Although we have talked about the growth of the global equity market, strictly speaking there is no international equity market in the sense that there are international currency and bond markets. Rather, many countries have their own domestic equity markets in which corporate stock is traded. The largest of these domestic equity markets are to be found in the United States, Great Britain, Japan, and Hong Kong. Although each domestic equity market is still dominated by investors who are citizens of that country and compa- nies incorporated in that country, developments are internationalizing the world equity market. Investors are investing heavily in foreign equity markets to diversify their portfo- lios. Facilitated by deregulation and advances in information technology, this trend seems to be here to stay.

An interesting consequence of the trend toward international equity investment is the internationalization of corporate ownership. Today it is still generally possible to talk about U.S. corporations, British corporations, and Japanese corporations, primarily be- cause the majority of stockholders (owners) of these corporations are of the respective nationality. However, this is changing. Increasingly, U.S. citizens are buying stock in com- panies incorporated abroad, and foreigners are buying stock in companies incorporated in the United States. Looking into the future, Robert Reich has mused about “the coming ir- relevance of corporate nationality.”24

A second development internationalizing the world equity market is that companies with historic roots in one nation are broadening their stock ownership by listing their stock in the equity markets of other nations. The reasons are primarily financial. Listing stock on a foreign market is often a prelude to issuing stock in that market to raise capital. The idea is to tap into the liquidity of foreign markets, thereby increasing the funds available for investment and lowering the firm’s cost of capital. (The relationship between liquidity and the cost of capital was discussed earlier in the chapter.) Firms also often list their stock on foreign equity markets to facilitate future acquisitions of foreign companies. Other reasons for listing a company’s stock on a foreign equity market are that the com- pany’s stock and stock options can be used to compensate local management and employ- ees, it satisfies the desire for local ownership, and it increases the company’s visibility with local employees, customers, suppliers, and bankers. Although firms based in developed nations were the first to start listing their stock on foreign exchanges, increasingly firms from developing countries who find their own growth limited by an illiquid domestic capi- tal market are exploiting this opportunity.

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356 Part 4 The Global Monetary System

Foreign Exchange Risk and the Cost of Capital

While a firm can borrow funds at a lower cost in the global capital market than in the do- mestic capital market, foreign exchange risk complicates this picture under a floating ex- change rate regime. Adverse movements in foreign exchange rates can substantially increase the cost of foreign currency loans, which is what happened to many Asian compa- nies during the 1997–1998 Asian financial crisis.

Consider a South Korean firm that wants to borrow 1 billion Korean won for one year to fund a capital investment project. The company can borrow this money from a Korean bank at an interest rate of 10 percent and, at the end of the year, pay back the loan plus interest for a total of W1.10 billion. Or the firm could borrow dollars from an international bank at a 6 percent interest rate. At the prevailing exchange rate of $1 = W1,000, the firm would borrow $1 million and the total loan cost would be $1.06 million, or W1.06 billion. By borrowing dollars, the firm could reduce its cost of capital by 4 percent, or W40 mil- lion. However, this saving is predicated on the assumption that during the year of the loan, the dollar/won exchange rate stays constant. Instead, imagine that the won depreciates sharply against the U.S. dollar during the year and ends the year at $1 = W1,500. (This occurred in late 1997 when the won declined in value from $1 = W1,000 to $1 = W1,500 in two months.) The firm still has to pay the international bank $1.06 million at the end of the year, but now this costs the company W1.59 billion (i.e., $1.06 million × 1,500). As a result of the depreciation in the value of the won, the cost of borrowing in U.S. dollars has soared from 6 percent to 59 percent, a huge rise in the firm’s cost of capital. Although this may seem like an extreme example, it happened to many South Korean firms in 1997 at the height of the Asian financial crisis. Not surprisingly, many of them were pushed into technical default on their loans.

Unpredictable movements in exchange rates can inject risk into foreign currency bor- rowing, making something that initially seems less expensive ultimately much more expen- sive. The borrower can hedge against such a possibility by entering into a forward contract to purchase the required amount of the currency being borrowed at a predetermined ex- change rate when the loan comes due (see Chapter 10 for details). Although this will raise the borrower’s cost of capital, the added insurance limits the risk involved in such a trans- action. Unfortunately, many Asian borrowers did not hedge their dollar-denominated short-term debt, so when their currencies collapsed against the dollar in 1997, many saw a sharp increase in their cost of capital.

When a firm borrows funds from the global capital market, it must weigh the benefits of a lower interest rate against the risks of an increase in the real cost of capital due to adverse exchange rate movements. Although using forward exchange markets may lower foreign exchange risk with short-term borrowings, it cannot remove the risk. Most im- portant, the forward exchange market does not provide adequate coverage for long-term borrowings.

LO 12-5 Understand how foreign exchange risks affect the cost of capital.

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F O C U S O N M A N A G E R I A L I M P L I C AT I O N S 

GROWTH OF THE GLOBAL CAPITAL MARKET The implications of the material discussed in this chapter for international busi-

ness are quite straightforward but no less important for being obvious. The growth of the global capital market has created opportunities for international businesses that wish to borrow and/or invest money. On the borrowing side, by using the global capital market, firms can often borrow funds at a lower cost

than is possible in a purely domestic capital market. This conclusion holds no

The Global Capital Market Chapter 12 357

matter what form of borrowing a firm uses—equity, bonds, or cash loans. The lower cost of capital on the global market reflects its greater liquidity and the general absence of government regulation. Government regulation tends to raise the cost of capital in most domestic capital markets. The global market, being transnational, escapes regulation. Balanced against this, however, is the foreign exchange risk associated with borrowing in a foreign currency. On the investment side, the growth of the global capital market is providing opportunities for firms, institutions, and individuals to diversify their investments to limit risk. By holding a diverse portfolio of stocks and bonds in different nations, an investor can reduce total risk to a lower level than can be achieved in a purely domestic setting. Once again, however, for- eign exchange risk is a complicating factor.

hedge fund, p. 349 Eurocurrency, p. 351

foreign bonds, p. 353 Eurobonds, p. 353

Key Terms

C H A P T E R S U M M A R Y

This chapter explained the functions and form of the global capital market and defined the implications of these for international business practice. This chapter made the following points:

 1. The function of a capital market is to bring those who want to invest money together with those who want to borrow money.

 2. Relative to a domestic capital market, the global capital market has a greater supply of funds avail- able for borrowing, and this makes for a lower cost of capital for borrowers.

 3. Relative to a domestic capital market, the global capital market allows investors to diversify port- folios of holdings internationally, thereby reduc- ing risk.

 4. The growth of the global capital market during recent decades can be attributed to advances in information technology, the widespread dereg- ulation of financial services, and the relaxation of regulations governing cross-border capital flows.

 5. A Eurocurrency is any currency banked outside its country of origin. The lack of government reg- ulations makes the Eurocurrency market attrac- tive to both depositors and borrowers. Due to the absence of regulation, the spread between the Eurocurrency deposit and lending rates is less than the spread between the domestic deposit

and lending rates. This gives Eurobanks a com- petitive advantage.

 6. The global bond market has two classifications: the foreign bond market and the Eurobond market. Foreign bonds are sold outside of the borrower’s country and are denominated in the currency of the country in which they are issued. A Eurobond issue is normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated. Eurobonds account for the lion’s share of international bond issues.

 7. The Eurobond market is an attractive way for companies to raise funds due to the absence of regulatory interference, less stringent disclosure requirements, and Eurobonds’ favorable tax status.

 8. Foreign investors are investing in other coun- tries’ equity markets to reduce risk by diversify- ing their stock holdings among nations.

 9. Many companies are now listing their stock in the equity markets of other nations, primarily as a prelude to issuing stock in those markets to raise additional capital. Other reasons for listing stock in another country’s exchange are to facilitate future stock swaps; to enable the company to use its stock and stock options for compensating local management and

employees; to satisfy local ownership desires; and to increase the company’s visibility among its local employees, customers, suppliers, and bankers.

10. When borrowing funds from the global capital market, companies must weigh the benefits of a lower interest rate against the risks of greater real costs of capital due to adverse exchange rate movements.

11. One major implication of the global capital mar- ket for international business is that companies can often borrow funds at a lower cost of capital in the international capital market than they can in the domestic capital market.

12. The global capital market provides greater oppor- tunities for businesses and individuals to build a truly diversified portfolio of international invest- ments in financial assets, which lowers risk.

358 Part 4 The Global Monetary System

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

 1. Why has the global capital market grown so rap- idly in recent decades? Do you think this growth will continue throughout the next decade? Why or why not?

 2. In 2008–2009, the world economy retrenched in the wake of a global financial crisis. Do you think the globalization of capital markets con- tribute to this crisis? If so, what can be done to stop global financial contagion in the future?

 3. A firm based in Norway has found that its growth is restricted by the limited liquidity of the Norwegian capital market. List the firm’s options for raising money on the global capital market. Discuss the pros and cons of each option, and make a recommendation. How might your rec- ommended options be affected if the Norwegian krona depreciates significantly on the foreign ex- change markets over the next two years?

 4. Happy Company wants to raise $2 million with debt financing. The funds are needed to finance

working capital, and the firm will repay them with interest in one year. Happy Company’s trea- surer is considering three options:

a.  Borrowing U.S. dollars from Security Pacific Bank at 8 percent.

b.  Borrowing British pounds from Midland Bank at 14 percent.

c.  Borrowing Japanese yen from Sanwa Bank at 5 percent.

If Happy borrows foreign currency, it will not cover it; that is, it will simply change foreign cur- rency for dollars at today’s spot rate and buy the same foreign currency a year later at the spot rate then in effect. Happy Company estimates the pound will depreciate by 5 percent relative to the dollar and the yen will appreciate 3 percent rela- tive to the dollar in the next year. From which bank should Happy Company borrow?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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

1. The top management team of your not-for-profit organization would like to find out more about investing in environmentally responsible compa- nies in Europe. FTSE develops various indexes for the global financial markets. A series of in- dexes, called ESG, cover social, environmental, and good governance standards. One of these is the Environmental Europe 40 Index. Download the index’s factsheet for your analysis. Evaluate the top 10 companies, countries, and industries repre- sented in this index. What patterns do you see?

2. The Bureau of Economic Analysis is an agency of the U.S. Department of Commerce. It lists data about the U.S. economic accounts, includ- ing current investment positions and the amount of direct investment by multinational corpora- tions in the United States and abroad. Prepare a brief report regarding the direct investments of other countries in the United States. Include in your report the leading countries in foreign di- rect investment.

The Global Capital Market Chapter 12 359

In 2013 senior managers at Alibaba, China’s largest e-commerce enterprise, decided that it was time to take the company public and offer its shares for sale to retail and institutional investors. Alibaba was founded in 1999 by a former English teacher, Jack Ma, with just $60,000 in capital. Often described as a fusion of Amazon and eBay, by 2013 Alibaba was already the world’s largest online e-commerce company. In 2012, transactions at its online sites totaled $248 billion, more than those of Amazon and eBay combined. Driven by rapid growth in China’s online shopping market, projections called for the company to reach online sales of $713 billion by 2017. Ma and his colleagues had several motives for the IPO. First, they wanted to raise capital to finance the infra- structure investment required at a company that was growing at breakneck speed. Second, publicly traded shares would give Alibaba a currency that it could use to acquire other enterprises (by offering its shares in ex- change for the shares of an acquired company). Third, a public market in Alibaba shares would be a major liquid- ity event for the large number of Alibaba employees who held stock in the enterprise. It would enable them to more easily sell shares in order to raise cash for other purchases. Initially, Alibaba considered doing an IPO in Hong Kong. The choice made sense. Hong Kong has a large and liquid stock market that attracts investors from all over the world. However, while Hong Kong is part of China, it retains its own legal system. Hong Kong’s stock exchange has a “one share one vote” requirement. Ma and his colleagues were opposed to this. Even though they would hold only a minority of shares after the IPO, they wanted to retain the ability to nominate more than half of the company’s board of directors, ensuring that they maintained control over the management of the enterprise. Alibaba entered into negotiations with the Hong Kong stock exchange to see if the rules could be changed, but to no avail. As it became increasingly apparent that the Hong Kong exchange was unwilling to change its rules in a timely manner, Alibaba made inquiries to the

New York Stock Exchange (NYSE) and the U.S. Securi- ties and Exchange Commission (SEC). The NYSE and SEC indicated that they would have no problem with Alibaba’s partners retaining control over more than half of all board seats. Alibaba realized that an offering on the NYSE would have other advantages beyond retaining control of the board. The NYSE is the largest and most liquid exchange in the world. The recent successful IPO of Facebook and Twitter had demonstrated that U.S. investors had an ap- petite for Internet offerings. Demand for Alibaba shares was expected to be high, raising the possibility that Alibaba might have a record-setting IPO. Moreover, if its shares were listed on the NYSE, this might make it easier for Alibaba to subsequently use those shares to acquire U.S. and other foreign enterprises, giving Alibaba a bigger global footprint. The biggest obstacle standing in the way of a U.S. listing was the Chinese government–imposed limits on foreign ownership of Chinese technology busi- nesses. Alibaba was able to circumvent these limits by establishing a complex corporate structure in which investors would actually own shares in a Cayman Island entity, Alibaba Group Holdings, which has contractual rights to all of the earnings of Alibaba China, but no ownership interest in the Chinese entity, which would continue to be owned by Ma and his partners. The IPO took place on the NYSE on September 18, 2014. The initial offering price was $68 a share, but de- mand was so strong that Alibaba’s shares opened at $92.70. Alibaba sold 368 million shares in the offering, or about 15 percent of the company. The IPO raised $25 billion for Alibaba, $6 billion more than originally estimated, and valued the company at $231 billion, making it the largest IPO in history.

Sources: S. D. Solomon, “Alibaba Investors Will Buy a Risky Corporate Structure,” The New York Times, May 6, 2014; T. Demos and J. Osawa, “Alibaba Debut Makes a Splash,” The Wall Street Journal, September 19, 2014; D. Thomas and E. Barreto, “Alibaba’s Choice of US IPO Spurred by Rivals, Hong Kong Impass,” Reuters, March 19, 2014.

C L O S I N G C A S E

Alibaba’s Record-Setting IPO

360 Part 4 The Global Monetary System

E n d n o t e s

 1. K. Linebaugh, “Record IPO Could Have Been Even Bigger,” The Wall Street Journal, October 21, 2006, p. B3.

 2. B. Solnik, “Why Not Diversify Internationally Rather Than Do- mestically?” Financial Analysts Journal, July 1974, p. 17.

 3. C. G. Luck and R. Choudhury, “International Equity Diversifi- cation for Pension Funds,” Journal of Investing 5, no. 2 (1996), pp. 43–53.

 4. W. N. Goetzmann, L. Li, and K. G. Rouwenhorst, “Long-Term Global Market Correlations,” The Journal of Business, January 2005, pp. 78–126.

 5. Ian Domowitz, Jack Glen, and Ananth Madhavan, “Market Segmentation and Stock Prices: Evidence from an Emerging Market,” Journal of Finance 3, no. 3 (1997), pp. 1059–68.

 6. Solnik, “Why Not Diversify Internationally Rather Than Domestically?”

 7. A. Lavine, “With Overseas Markets Now Moving in Sync with U.S. Markets, It’s Getting Harder to Find True Diversification Abroad,” Financial Planning, December 1, 2000, pp. 37–40.

 8. B. Solnik and J. Roulet, “Dispersion as Cross-Sectional Correla- tion,” Financial Analysts Journal 56, no. 1 (2000), pp. 54–61.

 9. W. Goetzmann, L. Li, and K. Rouwenhorst, “Long-Term Global Market Correlations,” Journal of Business 78 (2005), pp. 1–38. See also R. Vermeulen, “International Diversification during the Financial Crisis: A Blessing for Equity Investors?” Journal of International Money and Finance 35 (2013), pp. 104–23.

10. W. Goetzmann, L. Li, and K. Rouwenhorst, “Long-Term Global Market Correlations,” Journal of Business 78 (2005), pp. 1–38. See also R. Vermeulen, “International Diversification during the Financial Crisis: A Blessing for Equity Investors?” Journal of International Money and Finance 35 (2013), pp. 104–23.

11. Bank for International Settlements, BIS Quarterly Review, March 2013.

12. T. F. Huertas, “U.S. Multinational Banking: History and Prospects,” in Banks as Multinationals, ed. G. Jones (London: Routledge, 1990).

13. G. J. Millman, The Vandals’ Crown (New York: Free Press, 1995).

14. Goetzmann et al., “Long-Term Global Market Correlations”; Vermeulen, “International Diversification during the Financial Crisis: A Blessing for Equity Investors?”

15. P. Dicken, Global Shift: The Internationalization of Economic Activity (London: Guilford Press, 1992).

16. P. Dicken, Global Shift: The Internationalization of Economic Activity (London: Guilford Press, 1992).

17. M. Feldstein, “Global Capital Flows: Too Little, Not Too Much,” The Economist, June 24, 1995, pp. 72–73.

18. M. Feldstein, “Global Capital Flows: Too Little, Not Too Much,” The Economist, June 24, 1995, p. 73.

19. D. Duffy and L. Murry, “The Wooing of American Investors,” The Wall Street Journal, February 25, 1994, p. A14.

20. International Monetary Fund, World Economic Outlook (Washington, DC: IMF, 1998).

21. C. Schenk, “The Origins of the Eurodollar Market in London, 1955–1963,” Explorations in Economic History 35 (1998), pp. 221–39.

22. D. Waller, “Daimler in $250m Singapore Placing,” Financial Times, May 10, 1994.

23. L. Spears and C. Vannucci, “China’s Latest American IPOs Slump as Offerings Increase to Annual Record,” Bloomberg Businessweek, December 6, 2010.

24. R. Reich, The Work of Nations (New York: Knopf, 1991).

C a s e D i s c u s s i o n Q u e s t i o n s 1. Why did Jack Ma decide it was time to take

Alibaba public? 2. Why do you think the management of Alibaba

decided against doing the IPO in China’s main stock market, Shanghai? Why did they ultimately decide against Hong Kong?

3. What were the legal, financial, and strategic ad- vantages to Alibaba of undertaking its IPO in New York?

4. Because the IPO was undertaken in New York, does this make Alibaba an American enterprise?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

The Strategy of International Business L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO13 -1 Explain the concept of global strategy.

LO13-2 Recognize how firms can profit by expanding globally.

LO13-3 Understand how pressures for cost reductions and local responsiveness influence strategic choice.

LO13-4 Identify and choose the different global strategies for competing in the global marketplace.

13

©Bloomberg/Bloomberg/Getty Images

part five The Strategy and Structure of International Business

Sony’s Global Strategy

needs of various customers by incorporating technologies enhanced in the area of content creation. Beyond the 12 core segments that have served Sony well strategically for a long time, the company is embark- ing on global initiatives to create new business opportuni- ties. They are accelerating research and development (R&D) activities to bring about innovations that can, if suc- cessful, become new strategic business segments serving customers’ needs and wants. To strategically evaluate and nurture potential opportunities, Sony divides these into new business ventures (Life Space UX, Seed Acceleration Program, and Sports Entertainment) and R&D opportuni- ties (Future Lab Program and Sony Computer Science Laboratories Inc.). On the business venture side, Life Space UX is a con- cept that is defined by delivering unique experiences and facilitating new ways to transform a person’s living space. The Seed Acceleration Program’s goal is to gather and nurture new business ideas from beyond the boundaries of existing Sony organizations (which is very similar to many organizations’ strategies that are innovatively new). Additionally, with its range of products and services de- signed to enrich various everyday life situations, Sony is focused on a new business venture of providing discover- ies and experiences in sports. The Future Lab Program is a part of Sony’s heavy in- vestment in R&D. It embraces an approach to technologi- cal R&D that emphasizes an open creative environment and direct lines of communication with society, with the end goal being to co-create new lifestyles and customer value. At Sony Computer Science Laboratories Inc.—often abbreviated to Sony CSL—value is assessed based on achievements that can contribute to humanity and society, to new science and technology, to industrial progress, and to product development.

Sources: Anousha Sakoui and Yuji Nakamura, “Sony CEO Heads to Hollywood in Push to Revive Movie Studio,” Bloomberg Business- week, January 31, 2017; “New Business and R&D,” March 22, 2017 (sony.net/SonyInfo/CorporateInfo/newbusiness); “Here‘s Sony’s New Business Strategy,” The Economist, February 21, 2015; “Sony Global Corporate Strategy,” June 29, 2016 (sony.net/SonyInfo/IR/strategy).

O P E N I N G C A S E Sony Corporation (sony.com) is one of the most well- known companies in the world. With a heritage from Japan as a multinational conglomerate that was founded in 1946, the company is headquartered in Kōnan, Minato, Tokyo. Sony has annual sales of more than ¥8 trillion Japanese yen (about $72 billion U.S. dollars), 125,000 employees, and some 100 global subsidiaries and affiliates. The global strategy of Sony has been as an innovator in its industries of electronics, semiconductors, computers, video games, and telecommunications equipment. Strategically, Sony’s products and services can be clas- sified into 12 core business segments: TV and video, audio, digital camera, professional products and solutions, medi- cal, FelCa, semiconductors, smartphones and Internet, game and network services, pictures, music, and financial services. To integrate these 12 segments, Sony has a vision of “using our unlimited passion for technology, content and services to deliver groundbreaking new excitement and entertainment.” The mission is even clearer. Sony is “a com- pany that inspires and fulfills your curiosity.”* This strategic curiosity has served Sony well as a global innovator for more than seven decades. For exam- ple, in 1960, Sony launched the world’s first direct-view portable transistor TV and developed the world’s first transistor-based videotape recorder in 1961. The strategy for the future is through the stunning reality of visuals that can be created by big-screen TVs and dynamic sound, Sony plans to transform the viewing experience from “watching” to “feeling.” Behind the scenes, Sony has also spent more than 50 years honing its technological excellence in the field of broadcast- ing and in the professional products. The company’s prod- ucts are widely used in the production of movies and television shows, as well as in live sporting events. This has resulted in a high global market share for Sony and the company receiving a number of Emmy Awards—one of the most prestigious prizes in the broadcasting industry. Moving forward, Sony is placing a strategic emphasis on providing new value through end-to-end solutions that meet the

363

* “New Business and R&D,” March 22, 2017 (sony.net/SonyInfo/CorporateInfo/newbusiness).

364 Part 5 The Strategy and Structure of International Business

Introduction

Up to this point in the text, we have focused on the worldwide environment in which mul- tinational corporations and so-called SMEs (small and medium-sized enterprises) com- pete in the global marketplace.1 These chapters have included content on the different political, economic, and cultural institutions found in nations; the international trade and investment framework; and the international monetary system.

Starting with this chapter, our focus shifts from this “macro environment” to the firm itself and, in particular, to the actions managers can take to compete more effectively as an international business.2 To begin the sequence of chapters on running a firm, this chapter looks at how organizations can increase revenue (and profitability) by expanding their operations in foreign markets. We discuss the different strategies that firms pursue when competing around the world, consider the pros and cons of the strategies, and elaborate on the various factors that affect a firm’s choice of global strategy. Key issues in the global strategy chapter are value creation and global value chains (which later on also ties to the chapter that includes global supply chain management),3 and how multinational corpora- tions achieve superior performance.4

The strategy of Sony Corporation as an innovator in the industries of electronics, semi- conductors, computers, video games, and telecommunications equipment gives us a pre- view of some of the key issues discussed in this chapter. Basically, Sony believes that the best way to create value as well as to position the firm globally is to classify the firm’s product and service assortment into 12 core business segments: TV and video, audio, digi- tal camera, professional products and solutions, medical, FelCa, semiconductors, smart- phones and Internet, game and network services, pictures, music, and financial services.

To integrate these 12 segments, Sony has a vision of “using our unlimited passion for technology, content and services to deliver groundbreaking new excitement and entertain- ment.” The mission is even clearer. Sony is “a company that inspires and fulfills your curi- osity.” Sony’s management thrives on leveraging the whole firm as a value chain that takes advantage of its globally integrated R&D, production, marketing and sales, and customer service activities. It has a unique strength in making sure that the firm’s information sys- tem, company infrastructure, logistics, and human resources are world class, creating op- portunity across the 12 core business segments that other firms have a hard time competing with in the global marketplace.

Another example is represented by FedEx, as we illustrate in the accompanying Did You Know segment. FedEx is consistently recognized as one of the most admired brands in the world. Today, with 95 percent of the world’s consumers living outside the United States, FedEx has focused on making international shipping as easy as possible for customers who want to connect with opportunity in global markets. In that sense, FedEx is actually a mar- keting company that concentrates on the various country markets the company serves.5 FedEx’s global strategy is far less about transportation or even supply chain management; that they will deliver on time everywhere is now taken for granted. Customers expect more, and FedEx revamped its global strategy to serve markets with a variety of services.

Strategy and the Firm

When we talk about strategy and the firm, we refer to the firm in the most common way as a method to organize activities. This means that the firm can also be called multinational enterprise, multinational corporation, an international business, international organiza- tion, global company, and so on. A unique type of firm, though, is what we call an SME—a small and medium-sized enterprise. SMEs are companies that have fewer than 500 employ- ees (U.S.) or fewer than 250 employees (Europe). Throughout the text, we use a variety of terminologies in largely the same context for the larger firms, but we specify clearly when we talk about SMEs since these companies have global strategies that sometimes differ from their larger counterparts.6

Did You Know? Did you know FedEx’s global strategy focuses on more than transportation?

Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.

LO 13 -1 Explain the concept of global strategy.

The Strategy of International Business Chapter 13 365

Also, before we discuss the strategies that managers in the multinational enterprise can pursue, we need to review some basic principles of strategy. A firm’s strategy can be de- fined as the actions that managers take to attain the goals of the firm. For most firms, the preeminent goal is to maximize the value of the firm for its owners and its shareholders (subject to the very important constraint that the activities undertaken are done in a legal, ethical, and socially responsible manner—see Chapter 5 for details). To maximize the value of a firm, managers must pursue strategies that increase the profitability of the enterprise and its rate of profit growth over time (see Figure 13.1). Profitability can be measured in a number of ways, but for consistency, we define it as the rate of return that the firm makes on its invested capital (ROI), which is calculated by dividing the net profits of the firm by total invested capital.7 Profit growth is measured by the percentage increase in net profits over time. In general, higher profitability and a higher rate of profit growth will increase the value of an enterprise and thus the returns garnered by its owners, the shareholders.8

Managers can increase the profitability of the firm by pursuing strategies that lower costs or by pursuing strategies that add value to the firm’s products, which enables the firm to raise prices and/or to maintain an existing customer base.9 Managers can increase the rate at which the firm’s profits grow over time by pursuing strategies to sell more prod- ucts in existing markets or by pursuing strategies to enter new markets. Making a decision to expand internationally can help managers boost the firm’s profitability and increase the rate of profit growth over time.

VALUE CREATION

The way to increase the profitability of a firm is to create more value.10 The amount of value a firm creates is generally measured by the difference between its costs of production and the quality that consumers perceive in its products. In general, the more value customers place on a firm’s products, the higher the price the firm can charge for those products. However, the price a firm charges for a good or service is typically less than the value placed on that good or service by the customer. This is because the customer captures some of that value in the form of what economists call a consumer surplus.11 The customer is able to do this be- cause the firm is competing with other firms for the customer’s business, so the firm must charge a lower price than it could were it a monopoly supplier. Also, it is normally impossible to segment the market to such a degree that the firm can charge each customer a price that reflects a specific customer’s assessment of the value of a product, which economists refer to as a customer’s reservation price. For these reasons, the price that gets charged tends to be slightly less than the value placed on the product by many customers.

F I G U R E 1 3 .1

Determinants of enterprise value.

Profitability

Profit Growth

Reduce Costs

Add Value and Raise Prices

Sell More in Existing Markets

Enter New Markets

Enterprise Valuation

366 Part 5 The Strategy and Structure of International Business

Figure 13.2 illustrates these value concepts. The value of a product to an average con- sumer is V, the average price that the firm can charge a consumer for that product given competitive pressures and its ability to segment the market is P, and the average unit cost of producing that product is C (C comprises all relevant costs, including the firm’s cost of capital). The firm’s profit per unit sold (p) is equal to P − C, while the consumer surplus per unit is equal to V − P (another way of thinking of the consumer surplus is as “value for the money”; the greater the consumer surplus, the greater the value for the money the consumer gets). The firm makes a profit so long as P is greater than C, and its profit will be greater the lower C is relative to P. The difference between V and P is in part determined by the intensity of competitive pressure in the marketplace; the lower the intensity of com- petitive pressure, the higher the price charged relative to V.12 In general, the higher the firm’s profit per unit sold, the greater its profitability, all else being equal.

The firm’s value creation is measured by the difference between V and C (V − C); a company creates value by converting inputs that cost C into a product on which consum- ers place a value of V. A company can create more value (V − C) either by lowering pro- duction costs, C, or by making the product more attractive through superior design, styling, functionality, features, reliability, after-sales service, and the like, so that consumers place a greater value on it (V increases) and, consequently, are willing to pay a higher price (P increases). This discussion suggests that a firm has high profits when it creates more value for its customers and does so at a lower cost. We refer to a strategy that focuses primar- ily on lowering production costs as a low-cost strategy. We refer to a strategy that focuses primarily on increasing the attractiveness of a product as a differentiation strategy.13

Michael Porter has argued that low cost and differentiation are two basic strategies for creating value and attaining a competitive advantage in an industry.14 According to Porter, superior profitability goes to those firms that can create superior value, and the way to create superior value is to drive down the cost structure of the business and/or differenti- ate the product in some way so that consumers value it more and are prepared to pay a premium price. Superior value creation relative to rivals does not necessarily require a firm to have the lowest-cost structure in an industry or to create the most valuable product in the eyes of consumers. However, it does require that the gap between value (V) and cost of production (C) be greater than the gap attained by competitors.

STRATEGIC POSITIONING

Porter notes that it is important for a firm to be explicit about its choice of strategic em- phasis with regard to value creation (differentiation) and low cost, and to configure its in- ternal operations to support that strategic emphasis.15 Figure 13.3 illustrates his point. The convex curve in Figure 13.3 is what economists refer to as an efficiency frontier. The effi- ciency frontier shows all of the different positions that a firm can adopt with regard to adding value to the product (V) and low cost (C) assuming that its internal operations are configured efficiently to support a particular position (note that the horizontal axis in

V – P

P – C

C

V P

C

V – C

V = value of product to an average consumer

P = price per unit

C = cost of production per unit

V – P = consumer surplus per unit

P – C = profit per unit sold

V – C = value created per unit

F I G U R E 1 3 . 2

Value creation.

The Strategy of International Business Chapter 13 367

Figure 13.3 is reverse scaled—moving along the axis to the right implies lower costs). The efficiency frontier has a convex shape because of diminishing returns. Diminishing returns imply that when a firm already has significant value built into its product offering, increas- ing value by a relatively small amount requires significant additional costs. The converse also holds, when a firm already has a low-cost structure, it has to give up a lot of value in its product offering to get additional cost reductions.

Figure 13.3 plots three hotel brands with a global presence that cater to international travelers, Four Seasons, Marriott International, and Starwood (the Starwood conglomer- ate of hotel brands, such as Westin and Sheraton, was bought by Marriott in 2016). Four Seasons positions itself as a luxury chain and emphasizes the value of its product offering, which drives up its costs of operations. The Marriott and Starwood brands are positioned more in the middle of the market. Both emphasize sufficient value to attract international business travelers but are not luxury chains like Four Seasons. In Figure 13.3, Four Sea- sons and Marriott are shown to be on the efficiency frontier, indicating that their internal operations are well configured to their strategy and run efficiently. Starwood is inside the frontier, indicating that its operations are not running as efficiently as they might be and that its costs are too high. This implies that Starwood is less profitable than Four Seasons and Marriott and that its managers must take steps to improve the company’s perfor- mance. The purchase by Marriott of the Starwood collection of brands in 2016 was poten- tially a way to leverage the global strategy across multiple hotel brands.

Porter emphasizes that it is very important for management to decide where the com- pany wants to be positioned with regard to value (V) and cost (C), to configure operations accordingly, and to manage them efficiently to make sure the firm is operating on the ef- ficiency frontier. However, not all positions on the efficiency frontier are viable. In the in- ternational hotel industry, for example, there might not be enough demand to support a chain that emphasizes very low cost and strips all the value out of its product offering (see Figure 13.3). International travelers are relatively affluent and expect a degree of comfort (value) when they travel away from home.

A central tenet of the basic strategy paradigm is that to maximize its profitability, a firm must do three things: (1) pick a position on the efficiency frontier that is viable in the sense that there is enough demand to support that choice; (2) configure its internal opera- tions, such as manufacturing, marketing, logistics, information systems, human resources, and so on, so that they support that position; and (3) make sure that the firm has the right organization structure in place to execute its strategy. The strategy, operations, and organiza- tion of the firm must all be consistent with each other if it is to attain a competitive advantage and garner superior profitability. By operations we mean the different value creation ac- tivities a firm undertakes, which we review next.

F I G U R E 1 3 . 3

Strategic choice in the international hotel industry.

Low Cost (C)High Cost

Four Seasons

Starwood Marriott

E�ciency Frontier

Strategic Choices in This Area Not Viable in International Hotel Industry

In cr

e as

e d

V al

ue /D

i� e

re nt

ia tio

n (V

)

368 Part 5 The Strategy and Structure of International Business

THE FIRM AS A VALUE CHAIN

The operations of a firm can be thought of as a value chain composed of a series of dis- tinct value creation activities,16 including production, marketing and sales, materials man- agement, R&D, human resources, information systems, and the firm infrastructure. We can categorize these value creation activities, or operations, as primary activities and sup- port activities (see Figure 13.4).17 As noted, if a firm is to implement its strategy efficiently, and position itself on the efficiency frontier shown in Figure 13.3, it must manage these activities effectively and in a manner that is consistent with its strategy.

Primary Activities Primary activities have to do with the design, creation, and delivery of the product; its marketing; and its support and after-sale service. Following normal practice, in the value chain illustrated in Figure 13.4, the primary activities are divided into four functions: re- search and development, production, marketing and sales, and customer service.

Research and development (R&D) is concerned with the design of products and produc- tion processes. Although we think of R&D as being associated with the design of physical products and production processes in manufacturing enterprises, many service companies also undertake R&D. For example, banks compete with each other by developing new fi- nancial products and new ways of delivering those products to customers. Online banking and smart debit cards are two examples of product development in the banking industry. Earlier examples of innovation in the banking industry included automated teller machines, credit cards, and debit cards. Through superior product design, R&D can increase the func- tionality of products, which makes them more attractive to consumers (raising V). Alterna- tively, R&D may result in more efficient production processes, thereby cutting production costs (lowering C). Either way, the R&D function can create value.

Production is concerned with the creation of a good or service. For physical products, when we talk about production, we generally mean manufacturing. Thus, we can talk about the production of an automobile. For services such as banking or health care, “produc- tion” typically occurs when the service is delivered to the customer (e.g., when a bank originates a loan for a customer, it is engaged in “production” of the loan). For a retailer such as Walmart, “production” is concerned with selecting the merchandise, stocking the store, and ringing up the sale at the cash register. For MTV, production is concerned with the creation, programming, and broadcasting of content, such as music videos and the- matic shows. The production activity of a firm creates value by performing its activities efficiently so lower costs result (lower C) and/or by performing them in such a way that a higher-quality product is produced (which results in higher V).

F I G U R E 1 3 . 4

The value chain. Support Activities

Company Infrastructure

Information Systems Logistics Human Resources

R&D Production Marketing and Sales

Customer Service

Primary Activities

The Strategy of International Business Chapter 13 369

The marketing and sales functions of a firm can help create value in several ways.18 Through brand positioning and advertising, the marketing function can increase the value (V) that consumers perceive to be contained in a firm’s product. If these create a favorable impression of the firm’s product in the minds of consumers, they increase the price that can be charged for the firm’s product. For example, Ford produced a high-value version of its Ford Expedition SUV. Sold as the Lincoln Navigator and priced around $10,000 higher, the Navigator has the same body, engine, chassis, and design as the Expedition, but through skilled advertising and marketing, supported by some fairly minor features changes (e.g., more accessories and the addition of a Lincoln-style engine grille and nameplate), Ford has fostered the perception that the Navigator is a “luxury SUV.” This marketing strategy has increased the perceived value (V) of the Navigator relative to the Expedition and enables Ford to charge a higher price for the car (P).

Marketing and sales can also create value by discovering consumer needs and commu- nicating them back to the R&D function of the company, which can then design products that better match those needs. For example, the allocation of research budgets at Pfizer, the world’s largest pharmaceutical company, is determined by the marketing function’s assessment of the potential market size associated with solving unmet medical needs. Thus, Pfizer is currently directing significant monies to R&D efforts aimed at finding treatments for Alzheimer’s disease, principally because marketing has identified the treat- ment of Alzheimer’s as a major unmet medical need in nations around the world where the population is aging.

The role of the enterprise’s service activity is to provide after-sale service and support. This function can create a perception of superior value (V) in the minds of consumers by solving customer problems and supporting customers after they have purchased the prod- uct. Caterpillar, the U.S.-based manufacturer of heavy earthmoving equipment, can get spare parts to any point in the world within 24 hours, thereby minimizing the amount of downtime its customers have to suffer if their Caterpillar equipment malfunctions. This is an extremely valuable capability in an industry where downtime is very expensive. It has helped to increase the value that customers associate with Caterpillar products and thus the price that Caterpillar can charge.

Support Activities The support activities of the value chain provide inputs that allow the primary activities to occur (see Figure 13.4). In terms of attaining a competitive advantage, support activities can be as important as, if not more important than, the primary activities of the firm. Consider information systems; these systems refer to the electronic systems for managing

G L O B A L E D G E N E W S L E T T E R

In this Chapter 13, we are bringing you closer to running a globally oriented company based on the issues we have covered on country differences, global trade and investment envi- ronment, and the global money system. This is where many of you will “make your money” as strategic decision makers in corporations. This also means that you need to know what is current, important, and strategic in the global marketplace; your company’s products or services; and your company’s uniqueness in satisfying the needs and wants of customers. The globalEDGETM Newsletter can be subscribed to freely by providing your email contact information on the globalEDGE system. While more than 1.5 million people are active users of globalEDGE and more than 10 million users visit the site, the Newsletter has become a go-to feature to stay updated on new features and cutting-edge information that the site offers. Some 150,000 business executives subscribe to the free newsletter (globaledge. msu.edu/newsletters).

370 Part 5 The Strategy and Structure of International Business

inventory, tracking sales, pricing products, selling products, dealing with customer service inquiries, and so on. Information systems, when coupled with the communications fea- tures of the Internet, can alter the efficiency and effectiveness with which a firm manages its other value creation activities. Dell, for example, has used its information systems to attain a competitive advantage over rivals. When customers place an order for a Dell prod- uct over the firm’s website, that information is immediately transmitted, via the Internet, to suppliers, who then configure their production schedules to produce and ship that prod- uct so that it arrives at the right assembly plant at the right time. These systems have re- duced the amount of inventory that Dell holds at its factories to under two days, which is a major source of cost savings.

The logistics function controls the transmission of physical materials through the value chain, from procurement through production and into distribution. The effi- ciency with which this is carried out can significantly reduce cost (lower C), thereby creating more value. The combination of logistics systems and information systems is a particularly potent source of cost savings in many enterprises, such as Dell, where information systems tell Dell on a real-time basis where in its global logistics network parts are, when they will arrive at an assembly plant, and thus how production should be scheduled.

The human resource function can help create more value in a number of ways. It en- sures that the company has the right mix of skilled people to perform its value creation activities effectively. The human resource function also ensures that people are adequately trained, motivated, and compensated to perform their value creation tasks. In a multina- tional enterprise, one of the things human resources can do to boost the competitive posi- tion of the firm is to take advantage of its transnational reach to identify, recruit, and develop a cadre of skilled managers, regardless of their nationality, who can be groomed to take on senior management positions. They can find the very best, wherever they are in the world. Indeed, the senior management ranks of many multinationals are becoming increas- ingly diverse, as managers from a variety of national backgrounds have ascended to senior leadership positions. Japan’s Sony, for example, is now headed not by a Japanese national, but by Howard Stringer, a Welshman.

The final support activity is the company infrastructure, or the context within which all the other value creation activities occur. The infrastructure includes the organization struc- ture, control systems, and culture of the firm. Because top management can exert consider- able influence in shaping these aspects of a firm, top management should also be viewed as part of the firm’s infrastructure. Through strong leadership, top management can con- sciously shape the infrastructure of a firm and through that the performance of all its value creation activities.

Global Expansion, Profitability, and Profit Growth

Expanding globally allows firms to increase their profitability and rate of profit growth in ways not available to purely domestic enterprises.19 Firms that operate internationally are able to

1. Expand the market for their domestic products by selling those products (or ser- vices) in international markets.

2. Realize location economies by dispersing value creation activities to those world- wide locations where they can be performed most efficiently and effectively.

3. Realize greater cost economies from experience effects by serving an expanded global market from a geographically central location, thereby reducing the costs of value creation.

4. Earn a greater return by leveraging any valuable skills developed in foreign opera- tions and transferring them to other entities within the firm’s global network of operations.

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LO 13 -2 Recognize how firms can profit by expanding globally.

The Strategy of International Business Chapter 13 371

As we will see, however, a firm’s ability to increase its profitability and profit growth by pursuing these strategies is constrained by the need to customize its product offering, marketing strategy, and business strategy to differing national conditions, that is, by the imperative of localization.

EXPANDING THE MARKET: LEVERAGING PRODUCTS AND COMPETENCIES

A company can increase its growth rate by taking goods or services developed at home and selling them internationally. Almost all multinationals started out doing just this. For ex- ample, Procter & Gamble developed most of its best-selling products (such as Pampers disposable diapers and Ivory soap) in the United States and subsequently sold them around the world. Likewise, although Microsoft developed its software in the United States, from its earliest days, the company has always focused on selling that software in international markets. Automobile companies such as Volkswagen (Germany) and Toyota (Japan) also grew by developing products at home and then selling them in international markets. The returns from such a strategy are likely to be greater if indigenous competitors in the nations that a company enters lack comparable products. Thus, Toyota increased its profits by entering the large automobile market of North America, offering products that were different from those offered by local rivals (Ford and GM) by their superior quality and reliability.

The success of many multinational companies that expand in this manner is based not just upon the goods or services that they sell in foreign nations, but also upon the core competencies that underlie the development, production, and marketing of those goods or services. The term core competence refers to skills within the firm that competitors can- not easily match or imitate.20 These skills may exist in any of the firm’s value creation activities—production, marketing, R&D, human resources, logistics, general management, and so on. Such skills are typically expressed in product offerings that other firms find difficult to match or imitate. Core competencies are the bedrock of a firm’s competitive advantage. They enable a firm to reduce the costs of value creation and/or to create per- ceived value in such a way that premium pricing is possible.

For example, Toyota has a core competence in the production of cars. It is able to pro- duce high-quality, well-designed cars at a lower delivered cost than any other firm in the world. The competencies that enable Toyota to do this seem to reside primarily in the firm’s production and logistics functions.21 Similarly, IKEA has a core competence in the design of stylish and affordable furniture that can be manufactured at a low cost and flat-packed, McDonald’s has a core competence in managing fast-food operations (it seems to be one of the most skilled firms in the world in this industry), and Procter & Gamble has a core competence in developing and marketing name-brand consumer products (it is one of the most skilled firms in the world in this business).

Because core competencies are, by definition, the source of a firm’s competitive advan- tage, the successful global expansion by manufacturing companies such as Toyota and P&G was based not just on leveraging products and selling them in foreign markets, but also on the transfer of core competencies to foreign markets where indigenous competitors lacked them. The same can be said of companies engaged in the service sectors of an economy, such as financial institutions, retailers like IKEA, restaurant chains, and hotels. Expanding the market for their services often means replicating their business model in foreign nations (albeit with some changes to account for local differences, which we will discuss in more detail shortly). Firms like Starbucks and Subway, for example, expanded rapidly outside their home markets in the United States by taking the basic business model that they devel- oped at home and using that as a blueprint for establishing international operations.

LOCATION ECONOMIES

Earlier chapters revealed that countries differ along a range of dimensions—including the economic, political, legal, and cultural—and that these differences can either raise or lower the costs of doing business in a country. The theory of international trade also teaches that

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due to differences in factor costs, certain countries have a comparative advantage in the production of certain products. Japan might excel in the production of automobiles and consumer electronics; the United States in the production of computer software, pharma- ceuticals, biotechnology products, and financial services.22 For a firm that is trying to survive in a competitive global market, this implies that trade barriers and transportation costs permitting, the firm will benefit by basing each value creation activity it performs at that location where economic, political, and cultural conditions, including relative factor costs, are most conducive to the performance of that activity.

Firms that pursue such a strategy can realize what we refer to as location economies, which are the economies that arise from performing a value creation activity in the opti- mal location for that activity, wherever in the world that might be (transportation costs and trade barriers permitting).23 Locating a value creation activity in the optimal loca- tion for that activity can have one of two effects: It can lower the costs of value creation and help the firm achieve a low-cost position, and/or it can enable a firm to differentiate its product offering from those of competitors. In terms of Figure 13.2, it can lower C and/or increase V (which in general supports higher pricing), both of which boost the profit- ability of the enterprise.

For an example of how this works in an international business, consider ClearVision Optical, a manufacturer and distributor of eyewear. Started by David Glassman, the firm now generates annual gross revenues of more than $100 million. Not exactly small, but no corporate giant either, ClearVision is a multinational firm with production facilities on three continents and customers around the world. ClearVision began its move toward be- coming a multinational when its sales were still less than $20 million. At the time, the U.S. dollar was very strong, and this made U.S.-based manufacturing expensive. Low-priced imports were taking an ever-larger share of the U.S. eyewear market, and ClearVision real- ized it could not survive unless it also began to import. Initially the firm bought from inde- pendent overseas manufacturers, primarily in Hong Kong. However, the firm became dissatisfied with these suppliers’ product quality and delivery. As ClearVision’s volume of imports increased, Glassman decided the best way to guarantee quality and delivery was to set up ClearVision’s own manufacturing operation overseas. Accordingly, ClearVision found a Chinese partner, and together they opened a manufacturing facility in Hong Kong, with ClearVision being the majority shareholder.

The choice of the Hong Kong location was influenced by its combination of low labor costs, a skilled workforce, and tax breaks given by the Hong Kong government. The firm’s objective at this point was to lower production costs by locating value creation activities at an appropriate location. After a few years, however, the increasing industrialization of Hong Kong and a growing labor shortage had pushed up wage rates to the extent that it was no longer a low-cost location. In response, Glassman and his Chinese partner moved part of their manufacturing to a plant in mainland China to take advantage of the lower wage rates there. Again, the goal was to lower production costs. The parts for eyewear frames manufactured at this plant were shipped to the Hong Kong factory for final assem- bly and then distributed to markets in North and South America. The Hong Kong factory now employs 80 people and the Chinese plant between 300 and 400.

At the same time, ClearVision was looking for opportunities to invest in foreign eyewear firms with reputations for fashionable design and high quality. Its objective was not to re- duce production costs but to launch a line of high-quality differentiated, “designer” eye- wear. ClearVision did not have the design capability in-house to support such a line, but Glassman knew that certain foreign manufacturers did. As a result, ClearVision invested in factories in Japan, France, and Italy, holding a minority shareholding in each case. These factories now supply eyewear for ClearVision’s Status Eye division, which markets high- priced designer eyewear.24

Thus, to deal with a threat from foreign competition, ClearVision adopted a strategy intended to lower its cost structure (lower C): shifting its production from a high-cost loca- tion, the United States, to a low-cost location, first Hong Kong and later China. Then ClearVision adopted a strategy intended to increase the perceived value of its product

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(increase V) so it could charge a premium price (P). Reasoning that premium pricing in eyewear depended on superior design, its strategy involved investing capital in French, Italian, and Japanese factories that had reputations for superior design. In sum, ClearVision’s strategies included some actions intended to reduce its costs of creating value and other actions intended to add perceived value to its product through differentiation. The overall goal was to increase the value created by ClearVision and thus the profitability of the en- terprise. To the extent that these strategies were successful, the firm should have attained a higher profit margin and greater profitability than if it had remained a U.S.-based manu- facturer of eyewear.

Creating a Global Web Generalizing from the ClearVision example, one result of this kind of thinking is the cre- ation of a global web of value creation activities, with different stages of the value chain being dispersed to those locations around the globe where perceived value is maximized or where the costs of value creation are minimized.25 Consider Lenovo’s ThinkPad laptop computers (Lenovo is the Chinese computer company that purchased IBM’s personal computer operations in 2005).26 This product is designed in the United States by engineers because Lenovo believes that the United States is the best location in the world to do the basic design work. The case, keyboard, and hard drive are made in Thailand; the display screen and memory in South Korea; the built-in wireless card in Malaysia; and the micro- processor in the United States.

In each case, these components are manufactured and sourced from the optimal loca- tion given current factor costs. These components are then shipped to an assembly opera- tion in China, where the product is assembled before being shipped to the United States for final sale. Lenovo assembles the ThinkPad in Mexico because managers have calcu- lated that due to low labor costs, the costs of assembly can be minimized there. The mar- keting and sales strategy for North America is developed by Lenovo personnel in the United States, primarily because managers believe that due to their knowledge of the local marketplace, U.S. personnel add more value to the product through their marketing efforts than personnel based elsewhere.

In theory, a firm that realizes location economies by dispersing each of its value cre- ation activities to its optimal location should have a competitive advantage vis-à-vis a firm that bases all of its value creation activities at a single location. It should be able to better differentiate its product offering (thereby raising perceived value, V) and lower its cost structure (C) than its single-location competitor. In a world where competitive pressures are increasing, such a strategy may become an imperative for survival.

Some Caveats Introducing transportation costs and trade barriers complicates this picture. Due to favor- able factor endowments, New Zealand may have a comparative advantage for automobile assembly operations, but high transportation costs of parts that often would be heavy can make it an uneconomical location from which to serve global markets. Another caveat concerns the importance of assessing political and economic risks when making location decisions. Even if a country looks very attractive as a production location when measured against all the standard criteria, if its government is unstable or totalitarian, the firm might be advised not to base production there. (Political risk is discussed in Chapter 2.) Simi- larly, if the government appears to be pursuing inappropriate economic policies that could lead to foreign exchange risk, that might be another reason for not basing production in that location, even if other factors look favorable.

EXPERIENCE EFFECTS

The experience curve refers to systematic reductions in production costs that have been observed to occur over the life of a product.27 A number of studies have observed that a product’s production costs decline by some quantity about each time cumulative output

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doubles. The relationship was first observed in the aircraft industry, where each time cu- mulative output of airframes was doubled, unit costs typically declined to 80 percent of their previous level.28 Thus, production cost for the fourth airframe would be 80 percent of production cost for the second airframe, the eighth airframe’s production costs 80 percent of the fourth’s, the sixteenth’s 80 percent of the eighth’s, and so on. Figure 13.5 illustrates this experience curve relationship between unit production costs and cumulative output (the relationship is for cumulative output over time and not output in any one period, such as a year). Two things explain this: learning effects and economies of scale.

Learning Effects Learning effects refer to cost savings that come from learning by doing.29 Labor, for ex- ample, learns by repetition how to carry out a task, such as assembling airframes, most efficiently. Labor productivity increases over time as individuals learn the most efficient ways to perform particular tasks. Equally important in new production facilities, manage- ment typically learns how to manage the new operation more efficiently over time. Hence, production costs decline due to increasing labor productivity and management efficiency, which increases the firm’s profitability.

Learning effects tend to be more significant when a technologically complex task is re- peated because there is more that can be learned about the task. Thus, learning effects will be more significant in an assembly process involving 1,000 complex steps than in one of only 100 simple steps. No matter how complex the task, however, learning effects typically disappear after a while. It has been suggested that they are important only during the start-up period of a new process and that they cease after two or three years.30 Any decline in the experience curve after such a point is due to economies of scale.

Economies of Scale Economies of scale refer to the reductions in unit cost achieved by producing a large volume of a product. Attaining economies of scale lowers a firm’s unit costs and increases its profitability.31 Economies of scale have a number of sources. One is the ability to spread fixed costs over a large volume.32 Fixed costs are the costs required to set up a production facility, develop a new product, and the like. They can be substantial. For example, the fixed cost of establishing a new production line to manufacture semiconductor chips now exceeds $1 billion. Similarly, according to one estimate, developing a new drug and bring- ing it to market costs about $800 million and takes about 12 years.33 The only way to re- coup such high fixed costs may be to sell the product worldwide, which reduces average unit costs by spreading fixed costs over a larger volume. The more rapidly that cumulative sales volume is built up, the more rapidly fixed costs can be amortized over a large produc- tion volume, and the more rapidly unit costs will fall.

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The experience curve.

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Second, a firm may not be able to attain an efficient scale of production unless it serves global markets. In the automobile industry, for example, an efficiently scaled factory is one designed to produce about 200,000 units a year. Automobile firms would prefer to pro- duce a single model from each factory since this eliminates the costs associated with switching production from one model to another. If domestic demand for a particular model is only 100,000 units a year, the inability to attain a 200,000-unit output will drive up average unit costs. By serving international markets as well, however, the firm may be able to push production volume up to 200,000 units a year, thereby reaping greater scale economies, lowering unit costs, and boosting profitability.

Finally, as global sales increase the size of the enterprise, so its bargaining power with suppliers increases, which may allow it to attain economies of scale in purchasing, bargain- ing down the cost of key inputs and boosting profitability that way. For example, Walmart has used its enormous sales volume as a lever to bargain down the price it pays suppliers for merchandise sold through its stores.

Strategic Significance The strategic significance of the experience curve is clear. Moving down the experience curve allows a firm to reduce its cost of creating value (to lower C in Figure 13.2) and in- crease its profitability. The firm that moves down the experience curve most rapidly will have a cost advantage vis-à-vis its competitors. Firm A in Figure 13.5, because it is farther down the experience curve, has a clear cost advantage over firm B.

Many of the underlying sources of experience-based cost economies are plant-based. This is true for most learning effects as well as for the economies of scale derived by spreading the fixed costs of building productive capacity over a large output, attaining an efficient scale of output, and utilizing a plant more intensively. Thus, one key to progressing downward on the experience curve as rapidly as possible is to increase the volume produced by a single plant as rapidly as possible. Because global markets are larger than domestic markets, a firm that serves a global market from a single location is likely to build accumulated volume more quickly than a firm that serves only its home market or that serves multiple markets from multiple production locations. Thus, serving a global market from a single location is consistent with moving down the expe- rience curve and establishing a low-cost position. In addition, to get down the experi- ence curve rapidly, a firm may need to price and market aggressively so demand will expand rapidly. It will also need to build sufficient production capacity for serving a global market. Also, the cost advantages of serving the world market from a single loca- tion will be even more significant if that location is the optimal one for performing the particular value creation activity.

Once a firm has established a low-cost position, it can act as a barrier to new competi- tion. Specifically, an established firm that is well down the experience curve, such as firm A in Figure 13.5, can price so that it is still making a profit while new entrants, which are farther up the curve, are suffering losses. Intel is one of the masters of this kind of strategy. The costs of building a state-of-the-art facility to manufacture microprocessors are so large (now around $5 billion) that to make this investment pay Intel must pursue experience curve effects, serving world markets from a limited number of plants to maximize the cost economies that derive from scale and learning effects.

LEVERAGING SUBSIDIARY SKILLS

Implicit in our earlier discussion of core competencies is the idea that valuable skills are developed first at home and then transferred to foreign operations. However, for more mature multinationals that have already established a network of subsidiary op- erations in foreign markets, the development of valuable skills can just as well occur in foreign subsidiaries.34 Skills can be created anywhere within a multinational’s global network of operations, wherever people have the opportunity and incentive to try new

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ways of doing things. The creation of skills that help lower the costs of production, or enhance perceived value and support higher product pricing, is not the monopoly of the corporate center.

Leveraging the skills created within subsidiaries and applying them to other opera- tions within the firm’s global network may create value. McDonald’s increasingly is find- ing that its foreign franchisees are a source of valuable new ideas. Faced with slow growth in France, its local franchisees have begun to experiment not only with the menu, but also with the layout and theme of restaurants. Gone are the ubiquitous golden arches; gone too are many of the utilitarian chairs and tables and other plastic features of the fast-food giant. Many McDonald’s restaurants in France now have hardwood floors, exposed brick walls, and even armchairs. Half of the 1,200 or so outlets in France have been upgraded to a level that would make them unrecognizable to an American. The menu too has been changed to include premier sandwiches, such as chicken on fo- caccia bread, priced some 30 percent higher than the average hamburger. In France at least, the strategy seems to be working. Following the change, increases in same-store sales rose from 1 percent annually to 3.4 percent. Impressed with the impact, McDonald’s executives are considering similar changes at other McDonald’s restaurants in markets where same-store sales growth is sluggish, including the United States.35 Another exam- ple of a multinational firm leveraging subsidiary skills is given in the next Management Focus feature.

For the managers of the multinational enterprise, this phenomenon creates impor- tant new challenges. First, they must have the humility to recognize that valuable skills that lead to competencies can arise anywhere within the firm’s global network, not just at the corporate center. Second, they must establish an incentive system that en- courages local employees to acquire new skills. This is not as easy as it sounds. Creat- ing new skills involves a degree of risk. Not all new skills add value. For every valuable idea created by a McDonald’s subsidiary in a foreign country, there may be several failures. The management of the multinational must install incentives that encourage employees to take the necessary risks. The company must reward people for successes and not sanction them unnecessarily for taking risks that did not pan out. Third, man- agers must have a process for identifying when valuable new skills have been created in a subsidiary. And finally, they need to act as facilitators, helping transfer valuable skills within the firm.

PROFITABILITY AND PROFIT GROWTH SUMMARY

We have seen how firms that expand globally can increase their profitability and profit growth by entering new markets where indigenous competitors lack similar competencies, by lowering costs and adding value to their product offering through the attainment of lo- cation economies, by exploiting experience curve effects, and by transferring valuable skills between their global network of subsidiaries. For completeness, it should be noted that strategies that increase profitability may also expand a firm’s business and thus enable it to attain a higher rate of profit growth. For example, by simultaneously realizing location economies and experience effects, a firm may be able to produce a more highly valued product at a lower unit cost, thereby boosting profitability. The increase in the perceived value of the product may also attract more customers, thereby increasing revenues and profits as well.

Rather than raising prices to reflect the higher perceived value of the product, the firm’s managers may elect to hold prices low in order to increase global market share and attain greater scale economies (in other words, they may elect to offer consumers better “value for money”). Such a strategy could increase the firm’s rate of profit growth even further since consumers will be attracted by prices that are low relative to value. The strat- egy might also increase profitability if the scale economies that result from market share gains are substantial. In sum, managers need to keep in mind the complex relationship between profitability and profit growth when making strategic decisions about pricing.

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coordinates the movement and processing of iron and steel slabs, whereas in Burns Harbor, the same work was done by workers relying on phone calls and paper. Em- ployees at Gent had also made a number of modifications to reduce waste. They developed a specially designed nozzle attached to a huge hose that was used to remove flakes from hot steel. Placed at a more efficient angle, the same amount of surface impurities could be removed with less water. Welders at Gent also cut coils of steel to order, which kept waste to a minimum as well. By adopting the improvements pioneered in Gent, em- ployees at Burns Harbor found that they were able to sig- nificantly increase productivity. For example, by adopting the same computer software that the Gent workers had developed, employees at Burns Harbor were able to in- crease the average number of cauldrons of molten steel they made each day from 42 to 50. As a result of improve- ments such as these, employee productivity at Burns Harbor, measured by work hours per ton of steel produced, increased from around 2.0 to 1.32. By leveraging the skills developed at Gent, and applying them to the Burns Harbor steel mill, ArcelorMittal had boosted the performance of the acquired company, creating considerable value in the pro- cess and guaranteeing the future of the Burns Harbor mill.

Sources: John W. Miller and Alex MacDonald, “ArcelorMittal Says Steel Markets Are Stabilizing as Losses Narrow,” The Wall Street Jour- nal, May 6, 2016; Jan Hromadko and John W. Miller, “ArcelorMittal, Nippon Steel Buy ThyssenKrupp Alabama Steel Mill for $1.55 Billion,” The Wall Street Journal, November 29, 2013; J. W. Miller, “Indiana Steel Mill Revived with Lessons from Abroad,” The Wall Street Jour- nal, May 21, 2012.

ArcelorMittal is the world’s largest steelmaker with 210,000 employees in 60 countries, an infrastructure footprint in 19 countries, and more than 100 steelmaking facilities. Early on, ArcelorMittal perfected a simple strategy—buy rundown steel mills; cut costs; lay off excess workers; take actions to improve productivity, particularly through auto- mation; and transform the acquisition into a profitable en- terprise. It worked again and again all around the world. More recently, ArcelorMittal has kept the productivity gains coming by pursuing a strategy known in the com- pany as “twinning.” Mittal “twins” pairs of mills—usually of a similar size, age, product mix, and output level—against each other. The weaker mill is told to copy the practices of the stronger mill, while the stronger mill is told to keep its edge. Managers are summoned to regular meetings to compare their performance and to look for ways of im- proving the productivity of the weaker mill. In one example, a poorly performing plant in Burns Harbor, Indiana, was twinned with a high-performing mill in Gent, Belgium. More than 100 engineers and managers were flown from Burns Harbor to Gent and told to look at everything the Belgians did and copy them. The Belgium mill was one of the most efficient of its kind in the world, with work hours per ton of steel produced coming in at 1.25 versus an industry average of 2.0. The Americans quickly realized that Gent’s high perfor- mance was not due to lower pay—in fact, total pay plus benefits was higher in Gent than at Burns Harbor. Rather, the Belgium mill had adopted a number of processes that increased productivity. For example, in Gent a computer

Leveraging Skills Worldwide at ArcelorMittal

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LO 13 -3 Understand how pressures for cost reductions and local responsiveness influence strategic choice.

Cost Pressures and Pressures for Local Responsiveness

Firms that compete in the global marketplace typically face two types of competitive pres- sure that affect their ability to realize location economies and experience effects and to leverage products and transfer competencies and skills within the enterprise. They face pressures for cost reductions and pressures to be locally responsive (see Figure 13.6).36 These competitive pressures place conflicting demands on a firm. Responding to pressures for cost reductions requires that a firm try to minimize its unit costs. But responding to pres- sures to be locally responsive requires that a firm differentiates its product offering and marketing strategy from country to country in an effort to accommodate the diverse de- mands arising from national differences in consumer tastes and preferences, business practices, distribution channels, competitive conditions, and government policies. In

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some cases, companies also need to differentiate between segments within countries, placing an even greater pressure on cost than country customization. Because differentiation across countries can involve significant duplication and a lack of product standardiza- tion, it may raise costs.

While some enterprises, such as firm A in Figure 13.6, face high pressures for cost re- ductions and low pressures for local responsiveness, and others, such as firm B, face low pressures for cost reductions and high pressures for local responsiveness, many companies are in the position of firm C. They face high pressures for both cost reductions and local responsiveness. Dealing with these conflicting and contradictory pressures is a difficult strategic challenge, primarily because being locally responsive tends to raise costs.

PRESSURES FOR COST REDUCTIONS

In competitive global markets, international businesses often face pressures for cost reduc- tions. Responding to pressures for cost reduction requires a firm to try to lower the costs of value creation. A manufacturer, for example, might mass-produce a standardized prod- uct at the optimal location in the world, wherever that might be, to realize economies of scale, learning effects, and location economies. Alternatively, a firm might outsource cer- tain functions to low-cost foreign suppliers in an attempt to reduce costs. A service busi- ness such as a bank might respond to cost pressures by moving some back-office functions, such as information processing, to developing nations where wage rates are lower.

Pressures for cost reduction can be particularly intense in industries producing commodity-type products where meaningful differentiation on nonprice factors is difficult and price is the main competitive weapon. This tends to be the case for products that serve universal needs. Universal needs exist when the tastes and preferences of consumers in different nations are similar if not identical. This is the case for conventional commodity products such as bulk chemicals, petroleum, steel, sugar, and the like. It also tends to be the case for many industrial and consumer products, for example, handheld calculators, semiconductor chips, personal computers, and liquid crystal display screens. Pressures for cost reductions are also intense in industries where major competitors are based in low- cost locations, where there is persistent excess capacity and where consumers are powerful and face low switching costs. The liberalization of the world trade and investment environ- ment in recent decades, by facilitating greater international competition, has generally in- creased cost pressures.37

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Pressures for cost reductions and local responsiveness.

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PRESSURES FOR LOCAL RESPONSIVENESS

Pressures for local responsiveness arise from national differences in consumer tastes and preferences, infrastructure, accepted business practices, and distribution channels, and from host-government demands. Responding to pressures to be locally responsive requires a firm to differentiate its products and marketing strategy from country to country to ac- commodate these factors, all of which tends to raise the firm’s cost structure.

Differences in Customer Tastes and Preferences Strong pressures for local responsiveness emerge when customer tastes and preferences differ significantly between countries, as they often do for deeply embedded historic or cultural reasons. In such cases, a multinational’s products and marketing message have to be customized to appeal to the tastes and preferences of local customers. This typically creates pressure to delegate production and marketing responsibilities and functions to a firm’s overseas subsidiaries.

For example, some time ago the automobile industry moved toward the creation of “world cars.” The idea was that global companies such as General Motors, Ford, and Toyota would be able to sell the same basic vehicle the world over, sourcing it from centralized production locations. If successful, the strategy would have enabled automobile companies to reap significant gains from global scale economies. However, this strategy frequently ran aground on the hard rocks of consumer reality. Consumers in different automobile mar- kets seem to have different tastes and preferences and demand different types of vehicles. North American consumers show a strong demand for pickup trucks. This is particularly true in the South and West, where many families have a pickup truck as a second or third car. But in European countries, pickup trucks are seen purely as utility vehicles and are purchased primarily by firms rather than individuals. As a consequence, the product mix and marketing message needs to be tailored to consider the different nature of demand in North America and Europe.

Some have argued that customer demands for local customization are on the decline worldwide.38 According to this argument, modern communications and transport tech- nologies have created the conditions for a convergence of the tastes and preferences of consumers from different nations. The result is the emergence of enormous global markets for standardized consumer products. The worldwide acceptance of Subway sandwiches, McDonald’s hamburgers, Coca-Cola, Gap clothes, Apple iPhones, and Microsoft’s Xbox— all of which are sold globally as standardized products—are often cited as evidence of the increasing homogeneity of the global marketplace.

However, this argument may not hold in many consumer goods markets. Significant differences in consumer tastes and preferences still exist across nations and cultures. Man- agers in international businesses do not yet have the luxury of being able to ignore these differences, and they may not for a long time to come. For an example of a company that has discovered how important pressures for local responsiveness can still be, read the ac- companying Management Focus on Viacom Media Networks.

Differences in Infrastructure and Traditional Practices Pressures for local responsiveness arise from differences in infrastructure or tradi- tional practices among countries, creating a need to customize products accordingly. Fulfilling this need may require the delegation of manufacturing and production func- tions to foreign subsidiaries. For example, in North America, consumer electrical sys- tems are based on 110 volts, whereas in some European countries, 240-volt systems are standard. Thus, domestic electric appliances have to be customized for this differ- ence in infrastructure.

Although many national differences in infrastructure are rooted in history, some are quite recent. For example, in the wireless telecommunications industry different techni- cal standards exist in different parts of the world. A technical standard known as GSM is common in Europe, and an alternative standard, CDMA, is more common in the

Viacom International Media Networks, formerly the MTV Networks, has become a symbol of globalization. Viacom figures that every second of every day more than 2 million people are watching its network around the world, the ma- jority outside of the United States. Despite its international success, the original MTV’s global expansion got off to a weak start. In the 1980s, when the main programming fare was still music videos, it piped a single feed across Europe almost entirely com- posed of American programming with English-speaking veejays. Naively, the network’s U.S. managers thought Europeans would flock to the American programming. But while viewers in Europe shared a common interest in a handful of global superstars, their tastes turned out to be surprisingly local. After losing share to local competi- tors, who focused more on local tastes, MTV changed its strategy. It broke its service into “feeds” aimed at national or regional markets. While the company exercises cre- ative control over these different feeds, and while all the

Viacom International Media Networks channels have the same familiar frenetic look and feel of, for example, MTV in the United States, a significant share of the programming and content is now local. Although a lot of programming ideas still originate in the United States, with staples such as the Real World having equivalents in different countries, an increasing share of programming is local in conception. In Italy, MTV Kitchen combines cooking with a music countdown. Erotica airs in Brazil and features a panel of youngsters discussing sex. The Indian channel produces 21 homegrown shows hosted by local veejays who speak “Hinglish,” a city-bred version of Hindi and English. Many feeds still feature music videos by locally popular performers. This localization push reaped big benefits for MTV, allowing the network to capture viewers back from local imitators.

Sources: Tony Maglio, “Viacom International Media Networks Names David Lynn CEO,” The Wrap, January 11, 2017; M. Gunther, “MTV’s Passage to India,” Fortune, August 9, 2004, 117–122; B. Pulley and A. Tanzer, “Sumner’s Gemstone,” Forbes, February 21, 2000, pp. 107–11.

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United States and parts of Asia. Equipment designed for GSM will not work on a CDMA network and vice versa. Thus, companies such as Nokia, Motorola, and Samsung, which manufacture wireless handsets and infrastructure such as switches, need to cus- tomize their product offering according to the technical standard prevailing in a given country.

Differences in Distribution Channels A firm’s marketing strategies may have to be responsive to differences in distribution chan- nels among countries, which may necessitate the delegation of marketing functions to na- tional subsidiaries. In the pharmaceutical industry, for example, the British and Japanese distribution systems are radically different from the U.S. system. British and Japanese doctors will not accept or respond favorably to a U.S.-style high-pressure sales force. Thus, pharmaceutical companies have to adopt different marketing practices in Britain and Japan compared with the United States—soft sell versus hard sell. Similarly, Poland, Brazil, and Russia all have similar per capita income on a purchasing power parity basis, but there are big differences in distribution systems across the three countries. In Brazil, supermar- kets account for 36 percent of food retailing, in Poland for 18 percent, and in Russia for less than 1 percent.39 These differences in channels require that companies adapt their own distribution and sales strategy.

Host-Government Demands Economic and political demands imposed by host-country governments may require lo- cal responsiveness. For example, pharmaceutical companies are subject to local clinical testing, registration procedures, and pricing restrictions, all of which make it necessary that the manufacturing and marketing of a drug should meet local requirements. Be- cause governments and government agencies control a significant proportion of the

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health care budget in most countries, they are in a powerful position to demand a high level of local responsiveness.

More generally, threats of protectionism, economic nationalism, and local content rules (which require that a certain percentage of a product should be manufactured lo- cally) dictate that international businesses manufacture locally. For example, consider Bombardier, the Canadian-based manufacturer of railcars, aircraft, jet boats, and snow- mobiles. Bombardier has 12 railcar factories across Europe. Critics of the company ar- gue that the resulting duplication of manufacturing facilities leads to high costs and helps explain why Bombardier makes lower profit margins on its railcar operations than on its other business lines. In reply, managers at Bombardier argue that in Europe, infor- mal rules with regard to local content favor people who use local workers. To sell rail- cars in Germany, they claim, you must manufacture in Germany. The same goes for Belgium, Austria, and France. To try to address its cost structure in Europe, Bombardier has centralized its engineering and purchasing functions, but it has no plans to central- ize manufacturing.40

Rise of Regionalism Traditionally, we have tended to think of pressures for local responsiveness as being de- rived from national differences in tastes and preferences, infrastructure, and the like. While this is still often the case, there is also a tendency toward the convergence of tastes, prefer- ences, infrastructure, distribution channels, and host-government demands with a broader region that is composed of two or more nations.41 We tend to see this when there are strong pressures for convergence due to, for example, a shared history and culture or the establishment of a trading block where there are deliberate attempts to harmonize trade policies, infrastructure, regulations, and the like.

The most obvious example of a region is the European Union, and particularly the euro zone countries within that trade bloc, where there are institutional forces that are pushing toward convergence (see Chapter 9 for details). The creation of a single EU market—with a single currency, common business regulations, standard infrastructure, and so on— cannot help but result in the reduction of certain national differences among countries within the EU and the creation of one regional rather than several national markets. In- deed, at the economic level at least, that is the explicit intent of the EU.

Another example of regional convergence is North America, which includes the United States, Canada, and to some extent in some product markets, Mexico. Canada and the United States share history, language, and much of their culture, and both are members of NAFTA. Mexico is clearly different in many regards, but its proximity to the United States, along with its membership in NAFTA, implies that for some product markets (e.g., auto- mobiles) it might be reasonable to consider Mexico as part of a relatively homogeneous regional market. We might also talk about the Latin America region, where shared Spanish history, cultural heritage, and language (with the exception of Brazil, which was colonized by the Portuguese) means that national differences are somewhat moderated. It can also be argued that Greater China, which includes the city-states of Hong Kong and Singapore along with Taiwan, is a coherent region, as is much of the Middle East, where a strong Arab culture and shared history may limit national differences. Similarly, Russia and some of the former states of the Soviet Union, such as Belarus and Ukraine, might be considered part of a larger regional market, at least for some products.

Taking a regional perspective is important because it may suggest that localization at the regional rather than the national level is the appropriate strategic response. For example, rather than produce cars for each national market within Europe or North America, it makes far more sense for car manufacturers to build cars for the European or North American regions. The ability to standardize a product offering within a region allows for the attainment of greater scale economies, and hence lower costs, than if each nation had to have its own offering. At the same time, this perspective should not be pushed too far. There are still deep and profound cultural differences among France,

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Germany, and Italy—all members of the EU—that may in turn require some degree of local customization at the national level. For example, the United Kingdom is leaving the EU (e.g., Brexit) due to these national differences. Managers must thus make a judg- ment call about the appropriate level of aggregation given (1) the product market they are looking at and (2) the nature of national differences and trends for regional conver- gence. What might make sense for automobiles, for example, might not be appropriate for packaged food products.

Choosing a Strategy

Pressures for local responsiveness (e.g., due to customers’ needs and preferences) imply that it may not be possible for a firm to realize the full benefits from economies of scale, learning effects, and location economies. In fact, it may not be possible or even realistic to think that a firm can serve the global marketplace from a single, low-cost location, produc- ing a globally standardized product and marketing it worldwide to attain the cost reduc- tions associated with experience effects. The need to customize the product to local conditions may work against the implementation of such a strategy.

For example, automobile firms have found that Japanese, American, and European consumers demand different kinds of cars, and this necessitates producing products that are customized for regional markets. In response, firms such as General Motors, Honda, Ford, and Toyota are pursuing a strategy of establishing top-to-bottom design and produc- tion facilities in each of these important world regions to better serve local demands.42 Although such customization brings benefits, it also limits the ability of a firm to realize significant scale economies and location economies.

In addition, pressures for local responsiveness imply that it may not be possible to lever- age skills and products associated with a firm’s core competencies fully from one nation to another. Concessions often have to be made to local conditions—basically, it’s all about get- ting the sale. The trade-off between obtaining the sale or not by taking a standardized prod- uct and customizing it at least to some degree to the local customer needs is rooted in a cost/

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General Motors’ supercar, the Chevrolet Corvette Z06, being showcased in Stuttgart, Germany. ©Sergey Kohl/123RF

LO 13 - 4 Identify and choose the different global strategies for competing in the global marketplace.

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benefit analysis and opportunity assessment. Despite being depicted as “poster child” for the proliferation of standardized global products, even McDonald’s has found that it has to cus- tomize its product offerings (i.e., its menu) to account for national differences in tastes and preferences. As we can also see in several cases in this text, companies such as Domino’s, Subway, and other McDonald’s competitors also customize to local tastes and preferences.

How do differences in the strength of pressures for cost reductions versus those for lo- cal responsiveness affect a firm’s choice of strategy? Firms typically choose among four main strategic postures when competing internationally. These can be characterized as a global standardization strategy, a localization strategy, a transnational strategy, and an in- ternational strategy.43 The appropriateness of each strategy varies given the extent of pres- sures for cost reductions and local responsiveness. Figure 13.7 illustrates the conditions under which each of these strategies is most appropriate.

GLOBAL STANDARDIZATION STRATEGY

Firms that pursue a global standardization strategy focus on increasing profitability and profit growth by reaping the cost reductions that come from economies of scale, learn- ing effects, and location economies. Their strategic goal is to pursue a low-cost strategy on a global scale. The production, marketing, R&D, and supply chain activities of firms pur- suing a global standardization strategy are concentrated in a few favorable locations. Firms pursuing a global standardization strategy try not to customize their product offering and marketing strategy to local conditions because customization involves shorter production runs and the duplication of functions, which tend to raise costs. Instead, they prefer to market a standardized product worldwide so that they can reap the maximum benefits from economies of scale and learning effects. They also tend to use their cost advantage to support aggressive pricing in world markets.

A global standardization strategy makes the most sense when there are strong pressures for cost reductions and demands for local responsiveness are minimal. Increasingly, these conditions prevail in many industrial goods industries, whose products often serve univer- sal needs. In the semiconductor industry, for example, global standards have emerged, creating enormous demands for standardized global products. Companies such as Intel, Texas Instruments, and Motorola all pursue a global standardization strategy. However, these conditions are not always found in many consumer goods markets, where demands for local responsiveness remain high. The strategy is inappropriate when demands for local responsiveness can remain high.

F I G U R E 1 3 .7

Four basic strategies.

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LOCALIZATION STRATEGY

A localization strategy focuses on increasing profitability by customizing the firm’s goods or services so that they provide a good match to tastes and preferences in differ- ent national markets. Localization is most appropriate when there are substantial differ- ences across nations with regard to consumer tastes and preferences and where cost pressures are not too intense. By customizing the product offering to local demands, the firm increases the value of that product in the local market. On the downside, because it involves some duplication of functions and smaller production runs, customization lim- its the ability of the firm to capture the cost reductions associated with mass-producing a standardized product for global consumption. The strategy may make sense, however, if the added value associated with local customization supports higher pricing, which enables the firm to recoup its higher costs, or if it leads to substantially greater local demand, enabling the firm to reduce costs through the attainment of some scale econo- mies in the local market.

At the same time, firms still have to keep an eye on costs. Firms pursuing a localization strategy still need to be efficient and, whenever possible, to capture some scale economies from their global reach. As noted earlier, many automobile companies have found that they have to customize some of their product offerings to local market demands—for ex- ample, producing large pickup trucks for U.S. consumers and small, fuel-efficient cars for Europeans and Japanese. At the same time, these multinationals try to get some scale economies from their global volume by using common vehicle platforms and components across many different models, and manufacturing those platforms and components at ef- ficiently scaled factories that are optimally located. By designing their products in this way, these companies have been able to localize their product offering, yet simultaneously cap- ture some scale economies, learning effects, and location economies.

TRANSNATIONAL STRATEGY

We have argued that a global standardization strategy makes most sense when cost pres- sures are intense and demands for local responsiveness are limited. Conversely, a localiza- tion strategy makes most sense when demands for local responsiveness are high but cost pressures are moderate or low. What happens, however, when the firm simultaneously faces both strong cost pressures and strong pressures for local responsiveness? How can managers balance the competing and inconsistent demands such divergent pressures place on the firm? According to some researchers, the answer is to pursue what has been called a transnational strategy.

Two of these researchers, Christopher Bartlett and Sumantra Ghoshal, argue that com- petitive conditions are so intense that to survive, firms must do all they can to respond to pressures for cost reductions and local responsiveness. They must try to realize location economies and experience effects, to leverage products internationally, to transfer core competencies and skills within the company, and to simultaneously pay attention to pres- sures for local responsiveness.44 Bartlett and Ghoshal note that in the modern multina- tional enterprise, core competencies and skills do not reside just in the home country, but can develop in any of the firm’s worldwide operations. Thus, they maintain that the flow of skills and product offerings should not be all one way, from home country to foreign subsidiary. Rather, the flow should also be from foreign subsidiary to home country and from foreign subsidiary to foreign subsidiary. Transnational enterprises, in other words, must also focus on leveraging subsidiary skills.

In essence, firms that pursue a transnational strategy are trying to simultaneously achieve low costs through location economies, economies of scale, and learning effects; differentiate their product offering across geographic markets to account for local differ- ences; and foster a multidirectional flow of skills between different subsidiaries in the firm’s global network of operations. As attractive as this may sound in theory, the strategy is not an easy one to pursue since it places conflicting demands on the company. Differen- tiating the product to respond to local demands in different geographic markets raises

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costs, which runs counter to the goal of reducing costs. Companies such as 3M and ABB (one of the world’s largest engineering conglomerates) have tried to embrace a transna- tional strategy and found it difficult to implement.

How best to implement a transnational strategy is one of the most complex questions large multinationals are grappling with today. Few if any enterprises have perfected this stra- tegic posture. But some clues as to the right approach can be derived from a number of companies. For an example, consider the case of Caterpillar. The need to compete with low- cost competitors such as Komatsu of Japan forced Caterpillar to look for greater cost econo- mies. However, variations in construction practices and government regulations across countries mean that Caterpillar also has to be responsive to local demands. Therefore, Caterpillar confronted significant pressures for cost reductions and for local responsiveness.

To deal with cost pressures, Caterpillar redesigned its products to use many identical components and invested in a few large-scale component manufacturing facilities, sited at favorable locations, to fill global demand and realize scale economies. At the same time, the company augments the centralized manufacturing of components with assembly plants in each of its major global markets. At these plants, Caterpillar adds local product features, tailoring the finished product to local needs. Thus, Caterpillar is able to realize many of the benefits of global manufacturing while reacting to pressures for local responsiveness by differentiating its product among national markets.45 Caterpillar doubled output per em- ployee, significantly reducing its overall cost structure in the process. Meanwhile, Komatsu and Hitachi, which are still wedded to a Japan-centric global strategy, have seen their cost advantages evaporate and have been steadily losing market share to Caterpillar.

Changing a firm’s strategic posture to build an organization capable of supporting a transnational strategy is a complex and challenging task. Some would say it is too complex, because the strategy implementation problems of creating a viable organization structure and control systems to manage this strategy are immense.

INTERNATIONAL STRATEGY

Sometimes it is possible to identify multinational firms that find themselves in the fortu- nate position of being confronted with low cost pressures and low pressures for local responsiveness. Many of these enterprises have pursued an international strategy, tak- ing products first produced for their domestic market and selling them internationally with only minimal local customization. The distinguishing feature of many such firms is that they are selling a product that serves universal needs, but they do not face signifi- cant competitors, and thus unlike firms pursuing a global standardization strategy, they are not confronted with pressures to reduce their cost structure. Xerox found itself in this position after its invention and commercialization of the photocopier. The technol- ogy underlying the photocopier was protected by strong patents, so for several years Xerox did not face competitors—it had a monopoly. The product serves universal needs, and it was highly valued in most developed nations. Thus, Xerox was able to sell the same basic product the world over, charging a relatively high price for that product. Since Xerox did not face direct competitors, it did not have to deal with strong pressures to minimize its cost structure.

Enterprises pursuing an international strategy have followed a similar developmental pattern as they expanded into foreign markets. They tend to centralize product develop- ment functions such as R&D at home. However, they also tend to establish manufacturing and marketing functions in each major country or geographic region in which they do business. The resulting duplication can raise costs, but this is less of an issue if the firm does not face strong pressures for cost reductions. Although they may undertake some lo- cal customization of product offering and marketing strategy, this tends to be rather lim- ited in scope. Ultimately, in most firms that pursue an international strategy, the head office retains fairly tight control over marketing and product strategy.

Other firms that have pursued this strategy include Procter & Gamble and Microsoft. Historically, Procter & Gamble developed innovative new products in Cincinnati and

Evolution of Strategy at Procter & Gamble Founded in 1837, Cincinnati-based Procter & Gamble has long been one of the world’s most international compa- nies. Today P&G is a global colossus in the consumer products business with annual sales in excess of $70 billion, more than 50 percent of which are generated outside the United States. P&G sells more than 300 brands— including Ivory soap, Tide, Pampers, IAMS pet food, Crisco, and Folgers—to consumers in 180 countries. Historically the strategy at P&G was well established. The company developed new products in Cincinnati and then relied on semiautonomous foreign subsidiaries to manufacture, market, and distribute those products in dif- ferent nations. In many cases, foreign subsidiaries had their own production facilities and tailored the packaging, brand name, and marketing message to local tastes and preferences. For years this strategy delivered a steady stream of new products and reliable growth in sales and profits. However, sales growth at P&G has been slowing and even declined in recent years The essence of the problem was simple. P&G’s costs were too high because of extensive duplication of manu- facturing, marketing, and administrative facilities in differ- ent national subsidiaries. The duplication of assets made sense in the world of the 1960s, when national markets were segmented from each other by barriers to cross- border trade. Products produced in the United Kingdom, for example, could not be sold economically in Germany due to high tariff duties levied on imports. By the 1980s, barri- ers to cross-border trade were falling rapidly worldwide, and fragmented national markets were merging into larger regional or global markets. Also, the retailers through which P&G distributed its products were growing larger and more global, such as Walmart, Tesco from the United Kingdom, and Carrefour from France. These emerging global retailers were demanding price discounts from P&G. In the 1990s, P&G embarked on a major reorganization in an attempt to control its cost structure and recognize the new reality of emerging global markets. The company shut down some 30 manufacturing plants around the globe, laid off 13,000 employees, and concentrated production in

fewer plants that could better realize economies of scale and serve regional markets. It wasn’t enough! Sales growth remained sluggish, so in 1999, P&G launched its second reorganization of the decade. Named “Organization 2005,” the goal was to transform P&G into a truly global company. The company tore up its old organization, which was based on countries and regions, and replaced it with one based on seven self-contained global business units, ranging from baby care to food products. Each business unit was given complete responsibility for generating profits from its products and for manufacturing, marketing, and product de- velopment. Each business unit was told to rationalize produc- tion, concentrating it in fewer larger facilities; to try to build global brands wherever possible, thereby eliminating market- ing differences between countries; and to accelerate the de- velopment and launch of new products. P&G announced that as a result of this initiative, it would close another 10 factories and lay off another 15,000 employees, mostly in Europe where there was still extensive duplication of assets. The annual cost savings were estimated to be about $800 million. P&G planned to use the savings to cut prices and increase marketing spending in an effort to gain mar- ket share, and thus further lower costs through the attain- ment of scale economies. This time, the strategy seemed to be working. For most of the 2000s, P&G reported strong growth in both sales and profits. Significantly, P&G’s global competitors, such as Unilever, Kimberly-Clark, and Colgate- Palmolive, were struggling during the same time period. Unfortunately, since 2014, P&G has again seen a de- cline in sales, rendering the future for P&G up in the air. Some argue the recent decline is a function of currency hits, but surely that cannot be the full story. What will hap- pen to the usually reliable consumer giant in the future?

Sources: Alexander Coolidge, “P&G’s $300M Mason Expansion Presses Ahead,” Cincinnati Enquirer, February 2, 2017; Lauren Coleman-Lochner and Carol Hymowitz, “At Procter & Gamble, the Innovation Well Runs Dry,” Bloomberg Businessweek, September 6, 2012; J. G. Strauss, “Firm Restructuring into Truly Global Company,” USA Today, September 10, 1999, p. B2; Procter & Gamble 10K Report, 2005; M. Kolbasuk McGee, “P&G Jump-Starts Corporate Change,” Information Week, November 1, 1999, pp. 30–34.

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then transferred them wholesale to local markets (see the accompanying Management Focus). Similarly, the bulk of Microsoft’s product development work occurs in Redmond, Washington, where the company is headquartered. Although some localization work is undertaken elsewhere, this is limited to producing foreign-language versions of popular Microsoft programs.

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THE EVOLUTION OF STRATEGY

The Achilles’ heel of the international strategy is that over time, competitors inevitably emerge, and if managers do not take proactive steps to reduce their firm’s cost structure, it will be rapidly outflanked by efficient global competitors. This is exactly what happened to Xerox. Japanese companies such as Canon ultimately invented their way around Xerox’s patents, produced their own photocopiers in very efficient manufacturing plants, priced them below Xerox’s products, and rapidly took global market share from Xerox. In the final analysis, Xerox’s demise was not due to the emergence of competitors, for ultimately that was bound to occur, but due to its failure to proactively reduce its cost structure in advance of the emergence of efficient global competitors. The message in this story is that an international strategy may not be viable in the long term, and to survive, firms need to shift toward a global standardiza- tion strategy or a transnational strategy in advance of competitors (see Figure 13.8).

The same can be said about a localization strategy. Localization may give a firm a com- petitive edge, but if it is simultaneously facing aggressive competitors, the company will also have to reduce its cost structure, and the only way to do that may be to shift toward a transnational strategy. This is what Procter & Gamble has been doing (see the accompany- ing Management Focus). Thus, as competition intensifies, international and localization strategies tend to become less viable, and managers need to direct their companies toward either a global standardization strategy or a transnational strategy.

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F I G U R E 1 3 . 8

Changes in strategy over time.

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strategy, p. 365 profitability, p. 365 profit growth, p. 365 value creation, p. 366 operations, p. 367 core competence, p. 371

location economies, p. 372 global web, p. 373 experience curve, p. 373 learning effects, p. 374 economies of scale, p. 374 universal needs, p. 378

global standardization strategy, p. 383

localization strategy, p. 384 transnational strategy, p. 384 international strategy, p. 385

Key Terms

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C H A P T E R S U M M A R Y

This chapter reviewed basic principles of strategy and the various ways in which firms can profit from global expan- sion, and it looked at the strategies that firms competing globally can adopt. The chapter made the following points:

 1. A strategy can be defined as the actions that manag- ers take to attain the goals of the firm. For most multinational corporations, especially publicly traded firms, the preeminent goal is to maximize shareholder value. Maximizing shareholder value re- quires firms to focus on increasing their profitability and the growth rate of profits over time.

 2. International expansion may enable a firm to earn greater returns by transferring the product offerings derived from its core competencies to markets where indigenous competitors lack those product offerings and competencies.

 3. It may pay a firm to base each value creation activ- ity it performs at that location where factor condi- tions are most conducive to the performance of that activity. We refer to this strategy as focusing on the attainment of location economies.

 4. By rapidly building sales volume for a standard- ized product, international expansion can assist a firm in moving down the experience curve by real- izing learning effects and economies of scale.

 5. A multinational firm can create additional value by identifying valuable skills created within its foreign subsidiaries and leveraging those skills within its global network of operations. These leverage issues are part of the firm’s global value chains.

 6. The best strategy for a firm to pursue often depends on a consideration of the pressures for cost reductions and for local responsiveness.

 7. Firms pursuing an international strategy transfer the products derived from core competencies to foreign markets while undertaking some limited local customization.

 8. Firms pursuing a localization strategy customize their product offering, marketing strategy, and business strategy to national conditions.

 9. Firms pursuing a global standardization strategy focus on reaping the cost reductions that come from experience curve effects and location economies.

10. Many industries are now so competitive that firms must adopt a transnational strategy. This involves a simultaneous focus on reducing costs, transferring skills and products, and boost- ing local responsiveness. Implementing such a strategy may not be easy.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

 1. In a world of zero transportation costs, no trade barriers, and significant differences between nations with regard to factor conditions, firms must expand internationally if they are to survive. Discuss.

 2. Plot the position of the following firms on Figure 13.6: Procter & Gamble, IBM, Apple, Coca-Cola, Dow Chemical, Intel, and McDonald’s. In each case justify your answer.

 3. In what kind of industries does a localization strategy make sense? When does a global stan- dardization strategy make most sense?

 4. Reread the Management Focus on Procter & Gamble, and then answer the following questions:

a. What strategy was Procter & Gamble pursu- ing when it first entered foreign markets? Why do you think this strategy became less viable later on?

b. What strategy does P&G appear to be mov- ing toward? What are the benefits of this strategy? What are the potential risks associ- ated with it?

c. To what do you attribute P&G's recent sales decline?

 5. What do you see as the main organizational problems that are likely to be associated with implementation of a transnational strategy?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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

1. Your company, a white goods manufacturer (pri- marily major kitchen appliances) based in the

United States, has decided to pursue interna- tional expansion opportunities in sub-Saharan Africa. To achieve some economies of scale, your strategy is to minimize local adaptation.

The Strategy of International Business Chapter 13 389

Walk into an IKEA store anywhere in the world, and you would recognize it instantly. Global strategy standardization is rampant! The warehouse-type stores all sell the same broad range of affordable home furnishings, kitchens, acces- sories, and food. Most of the products are instantly recogniz- able as IKEA merchandise, with their clean yet tasteful lines and functional design. With a heritage from Sweden (IKEA was founded in 1943 as a mail order company, and the first store opened in Sweden in 1958), the outside of the store will be wrapped in the blue and yellow colors of the Swedish flag. IKEA have sales of €34.2 billion euros annually (about $37 billion U.S. dollars) and more than 150,000 employees. Interestingly, IKEA is responsible for about 1 percent of the world’s commercial-product wood consumption. The IKEA name comes from its founder—the acronym consists of the founder’s initials from his first and last names (Ingvar Kamprad) along with the first initials of the farm where he grew up (Elmtaryd) and his hometown in Sweden (Agunnaryd). Overall, Sweden has 20 IKEA stores, which is only fewer than in Germany (49 IKEA stores), the United States (42), France (32), and Italy (21). Spain also has 20 stores. With 351 stores in 46 countries, IKEA is the largest furniture retailer in the world. Basically, the furniture market is one of the least global markets, with local tastes, needs, and interests much different than for many other products across industries. The largest IKEA store is in Gwangmyeong, South Korea, at some 640,000 square feet. The IKEA store itself will be laid out as a maze that requires customers to walk through every department be- fore they reach the checkout stations. The stores are often structured as a one-way layout, leading customers coun- terclockwise along what IKEA calls “the long natural way.” This “way” is designed to encourage customers to see the store in its entirety. Cut-off points and shortcuts exist but are not easy to figure out. It is even difficult to get back out after having a meal in the famous IKEA res- taurant with its Swedish food (meatballs anyone?). Immediately before the checkout, there is an in-store warehouse where customers can pick up the items they

purchased. The furniture is all packed flat for ease of trans- portation and requires assembly by the customer. Value is stressed to a great extent (the price customers pay for the quality furniture they get). If you look at customers in the store, you will see that many of them are in there 20s and 30s. IKEA sells to the same basic customers worldwide: young, upwardly mobile people who are looking for tasteful yet inexpensive “disposable” furniture of a certain quality standard for the price they are willing to pay. A global network of more than 1,000 suppliers based in more than 50 countries manufactures most of the 12,000 or so products that IKEA sells. IKEA itself fo- cuses on the design of products and works closely with suppliers to bring down manufacturing costs. Developing a new product line can be a painstaking process that takes years. IKEA’s designers will develop a prototype design (e.g., a small couch), look at the price that rivals charge for a similar piece, and then work with suppliers to figure out a way to cut prices by 40 percent without compromis- ing on quality. IKEA also manufactures about 10 percent of what it sells in-house and uses the knowledge gained to help its suppliers improve their productivity, thereby low- ering costs across the entire supply chain. Look a little closer, however, and you will see subtle differences among the IKEA offerings in North America, Europe, and China. In North America, sizes are different to reflect the American demand for bigger beds, furnish- ings, and kitchenware. This adaptation to local tastes and preferences was the result of a painful learning experience for IKEA. When the company first entered the United States in the late 1980s, it thought that consumers would flock to its stores the same way that they had in western Europe. At first they did, but they didn’t buy as much, and sales fell short of expectations. IKEA discovered that its European-style sofas were not big enough, wardrobe draw- ers were not deep enough, glasses were too small, and kitchens didn’t fit U.S. appliances. So the company set about redesigning its offerings to better match American tastes and was rewarded with accelerating sales growth.

C L O S I N G C A S E

IKEA’s Global Strategy

Focusing on a comparison of two sub-Saharan African countries of your choice, prepare an ex- ecutive summary that features aspects of the product where standardization will simply not be possible and adaptation to local conditions will be essential.

2. A. T. Kearney publishes an annual study to help re- tailers prioritize their global development strategies

by ranking the retail expansion attractiveness of emerging countries based on a particular set of cri- teria. Find the latest version of this Global Retail Development Index. What criteria are used to iden- tify the attractiveness of the retail environment in emerging countries? Categorize the top 10 coun- tries by world region. Are there any of these coun- tries that surprise you? Why or why not?

390 Part 5 The Strategy and Structure of International Business

Lesson learned. When IKEA entered China in the 2000s, it made adaptations to the local market. The store layout re- flects the layout of many Chinese apartments, where most people live, and because many Chinese apartments have bal- conies, IKEA’s Chinese stores include a balcony section. IKEA has also had to shift its locations in China, where car ownership lags behind that in Europe and North America. In the West, IKEA stores are located in suburban areas and have lots of parking space. In China, stores are located near public transportation, and IKEA offers a delivery service so that Chinese customers can get their purchases home.

Sources: Lindsey Rupp, “Ikea, Dollar General CEOs Lobby Republicans in Tax Showdown,” Bloomberg Businessweek, March 7, 2017; D. L. Yohn, “How IKEA Designs Its Brand Success,” Forbes, June 10, 2015; J. Kane, “The 21 Emotional Stages of Shopping at IKEA, From Optimism to Total Defeat,” The Huffington Post, May 6, 2015; J. Leland, “How the Disposable Sofa Conquered America,” The New York Times Magazine, October 5, 2005, p. 45; “The Secret of IKEA’s Success,” The Economist, February 24, 2011; B. Torekull, Leading by Design: The IKEA Story (New York: HarperCollins, 1998); P. M. Miller, “IKEA with Chinese Characteristics,” Chinese Business Review, July–August 2004, pp. 36–69.

C a s e D i s c u s s i o n Q u e s t i o n s 1. IKEA is very Sweden-centric; that is, they like

doing it the Swedish way, from the names of the furniture to the management of the company.

Sweden is a neutral country so maybe this is the way to go for a global company, but, really, is it smart to be too centric to a specific country when you are a global corporation?

2. IKEA is also very “IKEA-centric.” For example, the IKEA store itself will be laid out as a maze that requires customers to walk through every de- partment before they reach the checkout sta- tions. This forced path can seem constraining to their customers who naturally are more free spir- ited than the IKEA management model. Can this spell trouble in the near future, or is the IKEA way a sustainable business model?

3. Strategically, having more than 1,000 suppliers result in a complex task of managing those sup- pliers, ensuring the quality of the products, and maintaining the IKEA brand. While we will ad- dress global supply chains later on, from a global strategy standpoint how would you manage IKEA’s global suppliers?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

E n d n o t e s

 1. Sui Sui and Matthias Baum, “Internationalization Strategy, Firm Re- sources and the Survival of SMEs in the Export Market,” Journal of International Business Studies 45, no. 7 (September 2014), pp. 821–41.

 2. Constantine S. Katsikeas, Neil A. Morgan, Leonidas C. Leonidou, and G. Tomas M. Hult, “Assessing Performance Outcomes in Marketing,” Journal of Marketing 80, no. 2 (2016), pp. 1–20.

 3. Tomas Hult, David Closs, and David Frayer, Global Supply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw- Hill Professional, 2014).

 4. Katsikeas et al., “Assessing Performance Outcomes in Marketing.”

 5. G. Tomas M. Hult and David J. Ketchen Jr., “Does Market Ori- entation Matter? A Test of the Relationship between Positional Advantage and Performance,” Strategic Management Journal 22, no. 9 (2001), pp. 899–906.

 6. Gary A. Knight and Daekwan Kim, “International Business Competence and the Contemporary Firm,” Journal of Interna- tional Business Studies 40, 2 (2009), pp. 255–73.

 7. More formally, ROIC = Net profit after tax ÷ Capital, where capi- tal includes the sum of the firm’s equity and debt. This way of cal- culating profitability is highly correlated with return on assets.

 8. T. Copeland, T. Koller, and J. Murrin, Valuation: Measuring and Managing the Value of Companies (New York: Wiley, 2000).

 9. Katsikeas et al., “Assessing Performance Outcomes in Marketing.”

10. Hult, Closs, and Frayer, Global Supply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage.

11. The concept of consumer surplus is an important one in econom- ics. For a more detailed exposition, see D. Besanko, D. Dranove, and M. Shanley, Economics of Strategy (New York: Wiley, 1996).

12. However, P = V only in the special case where the company has a perfect monopoly and where it can charge each customer a unique price that reflects the value of the product to that cus- tomer (i.e., where perfect price discrimination is possible). More generally, except in the limiting case of perfect price discrimina- tion, even a monopolist will see most consumers capture some of the value of a product in the form of a consumer surplus.

13. This point is central to the work of M. E. Porter, Competitive Advantage (New York: Free Press, 1985). See also chap. 4 in P. Ghemawat, Commitment: The Dynamic of Strategy (New York: Free Press, 1991).

14. M. E. Porter, Competitive Strategy (New York: Free Press, 1980).

The Strategy of International Business Chapter 13 391

15. M. E. Porter, “What Is Strategy?” Harvard Business Review, On-point Enhanced Edition article, February 1, 2000.

16. G. Tomas M. Hult, Forrest V. Morgeson III, Neil A. Morgan, Sunil Mithas, and Claes Fornell, “Do Firms Know What Their Customers Think and Why?” Journal of the Academy of Market- ing Science 45, no. 1 (2017), pp. 37–54.

17. Porter, Competitive Advantage.

18. Claes Fornell, Forrest V. Morgeson III, and G. Tomas M. Hult, “Stock Returns on Customer Satisfaction Do Beat the Market: Gauging the Effect of a Marketing Intangible,” Journal of Mar- keting 80, no. 5 (2016), pp. 92–107.

19. Empirical evidence does seem to indicate that, on average, interna- tional expansion is linked to greater firm profitability. For some examples, see M. A. Hitt, R. E. Hoskisson, and H. Kim, “Interna- tional Diversification, Effects on Innovation and Firm Perfor- mance,” Academy of Management Journal 40, no. 4 (1997), pp. 767–98; S. Tallman and J. Li, “Effects of International Diversity and Product Diversity on the Performance of Multinational Firms,” Academy of Management Journal 39, no. 1 (1996), pp. 179–96.

20. This concept has been popularized by G. Hamel and C. K. Prahalad, Competing for the Future (Boston: Harvard Business School Press, 1994). The concept is grounded in the resource-based view of the firm; for a summary, see J. B. Barney, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17 (1991), pp. 99–120; K. R. Conner, “A Historical Comparison of Resource-Based Theory and Five Schools of Thought within In- dustrial Organization Economics: Do We Have a New Theory of the Firm?” Journal of Management 17 (1991), pp. 121–54.

21. J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).

22. M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990).

23. Mark F Peterson, Mikael Søndergaard, Aycan Kara (2017), “Traversing cultural boundaries in IB: The complex relationships between explicit country and implicit cultural group boundaries at multiple levels,” Journal of International Business Studies, doi:10.1057/s41267-017-0082-z

24. Example is based on C. S. Trager, “Enter the Mini-multinational,” Northeast International Business, March 1989, pp. 13–14.

25. See R. B. Reich, The Work of Nations (New York: Knopf, 1991); P. J. Buckley and N. Hashai, “A Global System View of Firm Boundaries,” Journal of International Business Studies, January 2004, pp. 33–50; Yong Kyu Lew, Rudolf R Sinkovics, Mo YaminZaheer Khan, “Trans-Specialization Understanding in International Tech- nology Alliances: The Influence of Cultural Distance,” Journal of International Business Studies 47, no. 5 (2016), pp. 577–94.

26. D. Barboza, “An Unknown Giant Flexes Its Muscles,” The New York Times, December 4, 2004, pp. B1, B3.

27. G. Hall and S. Howell, “The Experience Curve from an Econo- mist’s Perspective,” Strategic Management Journal 6 (1985), pp. 197–212.

28. A. A. Alchain, “Reliability of Progress Curves in Airframe Pro- duction,” Econometrica 31 (1963), pp. 697–98.

29. Eric Fang and Shaoming Zou, “The Effects of Absorptive and Joint Learning on the Instability of International Joint Ventures in Emerging Economies,” Journal of International Business Studies 41, no. 5 (2010), pp. 906–24.

30. Hall and Howell, “The Experience Curve from an Economist’s Perspective.”

31. Markus Taussig, “Foreignness as Both a Global Asset and a Local Liability: How Host Country Idiosyncrasies and Business Activities Matter,” Journal of International Business Studies 48, no. 4 (2016), pp. 498–522.

32. For a full discussion of the source of scale economies, see D. Besanko, D. Dranove, and M. Shanley, Economics of Strategy (New York: Wiley, 1996).

33. This estimate was provided by the Pharmaceutical Manufactur- ers Association.

34. See J. Birkinshaw and N. Hood, “Multinational Subsidiary Evolu- tion: Capability and Charter Change in Foreign Owned Subsidiary Companies,” Academy of Management Review 23 (October 1998), pp. 773–95; A. K. Gupta and V. J. Govindarajan, “Knowledge Flows within Multinational Corporations,” Strategic Management Journal 21 (2000), pp. 473–96; V. J. Govindarajan and A. K. Gupta, The Quest for Global Dominance (San Francisco: Jossey-Bass, 2001); T. S. Frost, J. M. Birkinshaw, and P. C. Ensign, “Centers of Excellence in Multinational Corporations,” Strategic Management Journal 23 (2002), pp. 997–1018; U. Andersson, M. Forsgren, and U. Holm, “The Strategic Impact of External Networks,” Strategic Management Journal 23 (2002), pp. 979–96.

35. S. Leung, “Armchairs, TVs and Espresso: Is It McDonald’s?” The Wall Street Journal, August 30, 2002, pp. A1, A6.

36. C. K. Prahalad and Yves L. Doz, The Multinational Mission: Balancing Local Demands and Global Vision (New York: Free Press, 1987). Also see J. Birkinshaw, A. Morrison, and J. Hulland, “Structural and Competitive Determinants of a Global Integration Strategy,” Strategic Management Journal 16 (1995), pp. 637–55; P. Ghemawat, Redefining Global Strategy (Boston: Harvard Business School Press, 2007).

37. Prahalad and Doz, The Multinational Mission. Prahalad and Doz actually talk about local responsiveness rather than local customization.

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

39. W. W. Lewis. The Power of Productivity (Chicago: University of Chicago Press, 2004).

40. C. J. Chipello, “Local Presence Is Key to European Deals,” The Wall Street Journal, June 30, 1998, p. A15.

41. For an extended discussion see G. S. Yip and G. Tomas M. Hult, Total Global Strategy (Boston: Pearson, 2012); A. M. Rugman and A. Verbeke, “A Perspective on Regional and Global Strategies of Multinational Enterprises,” Journal of International Business Studies 35, no. 1 (2004), pp. 3–18; C. A. Bartlett and S. Ghoshal, Managing across Borders (Boston: Harvard Business School Press, 1989).

42. David Hollister, Ray Tadgerson, David Closs, and Tomas Hult, Second Shift: The Inside Story of the Keep GM Movement (New York: McGraw-Hill Professional, 2017).

43. Bartlett and Ghoshal, Managing across Borders.

44. Bartlett and Ghoshal, Managing across Borders. Pankaj Ghemawat makes a similar argument, although he does not use the term transnational. See Ghemawat, Redefining Global Strategy.

45. T. Hout, M. E. Porter, and E. Rudden, “How Global Companies Win Out,” Harvard Business Review, September–October 1982, pp. 98–108.

part five The Strategy and Structure of International Business

14

©vario images GmbH & Co.KG/Alamy Stock Photo

The Organization of International Business L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO14 -1 Explain what is meant by organizational architecture.

LO14-2 Describe the different organizational architecture choices that can be made in an international business.

LO14-3 Explain how the organizational architecture can be matched to global strategy to improve performance.

LO14-4 Discuss what is required for an international business to change its organizational architecture so that it better matches its global strategy.

Unilever’s Global Organization

similar as possible. The idea is to ensure that both groups of owners are treated as if they held shares in a single company. Unilever’s unity of operations is facilitated by a Deed of Mutual Covenants. This deed is an agreement between NV and PLC that provides for the allocation of assets within the Unilever Group. Relatedly, the Agreement for Mutual Guarantees of Borrowing also assists in the creation of the single operating platform where the objective, again, is to attain unity of management, operations, shareholders’ rights, purpose, and mission. In effect, this mutual guaran- tees agreement ensures that Unilever is financially as ro- bust as possible, using the combined strength of NV and PLC, when asking lenders for certain significant public borrowings. To structure its operations and management of the more than 400 brands, Unilever is organized into four main divisions: Foods, Refreshment (beverages and ice cream), Home Care, and Personal Care. These divisions employ about 170,000 people, produce sales of some €55 billion annually (about $60 billion U.S. dollars), and have 57 percent of their business in emerging markets. On a daily basis, a staggering number of 2.5 billion people worldwide use Unilever products (out of the 7.5 billion peo- ple in the world).

Sources: “About Unilever,” March 22, 2017 (unilever.com/about/ who-we-are/about-Unilever); “Unilever‘s Legal Structure and Founda- tion Agreements,” March 22, 2017 (unilever.com/investor-relations/ agm-and-corporate-governance/legal-structure-and-foundation- agreements); Port Sunlight, “Unilever: In Search of the Good Busi- ness,” The Economist, August 9, 2014; Rob Davies, “Unilever Bids to Heal Shareholder Rift Amid ‘Garage Sale’ Warnings,” The Guardian, March 19, 2017.

O P E N I N G C A S E Unilever (unilever.com) is a Dutch–British company co- headquartered in Rotterdam, Netherlands, and London, United Kingdom. The company was founded in 1930 by the merger of the Dutch margarine producer Margarine Unie and the British soapmaker Lever Brothers. Unilever owns more than 400 brands, but the core of its assortment are 14  brands that have annual sales of more than €1 billion: Axe/Lynx, Dove, Omo, Becel/Flora, Heartbrand ice creams, Hellmann’s, Knorr, Lipton, Lux, Magnum, Rama, Rexona, Sunsilk, and Surf. With the Dutch–British background, Unilever is a dual-listed company consisting of Unilever NV based in Rotterdam and Unilever PLC based in London. The dual- listed company operates as a single business, with a shared board of directors. However, Unilever NV and Unilever PLC have different shareholder constituencies, and shareholders cannot convert or exchange the shares of one company for shares of the other. The Unilever Group—integration of Unilever NV (Netherlands) and Unilever PLC (United Kingdom)—is orga- nized and made functional by a number of agreements between the parent companies of NV and PLC. These agreements, together with provisions in their respective articles of association, are jointly known as the Foundation Agreements. These Foundation Agreements enable Unilever to attain unity of management, operations, share- holders’ rights, purpose, and mission. Unilever’s Equalization Agreement regulates the com- mon rights of the shareholders of both NV and PLC. The objective of the Equalization Agreement is to ensure that the positions of these two sets of shareholders are as

393

394 Part 5 The Strategy and Structure of International Business

Introduction

The story of Unilever, which is profiled in the opening case, is similar to that of many multinationals over the past several decades. Many companies that operate globally start by initially pursuing a localization strategy (see Chapter 13). At this time, Unilever has both its Unilever NV (Netherlands) and Unilever PLC (United Kingdom) organizations. The integration of the NV and PLC organizations is coordinated via the Unilever Group. This organized “group” coordination is made functional by a number of agreements be- tween the parent companies of NV and PLC.

Unilever’s unity of operations is also facilitated by the Deed of Mutual Covenants. This deed is an agreement between NV and PLC that provides for the allocation of assets within the Unilever Group. To structure its operations and management of the company’s more than 400 brands, the Unilever Group is organized into four main divisions: Foods, Refreshment (beverages and ice cream), Home Care, and Personal Care. These divisions employ about 170,000 people, produce sales of some €55 billion euros annually (about $60 billion U.S. dollars), and have 57 percent of their business in emerging markets. On a daily basis, 2.5 billion people worldwide use Unilever products. This number is both stag- gering and remarkable given that the world has about 7.5 billion people (with a third of the world’s people using Unilever’s products daily).

The architecture that the Unilever Group has created gives power, responsibility, and accountability to both Unilever NV and Unilever PLC. At the same time, while Unilever recognizes the importance of countries for the purposes of culturally interfacing with cus- tomers and ensuring cooperation on local projects, Unilever’s centrally based management at the Unilever Group makes sure that country operations serve the best interests of the overall global business. In developing this architecture, Unilever tries to reap the gains from globalization, particularly with regard to realizing the scale and location economies that come from optimally configuring the global value chain for a business while continu- ing to recognize the importance of local responsiveness.

As suggested by the Unilever example, this chapter is concerned with identifying the organizational architecture that international businesses use to manage and direct their global operations. By organizational architecture, we mean the totality of a firm’s orga- nization, including formal organizational structure, control systems and incentives, pro- cesses, organizational culture, and people. The core argument outlined in this chapter is that superior enterprise profitability requires three conditions to be fulfilled.

First, the different elements of a firm’s organizational architecture must be internally consistent. For example, the control and incentive systems used in the firm must be con- sistent with the structure of the enterprise.

Second, the organizational architecture must match or fit the strategy of the firm—strategy and architecture must be consistent.1 For example, if a firm is pursuing a global standardiza- tion strategy but has the wrong kind of organizational architecture in place, it is unlikely that it will be able to execute that strategy effectively and poor performance may result.

Third, the strategy and architecture of the firm must not only be consistent with each other but also make sense given the competitive conditions prevailing in the firm’s markets— strategy, architecture, and competitive environment must all be consistent.2 For example, a firm pursuing a localization strategy might have the right kind of organizational architecture in place for that strategy. However, if it competes in markets where cost pressures are intense and demands for local responsiveness are low, it will still have inferior performance because a global standardization strategy is more appropriate in such an environment.

To explore the issues illustrated by examples such as Unilever, this chapter opens by discussing in more detail the concepts of organizational architecture and fit. Next, it turns to a more detailed exploration of various components of architecture—structure, control systems and incentives, organizational culture, and processes—and explains how these components must be internally consistent. (We look at the “people” component of archi- tecture in Chapter 19, where we discuss human resource strategy in the multinational firm.) After reviewing the various components of architecture, we look at the ways in

Did You Know? Did you know the most admired global companies have little in common?

Visit your instructor’s Connect® course and click on your eBook or SmartBook® to view a short video explanation from the authors.

The Organization of International Business Chapter 14 395

which architecture can be matched to strategy and the competitive environment to achieve high performance. The chapter closes with a discussion of organizational change. Periodi- cally, firms have to change or adapt their organization so that it matches new strategic and competitive realities.

Organizational Architecture

As noted in the introduction, the term organizational architecture refers to the totality of a firm’s organization, including formal organizational structure, control systems and incen- tives, organizational culture, processes, and people.3 Figure 14.1 illustrates these different elements.

By organizational structure, we mean three things: First, the formal division of the organization into subunits such as product divisions, national operations, and functions (most organizational charts display this aspect of structure); second, the location of decision- making responsibilities within that structure (e.g., centralized or decentralized); and third, the establishment of integrating mechanisms to coordinate the activities of subunits, including cross-functional teams and pan-regional committees.

Control systems are the metrics used to measure the performance of subunits and make judgments about how well managers are running those subunits. For example, his- torically Unilever measured the performance of national operating subsidiary companies according to profitability—profitability was the metric. Incentives are the devices used to reward appropriate managerial behavior. Incentives are very closely tied to performance metrics. For example, the incentives of a manager in charge of a national operating subsid- iary might be linked to the performance of that company. Specifically, she might receive a bonus if her subsidiary exceeds its performance targets.

Processes are the manner in which decisions are made and work is performed within the organization. Examples are the processes for formulating strategy, for deciding how to allocate resources within a firm, or for evaluating the performance of managers and giving feedback.4 Processes are conceptually distinct from the location of decision-making re- sponsibilities within an organization, although both involve decisions. While the CEO might have ultimate responsibility for deciding what the strategy of the firm should be (i.e., the decision-making responsibility is centralized), the process he or she uses to make that decision might include the solicitation of ideas and criticism from lower-level managers.

Organizational culture refers to the norms and value systems that are shared among the employees of an organization. Just as societies have cultures (see Chapter 4 for de- tails), so do organizations. Organizations can be viewed as societies of individuals who

LO 14 -1 Explain what is meant by organizational architecture.

Processes Incentives

and Controls

Structure

People

Culture

F I G U R E 1 4 .1

Organizational architecture.

396 Part 5 The Strategy and Structure of International Business

come together to perform collective tasks. They have their own distinctive patterns of culture and subculture.5 As we shall see, organizational culture can have a profound impact on how a firm performs. Finally, by people we mean not only the employees of the orga- nization, but also the strategy used to recruit, compensate, and retain those individuals and the type of people that they are in terms of their skills, values, and orientation (discussed in depth in Chapter 19).

As illustrated by the arrows in Figure 14.1, the various components of an organization’s architecture are not independent of each other: Each component shapes, and is shaped by, other components of the architecture. An obvious example is a strategy regarding people. This can be used proactively to hire individuals whose internal values are consistent with those that the firm wishes to emphasize in its organizational culture. Thus, the people component of architecture can be used to reinforce (or not) the prevailing culture of the organization. For example, Unilever has historically made an effort to hire managers who were sociable and placed a high value on consensus and cooperation, values that the enter- prise wished to emphasize in its own culture.6 P&G has made a concerted effort to hire people from countries in which it has operations; some 140 nationalities are represented in P&G’s workforce compared with the 180 countries in which it sells products. If a firm is going to maximize its profitability, it must pay close attention to achieving internal consis- tency between the various components of its architecture.

Organizational Structure

Organizational structure can be thought of in terms of three dimensions: (1) vertical differentiation, which refers to the location of decision-making responsibilities within a structure; (2) horizontal differentiation, which refers to the formal division of the organi- zation into subunits; and (3) integrating mechanisms, which are mechanisms for coordi- nating subunits.

VERTICAL DIFFERENTIATION: CENTRALIZATION AND DECENTRALIZATION

A firm’s vertical differentiation determines where in its hierarchy the decision-making power is concentrated.7 Are production and marketing decisions centralized in the offices of upper-level managers, or are they decentralized to lower-level managers? Where does the responsibility for R&D decisions lie? Are important strategic and financial decisions pushed down to operating units, or are they concentrated in the hands of top manage- ment? And so on. There are arguments for both centralization and decentralization.

Arguments for Centralization There are four main arguments for centralization. First, centralization can facilitate coor- dination and integration of operations. For example, consider a firm that has a component manufacturing operation in Taiwan and an assembly operation in Mexico. The activities of these two operations may need to be coordinated to ensure a smooth flow of products from the component operation to the assembly operation. This might be achieved by cen- tralizing production scheduling at the firm’s head office. Second, centralization can help ensure that decisions are consistent with organizational objectives. When decisions are decentralized to lower-level managers, those managers may make decisions at variance with top management’s goals. Centralization of important decisions minimizes the chance of this occurring.

Third, by concentrating power and authority in one individual or a management team, centralization can give top-level managers the means to bring about needed major organi- zational changes. Fourth, centralization can avoid the duplication of activities that occurs when similar activities are carried on by various subunits within the organization. For ex- ample, many international firms centralize their R&D functions at one or two locations to ensure that R&D work is not duplicated. Production activities may be centralized at key locations for the same reason.

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.

LO 14 -2 Describe the different organizational architecture choices that can be made in an international business.

The Organization of International Business Chapter 14 397

Arguments for Decentralization There are five main arguments for decentralization. First, top management can become over- burdened when decision-making authority is centralized, and this can result in poor deci- sions. Decentralization gives top management time to focus on critical issues by delegating more routine issues to lower-level managers. Second, motivational research favors decentral- ization. Behavioral scientists have long argued that people are willing to give more to their jobs when they have a greater degree of individual freedom and control over their work.

Third, decentralization permits greater flexibility—more rapid response to environmen- tal changes—because decisions do not have to be “referred up the hierarchy” unless they are exceptional in nature. Fourth, decentralization can result in better decisions. In a de- centralized structure, decisions are made closer to the spot by individuals who (presum- ably) have better information than managers several levels up in a hierarchy (for an example of decentralization to achieve this goal, see the Management Focus on Walmart’s international division). Fifth, decentralization can increase control. Decentralization can be used to establish relatively autonomous, self-contained subunits within an organization. Subunit managers can then be held accountable for subunit performance. The more re- sponsibility subunit managers have for decisions that impact subunit performance, the fewer excuses they have for poor performance.

Global Strategy and Centralization The choice between centralization and decentralization is not absolute.8 Frequently it makes sense to centralize some decisions and to decentralize others, depending on the type of decision and the firm’s strategy. Decisions regarding overall firm strategy, major financial expenditures, financial objectives, and legal issues are typically centralized at the firm’s headquarters. However, operating decisions, such as those relating to production, marketing, R&D, and human resource management, may or may not be centralized de- pending on the firm’s strategy.

Consider firms pursuing a global standardization strategy.9 They must decide how to disperse the various value creation activities around the globe so location and experience economies can be realized. The head office must make the decisions about where to locate R&D, production, marketing, and so on. In addition, the globally dispersed web of value creation activities that facilitates a global strategy must be coordinated. All of this creates pressures for centralizing some operating decisions.

B U S I N E S S B E A T

globalEDGE has partnered with the Michigan Business Network to offer a radio show called globalEDGE Business Beat (gBB). gBB is available worldwide to more than 200 countries via globalEDGE.msu.edu. Charles W. L. Hill is a regular guest on the radio show, which is hosted by Tomas Hult (both authors of this textbook). globalEDGE Business Beat covers in- terviews and discussions with a wide range of global leaders in business, government, and academe to spread the word about the latest thoughts, tools, and markets to succeed glob- ally. Oftentimes, these interviews focus on the best organizational architecture for compa- nies to develop to succeed globally. For example, top leaders from large organizations such as Domino’s, Saatchi and Saatchi X, and the U.S. Department of Commerce have been fea- tured. But focus is also placed on small and medium-sized companies and their globalization efforts. Additionally, there is a segment where Tomas Hult reports on what companies are currently doing to be globally competitive and what they plan to do in the next 5 to 20 years to stay competitive (with topics representing each of the chapters in this text). The podcasts are available on globalEDGE (see  globaledge.msu.edu/get-connected/globaledge- business-beat for podcasts and air times).

M A N A G E M E N T F O C U S

Walmart International When Walmart started to expand internationally in the early 1990s, the company set up an international division to oversee the process. The international division was based in Bentonville, Arkansas, at the company headquar- ters. Today, the international division oversees operations for Walmart as the largest global retailer in the world of 11,695 stores under 63 banners in 28 countries that collec- tively generate almost $500 billion in sales (2017). Some 2.2 million Walmart employees (“associates”) work in these international positions to serve more than 100 million

customers weekly. Forty percent of the customers are out- side the United States. In terms of reporting structure, the international division is divided into three regions—Europe, Asia, and the Americas— with the CEO of each region reporting to the CEO of the inter- national division, who in turn reports to the CEO of Walmart. Initially, the senior management of the international divi- sion exerted tight centralized control over merchandising strategy and operations in different countries. The reasoning was straightforward: Walmart’s managers wanted to make sure that international stores copied the format for stores, merchandising, and operations that had served the com- pany so well in the United States. They believed, naively per- haps, that centralized control over merchandising strategy and operations was the way to make sure this was the case. By the late 1990s, with the international division ap- proaching $20 billion in sales, Walmart’s managers con- cluded this centralized approach was not serving them well. Country managers had to get permission from their superiors in Bentonville before changing strategy and operations, and this was slowing decision making. Cen- tralization also produced information overload at the headquarters and led to some poor decisions. Walmart found that managers in Bentonville were not necessarily the best ones to decide on store layout in Mexico, mer- chandising strategy in Argentina, or compensation policy

Walmart store in Shanghai, China. ©kpzfoto/Alamy Stock Photo

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In contrast, the emphasis on local responsiveness in firms pursuing a localization strat- egy creates strong pressures for decentralizing operating decisions to foreign subsidiaries. Firms pursuing an international strategy also tend to maintain centralized control over their core competencies and to decentralize other decisions to foreign subsidiaries. Typi- cally, such firms centralize control over R&D in their home country but decentralize oper- ating decisions to foreign subsidiaries. For example, Microsoft Corporation, which fits the international mode, centralizes its product development activities (where its core compe- tencies lie) at its Redmond, Washington, headquarters and decentralizes marketing activi- ties to various foreign subsidiaries. Thus, while products are developed at home, managers in the various foreign subsidiaries have significant latitude for formulating strategies to market those products in their particular settings.10

The situation in firms pursuing a transnational strategy is more complex. The need to real- ize location and experience curve economies requires some degree of centralized control over global production centers. However, the need for local responsiveness dictates the de- centralization of many operating decisions, particularly for marketing, to foreign subsidiaries. Thus, in firms pursuing a transnational strategy, some operating decisions are relatively cen- tralized, while others are relatively decentralized. In addition, global learning based on the multidirectional transfer of skills between subsidiaries, and between subsidiaries and the cor- porate center, is a central feature of a firm pursuing a transnational strategy. The concept of global learning is predicated on the notion that foreign subsidiaries within a multinational

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in the United Kingdom. The need to adapt merchandising strategy and operations to local conditions argued strongly for greater decentralization. The pivotal event that led to a change in policy at Walmart was the company’s acquisition of Britain’s ASDA super- market chain. The ASDA acquisition added a mature and successful $14 billion operation to Walmart’s international division. The company realized that it was not appropriate for managers in Bentonville to be making all-important deci- sions for ASDA. Accordingly, the number of staff members located in Bentonville who were devoted to international op- erations was reduced by 50 percent. Country leaders were given greater responsibility, especially in the area of mer- chandising and operations. At that stage, Walmart was at the point where it was time to break away a little bit. Company representatives said that “You can’t run the world from one place. The countries have to drive the business.” Although Walmart has now decentralized decisions within the international division, it is still struggling to find the right formula for managing global sourcing. Ideally, the company would like to centralize sourcing in Bentonville so that it could use its enormous purchasing power to bar- gain down the prices it pays suppliers. As a practical mat- ter, however, this has not been easy to attain given that the product mix in Walmart stores has to be tailored to condi- tions prevailing in the local market. Currently, significant responsibility for sourcing remains at the country and re- gional level. However, Walmart would like to have a better and more efficient global sourcing strategy, such that it can negotiate on a global basis with key suppliers and can

simultaneously introduce new merchandise into its stores around the world. As merchandising and operating decisions have been decentralized, the international division has increasingly taken on a new role—that of identifying best practices and transferring them between countries. For example, the di- vision has developed a knowledge management system whereby stores in one country—let’s say, Argentina—can quickly communicate pictures of items, sales data, and ideas on how to market and promote products to stores in another country—such as Japan. The division is also start- ing to move personnel between stores in different coun- tries as a way of facilitating the flow of best practices across national borders. The division is continuously trying to be innovative and move Walmart away from its U.S.-centric mentality and by leveraging ideas implemented in foreign operations to improve the efficiency and effectiveness of Walmart’s operations. This is stressed by Walmart Interna- tional’s president and CEO, David Cheesewright, who said that “international is a growth engine for Walmart and to succeed we must focus on being in good businesses and running them well.”

Sources: Abha Bhattaral, “Walmart Is Asking Employees to Deliver Packages on Their Way Home from Work,” The Washington Post, June 1, 2017; M. Troy, “Wal-Mart Braces for International Growth with Personnel Moves,” DSN Retailing Today, February 9, 2004, pp. 5–7; “Division Heads Let Numbers Do the Talking,” DSN Retailing Today, June 21, 2004, pp. 26–28; “The Division That Defines the Future,” DSN Retailing Today, June 2001, pp. 4–7; Walmart 2013 annual report; “Innovating for Customers All Around the World,” http://news. walmart.com/executive-viewpoints/innovating-for-our-customers- all-around-the-world, accessed June 21, 2015.

firm have significant freedom to develop their own skills and competencies. Only then can these be leveraged to benefit other parts of the organization. A substantial degree of decen- tralization is required if subsidiaries are going to have the freedom to do this. For this reason too, the pursuit of a transnational strategy requires a high degree of decentralization.11

HORIZONTAL DIFFERENTIATION: THE DESIGN OF STRUCTURE

Horizontal differentiation is concerned with how the firm decides to divide itself into sub- units.12 The decision is normally made on the basis of function, type of business, or geo- graphic area. In many firms, just one of these predominates, but more complex solutions are adopted in others. This is particularly likely in the case of multinational firms, where the conflicting demands to organize the company around different products (to realize location and experience curve economies) and different national markets (to remain lo- cally responsive) must be reconciled.

The Structure of Domestic Firms Most firms begin with no formal structure and are run by a single entrepreneur or a small team of individuals. As they grow, the demands of management become too great for one individual or a small team to handle. At this point, the organization is split into functions reflecting the firm’s value creation activities (e.g., production, marketing, R&D, sales). These

400 Part 5 The Strategy and Structure of International Business

functions are typically coordinated and controlled by top management (see Figure 14.2). Decision making in this functional structure tends to be centralized.

Further horizontal differentiation may be required if the firm significantly diversifies its product offering, which takes the firm into different business areas. For example, Dutch multinational Philips Electronics NV began as a lighting company, but diversification took the company into consumer electronics (e.g., visual and audio equipment), industrial elec- tronics (integrated circuits and other electronic components), and medical systems (MRI scanners and ultrasound systems). In such circumstances, a functional structure can be too clumsy. Problems of coordination and control arise when different business areas are managed within the framework of a functional structure.13 For one thing, it becomes dif- ficult to identify the profitability of each distinct business area. For another, it is difficult to run a functional department, such as production or marketing, if it is supervising the value creation activities of several business areas.

To solve the problems of coordination and control, at this stage most firms switch to a product divisional structure (see Figure 14.3). With a product divisional structure, each divi- sion is responsible for a distinct product line (business area). Thus, Philips created divisions for lighting, consumer electronics, industrial electronics, and medical systems. Each product division is set up as a self-contained, largely autonomous entity with its own functions. The responsibility for operating decisions is typically decentralized to product divisions, which are then held accountable for their performance. Headquarters is responsible for the overall strategic development of the firm and for the financial control of the various divisions.

The International Division When firms initially expand abroad, they often group all their international activities into an international division. This has tended to be the case for firms organized on the basis of functions and for firms organized on the basis of product divisions. Regardless of the firm’s

Buying Units Plants Branch Sales Units Accounting Units

Purchasing Manufacturing Marketing Finance

Top Management

F I G U R E 1 4 . 2

A typical functional structure.

Buying Units Plants Branch Sales Units Accounting Units

Department Purchasing

Department Marketing

Department Manufacturing

Department Finance

Division Product Line B Division Product Line CDivision Product Line A

Headquarters

F I G U R E 1 4 . 3

A typical product divisional structure.

The Organization of International Business Chapter 14 401

domestic structure, its international division tends to be organized on geography. Figure 14.4 illustrates this for a firm whose domestic organization is based on product divisions.

Many manufacturing firms expanded internationally by exporting the product manufac- tured at home to foreign subsidiaries to sell. Thus, in the firm illustrated in Figure 14.4, the subsidiaries in countries 1 and 2 would sell the products manufactured by divisions A, B, and C. In time, however, it might prove viable to manufacture the product in each country, and so production facilities would be added on a country-by-country basis. For firms with a functional structure at home, this might mean replicating the functional structure in every country in which the firm does business. For firms with a divisional structure, this might mean replicating the divisional structure in every country in which the firm does business.

This structure has been widely used; according to a Harvard study, 60 percent of all firms that have expanded internationally have initially adopted it. A good example of a company that uses this structure is Walmart, which created an international division in 1993 to manage its global expansion (Walmart’s international division is profiled in the Management Focus). Despite its popularity, an international division structure can give rise to problems.14 The dual structure it creates contains inherent potential for conflict and coordination problems between domestic and foreign operations. One problem with the structure is that the heads of foreign subsidiaries are not given as much voice in the organization as the heads of domestic functions (in the case of functional firms) or divi- sions (in the case of divisional firms). Rather, the head of the international division is presumed to be able to represent the interests of all countries to headquarters. This ef- fectively relegates each country’s manager to the second tier of the firm’s hierarchy, which is inconsistent with a strategy of trying to expand internationally and build a true multinational organization.

Another problem is the implied lack of coordination between domestic operations and foreign operations, which are isolated from each other in separate parts of the structural hierarchy. This can inhibit the worldwide introduction of new products, the transfer of core

Country 1

General Manager (Product A, B, and/or C)

Country 2

General Manager (Product A, B, and/or C)

Functional units

Functional units

Headquarters

Domestic Division

General Manager Product Line A

Domestic Division

General Manager Product Line B

Domestic Division

General Manager Product Line C

International Division

General Manager Area Line

F I G U R E 1 4 . 4

One company’s international division structure.

402 Part 5 The Strategy and Structure of International Business

competencies between domestic and foreign operations, and the consolidation of global production at key locations so as to realize location and experience curve economies.

As a result of such problems, many firms that continue to expand internationally aban- don this structure and adopt one of the worldwide structures discussed next. The two ini- tial choices are a worldwide product divisional structure, which tends to be adopted by diversified firms that have domestic product divisions, and a worldwide area structure, which tends to be adopted by undiversified firms whose domestic structures are based on functions. These two alternative paths of development are illustrated in Figure 14.5. The model in the figure is referred to as the international structural stages model and was de- veloped by John Stopford and Louis Wells.15

Worldwide Area Structure A worldwide area structure tends to be favored by firms with a low degree of diversifica- tion and a domestic structure based on functions (see Figure 14.6). Under this structure, the world is divided into geographic areas. An area may be a country (if the market is large enough) or a group of countries. Each area tends to be a self-contained, largely autonomous entity with its own set of value creation activities (e.g., its own production, marketing, R&D, human resources, and finance functions). Operations authority and strategic decisions relat- ing to each of these activities are typically decentralized to each area, with headquarters re- taining authority for the overall strategic direction of the firm and financial control.

This structure facilitates local responsiveness. Because decision-making responsibilities are decentralized, each area can customize product offerings, marketing strategy, and

Foreign Product Diversity

Foreign Sales as a Percentage of Total Sales

Alternate Paths of Development

Worldwide Product Division Global Matrix

("Grid")

Area DivisionInternational

Division

F I G U R E 1 4 . 5

The international structural stages model. Source: J. M. Stopford and L. T. Wells, Strategy and Structure of the Multinational Enterprise (New York: Basic Books, 1972).

F I G U R E 1 4 . 6

A worldwide area structure.

North American Area

Latin American Area

European Area

Headquarters

Middle Eastern– African Area

Far East Area

The Organization of International Business Chapter 14 403

business strategy to the local conditions. However, this structure encourages fragmentation of the organization into highly autonomous entities. This can make it difficult to transfer core competencies and skills between areas and to realize location and experience curve economies. In other words, the structure is consistent with a localization strategy, but may make it difficult to realize gains associated with global standardization. Firms structured on this basis may encounter significant problems if local responsiveness is less critical than reducing costs or transferring core competencies for establishing a competitive advantage.

Worldwide Product Divisional Structure A worldwide product division structure tends to be adopted by firms that are reason- ably diversified and, accordingly, originally had domestic structures based on product divi- sions. As with the domestic product divisional structure, each division is a self-contained, largely autonomous entity with full responsibility for its own value creation activities. The headquarters retains responsibility for the overall strategic development and financial con- trol of the firm (see Figure 14.7).

Underpinning the organization is a belief that the value creation activities of each prod- uct division should be coordinated by that division worldwide. Thus, the worldwide prod- uct divisional structure is designed to help overcome the coordination problems that arise with the international division and worldwide area structures. This structure provides an organizational context that enhances the consolidation of value creation activities at key locations necessary for realizing location and experience curve economies. It also facili- tates the transfer of core competencies within a division’s worldwide operations and the simultaneous worldwide introduction of new products. The main problem with the struc- ture is the limited voice it gives to area or country managers since they are seen as subservi- ent to product division managers. The result can be a lack of local responsiveness, which, as Chapter 13 showed, can lead to performance problems.

Global Matrix Structure Both the worldwide area structure and the worldwide product divisional structure have strengths and weaknesses. The worldwide area structure facilitates local responsiveness, but it can inhibit the realization of location and experience curve economies and the trans- fer of core competencies between areas. The worldwide product division structure provides a better framework for pursuing location and experience curve economies and for transfer- ring core competencies, but it is weak in local responsiveness. Other things being equal, this suggests that a worldwide area structure is more appropriate if the firm is pursuing a localization strategy, while a worldwide product divisional structure is more appropriate for firms pursuing global standardization or international strategies. However, as we saw in

Functional Units Functional Units

Headquarters

Worldwide Product Group or Division A

Worldwide Product Group or Division B

Worldwide Product Group or Division C

Area 1

(Domestic)

Area 2

(International)

F I G U R E 1 4 .7

A worldwide product divisional structure.

404 Part 5 The Strategy and Structure of International Business

Chapter 13, other things are not equal. As Bartlett and Ghoshal have argued, to survive in some industries, firms must adopt a transnational strategy. That is, they must focus simul- taneously on realizing location and experience curve economies, on local responsiveness, and on the internal transfer of core competencies (worldwide learning).16

Some firms have attempted to cope with the conflicting demands of a transnational strategy by using a matrix structure. In the classic global matrix structure, horizontal dif- ferentiation proceeds along two dimensions: product division and geographic area (see Figure 14.8). The philosophy is that responsibility for operating decisions pertaining to a particular product should be shared by the product division and the various areas of the firm. Thus, the nature of the product offering, the marketing strategy, and the business strategy to be pursued in area 1 for the products produced by division A are determined by conciliation between division A and area 1 management. It is believed that this dual decision- making responsibility should enable the firm to simultaneously achieve its particular objectives. In a classic matrix structure, giving product divisions and geographic areas equal status within the organization reinforces the idea of dual responsibility. Individual managers thus belong to two hierarchies (a divisional hierarchy and an area hierarchy) and have two bosses (a divisional boss and an area boss).

ABB (Asea Brown Boveri), a large multinational corporation operating in robotics and the power and automation technology areas, was one of the initial “global matrix” compa- nies. After the merger of Swedish Asea with the Swiss Brown Boveri to create ABB, the company strategically opted to create a global matrix structure to leverage synergies and to be a truly “global” company. Inspiration for the global matrix came from the 1960s and U.S. president John F. Kennedy’s space program (National Aeronautics and Space Administra- tion, or NASA), which instituted a matrix organization to create synergies in energy, cre- ativity, and decision making, and also Dow Chemical’s early entry into this form of global matrix structure (see the accompanying Management Focus). However, ABB has since re- organized several times in search of an optimal organizational architecture. Oftentimes, as ABB has found out, running a company as an organizational global matrix is perhaps founded in structure and authoritative linkages across company hierarchy, but its success in reality depends on people’s knowledge and skills to make the global matrix work.

The reality of the global matrix structure is that it often does not work as well as the the- ory predicts. In practice, the matrix often is clumsy and bureaucratic. It can require so many meetings that it is difficult to get any work done. The need to get an area and a product divi- sion to reach a decision can slow decision making and produce an inflexible organization

Headquarters

Area 1 Area 2 Area 3

Product Division A

Product Division B

Product Division C

Manager Here Belongs to Division B and Area 2

F I G U R E 1 4 . 8

A global matrix structure.

The Organization of International Business Chapter 14 405

unable to respond quickly to market shifts or to innovate. The dual-hierarchy structure can lead to conflict and perpetual power struggles between the areas and the product divisions, catching many managers in the middle. To make matters worse, it can prove difficult to as- certain accountability in this structure. When all critical decisions are the product of nego- tiation between divisions and areas, one side can always blame the other when things go wrong. As a manager in one global matrix structure, reflecting on a failed product launch, said to the author, “Had we been able to do things our way, instead of having to accommo- date those guys from the product division, this would never have happened.” (A manager in the product division expressed similar sentiments.) The result of such finger-pointing can be that accountability is compromised, conflict is enhanced, and headquarters loses control over the organization. (See the accompanying Management Focus on Dow Chemical for an example of the problems associated with a matrix structure.)

In light of these problems, many firms that pursue a transnational strategy have tried to build “flexible” matrix structures based more on enterprisewide management knowledge networks, and a shared culture and vision, than on a rigid hierarchical arrangement. Within such companies the informal structure plays a greater role than the formal structure. We discuss this issue when we consider informal integrating mechanisms in the next section.

INTEGRATING MECHANISMS

The previous section explained that firms divide themselves into subunits. One way of coordinating these subunits is through centralization. If the coordination task is com- plex, however, centralization may not be very effective. Higher-level managers responsi- ble for achieving coordination can soon become overwhelmed by the volume of work required to coordinate the activities of various subunits, particularly if the subunits are large, diverse, and/or geographically dispersed. When this is the case, firms look toward integrating mechanisms, both formal and informal, to help achieve coordination. This section introduces the various integrating mechanisms that international businesses can use. But first, we explore the need for coordination in international firms and some im- pediments to coordination.

Strategy and Coordination in the International Business The need for coordination between subunits varies with the strategy of the firm.17 The need for coordination is lowest in firms pursuing a localization strategy, is higher in in- ternational companies, higher still in global companies, and highest of all in transna- tional companies. Firms pursuing a localization strategy are primarily concerned with local responsiveness. Such firms are likely to operate with a worldwide area structure in which each area has considerable autonomy and its own set of value creation functions. Because each area is established as a stand-alone entity, the need for coordination be- tween areas is minimized.

The need for coordination is greater in firms pursuing an international strategy and try- ing to profit from the transfer of core competencies and skills between units at home and abroad. Coordination is necessary to support the transfer of skills and product offerings between units. The need for coordination is also great in firms trying to profit from loca- tion and experience curve economies—that is, in firms pursuing global standardization strategies. Achieving location and experience curve economies involves dispersing value creation activities to various locations around the globe. The resulting global web of ac- tivities must be coordinated to ensure the smooth flow of inputs into the value chain, the smooth flow of semifinished products through the value chain, and the smooth flow of finished products to markets around the world.

The need for coordination is greatest in transnational firms, which simultaneously pursue location and experience curve economies, local responsiveness, and the multidirectional transfer of core competencies and skills among all the firm’s subunits (referred to as global learning). As with a global standardization strategy, coordination is required to ensure the smooth flow of products through the global value chain. As with an international strategy,

M A N A G E M E N T F O C U S

Dow—(Failed) Early Global Matrix Adopter A select few companies are major players globally in the chemical industry. These companies include Dow Chemi- cal, BASF, Bayer, DuPont, ExxonMobil, Formosa, Mitsubishi, and Shell. It is an industry that often takes heavy invest- ment, knowledge, and skills. At the same time, the barriers to the free flow of chemical products between nations largely disappeared several decades ago. This along with the commodity nature of most bulk chemicals has ushered in a prolonged period of intense price competition among the companies in the industry. In such a competitive envi- ronment, the company that wins the competitive race is the one with the lowest costs. The Dow Chemical Com- pany, usually referred to as just Dow (which is the same as its stock symbol), was long among the cost leaders. For years, Dow’s managers insisted that part of the credit should be placed at the feet of its “matrix” organization. Dow’s organizational matrix had three interacting elements: functions (e.g., R&D, manufacturing, marketing), businesses (e.g., ethylene, plastics, pharmaceuticals), and geography (e.g., Spain, Germany, Brazil). Managers’ job titles incorpo- rated all three elements—for example, plastics marketing manager for Spain—and most managers reported to at least two bosses. The plastics marketing manager in Spain might report to both the head of the worldwide plastics business and the head of the Spanish operations. The intent of the matrix was to make Dow operations responsive to both

local market needs and corporate objectives. Thus, the plastics business might be charged with minimizing Dow’s global plastics production costs, while the Spanish opera- tion might be charged with determining how best to sell plastics in the Spanish market. When Dow introduced this matrix structure as one of the first large multinational corporations to do so, the re- sults were less than promising; multiple reporting chan- nels led to confusion and conflict. The large number of bosses made for an unwieldy bureaucracy. The overlap- ping responsibilities resulted in turf battles and a lack of accountability. Area managers disagreed with managers overseeing business sectors about which plants should be built and where. In short, the structure didn’t work. In- stead of abandoning the structure, however, Dow decided to see if it could be made more flexible. After all, Dow wanted to draw on its people’s knowledge and skills in the fullest manner possible, and a matrix structure would do just that it thought. Dow’s decision to keep its matrix structure was prompted by its move into the pharmaceuticals industry. The company realized that the pharmaceutical business is very different from the bulk chemicals business. In bulk chemicals, the big returns come from achieving economies of scale in produc- tion. This dictates establishing large plants in key locations from which regional or global markets can be served. But in

406

coordination is required for ensuring the transfer of core competencies to subunits. However, the transnational goal of achieving multidirectional transfer of competencies requires much greater coordination than in firms pursuing an international strategy. In addition, a transna- tional strategy requires coordination between foreign subunits and the firm’s globally dis- persed value creation activities (e.g., production, R&D, marketing) to ensure that any product offering and marketing strategy is sufficiently customized to local conditions.

Impediments to Coordination Managers of the various subunits have different orientations, partly because they have dif- ferent tasks. For example, production managers are typically concerned with production issues such as capacity utilization, cost control, and quality control, whereas marketing managers are concerned with marketing issues such as pricing, promotions, distribution, and market share. These differences can inhibit communication between the managers. Quite simply, these managers often do not even “speak the same language.” There may also be a lack of respect between subunits (e.g., marketing managers “looking down on” pro- duction managers, and vice versa), which further inhibits the communication required to achieve cooperation and coordination.

Differences in subunits’ orientations also arise from their differing goals. For example, worldwide product divisions of a multinational firm may be committed to cost goals that

407

pharmaceuticals, regulatory and marketing requirements for drugs vary so much from country to country that local needs are far more important than reducing manufacturing costs through scale economies. A high degree of local respon- siveness is essential. Dow realized its pharmaceutical busi- ness would never thrive if it were managed by the same priorities as its mainstream chemical operations. Instead of abandoning its matrix, Dow decided to make it more flexible so it could better accommodate the differ- ent businesses, each with its own priorities, within a single management system. A small team of senior executives at headquarters helped set the priorities for each type of business. After priorities were identified for each business sector, one of the three elements of the matrix—function, business, or geographic area—was given primary authority in decision making. Which element took the lead varied according to the type of decision and the market or loca- tion in which the company was competing. Such flexibility required that all employees understand what was occur- ring in the rest of the matrix. Although this may seem con- fusing, for years Dow claimed this flexible system worked well and credited much of its success to the quality of the decisions it facilitated. Ultimately, however, Dow refocused its business on the chemicals industry, divesting itself of its pharmaceutical activities where the company’s performance had been

unsatisfactory. Reflecting the change in corporate strategy, Dow decided to abandon its matrix structure in favor of a more streamlined structure based on global business divi- sions. The change was also driven by the realization that the matrix structure was just too complex and costly to manage in the intensely competitive global environment, particularly given the company’s renewed focus on its commodity chemicals, where competitive advantage often went to the low-cost producer. As Dow’s CEO put it, “We were an organization that was matrixed and depended on teamwork, but there was no one in charge. When things went well, we didn’t know whom to reward; and when things went poorly, we didn’t know whom to blame. So we created a global divisional structure, and cut out layers of management. There used to be 11 layers of management between me and the lowest-level employees, now there are five.” In short, Dow ultimately found that a matrix struc- ture was unsuited to a company that was competing in very cost-competitive global industries, and it had to aban- don its matrix to drive down operating costs.

Sources: Rebecca Cook, “Dow Chemical, DuPont Plan $130 Billion Merger,” Newsweek, December 11, 2015; “Dow Draws Its Matrix Again, and Again, and Again,” The Economist, August 5, 1989, pp. 55–56; “Dow Goes for Global Structure,” Chemical Marketing Reporter, De- cember 11, 1995, pp. 4–5; R. M. Hodgetts, “Dow Chemical CEO William Stavropoulos on Structure and Decision Making,” Academy of Man- agement Executive, November 1999, pp. 29–35.

require global production of a standardized product, whereas a foreign subsidiary may be committed to increasing its market share in its country, which will require a nonstandard product. These different goals can lead to conflict.

Such impediments to coordination are not unusual in any firm, but they can be particu- larly problematic in the multinational enterprise with its profusion of subunits at home and abroad. Differences in subunit orientation are often reinforced in multinationals by the separations of time zone, distance, and nationality between managers of the subunits.

Formal Integrating Mechanisms The formal mechanisms used to integrate subunits vary in complexity from simple direct con- tact and liaison roles, to teams, to a matrix structure (see Figure 14.9). In general, the greater the need for coordination, the more complex the formal integrating mechanisms need to be.18

Direct contact between subunit managers is the simplest integrating mechanism. By this “mechanism,” managers of the various subunits simply contact each other whenever they have a common concern. Direct contact may not be effective if the managers have differ- ing orientations that act to impede coordination, as pointed out in the previous subsection.

Liaison roles are a bit more complex. When the volume of contacts between subunits increases, coordination can be improved by giving a person in each subunit responsibility for coordinating with another subunit on a regular basis. Through these roles, the people involved establish a permanent relationship. This helps attenuate the impediments to coor- dination discussed in the previous subsection.

When the need for coordination is greater still, firms tend to use temporary or perma- nent teams composed of individuals from the subunits that need to achieve coordination. They typically coordinate product development and introduction, but they are useful when

408 Part 5 The Strategy and Structure of International Business

any aspect of operations or strategy requires the cooperation of two or more subunits. Product development and introduction teams are typically composed of personnel from R&D, production, and marketing. The resulting coordination aids the development of products that are tailored to consumer needs and that can be produced at a reasonable cost (design for manufacturing).

When the need for integration is very high, firms may institute a matrix structure, in which all roles are viewed as integrating roles. The structure is designed to facilitate maximum inte- gration among subunits. The most common matrix in multinational firms is based on geo- graphic areas and worldwide product divisions. This achieves a high level of integration between the product divisions and the areas so that, in theory, the firm can pay close attention to both local responsiveness and the pursuit of location and experience curve economies.

In some multinationals, the matrix is more complex still, structuring the firm into geo- graphic areas, worldwide product divisions, and functions, all of which report directly to headquarters. Thus, within a company such as Dow Chemical before it abandoned its matrix in the mid-1990s (see the Management Focus), each manager belonged to three hierarchies. For example, a plastics marketing manager in Spain was a member of the Spanish subsidiary, the plastics product division, and the marketing function. In addition to facilitating local responsiveness and location and experience curve economies, such a matrix fosters the transfer of core competencies within the organization. This occurs be- cause core competencies tend to reside in functions (e.g., R&D, marketing). A structure such as this in theory facilitates the transfer of competencies existing in functions from division to division and from area to area.

However, as discussed earlier, such matrix solutions to coordination problems in multina- tional enterprises can quickly become bogged down in a bureaucratic tangle that creates as many problems as it solves. Matrix structures tend to be bureaucratic, inflexible, and charac- terized by conflict rather than the hoped-for cooperation. For such a structure to work, it needs to be flexible and to be supported by informal integrating mechanisms.19 The knowl- edge and skills of people are typically more important than the structural reporting lines in the global matrix hierarchy. Integration and coordination via a matrix organization structure should not override the flexibility to make decisions based on people’s knowledge and skills.

Informal Integrating Mechanism: Knowledge Networks In attempting to alleviate or avoid the problems associated with formal integrating mecha- nisms in general, and matrix structures in particular, firms with a high need for integration have been experimenting with an informal integrating mechanism: knowledge networks that are supported by an organizational culture that values teamwork and cross-unit coop- eration.20 A knowledge network is a network for transmitting information within an or- ganization that is based not on formal organizational structure, but on informal contacts

F I G U R E 1 4 . 9

Formal integrating mechanisms.

Direct Contact

Liaison Roles

Teams

Matrix Structures

Increasing Complexity of Integrating Mechanism

The Organization of International Business Chapter 14 409

between managers within an enterprise and on distributed information systems.21 The great strength of such a network is that it can be used as a nonbureaucratic conduit for knowledge flows within a multinational enterprise.22 For a network to exist, managers at different locations within the organization must be linked to each other at least indirectly. For example, Figure 14.10 shows the simple network relationships between seven manag- ers within a multinational firm. Managers A, B, and C all know each other personally, as do managers D, E, and F. Although manager B does not know manager F personally, they are linked through common acquaintances (managers C and D). Thus, we can say that managers A through F are all part of the network and also that manager G is not.

Imagine manager B is a marketing manager in Spain and needs to know the solution to a technical problem to better serve an important European customer. Manager F, an R&D manager in the United States, has the solution to manager B’s problem. Manager B men- tions her problem to all of her contacts, including manager C, and asks if they know of anyone who might be able to provide a solution. Manager C asks manager D, who tells manager F, who then calls manager B with the solution. In this way, coordination is achieved informally through the network, rather than by formal integrating mechanisms such as teams or a matrix structure.

For such a network to function effectively, however, it must embrace as many managers as possible. For example, if manager G had a problem similar to manager B’s, he would not be able to utilize the informal network to find a solution; he would have to resort to more formal mechanisms. Establishing companywide knowledge networks is difficult, and although network enthusiasts speak of networks as the “glue” that binds multinational companies together, it is far from clear how successful firms have been at building compa- nywide networks. Two techniques being used to establish networks are information sys- tems and management development policies.

Firms are using their distributed computer and telecommunications information sys- tems to provide the foundation for informal knowledge networks.23 Electronic mail, video- conferencing, high-bandwidth data systems, and web-based search engines make it much easier for managers scattered over the globe to get to know each other, to identify contacts that might help solve a particular problem, and to publicize and share best practices within the organization. Walmart, for example, now uses its intranet system to communicate ideas about merchandising strategy between stores located in different countries.

Firms are also using their management development programs to build informal net- works. Tactics include rotating managers through various subunits on a regular basis so they build their own informal network and using management education programs to bring managers of subunits together in a single location so they can become acquainted.

Knowledge networks by themselves may not be sufficient to achieve coordination if sub- unit managers persist in pursuing subgoals that are at variance with companywide goals.24 For a knowledge network to function properly—and for a formal matrix structure to work

A

B

F

E G

C D

F I G U R E 1 4 .1 0

A simple management network.

410 Part 5 The Strategy and Structure of International Business

also—managers must share a strong commitment to the same goals. To appreciate the nature of the problem, consider again the case of manager B and manager F. As before, manager F hears about manager B’s problem through the network. However, solving manager B’s prob- lem would require manager F to devote considerable time to the task. Insofar as this would divert manager F away from his own regular tasks—and the pursuit of subgoals that differ from those of manager B—he may be unwilling to do it. Thus, manager F may not call man- ager B, and the informal network would fail to provide a solution to manager B’s problem.

To eliminate this flaw, the organization’s managers must adhere to a common set of norms and values that override differing subunit orientations.25 In other words, the firm must have a strong organizational culture that promotes teamwork and cooperation. When this is the case, a manager is willing and able to set aside the interests of his own subunit when doing so benefits the firm as a whole. If manager B and manager F are committed to the same organizational norms and value systems, and if these organizational norms and values place the interests of the firm as a whole above the interests of any individual subunit, manager F should be willing to cooperate with manager B on solving her subunit’s problems.

Integrating Mechanisms Summary The message contained in this section on integrating mechanisms is crucial to understand- ing the problems of managing the multinational firm. Multinationals need integration— particularly if they are pursuing global standardization, international, or transnational strategies—but it can be difficult to achieve due to the impediments to coordination dis- cussed. Firms traditionally have tried to achieve coordination by adopting formal integrat- ing mechanisms. These do not always work, however, since they tend to be bureaucratic and do not necessarily address the problems that arise from differing subunit orientations. This is particularly likely with a complex matrix structure, and yet, a complex matrix struc- ture is required for simultaneously achieving location and experience curve economies, local responsiveness, and the multidirectional transfer of core competencies within the organization. The solution to this dilemma seems twofold. First, the firm must try to estab- lish an informal knowledge network that can do much of the work previously undertaken by a formal matrix structure. Second, the firm must build a common culture. Neither of these partial solutions, however, is easy to achieve.26

Control Systems and Incentives

A major task of a firm’s leadership is to control the various subunits of the firm—whether they be defined on the basis of function, product division, or geographic area—to ensure their actions are consistent with the firm’s overall strategic and financial objectives. Firms achieve this with various control and incentive systems. In this section, we first review the various types of control systems firms use to control their subunits. We briefly discuss in- centive systems. Then we look at how the appropriate control and incentive systems vary according to the strategy of the multinational enterprise.

TYPES OF CONTROL SYSTEMS

Four main types of control systems are used in multinational firms: personal controls, bu- reaucratic controls, output controls, and cultural controls. In most firms, all four are used, but their relative emphasis varies with the strategy of the firm.

Personal Controls Personal control is control achieved by personal contact with subordinates. This type of control tends to be most widely used in small firms, where it is seen in the direct supervision of subordinates’ actions. However, it also structures the relationships between managers at different levels in multinational enterprises. For example, the CEO may use a great deal of personal control to influence the behavior of his or her immediate subordinates, such as the heads of worldwide product divisions or major geographic areas. In turn, these heads may

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The Organization of International Business Chapter 14 411

use personal control to influence the behavior of their subordinates, and so on down through the organization. Jack Welch, the legendary CEO of General Electric who retired in 2001, had regular one-on-one meetings with the heads of all of GE’s major businesses (most of which are international).27 He used these meetings to probe the managers about the strategy, structure, and financial performance of their operations. In doing so, he essentially exercised personal control over these managers and, undoubtedly, over the strategies that they favored.

Bureaucratic Controls Bureaucratic control is control achieved through a system of rules and procedures that di- rects the actions of subunits. The most important bureaucratic controls in subunits within multinational firms are budgets and capital spending rules. Budgets are essentially a set of rules for allocating a firm’s financial resources. A subunit’s budget specifies with some preci- sion how much the subunit may spend. Headquarters uses budgets to influence the behavior of subunits. For example, the R&D budget normally specifies how much cash the R&D unit may spend on product development. R&D managers know that if they spend too much on one project, they will have less to spend on other projects, so they modify their behavior to stay within the budget. Most budgets are set by negotiation between headquarters manage- ment and subunit management. Headquarters management can encourage the growth of certain subunits and restrict the growth of others by manipulating their budgets.

Capital spending rules require headquarters management to approve any capital expen- diture by a subunit that exceeds a certain amount. A budget allows headquarters to specify the amount a subunit can spend in a given year, and capital spending rules give headquar- ters additional control over how the money is spent. Headquarters can be expected to deny approval for capital spending requests that are at variance with overall firm objectives and to approve those that are congruent with firm objectives.

Output Controls Output control involves setting goals for subunits to achieve and expressing those goals in terms of relatively objective performance metrics such as profitability, productivity, growth, market share, and quality. The performance of subunit managers is then judged by their ability to achieve the goals.28 If goals are met or exceeded, subunit managers will be rewarded. If goals are not met, top management will normally intervene to find out why and take appropriate corrective action. Thus, control is achieved by comparing actual per- formance against targets and intervening selectively to take corrective action. Subunits’ goals depend on their role in the firm. Self-contained product divisions or national subsid- iaries are typically given goals for profitability, sales growth, and market share. Functions are more likely to be given goals related to their particular activity. Thus, R&D will be given product development goals, production will be given productivity and quality goals, marketing will be given market share goals, and so on.

As with budgets, goals are normally established through negotiation between subunits and headquarters. Generally, headquarters tries to set goals that are challenging but realis- tic, so subunit managers are forced to look for ways to improve their operations but are not so pressured that they will resort to dysfunctional activities to do so (such as short-run profit maximization). Output controls foster a system of “management by exception,” in that so long as subunits meet their goals, they are left alone. If a subunit fails to attain its goals, however, headquarters managers are likely to ask some tough questions. If they don’t get satisfactory answers, they are likely to intervene proactively in a subunit, replacing top management and looking for ways to improve efficiency.

Cultural Controls Cultural control exists when employees “buy into” the norms and value systems of the firm. When this occurs, employees tend to control their own behavior, which reduces the need for direct supervision. In a firm with a strong culture, self-control can reduce the need for other control systems. We discuss organizational culture later. McDonald’s actively promotes organizational norms and values, referring to its franchisees and suppliers as

412 Part 5 The Strategy and Structure of International Business

partners and emphasizing its long-term commitment to them. This commitment is not just a public relations exercise; it is backed by actions, including a willingness to help suppliers and franchisees improve their operations by providing capital and/or management assis- tance when needed. In response, McDonald’s franchisees and suppliers are integrated into the firm’s culture and thus become committed to helping McDonald’s succeed. One result is that McDonald’s can devote less time than would otherwise be necessary to controlling its franchisees and suppliers.

INCENTIVE SYSTEMS

Incentives refer to the devices used to reward appropriate employee behavior. Many em- ployees receive incentives in the form of annual bonus pay. Incentives are usually closely tied to the performance metrics used for output controls. For example, setting targets linked to profitability might be used to measure the performance of a subunit, such as a global product division. To create positive incentives for employees to work hard to exceed those targets, they may be given a share of any profits above those targeted. If a subunit has set a goal of attaining a 15 percent return on investment and it actually attains a 20 percent return, unit employees may be given a share in the profits generated in excess of the 15 percent target in the form of bonus pay.

We return to the topic of incentive systems in Chapter 19 when we discuss human re- source strategy in the multinational firm. For now, however, several important points need to be made. First, the type of incentive used often varies depending on the employees and their tasks. Incentives for employees working on the factory floor may be very different from the incentives used for senior managers. The incentives used must be matched to the type of work being performed. The employees on the factory floor of a manufacturing plant may be broken into teams of 20 to 30 individuals, and they may have their bonus pay tied to the ability of their team to hit or exceed targets for output and product quality. In contrast, the senior managers of the plant may be rewarded according to metrics linked to the output of the entire operation. The basic principle is to make sure the incentive scheme for an individual employee is linked to an output target that he or she has some control over and can influence. The individual employees on the factory floor may not be able to exercise much influence over the performance of the entire operation, but they can influ- ence the performance of their team, so incentive pay is tied to output at this level.

Second, the successful execution of strategy in the multinational firm often requires significant cooperation between managers in different subunits. For example, as noted earlier, some multinational firms operate with matrix structures where a country subsid- iary might be responsible for marketing and sales in a nation, while a global product divi- sion might be responsible for manufacturing and product development. The managers of these different units need to cooperate closely with each other if the firm is to be success- ful. One way of encouraging the managers to cooperate is to link incentives to perfor- mance at a higher level in the organization. Thus, the senior managers of the country subsidiaries and global product divisions might be rewarded according to the profitability of the entire firm. The thinking here is that boosting the profitability of the entire firm re- quires managers in the country subsidiaries and product divisions to cooperate with each other on strategy implementation, and linking incentive systems to the next level up in the hierarchy encourages this. Most firms use a formula for incentives that links a portion of incentive pay to the performance of the subunit in which a manager or employee works and a portion to the performance of the entire firm, or some other higher-level organiza- tional unit. The goal is to encourage employees to improve the efficiency of their unit and to cooperate with other units in the organization.

Third, the incentive systems used within a multinational enterprise often have to be adjusted to account for national differences in institutions and culture. Incentive systems that work in the United States might not work, or even be allowed, in other countries. For example, Lincoln Electric, a leader in the manufacture of arc welding equipment, has used an incentive system for its employees based on piecework rates in its American factories

The Organization of International Business Chapter 14 413

(under a piecework system, employees are paid according to the amount they produce). While this system has worked very well in the United States, Lincoln has found that the system is difficult to introduce in other countries. In some countries, such as Germany, piecework systems are illegal, while in others the prevailing national culture is antagonistic to a system where performance is so closely tied to individual effort.

Finally, it is important for managers to recognize that incentive systems can have unin- tended consequences. Managers need to carefully think through exactly what behavior certain incentives encourage. For example, if employees in a factory are rewarded solely on the basis of how many units of output they produce, with no attention paid to the quality of that output, they may produce as many units as possible to boost their incentive pay, but the quality of those units may be poor.

CONTROL SYSTEMS, INCENTIVES, AND STRATEGY IN THE INTERNATIONAL BUSINESS

The key to understanding the relationship among international strategy, control systems, and incentive systems is the concept of performance ambiguity.

Performance Ambiguity Performance ambiguity exists when the causes of a subunit’s poor performance are not clear.29 This is not uncommon when a subunit’s performance is partly dependent on the performance of other subunits—that is, when there is a high degree of interdependence among subunits within the organization. Consider the case of a French subsidiary of a U.S. firm that depends on another subsidiary, a manufacturer based in Italy, for the products it sells. The French subsidiary is failing to achieve its sales goals, and the U.S. management asks the managers to explain. They reply that they are receiving poor-quality goods from the Italian subsidiary. The U.S. management asks the managers of the Italian operation what the problem is. They reply that their product quality is excellent—the best in the industry, in fact— and that the French simply don’t know how to sell a good product. Who is right, the French or the Italians? Without more information, top management cannot tell. Because they are dependent on the Italians for their product, the French have an alibi for poor performance. U.S. management needs to have more information to determine who is correct. Collecting this information is expensive and time-consuming and will divert attention away from other issues. In other words, performance ambiguity raises the costs of control.

Consider how different things would be if the French operation were self-contained, with its own manufacturing, marketing, and R&D facilities. The French operation would lack a convenient alibi for its poor performance; the French managers would stand or fall on their own merits. They could not blame the Italians for their poor sales. The level of performance ambiguity, therefore, is a function of the interdependence of subunits in an organization.

Strategy, Interdependence, and Ambiguity Now let us consider the relationships among strategy, interdependence, and performance ambiguity. In firms pursuing a localization strategy, each national operation is a stand- alone entity and can be judged on its own merits. The level of performance ambiguity is low. In an international firm, the level of interdependence is somewhat higher. Integration is required to facilitate the transfer of core competencies and skills. Since the success of a foreign operation is partly dependent on the quality of the competency transferred from the home country, performance ambiguity can exist.

In firms pursuing a global standardization strategy, the situation is still more complex. Recall that in a pure global firm the pursuit of location and experience curve economies leads to the development of a global web of value creation activities. Many of the activities in a global firm are interdependent. A French subsidiary’s ability to sell a product does depend on how well other operations in other countries perform their value creation activities. Thus, the levels of interdependence and performance ambiguity are high in global companies.

The level of performance ambiguity is highest of all in transnational firms. Transna- tional firms suffer from the same performance ambiguity problems that global firms do. In

414 Part 5 The Strategy and Structure of International Business

addition, since they emphasize the multidirectional transfer of core competencies, they also suffer from the problems characteristic of firms pursuing an international strategy. The extremely high level of integration within transnational firms implies a high degree of joint decision making, and the resulting interdependencies create plenty of alibis for poor performance. There is lots of room for finger-pointing in transnational firms.

Implications for Control and Incentives The arguments of the previous section, along with the implications for the costs of control, are summarized in Table 14.1. The costs of control can be defined as the amount of time top management must devote to monitoring and evaluating subunits’ performance. This is greater when the amount of performance ambiguity is greater. When performance ambigu- ity is low, management can use output controls and a system of management by exception; when it is high, managers have no such luxury. Output controls do not provide totally un- ambiguous signals of a subunit’s efficiency when the performance of that subunit is depen- dent on the performance of another subunit within the organization. Thus, management must devote time to resolving the problems that arise from performance ambiguity, with a corresponding rise in the costs of control.

Table 14.1 reveals a paradox. We saw in Chapter 13 that a transnational strategy is desirable because it gives a firm more ways to profit from international expansion than do localization, international, and global standardization strategies. But now we see that due to the high level of interdependence, the costs of controlling transnational firms are higher than the costs of controlling firms that pursue other strategies. Unless there is some way of reducing these costs, the higher profitability associated with a transnational strategy could be canceled out by the higher costs of control. The same point, although to a lesser extent, can be made with re- gard to firms pursuing a global standardization strategy. Although firms pursuing a global standardization strategy can reap the cost benefits of location and experience curve econo- mies, they must cope with a higher level of performance ambiguity, and this raises the costs of control (in comparison with firms pursuing an international or localization strategy).

This is where control systems and incentives come in. When we survey the systems that corporations use to control their subunits, we find that irrespective of their strategy, multi- national firms all use output and bureaucratic controls. However, in firms pursuing either global or transnational strategies, the usefulness of output controls is limited by substantial performance ambiguities. As a result, these firms place greater emphasis on cultural con- trols. Cultural control—by encouraging managers to want to assume the organization’s norms and value systems—gives managers of interdependent subunits an incentive to look for ways to work out problems that arise between them. The result is a reduction in finger- pointing and, accordingly, in the costs of control. The development of cultural controls may be a precondition for the successful pursuit of a transnational strategy and perhaps of a global strategy as well.30 As for incentives, the material discussed earlier suggests that the conflict between different subunits can be reduced and the potential for cooperation en- hanced if incentive systems are tied in some way to a higher level in the hierarchy. When performance ambiguity makes it difficult to judge the performance of subunits as stand- alone entities, linking the incentive pay of senior managers to the entity to which both subunits belong can reduce the resulting problems.

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TA B L E 1 4 .1

Interdependence, Performance Ambiguity, and the Costs of Control for the Four International Business Strategies

Performance Costs of Strategy Interdependence Ambiguity Control

Localization Low Low Low

International Moderate Moderate Moderate

Global High High High

Transnational Very high Very high Very high

The Organization of International Business Chapter 14 415

Processes

Processes, defined as the manner in which decisions are made and work is performed within the organization, can be found at many different levels within an organization.31 There are processes for formulating strategy, processes for allocating resources, processes for evaluating new-product ideas, processes for handling customer inquiries and complaints, processes for improving product quality, processes for evaluating employee performance, and so on. Often, the core competencies or valuable skills of a firm are embedded in its processes. Efficient and effective processes can lower the costs of value creation and add additional value to a product. For example, the global success of many Japanese manufac- turing enterprises in the 1980s was based in part on their early adoption of processes for improving product quality and operating efficiency, including total quality management and just-in-time inventory systems. Today, the competitive success of General Electric can in part be attributed to a number of processes that have been widely promoted within the company. These include the company’s Six Sigma process for quality improvement; its pro- cess for “digitalization” of business (using corporate intranets and the Internet to automate activities and reduce operating costs); and its process for idea generation, referred to within the company as “workouts,” where managers and employees get together for intensive ses- sions over several days to identify and commit to ideas for improving productivity.

An organization’s processes can be summarized by means of a flowchart, which illus- trates the various steps and decision points involved in performing work. Many processes cut across functions, or divisions, and require cooperation between individuals in different subunits. For example, product development processes require employees from R&D, manufacturing, and marketing to work together in a cooperative manner to make sure new products are developed with market needs in mind and designed in such a way that they can be manufactured at a low cost. Because they cut across organizational boundaries, performing processes effectively often requires the establishment of formal integrating mechanisms and incentives for cross-unit cooperation.

A detailed consideration of the nature of processes and strategies for process improve- ment and reengineering is beyond the scope of this text. However, it is important to make two basic remarks about managing processes, particularly in the context of an interna- tional business.32 The first is that in a multinational enterprise, many processes cut not only across organizational boundaries, embracing several different subunits, but also across national boundaries. Designing a new product may require the cooperation of R&D personnel located in California; production people located in Taiwan; and marketing lo- cated in Europe, America, and Asia. The chances of pulling this off are greatly enhanced if the processes are embedded in an organizational culture that promotes cooperation among individuals from different subunits and nations, if the incentive systems of the orga- nization explicitly reward such cooperation, and if formal and informal integrating mecha- nisms are used to facilitate coordination among subunits.

Second, it is particularly important for a multinational enterprise to recognize that valu- able new processes that might lead to a competitive advantage can be developed anywhere within the organization’s global network of operations.33 New processes may be developed by a local operating subsidiary in response to conditions pertaining to its market. Those pro- cesses might then have value to other parts of the multinational enterprise. The ability to create valuable processes matters, but it is also important to leverage those processes. This requires both formal and informal integrating mechanisms such as knowledge networks.

Organizational Culture

Chapter 4 applied the concept of culture to countries. Culture, however, is also a social construct ascribed to societies, including organizations.34 Thus, we can speak of organiza- tional culture and subcultures. The basic definition of culture remains the same, whether we are applying it to a macro (large) society such as a country, or subcultures within

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416 Part 5 The Strategy and Structure of International Business

countries, or a micro (small) society such as an organization or one of its subunits. Culture refers to a system of values and norms that are shared among people. Values are abstract ideas about what a group believes to be good, right, and desirable. Norms mean the social rules and guidelines that prescribe appropriate behavior in particular situations.

Values and norms express themselves as the behavior patterns or style of an organiza- tion that new employees are automatically encouraged to follow by their fellow employees. Although an organization’s culture is rarely static, it tends to change relatively slowly. Cultural changes often come from doing something or behaving a certain way over time. Seldom do we adopt a cultural change, and then behaviors ensue without having ever been done before. Instead, repeated behaviors lead to revised values and norms, which, in turn, emphasize the new cultural makeup (whether it be at the country or organizational level).

CREATING AND MAINTAINING ORGANIZATIONAL CULTURE

An organization’s culture comes from several sources. First, there seems to be wide agree- ment that founders or important leaders can have a profound impact on an organization’s culture, often imprinting their own values on the culture.35 A famous example of a strong founder effect concerns the Japanese firm Matsushita. Konosuke Matsushita’s almost Zen-like personal business philosophy was codified in the “Seven Spiritual Values” of Matsu- shita that all new employees still learn today. These values are (1) national service through industry, (2) fairness, (3) harmony and cooperation, (4) struggle for betterment, (5) courtesy and humility, (6) adjustment and assimilation, and (7) gratitude. A leader does not have to be the founder to have a profound influence on organizational culture. Jack Welch is widely cred- ited with having changed the culture of GE when he first became CEO, primarily by empha- sizing a countercultural set of values, such as risk taking, entrepreneurship, stewardship, and boundaryless behavior. It is more difficult for a leader, however forceful, to change an estab- lished organizational culture than it is to create one from scratch in a new venture. A blank slate on culture allows for the establishment of desired values and norms, while an existing culture and any change desired often results from implemented behaviors over time.

Another important influence on organizational culture is the broader social culture of the nation where the firm was founded and/or has significant operations. In the United States, for example, the competitive ethic of individualism looms large, and there is enormous social stress on producing winners. Many American firms find ways of rewarding and motivating individuals so that they see themselves as winners.36 The values of American firms often reflect the values of American culture. Similarly, the cooperative values found in many Japanese firms have been argued to reflect the values of traditional Japanese society, with its emphasis on group cooperation, reciprocal obligations, and harmony.37 Thus, although it may be a generalization, there may be something to the argument that organizational culture is influenced by national culture. This influence is particularly tricky in countries that are by design going through significant culture change (e.g., many eastern European countries). For example, China is more and more moving toward a market-based economy, while still having significant influence from the communist system; such an economy can create inconsistent cultural makeups for companies, especially foreign companies trying to operate in China.

A third influence on organizational culture is the history of the enterprise, which over time may come to shape the values of the organization. In the language of historians, orga- nizational culture is the path-dependent product of where the organization has been through time. For example, Koninklijke Philips Electronics NV, the Dutch multinational, long operated with a culture that placed a high value on the independence of national op- erating companies. This culture was shaped by the history of the company. During World War II, the Netherlands was occupied by the Germans. With the head office in occupied territories, power was devolved by default to various foreign operating companies, such as Philips’ subsidiaries in the United States and Great Britain. After the war ended, these subsidiaries continued to operate in a highly autonomous fashion. A belief that this was the right thing to do became a core value of the company.

Decisions that subsequently result in high performance tend to become institutional- ized in the values of a firm. In the 1920s, 3M was primarily a manufacturer of sandpaper.

The Organization of International Business Chapter 14 417

Richard Drew, who was a young laboratory assistant at the time, came up with what he thought would be a great new product—a glue-covered strip of paper, which he called “sticky tape.” Drew saw applications for the prod- uct in the automobile industry, where it could be used to mask parts of a vehicle during painting. He presented the idea to the company’s president, William McKnight. An unimpressed McKnight suggested that Drew drop the re- search. Drew didn’t; instead he developed the “sticky tape” and then went out and got endorsements from po- tential customers in the auto industry. Armed with this information, he approached McKnight again. A chastened McKnight reversed his position and gave Drew the go- ahead to start developing what was to become one of 3M’s main product lines—sticky tape—a business it dominates to this day.38 From then on, McKnight emphasized the im- portance of giving researchers at 3M free rein to explore their own ideas and experiment with product offerings. This soon became a core value at 3M and was enshrined in the company’s famous “15 percent rule,” which stated that researchers could spend 15 percent of the company time working on ideas of their own choosing. Today, new employees are often told the Drew story, which is used to illus- trate the value of allowing individuals to explore their own ideas.

Culture is maintained by a variety of mechanisms. These include (1) hiring and promo- tional practices of the organization, (2) reward strategies, (3) socialization processes, and (4) communication strategy. The goal is to recruit people whose values are consistent with those of the company. To further reinforce values, a company may promote individuals whose behavior is consistent with the core values of the organization. Merit review pro- cesses may also be linked to a company’s values, which further reinforces cultural norms.

Socialization can be formal, such as training programs that educate employees in the core values of the organization. Informal socialization may be friendly advice from peers or bosses or may be implicit in the actions of peers and superiors toward new employees. As for communication strategy, many companies with strong cultures devote a lot of atten- tion to framing their key values in corporate mission statements, communicating them of- ten to employees, and using them to guide difficult decisions. Stories and symbols are often used to reinforce important values (e.g., the Drew and McKnight story at 3M).

ORGANIZATIONAL CULTURE AND PERFORMANCE IN THE INTERNATIONAL BUSINESS

Management authors often talk about “strong cultures.”39 In a strong culture, almost all managers share a relatively consistent set of values and norms that have a clear impact on the way work is performed. New employees adopt these values very quickly, and employees who do not fit in with the core values tend to leave. In such a culture, a new executive is just as likely to be corrected by his subordinates as by his superiors if he violates the values and norms of the organizational culture. Firms with a strong culture are normally seen by outsiders as having a certain style or way of doing things. Lincoln Electric, featured in the accompanying Management Focus, is an example of a firm with a strong culture.

Strong does not necessarily mean good. A culture can be strong but bad. The culture of the Nazi Party in Germany was certainly strong, but it was most definitely not good. Nor does it follow that a strong culture leads to high performance. One study found that in the 1980s General Motors had a “strong culture,” but it was a strong culture that dis- couraged lower-level employees from demonstrating initiative and taking risks, which the authors argued was dysfunctional and led to low performance at GM.40 Also, a strong culture might be beneficial at one point, leading to high performance, but inappropriate at another time. The appropriateness of the culture depends on the context. In the 1980s, when IBM was performing very well, several management authors sang the

A new innovation by 3M—the command brand picture hanging strips and hooks. 3M is the maker of the well-known Post-it Notes and Scotch Tapes. ©TY Lim/Shutterstock

418 Part 5 The Strategy and Structure of International Business

praises of its strong culture, which among other things placed a high value on consensus- based decision making.41 These authors argued that such a decision-making process was appropriate given the substantial financial investments that IBM routinely made in new technology. However, this process turned out to be a weakness in the fast-moving com- puter industry of the late 1980s and 1990s. Consensus-based decision making was slow, bureaucratic, and not particularly conducive to corporate risk taking. While this was fine in the 1970s, IBM needed rapid decision making and entrepreneurial risk taking in the 1990s, but its culture discouraged such behavior. IBM found itself outf lanked by then-small enterprises such as Microsoft.

One study concluded that firms that exhibited high performance over a prolonged pe- riod tended to have strong but adaptive cultures. According to this study, in an adaptive culture most managers care deeply about and value customers, stockholders, and employ- ees. They also strongly value people and processes that create useful change in a firm.42 While this is interesting, it does reduce the issue to a very high level of abstraction; after all, what company would say that it doesn’t care deeply about customers, stockholders, and employees? A somewhat different perspective is to argue that the culture of the firm must match the rest of the architecture of the organization, the firm’s strategy, and the demands of the competitive environment for superior performance to be attained. All these elements must be consistent with each other.

Lincoln Electric provides another useful example (see the Management Focus). Lincoln competes in a business that is very competitive, where cost minimization is a key source of competitive advantage. Lincoln’s culture and incentive systems both encourage employees to strive for high levels of productivity, which translates into the low costs that are critical for Lincoln’s success. The Lincoln example also demonstrates another important point for international businesses: A culture that leads to high performance in the firm’s home na- tion may not be easy to impose on foreign subsidiaries! Lincoln’s culture has clearly helped the firm achieve superior performance in the U.S. market, but this same culture is very “American” in its form and difficult to implement in other countries. The managers and employees of several of Lincoln’s European subsidiaries found the culture to be alien to their own values and were reluctant to adopt it. The result was that Lincoln found it very difficult to replicate in foreign markets the success it has had in the United States. Lincoln compounded the problem by acquiring established enterprises that already had their own organizational culture. Thus, in trying to impose its culture on foreign operating subsidiar- ies, Lincoln had to deal with two problems: how to change the established organizational culture of those units, and how to introduce an organizational culture whose key values might be alien to the values held by members of that society. These problems are not unique to Lincoln; many international businesses have to deal with exactly the same problems.

The solution Lincoln has adopted is to establish new subsidiaries, rather than acquiring and trying to transform an enterprise with its own culture. It is much easier to establish a set of values in a new enterprise than it is to change the values of an established enterprise. A second solution is to devote a lot of time and attention to transmitting the firm’s organi- zational culture to its foreign operations. This was something Lincoln originally omitted. Other firms make this an important part of their strategy for internationalization.

The need for a common organizational culture that is the same across a multinational’s global network of subsidiaries probably varies with the strategy of the firm. Shared norms and values can facilitate coordination and cooperation between individuals from different subunits.43 A strong common culture may lead to goal congruence and can attenuate the problems that arise from interdependence, performance ambiguities, and conflict among managers from different subsidiaries. As noted earlier, a shared culture may help informal integrating mechanisms such as knowledge networks to operate more effectively. As such, a common culture may be of greater value in a multinational that is pursuing a strategy that requires cooperation and coordination between globally dispersed subsidiaries. This suggests that it is more important to have a common culture in firms employing a transna- tional strategy than a localization strategy, with global and international strategies falling between these two extremes.

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419

M A N A G E M E N T F O C U S

Lincoln Electric and Culture Lincoln Electric is one of the leading global manufacturers of welding products, arc welding equipment, welding con- sumables, plasma and oxy-fuel cutting equipment, and ro- botic welding systems. Lincoln’s success has been based on extremely high levels of employee productivity. The company attributes its productivity to a strong organiza- tional culture and an incentive scheme based on piece- work. Lincoln’s organizational culture dates back to James Lincoln, who in 1907 joined the company that his brother had established a few years earlier. Lincoln had a strong respect for the ability of the individual and believed that, correctly motivated, ordinary people could achieve ex- traordinary performance. He emphasized that Lincoln should be a meritocracy where people were rewarded for their individual effort. Strongly egalitarian, Lincoln removed barriers to communication between “workers” and “man- agers,” practicing an open-door policy. He made sure that all who worked for the company were treated equally; for example, everyone ate in the same cafeteria, there were no reserved parking places for “managers,” and so on. Lincoln also believed that any gains in productivity should be shared with consumers in the form of lower prices, with employees in the form of higher pay, and with sharehold- ers in the form of higher dividends. The organizational culture that grew out of James Lincoln’s beliefs was reinforced by the company’s incen- tive system. Production workers receive no base salary but are paid according to the number of pieces they pro- duce. The piecework rates at the company enable an employee working at a normal pace to earn an income equivalent to the average wage for manufacturing work- ers in the area where a factory is based. Workers have responsibility for the quality of their output and must re- pair any defects spotted by quality inspectors before the pieces are included in the piecework calculation. Since 1934, production workers have been awarded a semian- nual bonus based on merit ratings. These ratings are based on objective criteria (such as an employee’s level and quality of output) and subjective criteria (such as an employee’s attitudes toward cooperation and his or her dependability). These systems give Lincoln’s employees an incentive to work hard and to generate innovations

that boost productivity, for doing so influences their level of pay. Lincoln’s factory workers have been able to earn a base pay that often exceeds the average manufactur- ing wage in the area by more than 50 percent and re- ceive a bonus on top of this that in good years could double their base pay. Despite high employee compen- sation, the workers are so productive that Lincoln has a lower cost structure than its competitors. While this organizational culture and set of incentives works well in the United States, where it is compatible with the individualistic culture of the country, it did not translate easily into foreign operations. Early on, Lincoln expanded aggressively into Europe and Latin America, acquiring a number of local arc welding manufacturers. Lincoln left local managers in place, believing that they knew local conditions better than Americans. However, the local managers had little working knowledge of Lincoln’s strong organizational culture and were unable or unwilling to im- pose that culture on their units, which had their own long- established organizational cultures. Nevertheless, Lincoln told local managers to introduce its incentive systems in acquired companies. They frequently ran into legal and cultural roadblocks. In many countries, piecework is viewed as an exploitive compensation system that forces employees to work ever harder. In Germany, where Lincoln made an acquisition, it is illegal. In Brazil, a bonus paid for more than two years becomes a legal entitlement! In many other countries, both managers and workers were opposed to the idea of piecework. Lincoln found that many European workers val- ued extra leisure more highly than extra income and were not prepared to work as hard as their American counter- parts. Many of the acquired companies were also union- ized, and the local unions vigorously opposed the introduction of piecework. As a result, Lincoln was not able to replicate the high level of employee productivity that it had achieved in the United States, and its expansion pulled down the performance of the entire company.

Sources: Jill Jusko, “Lincoln Electric CEO: Meeting the Skills Gap Challenge,” IndustryWeek, October 9, 2014; J. O’Connell, “Lincoln Electric: Venturing Abroad,” Harvard Business School Case No. 9-398-095, April 1998; www.lincolnelectric.com.

420 Part 5 The Strategy and Structure of International Business

Synthesis: Strategy and Architecture

Chapter 13 identified four basic strategies that multinational firms pursue: localization, international, global, and transnational. So far in this chapter, we have looked at several aspects of organizational architecture, and we have discussed the interrelationships be- tween these dimensions and strategies. Now it is time to synthesize this material.

LOCALIZATION STRATEGY

Firms pursuing a localization strategy focus on local responsiveness. Table 14.2 shows that such firms tend to operate with worldwide area structures, within which operating decisions are decentralized to functionally self-contained country subsidiaries. The need for coordina- tion between subunits (areas and country subsidiaries) is low. This suggests that firms pursu- ing a localization strategy do not have a high need for integrating mechanisms, either formal or informal, to knit together different national operations. The lack of interdependence im- plies that the level of performance ambiguity in such enterprises is low, as (by extension) are the costs of control. Thus, headquarters can manage foreign operations by relying primarily on output and bureaucratic controls and a policy of management by exception. Incentives can be linked to performance metrics at the level of country subsidiaries. Since the need for integration and coordination is low, the need for common processes and organizational cul- ture is also quite low. Were it not for the fact that these firms are unable to profit from the realization of location and experience curve economies, or from the transfer of core compe- tencies, their organizational simplicity would make this an attractive strategy.

INTERNATIONAL STRATEGY

Firms pursuing an international strategy attempt to create value by transferring core com- petencies from home to foreign subsidiaries. If they are diverse, as most of them are, these firms operate with a worldwide product division structure. Headquarters normally main- tains centralized control over the source of the firm’s core competency, which is most typically found in the R&D and/or marketing functions of the firm. All other operating decisions are decentralized within the firm to subsidiary operations in each country (which in diverse firms report to worldwide product divisions).

The need for coordination is moderate in such firms, reflecting the need to transfer core competencies. Thus, although such firms operate with some integrating mechanisms, they are not that extensive. The relatively low level of interdependence that results translates into

LO 14 -3 Explain how the organizational architecture can be matched to global strategy to improve performance.

TA B L E 1 4 . 2

A Synthesis of Strategy, Structure, and Control Systems

Strategy

Structure Global and Controls Localization International Standardization Transnational

Vertical differentiation Decentralized Core competency Some centralization Mixed more centralized; centralization and rest decentralized decentralization

Horizontal Worldwide Worldwide Worldwide Informal matrix differentiation area structure product divisions product divisions

Need for coordination Low Moderate High Very high

Integrating mechanisms None Few Many Very many

Performance ambiguity Low Moderate High Very high

Need for cultural controls Low Moderate High Very high

The Organization of International Business Chapter 14 421

a relatively low level of performance ambiguity. These firms can generally get by with output and bureaucratic controls and with incentives that are focused on performance metrics at the level of country subsidiaries. The need for a common organizational culture and com- mon processes is not that great. An important exception to this is when the core skills or competencies of the firm are embedded in processes and culture, in which case the firm needs to pay close attention to transferring those processes and associated culture from the corporate center to country subsidiaries. Overall, although the organization required for an international strategy is more complex than that of firms pursuing a localization strategy, the increase in the level of complexity is not that great.

GLOBAL STANDARDIZATION STRATEGY

Firms pursuing a global standardization strategy focus on the realization of location and experience curve economies. If they are diversified, as many of them are, these firms oper- ate with a worldwide product division structure. To coordinate the firm’s globally dis- persed web of value creation activities, headquarters typically maintains ultimate control over most operating decisions. In general, such firms are more centralized than enterprises pursuing a localization or international strategy. Reflecting the need for coordination of the various stages of the firms’ globally dispersed value chains, the need for integration in these firms also is high. Thus, these firms tend to operate with an array of formal and in- formal integrating mechanisms. The resulting interdependencies can lead to significant performance ambiguities. As a result, in addition to output and bureaucratic controls, firms pursuing a global standardization strategy tend to stress the need to build a strong organizational culture that can facilitate coordination and cooperation. They also tend to use incentive systems that are linked to performance metrics at the corporate level, giving the managers of different operations a strong incentive to cooperate with each other to increase the performance of the entire corporation. On average, the organization of such firms is more complex than that of firms pursuing a localization or international strategy.

TRANSNATIONAL STRATEGY

Firms pursuing a transnational strategy focus on the simultaneous attainment of location and experience curve economies, local responsiveness, and global learning (the multidirec- tional transfer of core competencies or skills). These firms may operate with matrix-type structures in which both product divisions and geographic areas have significant influ- ence. The need to coordinate a globally dispersed value chain and to transfer core compe- tencies creates pressures for centralizing some operating decisions (particularly production and R&D). At the same time, the need to be locally responsive creates pressures for decen- tralizing other operating decisions to national operations (particularly marketing). Conse- quently, these firms tend to mix relatively high degrees of centralization for some operating decisions with relative high degrees of decentralization for other operating decisions.

The need for coordination is high in transnational firms. This is reflected in the use of an array of formal and informal integrating mechanisms, including formal matrix struc- tures and informal management networks. The high level of interdependence of subunits implied by such integration can result in significant performance ambiguities, which raise the costs of control. To reduce these, in addition to output and bureaucratic controls, firms pursuing a transnational strategy need to cultivate a strong culture and to establish incentives that promote cooperation between subunits.

ENVIRONMENT, STRATEGY, ARCHITECTURE, AND PERFORMANCE

Underlying the scheme outlined in Table 14.2 is the notion that a “fit” between strategy and architecture is necessary for a firm to achieve high performance. For a firm to succeed, two conditions must be fulfilled. First, the firm’s strategy must be consistent with the environment in which the firm operates. We discussed this issue in Chapter 13 and noted that in some industries a global standardization strategy is most viable, in others an international or trans- national strategy may be most viable, and in still others a localization strategy may be most viable. Second, the firm’s organizational architecture must be consistent with its strategy.

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If the strategy does not fit the environment, the firm is likely to experience significant performance problems. If the architecture does not fit the strategy, the firm is also likely to experience performance problems. Therefore, to survive, a firm must strive to achieve a fit of its environment, its strategy, and its organizational architecture. For example, consider Koninklijke Philips NV. For reasons rooted in the history of the firm, Philips operated until recently with an organization typical of an enterprise pursuing localization; operating decisions were decentralized to largely autonomous foreign subsidiaries. Historically, elec- tronics markets were segmented from each other by high trade barriers, so an organization consistent with a localization strategy made sense. However, by the mid-1980s, the indus- try in which Philips competed had been revolutionized by declining trade barriers, techno- logical change, and the emergence of low-cost Japanese competitors that utilized a global strategy. To survive, Philips needed to adopt a global standardization strategy itself. The firm recognized this and tried to adopt a global posture, but it did little to change its orga- nizational architecture. The firm nominally adopted a matrix structure based on world- wide product divisions and national areas. In reality, however, the national areas continued to dominate the organization, and the product divisions had little more than an advisory role. As a result, Philips’ architecture did not fit the strategy, and by the early 1990s, Philips was losing money. It was only after four years of wrenching change and large losses that Philips was finally able to tilt the balance of power in its matrix toward the product divisions. By the mid-1990s, the fruits of this effort to realign the company’s strategy and architecture with the demands of its operating environment finally showed up in improved financial performance.44

Organizational Change

Multinational firms periodically have to alter their architecture so that it conforms to the changes in the environment in which they are competing and the strategy they are pursu- ing. To be profitable, Philips had to alter its strategy and architecture so that both matched the demands of the competitive environment in the electronics industry, which had shifted from localization toward a global industry. While a detailed consideration of organizational change is beyond the scope of this book, a few comments are warranted regarding the sources of organization inertia and the strategies and tactics for implement- ing organizational change.

ORGANIZATIONAL INERTIA

Organizations are difficult to change. Within most organizations are strong inertia forces. These forces come from a number of sources. One source of inertia is the existing distribu- tion of power and influence within an organization.45 The power and influence enjoyed by individual managers are, in part, a function of their role in the organizational hierarchy, as defined by structural position. By definition, most substantive changes in an organization require a change in structure and, by extension, a change in the distribution of power and influence within the organization. Some individuals will see their power and influence in- crease as a result of organizational change, and some will see the converse. For example, Philips decided to increase the roles and responsibilities of its global product divisions and decrease the roles and responsibilities of its foreign subsidiary companies to combat orga- nizational inertia. This meant the managers running the global product divisions saw their power and influence increase, while the managers running the foreign subsidiary compa- nies saw their power and influence decline. As might be expected, some managers of for- eign subsidiary companies did not like this change and resisted it, which slowed the pace of change. Those whose power and influence are reduced as a consequence of organiza- tional change can be expected to resist it, primarily by arguing that the change might not work. To the extent that they are successful, this constitutes a source of organizational in- ertia that might slow or stop change.

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LO 14 - 4 Discuss what is required for an international business to change its organizational architecture so that it better matches its global strategy.

The Organization of International Business Chapter 14 423

Another source of organizational inertia is the existing culture, as expressed in norms and value systems. Value systems reflect deeply held beliefs, and as such, they can be very hard to change. If the formal and informal socialization mechanisms within an organiza- tion have been emphasizing a consistent set of values for a prolonged period, and if hiring, promotion, and incentive systems have all reinforced these values, then suddenly announc- ing that those values are no longer appropriate and need to be changed can produce resis- tance and dissonance among employees. For example, Philips historically placed a very high value on local autonomy. The changes the company decided to make implied a reduc- tion in the autonomy enjoyed by foreign subsidiaries, which was counter to the established values of the company and thus resisted.

Organizational inertia might also derive from senior managers’ preconceptions about the appropriate business model or paradigm. When a given paradigm has worked well in the past, managers might have trouble accepting that it is no longer appropriate. At Philips, granting considerable autonomy to foreign subsidiaries had worked very well in the past, allowing local managers to tailor product and business strategy to the conditions prevailing in a given country. Since this paradigm had worked so well, it was difficult for many man- agers to understand why it no longer applied. Consequently, they had difficulty accepting a new business model and tended to fall back on their established paradigm and ways of doing things. This change required managers to let go of long-held assumptions about what worked and what didn’t work, which was something many of them couldn’t do.

Institutional constraints might also act as a source of inertia. National regulations, in- cluding local content rules and policies pertaining to layoffs, might make it difficult for a multinational to alter its global value chain. A multinational might wish to take control for manufacturing away from local subsidiaries, transfer that control to global product divi- sions, and consolidate manufacturing at a few choice locations. However, if local content rules (see Chapter 7) require some degree of local production and if regulations regarding layoffs make it difficult or expensive for a multinational to close operations in a country, a multinational may find that these constraints make it very difficult to adopt the most effec- tive strategy and architecture.

IMPLEMENTING ORGANIZATIONAL CHANGE

Although all organizations suffer from inertia, the complexity and global spread of many multinationals might make it particularly difficult for them to change their strategy and architecture to match new organizational realities. Yet at the same time, the trend toward globalization in many industries has made it more critical than ever that many multination- als do just that. In industry after industry, declining barriers to cross-border trade and in- vestment have led to a change in the nature of the competitive environment. Cost pressures have increased, requiring multinationals to respond by streamlining their operations to re- alize economic benefits associated with location and experience curve economies and with the transfer of competencies and skills within the organization. Local responsiveness remains an important source of differentiation as well. To survive in this emerging com- petitive environment, multinationals must change not only their strategy but also their ar- chitecture so that it matches strategy in discriminating ways. The basic principles for successful organizational change can be summarized as follows: (1) unfreeze the organiza- tion through shock therapy, (2) move the organization to a new state through proactive change in the architecture, and (3) refreeze the organization in its new state.

Unfreezing the Organization Because of inertia forces, incremental change is often no change. Those whose power is threatened by change can too easily resist incremental change. This leads to the big bang theory of change, which maintains that effective change requires taking bold action early to “unfreeze” the established culture of an organization and to change the distribution of power and influence. Shock therapy to unfreeze the organization might include the closure of plants deemed uneconomic or the announcement of a dramatic structural

424 Part 5 The Strategy and Structure of International Business

reorganization. It is also important to realize that change will not occur unless senior managers are committed to it. Senior managers must clearly articulate the need for change so employees understand both why it is being pursued and the benefits that will flow from successful change. Senior managers must also practice what they preach and take the necessary bold steps. If employees see senior managers preaching the need for change but not changing their own behav- ior or making substantive changes in the organization, they will soon lose faith in the change effort, which then will flounder.

Moving to the New State Once an organization has been unfrozen, it must be moved to its new state. Movement requires taking action—closing operations; reorganizing the structure; reassigning responsibilities; changing control, incentive, and reward systems;

redesigning processes; and letting people go who are seen as an impediment to change. In other words, movement requires a substantial change in the form of a multinational’s orga- nizational architecture so that it matches the desired new strategic posture. For movement to be successful, it must be done with sufficient speed. Involving employees in the change effort is an excellent way to get them to appreciate and buy into the needs for change and to help with rapid movement. For example, a firm might delegate substantial responsibility for designing operating processes to lower-level employees. If enough of their recommen- dations are then acted on, the employees will see the consequences of their efforts and consequently buy into the notion that change is really occurring.

Refreezing the Organization Refreezing the organization takes longer. It may require that a new culture be estab- lished while the old one is being dismantled. Thus, refreezing requires that employees be socialized into the new way of doing things. Companies will often use management edu- cation programs to achieve this. At General Electric, where longtime CEO Jack Welch instituted a major change in the culture of the company, management education pro- grams were used as a proactive tool to communicate new values to organization mem- bers. On their own, however, management education programs are not enough. Hiring policies must be changed to ref lect the new realities, with an emphasis on hiring indi- viduals whose own values are consistent with that of the new culture the firm is trying to build. Similarly, control and incentive systems must be consistent with the new realities of the organization, or change will never take. Senior management must recognize that changing culture takes a long time. Any letup in the pressure to change may allow the old culture to reemerge as employees fall back into familiar ways of doing things. The communication task facing senior managers, therefore, is a long-term endeavor that re- quires managers to be relentless and persistent in their pursuit of change. One striking feature of Jack Welch’s two-decade tenure at GE, for example, is that he never stopped pushing his change agenda. It was a consistent theme of his tenure. He was always think- ing up new programs and initiatives to keep pushing the culture of the organization along the desired trajectory.

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Jack Welch, legendary former chair- man and chief executive officer of General Electric Corporation, attend- ing a press conference in New York. ©Erik Freeland/Getty Images

organizational architecture, p. 394 organizational structure, p. 395 control systems, p. 395 incentives, p. 395 processes, p. 395 organizational culture, p. 395 people, p. 396

vertical differentiation, p. 398 horizontal differentiation, p. 398 integrating mechanisms, p. 398 international division, p. 400 worldwide area structure, p. 402 worldwide product division

structure, p. 403

global matrix structure, p. 404 knowledge network, p. 408 personal control, p. 410 bureaucratic control, p. 411 output controls, p. 411 cultural controls, p. 412 performance ambiguity, p. 413

Key Terms

The Organization of International Business Chapter 14 425

C H A P T E R S U M M A R Y

This chapter identified the organizational architecture that can be used by multinational enterprises to manage and direct their global operations. A central theme of the chapter was that different strategies require different ar- chitectures; strategy is implemented through architecture. To succeed, a firm must match its architecture to its strat- egy in discriminating ways. Firms whose architecture does not fit their strategic requirements will experience performance problems. It is also necessary for the differ- ent components of architecture to be consistent with each other. The chapter made the following points:

1. Organizational architecture refers to the totality of a firm’s organization, including formal organi- zational structure, control systems and incentives, processes, organizational culture, and people.

2. Superior enterprise profitability requires three conditions to be fulfilled: the different elements of a firm’s organizational architecture must be internally consistent, the organizational architec- ture must fit the strategy of the firm, and the strategy and architecture of the firm must be consistent with competitive conditions prevailing in the firm’s markets.

3. Organizational structure means three things: the formal division of the organization into subunits (horizontal differentiation), the location of deci- sion-making responsibilities within that structure (vertical differentiation), and the establishment of integrating mechanisms.

4. Control systems are the metrics used to measure the performance of subunits and make judgments about how well managers are running those subunits.

5. Incentives refer to the devices used to reward appropriate employee behavior. Many employees receive incentives in the form of annual bonus pay. Incentives are usually closely tied to the performance metrics used for output controls.

6. Processes refer to the manner in which decisions are made and work is performed within the orga- nization. Processes can be found at many differ- ent levels within an organization. The core competencies or valuable skills of a firm are often embedded in its processes. Efficient and effective processes can help lower the costs of value cre- ation and add additional value to a product.

7. Organizational culture refers to a system of val- ues and norms that is shared among employees. Values and norms express themselves as the be- havior patterns or style of an organization that new employees are automatically encouraged to follow by their fellow employees.

8. Firms pursuing different strategies must adopt a different architecture to implement those strate- gies successfully. Firms pursuing localization, global, international, and transnational strategies all must adopt an organizational architecture that matches their strategy.

9. While all organizations suffer from inertia, the complexity and global spread of many multina- tionals might make it particularly difficult for them to change their strategy and architecture to match new organizational realities. At the same time, the trend toward globalization in many in- dustries has made it more critical than ever that many multinationals do just that.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. “The choice of strategy for a multinational firm must depend on a comparison of the benefits of that strategy (in terms of value creation) with the costs of implementing it (as defined by organiza- tional architecture necessary for implementa- tion). On this basis, it may be logical for some firms to pursue a localization strategy, others a global or international strategy, and still others a transnational strategy.” Is this statement correct?

2. Discuss this statement: “An understanding of the causes and consequences of performance

ambiguity is central to the issue of organizational design in multinational firms.”

3. Describe the organizational architecture that a transnational firm might adopt to reduce the costs of control.

4. What is the most appropriate organizational archi- tecture for a firm that is competing in an industry where a global strategy is most appropriate?

5. If a firm is changing its strategy from an interna- tional to a transnational strategy, what are the

426 Part 5 The Strategy and Structure of International Business

most important challenges it is likely to face in implementing this change? How can the firm overcome these challenges?

6. Reread the Management Focus on Walmart In- ternational; then answer the following questions:

a.  Why did the centralization of decisions at the headquarters of Walmart’s international division create problems for the company’s different national operations? Has Walmart’s response been appropriate?

b.  Do you think that having an international di- vision is the best structure for managing Walmart’s foreign operations? What prob- lems might arise with this structure? What other structure might work?

7. Reread the Management Focus on Dow Chemical; then answer the following questions:

a.  Why did Dow first adopt a matrix structure? What were the problems with this structure?

Do you think these problems are typical of matrix structures?

b.  What drove the shift away from the matrix structure for companies such as Dow and ABB? Does Dow’s structure now make sense given the nature of its businesses and the competitive environment it competes in?

8. Reread the Management Focus on Lincoln Electric; then answer the following questions:

a.  To what extent is the organizational culture of Lincoln Electric aligned with the firm’s strategy?

b.  How was the culture at Lincoln Electric created and nurtured over time?

c.  Why did Lincoln Electric’s culture and incentive systems work well in the United States? Why did it not take in other nations?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

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

1. Fortune conducts an annual survey and publishes the rankings of the world’s most admired compa- nies. Locate the most recent ranking available, and focus on the factors used to determine which companies are most admired. Prepare an executive summary of the strategic and organiza- tional success factors for a company of your choice.

2. You work at a European-based pharmaceutical company that is planning to expand operations to other parts of the world. To design the struc- ture of the organization as it expands internation- ally, management has requested additional information on the pharmaceutical sector world- wide. Use the Industry Profiles section on the globalEDGE site to prepare a risk assessment of the food and beverage industry that can help management gain a better understanding of the external environment in foreign markets.

The Procter & Gamble Company (P&G) is a force in the global marketplace. P&G is the biggest U.S. advertiser at some $5 billion annually, and it spends a staggering $9 billion annually worldwide on advertisement. Beyond ad spending, P&G is also the world’s largest maker of household products. It is a very large company with more than $80 billion in annual sales and with a net worth (sometimes referred to as “market capitalization”) greater than the gross domestic product (GDP) of most coun- tries. P&G markets products in more than 180 countries.

Geographically, these 180 countries are divided into the core markets of Asia; Europe; India, the Middle East, and Africa; Latin America; and North America. The company sells products to about 5 billion of the world’s 7 billion people. P&G organizes its many products into four industry- based sectors: (1) Baby, Feminine and Family Care; (2) Beauty, Hair and Personal Care; (3) Fabric and Home Care; and (4) Health and Grooming. In fact, P&G states that “we have made P&G’s organization structure an

C L O S I N G C A S E

Organizational Architecture at P&G

The Organization of International Business Chapter 14 427

important part of our capability to grow . . . it combines global scale benefits with a local focus to win with consumers and retail customers in each country where P&G products are sold.” To best serve the global markets, P&G decided that it would cut around 100 brands from its portfolio and focus on its core remaining 80 brands, which generated 95 per- cent of the company’s profits. Alan “A.G.” Lafley, then the company’s board chair, president, and CEO, said, “This will be a much simpler, much less complex com- pany of leading brands that’s easier to manage and oper- ate.” Additionally, P&G cut its marketing and advertising agency roster by 50 percent over the previous three years from around 6,000 to 3,000 companies in a bid to in- crease its marketing productivity. With the organizational size and product line breadth come both industry responsibility and business opportu- nity (see Chapter 5 on ethics, corporate social responsi- bility, and sustainability for a discussion of combining industry and business opportunities). P&G says that “our responsibility is to be an ethical corporate citizen” and the company articulates this in its Purpose Statement: “We will provide branded products and services of supe- rior quality and value that improve the lives of the world’s consumers, now and for generations to come. As a result, consumers will reward us with leadership sales, profit and value creation, allowing our people, our shareholders and the communities in which we live and work to prosper.” As P&G continues to streamline its product assort- ment, it focuses heavily on its Selling and Market Opera- tions (SMOs) as a mechanism to reach global customers in all four of its industry-based sectors. P&G views the SMOs as more of a name change from its old Market Development Organizations to a structure that supports each of the four industry sectors with “superior, effective and efficient selling, distribution, shelving, pricing execu- tion and merchandising—every day, every week—in every store.” The SMOs are staffed with employees represent- ing 140 different nationalities. At the same time, fewer

than 1 percent of job applicants actually get a job offer from P&G. There is strength in architecture (structure, people, incentives and control, culture, processes) at P&G.

Sources: Antoine Gara, “Reckitt Benckiser Is Building a 21st Century Procter & Gamble,” Forbes, February 10, 2017; Leonie Roderick, “P&G On How It Cut Agencies by Almost 50% to Optimize Its Marketing Spend,” Marketing Week, November 21, 2016; “Global Structure and Governance,” www.pg.com, accessed March 29, 2017; J. Neff, “Biggest Ad Spender P&G Has New North America Media Chief,” Advertising Age, January 15, 2015; “Around 100 Brands to Be Dropped by Procter and Gamble to Boost Sales,” CincinnatiNews.net, August 1, 2014; S. Ng, “P&G CEO Lafley Lays Groundwork for Exit,” The Wall Street Journal, April 13, 2015.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Advertising is important for most companies, es-

pecially companies such as P&G that sells mostly to end customers. But, most people already know about P&G products such as Charmin bathroom tissue and moist towelettes, Crest toothpaste, and so on. Does P&G really need to constantly put money into advertising when its products already have a strong hold in the global marketplace?

2. P&G cut its marketing and advertising agency roster by 50 percent over the past three years from around 6,000 to 3,000 companies in a bid to increase its marketing productivity, efficiency, and effectiveness. At a $9 billion worldwide spend on advertising, should P&G have more or fewer marketing and advertising agencies doing its advertising?

3. By consolidating and cutting 100 brands from its consumer portfolio of brands, does P&G run the risk of ultimately losing out on global market opportunities?

Design Elements: Implications (idea): ©ARTQU/Getty Images; Problem (jigsaw): ©ALMAGAMI/Shutterstock; All Others: ©McGraw-Hill Education.

E n d n o t e s

 1. This has long been a central theme of the strategic management literature. See, for example, C. W. L. Hill and R. E. Hoskisson, “Strategy and Structure in the Multiproduct Firm,” Academy of Management Review, 1987, pp. 331–41. Also see J. Wolf and W. G. Egelhoff, “A Reexamination and Extension of International

Strategy Structure Theory,” Strategic Management Journal 23 (2002), pp. 181–90.

 2. Eric M. Olson, Stanley F. Slater, and G. Tomas M. Hult, “The Performance Implications of Fit among Business Strategy,

428 Part 5 The Strategy and Structure of International Business

Marketing Organization Structure, and Strategic Behavior,” Journal of Marketing 69 (July 2005), pp. 49–65.

 3. D. Naidler, M. Gerstein, and R. Shaw, Organization Architecture (San Francisco: Jossey-Bass, 1992).

 4. Tomas Hult, David Closs, and David Frayer, Global Supply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill Professional, 2014).

 5. G. Morgan, Images of Organization (Beverly Hills, CA: Sage, 1986).

 6. “Unilever: A Networked Organization,” Harvard Business Review, November–December 1996, p. 138.

 7. The material in this section draws on John Child, Organizations (London: Harper & Row, 1984).

 8. See, for example, Mark F. Peterson, Mikael Søndergaard, and Aycan Kara, “Traversing Cultural Boundaries in IB: The Complex Relationships between Explicit Country and Implicit Cultural Group Boundaries at Multiple Levels,” Journal of Inter- national Business Studies, 2017 (doi:10.1057/s41267-017-0082-z).

 9. George S. Yip and G. Tomas M. Hult (2012), Total Global Strategy (Boston: Pearson, 2012).

10. Allan Cane, “Microsoft Reorganizes to Meet Market Challenges,” Financial Times, March 16, 1994, p. 1. Interviews by Charles Hill.

11. For research evidence that is related to this issue, see J. Birkinshaw, “Entrepreneurship in the Multinational Corporation: The Char- acteristics of Subsidiary Initiatives,” Strategic Management Journal 18 (1997), pp. 207–29; J. Birkinshaw, N. Hood, and S. Jonsson, “Building Firm Specific Advantages in Multina- tional Corporations: The Role of Subsidiary Initiatives,” Strate- gic Management Journal 19 (1998), pp. 221–41; I. Bjorkman, W. Barner-Rasussen, and L. Li, “Managing Knowledge Transfer in MNCs: The Impact of Headquarters Control Mechanisms,” Journal of International Business 35 (2004), pp. 443–60.

12. For more detail, see S. M. Davis, “Managing and Organizing Multinational Corporations,” in C. A. Bartlett and S. Ghoshal, Transnational Management (Homewood, IL: Richard D. Irwin, 1992). Also see Wolf and Egelhoff, “A Reexamination and Extension of International Strategy Structure Theory.”

13. A. D. Chandler, Strategy and Structure: Chapters in the History of the Industrial Enterprise (Cambridge, MA: MIT Press, 1962).

14. Davis, “Managing and Organizing Multinational Corporations.”

15. J. M. Stopford and L. T. Wells, Strategy and Structure of the Multinational Enterprise (New York: Basic Books, 1972).

16. C. A. Bartlett and S. Ghoshal, Managing across Borders (Boston: Harvard Business School Press, 1989).

17. Bartlett and Ghoshal, Managing across Borders; A. McDonnell, P. Gunnigle, and J. Lavelle, “Learning Transfer in Multinational Companies,” Human Resource Management Journal, 2010, pp. 23–43; George S. Yip and G. Tomas M. Hult, Total Global Strategy (Boston, MA: Pearson, 2012).

18. See J. R. Galbraith, Designing Complex Organizations (Reading, MA: Addison-Wesley, 1977).

19. M. Goold and A. Campbell, “Structured Networks: Towards the Well Designed Matrix,” Long Range Planning, October 2003, pp. 427–60.

20. Bartlett and Ghoshal, Managing across Borders; F. V. Guterl, “Goodbye, Old Matrix,” Business Month, February 1989, pp. 32–38; Bjorkman et al., “Managing Knowledge Transfer in MNCs”; M. T. Hansen and B. Lovas, “How Do Multinational Companies Leverage Technological Competencies?” Strategic Management Journal, 2004, pp. 801–22.

21. M. S. Granovetter, “The Strength of Weak Ties,” American Journal of Sociology 78 (1973), pp. 1360–80.

22. A. K. Gupta and V. J. Govindarajan, “Knowledge Flows within Multinational Corporations,” Strategic Management Journal 21, no. 4 (2000), pp. 473–96; V. J. Govindarajan and A. K. Gupta, The Quest for Global Dominance. (San Francisco: Jossey-Bass, 2001); U. Andersson, M. Forsgren, and U. Holm, “The Strategic Impact of External Networks: Subsidiary Performance and Competence Development in the Multinational Corporation,” Strategic Management Journal 23 (2002), pp. 979–96.

23. For examples, see W. H. Davidow and M. S. Malone, The Virtual Corporation (New York: HarperCollins, 1992).

24. Erkan Ozkaya, Cornelia Droge, G. Tomas M. Hult, Roger Calantone, and Elif Ozkaya, “Market Orientation, Knowledge Competence, and Innovation,” International Journal of Research in Marketing 32, no. 3 (2015), pp. 309–18.

25. W. G. Ouchi, “Markets, Bureaucracies, and Clans,” Administra- tive Science Quarterly 25 (1980), pp. 129–44.

26. For some empirical work that addresses this issue, see T. P. Murtha, S. A. Lenway, and R. P. Bagozzi, “Global Mind Sets and Cognitive Shift in a Complex Multinational Corporation,” Strategic Management Journal 19 (1998), pp. 97–114.

27. J. Welch and J. Byrne, Jack: Straight from the Gut (Warner Books: New York, 2001).

28. C. W. L. Hill, M. E. Hitt, and R. E. Hoskisson, “Cooperative versus Competitive Structures in Related and Unrelated Diver- sified Firms,” Organization Science 3 (1992), pp. 501–21.

29. Constantine S. Katskieas, Neil A. Morgan, Leonidas C. Leonidou, and G. Tomas M. Hult (2016), “Assessing Perfor- mance Outcomes in Marketing,” Journal of Marketing 80, no. 2 (2016), pp. 1–20.

30. Murtha et al., “Global Mind Sets.”

31. M. Hammer and J. Champy, Reengineering the Corporation (New York: Harper Business, 1993); Tomas Hult, David Closs, and David Frayer (2014), Global Supply Chain Management: Leveraging Processes, Measurements, and Tools for Strategic Cor- porate Advantage (New York: McGraw-Hill Professional, 2014); George S. Yip and G. Tomas M. Hult, Total Global Strategy (Boston: Pearson, 2012).

32. T. Kostova, “Transnational Transfer of Strategic Organizational Practices: A Contextual Perspective,” Academy of Management Review 24, no. 2 (1999), pp. 308–24.

33. Andersson et al., “The Strategic Impact of External Networks.”

34. E. H. Schein, “What Is Culture?” in P. J. Frost et al., Reframing Organizational Culture (Newbury Park, CA: Sage, 1991).

35. E. H. Schein, Organizational Culture and Leadership, 2nd ed. (San Francisco: Jossey-Bass, 1992).

36. G. Morgan, Images of Organization (Beverly Hills, CA: Sage, 1986).