FRANCHISES AND LICENSES
ARIZONA STATE UNIVERSITY
OMT 440 - INTERNATIONAL BUSINESS
WEEK 3
Firms wishing to enter a new market for manufacturing and/or marketing purposes may
use different types of entry modes. Entry modes can be defined as the institutional
arrangements through which firms introduce or introduce products, technologies, skills or
other resources into a market. This chapter discusses one form of entry modes, namely
franchising and licensing.
7.1 Franchise Concepts and Types:
Franchising is a form of contract-based entry mode, where one company grants or
provides property or other assistance to another company over a period of time. The
franchising company is known as the franchiser while the franchisee company is known as
the franchisee. The property provided is generally in the form of intangible assets such as
trademarks. At
Generally, this brand name is the most desired item by the franchisee. This is what makes it
difficult for small and little-known companies to attract the attention of franchisees.
However, this franchise contract is not only related to the brand name. Franchisers can also
provide various knowledge or skills (know-how), and technology related to certain products
or services.
There are various types of franchises that are commonly used. One of them is product
franchising, where the franchiser gives the franchisee the right to distribute their products. In
this case, the franchiser gives the right to use the company's trademark, but does not include
the business system as a whole. Furthermore, there is also a business format franchise in
which the franchisee obtains the right to operate under the franchiser's company brand name,
including obtaining its business operating system. In addition, there is a type of investment
franchise when the franchisee invests funds in the franchiser company with the aim of
obtaining future profits. Some examples of international companies that franchise are KFC,
McDonald's, Domino's, Burger king and Pizza Hut.
7.2 Aspects Covered in Franchising
Aspects of franchising include both positive and negative aspects. The positive aspects
include the various advantages of franchising. One of them relates to the use of franchising as
a form of entry mode that has low costs and risks. Franchising helps companies maintain
consistency through a standardized product replication process. However, some franchisees
may make slight modifications to the product or marketing system to suit local buyers. In
addition, franchising also has another advantage, which is that it accelerates the process of
geographical expansion. Another benefit of franchising is that gaining knowledge of local
culture and management skills helps reduce the risk of business failure and creates a
competitive advantage.
On the other hand, the negative aspects of franchising include the various problems
posed to both the franchiser and the franchisee. First, franchisers will find it difficult to
manage a large number of franchisees spread across various countries. This problem relates
to the concern that franchisees are unable to maintain consistent product quality and
promotional systems in different markets. In addition, franchising also has a negative impact
on franchisees in the form of loss of organizational flexibility as a result of the franchise
agreement. These franchise contracts generally limit the strategic choices of franchisee
companies and it is not uncommon for franchisee companies to be forced to promote
products originating from other divisions of the franchiser company.
7.3 The Role of Franchising in International Business
Franchising is one of the simplest forms of international business after export-import
activities. The existence of a franchise contract between one company and a company in
another country certainly has a major impact on international business activities between the
two countries. Through franchise contracts, companies can reduce their dependence on
domestic market demand. It has been explained earlier that franchising is a form of
international business that has a low level of risk and cost that attracts many entrepreneurs.
The existence of inter-company franchise relationships in These different countries also
encourage trade and business activities between the two countries.
Study 7
Millennial Generation Passive Income Franchise
Franchising as explained in 7.1 is an easy business to enter for beginners who want to start a
business or earn passive income. One of the biggest enthusiasts for this type of franchise
business globally is the millennial generation. Even in 2021, the interest of the millennial
generation to own a franchise business is higher than that of baby boomers, especially in
franchise trademarks with an auto-pilot system. The business fields that are most interested in
the millennial generation of franchise businesses are culinary and fashion. Most millennials
choose franchising because this type of business supports their lifestyle such as more flexible
time running a business, the knowledge or skills needed to run a business can be learned in a
short time without any special requirements with the help of a franchiser, and has low costs
and risks.
On the other hand, many millennials do not know or realize the negative aspects of
franchising. Especially if the trademark purchased is an international brand with an auto-pilot
system. First, the auto-pilot system will constrain franchisees from innovating their
franchises. Secondly, international brand franchises have different commodity standards from
domestic franchises, making it more difficult to maintain product quality consistency, as not
all domestic products comply with international standards. This will have an impact on
fluctuations in economic activity that occurs in franchises, such as product stock often runs
out with a long restock period. Third, not all international franchise products are suitable for
tastes and cultures in all countries. Fourth, the existence of laws protecting domestic non-
franchised businesses will certainly limit the strategic choices of franchising companies. As a
result, it often cooperates with local businesses and adjusts the company's products/services
according to regional potential, tastes, and local culture to make the franchise more stable and
attractive to the public.
7.4 License Concept:
A license is a form of contractual entry mode, where one company grants the right to use
property to another company for a certain period of time. The company that grants the license
is called the licensor and the licensee company is called the licensee. Similar to franchising,
the licensing company will also receive royalty payments of a certain percentage of the
revenue derived from the licensed property. Licenses generally cover various intangible
properties such as patents, copyrights, custom designs and trademarks.
Some types of licenses are exclusive license, nonexclusive license and cross licensing. An
exclusive license gives a company the exclusive right to conduct production and marketing
activities using the licensed property in a specific geographical area. On the other hand, a
non-exclusive license grants the right to use the property, but does not include access to the
market. Furthermore, cross-licensing occurs when companies use contracts or licensing
agreements to exchange intangible properties. Some of the international licensing companies
are Bluestar Alliance, ViacomCBS, Warner Media, and Starbucks.
7.5 Aspects Covered by the License:
Similar to franchising, licensing also has positive and negative aspects. There are several
advantages of using licenses as entry modes. First, the licensor can use the license as a source
of financing for international expansion. This is because most license agreements require the
licensee to contribute equipment and personnel.
investment, either through building production facilities or utilizing existing capacity. This
access provides great benefits to licensors that lack the funds and management resources to
expand. Second, licenses are less risky entry modes for licensor firms compared to other
forms of investment. This is because the license contract helps protect the licensor firm from
the risk of operating in an unstable market. Furthermore, licenses also help reduce the
possibility of the licensor company's products appearing in the black market. In addition, the
licensee also benefits from using the license contract as a tool to improve production
technology.
In addition to these positive aspects, licenses also have negative aspects which include
various disadvantages of using licenses as entry modes. The first drawback is the risk
associated with the failure of the licensee company to produce the desired output by the
licensor company. In addition, license contracts may also reduce the consistency of product
quality and marketing systems across different countries. Furthermore, there is a possibility
that the licensee company will become a competitor of the licensor company in the future. In
other words, a license contract may mean lending certain strategic properties to competing
companies.
7.6 Difference between Franchise and License:
Franchising and licensing have several differences. First, franchising gives a company
greater control over the sale of products in a target market. The franchisee must fulfill strict
procedures regarding product quality, daily management duties, and marketing promotions.
Second, although licenses are more common While licenses are used in the manufacturing
industry, franchises are mainly used in service industries such as entertainment, lodging,
restaurants and others. Thirdly, a license involves a one-time transfer of property, whereas a
franchise involves the provision of ongoing assistance to the franchisee.
7.7 Conclusion
This chapter discusses the concepts and types of franchises and licenses as contract-
based entry modes. The various types of franchises are product franchise, business format
franchise and investment franchise. Meanwhile, the various types of licenses consist of
exclusive license, non-exclusive franchise and cross franchise. Each franchise and license has
positive and negative aspects. The positive aspects of franchising include the use of
franchising as entry modes that are low risk and have relatively lower costs and encourage
business expansion. The negative aspects of franchising include the various problems caused
to the franchiser and franchisee. On the other hand, the positive aspects of licensing are
mainly the use of licenses as a source of financing in business expansion. Meanwhile, the
negative aspects of licensing include various risks arising from the license contract. Although
they look the same, franchising and licensing have some differences. The difference relates to
the procedure of using the property.
7.8 Key Terms
⚫
Franchise
⚫
Franchisee
⚫
Franchiser
⚫
Product franchise
⚫
Franchise format business
⚫
Investment franchise
⚫
License
⚫
Exclusive license
⚫
Nonexclusive franchise
⚫
Cross franchise
⚫
Entry modes
7.9 Concept Review
1. What is the role of franchising in international business? Explain!
2. What are the advantages of franchising? Explain!
3. Explain the negative aspects of licenses!
4. What are the positive aspects of licensing? Explain!
5Explain the difference between exclusive and non-exclusive licenses!
7.10 Problem- Problem
1. Find a product brand in Indonesia that acts as a franchiser. Explain whether franchising
provides benefits to the company? What risks are associated with granting the franchise?
Explain!
2. Explain the procedure of a license contract in Indonesia! Are there certain conditions and
procedures that must be met? Explain!
3. Explain the differences between licenses and franchises from various aspects! Which one is
more commonly used in Indonesia? Explain!
STRATEGIC ALLIANCE PARTNER
The previous chapter discussed franchising and licensing as contract-based forms of
international business. Chapter 8 continues Chapter 7 by discussing another form of
international business, namely strategic alliance partnerships. The discussion begins with the
concept of strategic alliance partnerships and their types. It then discusses the important
aspects of strategic alliance partnering and the important factors in maintaining a healthy
alliance.
8.1 Strategic Alliance Partner Concept
Strategic alliances are a form of business relationship between two or more entities that
agree to work together to achieve certain strategic goals. These relationships are formed
without involving the creation of a new company. Business alliance partnerships can be
formed for a short period of time or for several years depending on the objectives to be
achieved.
Business alliance partnerships can be formed between a company and its suppliers, buyers
and even competing companies. Sometimes in business alliance partners, each partner buys a
certain amount of shares or ownership. Thus, each company has a direct influence on the
future performance of its partner. This reduces the chances of one partner trying to take
advantage of the other. Some examples of strategic alliances are Uber and Spotify, Starbucks
and Target, Apple Pay and MasterCard, Disney and Chevrolet.
8.2 Types and Advantages of Strategic Alliance Partners
There are generally two types of strategic alliance partners, namely equity strategic
alliance and non-equity strategic alliance. An equity strategic alliance is a form of alliance
partnering where one company buys a certain amount of equity from another company or
business or both agree to buy equity from each other. If only one company buys a certain
amount of equity from the other, it is known as a partial acquisition, while if both companies
buy equity from each other, it is called a cross-equity transaction. On the other hand, a non-
equity alliance occurs without forming a new entity or sharing equity.
Strategic alliance partners have several advantages for companies. First, companies can
use business alliance partners to share project investment costs. This project can be the
development of new products with the aim of integrating more advanced technology or
shortening the life cycle of existing products. Second, companies can form business alliance
partners to take advantage of certain advantages of competitors. In addition, companies can
also utilize business alliance partners to gain access to distribution channels in certain
markets.
Study 8
Strategic Alliance Decision Making: Balancing Risk and Trust
In an inter-organizational relationship such as joint ventures and other types of alliances,
trust is a key factor in maintaining a healthy and successful relationship. Trust can facilitate
operational efficiency, improve responsiveness, and reduce opportunity costs that can arise
from monitoring and verifying the behavior of the counterparty. On the other hand, when one
party has given trust to another party (trustor), the opportunity for risk is also higher.
Traditionally, risk can be defined as the possibility of things happening that are opposite to
what is expected. In the process of making strategic alliances, a balance between risk and
trust is required. To explore the relationship between risk and trust, there are three questions
to consider:
(1) What could happen? What mistakes might arise?
(2) How likely is that to happen?
(3) If that happens, what will be the impact?
Although trustors and trustees may not have exactly the same goals, it is important to
have compatible goals that can be achieved together. Misaligned interests can be caused by
economic actors maximizing self-interest, manifested as alliance partners not fully
committing to the joint effort, or in opportunistic behavior where one or both partners seek to
maximize their own interests at the expense of the partner, such as trying to capture the
knowledge and technology of others. Several actions can be taken in the creation of strategic
alliances, for example, providing incentives to carry out commitments. Providing incentives
can be realized through contract terms.
8.3 Important Aspects of Strategic Alliances :
There are several aspects that play an important role in the success of strategic alliances.
First, strategic alliance partners must be accompanied by commitment and support from the
organizations or companies involved. This relates to the directors or managers who play an
important role in forming alliance partners. Second, strategic alliance partners are formed by
parties that are interrelated, both in terms of products, technology and markets. Similar to
other forms of international business, strategic alliance partners also relate to culture and
business experience. Furthermore, the companies or parties involved in strategic alliance
partnerships also have the same vision of goals and share organizational benefits and
experiences with each other. In addition, the decision-making process and communication
between partners are in the form of a horizontal hierarchy rather than a vertical hierarchy.
This means that communication takes place between employees at the same level of the
companies involved.
8.4 Maintaining a Healthy Alliance :
A healthy international alliance partner with great potential for success has several
characteristics. These characteristics represent a balance between interests, power, risks, and
potential profits as illustrated in Figure 8.1.
Healthy strategic alliances are generally formed with companies or partners that have similar
market power. Alliances formed from companies that have a large market share with smaller
companies are less likely to succeed. Further, all partners involved should maintain autonomy
and a high degree of flexibility. In addition, there should be equal or balanced ownership
participation between the parties involved. This aims to ensure that all benefits or profits
generated can be shared equally. To maintain a healthy strategic alliance, each company must
also maintain a fair and balanced contribution.
8.5 Conclusion:
A business alliance partner is a business relationship formed with the aim of achieving a
common goal. Strategic alliance partners can take the form of equity strategic alliance and
non-equity strategic alliance. The difference between the two types relates to whether the
alliance relationship is equity or non-equity involves the purchase of a certain amount of
equity from the companies involved. Furthermore, business alliance partners can be utilized
as a source of project funding or as a means of acquiring new technology. To form and
maintain healthy alliances, the parties involved should maintain a balance between interests,
power, risks and potential profits. In addition, companies must also pay attention to various
important aspects contained in strategic alliances. One of them is the high commitment and
support of the various parties involved in the strategic alliance.
8.6 Important terms
⚫
Strategic alliance partner
⚫
Equity strategic alliance
⚫
Non-equity strategic alliance
⚫
Partial acquisition
⚫
Cross equity transaction
8.7 Review Concept
1. What is a strategic alliance partner? Explain!
2. Explain the important aspects of strategic alliance partnering!
3. What are the advantages of strategic alliance partners? Explain!
4. What is the difference between equity and non-equity strategic alliance? Explain!
5. How to maintain a healthy alliance? Explain!
8.8 Problem- problem
1. Explain the various advantages of each type of strategic alliance partner!
2. Explain the procedure or process of forming a strategic alliance partner as a form of
international business!
3. Have any foreign companies entered the Indonesian market utilizing a form of strategic
alliance? Explain the alliance relationship between these foreign companies and their alliance
companies!
FOREIGN INVESTMENT
When the theory of international trade was created, most factors of production (raw
materials, labor, or capital goods) could not be moved across national or regional borders.
Today, however, almost all factors of production (except land) can be mobilized
internationally. These international capital flows are the essence of foreign direct investment.
This chapter discusses foreign direct investment (FDI) as a form of international business.
The discussion covers trends and patterns of FDI, theories of FDI, and government
intervention and policy instruments in FDI.
9.1 Trends and Patterns of Foreign Investment:
The development of globalization has encouraged many international companies in
emerging market countries to undertake foreign investment (FDI). FDI flows began to
increase along with reduced barriers to international trade. With reduced barriers to
international trade, companies began to realize that they had a great opportunity to build
production facilities in more efficient locations. This is what drives the inflow of foreign
capital into developing countries.
In 2012, developing countries attracted more FDI than developed countries for the first
time. In that year, developing countries accounted for 52% of total global FDI. On the other
hand, developed countries accounted for a smaller proportion of 42% of total global FDI. The
remaining 6% belonged to countries in Southeast Europe. Among developed countries, the
United States and Japan have the highest proportion of FDI. On the other hand, FDI flows in
developing countries vary widely. On the other hand, Africa has about 4% of the total global
FDI.
Figure 9.1 shows the development of FDI inflows in Indonesia from 1970 to 2019.
Available at It can be seen that from 1970 to 1997, FDI inflows experienced fairly stable
growth. However, from 1998 to 2000, FDI inflows had a negative value. This was also
influenced by the economic crisis that hit Indonesia at that time. Furthermore, since 2001,
FDI inflows again experienced drastic and fluctuating growth. However, this FDI flow has an
increasing trend.
9.2 New FDI, Joint Venture, Merger and Acquisition:
In addition to greenfield investment, mergers and acquisitions (M&As) are also a reason
for the increase in FDI in the long run. This is because these mergers and acquisitions serve
as a means of transportation for the inflow of FDI flows into a country. Companies operating
in developed countries often conduct cross-border mergers and acquisitions. However,
developing countries with emerging markets account for a larger proportion of merger and
acquisition activity. These merger and acquisition activities generally aim to gain access to
new markets, increase the competitiveness of the company, reduce the imbalance of the
company's product line in the global industry or reduce research and development,
production, distribution and other costs.
One company can also form joint ventures (JVs) with other companies in different
countries. A joint venture can be defined as a new company formed and jointly owned by two
or more entities to achieve a common business objective. Entities that form joint ventures can
be private companies, government agencies or government-owned companies. Each company
involved in a joint venture contributes certain management skills, marketing expertise,
market access, production technology, financial capital and other knowledge.
9.3 Investment Theory Foreign
There are different types of foreign investment (FDI) theories that aim to explain why
FDI is undertaken.
Figure 9.1 shows four types of FDI theories consisting of international product lifecycle,
market imperfection, eclectic theory, and market power. The following is an explanation of
each of these FDI theories.
1. International Product Life Cycle:
In addition to international trade, the international product lifecycle theory is also used
to explain FDI. This theory states that firms initially export and then engage in FDI as the
product moves through its life cycle. In the new product stage, product production activities
are carried out domestically due to the uncertainty of domestic demand. In addition,
production activities that are limited to domestic also aim to keep production close to the
institution product development department. Furthermore, in the maturing product stage, the
company begins to invest in the establishment of production facilities in countries that have
high demand. Then at the standardized product stage, with the increasing level of
competition that forces companies to reduce price levels, companies will build production
facilities in other countries that have low production costs. Thus, this theory explains how
firms conduct FDI in line with the movement of products throughout their life cycle.
2. Market Imperfection (Internalization)
A perfectly competitive market is a market that operates at a high level of efficiency.
This is illustrated by prices being at their lowest level. This form of perfectly competitive
market is very rare, even almost non-existent in the real world. This is because there are
various factors that cause the market to be imperfect. These market imperfections can include
trade barriers and the competitive advantage of one particular firm. Market imperfection
theory states that when there are factors that cause the market to be imperfect, companies will
engage in FDI. This FDI activity is carried out with the aim of internalizing transactions and
overcoming market imperfections.
3. Eclectic Theory
Eclectic theory states that firms undertake FDI when locations in a particular country
have certain advantages that make them attractive. These advantages can be in the form of
location advantage, ownership advantage, and internalization advantage. These location
advantages can be location characteristics that favor certain economic activities. Ownership advantage
is the advantage of possessing special assets such as a well-known brand name, technical know-how
or management capabilities. On the other hand, the internalization advantage comes from the
internalization of business activities. Eclectic theory states that if all three advantages are present, the
company will engage in FDI.
4. Market Power
Market power theory states that firms engage in FDI to establish a dominant market
position in a particular industry. Companies generally want to have a large market share
compared to their competitors. This is because a large market share can provide benefits in
the form of large profits. Firms can build a dominant market position through vertical
integration, which is the expansion of a firm's activities to the production stage that allows
the firm to control production factors or inputs (backward integration) or control the
distribution of its outputs (forward integration).
9.4 Managerial Considerations in Foreign Investment
The decision to engage in FDI involves several important components related to
corporate and market management. Companies that wish to undertake FDI generally consider
various matters such as power or control, production costs as well as industry and market
conditions that include consumer preferences and the actions of competing companies. The
following describes each of these managerial considerations.
1. Control:
In general, companies want to have a greater proportion of ownership and power over
their operations in different countries or locations. This is to ensure consistency in the
marketing of the company's products. However, when conducting FDI in a different country,
companies are faced with various regulations and rules set by the government in that country.
These regulations may limit the company's full ownership of its operations.
2. Purchase-or-Build Decision:
Another point for managers to consider relates to the decision of whether to acquire an
existing business or build a new business or factory (greenfield investment). Through
acquisition, the company will acquire pre-existing plant, equipment and employees.
However, if there is no suitable building or facility in the local market, then the company will
have to make a greenfield investment.
3. Production Cost:
There are many factors that affect production costs. Labor regulations have a significant
influence on overall production costs. This is because there are government regulations that
require companies to provide benefits to employees outside of working hours. In addition,
employee training costs and time that exceed the initial plan also contribute to the increase in
production costs. Although taxes and rental fees are low in the local market, they are likely to
increase in the future.
4. Customer Knowledge:
Consumer behavior also has an important influence on decisions about FDI activities. To
gain more knowledge about consumer behavior in the local market, the company must
conduct business operations directly in the market. This understanding of consumer behavior
is important for the long-term success and sustainability of the business. This is because each
country has different characteristics that suit specific product categories.
5. Following Clients:
Companies generally engage in FDI activities when other companies that they are
customers of have invested in other countries. This is often the case in industries where firms
have close relationships with other firms. This business practice often results in a group of
firms congregating in a particular geographical area because they complement each other in
terms of supplying inputs.
6. Following Rivals:
In addition to following other companies that act as key suppliers, a company's FDI
decision may also resemble a "following the leader" scenario. In this case, the company
conducts an FDI with the aim of following another company that acts as a first mover in a
particular market. These companies believe that if they do not do the same, then they could
potentially miss out on profit opportunities. This is often the case in industries where there
are few companies of large size.
9.5 Government Intervention in Foreign Investment :
Government intervention in FDI generally aims to protect cultural heritage, domestic
firms and protect employment. In this case, the government may set rules, regulations, and
various administrative requirements that must be met by foreign companies wishing to invest
in the country. However, competitive pressures among countries in attracting FDI flows
generally encourage governments to set policies that are attractive to foreign investors. The
following explains the reasons for government intervention in FDI, both from the host
country and home country perspectives.
1. Reasons for Host Country Intervention:
There are two main reasons behind host country government intervention in FDI. First,
the purpose of government intervention is to maintain the balance of payments. FDI inflows
are recorded as additions to the balance of payments so that the flow of funds from FDI has a
positive impact on the balance of payments. In addition, the government can also set local
content requirements for foreign companies to encourage local production. Second,
government intervention in FDI also aims to obtain various resources or benefits brought by
foreign companies. These benefits can be in the form of access to more advanced technology
as well as management skills and increased employment.
2. Reasons for Home Country Intervention:
Home country is the location or country where the company first conducts business or
invests. There are several reasons why governments set policies to inhibit outbound
investment flows. It This is because outward investment flows mean sending resources out of
the home country. Thus, it will reduce the resources that can be used for the development and
growth of the home country economy. Another reason is that outward investment flows can
negatively affect the balance of payments. This is because the value of output produced by
firms in the host country can replace exports of these goods that would otherwise have come
from the home country. In addition, the jobs created in the host country can also replace the
jobs available in the home country.
On the other hand, there are two main reasons for the government to implement policies
that favor outward investment flows. First, outward investment flows can improve
competitiveness in the long run. This is because highly competitive firms tend to do business
in favorable locations or countries and can improve their performance sustainably. Second,
governments generally favor outward investment from firms operating in sunset industries,
i.e. industries that use outdated production technology and employ low-skilled workers.
Study 9
FDI Challenges in South Africa
During a visit to China in 2010, South African president Jacob Zuma told the business
community in Beijing that "South Africa is open for business in a big way". In the same year,
during a visit to India, the same was said to the business community in Mumbai. The South
African government has done its best to promote the country to foreign investors, but their
efforts have faced some challenges when trying to prioritize bilateral relations and economic
diplomacy. The current President of South Africa, Cyril Ramaphosa, held a series of
investment summits in an attempt to attract investors to South Africa. At investment summits
in 2019, new investments totaling R238bn were pledged by the public and private sectors.
Despite this, the South African economy is still unable to surpass 1% growth despite the
promises made by foreign and local investors. South Africa inherited a weak economy, which
has led to delays in building strong institutions that can assist in developing the economy. In
addition to issues related to weak institutions, large expenditures increased the country's debt
deficit and negatively impacted the value of the currency. This challenge further affects
inflation. Institutions tasked with protecting the economy through inflation targeting failed,
which negatively impacted investor confidence. The cost of doing business in South Africa
continued to rise, and the government's ability to spend money was constrained.
9.6 Government Policy Instruments in Foreign Investment
The previous section discussed the reasons for government intervention in FDI activities.
Furthermore, this section will discuss the various instruments used by the government in
conducting these interventions.
1. Host Country Promotional Instruments
There are two types of instruments commonly used by host country governments to
encourage FDI flows. First, the government can use financial incentives to attract foreign
investors. These incentives can be in the form of low tax rates or loans with low interest rates.
Second, the government can encourage FDI inflows through infrastructure development. This
includes the development of telecommunication systems, road improvements, and other
facilities.
2. Host Country Barriers Instrument
In addition to promotion, host countries also have various instruments to restrict or
inhibit FDI inflows. One instrument that is often used is ownership restriction. In this case,
the government can set policies that prohibit foreign companies from investing or doing
business in certain types of industries. This prohibition is generally imposed on businesses
that are closely related to cultural and national security aspects. In addition, the government
can also set policies that affect international business practices in the host country.
3. Promotional Instruments from Home Country
Home country governments can encourage FDI outflows by setting various policies. One
of them is to offer insurance for various investment risks. The government can also offer
loans for companies that want to conduct FDI in other countries. In addition, there is another
way, which is to provide a tax reduction on corporate income obtained from investment. The
government can also exert political pressurefor host countries to relax policies that impede
FDI flows.
4. Home Country Barriers Instrument
There are two instruments that home country governments generally use to discourage
FDI flows. One is by setting a higher tax rate on the income earned from the investment. In
addition, the government can also penalize companies that invest in other countries.
9.7 Conclusion
This chapter discusses foreign direct investment (FDI) as a form of international
business. This FDI activity is strongly influenced by the development of globalization,
merger and acquisition activities and is closely related to joint venture activities. Various
theories that explain the reasons for FDI include the international product lifecycle theory,
market imperfection, eclectic theory, and market power. Furthermore, there are various
factors that must be considered by companies that want to conduct FDI. These factors are
control, purchase-or-build decision, production cost, customer knowledge, following clients,
and following rivals. This FDI activity is inseparable from government intervention. This
government intervention can be carried out by the host country or home country for various
reasons. In intervening, the government uses various policy instruments. The type of
instrument used depends on the government's objective, which is to encourage FDI or inhibit
FDI flows.
9.8 Important Terms
⚫
PMA
⚫
International product lifecycle theory
⚫
Market imperfection theory
⚫
Eclectic theory
⚫
Market power theory
⚫
Home country
⚫
Host country
9.9 Review Concept
1. How can the development of globalization encourage FDI activities? Explain!
2. What are the managerial factors that a company looking to engage in FDI should
consider? Explain!
3. Explain the difference between mergers and acquisitions with
joint venture!
4. Why do host country governments intervene in FDI? Explain!
5. Why do home country governments intervene in FDI? Explain!
6. What are the host country policies that support FDI activity?
7. Explain the meaning of the international product lifecycle theory!
8. What are the host country policies that hinder FDI activity?
9. Based on the eclectic theory, what advantages should a company that wants to engage in
FDI have? Explain!
10. Explain what ownership restriction means!
9.10 Problem- Problem
1. Explain what forms of Indonesian government policies support the flow of FDI!
2. Explain the patterns and trends of FDI in the Asian region over the past decade!
3. Explain how FDI flows help economic development in developing countries!
REGIONAL ECONOMIC INTEGRATION
This chapter focuses on regional efforts to shape and promote the free flow of trade and
investment. The discussion starts with the concept of regional economic integration and its
different levels. This is followed by arguments on the advantages and disadvantages of
regional economic integration. Finally, there is a discussion of the various regional trade
agreements that have been established in Europe, the Americas, and Asia.
10.1 Concepts and Levels of Economic Integration Regional:
Regional economic integration (regionalism) is the process by which a group of
countries in a particular geographic region cooperate to reduce or eliminate barriers to the
flow of goods, labor, and capital. A group of countries in a particular geo- graphic area that
are members of this economic integration hereafter referred to as regional trading blocs.
Image 10.1 shows the five levels of economic integration. These are free trade area, custom
union, common market, economic union and political union. An explanation of each of these
levels follows.
1. Free Trade Area:
A free trade area is an economic integration that aims to remove all trade barriers
between member countries. However, each country retains the freedom to set trade barriers
for non-member countries. The trade policies set also vary between countries. A free trade
area is the lowest level of economic integration that two or more countries can form. Member
countries of a free trade area seek to eliminate trade barriers, both tariff and non-tariff
barriers.
2. Customs Union:
Custom unions are a level of economic integration where there is an agreement to
abolish all forms of economic integration trade barriers between member countries and
establish uniform trade policies for non-member countries. Thus, the difference between a
custom union and a free trade area lies in the treatment of non-member countries. Member
countries of a custom union establish equal and uniform trade treatment for non-member
countries. Countries that join a custom union can also negotiate as a single entity with
international organizations such as the WTO.
3. Common Market
A common market is a level of economic integration where countries agree to remove all
barriers to trade, including barriers to the flow of labor and capital. As such, the common
market integrates elements of the free trade area and custom union, but adds the flow of
labor and capital factors of production. This form of integration is difficult to implement
because it requires coordination in the areas of economic and labor policies. In addition, it
will unfairly benefit certain countries as labor tends to move to countries with relatively
higher wage rates and capital flows tend to go to countries with higher rates of return.
4. Economic Union
Economic union is a level of economic integration in which member countries agree to
remove all forms of barriers to trade, labor and capital flows, establish uniform policies
towards non-member countries and coordinate economic policies. Economic integration is at
a higher level than the common market because it requires countries to be member countries
to harmonize policies in the tax field,
monetary and fiscal and create a common currency.
5. Political Union
Political union is a form of economic integration that requires member countries to
coordinate on various aspects of political and economic policies. Political union requires
member countries to have the same economic and political stance towards non-member
countries. However, this form of integration still provides freedom for member countries to
set political and economic policies regarding their country's territory.
10.2 Pros and Cons of Economic Integration Regional
The purpose of economic integration is not only to encourage increased trade and
investment flows, but also to improve living standards in member countries. Economic
integration helps member countries to achieve lower product price levels, greater product
choice and increased productivity. In addition, economic integration can also have another
purpose, which is to protect intellectual property rights and the environment.
As such, this integration has various advantages that provide great benefits to member
countries. The main benefit is the increase in the amount or volume of trade (trade creation).
Economic integration helps countries to forge agreements on trade and political cooperation.
In addition, economic integration also expands employment opportunities by supporting labor
flows between countries. Trade agreements also help reduce tariff costs in favor of the
company.
In addition to the benefits, economic integration also has various drawbacks. Economic
integration can lead to trade diversion from countries that are not members of economic
integration. This can lead to increased trade with less efficient producers or companies in
member countries. The formation of economic integration also encourages increased
efficiency of companies operating in member countries, while other industries that require
less skilled labor will move to other countries with low wage rates. It will thus lead to a flow
of labor to countries with lower wage rates. In addition, economic integration is also related
to the cultural element. Some arguments state that countries will lose their unique national
identity as they are required to cooperate and adjust with other countries that are members of
the same economic integration.
10.3 Regional Integration in Europe
Economic integration efforts in Europe began after World War II. Initially, economic
integration was the preserve of a select group of countries and involved a few industries.
1. European Union
After the end of World War II, Europeans faced the enormous challenge of rebuilding
their nations and increasing industrial strength. In 1951, Belgium, France, West Germany and
Italy, Luxembourg and the Netherlands signed the Treaty of Paris and formed the European
Union European Coal and Steel Community. It aimed to remove trade barriers on coal, iron,
and copper. Later in 1957, the member states of the European Coal and Steel Community
signed the Treaty of Rome and formed the European Economic Community with the aim of
supporting transportation systems and uniform policies in agriculture. The scope of the
community was then expanded in 1967 by adding various other industries and adding many
new members. The European Economic Community was then renamed the European
Community. After undergoing further developments in 1973, 1981, 1986,
1995, 2004, and 2007, the community was renamed the European Union (EU).
Furthermore, in 2007, the EU experienced significant growth with the addition of 12
new members. The development of the EU was supported by the Single European Act and
the Maastricht Treaty. The EU's attempt to create a single currency is illustrated by the
European Monetary Union, which is the EU's plan to establish a single central bank and
currency. Within the EU, there are five institutions that play an important role in overseeing
and carrying out economic and political integration activities. These are known as the
European Parliament, Council of the EU, European Commission, Court of Justice and Court
of Auditors.
2. European Free Trade Association (EFTA)
Some countries in Europe refused to join the EU, which has ambitious goals. This was
due to fear of opposition and loss of national sovereignty. Some countries did not want to be
members of the common market, but wanted to form a free trade area. Furthermore, in 1960,
Several countries in Europe formed the European Free Trade Association (EFTA) which
focuses on industrial trade rather than trade in consumer goods. Some of the countries that are
members of EFTA are Switzerland, Iceland, Liechtenstein, and Norway.
10.4 Regional Integration in the Americas
The success of economic integration in Europe has encouraged other countries to form
trading blocs. Countries in the Latin American region began to form economic integration
agreements as early as 1960. However, these economic integration efforts only began to
experience significant development in the 1980s and 1990s. The following is an explanation
of some of the economic integration that exists in the Americas.
1. North American Free Trade Agreement (NAFTA)
Canada and the United States have long established trade agreements involving various
industry sectors, including automotive. In 1989, the US-Canada Free Trade Agreement was
formed in an effort to eliminate all forms of tariffs on bilateral trade between the two
countries. Subsequently, growing inte- gration efforts in Europe led to the urgency of
establishing a trading block area in North America that included Mexico. In 1981, Canada,
Mexico and the United States then formed the North American Free Trade Agreement
(NAFTA). As a free trade agreement, NAFTA has eliminated all forms of tariff and non-tariff
trade barriers. In addition, the agreement also required the liberalization of government
practices, including the provision of subsidies.
2. Central American Free Trade Agreement (CAFTA-DR)
The benefits of free trade have led to the formation of another trading bloc between the
United States and six other countries. In 2006, the United States along with Costa Rica, El
Salvador, Guatemala, Honduras, Nicaragua, and the Dominican Republic formed the Central
American Free Trade Agreement (CAFTA-DR). Prior to the formation of CAFTA-DR, the
member countries had frequent trade activities. The CAFTA-DR agreement provides several
benefits for the United States. This is because CAFTA-DR aims to reduce tariff and non-
tariff barriers to export goods originating from the United States. In addition, the agreement
also requires countries in the Central America and Dominican Republic to reform their legal
and business environments to encourage investment and competition, protect intellectual
property rights and support transparency of the rule of law.
3. Andean Community (CAN)
Other integration efforts in Latin America continued to develop. In 1961, the Latin
American Free Trade Association (LAFTA) was formed, aiming to create a free trade area by
1971 to 1980. However, due to a debt crisis in South America and objections from member
countries to eliminate protectionist practices, the agreement was dissolved. The dissolution of
LAFTA led to the creation of two regional trading blocs, the Andean Community (CAN) and
the Latin American Integration Association.
The Andean Community (Comunidad Andina de Naciones or CAN) involves four
countries in South America located in the Andes mountain range. The four countries These are
Bolivia, Colombia, Ecuador and Peru. Its main objectives are to reduce tariff levels among member
countries, establish a uniform tariff policy towards non-member countries and harmonize policies in
transportation and some industries. CAN had the goal of achieving a common market by 1995.
However, this goal was hampered by various factors. One of them is the political ideology of member
countries that reject the concept of free trade.
4. Southern Common Market (MERCOSUR)
In 1988 Argentina and Brazil formed the Southern Common Market (El Mercado Comun
del Sur or MERCOSUR) which further included Paraguay and Uruguay in 1991, and
Venezuela in 2006. Some of MERCOSUR's fellow members are Bolivia, Chile, Colombia,
Ecuador and Peru. Mexico, on the other hand, has observer status in the MERCOSUR
community. At its inception, MERCOSUR successfully pushed for trade and investment
liberalization, including becoming the most powerful trading bloc in the entire Latin
American region.
5. Central America and the Caribbean
Countries in the Central American and Caribbean regions formed two integration efforts
known as the Caribbean Community and Common Market (CARICOM) and the Central
American Common Market (CACM). CARICOM was formed in 1973 and consists of 15 full
members, 5 associate members, and 8 observers. Although the Bahamas is one of the member
states of the CARICOM community, it does not belong to the common market. The main
objective of CARICOM is to create a single market free of barriers to the flow of trade in
goods and factors of production, including services, capital, and labor.
On the other hand, the CACM was formed in 1961 with the aim of creating a common
market between Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. However, the
CACM was unable to achieve this goal due to the war between El Savador and Honduras and
various conflicts in other member countries. However, the growing peace between member
countries is starting to create business opportunities that drive economic growth.
6. Free Trade Area of the Americas (FTAA)
The Free Trade Area of the Americas (FTAA) aims to create the most extensive free
trade area, starting from northern Alaska to southern Tierra del Fuego in South America. The
FTAA consists of 34 member countries that create a trading bloc across the region. The
original plan for the agreement was formed at the first meeting in 1994 and was known as the
Summit of the Americas. Then four years later at the Second Summit, the commitment of the
member countries was reinforced. In 2001, another Third Summit was held to address protests
against the FTAA.
Study 10
China - ASEAN Economic Relations after the Establishment of Free Trade Area
The China-Association of Southeast Asian Nations (ASEAN) Free Trade Area (CAFTA) has
been in effect since January 1, 2010. The relaxation of rules related to trade and investment
under CAFTA has strengthened the economic relationship between China and the ten
ASEAN countries. ASEAN now ranks as China's largest source of imports and third largest
export destination, after the US and Hong Kong. Meanwhile, China is ASEAN's largest
import source and export market. The benefits received in bilateral Free Trade Area
relationships often differ based on each country's comparative advantage. The major changes
in bilateral economic relations after the establishment of CAFTA are:
(1) In terms of goods trade relations, China's overall trade balance with ASEAN has changed
from deficit to surplus since 2012. China's growing trade surplus is derived from Vietnam
which is the largest contributing country. Steel and iron are the most important products in
China's trade surplus with ASEAN, reflecting China's excess steel production in recent years.
From a theoretical point of view, it also shows that China's exports of steel products meet
ASEAN countries' demand for construction projects or for their domestic manufacturing
purposes.
(2) Investment relations have also changed with CAFTA. With higher labor rates, ASEAN
countries are shifting in country selection for labor-intensive industries. While ASEAN
investors focus on manufacturing and services in China, Chinese investment in ASEAN has
shifted from energy-related sectors to manufacturing and services over the past decade. This
shift has led to a different situation where ASEAN investment in China has slowed down
while China's investment in ASEAN has experienced noticeable growth.
(3) Bilateral relations in services trade have a lot of potential to be developed although services
trade is currently less significant than trade in goods. Financial services and tourism are two
important sectors that ASEAN can tap from the booming Chinese market, while China has
comparative advantages in construction services, telecommunications, computer and
information services, and other business services.
10.5 Regional Integration in Asia :
Integration efforts outside the Americas and Europe tend to have looser agreements. One
of the most widely recognized economic integrations in Asia is ASEAN, which was formed
in 1967. More on the ASEAN community will be discussed in the next section. In addition to
ASEAN, in 1989, countries in Asia also formed another organization known as the Asia
Pacific Economic Cooperation (APEC). This organization began with a forum opened by 12
countries. Currently, APEC consists of 21 member countries.
The establishment of the APEC organization was not aimed at creating a new trading
bloc other than ASEAN, but rather aimed to strengthen the multilateral trading system and
expand global economic activity. This was done by simplifying trade and investment
procedures among member economies. APEC succeeded in reducing the average tariff rate
from 15% to 7.5%. Various further developments can provide positive benefits to business
activities in member economies.
10.6 Economic Community ASEAN:
In 1967, five countries in Asia agreed to form an economic integration known as the
Association of Southeast Asian Nations (ASEAN). The five countries were Indonesia,
Malaysia, the Philippines, Singapore and Thailand. Brunei decided to join in 1984, followed
by Vietnam in 1995, Laos and Myanmar in 1997, and Cambodia in 1998. The decision to
admit Cambodia, Laos and Myanmar was criticized by the West. However, ASEAN
members felt that adding these three countries would strengthen their coalition against China.
This was because at that time, China had the power resources at lower prices, as well as being
rich in labor and capital goods.
ASEAN was formed in response to threats emanating from the external and internal
environment. This environmental context relates to the Cold War that started from 1947 to
1989 after the end of World War II. At that time, there were only two politically powerful
countries, the United States and the Soviet Union. In addition, the regional level is also filled
with various territorial disputes known as conventional conflict. Some of them are the Sabah
dispute between the Philippines and Malaysia (1962), the Batu Putih Island dispute between
Malaysia and Singapore (1976), border tensions between Malaysia and Thailand and the
Sipadan and Ligitan dispute between Indonesia and Malaysia.
During the 1970s and 1980s, almost all ASEAN member states faced problems of
economic development and political stability. This was addressed by ASEAN through the
declaration of its main objective, which was to develop and harmonize inter-regional
relations based on the principles of mutual respect and peace. The establishment of ASEAN
basically has three main purposes. First, ASEAN was formed with the aim of promoting the
economic, social and cultural development of countries in the Asian region. Second, the
formation of ASEAN also aims to protect political and economic stability. Third, ASEAN
was formed as a forum to resolve various issues fairly and peacefully. Thus, the ASEAN
economic integration is based on It is about political and economic understanding to form
sovereign states. Furthermore, to build economic cooperation, ASEAN came up with three
initiatives that were expected to have a regional impact. The three initiatives are known as the
ASEAN Growth Triangle Project, ASEAN Free Trade Area (AFTA), and the ASEAN
Investment Area Project. The following describes each of the three initiatives.
1. ASEAN Growth Triangle Project (SIJORI: Singapore- Johor-Riau):
The triangle growth of sub-regional economic regions includes geographically
contiguous or border-crossing regions of two, three or four countries that cooperate and
integrate economic activities. These activities are limited to political and economic systems,
but involve the flow of goods, services and labor. The idea underlying the growth triangle is
that the diversification of factors of production between different regions can lead to
increased competitive advantage.
This cooperation involving Singapore, Johor and Riau (SIJORI) was originally proposed
by Goh Chok Tong who was the deputy Prime Minister of Singapore in 1989. This
cooperation provides economic benefits for each country involved which is a major
consideration in forming the ASEAN Growth Triangle. SIJORI is located on a strategic sea
line connecting the South China Sea and the Indian Ocean through the Straits of Malacca.
Johor has vast plantation areas and good infrastructure. On the other hand, Riau Island, which
is part of Indonesia's Riau Province, is an oil and natural gas producer located close to
Singapore, Bintan, Bulan and other borders. In addition, Singapore is located between Riau
and Johor and has progressive economic development.
In March 1996, the Indonesia-Malaysia-Singapore Growth Triangle (IMS-GT) concept
was extended to West Sumatra (Indonesia) and Negeri Sembilan, Malacca and Pahang. At
that time, six working groups were formed and divided into working groups on infrastructure
and services (held by Indonesia), agriculture, natural resources, human resources
development and mobility (held by Malaysia) and tourism and industry (Indonesia).
Furthermore, there are other economic integrations known as the Indo- nesia-Malaysia-
Thailand Growth Area (IMT-GT) which was established in 1991 and the Brunei-Indonesia-
Malaysia-Phillipines (BIMP-EAGA) which was formed in 1993.
2. ASEAN Free Trade Area (AFTA):
Another economic cooperation scheme established by ASEAN is AFTA. During the
ASEAN members meeting in Kuala Lumpur in 1997, the leaders re-established the
commitment to encourage regional cooperation in Southeast Asia in the spirit of justice and
cooperation that contributes to the creation of peace, progress and prosperity of member
countries. One of the tips taken to encourage economic development and cooperation and
integration in the economic field is to establish AFTA. The establishment of AFTA aims to
liberalize trade in services, intensify regional and sub-regional cooperation, and strengthen
the multilateral trading system. The specific implementation of AFTA can be found in the
Hanoi Plan of Action (1998). To support this implementation, ASEAN undertook trade
liberalization to reduce tariff levels, conduct customs harmonization, standards of conformity
and assessment and other activities.
3. ASEAN Investment Area (IAI):
The establishment of the ASEAN Investment Area (IAI) has several objectives. First, the
establishment of the IAI aims to encourage the role of the private sector in cooperation with
the private sector investment. Second, IAI aims to strengthen industrial relations among
ASEAN member states. This is done by providing various incentives to encourage
investment flows. Third, IAI also establishes a coordinated program with the aim of attracting
investment flows, both from member countries and outside ASEAN members. Furthermore,
these investment opportunities are also open to all types of industries, both manufacturing
and non-manufacturing.
In order to achieve the set objectives, ASEAN has also made various efforts through the
ASEAN Plan of Action on Cooperation and Promotion on Foreign Direct Investment and
Intra ASEAN Investment. In addition, there are also other programs known as the Joint
Promotion Program on Publicity, Image Building and Marketing of ASEAN's Investment
Regime, Consultation and Information Exchange and Evaluation unit and ASEAN Investment
analysis.
10.7 Conclusion:
Regional economic integration is an attempt to remove all barriers to the flow of goods,
services, labor and capital. This economic integration has five levels consisting of free trade
area, custom union, common market, economic union, and political union. The closer to
political union, the higher the level of integration. Economic integration has several
advantages, including increasing the amount of international trade and political economy
agreements. On the other hand, the disadvantages of economic integration can include trade
diversion and the threat of loss of national identity. Some of the existing economic
integrations in Europe are the EU and EFTA. Economic integration in Europe also triggered
the formation of economic integration in the Americas, namely NAFTA, CAFTA-DR, CAN,
MERCOSUR, CARICOM, CACM and FTAA. On the other hand Other economic integration
efforts were also established in the Asian region, namely ASEAN and APEC.
10.8 Important Terms
⚫
Regional economic integration
⚫
Trading bloc
⚫
Free trade area
⚫
Custom union
⚫
Common market
⚫
Economic union
⚫
Political union
⚫
European Union
⚫
EFTA
⚫
NAFTA
⚫
CAFTA-DR
⚫
CAN
⚫
MERCOSUR
⚫
CARICOM
⚫
CACM
⚫
FTAA
⚫
ASEAB
⚫
APEC
10.9 Review Concept
1. Explain what is meant by regional econo- mi integration!
2. What are the objectives of establishing regional economic integration? Explain!
3. What is a trading bloc?
4. Explain the difference between a free trade area and a common market!
5. Name and explain the five levels of regional economic integration!
6. Explain the origins of economic integration in the European region!
7. What are the advantages of regional economic integration? Explain!
8. What are the disadvantages of regional economic integration? Explain!
9. What economic integration is there in the Americas?
10. Explain the purpose of establishing the ASEAN community!
10.10 Problem- Problem
1. Look for information on the development of the ASEAN community. How has trade
developed in ASEAN member countries over the last decade? Also, explain the role of
ASEAN for the economic development in Asia!
2. Explain the advantages and benefits of economic integration in the Americas! How has
economic integration helped the US to boost its export activities? Explain!
3. There are five levels of regional economic integration. Describe the characteristics of each
level! What are the differences between each level? Explain!
